Incentive Contracts and Price Differential Acceptance Tests

Abstract

It may be economically advantageous to both consumer and producer to enter into an incentive type contract in which the price paid for a product depends upon the outcome of an acceptance test. If no test is performed, a product of some minimum quality is produced and the consumer suffers a considerable penalty. The outcome of the test will reflect, to some degree, the quality of the product. If the consumer agrees to pay a premium dependent upon the outcome, the producer will be motivated to invest money in improving his product and both parties may expect to profit from the arrangement. This paper constitutes an unconventional approach to acceptance testing, in which the test is viewed not as a procedure to obtain information but rather as motivation toward product improvement. Admissible strategies are defined and their properties are studied. An application to repairable systems is considered in detail. © Taylor & Francis Group, LLC.