Strategic decentralization, bargaining, and transfer pricing in supply chain efficiency

This thesis examines the role of strategic decentralization, bargaining, and transfer pricing in supply chain efficiency. The first essay analyzes how strategic delegation using stock options can affect investment hold-up problems in vertical relationships. In vertical relationships, underinvestment problems can arise because sunk investment costs are ignored in ex post negotiation. However, the delegation of bargaining rights to the upstream manager coupled with stock options makes the sunk investment costs relevant costs from the manager's perspective. The sunk investment costs are now reversible depending on his exercise decision. Thus, under option-based compensation, the relevant investment costs create the upstream manager's bargaining power and thereby increase transaction price in negotiation. The resulting increased transaction price improves the upstream profit and the improved return on investment induces greater investment by the upstream firm. Despite the higher induced transaction price, the downstream firm's profit can also improve because the greater induced investment enhances the viability of the supply chain. Such supply chain gains also naturally translate into gains in consumer surplus.The second essay investigates the role of decentralization and vertical licensing in a durable goods market. A monopolist in a durable goods market faces an over-investment problem in its R&D decision because it cannot commit to a value of a new investment in the future which makes its own product obsolete. This paper demonstrates that decentralization and vertical licensing can help address the overinvestment problem and increase a firm's profit. An internal conflict caused by decentralization is a natural commitment tool for the monopolist to keep its investment level down. However, decentralization can also lower the investment too far. In such cases, permitting vertical licensing from the R&D division to a potential rival enables the firm to better manage its investment level. The competition induced by vertical licensing decreases the downstream division's profit but the advantage to the R&D division from added investment and an expanded market dominates. The result implies that often observed decentralization and licensing across rivals can be a means of overcoming the time inconsistency problem in a firm's R&D activities.The third essay shows the role of decentralization in coordinating market competition and vertical efficiency. There are many circumstances in which manufacturers provide inputs to wholesale customers only to subsequently compete with these wholesale customers in the retail realm. Such dual distribution arrangements commonly suffer from excessive encroachment in that the manufacturer's ex post retail aggression is harmful ex ante because it undercuts potential wholesale profits. This paper demonstrates that with dual distribution, a manufacturer can benefit from decentralized control and the use of transfer prices above marginal cost. Though these arrangements often create coordination concerns, a moderate presence of such concerns permits the manufacturer to credibly convey to its wholesale customer that it will not excessively encroach on its retail territory. This, in turn, permits the manufacturer to reap greater wholesale profits. We also note that this force can point to a silver lining in arm's length (parity) requirements on transfer pricing in that they can solidify commitments to a particular retail posture.