Sourcing Flexibility, Spot Trading, and Procurement Contract Structure

Pamela Pen-Erh Pei · David Simchi‐Levi · Tunay I. Tunca

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Supply Chain and Inventory Management Capital Investment and Risk Analysis Auction Theory and Applications

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.

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References

1988The Theory of Industrial Organization 1981The Economics of Organization: The Transaction Cost Approach 1981Optimal Auction Design 1987Electronic markets and electronic hierarchies 1993Dynamic Asset Pricing Theory.2003Supply Chain Coordination with Contracts 2005Supply Chain Coordination with Revenue-Sharing Contracts: Strengths and Limitations 1989Handbooks in operations research and management science

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2018Determinants of sourcing flexibility and its impact on performance 2019Optimal option purchase decision of a loss-averse retailer under emergent replenishment 2013The role of spot market in a decentralised supply chain under random yield 2014Optimal procurement of long-term contracts in the presence of imperfect spot market 2012Demand Uncertainty and Excess Supply in Commodity Contracting 2014Supply chain coordination with dual procurement sources via real-option contract

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