Transcript Plambeck - Stanford University

Breach Remedy, Renegotiation and
Design of Supply Contracts
Erica L. Plambeck
Terry A. Taylor
Graduate School of Business
Stanford University
Graduate 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
Contract Manufacturing of Biologics
biotech firms
invest in R+D
contract
realize
demand
Lonza builds
capacity
renegotiation
production
capacity
allocation
+ efficient capacity utilization, pool uncertain demands
-?
Contract Manufacturing of Biologics
biotech firms
invest in R+D
contract
realize
demand
Lonza builds
capacity
renegotiation
production
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
Contract Manufacturing of Biologics
biotech firms
contract invest in R+D
realize
demand
Lonza builds
capacity
renegotiation
production
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)
Court Remedies for Breach of Contract
Specific Performance Expectation Damages
pay $ to put injured firm in
must perform contract
(prohibitively large $ penalty) same financial position as if
contract were performed
manufacturer must deliver Q manufacturer can deliver
unless buyer agrees to less
< Q , pay for lost revenue
or substitute capacity
awarded on discretionary
routine in procurement
basis for “unique” items
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
Expectation
Damages
powerful
manufacturer
buyers have
some
bargaining
power
Specific
Performance
first best with simple
reservation contracts
excess capacity,
too little R&D
too little capacity,
excess R&D
first best with simple
reservation contracts*
tradable options
 profit
Qi
E[share of optimal capacity]
* 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 remanufacturing
Suggestions ?