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Competition and Diversification Effects in Supply Chains with Supplier Default Risk

  • Volodymyr Babich

    ()

    (Industrial and Operations Engineering Department, University of Michigan, Ann Arbor, Michigan 48109)

  • Apostolos N. Burnetas

    ()

    (Department of Mathematics, University of Athens, Athens, Greece)

  • Peter H. Ritchken

    ()

    (Department of Banking and Finance, Weatherhead School of Management, Case Western Reserve University, Cleveland, Ohio 44106)

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    We study the effects of disruption risk in a supply chain where one retailer deals with competing risky suppliers who may default during their production lead times. The suppliers, who compete for business with the retailer by setting wholesale prices, are leaders in a Stackelberg game with the retailer. The retailer, facing uncertain future demand, chooses order quantities while weighing the benefits of procuring from the cheapest supplier against the advantages of order diversification. For the model with two suppliers, we show that low supplier default correlations dampen competition among the suppliers, increasing the equilibrium wholesale prices. Therefore the retailer prefers suppliers with highly correlated default events, despite the loss of diversification benefits. In contrast, the suppliers and the channel prefer defaults that are negatively correlated. However, as the number of suppliers increases, our model predicts that the retailer may be able to take advantage of both competition and diversification.

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    File URL: http://dx.doi.org/10.1287/msom.1060.0122
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    Article provided by INFORMS in its journal Manufacturing & Service Operations Management.

    Volume (Year): 9 (2007)
    Issue (Month): 2 (October)
    Pages: 123-146

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    Handle: RePEc:inm:ormsom:v:9:y:2007:i:2:p:123-146
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    1. Jarrow, Robert A & Turnbull, Stuart M, 1995. " Pricing Derivatives on Financial Securities Subject to Credit Risk," Journal of Finance, American Finance Association, vol. 50(1), pages 53-85, March.
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    5. Sanjiv Das & Darrell Duffie & Nikunj Kapadia & Leandro Saita, 2006. "Common Failings: How Corporate Defaults are Correlated," NBER Working Papers 11961, National Bureau of Economic Research, Inc.
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    7. Vidal, Carlos J. & Goetschalckx, Marc, 1997. "Strategic production-distribution models: A critical review with emphasis on global supply chain models," European Journal of Operational Research, Elsevier, vol. 98(1), pages 1-18, April.
    8. J. Michael Harrison & Stanley R. Pliska, 1981. "Martingales and Stochastic Integrals in the Theory of Continous Trading," Discussion Papers 454, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
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