Supply Diversification Under Price Dependent Demand and Random Yield

Abstract

Supply diversification and pricing are two common mechanisms for dealing with supply yield uncertainty. This paper studies the interplay of the two mechanisms when both mechanisms are employed by a firm that faces production yield uncertainty. We compare the optimal sourcing decisions under two distinct pricing schemes: (1) ex ante pricing - the firm simultaneously makes the sales price and sourcing decisions before production takes place; (2) responsive pricing - the pricing decision is postponed until after the production yield realization. Although the firm is better off with responsive pricing, the impact of pricing on the optimal sourcing decision and the firm's need for supply diversification is less clear and is dependent on factors such as unit procurement cost, supply portfolio, and supply reliability. For the case of one unreliable supplier, we show that responsive pricing mitigates the overage and underage risks imposed by yield uncertainty, and results in a lower [higher] optimal order quantity than that under ex ante pricing when the procurement cost is low [high]. For the case of one unreliable and one reliable suppliers, we find that an ex ante pricing firm finds no value in supply diversification, but responsive pricing gives rise to the need for supply diversification. For the case of two unreliable suppliers, we prove that responsive pricing promotes [discourages] supply diversification when supply reliability is low [high]. When supply reliability is moderate, responsive pricing promotes [discourages] supply diversification when the unit procurement cost is low [high].