Sales Contracts for Component Supply

Assume that the product in question is technically complex and that it needs to be supplied on a semicontinuous basis.52 Assume also, unless deterred by reason ot contractual disabilities, that periodic redesign and/ or eolume changes are made in response to changing environmental con- lions. Three alternative supply arrangements can be considered: a once- for-all contingent claims contract, an incomplete long-term contract, and a series of short-term contracts.

1. Contingent Claims Contracts

The limitations of complex contingent claims contracts have been set out in previous chapters (see especially Section 3.1 of Chapter 4). Bounded rationality makes it impossible, or prohibitively costly, to attempt to write the comprehensive contract in which contingent supply relations are exhaustively stipulated. Consider, therefore, an intermediate form of contracting-namely, incomplete long-term contracts which include a profit- sharing arrangement and sequential spot contracts.

2. Incomplete Long-Term Contracts

That incomplete contracts, without more, pose trading risks is obvious: the natural posture for each party is to bargain opportunistically when contractual ambiguities develop. But might the hazards of contractual incompleteness be overcome by (1) introducing a general clause into the contract to the effect that the parties agree to be guided during contract execution by joint-profit maximization considerations, and (2) inventing an appropriate sharing rule in order to induce the parties to adhere to the agreement? The purpose of such an arrangement is to encourage the parties to behave cooperatively, in a joint-profit maximizing way, when unforeseen contingencies develop.

The issue is of interest not merely for our purposes here but also because it has a bearing on what Hurwicz refers to as “incentive compati- bility” (1972, pp. 320-334; 1973, pp. 23-27). The questions of concern to urwicz are (1) whether participants to a nonatomistic market exchange, who do not openly defy the prescribed rules ( the rule of principal interest is that they behave as price takers), can successfully cheat, and (2) whether  alternative rules of market exchange can be devised which lead to Pareto optimality. He shows that price-taking rules can be successfully evaded if parties employ false preference maps (1972, pp. 324-332). He also contends that autonomous bilateral trading with a sharing rule sometimes leads to joint profit maximization (1973, pp. 25-26).

This last result crucially depends, however, on an assumption that one of the parties behaves throughout as a fully truthful price taker.54 I submit that sharing rules will not reliably lead to joint profit maximization if both parties are treated symmetrically and are allowed to enter false statements or produce false signals.55 Consider the following sharing rule arrangements:

  1. Faced with an unanticipated change in circumstances, the parties will
    • earn π1 and π2 respectively if no adaptation is made (that is, present period practices are unchanged from the previous period),
    • earn G + π1 + π2 if they adapt in such a way as to joint-profit maximize.
  2. The rules for dividing G between the parties are as follows (where 0 < a < 1):
    • party 1 will receive

a G if a G> π1 and (1-a) G + π2;

π1 if a G <π1;

G-π2 if (1-a) G<π2 (in which case party 2 gets π2 and G-π2>π1).

  • party 2 will receive

(1-a)G if (1-a)G> π2 and aG >π1 ;

π2 if (1-a)G<π2 ;

G-π1 if aG<π1 (in which case party 1 gets π1 and G-π1 >π2).

Since each party can do no worse and will usually do better by adapting and employing the sharing rule, the incomplete contract does not appear to impede efficiency or occasion costly haggling. Rather, the contrivance of a general clause and sharing rule seems to give the parties to an incom-plete long-term contract the requisite incentives to adapt efficiently in a joint- profit maximizing way.

But. as might be anticipated, there is a hitch. The foregoing assumes that π1, π2 and G are all known or can easily be estimated-while in fact they are unknown and , despite great effort and expense, can ordinarily be estimated only imperfectly. Uncertain revenue streams and, even more uncertain cost streams must be estimated, u To the extent that informai tion sets incompletely overlap – which, given task idiosyncracies and differential exposure to environmental circumstances, they clearly will – each party can be expected to supply incomplete and biased data to the estimators when this suits its purposes. Costly haggling predictably ensues. 0 Hurwicz finesses these issues by assuming that one of the parties to the transaction is continuously truthful, which is plainly heroic.

3. Sequential Spot Contracts

Both complete and incomplete once-for-all contracts thus experience difficulties. The former are flawed by the great cost of anticipating con- tingencies and specifying efficient adaptations at the outset. Despite the contrivance of a general clause and sharing rule, the latter is beset by costly haggling. Might then short-term contracts be employed instead? These presumably would permit terms to be redrawn at the contract renewal interval; new information could be appropriately taken into account as events unwind; and only a short-term forecast of the immediate future would be required.

But while short-term contracts have advantages in these respects, they also pose distinctive problems of their own. Thus, if either (1) efficient supply requires investment in special purpose, long-lived equipment, or (2) the winner of the original contract acquires a cost advantage by reason of first- mover advantages (such as a unique location or learning, including the acquisition of undisclosed or proprietary technical and managerial procedures and task-specific labor skills), resort to short-term contracts as a means of filling a semicontinuous supply requirement is unlikely to prove satisfactory.

The difficulty with condition (1) is that optimal investment considerations favor the award of a long-term contract in order to permit the supplier confidently to amortize his investment.56 57 But, as just indicated, incomplete long-term contracts pose adaptive, sequential decision-making problems. Consequently, in this instance, optimal investment and optimal sequential adaptation processes are in conflict.

Whether first-mover advantages, assuming that they exist, have any bearing on vertical integration might be disputed on the grounds that initial bidders will capitalize anticipated future gains. While this is surely correct, the argument is hardly dispositive. For one thing, unless the total supply requirements are stipulated, “buying in” strategies are risky. Also, and relatedly, the alternative supply price is not independent of the terms that the buyer may subsequently offer to rivals. Moreover, alternative supply price is merely an upper bound; an aggressive buyer may attempt to obtain a price at the level of current costs on each round. Haggling could be expected to ensue. Short-term contracts thus experience what may be serious limitations in circumstances where nontrivial first-mover advantages obtain.

It is relevant to note that the technological interdependency condition involving flow process economies between otherwise separable stages of production is really a special case of the contractual incompleteness argument. The contractual dilemma is this: On the one hand, it may be prohibitively costly, if not infeasible, to specify contractually the full range of contingencies and stipulate appropriate responses between stages. On the other hand, if the contract is seriously incomplete in these respects but, once the original negotiations are settled, the contracting parties are locked into a bilateral exchange, the divergent interests between the parties will predictably lead to individually opportunistic behavior and joint losses. The advantages of integration thus are not that technological (flow process) economies are unavailable to nonintegrated firms, but that integration harmonizes interests (or reconciles differences, often by fiat) and permits an efficient (adaptive, sequential) decision-process to be utilized. More generally, arguments favorable to integration that turn on “supply reliability” considerations commonly reduce to the contractual incompleteness issue.

Source: Williamson Oliver E. (1975), Markets and hierarchies: Analysis and antitrust implications, A Study in the Economics of Internal Organization, The Free Press.

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