Capacity Management and Price Discrimination under Demand Uncertainty Using Option Contracts

Abstract

This chapter considers the use of option contracts as a price discrimination tool under demand uncertainty to improve supplier profit and supply chain efficiency. Option contracts have long been used to manage demand or supply uncertainty, and the cost of the option is simply considered as the cost to avoid uncertainties. We give an example in a supply chain setting where a supplier has more than one downstream customer with private information. Under such a scenario, our game theoretical model shows that the option price shall be set taking into account the fact that only the customers who are more concerned about the demand uncertainty will purchase. Therefore, the supplier should be able to charge more for a unit of option contract compared to the traditional pricing method where simple expectations are taken. The supplier’s profit improves in three ways. First, the high type customers pay higher marginal prices on average. Second, the high type customers’ demand is satisfied as a first priority, guaranteeing allocation efficiency. Third, the supplier can observe the number of options being purchased and so determine customer types, improving capacity decision efficiency. We compare our results to those of classical second degree price discrimination literature. We show that the use of option contracts guarantee the same level of supplier profit as the level of second degree price discrimination. The overall supply chain efficiency improves to the full information benchmark.