Second Sourcing vs. Sole Sourcing with Capacity Investment and Asymmetric Information

We study the decision of a manufacturer (buyer), expecting new sourcing opportunities in the future, to select between a sole and a second sourcing mechanism for a non-commodity component. In a sole sourcing mechanism, the buyer commits to source from the current supplier. In a second sourcing mechanism, the buyer keeps the option open to source from a new supplier in the future. For a buyer that sources complex non-commodity inputs, this decision has to take into consideration supplier capacity investment, uncertain demand, supplier learning, and information asymmetry on the supply cost. Considering these factors, we compare sole and second sourcing mechanisms, and identify when a mechanism is preferred over the other. We find that (1) both a high and low capacity cost may benefit second sourcing (under the condition that the entrant’s cost is relatively low), (2) second sourcing is favored more when the buyer faces a higher level or more uncertainty of the future demand, and (3) second sourcing may result in over investment of the initial capacity.