Cost‐raising internalization in supply chain design

We investigate the supply chain design decisions faced by a focal retailer that participates in a two‐tier supply chain with another competing retailer and a common upstream supplier. The operations literature has traditionally approached supply chain network design with the objective of minimizing the overall costs from a centralized standpoint. We study the strategic consequences of the focal retailer's supply chain design decisions, and demonstrate how pursuing “cost‐raising” internalization could be beneficial. We build a stylized game‐theoretic model that captures the cost implications of the focal retailer's internalization decisions, and analyze the impact of these decisions on the equilibrium outcome. Under various assumptions on the nature of retail competition and supply chain contracts, we obtain simple and intuitive sufficient conditions for the profitability of cost‐raising internalization. Moreover, we study how the intensity of horizontal and vertical competition, respectively, may influence the focal retailer's supply chain decisions. Finally, we examine the impact of cost‐raising internalization on consumer surplus and channel performance, and find that welfare may increase under certain conditions. Our results challenge the presumption that supply chains always benefit from lowering their costs and highlight the fact that strategic considerations can sometimes lead a firm to make cost‐raising decisions within its supply chain.