Bid-taker power and supply base diversification

Abstract

We study a buyer who periodically auctions off short-term supply contracts among her supply base. To mitigate significant cost shocks to procurement, the buyer can diversify her supply base by selecting suppliers from different regions. We find that the buyer's decision to diversify depends on her bid-taker power-that is, her ability to choose the auction mechanism. At one extreme, when the buyer has full bid-taker power and thus can dictatorially implement the optimal mechanism, she always prefers to diversify. At the other extreme, when the buyer uses a reverse English auction with no reserve price due to her lack of bid-taker power, she generally prefers to protect herself against potential price escalation from cost-advantaged suppliers by diversifying less. The managerial insight is that the more bid-taker power the buyer has to control price escalation from cost-advantaged suppliers the more she prefers a diversified supply base. This insight is shown to be robust to correlation between regional costs, ex ante asymmetry between regions, and intermediate levels of bid-taker power. © 2014 INFORMS.