Sourcing Flexibility, Spot Trading, and Procurement Contract Structure

Pamela Pen-Erh Pei (), David Simchi-Levi () and Tunay I. Tunca ()
Additional contact information
Pamela Pen-Erh Pei: United BioSource, Lexington, Massachusetts 02420
David Simchi-Levi: Operations Research Center, Massachusetts Institute of Technology, Cambridge, Massachusetts 02137
Tunay I. Tunca: Graduate School of Business, Stanford University, Stanford, California 94305

Operations Research, 2011, vol. 59, issue 3, 578-601

Abstract: We analyze the structure and pricing of option contracts for an industrial good in the presence of spot trading. We combine the analysis of spot trading and buyers' disparate private valuations for different suppliers' products, and we jointly endogenize the determination of three major dimensions in contract design: (i) sales contracts versus options contracts, (ii) flat-price versus volume-dependent contracts, and (iii) volume discounts versus volume premia. We build a model in which a supplier of an industrial good transacts with a manufacturer who uses the supplier's product to produce an end good with an uncertain demand. We show that, consistent with industry observations, volume-dependent optimal sales contracts always demonstrate volume discounts (i.e., involve concave pricing). However, options are more complex agreements, and optimal option contracts can involve both volume discounts and volume premia. Three major contract structures commonly emerge in optimality. First, if the seller has a high discount rate relative to the buyer and the seller's production costs or the production capacity is low, the optimal contracts tend to be flat-price sales contracts. Second, when the seller has a relatively high discount rate compared to the buyer but production costs or production capacity are high, the optimal contracts are sales contracts with volume discounts. Third, if the buyer's discount rate is high relative to the seller's, then the optimal contracts tend to be volume-dependent options contracts and can involve both volume discounts and volume premia. However, when the seller's production capacity is sufficiently low, it is possible to observe flat-price option contracts. Furthermore, we provide links between production and spot market characteristics, contract design, and efficiency.

Keywords: supply chain management; procurement; contract pricing (search for similar items in EconPapers)
Date: 2011
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (18)

Downloads: (external link)
http://dx.doi.org/10.1287/opre.1100.0905 (application/pdf)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:inm:oropre:v:59:y:2011:i:3:p:578-601

Access Statistics for this article

More articles in Operations Research from INFORMS Contact information at EDIRC.
Bibliographic data for series maintained by Chris Asher ().