Quality and Double Sided Moral Hazard in Share Contracts

AbstractThe objective of this paper is to analyze the effect of linear sharing contracts when downstream retail prices are used for compensation in a context of imperfect information about food quality. Such outcome-sharing through retail price contracts can be explained directly by agency theory. While the case of both parties being subject to moral hazard due to supplying unobservable efforts has been considered in the literature, we believe our specification is new and more realistic, as we consider the quantity-quality trade-off for the grower, ignored in previous double moral hazard models. With the help of a simulation exercise, we prove that an outcome-conditioned share reduces an agent's incentive to make an effort in quality input.Key words: share-contract, double moral-hazard, quality, agency theory, simulation, incentive(ProQuest: . denotes formulae omitted.)IntroductionIn the last ten years, the competitiveness of food companies in national and international markets has depended on their ability to adopt production processes which meet food safety and quality requirements. In order to build and maintain consumer trust in food quality and safety, quality assurance is of major importance in the food sector (Van der Spiegel et al 2003). The best way for a processor to prevent food quality failures is to make sure that he acquires high-quality inputs (Starbird 2005). But the effort a grower makes to produce a high quality input is usually only known to the grower himself and not observable for the processor. Indeed, the grower may have no incentive to share this information with the processor. As quality measurement is subject to significant diagnostic and sampling error, a processor cannot be sure that a grower has fulfilled a promise to deliver high quality inputs. This creates what is known in general economic literature as a moral hazard problem (Holmstrom 1979; Stiglitz 1989). Consumers want, and are willing to pay for, food quality. However, before they buy a product, they do not often know whether its quality is good or poor. Most food quality properties can be classified as credence characteristics, as they cannot be inferred before, and sometimes even after, the purchase (Darby and Kami 1973; Caswell and Mojduzska 1996). Consequently, food market operations often suffer from imperfect and asymmetric information. In order to mitigate uncertainty about food quality, a strategy adopted by processors is in some way to signal a product's quality level (Akerlof 1970). However, the marketing effort made by processors to reveal private information about quality cannot be equalled by growers as, for example, they may be unable to inspect how salespeople work. Even when it is possible, the costs are prohibitive.Growers and processors, then, can contribute to final product quality in terms of proauction and marketing effort, respectively. Since such effort is mutually imperfectly observed, and its impact on final product quality can only be imperfectly measured, there is room for opportunism on both sides. Food quality may therefore present a double moral hazard problem.This paper makes a direct contribution to the literature on food quality problems within the economics of information field. According to Weiss (1995), a key paradigm for the analysis of incentives and rewards in the presence of asymmetries associated with food quality attributes is principal-agent theory. Rooted in the economics of food quality, Elbasha and Riggs (2003) used a double moral hazard model to show that when preventive measures are not observable, the food safety effort of both producers and consumers will be suboptimal. Subsequently, Balachandran and Rakhakrishnan (2005) examined a supply chain in which the final product consisted of components made by a buyer and a supplier. Examining a warranty/penalty contract between the buyer and the supplier, in a double moral-hazard model, they concluded that the first-best quality is achieved if the supplier is not held responsible for the buyer's defects. …