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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. Motivation: Biopharmaceuticals. 1990 BI builds capacity for tPA Activase, plans $1 B revenue
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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
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 contract renegotiation capacity allocation biotech firms invest in R+D realize demand production Lonza builds capacity + efficient capacity utilization, pool uncertain demands - ?
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
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)
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 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
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 ?