Pricing and Quality Provision in a Supply Relationship : A Model of Efficient Relational Contracts

We model how quality concerns affect the relationship between a firm and its supplier. A firm concerned about uncontractible quality for a customizable good has to pay higher prices to sustain a relationship with the supplier. If the customizable good has sufficiently volatile demand, then a contract that includes a constant unit price premium only for this good cannot be sustained. Instead, the downstream firm pays a premium both for the customizable good and also for a good with more stable demand that is correlated with demand for the customizable good. Our results imply that a supplier of customized goods should also supply other products, which can include goods that do not require customization, and both the supplier and buyer benefit from the greater pricing flexibility they achieve by trading multiple goods