Make-to-order supply chain coordination through option contract with random yields and overconfidence

Abstract

This paper investigates a two-echelon supply chain with a supplier and a manufacturer with yield uncertainty. We assume that the manufacturer is overconfident about its yield and examine how this could impact on the performance for each company and the supply chain. We propose option contracts to be used to coordinate the ordering and production across the supply chain. A wholesale price contract without overconfidence (i.e., with complete rationality) about the manufacturer's yield is first developed as a benchmark. Based on that, we analyze the impact of overconfidence on the decisions and the expected profits for each player in the supply chain under the wholesale price contract. This setting is then applied to the case of option contracts. We derive analytical results on the decisions and the expected profits, and propose conditions for the option price and the option execution price to achieve supply chain coordination. Overall we find that overconfidence has an adverse impact on the performance of both companies. Their expected profits will decline as the level of overconfidence goes up. Option contracts can improve the performance for both companies but cannot completely eliminate the impact of overconfidence. This paper therefore could be used to guide the coordination and cooperation of companies along a supply chain when there exists yield uncertainty and overconfidence. Our propositions are validated through numerical experiments on a hypothetical case and supported by extensive parameter sensitivity analyses.