Simple Contracts for Reliable Supply

Supply reliability may suffer due to events such as labor strikes that disrupt capacity (random capacity) or manufacturing defects that result in yield losses (random yield). Suppliers can enhance reliability by process improvement and overproduction, but these mitigating actions are often not contractible. Moreover, the investment in mitigation depends critically on the design of the procurement process: whether the buyer determines the production quantity (control) or the supplier does (delegation). Complex contracts, typically with a penalty clause, can be used to coordinate the supply chain. However, evidence suggests that simple wholesale price contracts are widely used. Our main finding is that such simple contracts can perform well (in terms of supply-chain profits) depending on the type of supply risk and the procurement process design. We find that for random capacity, irrespective of the process design, contract performance is monotonically increasing in the supplier’s bargaining power, suggesting that simple contracts perform well when the supplier is powerful. However, this monotonicity trend is reversed for random yield with control: in that case, simple contracts perform well when the buyer is powerful. For random yield with delegation, simple contracts perform well when either party is powerful. Our findings provide insight and guidance regarding when simple contracts suffice, and when more complex coordinating contracts are warranted.