Controlling for supplier switching in the presence of real options and asymmetric information

Abstract

Applying a real option approach, this paper examines how asymmetric information alters key variables of a firm’s supplier switching process, such as the timing of contracting (hurried versus delayed contracting), transfer payments, set-up, switching, and abandonment decisions. In a symmetric information setting, delayed contracting is unambiguously beneficial. Abandoning the once established relation with the entrant supplier is never an issue. In contrast, under asymmetric information hurried contracting with potentially abandoning the relation can be beneficial. Consistent with adverse selection models, we find that under delayed contracting, in equilibrium, the firm switches less frequently to the entrant supplier (switching inertia). Surprisingly, we also find that under hurried contracting the firm switches more frequently to the entrant supplier (switching acceleration) and may abandon the relation. Finally, we study how these key variables of the supplier switching process change when also the incumbent supplier has private information (two-sided asymmetric information case).

Introduction

How should a firm structure its supplier selection process? Supplier selection plays an important role for efficiency improvements (Nelson et al., 2001, Li et al., 2009). As frequently outlined by the supply chain literature, the supplier selection process is rather complex, embedding a variety of quite different real options (Weber et al., 1991, Degraeve et al., 2000, De Boer et al., 2001, Wagner and Johnson, 2004, Ho et al., 2010). For instance, a buying firm can wait with establishing a supply chain relation and abandoning a once established relation in order to switch to an alternative supplier. In contrast, there exists evidence that firms do not exercise the option to wait and rush their supplier selection decisions (Rubinstein, 1994, Power et al., 2004, McIvor, 2008, Bae et al., 2010). Since agency conflicts between various supply chain partners can arise (Anupindi and Bassok, 1999, Cachon, 2003, Cachon and Lariviere, 2005, Kraiselburd et al., 2004), a natural question is how agency conflicts alter key variables of the supplier switching process, such as the contractual design, set-up, switching, and abandonment decisions.

Although the supply chain literature frequently emphasizes the complexity and importance of the supplier switching process (Li et al., 2006, Tähtinen and Vaaland, 2006), the academic operations research literature has not explored this topic in depth (Wagner and Friedl, 2007). To address this issue, Wagner and Friedl (2007) have developed a seminal framework to analyze one-shot supplier switching decisions when a buying firm has asymmetric information about the entrant supplier’s production costs. Since the buying firm has to pay the entrant supplier information rents for his private cost information, it is optimal for the buying firm to switch to the entrant supplier less frequently compared to the case of symmetric information (switching inertia). In a one-shot framework, abandoning the once established relation with the entrant supplier is never optimal. This framework provides important insights for static one-shot supplier switching decisions under asymmetric information when the entrant supplier’s production process is already in place.

To account for the complexity of the supplier switching process, we apply a real option approach. In particular, we incorporate into Wagner and Friedl’s (2007) static framework an option to wait with establishing a supply chain with an entrant supplier and an option to abandon this relation subsequently. The buying firm can either contract with the entrant supplier early (hurried contracting), where the entrant supplier has imperfect information about its costs, or late (delayed contracting), where the supplier has perfect cost information. Establishing the supply chain with the entrant supplier induces nonrecoverable fixed costs. The buying firm can abandon the once established relation subsequently. In particular, this paper examines how asymmetric information alters key variables of a firm’s supplier switching process, such as the timing of contracting (hurried versus delayed contracting), transfer payments, set-up, switching, and abandonment decisions.

Investigating as a benchmark the first-best situation of symmetric information, we find that the buying firm unambiguously prefers delayed contracting over hurried contracting. Under delayed contracting the set-up decision can be made under perfect information, while under hurried contracting the set-up decision has to be made under imperfect information. In other words, consistent with the traditional real option literature, the option to wait has a positive value (Dixit and Pindyck, 1994, Hull, 2006). In equilibrium, the associated switching decision is surprisingly simple; the buying firm switches to the entrant supplier if its total costs are below the incumbent supplier’s price (and vice versa). Abandoning the established supply chain is not an issue since the buying firm can establish the supply under perfect cost information. The abandonment option is worthless.

Accounting for asymmetric cost information substantially alters the contracting and switching decisions. Under delayed contracting, the buying firm has to pay the entrant supplier information rents for his private cost information. In contrast, hurried contracting has the advantage of eliciting the entrant supplier’s information rents, while it has the drawback of establishing the supply chain under imperfect information. If the buying firm abandons the supply chain subsequently, it has to incur unnecessary fixed costs. Since high fixed costs indicate a need for more precise information about the supply chain’s costs, delayed contracting dominates hurried contracting for high fixed costs. In contrast, lower fixed costs increase the buying firm’s willingness to establish the supply chain which, in turn, requires handling the asymmetric information problem more efficiently. Accordingly, hurried contracting dominates delayed contracting for low fixed costs (and vice versa). Summing up, asymmetric information decreases the value of the option to wait with contracting and increases the value of the abandoning option.

