We develop an option model to quantify and price a flexible supply contract, by which the buyer (a manufacturer), in addition to a committed order quantity, can purchase option contracts and decide whether or not to exercise them after demand is realized. We focus on deriving (a) the optimal order decision of the buyer, in terms of both the committed order quantity and the number of option contracts; and (b) the optimal pricing decision of the seller (who supplies raw materials or components to the manufacturer), in terms of both the option price and the exercise price. We show that the option contracts shift part of the buyer's risk due to demand uncertainty to the supplier, who, in turn, is compensated by the additional revenue obtained from the options. We also show that a better alternative to the two parties' individual optimization is for them to negotiate a mechanism to share the profit improvement over the no-flexibility contract. Indeed, in some cases, this profit sharing may achieve channel coordination.
By: Feng Cheng, Markus Ettl, Grace Y. Lin, David D. Yao, Maike Schwarz
Published in: RC22412 in 2002
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