A Principal-Agent Model for Product Specification and Production

This paper develops and analyzes a principal-agent model for product specification and production motivated by “core buying” decisions at Ford Motor Company. This model focuses on two important elements of the “core” buyer’s responsibility: (1) assessing the supplier’s capability and (2) allocating some or all of a fixed level of some buyer-internal resource to help the supplier. Under the contracting scheme we model, the buyer (a principal whom we call “she”) delegates the majority of product-specification and production activity to the supplier (an agent whom we call “he”), but retains the flexibility to commit a given, observable amount of an internally-available resource (e.g., engineering hours) to help the supplier. The supplier, in turn, allocates his resource (e.g., engineering hours) to produce the finished product. As in the motivating scenario, both the supplier’s resource allocation and capability are assumed to be hidden from the buyer. Hence, the principal’s problem is to determine a menu of (resource-commitment, transfer-price) contracts to minimize her total expected cost. Drawing on known results from information economics, we identify two cost structures “substitutes” and “complements” and provide the corresponding optimal “screening” contract. Our contribution is, first, to formulate the product-specification and production problem as a principal-agent model; second, and more important, to illustrate the strategic value of a buyer’s level of involvement in the supplier’s production process in reducing agency losses. In other words our analysis provides one answer to the question: “Why would/should a buyer provide physical, financial, or intellectual resources to help a supplier?” The answer: Because the offer of such help during the contracting process can provide otherwise hidden information about supplier capability. We then describe two applications of the model one in inventory management and one in pharmaceutical drug discovery to illustrate its applicability and versatility. Finally, we use insights from the model to suggest hypotheses for empirical study. June 2001; April 2002 The authors have benefited from discussions with Erica Plambeck, Charlie Fine, and Steve Eppinger. Iyer and Schwarz acknowledge the financial support of the Ford Foundation. Zenios’ research was supported by the National Science Foundation grant SBER-9982446. An earlier version of this paper was titled “Screening Contracts for Product and Process Development: A Principal-Agent Model.”