Multi-tiered Supply Chain Risk Management

We study contracting for a three-tier supply chain consisting of a buyer, a supplier, and a sub-supplier where disruptions of random length occur at the sub-supplier. As is common in supply chains, the buyer has a direct relationship with the supplier but not the sub-supplier; that is, the buyer has limited supply chain visibility. Both the supplier and the sub-supplier can reserve emergency capacity proactively to protect the supply chain from a disruption. We study how the buyer and the supplier can guarantee that the correct level of emergency capacity is reserved. Due to two types of inefficiencies--a special form of double marginalization and the substitution effect--the supply chain is misaligned in its decentralized form, leading to either under or over-reservation of emergency capacity by the sub-supplier depending on the cost structure of the supply chain. The lack of visibility prevents the buyer from directly contracting with the sub-supplier to eliminate these inefficiencies. Yet, he can coordinate the supply chain through cascading: i.e., contracting with the supplier (using a value-based carrot-and-stick contract), who in turn contracts with the sub-supplier (using a cost-based carrot-and-stick or two-level wholesale price contract, depending on the cost structure of the supply chain). Although the sub-supplier is the source of limited visibility in the supply chain and is the party with private information, the supplier is the one that benefits from this limited visibility and is the party that receives information rent from the buyer.