Supply chain coordination under asymmetric information and partial vertical integration

Supply chain contracting is known to suffer from inefficiency in the presence of asymmetric information. Full vertical integration would eliminate the informational inefficiency but can be strategically undesirable. Yet today’s supply chain partnerships exhibit a certain degree of partial vertical integration via equity ties between the firms. Such governance forms received limited attention in supply chain research. Management literature suggests that partial vertical integration may help the firms to ease contracting problems by aligning their incentives, and thus improve the total surplus. We address this proposition by studying a model of a partially integrated supply chain in which the buyer holds an equity stake in the supplier. We adopt an operational perspective and investigate contracting between the firms within the joint economic lot size framework. We demonstrate that in this classical setting, partial integration can in fact be sufficient for eliminating informational inefficiency and achieving coordination. However, contrary to what one may expect, a tighter integration may harm supply chain performance and defeat coordination. We explain the underlying mechanism and investigate it analytically and numerically. Our results characterize sensitivity of supply chain performance to the degree of integration and stress the importance of the operational planning perspective for strategic decision making.