Pricing Policies Contingent on Observed Product Quality

Eugene P. Durbin
1966 Technometrics  
Expanded use of incentive contracts has created interest in procurement arrangements in which unit purchase price varies as a function of observed product quality. Under the assumption that at a knovn cost, a producer can control the true quality of his output, a production and procurement situation is described in which a riskaverse producer and consumer both attempt to maximize expected profit --the consumer by selecting a pricing strategy and sample size, and the producer by then selecting
more » ... e product quality. Let product quality be denoted by p. The consumer will desire the selected product quality to be some p . If at a fixed sample size, n, a price schedule exists which is acceptable to the riskaverse producer and also maximizes producer expected profit at p , this price schedule is a "motivating" price schedule. For fixed (n,p), a motivating price schedule must be the solution to a specified linear programming problem. It will be a piecewise constant function of the observed quality and need have no more than six distinct price levels. A method of deriving continuous, piecewise-linear price schedules is briefly described, and extensions of the basic approach are noted.
doi:10.1080/00401706.1966.10490329 fatcat:uji6tgqezvbn3o6gpa5m5asteq