Discrete Dynamics in Nature and Society

Volume 2015 (2015), Article ID 502021, 16 pages

http://dx.doi.org/10.1155/2015/502021

## Supply Chain Bilateral Coordination with Option Contracts under Inflation Scenarios

School of Management and Economics, University of Electronic Science and Technology of China, Chengdu 611731, China

Received 28 January 2015; Accepted 21 April 2015

Academic Editor: Chuanxi Qian

Copyright © 2015 Nana Wan and Xu Chen. This is an open access article distributed under the Creative Commons Attribution License, which permits unrestricted use, distribution, and reproduction in any medium, provided the original work is properly cited.

#### Abstract

There exist obvious changes in price and demand during the inflationary period, both of which are regarded as the key factors leading to supply chain uncertainty. In this paper, we focus our discussion on price increase and demand contraction caused by inflation, integrate the effect of inflation and option contracts within the model framework, and analyze how to use option contracts to achieve supply chain coordination under inflation scenarios. We consider a one-period two-stage supply chain consisting of one supplier and one retailer and explore the effect of inflation on the optimal ordering and production decisions under three different types of contracts: wholesale price contracts, option contracts, and portfolio contracts. Moreover, we explore the impact of option contracts on the supply chain through using wholesale price contracts model as the benchmark. We find that the retailer prefers adopting portfolio contracts, but the supplier prefers providing option contracts under inflation scenarios. Ultimately, option contracts will be implemented owing to the supplier’s market dominant position. In addition, we discuss the supply chain bilateral coordination mechanism with option contracts from the perspectives of two members and derive that option contracts can coordinate the supply chain and achieve Pareto improvement under inflation scenarios.

#### 1. Introduction

Along with the continued development of economic globalization, economy in one country is more susceptible to what happens in other countries. Owing to the global financial crisis, inflation has been emerging in recent years. This is true not only in developing countries but also in developed countries. According to the latest reports by Statistics, the global inflation rate from 2004 to 2014 has always deviated far from 2% inflation target [1], which suggests that inflation has a negative impact on the enterprise operation and poses a threat to the real economics. As we have seen, a lot of issues seem to appear as the inflationary pressure spreading to all aspects of the economy. The most obvious changes that occur during inflation are price and demand, both of which are considered as the significant factors impacting supply chain risk. We can observe that there exists a remarkable increase in price due to the effect of inflation. Over the past few years, food prices have climbed to previously unknown heights and nonfood prices have gone up dramatically around the world. People need to spend more money to buy the same goods and services than they did in the past. Moreover, we can also observe that there exists a remarkable decrease in demand due to the effect of inflation. In recent years, sales of many items such as clothing and cars continue to shrink and a large number of firms are trapped in the survive crisis. The main reason for this feature is because wages fail to keep up with rising price under inflation scenarios, which results in the relative decline of individual incomes and the direct reduction of purchasing powers. Since companies are inseparable from their partners, the effect of inflation can exert great influence on the daily operations of the supply chain. Thus, how to manage these two risks just mentioned becomes the key issue that needs to be addressed urgently in supply chain management applications. So far, the effect of inflation has been studied in inventory management applications, but it has not been addressed in supply chain management applications. Motivated by this, we plan to study how the supply chain members make the optimal decision policies under inflation scenarios.

Options have been demonstrated to be a viable instrument to protect against the effect of inflation in financial applications [2]. We introduce option contracts into supply chain management to hedge the risk of price increase and demand contraction caused by inflation. It is worth noting that options in supply chain management applications, different from options in financial applications, are considered as real options. In addition, option contracts are always classified into three categories [3, 4] and we limit our discussion to call option contracts in this paper. Option contracts can help the demand-side obtain the goods after the market demand is realized and provide the demand-side with more flexibility to accommodate changing market. Option contracts can also help the supply-side make a production plan that maximizes its own profit and provide the supply-side with more flexibility to reduce the production cost. In the real world, many famous companies such as HP [5], Sun [6], and IBM [7] adapt derivatives of option contracts to purchase various inputs such as memory chips and scanner assemblies. Since then, extensive attentions from scholars are paid to option contracts. So far, there are many papers relating to option contacts under various scenarios in supply chain management applications. However, all these papers do not consider the effect of inflation. Motivated by this, we plan to study whether option contracts are an efficient tool to resolve channel conflicts and achieve channel coordination under inflation scenarios.

