Breach Remedy, Renegotiation and

Design of Supply Contracts

Erica L. Plambeck Terry A. Taylor

Graduate School of Business Graduate School of Business
Stanford University Columbia University
 Motivation: Biopharmaceuticals
1990 BI builds capacity for tPA Activase, plans $1 B revenue
Mid-90s drug fails, BI sells plant to Immunex at a loss
Late 90s 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 realize

renegotiation production
invest in R+D contract demand

Lonza builds capacity

capacity allocation

+ efficient capacity utilization, pool uncertain demands

-?
 Contract Manufacturing of Biologics

biotech firms realize

renegotiation production
invest in R+D contract demand

Lonza builds capacity

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 realize

renegotiation production
contract invest in R+D demand

Lonza builds capacity

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

must perform contract pay $ to put injured firm in
(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
promisors 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

 Conclusions

Expectation Specific
Damages Performance

powerful first best with simple excess capacity,

manufacturer reservation contracts too little R&D

buyers have too little capacity, first best with simple

some excess R&D reservation contracts*
bargaining
power tradable options Qi
profit 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 ?