Bargaining Power and Supply Base Diversification

Abstract:     
We examine a supply base diversification problem faced by a buyer who periodically holds auctions to award short term supply contracts among a cohort of suppliers (i.e., the supply base). To mitigate significant cost shocks to procurement, the buyer can diversify her supply base by selecting suppliers from different regions. We find that the optimal degree of supply base diversification depends on the buyer's bargaining power, i.e., the buyer's ability to choose the auction mechanism. At one extreme, when the buyer has full bargaining power and thus can dictatorially implement the optimal mechanism, she prefers to fully diversify. At the other extreme, when the buyer uses a reverse English auction with no reserve price due to her lack of bargaining power, she may consider protecting herself against potential price escalation from cost-advantaged suppliers by using a less diversified supply base. We also examine cases where the buyer has intermediate bargaining power and can employ a reserve price and/or a first-price sealed-bid auction, and we find that in general the more bargaining power the buyer has to control price escalation from cost-advantaged suppliers the more she prefers a diversified supply base.

Keywords: Procurement, diversification, auctions

JEL Classifications: D44, H57, C72, C78, D81

Working Paper Series