On the other hand, the coordination problem has always been an important part in the study on supply chain management. As we know, there exists double marginalization phenomenon under the decentralized decision-making [8]. The primary purpose of channel coordination is to prompt the members involved to carry out the actions which are consistent with the supply chain’s objective [9]. To the best of our knowledge, except for some scenarios such as random yield, the supply-side is always assumed to adopt the make-to-order production policy and commit to manufacturing the products up to the order requirement of the demand-side under various contract types such as buyback contracts and revenue sharing contracts. In this case, supply chain coordination can be achieved only when the demand-side decision under the decentralized situation is the same as the integrated decision under the centralized situation. At this moment, how to make a nonintegrated supply chain coordinate is simplified to the supply chain unilateral coordination from the demand-side perspective. However, the supply-side has a strong incentive to decide the production quantity according to the profit maximization rule in the presence of option contracts. The major reason is because option contracts give the right, not the obligation, to obtain the items and so the demand-side may not exercise all the options purchased. Obviously, this poses a challenge on the implementation of supply chain unilateral coordination mechanism in the presence of option contracts. Motivated by this, we design the supply chain bilateral coordination mechanism from the perspective of both the demand-side and the supply-side in the presence of option contracts.

In this paper, we consider one-period two-stage supply chain which contains one supplier and one retailer. Considering price increase and demand contraction due to the effect of inflation, we introduce option contracts into supply chain decision-making in order to hedge against these risks just mentioned. This paper mainly solves the following problems.(1)What are the optimal ordering and production policies for the supply chain members in the presence of option contracts under inflation scenarios?(2)What are the optimal expected profits for the supply chain members in the presence of option contracts under inflation scenarios?(3)What effect does inflation have on the optimal ordering and production policies?(4)What effect do option contracts have on supply chain under inflation scenarios?(5)How should option contracts be set to achieve supply chain coordination under inflation scenarios?

The main contributions of our work are as follows.(1)To the best of our knowledge, there are no published papers that study the use of option contracts to protect against the effect of inflation in supply chain management applications. We develop supply chain models that incorporate the effect of inflation and option contracts in this paper. Our objective is to provide management insights into the effect of inflation and option contracts on the supply chain.(2)We explore the effect of inflation on the retailer’s optimal ordering policy and the supplier’s optimal production policy and gain many management interesting results.(3)We explore the impact of option contracts on the supply chain through using wholesale price contracts model as the benchmark and discuss which kind of contracts is more suitable for supply chain members under inflation scenarios.(4)We design the bilateral coordination mechanism from the perspective of both the supplier and the retailer and achieve an efficient channel under inflation scenarios.

The remaining part of this paper is structured as follows. A summary of related literature is presented in Section 2. The model formulation and assumptions are given in Section 3. We establish supply chain models with three different contracts and explore the effect of inflation on the optimal decision policies in Section 4. We discuss the impact of option contracts on the supply chain decisions and performance in Section 5. Coordination conditions with option contracts under inflation scenarios are considered in Section 6. We provide a numerical example to illustrate the effect of inflation on the optimal decisions and the optimal expected profits in Section 7. We conclude our findings in Section 8 and highlight possible future work.

#### 2. Literature Review

We first review the literature on enterprise operation management under inflation scenarios. Dey et al. [10] solve a deteriorating inventory problem with two warehouses considering time value of money and interval-valued lead time under inflation. Jaggi and Khanna [11] formulate an inventory model for deteriorating items with inflation-induced demand when trade credit policy and time discounting with allowable shortages are considered. Yang et al. [12] investigate the optimal replenishment policy with stock-dependent consumption rate under inflation when partial backlogging is considered. Sarkar et al. [13] establish an EMQ model with time-dependent demand and an imperfect production process under inflation and time value of money. Tripathi [14] investigates the optimal pricing and ordering decisions for a deteriorating inventory when demand is a function of price inflation and delay in payment is permissible. Taheri-Tolgari et al. [15] study the production problem for imperfect items where inflation and inspection errors are considered. Mirzazadeh [16] deals with a deteriorating inventory model with inflation-dependent demand and partial backlogging under stochastic inflationary conditions. Guria et al. [17] present an inventory policy considering inflation and selling price-dependent demand under deterministic and stochastic planning horizons. Mousavi et al. [18] use the mixed binary integer mathematical programming approach to resolve multi-item multiperiod inventory control problem considering quantity discounts, interest, and inflation factors. Gilding [19] proposes the optimal inventory replenishment schedule with time-dependent demand and inflation in a finite time horizon. Pal et al. [20] formulate a production inventory model with the effect of inflation under fuzzy environment. These papers are from the viewpoint of inventory management and mainly focus on the optimal replenishment or production strategy for one single enterprise under inflationary conditions. They do not consider the effect of inflation on a supply chain. In addition, they do not also consider option contracts.

