Second Sourcing vs. Sole Sourcing with Capacity Investment and Asymmetric Information

Manufacturing and Service Operations Management, Forthcoming

Posted: 1 Feb 2009 Last revised: 25 Sep 2009

See all articles by Cuihong Li

Cuihong Li

University of Connecticut - Department of Operations & Information Management

Laurens Debo

Dartmouth College - Tuck School of Business

Date Written: June 16, 2008

Abstract

We study the decision of a manufacturer (the buyer), expecting new sourcing opportunities in the future, in selecting between sole- and second-sourcing strategies for a noncommodity component. In a sole-sourcing strategy, the buyer commits to source from a single supplier (the incumbent) over the entire horizon. In a second-sourcing strategy, the buyer keeps the option open to source from a new supplier (the entrant) in the future. Supplier costs are private information, and the incumbent's cost may change in the future due to learning. The buyer is relatively sure about current demand but uncertain about future demand. A supplier has to invest in capacity in order to produce the inputs for the buyer. With future private cost information, the incumbent earns rent in the future, and this prospective rent influences the incumbent's decision early in the horizon. On one hand, a second-sourcing strategy allows the buyer to take advantage of alternative sourcing opportunities, lowering her future cost. This reduction of the future cost resulting from the option of using an alternative supplier is referred to as the emph {option value} of second sourcing. On the other hand, the future supplier competition in second-sourcing hurts the incumbent's future profit. The expectation of a lower future profit in second sourcing (compared to sole sourcing) induces the incumbent to ask for a higher price at the beginning of the horizon. This causes more initial sourcing cost for the buyer in second sourcing than in sole sourcing. We refer to such increase of the initial cost due to the opportunity of introducing future supplier competition as the emph {cost of future supplier competition} of second sourcing.

The overall benefit of second sourcing relative to sole sourcing is influenced by the demand distribution and capacity cost. If the demand increases over time with positive probability, the incumbent's initial capacity may not be able to cover all future demand. If the capacity is cheap, the entrant may serve as an exclusive supplier, ousting the incumbent. In this case, the option value of second sourcing is high. If the capacity is expensive, the entrant may serve as a supplementary supplier by receiving only the demand in excess of the incumbent's installed capacity. In this case, the cost of future supplier competition is low while the option value is still significant. Thus second sourcing is better than sole sourcing not only when the capacity cost is low, but also when it is high (under the condition that demand increases over time with positive probability and the entrant's cost is relatively low). For intermediate capacity cost, the cost of future supplier competition dominates the option value and hence, sole sourcing is preferred. We also find that second sourcing is more attractive when the buyer expects the demand to increase in the future, or expects the future demand to be more volatile. Finally, more initial capacity of the incumbent strengthens the incumbent's competitiveness against the entrant, reducing the cost of future supplier competition. As a result, we find that second sourcing may lead to overinvestment of the initial capacity.

Keywords: sourcing, supplier relationship, auction

Suggested Citation

Li, Cuihong and Debo, Laurens, Second Sourcing vs. Sole Sourcing with Capacity Investment and Asymmetric Information (June 16, 2008). Manufacturing and Service Operations Management, Forthcoming. Available at SSRN: https://ssrn.com/abstract=1335050

Cuihong Li (Contact Author)

University of Connecticut - Department of Operations & Information Management ( email )

368 Fairfield Road
Storrs, CT 06269-2041
United States

Laurens Debo

Dartmouth College - Tuck School of Business ( email )

Hanover, NH 03755
United States

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