Publisher Summary This chapter reviews the supply chain coordination with contracts. Numerous supply chain models are discussed. In each model, the supply chain optimal actions are identified. The chapter extends the newsvendor model by allowing the retailer to choose the retail price in addition to the stocking quantity. Coordination is more complex in this setting because the incentives provided to align one action might cause distortions with the other action. The newsvendor model is also extended by allowing the retailer to exert costly effort to increase demand. Coordination is challenging because the retailer's effort is noncontractible—that is, the firms cannot write contracts based on the effort chosen. The chapter also discusses an infinite horizon stochastic demand model in which the retailer receives replenishments from a supplier after a constant lead time. Coordination requires that the retailer chooses a large basestock level.

Supply Chain Coordination with Contracts

This paper discusses firm behavior, market performance, and the public and private institutions that arise in systems markets, i.e., markets where consumers use compatible components together to generate benefits. In such markets, which include communications networks and 'hardware/software' networks, popular products are inherently more valuable. These 'network effects' can drive corporate strategies and are critical in understanding innovation in many high-technology markets. The discussion here emphasizes the dynamics of consumer adoption decisions in the presence of network effects, competition between incompatible systems, and how suppliers choose which components are compatible and which are not.

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Systems Competition and Network Effects

How open is innovation

Under a revenue-sharing contract, a retailer pays a supplier a wholesale price for each unit purchased, plus a percentage of the revenue the retailer generates. Such contracts have become more prevalent in the videocassette rental industry relative to the more conventional wholesale price contract. This paper studies revenue-sharing contracts in a general supply chain model with revenues determined by each retailer's purchase quantity and price. Demand can be deterministic or stochastic and revenue is generated either from rentals or outright sales. Our model includes the case of a supplier selling to a classical fixed-price newsvendor or a price-setting newsvendor. We demonstrate that revenue sharing coordinates a supply chain with a single retailer (i.e., the retailer chooses optimal price and quantity) and arbitrarily allocates the supply chain's profit. We compare revenue sharing to a number of other supply chain contracts (e.g., buy-back contracts, price-discount contracts, quantity-flexibility contracts, sales-rebate contracts, franchise contracts, and quantity discounts). We find that revenue sharing is equivalent to buybacks in the newsvendor case and equivalent to price discounts in the price-setting newsvendor case. Revenue sharing also coordinates a supply chain with retailers competing in quantities, e.g., Cournot competitors or competing newsvendors with fixed prices. Despite its numerous merits, we identify several limitations of revenue sharing to (at least partially) explain why it is not prevalent in all industries. In particular, we characterize cases in which revenue sharing provides only a small improvement over the administratively cheaper wholesale price contract. Additionally, revenue sharing does not coordinate a supply chain with demand that depends on costly retail effort. We develop a variation on revenue sharing for this setting.

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Supply Chain Coordination with Revenue-Sharing Contracts: Strengths and Limitations

There has been a recent surge of interest in open source software development, which involves developers at many different locations and organizations sharing code to develop and refine programs. To an economist, the behavior of individual programmers and commercial companies engaged in open source projects is initially startling. This paper makes a preliminary exploration of the economics of open source software. We highlight the extent to which labor economics, especially the literature on ‘career concerns’, and industrial organization theory can explain many of these projects’ features. We conclude by listing interesting research questions related to open source software.

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Some Simple Economics of Open Source

U.S. patent reform over the past two decades has strengthened the legal enforcement of patent rights and has extended protection to new subject matter, such as genetically engineered life ...

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The Economics of Patents: Lessons from Recent U.S. Patent Reform

This article extends the theory of optimal patents to allow for costly imitation of patented innovations. With costly imitation, a rival's decision to imitate depends on the length of patent protection awarded to the patentee: the longer the patent life, the more likely it is that rivals will "invent around" the patented product. Extending patent life, therefore, may not provide the innovator with increased incentives to research or to patent the innovation. In this case, I find that optimal patent lives are sufficiently short to discourage imitation. With both patent length and breadth as instruments, the optimal policy consists of broad patents (no imitation allowed) with patent lives adjusted to achieve the desired reward. These results are in sharp contrast to recent results on the optimality of narrow, infinitely long patents.

Patent Policy and Costly Imitation

Licensing contracts for newly patented innovations are observed to vary along several dimensions, including the form and size of the payment to the inventor (fixedfee versus some output-based royalty), the degree of exclusivity, and the division of rents. In this article, we show that theform of the contract can be explained by two problems in technology exchange: the superiority of a licensor's precontractual information about the economic value of the innovation and thefact that sharing this information with the licensee mayfacilitate imitation. We show that a licensor signals her technology type with an output-based payment (or royalty) and may leave some of the rents with the licensee. Conditions under which exclusive license contracts (linear and nonlinear) and nonexclusive linear contracts are used to transfer technology are identified.

Technology transfer under asymmetric information

The potential of an incumbent firm to retain its dominant position in a market is a focal point of the modem theory of industrial organization. A recent literature examines this issue for markets in which challengers threaten an incumbent's position by engaging in research for a new technology. Richard Gilbert and David Newbery (1982) show that an incumbent firm with a firstmover advantage will preempt potential entrants by inventing a new technology slightly earlier than would its rivals. In a stochastic R D therefore its introduction does not alter the decision to research. When the pre-innovation market is characterized by an incumbent and potential entrants, Stephen Salant (1984) shows that licensing ex post to innovation can alter the research decision as anticipation of the returns from future licensing encourages research by the entrant. As a counterpoint to the Salant result, I find that licensing ex ante to research may discourage further research by the entrant. Indeed, this strategic incentive for licensing may be so strong as to persuade the incumbent as well as the entrant to terminate research activity. To isolate this incentive for licensing from the one discussed by Salant, a simple model is constructed in which licensing of future technologies is not desirable. Anecdotal evidence suggests that the strategic incentive does lead innovators in some markets to license their technologies. Examples of this information sharing are prevalent in markets where technological change is rapid. In the 1940's, Standard Oil of New Jersey discovered a process for synthetic rubber. It traded patent rights on this process for a synthetic oil production process discovered by Farben, a German rubber company. In both the synthetic oil and synthetic rubber markets, rival companies were *Department of Economics, Scarsborough College, University of Toronto, Toronto, Ontario, Canada, M5S lAl. I thank Jon Cohen and Ron Saunders for discussions that inspired this paper. I am also grateful to Yehuda Kotowitz, Andy McLennan, Jennifer Reinganum, Ralph Winter, Myma Wooders, two anonymous referees, and seminar participants at the University of Toronto for helpful comments on earlier drafts.

Deterrence by Market Sharing: A Strategic Incentive for Licensing

This article analyzes licensing in a noncooperative R&D game. We ask two questions. What are the incentives for licensing a production technology and what is the impact of licensing on the pattern of innovation and the consequent evolution of industry costs and market structure? The gainsfrom trading information through licensing contracts are achieved through the replacement of inefficient production techniques (the ex post incentive) and the elimination of inefficient research expenditures (the ex ante incentive). In a duopoly the availability of licensing encourages research when the firms' initial production technologies are close in costs and discourages research when initial costs are asymmetric.

Nancy Gallini

Papers

The Economics of Patents: Lessons from Recent U.S. Patent Reform

Patent Policy and Costly Imitation

Technology transfer under asymmetric information

Deterrence by Market Sharing: A Strategic Incentive for Licensing

Licensing in the theory of innovation