Optimal forward contract design in a supply chain with asymmetric cost information

Abstract

In a buyer-led supply chain, the buyer utilizes a forward contract to effectively cope with the risk brought by uncertainty in demand and raw material prices. However, the production cost, as private information of the supplier, will inevitably affect the formulation of a forward contract. This study constructs a procurement system consisting of a buyer, a supplier, and an imperfect spot market to explore how the buyer designs the forward contract under asymmetric cost information. By applying the principal-agent theory, this study allows the buyer to maximize profits while disclosing the supplier's cost information. The results obtained indicate that in order to screen the cost type, the forward order quantity from the high-cost supplier is downward distorted. Asymmetric cost information will reduce the buyer's profits, but bring additional information rent to the supplier. Interestingly, it is also observed that asymmetric material cost information can discourage the buyer from engaging in speculative activities in the spot market. While the existence of a well-developed raw material spot market with a reduced price provides the buyer with an alternative way to make procurement, which mitigates the negative impacts of his cost information disadvantages.