Supply Disruptions, Asymmetric Information, and a Backup Production Option

Abstract

We study a manufacturer that faces a supplier privileged with private information about supply disruptions. We investigate how risk-management strategies of the manufacturer change and examine whether risk-management tools are more or less valuable in the presence of such asymmetric information. We model a supply chain with one manufacturer and one supplier, in which the supplier's reliability is either high or low and is the supplier's private information. On disruption, the supplier chooses to either pay a penalty to the manufacturer for the shortfall or use backup production to fill the manufacturer's order. Using mechanism design theory, we derive the optimal contract menu offered by the manufacturer. We find that information asymmetry may cause the less reliable supplier type to stop using backup production while the more reliable supplier type continues to use it. Additionally, the manufacturer may stop ordering from the less reliable supplier type altogether. The value of supplier backup production for the manufacturer is not necessarily larger under symmetric information; for the more reliable supplier type, it could be negative. The manufacturer is willing to pay the most for information when supplier backup production is moderately expensive. The value of information may increase as supplier types become uniformly more reliable. Thus, higher reliability need not be a substitute for better information.supply risk, mechanism design, contract, nondelivery penalty

Decentralized Supply Risk Management

“…Yang et al (2009a), Chaturvedi andMartínez-de-Albéniz (2010), andYang et al (2009b) study asymmetric information about the supplier's likelihood of experiencing a disruption and about the supplier's production cost. Baiman et al (2000) and Lim (1997) study asymmetric information about the supplier's ability to produce non-defective items.…”

“…Supplier qualification screening/risk discovery: Wan and Beil (2009) Wan and Beil (2008), and Yang et al (2009b). These papers are reviewed in Section 4.…”

“…Creating external or internal backup sources of supply: Babich (2006) and Yang et al (2009a) allow the possibility that either the buyer or the supplier or both have access to a source of backup production in the event of a disruption.…”

“…This kind of competition effect is highlighted in recent papers studying buyer-supplier relationships where the supplier has private information about its costs and supply risks. In Yang et al (2009b) and Chaturvedi and Martínez-de-Albéniz (2010), the buyer does not know the suppliers' types. Suppliers' types determine their production reliabilities and production costs.…”

Technical Note—Nonlinear Pricing Competition with Private Capacity Information

“…Several recent works study dual-sourcing motivated by disruption and risk management; see Tomlin and Wang (2005), Babich et al (2007), Yang et al (2012), Gümüs et al (2010). In these works, usually the capacity of each supplier is modeled with a Bernoulli random variable, with some probability the supplier fails to produce any supply and with the remaining probability yields a certain quantity.…”