Risk Aversion and Supply Chain Contract Negotiation

Abstract

We employ the Nash bargaining solution to determine the value of an opportunity to negotiate a contract in an archetypal supply chain game. This unifies the allocation of payoffs and the selection of the type of contract in a bilateral supply chain; a supplier delivers goods to a news vendor retailer who stocks in anticipation of stochastic seasonal demand. Both firms have concave, ordinal utility functions which allows us to model both risk-neutrality and risk-aversion. We characterize the Nash-optimal contracts, and contrast the cases where both firms are risk-neutral and where at least one of the firms is risk-averse. Risk aversion, it turns out, has a significant impact on the contract terms and one firm's risk aversion may be advantageous to the other. This suggests that each firm should strive to find a supply chain partner based on its own and its prospective partner's sensitivities to risk. For example, risk-neutral firms have an incentive to avoid other risk-neutral firms as their supply chain partners.

Keywords: Supply chain coordination, risk-aversion, supply contracts, bargaining