The Impact of Demand Signal Quality On Optimal Decisions in Supply Contracts

Abstract

In this chapter, we consider two-stage “flexible” supply contracts for advanced reservation of capacity or advanced procurement of supply. With a contract of this type, an initial quantity decision(s) is made with limited demand information. After learning new information about the demand (a demand signal), a final decision can be made that is constrained by the initial decision(s). We consider the scenario in which a large supplier offers a standard contract to a small manufacturer. Motivated by contracts in the semiconductor industry, we focus on a general options-futures contract that allows for initial reservation of capacity as a less expensive, non-refundable firm commitment or as a more expensive but flexible option. We also consider other contracts in the literature that are special cases of the options-futures contract: the options contract, the backup contract, and the quantity-flexibility contract.