Theory and Methodology A lemons market? An incentive scheme to induce truth-telling in third party logistics providers Wei Shi Lim * Faculty of Business Administration, National University of Singapore, 10 Kent Ridge Crescent, Singapore 119260, Singapore Received 8 September 1998; accepted 27 April 1999 Abstract In this paper, we develop a game-theoretic model that studies the contract design problem of a third party logistics buyer when he is faced with a third party logistics provider and the quality of service and the cost of providing the service are private information to the latter. We apply the Revelation Principle to our analysis and characterise the optimal contract. We show that the contract oered to the service provider with low capability does not include any penalty for failure to comply to preset standards; neither does it include a gain-sharing scheme – the remuneration consists of an initial fixed payment which is independent of the level of performance. However, the contract oered to the service provider with high capability includes either a penalty scheme or a gain-sharing scheme. Furthermore, the more attractive the gain-sharing scheme (or alternatively, the more severe the penalty), the less the initial remuneration and vice versa. Finally, we prove that the proposed optimal contract is independent of the ex-ante beliefs which the service buyer has on the capability and the cost of the service provider. Ó 2000 Elsevier Science B.V. All rights reserved. Keywords: Game theory; Logistics; Revelation principle; Contract design; Quality; Cost 1. Introduction Third party logistics, contract logistics, inte- grated logistics, outsourced logistics – by any other name, third party logistics will continue to sweep through businesses, as it has done in recent years as the last competitive bastion of the 1990s. In essence, third party logistics refers to multiple lo- gistics services provided by a single vendor on a contractual basis (Bradley, 1994). It incorporates services such as inventory management, ware- housing, procurement, transportation, systems administration, information systems, materials sub-assembly, contract manufacturing, kitting and import and export assistance. With reference to the military origin of the term ‘‘logistics’’, third party logistics is all about getting the right prod- ucts to the right place at the right time, and at the right cost, all with the help of an outsider. The important role of logistics in modern business is well known. The irony is: Why would European Journal of Operational Research 125 (2000) 519–525 www.elsevier.com/locate/dsw * Tel.: +65-874-6263; fax: +65-779-2621. 0377-2217/00/$ - see front matter Ó 2000 Elsevier Science B.V. All rights reserved. PII: S 0 3 7 7 - 2 2 1 7 ( 9 9 ) 0 0 2 1 0 - 6