Strategic Capacity Investments and Competition for Supply Contracts
44 Pages Posted: 26 Oct 2007
Date Written: October 21, 2007
Suppliers often make proactive investments in capacity to strategically position themselves to win a contract with a monopolist buyer. Such investments reduce the suppliers' variable costs of serving the buyer's demand. We show that an auction mechanism does not always benefit the payment-minimizing buyer, the supply chain, or society. We identify scenarios where the buyer can implement the supply chain and socially optimal solution by committing to a bilateral relationship with fair reimbursement, and forgoing the benefits of competition altogether. We explore the role of commitment by the buyer (to a procurement mechanism) and by the suppliers (to a capacity level) by analyzing different timing games under symmetric and asymmetric information about suppliers' types. We show that it never pays the suppliers to commit first. Equilibrium capacity investments and cost structures depend upon the buyer's bargaining power (opportunity cost). However, the winning supplier's investments are almost always below the supply chain optimal level. Our results suggest two simple solutions for a buyer to motivate capacity investments: 1. Commit Early and Be Fair (suppliers invest and get paid for their efforts); or, 2. (Appear to) Be Generous (let everyone have a shot at winning the contract).
Keywords: supply contracts, procurement auctions, capacity investments, asymmetric information
JEL Classification: C72, D43, D44, D82, L14, M11
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