Signaling and Contract Choice in After-Sales Service

The extant literature on after-sales service support suggests an implicit consensus around the (Pareto) superiority of performance-based contracts (PBC) over traditional time-and-material contracts. However, when product technology is new, a setting in which the vendor possesses superior information on product reliability, there is compelling evidence to suggest that buyers prefer the traditional contracts. We undertake the first investigation into the role of after-sales contracts as a mechanism for signaling reliability. We find that while both PBC and the traditional contracts allow perfect signaling and coordinate the after-sales supply chain, only PBC allow the vendor to appropriate all rents. When the choice of contract class is endogenous, we show that this observation provides a formal explanation for the buyers’ observed contractual preference. We also analyze the interaction of asymmetric information with moral hazard and find that PBC lead to overinvestment in inventory; we propose a contractual innovation that recovers efficiency.