Contracts and Capacity Investment in Supply Chains

Abstract

Suppliers are often reluctant to invest in capacity if they believe that they will be unable to recover their investment costs in subsequent transactions with buyers. In theory, a number of different contracts can solve this issue and induce first-best investment levels by the supplier. In this study, we investigate the performance of these contracts in a two-tier supply chain. We develop an experimental design where retailers and suppliers bargain over contract terms-and have the ability to make multiple back-and-forth offers-while also providing feedback on the offers they receive. One key result from our study is that an option contract and a service-level agreement are best at increasing first-best investment levels and overall supply chain profits. However, these same contracts also generate the largest inequity in expected profits between the two parties. We find that both of these results are driven by the bargaining tendencies of retailers and suppliers, which we refer to as "superficial fairness." In particular, retailers and suppliers place more emphasis on negotiating the wholesale price, while partially overlooking any secondary parameter, such that final wholesale prices end up roughly halfway between the retailer's selling price and the supplier's production cost. We show that this bargaining behavior contributes to higher investment levels observed in the option contract and service-level agreement, along with the inequitable payoffs.

A Survey of the Hold‐up Problem in the Experimental Economics Literature

“…Under this design, it is easier to distinguish the motives and behaviors of the two parties. A number of experiments with such unilateral investment stage still adopt bargaining mechanisms, which assign symmetric bargaining power to both parties, for example, the one‐shot Nash demand game (Ellingsen and Johannesson, 2004a) and the multi‐round alternating offer game (Sonnemans et al ., 2001; Oosterbeek et al ., 2003; Sloof et al ., 2004; Davis and Leider, 2018). The bargaining procedure of Sonnemans et al .…”

Stochastic production capacity: A bane or a boon for quick response supply chains?

“…Yang, Ng, and Ni (2017) investigated the flexible capacity strategy in an asymmetric oligopoly market under demand uncertainty and competition. Other related studies include investigation of supply chain contracts that can be used to induce the manufacturer to expand capacity (eg, Davis & Leider, 2018;Özer & Wei, 2006), exploration of the role of manufacturing flexibility in competition (Goyal & Netessine, 2007), studying the effect of advance selling on capacity planning (Boyacı & Özer, 2010), analysis of the capacity decision problem with advance demand information (Bernstein & DeCroix, 2015), and investigation of stochastic capacity investment with budget constraints (Boyabatlı, Leng, & Toktay, 2016). Similar to the above reviewed works, in this paper we study the case where a capacitated manufacturer can add capacity at an additional cost after capacity demand realization.…”

Multidimensional Bargaining and Inventory Risk in Supply Chains: An Experimental Study

“…Haruvy et al (2017) use an experimental design where one of two parties in a two-stage supply chain can make repeated good-faith offers and the other player can reject offers until they choose to accept. Davis and Leider (2018) study capacity investment decisions in two-stage supply chains across a variety of contracts, in an unstructured bargaining environment.…”