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Implications of Renegotiation for Optimal Contract Flexibility and Investment

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  • Erica L. Plambeck

    (Graduate School of Business, Stanford University, Stanford, California 94305)

  • Terry A. Taylor

    (Haas School of Business, University of California, Berkeley, California 94720)

Abstract

In a stylized model of biopharmaceutical contract manufacturing, this paper shows how the potential for renegotiation influences the optimal structure of supply contracts, investments in innovation and capacity, the way scarce capacity is allocated, and firms' resulting profits. Two buyers contract for capacity with a common manufacturer. Then, the buyers invest in innovation (product development and marketing) and the manufacturer builds capacity. Finally, the firms may renegotiate to allow a buyer facing poor market conditions to purchase less than the contractual commitment and a buyer facing favorable conditions to purchase more. We show that renegotiation can greatly increase the firms' investments and profits, provided that the contracts are designed correctly. Failing to anticipate renegotiation leads to contracts that allow too much flexibility in the buyer's order quantity, and perform poorly relative to contracts designed to anticipate renegotiation. We provide clear conditions under which quantity flexibility contracts with renegotiation coordinate the system. Where quantity flexibility contracts fail, employing tradable options improves performance.

Suggested Citation

  • Erica L. Plambeck & Terry A. Taylor, 2007. "Implications of Renegotiation for Optimal Contract Flexibility and Investment," Management Science, INFORMS, vol. 53(12), pages 1872-1886, December.
    • Handle: RePEc:inm:ormnsc:v:53:y:2007:i:12:p:1872-1886
    DOI: 10.1287/mnsc.1070.0731
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    References listed on IDEAS

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