Contracting for Product Support Under Information Asymmetry

In after-sales product support, both literature and practice have highlighted the advantages of paying for performance under performance-based contracts (PBC) over the more traditional transaction-based contracts (TBC) that tie supplier payments to each repair incident. Although PBC is believed to better align incentives in the supply chain when the supplier’s private effort is difficult to verify, emerging technologies can make the repair process more transparent, which can eliminate the supplier’s moral hazard problem. Meanwhile, fast growth of service outsourcing for established products makes information asymmetry with regards to product failure rates a new challenge for maintenance, repair, and overhaul (MRO) operations. To analyze this changing environment, we build a stylized adverse selection model and explore which contract is more efficient in dealing with information asymmetry. We assume that equipment failure rates are only known by the customer, whose outside options are type dependent. The uninformed supplier has to design appropriate mechanisms to overcome the disadvantages of this information structure while maximizing profits. We show that the two contracts demonstrate different screening ability, and TBC may be preferred over PBC. Type-dependent outside options can lead to countervailing incentives, making PBC immune to information asymmetry and enabling it to achieve the first-best outcome. When the differential of outside options has a relatively stronger effect compared with the differential of failure rates, TBC can bring the supplier a higher ex ante payoff than PBC. Our paper brings to light a heretofore unknown advantage of TBC, and we demonstrate when these contracts are likely to be observed in the third-party MRO market.