Supplier Competition and Cost Reduction with Endogenous Information Asymmetry

32 Pages Posted: 12 Jan 2018 Last revised: 12 Mar 2019

See all articles by Cuihong Li

Cuihong Li

University of Connecticut - Department of Operations & Information Management

Date Written: January 2019

Abstract

We consider a buyer sourcing from multiple competing suppliers who exert cost reduction efforts before procurement contracts are awarded. The supply chain is subject to the classic hold-up problem--as the lack of a contract commitment hinders suppliers' incentives to make investment upfront--complicated with supplier competition. With deterministic cost-reduction outcomes, suppliers will not exert any effort if this effort is observable, and a pure strategy equilibrium does not exist if the effort is unobservable. We analyze the mixed strategy equilibrium with unobservable supplier effort, in which suppliers randomize their efforts and the buyer designs an optimal procurement mechanism. We show that the optimal procurement mechanism can be implemented by a conventional single-price reverse auction with a random reserve price. The mixed strategy of supplier effort generates endogenous information asymmetry on supplier costs that provides suppliers with information rent, which sustains their efforts. The endogenous information asymmetry improves effort efficiency (by inducing positive supplier effort) yet introduces trade inefficiency (by causing the possible failure of trade between the parties). While increasing supplier competition (measured by the number of suppliers) hurts the effort efficiency, it improves the trade efficiency. As a result, the buyer is always better off introducing supplier competition by including more than one supplier in the supply base. However, the desired supply base size (number of suppliers) depends on the product revenue: for high-margin goods, the optimal size is achieved with two suppliers, whereas for low-margin goods, a larger supply base is better for the buyer. We show that the result based on deterministic cost reduction can be established as a limit of the case when uncertainty in cost reduction exists and shrinks to null. Our study helps to understand the impact of supplier competition when supply chain parties deliberately make their actions unpredictable to avoid being held up. The findings provide managerial guidance on procurement auction and supply base designs.

Keywords: Hold-up, Mixed strategy, Supplier competition, Supply base design, Procurement mechanism

Suggested Citation

Li, Cuihong, Supplier Competition and Cost Reduction with Endogenous Information Asymmetry (January 2019). University of Connecticut School of Business Research Paper No. 18-10. Available at SSRN: https://ssrn.com/abstract=3098877 or http://dx.doi.org/10.2139/ssrn.3098877

Cuihong Li (Contact Author)

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

368 Fairfield Road
Storrs, CT 06269-2041
United States

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