Quality investment, inspection policy, and pricing decisions in a decentralized supply chain

Abstract This paper studies the interaction between two key quality management decisions—input conformance quality and inspection policy—and related wholesale and retail prices in a two echelon supply chain. Market demand depends on the retail price as well as the end‐product conformance quality, which itself depends on the input quality and the inspection scheme. Consistent with previous empirical findings in the literature, we show that an increase in quality does not always result in higher prices for consumers due to the cost‐lowering effect of better quality. We also show that a lower input quality may still result in higher end‐product quality because of how it might incentivize more and/or better inspection. Any interaction between input quality and inspection policy becomes more pronounced in the decentralized system due to incentive asymmetry between the channel partners. This makes the adoption of a full‐inspection policy more likely there compared to an integrated system. Indeed, while vertical competition due to decentralization results in higher prices for customers, it can also result in better quality of end products. Another interesting finding in the decentralized setting is that, somewhat counterintuitively, a player may indeed opt to bear a higher share of the penalty for defective products sold to consumers resulting in higher profits for the player.