Professor, Washington University in St. Louis
This presentation discusses recent research on a theory that explains how automakers apportion raw material cost fluctuations that their suppliers face and empirically tests that theory using a unique data set of procurement contracts at BMW. The basic premises behind our explanations are that both demands for particular models of cars and the prices of raw materials that are used to produce these cars fluctuate over time and that automakers respond to shifting market conditions by adjusting output, which is something we document empirically. The extent of this adjustment depends on the contracts automakers use to procure parts. The auto industry broadly uses two types of supply agreements: the price adjustment agreement (PA) and the material plus surcharge agreement (MPS). The marginal price with either contract is cost plus surcharge. The difference is that the “cost” with the MPS (PA) contract is indexed to the supplier’s actual (expected) cost. When raw material cost information is symmetric, we show that the MPS contract is a better choice for the automaker because it maximizes the total surplus. Often, however, automakers are not privy to the costs that suppliers pay for raw materials, i.e., cost information is asymmetric. In such cases, the automaker faces a trade-off between the efficiency that is lost by choosing the PA contract and the information rent that she must pay by selecting the MPS contract. The following factors emerge as critical determinants in an automaker’s contract choice: raw material cost variability, the supplier’s reservation payoff, the elasticity of consumer demand, and information asymmetry. We conclude by empirically testing our predictions on a unique data set of contractual arrangements provided to us by BMW.