Option pricing with downward-sloping demand curves: the case of supply chain options

Option pricing with downward-sloping demand curves: the case of supply chain options

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Article ID: iaor20073464
Country: United States
Volume: 51
Issue: 4
Start Page Number: 566
End Page Number: 580
Publication Date: Apr 2005
Journal: Management Science
Authors: ,
Keywords: supply & supply chains, game theory
Abstract:

This article investigates the role of option contracts in a supply chain when the demand curve is downward sloping. We consider call (put) options that provide the retailer with the right to reorder (return) goods at a fixed price. We show that the introduction of option contracts causes the wholesale price to increase and the volatility of the retail price to decrease. In general, options are not zero-sum games. Conditions are derived under which the manufacturer prefers to use options. When this happens the retailer is also better off, if the uncertainty in the demand curve is low. However, if the uncertainty is sufficiently high, then the introduction of option contracts alters the equilibrium prices in a way that hurts the retailer.

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