Renegotiation of Supply Contracts

Renegotiation of Supply Contracts

By Erica Plambeck, Terry Taylor
2002Working Paper No. 1764

After entering into supply contracts, frims often later renegotiate the terms of those contracts. For example, firms that obtain market demand information after signing supply contracts may benefit by renegotiating the contracts to allow buyers facing poor market conditions to purchase less than their contractual commitment and allowing buyers 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 flexibility 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 firms make investments in innovation and capacity, the way capacity is allocated, and the resulting profits of firms. We provide clear conditions under which the potential for renegotiation stimulates or retards innovation. Renegotiation can greatly increase system profit, provided that contracts are designed to anticipate renegotiation. Anticipating the possibility of renegotiation significantly impacts how contracts should be designed. Failing to anticipate renegotiation typically leads to contracts that contain far too much flexibility. Such contracts perform poorly relative to contracts designed to anticipate renegotiation. Finally, employing tradeable options can lead to even greater system profit than optimal quantity flexibility contracts that anticipate renegotiation.