From Vendors to Partners: Information Technology and Incomplete Contracts in Buyer-Supplier Relationships

As search costs and other coordination costs decline, theory predicts that firms should optimally increase the number of suppliers with which they do business. Despite recent declines in these costs due to information technology, there is little evidence of an increase in the number of suppliers used. On the contrary, in many industries, firms are working with fewer suppliers. This suggests that other forces must be accounted for in a more complete model of buyer supplier relationships. This article uses the theory of incomplete contracts to illustrate that incentive considerations can motivate a buyer to limit the number of employed suppliers. To induce suppliers to make investments that cannot be specified and enforced in a satisfactory manner via a contractual mechanism, the buyer must commit not to expropriate the ex post surplus from such investments. Under reasonable bargaining mechanisms, such a commitment will be more credible if the buyer can choose from fewer alternative suppliers. Information technology increases the importance of noncontractible investments by suppliers, such as quality, responsiveness, and innovation; it is shown that when such investments are particularly important, firms will employ fewer suppliers, and this will be true even when search and transaction costs are very low.