Supply contract design under price volatility and competition

Abstract

This study analyses index-based contract designs and contract equilibria in a competitive setting. We consider a two-echelon supply chain consisting of two manufacturers and a retailer. Each manufacturer procures a commodity in a spot market and uses such a commodity to produce a product. The manufacturers initially choose either an index-based or fixed-price contract. Thereafter, the manufacturer that adopts an index-based contract designs the contract price on the basis of the spot and forward prices of its input commodity. Finally, the two products are sold through the common retailer. Our analysis indicates that an index-based contract provides a manufacturer with a contingent pricing mechanism, thereby enabling the contract price to respond to the spot price of its input commodity. If only one manufacturer adopts an index-based contract, then the contract price is designed to respond positively to the corresponding spot price, while the contract design constantly benefits the designer but may either benefit or hurt the rival and retailer. If both manufacturers adopt an index-based contract, then the contract price may be designed to respond negatively to the corresponding spot price. The reason is that the manufacturer intends to dampen competition by adopting an opposite contract price design. Further study shows that in equilibrium, both manufacturers consistently adopt an index-based contact if the spot prices are positively correlated. However, differentiated contract strategies may be optimal for manufacturers if the correlation is negative.