Signaling Product Quality with After-Sales Service Contracts

Due to its complex nature, after-sales service support for systems such as aircraft engines is commonly outsourced to the vendor. A key input to contracting for such support is system reliability. When producttechnology is new, the vendor often knows more about reliability than the buyer, potentially leading to contractual inefficiencies. This paper examines the role of after-sales contracts as a mechanism for signaling reliability. We focus on two commonly encountered categories of contracts, the (generalized) Time and Material contract and the performance-based contract (PBC). We find that they differ substantially in their ability to signal reliability, achieve system efficiency, and allocate rents in the supply chain. While the vendor of a reliable product is always better-off with PBC, the same is not true for the buyer or the vendor of an unreliable product. This sheds new light on the on-going debate regarding the relative merits of the two contracting strategies.