Procurement Contracts in the Presence of Endogenous Disruption Risk

Abstract

ABSTRACTWe consider a manufacturer facing an unreliable supplier with high or low type on initial reliability. The private reliability can be enhanced through process improvement initiated by either manufacturer (manufacturer‐initiated improvement, MI) or supplier (supplier‐initiated improvement, SI). We derive optimal procurement contracts for both mechanisms and find that the moral hazard does not necessarily generate more profit for high‐type supplier. Furthermore, information asymmetry causes a greater possibility of not ordering from low type in SI than MI. For low type, when an upward effort distortion appears in both mechanisms, a decreased (increased) unit penalty should be imposed in MI (SI) compared with symmetric information case. Although possibly efficient effort from the supplier could yield greater channel profit in SI, several scenarios violate this expectation. However, the manufacturer's expected profit in MI is no less than that in SI. When MI is extended to MSI where both manufacturer and supplier can exert effort, the expected profits of two parties are equal to those in SI. We further extend SI to SID, where both process improvement and dual‐sourcing are available. The manufacturer considers the trade‐off between the benefit from diversification and the loss from dual information rent to decide to choose SID or MI. By comparing SID with pure dual‐sourcing, we find that supplier's process improvement could either accelerate or retard the exercise of dual‐sourcing.