Strategic Capacity Investments and Competition for Supply Contracts

44 Pages Posted: 26 Oct 2007

See all articles by Ying Li

Ying Li

Texas A&M University - Department of Information & Operations Management

Sudheer Gupta

Simon Fraser University

Date Written: October 21, 2007

Abstract

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

Suggested Citation

Li, Ying and Gupta, Sudheer, Strategic Capacity Investments and Competition for Supply Contracts (October 21, 2007). Available at SSRN: https://ssrn.com/abstract=1024663 or http://dx.doi.org/10.2139/ssrn.1024663

Ying Li (Contact Author)

Texas A&M University - Department of Information & Operations Management ( email )

430 Wehner
College Station, TX 77843-4218
United States

Sudheer Gupta

Simon Fraser University ( email )

Burnaby, British Columbia V5A 1S6
Canada

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