Implications of Breach Remedy and Renegotiation for Design of Supply Contracts

A manufacturer writes supply contracts with N buyers. Then, the buyers invest in innovation, and the manufacturer builds capacity. Finally, demand is realized, and the firms renegotiate the supply contracts to achieve an efficient allocation of capacity among the buyers. The court remedy for breach of contract (specific performance versus expectation damages) affects how the firms share the gain from renegotiation, and hence how the firms make investments ex ante. The objective is to design supply contracts that will induce the buyers and manufacturer to make the first best investments. When the manufacturer is dominant and the breach remedy is expectation damages, the first best is achieved with simple advance purchase contracts. In contrast, with a dominant manufacturer and specific performance, the first best may not be achieved. A "tradable options" clause is needed to increase the buyers' incentive for investment. When the buyers have significant bargaining power and the breach remedy is expectation damages, simple advance purchase contracts will always result in underinvestment in capacity and overinvestment in innovation by the buyers. However, if the separability condition proposed in Edlin and Reichelstein (1996) holds and the breach remedy is specific performance, then the first best is achieved with simple advance purchase contracts. Finally, building on Maskin and Moore (1999) we describe more complex contracts that induce the first best where simple advance purchase contracts fail.