The Role of Commitment and Contract Design inSupplier Relationships with Common Uncertainty

In this paper we consider a repeated interaction between a manufacturing rm and a subcontractor. The moral hazard problem present in this relationship is aggravated by the fact that both parties do not have perfect knowledge about the base cost level of the project carried out by the subcontractor but only have identical a priori beliefs. Short term and long term contracts are compared in a two-period framework and it is shown that given common uncertainty about the base cost level of the project short term contracts are preferable to long term contracts if the parties can update their beliefs according to incoming information. On the other hand it is demonstrated that long term contracts may be preferable if additional information about the base cost level is received between the periods.