Contracting with multiple suppliers: A multi‐item buyer's make versus buy decision

Abstract

We consider a multi‐item buyer's make versus buy decision. The buyer sells two substitutable products with uncertain demand. Each product requires a different item, which the buyer procures from two separate suppliers (one for each item) who offer quantity‐payment contracts under asymmetric information. The buyer can make one of the items but not both. We compare the buyer's expected profit between buying both the items and making one item (and buying the other), when it can make the item at the same cost as the supplier, as well as gain reactive production capability by making. We find that the buyer's profit when buying both items is higher than for making one item if product substitutability is above a threshold (but not extremely high). This is because the interaction between the suppliers' contracts increases the buyer's informational rents more when buying from both suppliers, as compared to one supplier, as product substitutability increases. On the contrary, in the complete information scenario (and under wholesale price contracts), we find that the buyer will never prefer to buy both the items as compared to making one item, as long as product substitutability is not extremely high. These are novel findings on how inter‐linked contracts under incomplete information and product substitutability can influence a buyer's make versus buy decision in a counter‐intuitive manner. Managerially, these results imply that a multi‐product buyer may prefer to keep buying from its supplier even when it can produce the item at the same cost as the supplier.