Market price uncertainty, risk aversion and procurement: Combining contracts and open market sourcing alternatives

We evaluate the implications of concurrent utilization of “contracts” and “open market” arrangements by a risk averse buyer in continuous procuring of a standardized product of known demand over a specified time period. The buyer being risk averse is concerned about the magnitude and uncertainty of expenses. The contract price is deterministic and the market price is stochastic. Cases when the two price processes are exogenous, and when the contract price is endogenously linked to volume of procurement and market price are examined. Models are developed to determine the optimal pattern of procurement from the two arrangements for specified price, risk aversion and contract duration parameters. The study finds that optimal procurement from market increases with contract price premium but decreases with degree of risk aversion and market price uncertainty. Usefulness of alternate forms of contracts when contract and market alternatives are used concurrently is discussed. Application of the models to hypothetical datasets compares the relative usefulness of alternate forms of integrating contract and market alternatives, and of complete reliance on “contract” or “market” alternatives.

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