Supply Chain Contracting in Environments with Volatile Input Prices and Frictions

Problem description: Purchase costs of raw materials required in production tend to fluctuate over time. Mild cost fluctuations merely affect firms’ profitability. Significant variations can lead to supply chain disruption. What are the best contracts to be used in supply chains exposed to fluctuating raw material costs? We ask this question in two contexts—in the presence and the absence of working capital constraint. Academic/practical relevance: We add a framework on how to optimally contract in the presence of stochastic costs and working capital constraints and help managers understand how they can increase profitability. Methodology: We present a game-theoretic study of a bilateral monopoly supply chain with stochastic demand, stochastic input costs, production lead times, and working capital constraints. The upstream firm announces a supply contract to which the downstream firm responds with an order quantity. The contract is a single-price, multi-instrument contract with optional default penalties...