Optimal sequential contract with a risk‐averse supplier

Abstract

We study optimal contracts in environments where a risk‐averse supplier discovers cost information privately and gradually over time: the supplier is privately informed about its cost uncertainty at the time of contracting and discovers the realization of cost condition privately after contracting and before production. We show that both the buyer and the supplier prefer more cost uncertainty when the supplier is not very risk‐averse but less cost uncertainty when the supplier is sufficiently risk‐averse. However, the buyer always prefers to contract before the cost uncertainty resolves regardless of the supplier's degree of risk aversion. The nature of the optimal contract also depends on the supplier's risk preference. A separating contract is optimal when the supplier is not very risk‐averse; however, a pooling contract, which offers the same contract terms regardless of the cost uncertainty, can be optimal when the supplier becomes sufficiently risk‐averse. Moreover, the optimal production schedule is often characterized by “inflexible rules.”

Optimal risk sharing with ex post private information: Rules versus discretion

“…In contrast, we show that rules can arise, in the absence of countervailing incentives, as an optimal solution to the conflict among risk sharing, production efficiency, and information revelation. Salanié (1990), Laffont andRochet (1998), andDai (2021) study optimal procurement contracts between a risk neutral buyer and a risk averse supplier with common information on contract parties' risk preferences. They show that "bunching" arises in the supply contract for the worst states of nature.…”