Option Contracts and Capacity Management—Enabling Price Discrimination under Demand Uncertainty

Abstract

We explore using an option contract as a price discrimination tool under demand uncertainty. In our capacity game model, a monopolistic supplier has to build capacity before observing the uncertain demand. The demand is generated by two potential customers, who privately know their own types. The types could be either high or low, differing in willingness to pay for each unit of demand. To discriminate between the customer types, the supplier designs option contracts so that only the high type will buy options in advance. The high type will do so because the options can hedge their risk of demand loss when capacity is tight. The supplier profits in three ways. First, the high type customers pay higher marginal prices on average. Second, the high type customers' demand is satisfied as a first priority, guaranteeing allocation efficiency. Third, the supplier can observe the number of options being purchased and so determine customer types, improving capacity investment efficiency. We compare our results to those of classical second degree price discrimination. We show that our proposed framework guarantees the same level of supplier profit even when the supplier cannot discriminate between the customers by bundling products.

Equilibrium analysis of capacity allocation with demand competition

“…Cachon and Lariviere [4,5] analyze incentives, equilibrium ordering decisions, and supply chain performance under a variety of capacity allocation mechanisms, and demonstrate how several allocation schemes are vulnerable to false information and show that truth inducing schemes help allocate capacity among retailers but can distort supplier choice of total capacity. Fang and Whinston [9] design an option contract for a supply chain where, from the supplier's perspective, each retailer's marginal utility for the capacity is either high or low. This design achieves the same expected profit as when the supplier knows the number of retailers of each type before investing in capacity.…”

Optimization of protections against supply chain risks due to intentional acts

“…Sourcing risks include single source risk [19], flexible supplier sourcing [15] and risks regarding supplier selection and outsourcing [1]. Studies about manufacture risks mainly discuss production capacity risk [8] and operational disruption [23]. Deliver risks is caused by demand volatility, balance of unmet demand and excess inventory, while these issues are often affected by the forecasting difficulties [22].…”

Cooperative and Noncooperative Games for Capacity Planning and Scheduling

“…First, we discuss the work of Cachon and Lariviere [4][5][6], who analyze incentives, equilibrium, and supply chain performance under a variety of capacity planning and allocation mechanisms based on order sizes or past sales. Next, we discuss research by Fang and Whinston [17] and Ganesh et al [20], who study capacity allocation using option contracts and pricing. Also, we describe capacity planning and allocation models with applications to semiconductor manufacturing (Mallik and Harker [32], Karabuk and Wu [30]) and to network communications (Niyato and Hossain [38]).…”

“…Fang and Whinston [17] consider a supply chain in which a monopolistic supplier sells to two risk neutral customers. The paper designs an option contract that guarantees either delivery by the supplier or compensation for failure to deliver.…”

“…The supplier can seek information from the retailers besides order quantities and past sales and then use the information obtained to facilitate capacity allocation decisions by the individual retailers. See Cachon and Lariviere [4] and Fang and Whinston [17].…”