Should Brands Tighten Certi Cation Standards? Sourcing .
Should Brands Tighten Certification Standards?Sourcing under Supplier-Certifier Collusion RiskLi ChenSamuel Curtis Johnson Graduate School of Management, Cornell University, Ithaca, NY 14853li.chen@cornell.eduShiqing YaoCUHK Business School, The Chinese University of Hong Kong, Shatin, Hong Kongyaoshiqing@gmail.comKaijie ZhuCUHK Business School, The Chinese University of Hong Kong, Shatin, Hong Kongkzhu@baf.msmail.cuhk.edu.hkWhile enjoying low costs in sourcing from emerging economies, global brands also face serious quality risksin the form of supplier noncompliance with basic environmental and labor standards. Such supplier qualityproblems are usually latent at the contracting stage, but could cause the brands significant financial andreputational damages at a later time, creating a classic “lemons problem.” A common approach to mitigatingthis problem is to screen the suppliers via third-party quality certifications. However, in regions with laxlaw enforcement, a substandard supplier may very well bribe the certifier to pass the certification. Given thepossibility of such supplier-certifier collusion, should the buyer tighten or loosen the certification standard?In this paper, we develop an analytical model to answer this intriguing question. Specifically, we assumethe buyer offers the supplier a take-it-or-leave-it contract consisting of a uniform payment and a minimumquality standard. The collusion, modeled as a side contract between a substandard supplier and an unethicalcertifier, takes place after the buyer makes the first move. We show that the equilibrium certification standardcan be either higher or lower than the standard in a collusion-free setting. The result is driven by three keyfactors: the probability of the certifier being ethical/unethical, the certifier’s penalty cost upon the collusionbeing discovered, and the buyer’s externality cost due to the collusion. We also find that, to prevent collusion,punishing the colluding certifier alone may backfire sometime, but holding the buyer accountable for thecollusion scandal is always effective (even though the buyer does not directly involve in the supplier-certifiercollusion). Finally, we extend the model by considering the effects of mandatory standard and price premium.Our analysis suggests that all else being equal, a high mandatory standard or a high price premium mayinduce more collusion in equilibrium.Key words : Sourcing, Supplier Responsibility, Certification, Collusion, Information Asymmetry1.IntroductionGlobal brands have increasingly relied on supply sources in emerging economies over the pastdecades. Sourcing from emerging economies obviously has the low cost advantage. However, inrecent years, there have been heightened concerns about the risks of supplier noncompliance withbasic environmental, labor and safety standards. In 2013, a factory building collapsed outside1
2Dhaka, Bangladesh, killing more than 1,000 garment workers; it was later found that the building“was constructed with substandard materials and in blatant disregard for building codes” (Yadley2013). Close to a dozen western companies including Benetton, Mango, Primark and Walmartsourced from the factories housed in the building, and had to face various financial and reputationaldamages as a result of the incident (https://en.wikipedia.org/wiki/2013 Savar building collapse).This kind of supplier noncompliance problems can be viewed as a quality problem, involvingeither physical (material) quality defects or soft (process) quality defects (Chen and Lee 2016).Such defects are usually latent at the sourcing and contracting stage, but may be discoveredlater by various sources, such as local government inspectors, nongovernmental activists, internalwhistleblowers, or the occurrence of actual accidents. The public revelation of quality problemsmay cause the buyer additional costs in the form of product recalls or brand damages, even thoughthe defects were not known to the buyer beforehand. This is a classic “lemons problem” (Akerlof1970). To mitigate the information asymmetry, a widely-used instrument in practice is supplierquality certification, which has seen a surging popularity in emerging economies in recent years(O’Kelly 2012).A well-designed quality certification program can help companies screen out low quality suppliersin theory, but it also faces many practical challenges. With thousands of small suppliers scatteredin the far-flung corners of the world, it is difficult, if not impossible, for companies to do certification themselves. A common practice is to delegate the certification process to a local third-partycertifier. In regions with lax law enforcement, this could breed corruptions: A substandard supplierseeking a lucrative production contract from a global brand may very well bribe the certifier tofalsify the certification result. According to an investigation report by China Labor Watch (2009,p. 8), “[d]uring the audit process, after auditors have identified serious violations of which thefactory is also aware, some factories will offer bribes in order to pass the audit and some auditorswill accept the bribes.” Indeed, this form of supplier-certifier collusion was one of the main causesfor the building collapse tragedy in Bangladesh. Transparency International Bangladesh (2013, p.23) reported that “[a] factory owner of Dhaka said, ‘30 to 40 thousand taka is needed to get factory certificate and five to 10 thousand for renewal.’ Factory owners think this illegal exchange ofmoney is normal for the quick establishment of factories, avoiding unwanted obstacles and obtainingcertificates easily even without proper documents.” Obviously, this supplier-certifier collusion compromises the integrity of certification results, making it less effective for quality screening purposes.Furthermore, contracting with a falsely certified supplier may also mean additional public-relationtroubles for the buyer when the scandal becomes public.In this paper, we seek to answer three main research questions. First, how should companies setcertification standards under the possible supplier-certifier collusion? Second, what are the driving
3factors for collusion and how do they affect the contracting strategy and collusion prevention inequilibrium? Third, what are the effects of mandatory standard and price premium under collusion?To address these research questions, we consider a buyer sourcing a product from a supplierwhose production quality level is a random draw from a uniform distribution. Because the supplier’squality level is private information, the buyer sets a certification standard for a minimum qualitylevel. If the supplier passes the certification, the buyer awards the supplier a sourcing contractwith a predetermined payment. Since most global brands have predominant negotiation power oversmall suppliers in emerging economies, we model the contracting relationship as a sequential-moveStackelberg game, with the buyer being the leader who offers a take-it-or-leave-it contract to thesupplier. To obtain certification, the supplier needs to be inspected by a third-party certifier. Weassume the certifier can be either ethical or unethical with certain probability. If the certifier isunethical, it would entertain a bribery offer from a substandard supplier. Following the game theoryliterature (e.g., Tirole 1992 and Che 1995), we model the collusion between a substandard supplierand an unethical certifier as a side contract between the two parties after the buyer makes the firstmove. The payment of this side contract (i.e., the bribe) is determined by the certifier’s expectedpenalty cost for committing the fraud. We further assume that the buyer may incur an externalitycost if the certification scandal is discovered by the general public (even through the buyer doesnot involve in the collusion). Therefore, in our model, the collusion outcome is driven by three keyfactors: the probability of the certifier being ethical/unethical, the certifier’s penalty cost upon thefraud being discovered, and the buyer’s externality cost due to the supplier-certifier collusion.We first establish a lemons condition in the absence of quality certification, that is, the buyermay stop sourcing from the supplier and obtain zero profit if the loss associated with the latentsupplier quality problem is above certain threshold. Under the same (lemons) condition, we furthershow that, with the aid of quality certification, the buyer can always obtain positive profit in acollusion-free setting (i.e., when the certifier is perfectly ethical). This is intuitive as collusion-freecertification helps mitigate the inefficiency caused by information asymmetry. However, when thepotential supplier-certifier collusion is factored in, we show that the no-trade outcome reemergesif the colluding certifier’s penalty cost is low and the buyer’s externality cost of collusion is high.Thus, the supplier-certifier collusion introduces additional inefficiency.We then focus on the case in which sourcing from the supplier remains profitable for the buyer.In this case, the buyer needs to set the certification standard to balance the following tradeoff:Setting the standard too high increases the chance of the supplier falling below the standardand thus seeking collusion with the certifier; however, setting it too low may reduce the bribepayment required and thus lower the bar for collusion. We show that the equilibrium certificationstandard can be either higher or lower than the standard in the collusion-free setting. Specifically,
4when the ethical certifier probability is high, the colluding certifier’s penalty cost is low, and/orthe buyer’s externality cost is low, the equilibrium certification standard is set lower than thatin the collusion-free case. On the other hand, when the ethical certifier probability is low, thecolluding certifier’s penalty cost is high, and/or the buyer’s externality cost is high, the equilibriumcertification standard is set strictly greater than that in the collusion-free case. Thus, the buyerneeds to carefully examine its sourcing environment and cost structure to determine the optimalcertification standard.Interestingly, we find that the equilibrium collusion occurrence probability may increase as thecertifier’s penalty cost increases. While increasing the certifier’s penalty cost can deter collusionbetween the supplier and the certifier, it can also induce the buyer to lower the certification standardin equilibrium. The latter effect may reduce the actual penalty levied on the colluding certifier,leading to an