Simple Relational Contracts for Capacity Investment: Price- Only vs. Quantity-Commitment

Simple Relational Contracts for Capacity Investment: Price- Only vs. Quantity-Commitment

By
Erica Plambeck, Terry A. Taylor
Manufacturing and Service Operations Management.
2007, Vol. 9, Issue 1, Pages 94-113

Because of long lead times associated with product development and building capacity, a supplier must initiate investment in capacity when the product development effort is ongoing. Because the product is ill defined at this point in time, the buyer is unable to commit to the future terms of trade through a courtenforceable contract. Instead, to provide incentives for capacity investment, the buyer informally promises future terms of trade. The prospect of future interaction creates an incentive for the buyer to pay the supplier as promised. We characterize optimal price-only and price-and-quantity promises and compare their performance. If the production cost is low and either the capacity cost is low or the discount factor is high, then the buyer should promise to purchase a specific quantity rather than simply promise to pay a per unit price; otherwise, the buyer should simply promise to pay a specified unit price