Diversification,supplier selection,and order allocation under yield risks and strategic rivalry

Abstract

This article examines supply-base configuration, supplier selection, and order allocation under supply risk and downstream rivalry. We develop a Cournot duopoly model in which two firms sell partially substitutable products and procure a critical input from two unreliable suppliers with asymmetric cost-risk profiles and correlated yield risks. We formulate a two-stage game: firms first choose their supply bases either endogenously or under a one-sided sourcing-flexibility structure and then allocate orders across selected suppliers. We derive closed-form, supplier-specific sourcing thresholds that quantify the marginal revenue gain from adding either supplier to an otherwise sole-sourced supply base. These thresholds vary systematically with supplier heterogeneity, yield correlation, the rival’s sourcing strategy, and competition intensity. In the endogenous sourcing game, supply-base choices are structurally independent of strategic rivalry—which affects only equilibrium order allocations—and the unique equilibrium takes the form of either mutual dual-sourcing or mutual sole-sourcing from the same supplier. Yet mutual dual-sourcing can be Pareto-dominated by distinct-supplier sole-sourcing. This Prisoner’s Dilemma arises only when yield correlation exceeds an explicit cutoff that declines with competition intensity. We also identify conditions under which the classical cost-based supplier-selection rule fails: above a critical correlation threshold, firms may optimally sole-source from the supplier with the higher effective cost because it is more reliable, and that equilibrium is Pareto-optimal. Under one-sided sourcing flexibility, when the rival is committed to sole-sourcing, both the sourcing threshold for the locked-in supplier and the correlation cutoff for supplier-selection reversal decline, strengthening the flexible firm’s incentive to sole-source from the other supplier. Finally, we show how the extent of firms’ supply-base overlap shapes strategic interaction and equilibrium order allocation under correlated yield risks.