We now examine the literature on supply chain management with option contracts. Li et al. [21] investigate the value of forward contracts and option contracts on a supplier-retailer system with asymmetric information, in which both members face price and demand uncertainty. Zhao et al. [22] adopt a cooperative game method to study the coordination problem with option contracts. They find that option contracts can coordinate the supply chain to achieve Pareto improvement. Xu [23] obtains the optimal procurement and production decisions in a supplier-manufacturer system under option contracts when the uncertainties such as the supplier’s production yield, the instant price, and the market demand are considered. Fu et al. [24] concentrate on a single-period portfolio procurement problem and then extend the discussion to a two-period setting when both the demand and the spot price are random. Xia et al. [25] analyze how to share the supply disruption risk and the demand random risk under two different contract mechanisms: wholesale price contracts and option contracts. They find that the benefit of reliable supplier depends on the type of contracts and the buyer prefers the reliable supplier under option contracts. Chen and Shen [26] describe that portfolio contracts bring more benefit for the supply chain members than wholesale price contracts in the presence of a service requirement. They also consider the conditions for the channel coordination with a service requirement. Liang et al. [27] analyze the value of option contracts on the relief material supply chain and find that option contract mechanism can help reduce the impact of disaster and maintain social stability. Lee et al. [28] study the multiple-supplier procurement problem with capacity constraints and fixed ordering costs, when option contracts and spot market are simultaneously used by the buyer. Liu et al. [29] introduce option contracts into container planning mechanism and analyze the application strategies of unilateral and bidirectional option contracts in different practical scenarios. Chen et al. [30] investigate how to apply option contracts to coordinate a channel which contains one supplier and one loss-averse retailer. Hu et al. [31] establish the decision-making model in a manufacturer-retailer system with option contracts and partial backordering when both the production yield and the market demand are stochastic. These papers do not discuss the effect of inflation on a supply chain.

We eventually review the literature on supply chain coordination with contracts. Several contracts such as revenue sharing contracts and buyback contracts are proved to be an efficient approach to coordinate the supply chain under different scenarios. Linh and Hong [32] study how to coordinate a supply chain through revenue sharing contracts in the two-period setting. Xiao et al. [33, 34] design a mechanism to coordinate a manufacturer-retailer system through buyback contracts and investigate the effects of the consumer return on the coordination strategy. Chiu et al. [35] describe how the policy which contains wholesale price, channel rebate, and returns can achieve the supply chain coordination with both additive and multiplicative price-dependent demands. A comprehensive analysis on supply chain coordination with contracts can be found in Cachon [36]. In these papers, the discussion on the seller’s production decision is neglected and only the buyer’s order quantity needs coordination. However, the seller can plan the production schedule that maximizes its own profit in the presence of option contracts. To the best of our knowledge, only two papers [26, 30] discuss how to coordinate both the buyer’s ordering quantity and the seller’s production quantity. All the other papers considering option contracts assume that the seller adopts the make-to-order production policy. However, these two papers above do not consider both option contracts and portfolio contracts simultaneously. In addition, all the papers do not discuss the effect of inflation on the supply chain.

