OPTIMAL PROCUREMENT STRATEGY UNDER SUPPLY RISK

Abstract

With the rapid expansion of global business, newer suppliers with cheaper but possibly unreliable technologies have entered the marketplace to win orders from buyer firms by beating the price of their perfectly reliable (but expensive) competitors. We model the procurement problem as a Nash game where the buyer has to allocate its purchases between an expensive but reliable supplier, and a cheaper but unreliable supplier. The suppliers specify prices for different proportions of the order awarded to them. Our analysis shows that, when perfect information is available about the reliability level of the unreliable supplier, the Nash equilibrium is a sole-sourcing allocation and that the supplier selection decision depends on the reliability and cost differentials between the two suppliers. In addition, we model the case when the buyer and the reliable supplier have limited information about the reliability of the unreliable supplier. Even in such an asymmetric scenario, the buyer's equilibrium allocation is a sole-sourcing outcome, but depending on system conditions either a separating or a pooling equilibrium is possible. An interesting insight into the effect of information asymmetry is that it can result in higher or lower profits/costs for the channel partners (compared to the perfect information case). As such, the buyer may even benefit from information asymmetry regarding unreliable supplier due to its impact on the degree of competition between the two suppliers.

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