Horizontal Capacity Coordination for Risk Management and Flexibility: Pay Ex Ante or Commit a Fraction of Ex Post Demand?

Motivated by the dual-sourcing and contracting practices in the semiconductor industry, we study two prevailing types of contracts that deal with horizontal-capacity-coordination issues between two possible sources: an integrated device manufacturer IDM and a foundry. IDMs both design and manufacture semiconductor devices, whereas foundries concentrate only on manufacturing. Because production capacity is capital intensive, IDMs often make decisions on whether to manufacture each device internally or subcontract to foundries. Two types of contracts are most frequently used in such settings. Under α-contracts, a fixed fraction α of ex post realized demand is committed to subcontract to the foundry and serves as an incentive for the foundry to build capacity. Under reservation contracts, an ex ante capacity reservation fee is paid to the foundry as an incentive to build capacity. Because of the different nature of incentives under these contracts, it is unclear which type of contract maximizes the IDM's expected profit. Furthermore, IDMs and their customers often prefer dual sourcing to sole sourcing for risk-management purposes. This paper studies the relationship between the two types of contracts, both with and without dual-sourcing constraints and shows the effect of a dual-sourcing preference on contract selection. Our analysis offers supporting rationale for the coexistence of α-contracts and reservation contracts in practice and provides insights on horizontal capacity coordination beyond the semiconductor industry.