Supplier Competition and Cost Improvement

Abstract

Buyers have two levers to enhance their supply base performance: fostering supplier competition and inducing suppliers to improve. The competition–improvement relation between the two levers has important implications for supply base design. We study a buyer facing two potential suppliers that can exert cost-reduction efforts, examining the interplay of supplier competition and supplier cost improvement under various information structures (i.e., the supplier effort is observable or unobservable) and commitment capabilities (i.e., the buyer may not commit, or may commit to a full or partial procurement mechanism, before suppliers exert efforts). We find that the two identical suppliers may choose unequal efforts, resulting in an asymmetric equilibrium outcome that enhances the performance of dual sourcing. Moreover, the competition–improvement relation depends on the effort observability. Whereas supplier competition always leads to lower improvement effort when the effort is unobservable, it may induce higher effort when the effort is observable. Thus, a trade-off between supplier competition and supplier effort is not always necessary in supply base design. Comparing the observable- and unobservable-effort cases, we demonstrate a detrimental effect of supplier effort observability on the buyer profits. Finally, we show that more commitment expands the presence of asymmetric equilibria, enhancing dual sourcing, and the partial commitment strengthens the positive effect of competition on observable efforts while maintaining the detrimental effect of effort observability. This paper was accepted by Serguei Netessine, operations management.