Incentive Contracting Based Upon Consumer Indifference

In contract purchasing, price is often negotiated, given a reliability specification. Prior to procurement a sample is taken to determine if the product meets the reliability specification. This paper considers an alternative approach in which the contract price reflects actual field performance for an item subject to two types of failures. A consumer indifference curve that specifies the predicted break-even point between price and reliability is used to establish the initial purchase price. The actual purchase price is determined by estimating the break-even point based upon a sample of failures. Both the vendor and consumer agree upon the statistical methods for revising the price at purchase time. In this manner, more reliable products yield higher prices than less reliable products, thus resulting in a quantifiable incentive contract.