Sourcing with Deferred Payment and Inspection under Supplier Product Adulteration Risk

Abstract

We study the deferred payment and inspection mechanisms for mitigating supplier product adulteration, with endogenous procurement decision and general defect discovery process. We first derive the optimal deferred payment contract, which reveals that either entire or partial deferral can arise, depending on the moral hazard severity and the information accumulation rate. Because of the supplier's incentive to adulterate, the optimal procurement quantity under deferred payment generally is smaller than the first‐best quantity. We then investigate the inspection mechanism and characterize the equilibrium. We find that under the inspection mechanism, the optimal procurement quantity is no less than the first best. A comparison between these two mechanisms shows that the deferred payment mechanism generally can outperform the inspection mechanism when either the market size is small or the profit margin is low. However, we find that these two mechanisms can also be complementary, for which we characterize a necessary condition.

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