increase in the equilibrium collusion probability. Moreover, we find that the collusionprobability is strictly decreasing in the buyer’s externality cost of the supplier-certifier collusion.This is because increasing the externality cost enables the buyer to internalize the cost of collusionand thus aligns its incentive with collusion prevention.We further extend our model to incorporate two additional features. First, industry regulationsmay impose a mandatory quality standard (e.g., Besanko et al. 1987; Ronnen 1991). We incorporatethis mandatory standard feature into our model and investigate its impact on the equilibriumoutcome. We find that imposing a high mandatory standard may increase collusion probability insome cases. Thus, to prevent collusion, one needs to carefully examine the industry cost structureto determine the most appropriate mandatory standard. Second, consumers are often willing topay a premium for products with high certification standard (Nielsen 2014). We incorporate thisprice premium feature into our model and investigate its impact on the equilibrium outcome. Wefind that price premium for high standard does not help reduce the collusion probability in mostcases. What the price premium does is essentially subsidize the externality cost for the buyer whena false certification of the premium standard is discovered. Thus, it actually provides an additionalincentive for the buyer to turn a blind eye on the supplier-certifier collusion.In summary, the contribution of our paper is three-fold. First, we introduce collusion as themain cause for certification inaccuracy, whereas in the existing literature certification inaccuracy istypically modeled as a simple probability parameter (see Hwang et al. 2006; Chen and Lee 2016).Second, to our knowledge, our paper is the first to rigorously model and investigate the impact ofsupplier-certifier collusion on the buyer’s sourcing contract strategy. The economic tradeoffs facedby the colluding parties greatly enrich our discussion of the problem. Third, our analysis revealsnew insights into the contracting problem under supplier-certifier collusion. Specifically, we showthat the presence of supplier-certifier collusion can induce the buyer to either tighten or loosen the
5certification standard in equilibrium. The result is driven by three key factors: the probability ofthe certifier being ethical/unethical, the certifier’s penalty cost upon the collusion being discovered,and the buyer’s externality cost due to the collusion. We also find that, to prevent collusion,punishing the colluding certifier alone may backfire sometime, but holding the buyer accountablefor the collusion scandal is always effective (even though the buyer does not directly involve inthe supplier-certifier collusion). In addition, our research suggests that, all else being equal, a highmandatory standard or a high price premium may induce more collusion in equilibrium.The remaining paper is organized as follows. We review the related literature in §?, and presentour model and formulate the contracting problem in §?. Detailed equilibrium analyses and resultsfor the problem are provided in §?. We further provide two model extensions involving mandatorystandard and price premium in §?. Finally, §? contains our concluding remarks. All proofs canbe found in the Appendix.2.Literature ReviewOur paper is closely related to three streams of literature. The first stream is the emerging studies ofsustainable and socially responsible sourcing. Chen et al. (2013) examine the procurement problemfaced by ITC and illustrate the impact of supplier training on product delivery. Kraft and Raz(2013) study how the competition in the market influences manufacturers’ decision on eliminatingproduct toxicity. Guo et al. (2015) demonstrate the impact of socially responsible consumers ona buyer’s selection between responsible suppliers and risky suppliers. Huang et al. (2015) analyzehow a buyer can improve the social responsibility of a tier 2 supplier. Plambeck and Taylor (2015)consider a supplier’s deceptive effort to pass its buyer’s quality audit and show how such effortmay influence the effectiveness of the audit. Xu et al. (2015) study how a buyer’s contract designand internal inspections can deter child labor use. Chen and Lee (2016) investigate the role ofsupplier certification in helping a buyer choose its supplier under the ethical risk. Chen et al. (2016)examines how the supply chain transparency and non-governmental organization scrutiny affectsupply chain sustainability.We contribute to the stream of the literature by explicitly modeling risk of the supplier-certifiercollusion and analyzing its influence on a buyer’s sourcing contract strategy. It is worthwhilementioning while Chen and Lee (2016) also take into account supplier certification, they treatcertification noise as an exogenous probability parameter. On the contrary, we endogenize theprocess of the supplier-certifier collusion and then study the buyer’s equilibrium strategy in thepresence of such risk. As a result, the results and insights generated from our study are new andunique.The second related stream is the certification literature. Following the seminal work by Akerlof(1970), several studies address the asymmetric information problem related to product quality.