#### 3. Model Formulation and Assumptions

We consider a one-period two-stage supply chain, in which one supplier manufactures one type of seasonal products, and one retailer purchases from the upstream supplier and sells to the downstream consumers. The retailer obtains the products through three different contracts, respectively: wholesale price contracts, option contracts, and portfolio contracts consisting of wholesale price contracts and option contracts. Under wholesale price contracts, the retailer places a firm order, denoted as , at unit wholesale price before the selling period. Then, the supplier receives the firm order and manufactures the products up to at unit production cost . When the selling period starts, the retailer obtains the products through the firm order. Under option contracts, the retailer only purchases call options, denoted as , at unit purchase price before the selling period. Then, the supplier receives the options order and manufactures the products up to . During the selling period, the retailer observes the realized market demand and then determines how much products to obtain through the options order at unit exercise price . Under portfolio contracts, the retailer places a firm order, denoted as , and purchases call options, denoted as . Then, the supplier receives the orders of the two different types and manufactures the products up to . When the selling period starts, the retailer obtains the products through the firm order. During the selling period, the retailer obtains the additional products through the options order. The retailer incurs a unit shortage cost for each unsatisfied demand. The supplier incurs a unit penalty cost for each exercised option that cannot be immediately filled. Thus, the supplier’s unit penalty cost represents the cost to obtain an additional unit of product by expediting production or buying from an alternative source.

In the seasonal product industry, the length of selling period is short but the length of production lead time is long [37]. During the production lead time, both the retail price and the market demand vary with time owing to the effect of inflation. In reality, sometimes the production lead time is considered to be exogenous [33, 34]. The empirical studies [38, 39] show that the length of production lead time is uncertain. We assume that the length of production lead time, denoted as , is an exogenous random variable over with probability density function (PDF) . Similar to Jaggi and Khanna [11], we assume that unit retail price, denoted as , follows a continuous exponential growth during the production lead time under inflation scenarios; that is, , where is the initial retail price and () is the price rising factor. Similar to Xiao et al. [33, 34], we assume that the market demand, denoted as , is decomposed into a deterministic form and a nondeterministic error ; that is, , where is a decreasing function of the production lead time owing to the effect of inflation and is a random variable over with probability density function (PDF) and strictly increasing cumulative distribution function (CDF) . , , and denote the tail distribution. As we know, various time-varying functions can be used to describe such as linear, Weibull, and exponential distribution forms. Similar to Tripathi [14], an exponentially decreasing pattern is used to describe the market contraction caused by the effect of inflation for the purpose of making the model analytically tractable; that is, , where is the initial market scale and () is the demand contraction factor.

Throughout this paper, we use the parameters and variables as shown in “Notations.”

We assume that the supply chain members are rational and self-interested and all the information available is symmetric between the supplier and the retailer. Moreover, we assume that the retailer’s initial inventory is zero and any excess product either owned by the retailer or by the supplier can be ignored. Furthermore, we assume that and . The first condition can ensure profits for two parties. The second condition can ensure that the retailer places a firm order and purchases call options simultaneously.

#### 4. Supply Chain Models

In this section, we plan to study the retailer’s optimal ordering policy and the supplier’s optimal production policy considering the effect of inflation under three different types of contracting arrangement: wholesale price contracts, option contracts, and portfolio contracts.

##### 4.1. Wholesale Price Contracts Model

###### 4.1.1. Optimal Ordering Policy under Wholesale Price Contracts

Since wholesale price contracts are widely used in practice, we use wholesale price contracts model as the benchmark and compare with option contracts model and portfolio contracts model developed in the remaining part.

Under wholesale price contracts, only products are purchased from the upstream supplier and the expected profit of the retailer, denoted as , is given by

The first term is the sales revenue. The second term is the costs of purchasing products, and the last term is the shortage cost. Then, the above equation can be simplified as

As to the retailer’s optimal ordering policy under wholesale price contracts, we can derive the following proposition.

Proposition 1. *Under wholesale price contracts, the retailer’s optimal firm order quantity is*

*Proof. *From (2), we can derive that − and , so is concave in . Let ; we can obtain that the optimal solution to (2) is .

*This proposition shows that the effect of inflation has a significant impact on the retailer’s optimal ordering policy under wholesale price contracts. We have the following corollary.*

*Corollary 2. The retailer’s optimal firm order quantity under wholesale price contracts is decreasing in and increasing in .*

*Proof. *Let ; we can derive that / and − ; that is, the retailer’s optimal firm order quantity under wholesale price contracts is decreasing in and increasing in .

