SUBCONTRACTING, RENEGOTIATION OF CONTRACT AND QUALITY PROVISION

In a principal-agent framework under moral hazard, when the monopolist can pass on the liability of any defect of the product to the subcontractors, and cannot credibly commit to a high level of investment, he actually chooses a low investment level and supplies a low quality product if the product replacement cost is below a critical level. However, under contract renegotiation, when the monopolist is taking the entire risk of replacing the defective product, he will profitably choose high investment level and serves high quality product. But the results show that the monopolist will choose to renegotiate the contract only for limited values of product replacement cost, even if renegotiation is socially optimal.