Decision, Risk & Operations Working Papers Series Supply Chain Relationships and Contracts: The Impact of Repeated Interaction on Capacity Investment and Procurement

Consider a firm developing an innovative product. Due to market pressures, production must begin soon after the product development effort is complete, which requires that an upstream supplier invests in capacity while the design of the product and production process are in flux. Because the product is ill-defined at this point in time, the firms are unable to write court-enforceable contracts that specify the terms of trade or the supplier's capacity investment. However, the firms can adopt an informal agreement (relational contract) regarding the terms of trade and capacity investment. The potential for future business provides incentive for the firms to adhere to the relational contract. We show that the optimal relational contract may be complex, requiring the buyer to order more than her demand to indirectly monitor the supplier's capacity investment. We propose a simpler relational contract and show that it performs very well for a broad range of parameters. Finally, we identify characteristics of the business environment that make relational contracting particularly valuable.

[1]  Jonathan Levin.  Relational Incentive Contracts , 2003 .

[2]  J. H. Dyer.  Effective interim collaboration: how firms minimize transaction costs and maximise transaction value , 1997 .

[3]  E. Fehr,et al.  Reciprocity as a contract enforcement device: experimental evidence , 1997 .

[4]  A. Rubinstein.  Perfect Equilibrium in a Bargaining Model , 1982 .

[5]  B. Klein,et al.  Vertical Integration, Appropriable Rents, and the Competitive Contracting Process , 1978, The Journal of Law and Economics.

[6]  E. Stacchetti,et al.  Towards a Theory of Discounted Repeated Games with Imperfect Monitoring , 1990 .

[7]  Erica L. Plambeck,et al.  Simple Relational Contracts to Motivate Capacity Investment: Price Only vs. Price and Quantity , 2007, Manuf. Serv. Oper. Manag..

[8]  Kevin J. Murphy,et al.  Relational Contracts and the Theory of the Firm , 1997 .

[9]  D. D. de Quervain,et al.  The Neural Basis of Altruistic Punishment , 2004, Science.

[10]  T. Malone,et al.  Bringing the market inside. , 2004, Harvard business review.

[11]  Gérard P. Cachon.  Supply Chain Coordination with Contracts , 2003, Supply Chain Management.

[12]  Curtis R. Taylor,et al.  Competition or Compensation: Supplier Incentives Under the American and Japanese Subcontracting Systems , 1997 .

[13]  Fangruo Chen,et al.  Information Sharing and Supply Chain Coordination , 2003, Supply Chain Management.

[14]  G. Ryzin,et al.  On the Relationship Between Inventory Costs and Variety Benefits in Retailassortments , 1999 .

[15]  Ernst Fehr,et al.  Reciprocity as a Contract Enforcement Device , 2001 .

[16]  Mari Sako,et al.  Price, Quality and Trust: Inter-firm Relations in Britain and Japan , 1992 .

[17]  Albert Y. Ha.  Supplier‐buyer contracting: Asymmetric cost information and cutoff level policy for buyer participation , 2001 .

[18]  Charles J. Corbett,et al.  Stochastic Inventory Systems in a Supply Chain with Asymmetric Information: Cycle Stocks, Safety Stocks, and Consignment Stock , 2001, Oper. Res..

[19]  Drew Fudenberg,et al.  Game theory (3. pr.) , 1991 .

[20]  J. Nash.  THE BARGAINING PROBLEM , 1950, Classics in Game Theory.

[21]  Eric T. Bradlow,et al.  Promises and Lies: Restoring Violated Trust , 2004 .

[22]  O. Williamson.  Transaction-Cost Economics: The Governance of Contractual Relations , 1979, The Journal of Law and Economics.

[23]  O. Hart,et al.  Property Rights and the Nature of the Firm , 1988, Journal of Political Economy.

[24]  Sanford J. Grossman,et al.  The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration , 1986 .

[25]  Tunay I. Tunca,et al.  Supply Auctions and Relational Contracts for Procurement , 2006, Manuf. Serv. Oper. Manag..

[26]  M. Whinston,et al.  Incomplete Contracts, Vertical Integration, and Supply Assurance , 1993 .

[27]  O. Hart,et al.  Incomplete Contracts and Renegotiation , 1988 .

[28]  Stewart Macaulay,et al.  Non-Contractual Relations in Business , 2009 .

[29]  Robert M. Fuhrer,et al.  Coordinating Investment, Production, and Subcontracting , 1999 .

[30]  George P. Baker,et al.  BRINGING THE MARKET INSIDE THE FIRM , 2001 .

[31]  R. Myerson.  Incentive Compatibility and the Bargaining Problem , 1979 .

[32]  E. Plambeck,et al.  Supply Chain Relationships and Contracts: The Impact of Repeated Interaction on Capacity Investment and Procurement , 2003 .

[33]  Steven Tadelis,et al.  Incentives Versus Transaction Costs: A Theory of Procurement Contracts , 2001 .

[34]  Christian Terwiesch,et al.  Sharing Forecast Information in a Long-term Supply Chain Relationship , 2006 .

[35]  Morris A. Cohen,et al.  Measuring Imputed Cost in the Semiconductor Equipment Supply Chain , 2003, Manag. Sci..

[36]  D. Fudenberg,et al.  Digitized by the Internet Archive in 2011 with Funding from Working Paper Department of Economics the Folk Theorem with Imperfect Public Information , 2022 .

[37]  Erica L. Plambeck,et al.  Partnership in a Dynamic Production System with Unobservable Actions and Noncontractible Output , 2006, Manag. Sci..

[38]  Gérard P. Cachon,et al.  Contracting to Assure Supply: How to Share Demand Forecasts in a Supply Chain , 2001, Manag. Sci..