Multi-period dynamic supply contracts with cancellation

This paper considers a class of multi-period dynamic supply contracts in which a buyer orders a product from a supplier in each period and the supplier allows the buyer to cancel a portion of an outstanding order with penalty during a planning horizon. We assume that both the buyer and the supplier have common knowledge. We first characterize the buyer's ordering and canceling policy that minimizes his expected cost during the planning horizon. We also characterize the supplier's optimal production policy under a very mild assumption on the costs of production and storage. Based on this structure, we then use simulation to show how the supplier chooses cancellation costs that minimize her expected cost during the planning horizon. Our simulation shows that both the buyer and the supplier would benefit from the contract.