Subcontracting and Economic - Indian Institute of Public Administration

Subcontracting And Economic Reforms In India With Special Reference To Agro-based Industries In India
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A Theoretical Model of
Subcontracting for High Quality
The following is a model applicable to a new processed
food introduced under monopoly. Although some modifications
are needed to fit it in the monopolistic competition
models, which may be prevalent for some food
products, the essence of the story does not change.
Chatterjee and Raychaudhuri (2000) originally proposed
this type of a model.
The Model
In this model we try to find whether it is possible for the
parent monopoly large firm to maintain the quality level
of the final product in the industry with subcontracting.
We assume that a monopolist is bringing a new product
into the market and that the product is a non-durable
processed food commodity. The production process is
subdivided into two stages. Subcontracting small firms
undertake the first stage of the production process. In
the second stage, the monopolist finishes the product
and supplies it to the market.
It is assumed that quality level of the final product is
determined by the quality of the unfinished product
supplied by the subcontractors to the monopolist. The
monopolist only finishes the product and supplies it to
the market. The contractor can supply a high or low
quality product.
In this paper, we assume that the monopolist has no
information about the product quality served by the sub-
contractors, thus the quality level of the final product is
also unknown to him. In this case we consider that there
are two periods. The consumers can infer about the quality
of the product at the end of the first period. In the
second period, the product quality is common knowledge.
The product becomes obsolete at the end of the
second period. We assume that in the first period, consumers
form an expectation about the quality of the product
supplied by the monopolist and this expectation is
formed exogenously (Metrick and Zeckhauser, 1996).
Given these assumptions, we try to find the incentives
scheme, which will induce the agent firms to produce a
high quality product, whereby the monopolist can continue
to exist in the market in the second period.
We assume that a monopolist is facing a continuum of
consumers with the index of willingness to pay defined
by the variable θ, where θ is distributed uniformly over
the range [ θ, θ]
with unit density. We define ‘q’ as the quality
level of the final product, where ‘q’ can assume two different
values q h
and q l
where q h
> q l
. It is assumed that a
representative consumer considers that the quality of the
product is high with probability µ. This probability is independent
of firm’s pricing decision that is, µ is exogenously
given. In the first period the consumer expects that a firm
will supply quality level ‘ ’ where
q = µq h
+(1-µ) q l
q h
>q l
-------------------------- 1
It is assumed that consumers will infer about the quality
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