Second Sourcing vs. Sole Sourcing with Capacity Investment and Asymmetric Information

Abstract

We study the decision of a manufacturer (the buyer), expecting new sourcing opportunities in the future, in selecting between sole- and second-sourcing strategies for a noncommodity component. In a sole-sourcing strategy, the buyer commits to sourcing from a single supplier (the incumbent) over the entire horizon. In a second-sourcing strategy, the buyer keeps the option open to source from a new supplier (the entrant) in the future. Supplier costs are private information, and the incumbent's cost may change in the future because of what it has learned. The buyer is relatively sure about current demand but uncertain about future demand. A supplier has to invest in capacity to produce the inputs for the buyer. With future private cost information, the incumbent earns rent in the future, and this prospective rent influences the incumbent's decision early in the horizon. On one hand, a second-sourcing strategy allows the buyer to take advantage of alternative sourcing opportunities, lowering her future cost. This benefit to the buyer is referred to as the option value of second sourcing. On the other hand, the future supplier competition in second-sourcing hurts the incumbent's future profit. The expectation of a lower future profit in second sourcing induces the incumbent to ask for a higher price at the beginning of the horizon. This causes more initial sourcing cost for the buyer in second sourcing than in sole sourcing, and is referred to as the cost of future supplier competition of second sourcing.The overall benefit of second sourcing relative to sole sourcing is influenced by the demand distribution and capacity cost. If the demand increases over time with positive probability, the incumbent's initial capacity may not be able to cover all future demand. If the capacity is cheap, the entrant may serve as an exclusive supplier, ousting the incumbent. In this case, the option value of second sourcing is high. If the capacity is expensive, the entrant may serve as a supplementary supplier by receiving only the demand in excess of the incumbent's installed capacity. In this case, the cost of future supplier competition is low and the option value is still significant. Thus second sourcing is better than sole sourcing not only when the capacity cost is low, but also when it is high (under the condition that demand increases over time with positive probability and the entrant's cost is relatively low). For intermediate capacity cost, the cost of future supplier competition dominates the option value; hence, sole sourcing is preferred. We also find that second sourcing is more attractive when the buyer expects the future demand to be higher or more volatile. Finally, more initial incumbent capacity strengthens the incumbent's competitiveness against the entrant, reducing the cost of future supplier competition. As a result, we find that second sourcing may lead to overinvestment of the initial capacity.