Supply Chain Relationships and Contracts: The Impact of Repeated Interaction on Capacity Investment and Procurement

Consider a firm that is developing a highly innovative product. Producing the product requires that an upstream supplier invest in production capacity well in advance. Because the product is ill-defined at the time when the supplier initiates his capacity investment, the firms are unable to write court-enforceable contracts that specify the terms of trade. The supplier faces a classic hold up problem. When the firms finally do negotiate the terms of trade, his cost of capacity will be sunk (irrelevant). Anticipating this, the supplier will underinvest in capacity. However, with repeated new product introduction and capacity investment, the firms may adopt informal terms of trade: The buyer promises to purchase at a price that reflects the cost of capacity, and the supplier increases his capacity investment. The value of future cooperation creates an incentive for the buyer to pay the supplier as promised. Assuming symmetric information about demand, capacity and production costs, we derive optimal informal terms of trade that are appealingly simple. Then, assuming that the buyer cannot observe the supplier's capacity investment and the supplier cannot observe the buyer's demand, we compare the performance of informal price-only and quantity commitment agreements. If the production cost is low and either the capacity cost is low or the discount factor is high, then the buyer should promise to purchase a specific quantity rather than simply promise to pay a per unit price; otherwise, the buyer should simply promise to pay a specified unit price.