“Pricing Novel Goods”

Toomas Hinnosaar

University of Nottingham

Abstract: We study a buyer-seller problem of a novel good for which the seller does not yet know the production cost. A contract can be agreed upon at either the ex-ante stage, before learning the cost, or at the ex-post stage, when both parties will incur a costly delay, but the seller knows the production cost. We show that the optimal ex-ante contract for a profit-maximizing seller is a fixed price contract with an ``at-will'' clause: the seller can choose to cancel the contract upon discovering her production cost. However, sometimes the seller can do better by offering a guaranteed-delivery price at the ex-ante stage and a second price at the ex-post stage if the buyer rejects the first offer. Such a ``limited commitment'' mechanism can raise profits, allowing the seller to make the allocation partially dependent on the cost while not requiring it to be embedded in the contract terms. Analogous results hold in a model where the buyer does not know her valuation ex-ante and offers a procurement contract to a seller.