Supplier Competition with Option Contracts for Discrete Blocks of Capacity

What is it about?

When a firm faces an uncertain demand, it is common to procure supply using some type of option in addition to spot purchases. A typical version of this problem involves capacity being purchased in advance, with a separate payment made that applies only to the part of the capacity that is needed. We consider a discrete version of this problem in which competing suppliers choose a reservation price and an execution price for blocks of capacity, and the buyer, facing known distributions of demand and spot price, needs to decide which blocks to reserve. We show how to solve the buyer's (combinatorial) problem efficiently and also show that suppliers can do no better than offer blocks at execution prices that match their costs, making profits only from the reservation part of their bids. Finally we show that in an equilibrium the buyer selects the welfare maximizing set of blocks.

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Why is it important?

When a buyer is uncertain about demand and pays in advance to reserve capacity, it is attractive to have a portfolio of suppliers, including some with a high execution price if their reservation price is low enough. Capacity from the high-priced suppliers will only be used if demand turns out to be very high. In this paper, we consider suppliers with different characteristics who compete to supply blocks of capacity. The discreteness of the problem requires a combinatorial approach. The authors show that, when there is a requirement for the buyer to purchase a whole block of capacity, suppliers should offer capacity at execution prices that match their costs, so that the suppliers only make profits from the reservation part of their bids. Moreover, at the equilibrium the buyer chooses the welfare maximizing set of blocks.