The value of backup supply for mitigating disruption risk with equity finance

Abstract

Based on the policy incentives for equity financing and firms' awareness of managing supply disruption risk, this paper examines a two-tier supply chain. A large manufacturer can purchase products either from a capital-constrained unreliable supplier who has disruption risk or a reliable backup supplier with a higher cost. We investigate the value and interactive use of the backup supplier and equity financing on firms' performances. The results show both the backup supplier and equity financing alone can always benefit the manufacturer, but the unreliable supplier can become worse off. However, when the backup supplier and equity financing interact, their impact changes dramatically. Under equity financing, the backup supplier can make the unreliable supplier better, and the effect of the backup supplier on disruption risk management differs with different wholesale prices. Moreover, with a backup supplier, equity financing can benefit both the manufacturer and the unreliable supplier. Specifically, with the backup supplier, the unreliable supplier can lose all autonomy on whether or not to raise equity financing. Then, the manufacturer and unreliable supplier can achieve Pareto optimality due to ‘bidirectional free riding’. These insights provide strategic guidance for product ordering, enabling firms to manage disruption risk better and achieve high profitability.