Competition in the supply option market

This paper develops a multi-attribute competition model for procurement of short life cycle products. In such an environment, the buyer installs dedicated production capacity at the suppliers before the demand is realized. Final production orders are decided after demand materializes. Of course, the buyer is reluctant to bear all the capacity and inventory risk, and thus signs flexible contracts with several suppliers. We model the suppliers' offers as option contracts, where each supplier charges a reservation price per unit of capacity, and an execution price per unit of delivered supply. These two parameters illustrate the trade-off between total price and flexibility of the contract, and are both important to the buyer. We model the interaction between the suppliers and the buyer as a game in which the suppliers are the leaders and the buyer is the follower. Specifically, suppliers compete to provide supply capacity to the buyer and the buyer optimizes its expected profit by selecting one or more suppliers. We characterize the suppliers' equilibria in pure strategies for a class of customer demand distributions. In particular, we show that this type of interaction gives rise to cluster competition. That is, in equilibrium, suppliers tend to be clustered in small groups of two or three suppliers each, such that within the same group all suppliers use similar technologies and offer the same type of contract. Finally, we show that in equilibrium, the supply chain inefficiencies, i.e., the loss of profit due to competition, are in general at most 25% of the profit of a centralized supply chain, for a wide class of demand distributions.