Contracting for technology improvement: The effect of asymmetric bargaining power and investment uncertainty

Abstract

Investment in technology improvement (TI) measures that reduce the consumption rate of input commodities (like fuel, energy, water, etc.) yields significant economic and sustainability benefits. Yet, evidence shows that the so-called holdup problem leads to inefficient levels of investment in TI. The suppliers refrain from investing in TI because they fear that a buyer with greater bargaining power will use TI-related cost reductions to push prices down—in the purchase bargaining process—and thereby further reduce the supplier’s profit margin. Conventional wisdom suggests that higher bargaining power on the buyer’s side aggravates this problem. In a two-tier supplier–buyer setting, we study the role of relative bargaining power along with technology uncertainty—i.e., the risk associated with investment return—on TI investment levels by the supplier. We challenge conventional wisdom to show that there is an inverse U-shaped relationship between buyer bargaining power and TI investment by the supplier and characterize how technology uncertainty moderates this relationship. We study and rank various contracting arrangements commonly used in industry, including the price commitment and shared investment contracts to remedy the investment inefficiencies resulting from the bargaining process.