Supply chain network equilibrium with strategic supplier investment: A real options perspective

Abstract

This article develops a network equilibrium model that studies competing supply chain firms who can strategically invest in new capacity at suppliers under cost and demand uncertainty. We model the decision-making process of each supply chain firm as a stochastic optimization problem. We formulate the equilibrium conditions of all supply chain firms using the variational inequality theory. Analytical results establish connections from the supplier investment decisions to real put and call options. Option pricing theory is applied to show that the value of supplier capacity investment will increase if the demand uncertainty or the cost uncertainty increases, and will decrease if the price sensitivity or the cost factor increases. Numerical experiments are conducted to confirm and extend the analytical results, and to investigate the decision-making and profits of different supply chain firms in more complex and realistic settings. Our results also suggest that manufacturers should strategically invest in a portfolio of complementary suppliers with different risk characteristics that serve different purposes.