Using backup supply with responsive pricing to mitigate disruption risk for a risk-averse firm

Abstract

We consider a risk-averse firm’s sourcing problem with two suppliers: a dedicated one and a backup one. The dedicated supplier charges a lower wholesale price, but faces potential disruption risk. The backup supplier is assumed to be perfectly reliable, but charges a higher wholesale price. To mitigate the disruption risk, the firm uses a joint backup supply and responsive pricing strategy. We consider three common backup strategies between the firm and the backup supplier: advance purchase, reservation and contingency purchase. We derive under what conditions each strategy could be optimal. The results show that the thresholds that determine the optimal backup supply strategy are affected by the risk aversion level. When the risk aversion level is not extremely high, the firm should choose among the three backup suppliers by considering the disruption probability and the reservation fee. Firms with a higher risk aversion level tend to rely more on ex-ante preventive efforts (i.e. reservation or advance purchase strategies). When the risk aversion level is extremely high, the firm never considers the contingency purchase strategy, even for a low-probability disruption event. Additionally, market conditions yield non-negligible influences on the firm’s strategic choices due to the existence of risk aversion.

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