*From Corollary 2, we can see that when the demand contraction factor grows, the retailer will reduce the size of the firm order. When the price rising factor grows, the retailer will enlarge the size of the firm order. Since both price and demand vary in two opposite directions due to the effect of inflation, this poses a challenge for the retailer to decide whether to increase or decrease the size of the firm order. At this moment, the retailer needs to seek the right balance between the rising price and the shrinking demand. When the increase in the retail price is more obvious, the retailer will increase the firm order quantity. When the decrease in the market demand is more obvious, the retailer will decrease the firm order quantity.*

*4.1.2. Optimal Production Policy under Wholesale Price Contracts*

*Since the retailer obtains the products through the firm order at the beginning of the selling period, the supplier’s optimal production quantity is equivalent to the retailer’s optimal firm order quantity under wholesale price contracts. That is, . Obviously, the supplier’s optimal production quantity under wholesale price contracts is also decreasing in and increasing in .*

*Under wholesale price contracts, the optimal expected profit of the supplier, denoted as , is given by*

*4.2. Option Contracts Model*

*4.2.1. Optimal Ordering Policy under Option Contracts*

*Under option contracts, only call options are purchased from the upstream supplier and the expected profit of the retailer, denoted as , is given by*

*The first term is the sales revenue. The second term is the costs of purchasing call options. The third term is the costs of exercising call options, and the last term is the shortage cost. Then, the above equation can be simplified as*

*As to the retailer’s optimal ordering policy under option contracts, we can derive the following proposition.*

*Proposition 3. Under option contracts, the retailer’s optimal options order quantity is*

*Proof. *From (6), we can derive that and , so is concave in . Let ; we can obtain that the optimal solution to (6) is .

*This proposition shows that the effect of inflation has a significant impact on the retailer’s optimal ordering policy under option contracts. We have the following corollary.*

*Corollary 4. The retailer’s optimal options order quantity under option contracts is decreasing in and increasing in .*

*Proof. *Let ; we can derive that = − and /; that is, the retailer’s optimal options order quantity under option contracts is decreasing in and increasing in .

*From Corollary 4, we can see that when more call options are purchased, the retailer has a higher ability to be resistant to the price rising and a lower ability to be resistant to the demand contraction. When fewer call options are purchased, the retailer has a lower ability to be resistant to the price rising and a higher ability to be resistant to the demand contraction. Owing to the effect of inflation, the retailer must make careful observations on the changes in price and demand and then decide whether to increase or decrease the options order. When the increase in the retail price is more obvious, the retailer will order more call options. When the decrease in the market demand is more obvious, the retailer will order fewer call options.*

*4.2.2. Optimal Production Policy under Option Contracts*

*4.2.2. Optimal Production Policy under Option Contracts*

*Since the retailer obtains the products through the options order during the selling period and the retailer may not exercise all the options purchased, the supplier’s optimal production quantity cannot exceed the retailer’s optimal options order quantity under option contracts. That is, .*

*Under option contracts, the optimal expected profit of the supplier, denoted as , is given by*

*The first term is the revenue realized from options sales. The second term is the revenue realized from exercised options. The third term is the penalty cost, and the last term is the production cost. Then, the above equation can be simplified as*

*The supplier’s decision problem under option contracts is described as*

*As to the supplier’s optimal production policy under option contracts, we can derive the following proposition.*

*Proposition 5. Under option contracts, the supplier’s optimal production quantity satisfieswhere .*

*Proof. *From (9), we can derive that and , so is concave in . Let ; we can derive that the optimal solution to (9) is .

Considering the constraint in (10), the supplier’s optimal production quantity under option contracts satisfies

*This proposition shows that, owing to the production constraint condition, the supplier’s optimal production quantity under option contracts is expressed as an interval. If , the production constraint condition is ineffective. If , the production constraint condition is effective. At this point, the supplier will try the best to raise the production quantity so as to improve the expected profit. Obviously, the production quantity equivalent to the options order quantity is the supplier’s best choice. Moreover, this proposition also shows that the effect of inflation also has a significant impact on the supplier’s optimal production policy under option contracts. We have the following corollary.*

*Corollary 6. The supplier’s optimal production quantity under option contracts is decreasing in and nondecreasing in .*

*Proof. *Let . From Proposition 5, we see that if , then . We can deduce that − and , so in this case the supplier’s optimal production quantity is decreasing in and constant in . If , then . The supplier’s optimal production quantity is decreasing in and increasing in . Hence, the supplier’s optimal production quantity under option contracts is decreasing in and nondecreasing in .

