In the electronics industry and others, original equipment manufacturers (OEMs) are selling their production facilities to contract manufacturers (CMs). The CMs achieve high capacity utilization through pooling (supplying many different OEMs). Meanwhile, the OEMs focus on innovation: research and development, product design, and marketing. We examine how this change in industry structure affects investment in innovation and capacity, and thus profitability. In particular, innovation is noncontractible, so OEMs will invest less in innovation than is ideal for the industry as a whole. Hence, although contract manufacturing improves capacity utilization, it may reduce the profitability of the industry as a whole by weakening the incentives for innovation. Contract manufacturing is not the only means to achieve capacity pooling. Alternatively, the OEMs can pool capacity with one another through supply contracts or a joint venture. This may result in underinvestment or overinvestment in innovation and capacity, but always increases profitability. We find that the sale of production facilities to a CM improves profitability for the industry as a whole if and only if OEMs are subsequently in a strong bargaining position vis-à-vis the CM. If the OEMs are indeed very strong, the gain from pooling capacity via contract manufacturing is maximized in industries with moderate cost of capacity.

Acommon characteristic of basic material manufacturers (which account for 85% of all industrial energy use) and of cleantech manufacturers is that they are price takers in their input and output markets. Variability in those prices has implications for how much a manufacturer should invest in three fundamental types of process improvement. Input price variability reduces the value of improving input efficiency (output produced per unit input) but increases that of capacity efficiency (the rate at which a production facility can convert input into output). Output price variability increases the value of capacity efficiency, but it increases the value of input efficiency if and only if the expected margin is small. Moreover, as the expected input cost rises, the value of input efficiency decreases. A third type of process improvement is to develop flexibility in input efficiency versus capacity efficiency (the ability to respond to a rise in input cost or fall in output price by increasing inputefficiency at the expense of capacity efficiency). The value of this flexibility decreases with variability in input and output prices if and only if the expected margin is thin. Together, these results suggest that a carbon tax or cap-and-trade system may reduce investment by basic material manufacturers in improving energy efficiency. © 2013 INFORMS.

In a stylized model of biopharmaceutical contract manufacturing, this paper shows how the potential for renegotiation influences the optimal structure of supply contracts, investments in innovation and capacity, the way scarce capacity is allocated, and firms' resulting profits. Two buyers contract for capacity with a common manufacturer. Then, the buyers invest in innovation (product development and marketing) and the manufacturer builds capacity. Finally, the firms may renegotiate to allow a buyer facing poor market conditions to purchase less than the contractual commitment and a buyer facing favorable conditions to purchase more. We show that renegotiation can greatly increase the firms' investments and profits, provided that the contracts are designed correctly. Failing to anticipate renegotiation leads to contracts that allow too much flexibility in the buyer's order quantity, and perform poorly relative to contracts designed to anticipate renegotiation. We provide clear conditions under which quantity flexibility contracts with renegotiation coordinate the system. Where quantity flexibility contracts fail, employing tradable options improves performance. © 2007 INFORMS.

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.

Consider a firm developing an innovative product. Due to market pressures, production must begin soon after the product development effort is complete, which requires that an upstream supplier invests in capacity while the design of the product and production process are in flux. Because the product is ill-defined at this point in time, the firms are unable to write court-enforceable contracts that specify the terms of trade or the supplier's capacity investment. However, the firms can adopt an informal agreement (relational contract) regarding the terms of trade and capacity investment. The potential for future business provides incentive for the firms to adhere to the relational contract. We show that the optimal relational contract may be complex, requiring the buyer to order more than her demand to indirectly monitor the supplier's capacity investment. We propose a simpler relational contract and show that it performs very well for a broad range of parameters. Finally, we identify characteristics of the business environment that make relational contracting particularly valuable. © 2007 INFORMS.

This paper considers two firms that engage in joint production. The prospect of repeated interaction introduces dynamics, in that actions that firms take today influence the costliness and effectiveness of actions in the future. Repeated interaction also facilitates the use of informal agreements (relational contracts) that are sustained not by the court system, but by the ongoing value of the relationship. We characterize the optimal relational contract in this dynamic system with double moral hazard. We show that an optimal relational contract has a simple form that does not depend on the past history. The optimal relational contract may require that the firms terminate their relationship with positive probability following poor performance. We show how process visibility, which allows the firms to better assess who is at fault, can substantially improve system performance. The degree to which process visibility eliminates the need for termination depends on the nature of the dynamics: If the buyer's action does not influence the dynamics, the need for termination is eliminated; otherwise, termination may be required.

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 firms may also engage in renegotiation design, inserting simple clauses into the supply contract to shape the outcome of renegotiation. For example, when a buyer grants a financial "hostage" to the manufacturer or is charged a per diem penalty for delay in bargaining, the manufacturer captures the gain from renegotiation. "Tradable options," which grant buyers the right to trade capacity without intervention from the manufacturer, return the gain from renegotiation to the buyers. This paper proves that, under surprisingly general conditions, the firms can coordinate their investments with the simplest of supply contracts (fixed-quantity contracts). This may require renegotiation design, and certainly requires that the firms understand the breach remedy and set their contract parameters accordingly. © 2007 INFORMS.

Prominent buyers' brands have been damaged because their suppliers caused major harm to workers or the environment, e.g., through a deadly factory fire or release of toxic chemicals. How can buyers motivate suppliers to exert greater care to prevent such harm? This paper characterizes a "backfiring condition" under which actions taken by prominent buyers (increasing auditing, publicizing negative audit reports, providing loans to suppliers) motivate a supplier to exert greater effort to pass the buyer's audit by hiding information and less care to prevent harm. Intuitively appealing actions for a buyer (penalizing a supplier for harming workers or the environment, or for trying to deceive an auditor) may be similarly counterproductive. Contrary to conventional wisdom, squeezing a supplier's margin (by reducing the price paid to the supplier or increasing wages for workers) motivates the supplier to exert greater care to prevent harm-under the backfiring condition. Whereas the necessary and sufficient condition depends on the relative convexity of the supplier's hiding cost function, a simple sufficient condition is that the supplier is likely to successfully hide information from the auditor, in equilibrium. Anecdotal evidence suggests that the backfiring condition is prevalent or becoming increasingly so. Similar insights apply to mitigation of unauthorized subcontracting.

Firms have an incentive to test competitors' products to reveal violations of safety and environmental standards, in order to have competitors' products blocked from sale. This paper shows that testing by a regulator crowds out testing by competitors, and can reduce firms' efforts to comply with the product standard. Relying on competitor testing (i.e., having the regulator test only to verify evidence of violations provided by competitors) is most effective in large or concentrated markets in which firms have strong brands and high quality, and for standards that are highly valued by consumers. Under those conditions, firms tend to test competitors' products and exert high compliance effort. Conversely, unless compliance is highly valued by consumers, a firm with low quality does not draw testing from competitors, and so does not comply. Enforcing a product standard through competitor testing encourages entry by such low-quality, noncompliant firms and can reduce quality investment by incumbents. Stripping offending products of labels (such as "Energy Star"), instead of blocking them from the market, eliminates the problem of entry by low-quality, noncompliant firms, but may reduce incumbents' compliance efforts.