Breach Remedy, Renegotiation and Design of Supply Contracts

Erica L. PlambeckGraduate School of Business

Stanford University

Terry A. TaylorGraduate 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

biotech firms invest in R+D

Lonza builds capacity

realizedemand

production

Contract Manufacturing of Biologics

contractrenegotiation

capacity allocation

+ efficient capacity utilization, pool uncertain demands

- ?

biotech firms invest in R+D

Lonza builds capacity

realizedemand

production

Contract Manufacturing of Biologics

contractrenegotiation

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

biotech firms invest in R+D

Lonza builds capacity

realizedemand

production

Contract Manufacturing of Biologics

contractrenegotiation

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)

Specific Performance Expectation Damages

must perform contract (prohibitively large $ penalty)

pay $ to put injured firm in same financial position as if contract were performed

manufacturer must deliver Q unless buyer agrees to less

manufacturer can deliver < Q , pay for lost revenue or substitute capacity

awarded on discretionary basis for “unique” items

routine in procurement

Court Remedies for Breach of Contract

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

SpecificPerformance

ExpectationDamages

first best with simple reservation contracts

excess capacity,too little R&D

too little capacity,excess R&D

powerfulmanufacturer

buyers havesome

bargainingpower

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 remanufacturingSuggestions ?