Capacity Investment under Demand Uncertainty: The Option Value of Subcontracting

We study the financial value of subcontracting by analyzing a competitive stochastic investment game with recourse. The manufacturer and subcontractor decide separately on the capacity investment levels. Then demand uncertainty is resolved and both parties have the option to subcontract when deciding on their production and sales. First, we study price-only contracts where an ex-ante transfer price is set for each unit supplied by the subcontractor. We characterize the sub-game perfect investment strategy and present an outsourcing condition. Manufacturer and supplier capacity levels are imperfect substitutes that, surprisingly, are more sensitive to changes in the cost structure than in the revenue structure. Uncertainty is the key reason, and we show that manufacturers will subcontract more when the level or market risk increases and when markets are more negatively correlated. As with financial options, this is accompanied by an increase in the option value of subcontracting. Second, we consider an inconplete contract, so that both parties negotiate over the subcontracting transfer. Depending on the manufacturere's "bargaining power," system performance can exceed that with price-only contracts. Finally, the third contract type is a state-dependent price-only contract for which we show an equivalence result with the bargaining contract. While subcontracting with these three contract types improves system performance, it cannot eliminate all decentralization costs (or "coordinate" the supply system). Key Words: Real investments, capacity planning, subcontracting, outsourcing, supply contracts.