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A supplier must invest and build specific capacity for its buyer to lower variable production cost long before uncertainties have been resolved. Bearing the upfront capacity and cost-reduction investment costs, the supplier under-builds the specialized capacity and under-invests in cost reduction. To resolve this issue, the supply chain partners often rely on informal agreements plus ex post renegotiation. This paper shows that neither quantity commitment only or price only initial agreement can induce the supplier to invest and build specific capacity at the channelefficient level. The supplier will over-invest but under-build the specific capacity under quantity commitment only contracts, and will under-invest but over-build the specific capacity under priceonly initial contracts. There exists an initial quantity plus price contract or option contract that induces the supplier to build the capacity and invest in cost reduction at the first-best level with or without ex post renegotiation. To improve the channel efficiency, the firms will renegotiate ex post with probability one under the quantity plus contract, but will renegotiate only if realized demand is high so that options are exercised up.

Specific Capacity Investment in Supply Chains With Renegotiation