*From Corollary 6, we can see that when the increase in the retail price is more obvious, the supplier will observe the operation status carefully and then decide whether to increase or maintain the production quantity. When the decrease in the market demand is more obvious, the supplier will reduce the production quantity.*

*4.3. Portfolio Contracts Model*

*4.3. Portfolio Contracts Model*

*4.3.1. Optimal Ordering Policy under Portfolio Contracts*

*4.3.1. Optimal Ordering Policy under Portfolio Contracts*

*Under portfolio contracts, both products and call options are purchased from the upstream supplier and the expected profit of the retailer, denoted as , is given by*

*The first term is the sales revenue. The second term is the costs of purchasing products. The third term is the costs of purchasing call options. The fourth term is the costs of exercising call options, and the last term is the shortage cost. Set . Note that determining is equivalent to determining . Then, the above function can be rewritten as*

*As to the retailer’s optimal ordering policy under portfolio contracts, we can derive the following proposition.*

*Proposition 7. Under portfolio contracts, the retailer’s optimal firm order quantity isThe retailer’s optimal total order quantity is*

*Proof. *From (14), we can derive that , , − , < 0, and . HenceSo is concave in and . Let and ; we can obtain that the optimal solution to (14) is and .

*From Proposition 7, we can deduce that the retailer’s optimal options order quantity is described as , which implies that the optimal total order quantity is always higher than the optimal firm order quantity under portfolio contracts. Note that is equivalent to . This inequality shows that if the supplier charges an exorbitant option price, the retailer will refuse to order any options. Moreover, this proposition shows that the effect of inflation has a significant impact on the retailer’s optimal ordering policy under portfolio contracts. We have the following corollary.*

*Corollary 8. The retailer’s optimal firm order quantity under portfolio contracts is decreasing in and constant in .*

*Proof. *Let ; we can derive that = and ; that is, the retailer’s optimal firm order quantity under portfolio contracts is decreasing in and constant in .

*Corollary 9. The retailer’s optimal total order quantity under portfolio contracts is decreasing in and increasing in .*

*Proof. *Let ; we can derive that = − and − ; that is, the retailer’s optimal total order quantity under portfolio contracts is decreasing in and increasing in .

*From Corollaries 8 and 9, we can see that when the rising degree of price runs faster than the falling degree of demand, the retailer will raise the total order quantity through increasing the options order quantity. It is worth noting that the retailer does not attempt to make any alteration in the firm order quantity under this situation. When the falling degree of demand runs faster than the rising degree of price, the retailer will reduce both the firm order quantity and the total order quantity.*

*4.3.2. Optimal Production Policy under Portfolio Contracts*

*4.3.2. Optimal Production Policy under Portfolio Contracts*

*Since the firm order is required to be delivered to the downstream retailer at the beginning of the selling period, the supplier’s optimal production quantity cannot remain below the retailer’s optimal firm order quantity under portfolio contracts. Moreover, since the retailer can obtain the additional products through the options order during the selling period and the options exercising quantity may not exceed the options order quantity, the supplier’s optimal production quantity cannot surpass the retailer’s optimal total order quantity under portfolio contracts. That is, .*

*Under portfolio contracts, the optimal expected profit of the supplier, denoted as , is given by*

*The first term is the revenue realized from firm orders. The second term is the revenue realized from options sales. The third term is the revenue realized from exercised options. The fourth term is the penalty cost and the last term is the production cost. Then, the above equation can be simplified as*

*The supplier’s decision problem under portfolio contracts is described as*

*As to the supplier’s optimal production policy under portfolio contracts, we can derive the following proposition.*

*Proposition 10. Under portfolio contracts, the supplier’s optimal production quantity satisfieswhere .*

*Proof. *From (19), we can derive that and , so is concave in . Let ; we can derive that the optimal solution to (19) is .

