Flexibility and coordination in a supply chain with bidirectional option contracts and service requirement

Option contracts have been increasingly employed by supply chain firms as a popular strategy to hedge against the risk of unanticipated demand. This paper examines the impact of bidirectional option contracts on a two echelon supply chain consisting of a supplier and a retailer taking into consideration of a service requirement. We characterize the optimal solutions for the retailer and the supplier with and without bidirectional option contracts in the presence of a service requirement. By benchmarking to the model without bidirectional options, we explore the effect of bidirectional option contracts on the supply chain. Our study shows that the service level with bidirectional option contracts is equivalent to (higher than) that without them when the service requirement is (not) binding. In addition, bidirectional option contracts are indeed beneficial to both the retailer and the supplier. Furthermore, by investigating the effect of the service level on the supply chain, we find that the maximum expected profit of the retailer is non-increasing in the service requirement while that of the supplier is non-decreasing in the service requirement, either with or without bidirectional option contracts. Finally, a distribution-free coordination condition is proposed to achieve the Pareto improvement in the presence of bidirectional option contracts and a service requirement.