False quality claims: Prevention and supply chain implications

Abstract False quality claims have recently rocked the automobile industry. To promote customer demand while seemingly complying with regulations, manufacturers may cheat even at the risk of incurring severe penalties. As a result, the production horizon becomes uncertain. Assuming it is socially critical to enforce quality standards (e.g., specific emission levels or safety levels for food, drugs, or transportation), we study dynamic production policies under the threat of penalties and assess when a false quality claim can be optimal for the firm. We find that regardless of the specific form of a convex penalty function, the production rate will gradually decrease to slow down the increase in the probability of getting caught. We show that the government or regulatory department can determine a minimal finite penalty to prevent the manufacturer from cheating. In the context of an underlying supply chain, we show that vertical competition between the manufacturer and its suppliers can play a socially positive role by reducing the batch produced under a false quality claim.