Option Contracts in Supply Chains

Abstract

This paper considers optimal contracts in supply chains that consist of n≥ 2 firms and face a potential investment hold‐up problem. We show that option contracts may solve the incentive problems. First, we provide case‐study evidence for the use of option contracts in the semiconductor industry. As our second contribution, we generalize the earlier option contract approach by introducing continuous quantities. Third, we extend the setting to n parties. For long supply chains, the first‐best allocation can be achieved if there is a particular order of renegotiations.