Specific capacity investment in supply chains

Abstract

In a supply chain composed of a supplier and a buyer, the supplier must make two decisions, buyer-specific capacity and cost-reduction investment for each unit of the installed specialized capacity, before demand uncertainties have been resolved. However, because capacity is not verifiable, the firms cannot commit to firm contract terms. Bearing the upfront investment cost, the supplier under-builds specific capacity and under-invests in the cost-reduction innovation, thereby lowering supply chain efficiency. A common arrangement is that the parties agree to some initial contract terms ex ante, and may renegotiate ex post. This paper investigates whether several common types of contract can induce the supplier to build specialized capacity and invest in cos-reduction innovation at the first-best levels, and how ex post renegotiation affects the results. Under quantity-only contracts, the supplier will over-invest in cost-reduction innovation but under-build specific capacity either with or without ex post renegotiation. Under price-only contracts, the supplier will under-invest in cost-reduction innovation but over-build specific capacity. Ex post renegotiation improves the channel profit and brings the supplier’s decisions closer to the firstbest, but its decisions remain suboptimal. However, there exist one quantity-plus-price initial agreement and a schedule of option contracts that yield the first-best decisions. The price/quantities do not change whether ex post renegotiation is permissible. However, channel efficiency and the firms’ profits improve when ex post renegotiation is permissible. Because of the flexibility of option contracts, the firms renegotiate only if the buyer exercises up options and wants to buy more ex post, while they renegotiate with certainty under the optimal quantity-plus-price initial contract.