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Simple Relational Contracts to Motivate Capacity Investment: Price Only vs. Price and Quantity

Graduate School of Business, Columbia University, New York, New York 10027 and Tuck School of Business, Dartmouth College, Hanover, New Hampshire 03755
Graduate School of Business, Stanford University, Stanford, California 94305
tat2002{at}columbia.edu
elp{at}stanford.edu

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 court-enforceable 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.

Key Words: relational contracts; supply chain management; capacity investment; price-only contracts
History: Received: January 28, 2006; accepted: August 20, 2006.

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