Considering the constraint in (20), the supplier’s optimal production quantity under portfolio contracts satisfies

*This proposition shows that, owing to the production constraint condition, the supplier’s optimal production quantity under portfolio contracts is expressed as an interval. If , the constraint condition plays an important role in the production decision. At this point, the supplier will make every effort to reduce the production quantity so as to increase the expected profit. Obviously, the production quantity equivalent to the firm order quantity is the supplier’s best choice. If , the constraint condition plays no role in the production decision. If , the constraint condition plays an important role in the production decision. At this point, the supplier will try the best to raise the production quantity so as to increase the expected profit. Obviously, the production quantity equivalent to the total order quantity is the supplier’s best choice. Moreover, this proposition also shows that the effect of inflation also has a significant impact on the supplier’s optimal production policy under portfolio contracts. We have the following corollary.*

*Corollary 11. The supplier’s optimal production quantity under portfolio contracts is decreasing in and nondecreasing in .*

*Proof. *Let . From Proposition 10, we see that if , then . The supplier’s optimal production quantity is decreasing in and constant in . If , then . We can deduce that / and = , so in this case the supplier’s optimal production quantity is decreasing in and constant in . If , then . The supplier’s optimal production quantity is decreasing in and increasing in . Hence, the supplier’s optimal production quantity under portfolio contracts is decreasing in and nondecreasing in .

*From Corollary 11, we can see that when the rising degree of price runs faster than the falling degree of demand, the supplier will observe the operation status carefully and then decide whether to increase or maintain the production quantity. When the falling degree of demand runs faster than the rising degree of price, the supplier will reduce the production quantity.*

*5. The Impact of Option Contracts*

*5. The Impact of Option Contracts*

*In this section, we plan to explore the impact of option contracts on supply chain through comparing with the results under different contracting arrangements.*

*5.1. The Impact of Option Contracts on Supply Chain Decisions*

*5.1. The Impact of Option Contracts on Supply Chain Decisions*

*Comparing the retailer’s optimal order quantity among these three different contracts, we consider the impact of option contracts on the retailer’s ordering decision.*

*Proposition 12. The retailer’s optimal order quantity under three different types of procurement contracts is as follows: the maximum is the optimal total order quantity under portfolio contracts and the optimal options order quantity under option contracts, the medium is the optimal firm order quantity under wholesale price contracts, and the minimum is the optimal firm order quantity under portfolio contracts. That is, .*

*Proof. *From (7) and (16), we can deduce that . From (3) and (15), we can deduce that + . Recalling that is concave in , it follows that .

From (3) and (7), we can deduce that − . Recalling that is concave in , it follows that . So, .

*Proposition 12 explains the change that occurs in the retailer’s optimal ordering policy after introducing option contracts under inflation scenarios. Since the same market environment is faced, the retailer’s optimal options order quantity under option contracts is equivalent to the retailer’s optimal total order quantity under portfolio contracts. Moreover, since call options give only the right, but not the obligation, to obtain the products, the retailer can choose to exercise call options or not use them at all. Obviously, the presence of option contracts provides more flexibility for the retailer than wholesale price contracts. Thus, the optimal aggregate order quantity under portfolio contracts is always higher than the optimal firm order quantity under wholesale price contracts. In addition, the optimal options order quantity under option contracts is always higher than the optimal firm order quantity under wholesale price contracts. In other words, comparing with the case of wholesale price contracts, the retailer will increase the order quantity so as to reduce the shortage cost caused by unsatisfied demand in the presence of option contracts. Furthermore, call options give the retailer the right to adjust the order quantity upwards. Obviously, the presence of option contracts will suppress the retailer’s purchasing behavior and restrains increasing the firm order quantity. Thus, the optimal firm order quantity under wholesale price contracts is higher than that under portfolio contracts.*

*Contrasting the supplier’s optimal production quantity among these three different contracts, we consider the impact of option contracts on the supplier’s production decision.*

*Proposition 13. If , then . If , then . If , then .*

*Proof. *Let . From Propositions 5 and 10, we can derive the following conclusions. If , then and . We can obtain . If , then and . We can obtain . If , then and . We can obtain . If , then and . We can obtain .

*Proposition 13 explains the change that occurs in the supplier’s optimal production policy after introducing option contracts under inflation scenarios. Owing to the production constraint condition, the supplier’s production decision becomes more complicated but more flexible after introducing option contracts. Moreover, the supplier’s optimal production quantity under portfolio contracts is not less than that under option contracts. The main reason is that the supplier must deliver the firm order at the beginning of the selling period under portfolio contracts. In contrast, the supplier does not need to deliver a certain quantity of products at the beginning of the selling period under option contracts.*

*Now we summarize the conclusions regarding the impact of option contracts on the supply chain members’ optimal decision policies under inflation scenarios in Table 1.*