Implications of Renegotiation for Optimal Contract Flexibility and Investment

After entering into supply contracts, firms 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 facing 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 firms' investments in innovation and capacity, the allocation of capacity, and the resulting profits. Renegotiation can greatly increase the firms' profits, provided that contract parameters are chosen correctly. Failing to anticipate renegotiation leads to contracts that contain far too much flexibility, and perform poorly relative to contracts designed to anticipate renegotiation. We provide clear conditions under which a quantity flexibility contracts with renegotiation coordinate the system. Where quantity flexibility contracts fail, we show that tradable options perform very well.