Competition under Diseconomies of Scale: The Role of Subcontracting and Single‐Sourcing Commitment

Abstract

ABSTRACTThis article studies a supplier competition model in situations with flexible resources where suppliers face diseconomies of scale. Under such a situation, it is generally believed that a buyer may split an order across different suppliers; and even if the buyer chooses only one supplier, the winning supplier may subcontract part of the work to the others. My results, however, show that the buyer always prefers to commit to single‐sourcing prior to running a procurement auction. This is because such commitment eliminates the “assurance” of getting a positive order from the buyer, thus intensifying supplier competition. I also find that subcontracting may be beneficial (detrimental) to the buyer if the subcontract is determined by the winning (losing) supplier of the bidding game. Finally, I show that, for the case with linear costs, the buyer is always better off when subcontracting is considered.