breach remedy, renegotiation and design of supply contracts erica l. plambeck graduate school of...
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Breach Remedy, Renegotiation and Design of Supply Contracts
Erica L. PlambeckGraduate School of Business
Stanford University
Terry A. TaylorGraduate School of Business
Columbia University
Motivation: Biopharmaceuticals 1990 BI builds capacity for tPA Activase, plans $1 B revenue Mid-90’s drug fails, BI sells plant to Immunex at a loss Late 90’s unanticipated success of Enbrel, Rituxan, etc. Dosing 10-100 times greater than expected 3-4 year leadtime to build capacity, obtain FDA approval Lonza, BI: reserve capacity 3 years in advance, steep fees some firms drop or postpone promising drug R&D projects
biotech firms invest in R+D
Lonza builds capacity
realizedemand
production
Contract Manufacturing of Biologics
contractrenegotiation
capacity allocation
+ efficient capacity utilization, pool uncertain demands
- ?
biotech firms invest in R+D
Lonza builds capacity
realizedemand
production
Contract Manufacturing of Biologics
contractrenegotiation
capacity allocation
Watch Out for “Hold Up” Problem (Plambeck & Taylor, 2001) : Outsourcing profit if buyer is “powerful”, e.g.
– CM has excess capacity or competition– or needs future business
Otherwise, firms should own capacity Contract to pool capacity: STRATEGIC and EARLY
biotech firms invest in R+D
Lonza builds capacity
realizedemand
production
Contract Manufacturing of Biologics
contractrenegotiation
capacity allocation
CHALLENGE: Design supply contracts that induce “first best” innovation and capacity investment (max. total expected profit)
SURPRISE: Often, simple reservation contracts are optimal: depends on remedy for breach of contract, bargaining power assumes common information (Plambeck & Taylor, 2003)
Specific Performance Expectation Damages
must perform contract (prohibitively large $ penalty)
pay $ to put injured firm in same financial position as if contract were performed
manufacturer must deliver Q unless buyer agrees to less
manufacturer can deliver < Q , pay for lost revenue or substitute capacity
awarded on discretionary basis for “unique” items
routine in procurement
Court Remedies for Breach of Contract
Literature Review
Efficient breach theory: ED remedy encourages promisor’s breach where the resulting profits to promisor exceed loss to promisee (Holmes, 1881)
Econ and supply chain lit implicitly assumes SP
Scholars begin to advocate routine availability of SP: efficient breach with SP through renegotiation ED is complex, undercompensatory(Varadarjan,2001) ED skews investment (Edlin&Reichelstein,1996)
Firms use reputation/relational contract to guarantee SP because courts do not (De Alessi,1994)
Conclusions
SpecificPerformance
ExpectationDamages
first best with simple reservation contracts
excess capacity,too little R&D
too little capacity,excess R&D
powerfulmanufacturer
buyers havesome
bargainingpower
first best with simple reservation contracts*
Qi
E[share of optimal capacity]
tradable options profit
* requires separability condition
Ongoing Research
Contract EARLY to avoid “Hold Up”
In designing supply contract, anticipate renegotiation
Outcome of renegotiation depends on court remedy for breach of contract (even if we never go to court)
Specific performance remedy may become routine
Ongoing Research on Outsourcing
Information asymmetry
“Relational” contracts (enforced by value of future business, not the courts)
Scope of responsibility for CM: design? procurement?
Product recovery and recycling or remanufacturingSuggestions ?