Supplier Behavior in Capacity Investment Competition: An Experimental Study

Abstract

© 2016 Production and Operations Management Society Many manufacturers ensure supply capacity by using more than one supplier and sharing their capacity investment costs via supplier development programs. Their suppliers face competitive pressure from peers despite the reduced capacity investment cost. Although standard game theory makes clear prediction that cost sharing increases the suppliers' capacity choice and supply chain profit, the complex decision environment of capacity competition makes it interesting to test whether the theory predictions are robust and, if not, whether systematic deviations occur. We present a laboratory experiment study. The experiment data show that supplier subjects invested in higher capacities than what our theoretical analysis predicted, resulting in profit loss for the supply chain. Our econometric analysis indicates that the subjects are bounded rational and their concern for relative standing may be the potential driver of capacity over-investment. Based on the experimental findings, we study a modified cost-sharing mechanism that adapts to the behavioral biases. Its performance is validated in a second experiment.