Can a Supplier’s Yield Risk Be Truthfully Communicated via Cheap Talk?

Abstract

Problem definition: When a firm (buyer) outsources the production of a new product/component to a supplier subject to random yield, a major challenge is that the supplier’s yield is usually private information. In practice, yield information is often shared via nonbinding communication—for example, a supplier self-assessment report. We examine whether such communication can be truthful and credible. Methodology/results: We analyze a cheap-talk game in which, given a simple contract that specifies the prices for each unit ordered and for each effective unit delivered, the supplier first communicates its yield level, and then the buyer determines an order quantity. We prove that truthful communication can emerge in equilibrium. To do so, we first show that if knowing the supplier’s type, the buyer will either inflate or reduce the order quantity to cope with a lower yield, depending on the product’s market potential. Under asymmetric information, the supplier will truthfully communicate its type if (i) the buyer with a high market potential intends to inflate the order quantity for a lower yield, but the buyer with a low market potential prefers to do the reverse; and (ii) the supplier is uncertain about the product’s market potential, which is the buyer’s private information, and anticipates that a hard-to-make product is more likely to have a higher market potential. Managerial implications: Truthful cheap-talk communication can emerge in equilibrium when the product’s market size and yield are negatively correlated. Truthful communication always benefits the buyer and consumers and may benefit the supplier if the product has sufficient market potential and the supplier’s production cost is not too high. Moreover, the buyer can be better off paying more for the input quantity (although part of the output is defective) or paying a higher wholesale rate if the adjustment in payment terms enhances communication credibility.Supplemental Material: The online appendix is available at https://doi.org/10.1287/msom.2023.0089 .