6Viscusi (1978) illustrates that in the presence of certification, the market incurs an unravelingprocess. Lizzeri (1999) examines the strategy of certification intermediaries on the provision ofquality information. Harbaugh et al. (2011) investigate the labeling problem when the customersare ill-informed. Strausz (2005) shows that, in order to prevent fraudulent behavior in certification,the certification fee charged by a certifier may even be higher than the static monopoly price. Stahland Strausz (2010) provide theoretical reasons for the advantage of seller-induced certification.Our paper differs from these certification papers in two aspects. First, in our model the certification standard is determined by a buyer, whereas most papers in the literature assume thatthe certifier is a monopolist and has the ability to manipulate certification standards (e.g., Lizzeri1999, Strausz 2005 and Stahl and Strausz 2010). Second, we consider a model with the certifier canbe either ethical or unethical. In the certification literature, the certifier is usually assumed to beintrinsically unethical and it is the certifier’s reputational concern that prevents it from colluding(e.g., Strausz 2005).Our study is also closely related to the monitoring literature under the risk of collusion. Tirole(1992) analyzes the impact of collusion in a principal-agent-supervisor setting and proposes thecollusion-proof principle. Laffont and Martimort (2000) extend the analysis to the asymmetricinformation case. Kofman and Lawarrée (1993) study the difference between the internal andexternal auditors, where the external auditor is more expensive but is immune to collusion. Strausz(1997) shows that preventing collusion is cost-free in the presence of supervisor-agent collusion.Following the work by Strausz (1997), Vafaı̈ (2005) demonstrates that preventing collusion becomescostly when the outcome of an agent’s action is uncertain. In addition, many papers demonstratecollusion can be an equilibrium outcome in various models (e.g., Kofman and Lawarrée 1996, Che1995, Quesada 2004, Khalil and Lawarrée 2006, and Khalil et al. 2010).Three modeling features of our paper are different from this stream of literature. First, in orderto focus on the supplier-certifier collusion issue, we do not consider the possible contracting relationship between the buyer and the certifier in our model, whereas in the principal-agent-supervisormodel framework, the principal (the buyer in our model) is able to incentivize the supervisor (thecertifier in our model) via contract design. Second, we model supplier quality as a continuousvariable, so that we can study how the buyer can set the quality standard over a continuum in asourcing contract. In contrast, most papers in this research stream assume the supplier quality isbinary. Under a binary quality level, setting the quality standard becomes a trivial problem. Third,we consider the buyer’s externality cost of the supplier-certifier collusion in our model, which webelieve reflects the industry reality given the recent heightened concerns in supplier responsibilityproblems. Such externality cost is usually ignored in this stream of literature.
73.Model SetupConsider a supply chain in which a buyer sources one unit of a product from a supplier. Thesupplier has private information about its production quality level x, which is uniformly distributedover [0, 1]. The production quality can affect either the product’s physical quality or soft quality(e.g., whether the production process is in compliance with certain labor and safety regulations;see Chen and Lee 2016 for a detailed discussion). We assume that the production cost is cx forquality level x, with c 0. The supplier has zero reservation profit.The buyer sells the product to consumers at a price v. However, a product with inferior qualitymay result in a loss for the buyer in product recalls and/or brand damages. We model the expectedloss from a product with inferio
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