Long-Term Contracting: The Role of Private Information in Dynamic Supply Risk Management

Abstract

We examine the critical role of evolving private information in managing supply risk. The problem features a dyadic channel where a dominant buyer operates a multiperiod inventory system with lost sales and fixed cost. He replenishes from a supplier, whoseprivate stateof production is vulnerable to random shocks andevolves dynamicallyover time. We characterize the optimal inventory policy with a simple semi-stationary structure; it distorts order quantity for limiting information rent only in the initial period; the optimal payment compensates for production cost in every period but concedesrealinformation rent only in the initial period. These properties allow us to derive an easy-to-implement revenue-sharing contract that facilitatesex antestrategic planning andex postdynamic execution. This work advances our understanding on when and how to use private information in dynamic risk management.