Supply Base Design for Supplier Competition and Investment of Effort under Cost and Demand Uncertainties

Supplier competition and investment of effort are important concerns in supply base design. They are affected not only by the number of suppliers, but also by their capacity profile. This paper studies supply base design in terms of the number and capacities of suppliers, considering both supplier competition and investment of cost-reduction effort. We analyze a buyer who invests in capacities for two available suppliers. Given the capacity investment, suppliers exert cost-reduction effort. The realized production cost of a supplier is uncertain and is private information. After the costs and demand are realized, an auction is conducted to determine the quantity sourced from and the price paid to each supplier. The buyer benefits from both symmetry and asymmetry between suppliers in capacity: A symmetric supply base is effective at inducing supplier competition, while an asymmetric supply base delivers great value from suppliers’ cost-reduction efforts. As a result, we find that the buyer may invest in capacity for only one supplier (sole sourcing), equal capacities for both suppliers (symmetric dual sourcing), or positive but unequal capacities for both suppliers (asymmetric dual sourcing), even though the suppliers are ex ante identical. We show that asymmetric dual sourcing is possible only in the presence of demand uncertainty, and the policy arises for intermediate capacity costs. We also find that, if the cost of supplier effort is low, with increasing demand uncertainty the optimal supply base structure shifts from symmetric dual sourcing to sole sourcing or asymmetric dual sourcing, along with reduction of the total capacity. Finally, we consider different timing scenarios for purchasing price and capacity investment decisions, investigate when the buyer may choose to commit to purchasing prices before the realization of supplier costs, or to postpone capacity investment decisions until after the cost realization, and compare the choice of supply base design under each mechanism.