Supply Side Story: Risks, Guarantees, Competition and Information Asymmetry

Management Science, Forthcoming

50 Pages Posted: 26 Dec 2010 Last revised: 22 Jun 2011

See all articles by Mehmet Gumus

Mehmet Gumus

McGill University - Desautels Faculty of Management

Saibal Ray

McGill University - Desautels Faculty of Management

Haresh Gurnani

Wake Forest University School of Business

Date Written: December 26, 2010

Abstract

The risk of supply disruption increases as firms seek to procure from cheaper, but unproven, suppliers. In this paper, we model a supply chain consisting of a single buyer and two suppliers, both of whom compete for the buyer's order and face risk of supply disruption. One supplier is comparatively more reliable but more expensive, while the other, unreliable one is cheaper but faces higher risk of supply disruption. Moreover, the risk level of the unreliable supplier may be private information for her, and this lack of visibility further contributes to the buyer's purchasing risk. In such settings, the unreliable supplier often offers a price and quantity (P&Q) guarantee to the buyer as part of her contract terms. Our objective is to study the underlying motivation for such a guarantee offer and the effects of the offer on the competitive intensity in the chain and the performance of the chain partners. Our model also includes a spot market that can be utilized by any party in the chain to buy or to sell. The price in the spot market is random and depends partially on the amount of capacity accessible by the two suppliers; there is also a positive spread between buying and selling prices in this market. We analytically characterize the equilibrium contracts for the two suppliers, and the buyer's procurement strategy (sole- or dual- or spot-sourcing) for both symmetric and asymmetric information cases. Our analysis indicates that supply guarantee plays two important roles. First, it allows the unreliable supplier to better compete against the more reliable one by providing supply assurance to the buyer. More importantly, when information asymmetry risk is high, a guarantee offer may enable the unreliable supplier to credibly signal her true supply risk to the buyer, thereby improving visibility into the chain. This signal can also be used by the buyer to infer the expected spot market price. In spite of the above benefits, from the buyer's perspective, a guarantee provision in an asymmetric setting may not be always desirable. Rather, it can reduce the competition between the suppliers, which generates higher contract prices, and, consequently, higher costs for the buyer. In contrast, competing with a guarantee-providing, less risky unreliable supplier may actually result in higher profits for the more reliable supplier.

Keywords: Supply Risk Management, Asymmetric Information, Signaling, Guarantees, Stochastic Spot Market

Suggested Citation

Gumus, Mehmet and Ray, Saibal and Gurnani, Haresh, Supply Side Story: Risks, Guarantees, Competition and Information Asymmetry (December 26, 2010). Management Science, Forthcoming, Available at SSRN: https://ssrn.com/abstract=1731287

Mehmet Gumus (Contact Author)

McGill University - Desautels Faculty of Management ( email )

1001 Sherbrooke St. West
Montreal, Quebec H3A1G5 H3A 2M1
Canada

Saibal Ray

McGill University - Desautels Faculty of Management ( email )

1001 Sherbrooke St. (W)
Montreal, Quebec H3A 2M1
Canada

HOME PAGE: http://people.mcgill.ca/saibal.ray/

Haresh Gurnani

Wake Forest University School of Business ( email )

2601 Wake Forest Road
Winston-Salem, NC 27109
United States

HOME PAGE: http://business.wfu.edu/directory/haresh-gurnani/ Haresh Gurnani

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