Quality implications of warranties in a supply chain

We examine a supply chain in which the final product consists of components made by a buyer and a supplier. In the single moral-hazard case, the buyer's quality is observable, whereas in the double moral-hazard case, the buyer's quality is not observable. The supplier's quality is not observable in both the single and double moral-hazard cases. In each case, we examine a warranty/penalty contract between the buyer and the supplier based on information from incoming inspection and external failures. When the warranty contract is based on information from external failures in the single moral-hazard case, the first-best quality is achieved, whereas in the double moral-hazard case, the first-best quality is achieved if the supplier is not held responsible for the buyer's defects. When the warranty contract is based on information from incoming inspection, the first-best is achieved in both the single and double moral-hazard cases, even when the incoming inspection does not identify all of the supplier's defectives. An analysis of whether the penalty on the supplier in each case meets a fairness criterion – that is, the penalty does not exceed the manufacturer's external failure cost – indicates that the fairness criterion is met by the warranty contract based on information from incoming inspection when the first-best incoming inspection is sufficiently high. However, if the first-best incoming inspection is low and the precision of pinpointing the supplier's responsibility for external failure is sufficiently high, the warranty contract based on external failures could satisfy the fairness criterion.