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Coordinating Investment, Production, and Subcontracting

  • Jan A. Van Mieghem

    (Kellogg Graduate School of Management, Northwestern University, 2001 Sheridan Road, Evanston, Illinois 60208-2001)

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    We value the option of subcontracting to improve financial performance and system coordination by analyzing a competitive stochastic investment game with recourse. The manufacturer and subcontractor decide separately on their capacity investment levels. Then demand uncertainty is resolved and both parties have the option to subcontract when deciding on their production and sales. We analyze and present outsourcing conditions for three contract types: (1) price-only contractswhere an ex-ante transfer price is set for each unit supplied by the subcontractor; (2) incomplete contracts, where both parties negotiate over the subcontracting transfer; and (3) state-dependentprice-only and incomplete contracts for which we show an equivalence result. While subcontracting with these three contract types can coordinate productiondecisions in the supply system, only state-dependent contracts can eliminate all decentralization costs and coordinate capacity investmentdecisions. The minimally sufficient price-only contract that coordinates our supply chain specifies transfer prices for a small number (6 in our model) of contingent scenarios. Our game-theoretic model allows the analysis of the role of transfer prices and of the bargaining power of buyer and supplier. We find that sometimes firms may be better off leaving some contract parameters unspecified ex-ante and agreeing to negotiate ex-post. Also, a price-focused strategy for managing subcontractors can backfire because a lower transfer price may decrease the manufacturer's profit. Finally, as with financial options, the option value of subcontracting increases as markets are more volatile or more negatively correlated.

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    Article provided by INFORMS in its journal Management Science.

    Volume (Year): 45 (1999)
    Issue (Month): 7 (July)
    Pages: 954-971

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    Handle: RePEc:inm:ormnsc:v:45:y:1999:i:7:p:954-971
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    1. Grossman, Sanford J & Hart, Oliver, 1985. "The Cost and Benefits of Ownership: A Theory of Vertical and Lateral Integration," CEPR Discussion Papers 70, C.E.P.R. Discussion Papers.
    2. Harrison, J. Michael & Van Mieghem, Jan A., 1999. "Multi-resource investment strategies: Operational hedging under demand uncertainty," European Journal of Operational Research, Elsevier, vol. 113(1), pages 17-29, February.
    3. Lode Li, 1992. "The Role of Inventory in Delivery-Time Competition," Management Science, INFORMS, vol. 38(2), pages 182-197, February.
    4. Morton I. Kamien & Lode Li, 1990. "Subcontracting, Coordination, Flexibility, and Production Smoothing in Aggregate Planning," Management Science, INFORMS, vol. 36(11), pages 1352-1363, November.
    5. Morton I. Kamien & Lode Li & Dov Samet, 1989. "Bertrand Competition with Subcontracting," RAND Journal of Economics, The RAND Corporation, vol. 20(4), pages 553-567, Winter.
    6. Jan A. Van Mieghem & Maqbool Dada, 1999. "Price Versus Production Postponement: Capacity and Competition," Management Science, INFORMS, vol. 45(12), pages 1639-1649, December.
    7. Hanson, Gordon H, 1995. "Incomplete Contracts, Risk, and Ownership," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 36(2), pages 341-63, May.
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