Managing Opportunistic Supplier Product Adulteration: Deferred Payments, Inspection, and Combined Mechanisms. Extended Technical Report

Recent cases of product adulteration by foreign suppliers have compelled many manufacturers to rethink approaches to deterring suppliers from cutting corners, especially when manufacturers cannot fully monitor and control the suppliers' actions. In this paper, we study three mechanisms for dealing with product adulteration problems: (a) the deferred payment mechanism---the buyer pays the supplier after the deferred payment period only if no adulteration has been discovered by the customers; (b) the inspection mechanism---the buyer pays the supplier immediately, contingent on product passing the inspection; and (c) the combined mechanism---a combination of the deferred payment and inspection mechanisms. We show that the inspection mechanism cannot completely deter the suppliers from product adulteration, whereas the deferred payment mechanism can. Surprisingly, the combined mechanism is redundant: either the inspection or the deferred payment mechanisms perform just as well. Finally, we identify four factors that determine the dominance of deferred payment mechanism over the inspection mechanism: (a) the inspection cost relative to inspection accuracy, (b) the buyer's liability for adulterated products, (c) the difference in financing rates for the buyer and the supplier relative to the defects discovery rate by customers, and (d) the difference in production costs for adulterated and unadulterated product. We find that the deferred payment mechanism is preferable to inspection if the threats of adulteration (either incentive to adulterate or the consequences) are low.