Benefits of sourcing alternative inputs of manufacturers for suppliers

Abstract

A downstream manufacturer can procure high‐quality inputs from its upstream raw material supplier to produce finished products with high quality. The manufacturer may also have the option to source alternative cheaper low‐quality inputs to partially replace the inputs from its supplier to produce finished products of lower quality. That is, the manufacturer can use a mixture of the supplier's inputs and alternative ones in product design such that product quality depends on the proportion of each input used in products. We endogenize this product quality decision in a simple analytical model to study the impact of this option on the supplier's profits. Intuitively, the option of sourcing alternative inputs could hurt the supplier in two ways: It sells fewer inputs, and it needs to set a lower wholesale price due to competitive pressure. However, our study reveals an opposite finding: The supplier can benefit not only by selling more inputs but also by setting a higher wholesale price when the manufacturer has the option of sourcing alternative low‐quality inputs. This interesting finding is due to the wholesale price push‐up effect: The upstream supplier may deliberately raise the wholesale price when sourcing alternative inputs is an option for the downstream manufacturer. This increased wholesale price encourages the manufacturer to use a higher proportion of alternative cheaper inputs in its product design; as a result, the manufacturer's marginal cost is reduced, which leads to a decrease in its retail price. Therefore, consumer demand for the manufacturer's products becomes higher, which in turn results in higher manufacturer demand for the supplier's inputs. Moreover, we show that despite this higher wholesale price, the manufacturer can earn higher profits by optimally charging a lower retail price. Furthermore, we find that the wholesale price of the supplier's inputs can exceed the manufacturer's retail price, thereby leading to a negative profit margin for the manufacturer from using the supplier's inputs. Finally, we demonstrate the robustness of our findings under several model extensions.