An Options Approach to Enhance Economic Efficiency in a Dyadic Supply Chain

In this article we present a framework to analyze the efficiency-enhancing impact of contingency contracts. At the beginning of the contract, market session in period 0, the seller announces a two-part tariff applicable to obtaining options on slots of his capacity. This entitles the buyer to a non-storable good or dated service provided by the seller. The buyer in turn decides how many options to purchase. Both parties act under state-contingent uncertainty concerning demand, costs, and spot price. In the spot market in period 1, with uncertainty resolved, the buyer determines his optimal contract and spot consumption portfolio, while the seller offers potentially remaining capacity at the prevailing spot market price. The opportunity of long-term capacity trading and planning provides the seller with an instrument of efficient cost management resulting in lower marginal cost related to long-term capacity allocation as opposed to those associated with allocation on short-notice. Economic efficiency is enhanced in the options scenario as compared to the one obtained in a pure spot market.