Managing Quality Uncertainty Through Contingency Pricing

We analyze quality-contingent prices as a mechanism for mitigating the effects of quality uncertainty in e-commerce and IT goods services. A contingency pricing contract specifies a sequence of possible quality levels and corresponding prices. When the public performance probabilities differ from the firm’s private (and true) probabilities, contingency pricing can expand market size and the likelihood of market existence. When the market underestimates the firm’s ability to deliver quality, contingent price contracts are strictly optimal and increase the fraction of buyers. The optimal pricing scheme has a full-price rebate for mis-performance. These results have actionable value in IT-intensive contexts such as electronic retailing, application service providers, telecommunications services, business exchanges, and online financial trading services where the information infrastructure allows easy capture, quantification, verifiability and dissemination of quality and performance information.