Using Option-Based Compensation to Enhance Supply Chain Efficiency
31 Pages Posted: 30 Jul 2007 Last revised: 4 Nov 2007
Date Written: November 1, 2007
This paper examines how the choice of an upstream firm's compensation structure can affect investment hold-up problems in vertical relationships. I show that employing option-based compensation can mitigate an investment hold-up problem by creating more bargaining power. Intuitively, the limited downside of an option spurs aggressive negotiation, and such aggressiveness is made more pronounced when a sunk investment renders the option out of the money if negotiations break down. The resulting increased transaction price improves the upstream profit, and the improved return on investment induces more investment of the upstream firm. Despite the higher induced transaction price, the downstream firm's profit can also improve, because the more induced investment enhances the viability of the supply chain. Such supply chain gains also naturally translate into gains in consumer surplus.
Keywords: Stock Options, Sunk Cost, Negotiation, Investment.
Suggested Citation: Suggested Citation