The contract decision substantially influences the switching decision. In line with Wagner and Friedl (2007), under delayed contracting the agency problem aggravates switching inertia, i.e. the buying firm switches to the entrant supplier less frequently compared to the symmetric information case. In contrast, under hurried contracting accelerated switching occurs in that the buying firm switches to the entrant supplier more frequently compared to the symmetric information case. Additionally, the buying firm potentially abandons a once established supply chain with the entrant supplier. Thus, to alleviate agency problems, the buying firm accepts the potential loss of initializing an inefficient supply chain. Summing up, in equilibrium, the buying firm’s switching decision becomes more complex than in the symmetric information case. While previous literature on adverse selection models has pointed to switching inertia, our study shows, surprisingly, that switching acceleration in connection with abandonment can be optimal.

Finally, we investigate how the incumbent supplier’s price affects the contracting, switching and abandonment decisions. In particular, we extend our basic set-up to the two-sided asymmetric information case where the incumbent supplier has private information about his costs. Asymmetric information increases the incumbent supplier’s price which, in turn, diminishes the efficiency of the relation with him. Hence, the possibility of incurring unnecessary fixed costs by abandoning a once established supply chain with the entrant supplier decreases. As a consequence, hurried contracting becomes more attractive.

Our analysis is closely related to the limited literature on supplier switching decisions under asymmetric information. In particular, our paper is closely related to Wagner and Friedl, 2007, Pfeiffer, 2010, Friedl and Wagner, 2012. Pfeiffer (2010) studies the design of supplier switching contracts when the entrant supplier learns privately his production costs over time. As mentioned, Friedl and Wagner (2012) investigate a static switching decision when the buying firm can also engage in supplier development. Similarly, Demski et al. (1987) find that due to agency-conflicts it can be optimal for the buying firm replacing the incumbent supplier even when there is a cost advantage compared to the entrant supplier. Pfeiffer (2010) studies the design of supplier switching contracts when the entrant supplier learns privately his production costs over time. Extending supplier selection models (e.g., Degraeve et al., 2005, Narasimhan et al., 2006, Ernst et al., 2007), for instance, Sucky (2007) studies the (total relevant strategic) costs of switching from incumbent to entrant suppliers. Heijboer (2003, pp. 148–160) studies the optimal renegotiation time of a contract for a commodity group considering renegotiation costs and the substitution of cheaper products. Li and Debo (2009) find that delaying supplier switching may increase investment incentives if switching costs are not too high. Our paper adds to this literature by analyzing how the timing of contracting alters key variables of the supplier switching process, such as the entrant supplier’s information rents, the supply chain contract, set-up, switching and abandonment decisions.

Broadly interpreted, our paper complements the literature of real options and agency conflicts that has studied other economic problems. Arya and Glover, 2003, Pfeiffer and Schneider, 2007 study capital budgeting decisions in the presence of an abandonment option. Arya and Glover, 2001, Antle et al., 2001, Antle et al., 2007 analyze how an option to wait for mutually exclusive investment projects can mitigate adverse selection problems. Grenadier and Wang, 2005, Bouvard, 2010, Mæland, forthcoming propose models of investment timing by managers in decentralized firms. Our paper differs from these papers in that it studies the interrelation of two real options, i.e. waiting and abandonment options, and how that affects the supplier switching process.

Our paper also refers to the literature on supply chain contracts (for an overview see Anupindi and Bassok, 1999, Sahin and Robinson, 2002, Wu et al., 2002, Cachon, 2003, Kraiselburd et al., 2004). Abstracting from the supplier switching process, this literature includes problems of asymmetric information regarding cost (Corbett and de Groote, 2000, Ha, 2001, Corbett et al., 2004, Corbett et al., 2005, Lutze and Özer, 2008), quality (Baiman et al., 2000, Lim, 2001, Kaya and Özer, 2009), market demand and forecasts (Özer and Wei, 2006, Taylor, 2006, Özer et al., 2007, Frascatore and Mahmoodi, 2008, Lin et al., 2010, Zhao et al., 2010), and strategic interactions between markets (Arya and Mittendorf, 2010, Arya and Pfeiffer, 2011).

The remainder of the paper is organized as follows. Section 2 presents the model. Section 3.1 analysis the benchmark case of symmetric cost information. Section 3.2 studies delayed versus hurried contracting in the presence of asymmetric information. Section 4 studies the impact of the incumbent supplier on the supplier switching process. Finally, Section 5 concludes the paper.