1. Breach Remedy, Renegotiation and Design of Supply Contracts Erica L. Plambeck Graduate School of Business Stanford University Terry A. Taylor Graduate School of Business Columbia University

2. Motivation: Biopharmaceuticals  1990 BI builds capacity for tPA Activase, plans $1 B revenue  Mid-90’s drug fails, BI sells plant to Immunex at a loss  Late 90’s unanticipated success of Enbrel, Rituxan, etc.  Dosing 10-100 times greater than expected  3-4 year leadtime to build capacity, obtain FDA approval  Lonza, BI: reserve capacity 3 years in advance, steep fees  some firms drop or postpone promising drug R&D projects

3. biotech firms invest in R+D Lonza builds capacity realize demand production Contract Manufacturing of Biologics contract renegotiation capacity allocation + efficient capacity utilization, pool uncertain demands - ?

4. biotech firms invest in R+D Lonza builds capacity realize demand production Contract Manufacturing of Biologics contract renegotiation capacity allocation Watch Out for “Hold Up” Problem (Plambeck & Taylor, 2001) :  Outsourcing  profit if buyer is “powerful”, e.g. –CM has excess capacity or competition –or needs future business  Otherwise, firms should own capacity  Contract to pool capacity: STRATEGIC and EARLY

5. biotech firms invest in R+D Lonza builds capacity realize demand production Contract Manufacturing of Biologics contract renegotiation capacity allocation CHALLENGE: Design supply contracts that induce “first best” innovation and capacity investment (max. total expected profit) SURPRISE: Often, simple reservation contracts are optimal:  depends on remedy for breach of contract, bargaining power  assumes common information (Plambeck & Taylor, 2003)

6. Specific PerformanceExpectation Damages must perform contract (prohibitively large $ penalty) pay $ to put injured firm in same financial position as if contract were performed manufacturer must deliver Q unless buyer agrees to less manufacturer can deliver < Q, pay for lost revenue or substitute capacity awarded on discretionary basis for “unique” items routine in procurement Court Remedies for Breach of Contract

7. Literature Review  Efficient breach theory: ED remedy encourages promisor’s breach where the resulting profits to promisor exceed loss to promisee (Holmes, 1881)  Econ and supply chain lit implicitly assumes SP  Scholars begin to advocate routine availability of SP:  efficient breach with SP through renegotiation  ED is complex, undercompensatory (Varadarjan,2001)  ED skews investment (Edlin&Reichelstein,1996)  Firms use reputation/relational contract to guarantee SP because courts do not (De Alessi,1994)

8. Conclusions Specific Performance Expectation Damages first best with simple reservation contracts excess capacity, too little R&D too little capacity, excess R&D powerful manufacturer buyers have some bargaining power first best with simple reservation contracts* Q i E[share of optimal capacity] tradable options  profit * requires separability condition

9. Ongoing Research  Contract EARLY to avoid “Hold Up”  In designing supply contract, anticipate renegotiation  Outcome of renegotiation depends on court remedy for breach of contract (even if we never go to court)  Specific performance remedy may become routine

10. Ongoing Research on Outsourcing  Information asymmetry  “Relational” contracts (enforced by value of future business, not the courts)  Scope of responsibility for CM: design? procurement?  Product recovery and recycling or remanufacturing Suggestions ?