Contracts and Capacity Investment in Supply Chains

Suppliers are often reluctant to invest in capacity if they believe that they will be unable to recover their investment costs in subsequent transactions with buyers. In theory, a number of different contracts can solve this issue and induce first-best investment levels by the supplier. In this study, we investigate the performance of these contracts in a two-tier supply chain. We develop an experimental design where retailers and suppliers bargain over contract terms—and have the ability to make multiple back-and-forth offers—while also providing feedback on the offers they receive. One key result from our study is that an option contract and a service-level agreement are best at increasing first-best investment levels and overall supply chain profits. However, these same contracts also generate the largest inequity in expected profits between the two parties. We find that both of these results are driven by the bargaining tendencies of retailers and suppliers, which we refer to as “superficial fairness.” In particular, retailers and suppliers place more emphasis on negotiating the wholesale price, while partially overlooking any secondary parameter, such that final wholesale prices end up roughly halfway between the retailer’s selling price and the supplier’s production cost. We show that this bargaining behavior contributes to higher investment levels observed in the option contract and service-level agreement, along with the inequitable payoffs. The online appendix is available at https://doi.org/10.1287/msom.2017.0654 .