Wholesale price contracts for reliable supply

Hwang, W, Bakshi, N and DeMiguel, V (2018) Wholesale price contracts for reliable supply. Production and Operations Management, 27 (6). pp. 1021-1037. ISSN 1059-1478

Abstract

Firms can enhance the reliability of their supply through process improvement and overproduction. In decentralized supply chains, however, these mitigating actions may be the supplier's responsibility yet are often not contractible. We show that wholesale price contracts, despite their simplicity, can perform well in inducing reliable supply, and we identify when and why they perform well. This could explain the widespread use of wholesale price contracts in business settings with unreliable supply. In particular, we investigate how the performance of wholesale price contracts depends on the interplay between the nature of supply risk and the type of procurement process. Supply risk is classified as random capacity when events such as labor strike disrupt the firm's ability to produce, or as random yield when manufacturing defects result in yield losses. The procurement process is classified as control when the buyer determines the production quantity, or as delegation when instead the supplier does. Analyzing the four possible combinations, we find that for random capacity, irrespective of the procurement process type, contract performance monotonically increases with the supplier's bargaining power; thus, wholesale price contracts perform well when the supplier is powerful. However, this monotonic trend is reversed for random yield with control: in that case, wholesale price contracts perform well when instead the buyer is powerful. For random yield with delegation, wholesale price contracts perform well when either party is powerful.