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A real options model of the supply chain with revenue-sharing and volume flexibility
We analyze a revenue sharing contract within a decentralized supply chain, extending prior works to a multiperiod setting under buyer production flexibility. We model a buyer’s capacity choice and utilization under external procurement, where quantities are obtained from a supplier firm. The supplier firm chooses a revenue sharing contract with the buyer by internalizing the impact this would have on buyer decisions relating to capacity, utilization choice and the final downstream price of the product. Our framework provides a valuation of the buyer and supplier firms under uncertainty and predictions on the optimal capacity choice of firms in downstream markets and the pricing policy of upstream firms in relation to buyer capacity constraints, the volatility and growth of downstream prices, and the elasticity of demand. We find that for a fixed revenue sharing contract a high volatility of downstream demand results in higher installed capacity by the buyer to account for future flexibility to adjust production which makes a given contract more valuable for both the buyer and supplier. We generally find however a higher revenue share claimed by the supplier when downstream demand is more volatile. In an extension of this framework we also show that suppliers could impose minimum order quantities to extract value from a buyer firm by limiting buyer’s production flexibility. We also consider the decisions of a vertically integrated firm showing that the gains from vertical integration are higher when volatility is high, that is, when production flexibility is more important.