Supply-Side Story: Risks, Guarantees, Competition, and Information Asymmetry

The risk of supply disruption increases as firms seek to procure from cheaper, but unproven, suppliers. We model a supply chain consisting of a single buyer and two suppliers, both of which compete for the buyer's order and face risk of supply disruption. One supplier is comparatively more reliable but also more expensive, whereas the other one is less reliable but cheaper and faces higher risk of disruption. Moreover, the risk level of the unreliable supplier may be private information, and this lack of visibility increases the buyer's purchasing risk. In such settings, the unreliable supplier often provides a price and quantity (P&Q) guarantee to the buyer. Our objective is to study the underlying motivation for the guarantee offer and its effects on the competitive intensity and the performance of the chain partners. Our model also includes a spot market that can be utilized by any party to buy or to sell. The spot market price is random, partially depends on the available capacity of the two suppliers, and has a positive spread between buying and selling prices. We analytically characterize the equilibrium contracts for the two suppliers and the buyer's optimal procurement strategy. First, our analysis shows that P&Q guarantee allows the unreliable supplier to better compete against the more reliable one by providing supply assurance to the buyer. More importantly, when information asymmetry risk is high, use of a guarantee may enable the unreliable supplier to credibly signal her true risk, thereby improving visibility into the chain. This signal can also be used by the buyer to infer the expected spot market price. In spite of these benefits, a guarantee offer in an asymmetric setting may not always be desirable for the buyer. Rather, it can reduce competition between the suppliers, resulting in higher costs for the buyer. This paper was accepted by Martin Lariviere, operations management.