Strategic Dynamic Sourcing from Competing Suppliers with Transferable Capacity Investment

We study the supplier relationship choice for a buyer that invests in transferable capacity operated by a supplier. With a long-term relationship, the buyer commits to source from a supplier over a long period of time. With a short-term relationship, the buyer leaves open the option of switching to a new supplier in the future. The buyer has incomplete information about a supplier’s efficiency, and thus uses auctions to select suppliers and determine the contracts. In addition, the buyer faces uncertain demand for the product. A long-term relationship may be beneficial for the buyer because it motivates more aggressive bidding at the beginning, resulting a lower initial price. A short-term relationship may be advantageous because it allows switching, with the capacity transferred at some costs, to a more efficient supplier in the future. We find that there exists a critical level of switching costs above which a long-term relationship is better for the buyer than a short-term relationship. In addition, this critical switching cost decreases with demand uncertainty, implying a long-term relationship more favorable for a buyer facing volatile demand. Finally, we find that in a long-term relationship, capacity can be either higher or lower than in a short-term relationship.