Contracts and Capacity Investment in Supply Chains

Suppliers are often reluctant to invest in capacity if they feel that they will be unable to recover their initial investment costs in subsequent negotiations with buyers. In theory, a number of different coordinating contracts can solve this issue and induce first best investment levels by the supplier. In this study, we experimentally evaluate the performance of these contracts in a twostage supply chain. We develop an experimental design where retailers and suppliers bargain over contract terms, and both roles have the ability to make multiple back-and-forth offers while also providing feedback on the offers they receive. Our main result suggests that an option contract, where the retailer promises to pay a fixed fee to the supplier when the supplier opts to invest in capacity, is best at increasing investment levels and overall supply chain profits. Furthermore, after investigating the evolution of offers during bargaining, we observe that participants tend to place particular emphasis on “superficial fairness.” Specifically, participants focus more on setting a wholesale price that is in the middle of the available contracting space, while largely ignoring the coordinating contract parameter. We show that this behavioral tendency drives the favorable performance of the option contract, and proceed to investigate this superficial fairness hypothesis in three additional out-of-sample experiments and find that it explains the data well.