Investment Efforts Under Complementary Sourcing: The Role of Market Risk and Endogenous Pricing

Abstract

Complementary sourcing, where a product depends on both a supplier's and a manufacturer's engineering and production efforts, is ubiquitous in modern supply chains. A unique feature of complementary sourcing is that efforts by one party enhance the marginal value of the other party's efforts. While this positive spillover effect can benefit both parties, it is well established in the literature that it paradoxically induces a first-mover disadvantage; neither party is willing to exert efforts ex ante, resulting in significant lost opportunities for improving sourcing performance. The question we consider in this paper is whether the first-mover disadvantage is a valid concern in more realistic sourcing environments where the market is risky and price is endogenous. We analyze a sequential-investment model and investigate how market risk and endogenous pricing affect the first-mover disadvantage. In the presence of market risk, the first mover may face greater market uncertainty than the second mover, and thus is at an apparent disadvantage. Surprisingly, we find the introduction of market risk can favor the first mover. In effect, the presence of market risk weakens the second mover's ability to free ride on the first mover's investment, which increases the leverage of the first mover. This finding persists with exogenous pricing even if the first mover has weak power. Our results suggest that the first-mover disadvantage identified in the extant literature ignores the operational aspect of practical sourcing environments, and sourcing managers should recognize that advance effort investment is often beneficial in more realistic complementary sourcing environments.

Keywords: complementary sourcing, effort investment, market risk, pricing

JEL Classification: M11