Economics of Supply Chain Contracting for Quality

This paper models and solves contracting schemes for both when quality is perfectly observable and when quality is not perfectly observable in supply chain. When quality is perfectly observable, the first-best optimal solution which is that the marginal utility of procurer obtained from the quantity and quality supplied by suppliers (the price) is equal to the marginal cost to produce the quantity and quality is obtained. However, when quality is not perfectly observable to procurers the optimal solution cannot be the first-best but the second-best where the price is greater than the marginal cost to produce the quantity and quality and social welfare is less than that of the first-best solution.