Contracting for Product Support Under Information Asymmetry

Performance-based contracts (PBC) have become ubiquitous in industries ranging from aerospace and defense to computer support services. Despite advantages of paying for performance under PBC that have been highlighted in many previous studies, the more traditional Transaction-based Contracts (TBC) that tie supplier payments to each repair incident are still widely adopted. To explain this phenomenon, we build a stylized adverse selection model to explore the hidden superiorities of TBC in screening products with different failure rates only known by the customer. The uninformed supplier has to design proper mechanisms so as to overcome disadvantages in the information structure while maximizing pro ts. We show that, when repair capacity is veri able, which is increasingly enabled by modern IT technologies in practice, TBC can achieve separation of product failure rates without losing effciency in setting repair capacity, whereas distinguishing failure rates under PBC requires interactions of pricing and capacity decision, resulting in overinvestment in repair capacity. In such a case the customer may prefer TBC (PBC) if she has a lower (higher) outside option, and the supplier may have an opposite preference. Moreover, given intermediate values of the outside options, TBC can be both preferred by the supplier and the customer. Only when repair capacity is unobservable PBC becomes better at screening than TBC. Our paper brings to light a heretofore unknown advantage of TBC and it demonstrates when these contracts are likely to be observed in the third-party MRO market despite seeming superiority of PBC which has been widely cited