Strategic capability investments and competition for supply contracts

Suppliers often make proactive investments to strategically position themselves to win contracts with a large buyer. Such investments reduce the suppliers’ variable costs of serving the buyer’s demand. We show that an auction mechanism does not always benefit the buyer, the supply chain, or the society. We identify scenarios where the buyer can implement the supply chain and socially optimal solution by committing to a bilateral relationship with fair reimbursement, and forgoing the benefits of competition altogether. We explore the role of commitment by the buyer (to a procurement mechanism) and by the suppliers (to an investment level) by analyzing different timing games under symmetric and asymmetric information about suppliers’ types. We show that it never benefits anyone for the suppliers to commit first. Equilibrium investments and cost structures depend upon the buyer’s bargaining power (opportunity cost). However, the winning supplier’s investments are almost always below the supply chain optimal level.

► Bilateral relations can dominate competitive procurement.
► Buyer’s attempts to hold up the supplier can hurt the supply chain and society.
► Auction mechanisms do not always generate the most efficient result for the buyer, the supply chain and society.
► The sequence of commitment affects equilibrium outcomes.
► Equilibrium investments and cost structures depend on the buyer’s bargaining power.