Supplier Competition with Option Contracts for Discrete Blocks of Capacity

When a firm faces an uncertain demand, it is common to procure supply usingsome type of option in addition to spot purchases. A typical version of this probleminvolves capacity being purchased in advance, with a separate payment made that appliesonly to the part of the capacity that is needed. We consider a discrete version of thisproblem in which competing suppliers choose a reservation price and an execution pricefor 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 atexecution prices that match their costs, making profits only from the reservation part oftheir bids. Finally we show that in an equilibrium the buyer selects the welfare maximizingset of blocks.Restricted Access: Metadata Onl