We propose the use of quality contingent prices, where a firm announces quality-price pairs for various levels of quality instead of a single price, as a mechanism for mitigating quality uncertainty. Contingency pricing is especially applicable to IT-intensive commerce where quality uncertainty is prevalent. The modern IT infrastructure allows easy capture, verification, and dissemination of performance and quality data essential for the implementation of contingency pricing framework. Under very broad conditions, we show that when the market underestimates firm performance, it is optimal to design a full-rebate contingent contract. The optimal quality threshold is set at the quality level that maximizes the gap between market and actual performance probabilities, and the optimal market size is independent of the quality threshold. When contingency pricing is optimal, it is sufficient to consider two-part contingent contracts: two-part contract performs as well as any multipart contract. Use of contingent prices include IT-intensive settings such as ASP service levels, Internet connectivity, and transaction execution in financial services.
Bhargava, Hemant and Sandaresan, Shankar, "Optimal Design of Contingency Pricing in IT-Intensive Commerce" (2002). ICIS 2002 Proceedings. 29.