Supply Risk Mitigation Via Supplier Diversification and Improvement: An Experimental Evaluation

Abstract

Due to the trend towards decentralization and greater complexity in supply chains, companies are increasingly exposed to supply risks. Various strategies to mitigate supply risks have been developed using modeling- based approaches, including risk diversification by dual sourcing and direct investment to improve supplier performance. Yet, despite the overwhelming evidence that managerial decisions are influenced by behavioral factors particularly under risk and uncertainty, such behavioral factors are typically not considered by previous theoretical studies. In this paper, we use controlled lab experiments to evaluate the performances of dual sourcing and single sourcing with supplier improvement strategies to mitigate risks of a buyer facing suppliers with different costs and risk profiles, and develop behavioral theories to elucidate the decision-making process under supply risks more effectively. With dual sourcing, human buyers do not diversify their orders effectively (relying on a more even allocation of orders between suppliers than theory suggests) and exhibit quantity hedging behavior. To explain this phenomenon, we propose and empirically validate a behavioral theory in which human buyers choose order quantities to minimize their disutility from order allocation errors between suppliers. Human buyers use the single sourcing with supplier improvement strategy relatively effectively, despite being subject to supplier selection errors due to bounded rationality.