Renegotiation of Supply Contracts By Erica L . Plambeck

After entering into supply contracts, ...rms often later renegotiate the terms of those contracts. For example, ...rms that obtain market demand information after signing supply contracts may bene...t by renegotiating the contracts to allow buyers facing poor market conditions to purchase less than their contractual commitment and allowing buyers facing favorable conditions to purchase more. Consider a setting in which two buyers invest in innovation (product development, marketing) and obtain supply from a single manufacturer through quantity ‡exibility contracts, which specify the minimum quantity the manufacturer must supply and the minimum quantity the buyer must purchase. The potential for renegotiation of the supply contracts has important implications for the way ...rms make investments in innovation and capacity, the way capacity is allocated, and the resulting pro...ts of ...rms. We provide clear conditions under which the potential for renegotiation stimulates or retards innovation. Renegotiation can greatly increase system pro...t, provided that contracts are designed to anticipate renegotiation. Anticipating the possibility of renegotiation signi...cantly impacts how contracts should be designed: Failing to anticipate renegotiation typically leads to contracts that contain far too much ‡exibility. Such contracts perform poorly relative to contracts designed to anticipate renegotiation. Finally, employing tradable options can lead to even greater system pro...t than optimal quantity ‡exibility contracts that anticipate renegotiation.