A lemons market? An incentive scheme to induce truth-telling in third party logistics providers

In this paper, we develop a game-theoretic model that studies the contract design problem of a third party logistics buyer when he is faced with a third party logistics provider and the quality of service and the cost of providing the service are private information to the latter. We apply the Revelation Principle to our analysis and characterise the optimal contract. We show that the contract offered to the service provider with low capability does not include any penalty for failure to comply to preset standards; neither does it include a gain-sharing scheme - the remuneration consists of an initial fixed payment which is independent of the level of performance. However, the contract offered to the service provider with high capability includes either a penalty scheme or a gain-sharing scheme. Furthermore, the more attractive the gain-sharing scheme (or alternatively, the more severe the penalty), the less the initial remuneration and vice verse. Finally, we prove that the proposed optimal contract is independent of the ex-ante beliefs which the service buyer has on the capability and the cost of the service provider. (C) 2000 Elsevier Science B.V. All rights reserved.