Ecology studies

1
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
2
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 RD
  projects

3
Contract Manufacturing of Biologics
biotech firms invest in RD
realize demand
production
Lonza builds capacity

• efficient capacity utilization, pool uncertain
  demands
• - ?

4
Contract Manufacturing of Biologics
biotech firms invest in RD
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

5
Contract Manufacturing of Biologics
biotech firms invest in RD
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)

6
Court Remedies for Breach of Contract
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 lt Q , pay for lost revenue or substitute capacity
awarded on discretionary basis for unique items routine in procurement
7
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 (EdlinReichelstein,1996)
• Firms use reputation/relational contract to
  guarantee SP because courts do not (De
  Alessi,1994)

8
Conclusions
Specific Performance
Expectation Damages
first best with simple reservation contracts
excess capacity, too little RD
powerful manufacturer
too little capacity, excess RD
buyers have some bargaining power
first best with simple reservation
contracts Qi Eshare of optimal capacity
tradable options ? profit
requires separability condition
9
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

10
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 ?