Supply Disruptions, Asymmetric Information, and a Dual Sourcing Option

Abstract:     
We study a manufacturer's strategic use of a dual-sourcing option when facing suppliers who possess private information about their likelihood of experiencing a supply disruption. The manufacturer can diversify its supply by ordering from both suppliers, but we find that the cost of doing so is inflated under asymmetric information due to the suppliers' incentives to misrepresent their reliabilities. If the manufacturer instead sole-sources, competition between the suppliers curbs their informational rents. Therefore, asymmetric information pushes the manufacturer away from diversification and towards sole-sourcing. Surprisingly, the additional cost that asymmetric information imposes on diversification may cause the manufacturer to cease diversifying in reaction to uniformly eroding supply base reliability, while it would do just the opposite under symmetric information. Despite these trends away from diversification, the value of the dual-sourcing option should not be underestimated for manufacturers who are unsure of their suppliers' reliabilities - the dual-sourcing option is actually more valuable under asymmetric information than under symmetric information if the manufacturer's cost of replacing a unit lost due to a disruption is moderate. We also analyze the effect of codependence between supply disruptions, and find that a reduction in supplier codependence increases the manufacturer's value of information. Therefore, strategic actions to reduce codependence between supply disruptions should not be seen as a substitute for learning about the suppliers' reliabilities.

Keywords: Supply Risk, Mechanism Design, Diversification

JEL Classifications: L15, C72, D24, D82

Working Paper Series