Breach Remedy, Renegotiation and Design of Supply Contracts

1. Breach Remedy, Renegotiation and Design of Supply Contracts Erica L. Plambeck Graduate School of Business Stanford University Terry A. Taylor Graduate School of Business Columbia University

2. 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

3. Contract Manufacturing of Biologics contract renegotiation capacity allocation biotech firms invest in R+D realize demand production Lonza builds capacity + efficient capacity utilization, pool uncertain demands - ?

4. Contract Manufacturing of Biologics contract renegotiation capacity allocation biotech firms invest in R+D realize demand production Lonza builds capacity 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

5. Contract Manufacturing of Biologics contract renegotiation capacity allocation biotech firms invest in R+D realize demand production Lonza builds capacity 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)

6. Court Remedies for Breach of Contract

7. 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)

8. Conclusions Expectation Damages Specific Performance first best with simple reservation contracts excess capacity, too little R&D powerful manufacturer buyers have some bargaining power too little capacity, excess R&D first best with simple reservation contracts* Qi E[share of optimal capacity] tradable options profit * requires separability condition

9. 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

10. 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 ?