Product Quality Selection: Contractual Agreements and Supplier Competition in an Assemble-to-Order Environment

We consider a multi-supplier, single-manufacturer supply chain where each supplier sells a different component at varying quality levels. The manufacturer has to decide on which quality level to choose for each component, trading-off the total cost and total quality. Each supplier decides on a price per unit quality level for its component. We characterize the strategic interaction among the suppliers and analyze the inefficiencies. We find that the inefficiencies due to such quality competition can be quite significant. We then propose and analyze several mechanisms, such as quality-price schedules and revenue sharing, that restore efficiency.