Supply contracts, profit sharing, switching, and reaction options

A common theme in the studies of flexible supply contracts has been the producer's profit-maximization problem without regard to the suppliers' reactions. However, suppliers do react and protect their downside against producer's operating policies by revising their strategies in a manner consistent with their profit-maximization objectives. This fact motivates our work. Using a real-options (contingent claims) approach, we analyze and value supply contracts in a setting characterized by exchange rate uncertainty, supplier-switching options, order-quantity flexibility, profit sharing, and supplier reaction options. We also use basic diversification concepts, from portfolio theory, to analyze risk reduction in a unique framework. Given this setup, we explicitly model how flexibility can be mutually beneficial to both the producer and the suppliers. Using this model, we concurrently solve and examine the dual optimization problem for the suppliers and the producer. Our approach also endogenizes the extent and degree of profit sharing through the resulting optimal policies. We also analyze what induces the producer and the suppliers to accept flexibility in their contracts.