Contract Manufacturing Relationships

Contract manufacturing enables intellectual property holders to enjoy scale economies, reduce labor costs and free up capital. However, in many scenarios contract manufacturing is a double-edged sword, rife with entrenchments, threats of predation or hold up. I explore these contract manufacturing problems in a non-recursive relational contract setting. These non-recursivities appear in at least two scenarios: First, a setting where there is learning by doing, but the accumulated expertise can also be used by the agent to compete against the principal. Second, a setting where there are multiple potential producers, but these contract manufacturers have prior entrenchments effecting their costs and can hold up the client. The analysis of these relations requires a novel methodological approach. A key contribution is that despite the non-recursive nature of these relationships, in both settings the principal optimal contract is characterized by a simple index rule, which does not depend on history or other agents. JEL-Classification: C73, D86, L14, L21 ∗Department of Managerial Economics and Decision Sciences, Kellogg School of Management, Northwestern University, Evanston, IL 60208, USA