Short vs. long-term procurement contracts when supplier can invest in cost reduction

In dynamic markets where cost of components changes fast, buyers typically auction off regular short-term contracts to fully leverage supplier competition in each period to continuously source from the lowest-cost supplier. However, too much competition through short-term contracts does not incentivize the incumbent supplier to make relation-specific investments in reducing costs, as future business is not assured. We investigate this trade-off, between leveraging supplier competition in each period versus incentivizing incumbent’s investment, with a stylized two-period model in which the buyer decides whether to auction off short-term contracts in each period or auction off a single long-term contract spanning both periods. In both cases, we characterize the optimal incumbent supplier’s investment, the suppliers’ equilibrium bidding strategy and the buyer’s expected cost. Our analysis shows that the supplier always invests more in a long-term contract. However, the buyer’s cost depends on supply base size: it prefers short-term contracts for large supply base size, otherwise it prefers long-term contract. Moreover, we find that system cost is typically lower with short-term contracts and that the suppliers are always better off with short-term contracts. Finally, adding non-discriminatory or discriminatory reserve prices to our model does not fundamentally modify the trade-off, but we find that auctions with discriminatory reserve price are better at balancing this trade-off compared to long or short-term contracts.