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Simple Contracts to Assure Supply Under Noncontractible Capacity and Asymmetric Cost Information

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  • Ehsan Bolandifar

    () (CUHK Business School, Chinese University of Hong Kong, Shatin, N.T., Hong Kong)

  • Tianjun Feng

    () (School of Management, Fudan University, Shanghai, China 200433)

  • Fuqiang Zhang

    () (Olin Business School, Washington University in St. Louis, St. Louis, Missouri 63130)

Abstract

This paper studies a global sourcing problem where a buyer sources a product from a supplier to satisfy uncertain market demand. With the increasing length and complexity of today’s global supply chains, the buyer may face two issues when designing the sourcing contract: adverse selection (i.e., the supplier’s cost structure is private information) and noncontractible capacity (i.e., the supplier’s capacity investment is not contractible). We show that noncontractible capacity does not necessarily lead to a lower profit for the buyer, but it may require a more complex contract format to achieve the optimal (second-best) profit. Interestingly, we find that a single, linear contract (or a two-part tariff) could be optimal for the buyer under certain conditions. Even when such a contract is suboptimal, it can deliver close-to-optimal profit for the buyer for a wide range of situations. These findings indicate that the value of using a complex menu of contracts is negligible in such a supply chain setting. A simple two-part tariff is an attractive option for buyers whose goal is to ensure supply while facing both cost uncertainty and contractibility issues. The paper also provides a new explanation for the prevalence of such simple contracts in practice.

Suggested Citation

  • Ehsan Bolandifar & Tianjun Feng & Fuqiang Zhang, 2018. "Simple Contracts to Assure Supply Under Noncontractible Capacity and Asymmetric Cost Information," Manufacturing & Service Operations Management, INFORMS, vol. 20(2), pages 217-231, May.
  • Handle: RePEc:inm:ormsom:v:20:y:2018:i:2:p:217-231
    DOI: 10.1287/msom.2017.0628
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    File URL: https://doi.org/10.1287/msom.2017.0628
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