Supply Diversification with Responsive Pricing

Abstract

We study sourcing and pricing decisions of a firm with correlated suppliers and a price-dependent demand. With two suppliers, the insight -- cost is the order qualifier while reliability is the order winner -- derived in the literature for the case of exogenously determined price and independent suppliers, continues to hold when the suppliers' capacities are correlated. Moreover, a firm orders only from one supplier if the effective purchase cost from him, which includes the imputed cost of his unreliability, is lower than the wholesale price charged by his rival. Otherwise, the firm orders from both. Furthermore, the firm's diversification decision does not depend on the correlation between the two suppliers' random capacities. However, its order quantities do depend on the capacity correlation, and the total order quantity decreases as the capacity correlation increases in the sense of the supermodular order. With more than two suppliers, the insight no longer holds. That is, when ordering from two or more suppliers, one is the lowest-cost supplier and the others are not selected on the basis of their costs. We conclude the paper by developing a solution algorithm for the firm's optimal diversification problem.

Keywords: diversification, correlated suppliers, responsive pricing

JEL Classification: C61, C44