B2B Supplier Management, Inve

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B2B: Supplier Management,
Investments in Information
System s, and Codifiability
M ordechai Levi
A Dissertation
In
Operations and Information Management
for the Graduate Group in Managerial Science and Applied Economics
Presented to the Faculties of the University of Pennsylvania in Partial
Fulfillment of the Requirements of the Degree of Doctor of Philosophy
2002
Graduate Group Chairperson
UMI Number 3043905
Copyright 2002 by
Levi, Mordechai
All rights reserved.
UMI’
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© [2002] by [Mordechai Levi]
All rights reserved.
Dedicated to my Parents, Avraham and Yehudit Levi
to my wife, Adva Dinur-Levi
and
to Shira, my daughter
in
Acknowledgments
I would like to thank Morris Cohen, Howard Kunreuther, Eli Snir, and
Dennis Yao for many helpful comments on earlier drafts of the material in
this dissertation. I am very grateful for Lorin H itt’s comments on all of the
material and especially his invaluable assistance on the empirical part. I
have been helped by Kate Fang and the rest of the administrative staff of
the Operations and Information Department at The Wharton School. I am
highly indebted to my wife, Adva Dinur-Levi, who throughout my studies
and the years it took to reach here helped me with support, advice, and
provided me with the insight to the key idea of codifiability, without which
this dissertation would not be as it is. More them anyone, I am forever
indebted and thankful to my advisor, Paul Kleindorfer for his multi-faceted
support, guidance, knowledge, and wisdom, which have carried me through
out my graduate studies and the completion of this manuscript. All errors
and omissions are solely my responsibility. This dissertation was supported
in part by the Institute of Supply Management (ISM, formerly NAPM).
iv
Abstract
B2B: Supplier Management, Investments in Information
Systems, and Codifiability
Mordechai Levi
Paul R. Kleindorfer
B2B e-commerce requires substantial investments by suppliers and buyers
in information systems find related infrastructure. As has become evident re
cently, generating trade via e-Marketplaces and exchanges is not easy. More
than 1,000 exchanges were built in the past few years and B2B trade through
those is expected to reach trillions of dollars. However, more than 90% of
these exchanges and marketplaces have generated very low trade activity
and many have had to close down. Contradicting early predictions, suppli
ers have not rushed to join these exchanges, for various reasons, the most
salient of is fear of margin erosion. In order to analyze supplier management
strategy in this context I build an analytical framework. This framework
allows analysis of both the selection and control questions. In Chapter 2
the questions of incentives (control) for suppliers’ investments in informa
tion systems is solved, while in Chapter 3 I analyze the question of how
many, and which, suppliers should a buyer use to generate optimal invest-
ments by suppliers in the resulting relationship. Out of this investigation
emerges an important factor in determining strategy, namely the codifiabil
ity of transaction knowledge. Codifiability, some level of which is necessary
for electronically mediated transactions, is shown to determine how many
suppliers can be used. While the concept of codifiability is not new, its ap
plication to inter-firm relationships is novel. To examine the framework and
the hypotheses generated in Chapter 3, an empirical study on a procurement
department of a leading chemical firm is performed. I find that the model
is strongly supported and that codifiability and transferability of transac
tion knowledge are important factors in determining supplier management
strategy and performance. Building on these findings, chapter 4 uses an
analytical model to examine how codifiability affects the mix of contract and
spot-market procurement. I find lower codifiability to shift the mix towards
contracts, which allow an orderly negotiation process on the details of the
transaction, thus strengthening Chapter 3’s results. Details of the resulting
market equilibrium arising from various degrees of codifiability are presented
as one important implication of this modeling framework.
vi
Contents
1 Introduction 1
1.1 Historical Perspective.................................................................... 3
1.2 Supplier Management in P e rs p e c tiv e ........................................ 10
1.3 Dissertation O u t l i n e .................................................................... 13
2 Incentives for Suppliers’ Investm ents in Information System s 25
2.1 Introduction........................................ 25
2.2 Supplier Management:An Overview of the Issu es.......................... 32
2.3 Modeling Fram ew ork........................................................................ 47
2.3.1 The C o n te st........................................................................ 48
2.3.2 The Buyer’s P ro b le m ............................................................54
2.3.3 In c e n tiv es........................................................................... 59
2.4 D iscussion....................................................................................... 64
vii
2.5 Appendix A ...................................................................................68
3 T he O ptim al Num ber o f Suppliers and Codifiability 71
3.1 Introduction ........................................................................................71
3.2 Modeling F ram ew ork....................................................................... 80
3.2.1 Assumptions.......................................................................... 85
3.2.2 Time L in e ..............................................................................86
3.2.3 N o ta tio n s ..............................................................................87
3.3 A n a ly sis............................................................................................. 88
3.3.1 Version 1: Contractible Investm ents.................................. 91
3.3.2 Version 2: Unobservable In v e stm e n ts ................................97
3.4 C odifiability..................................................................................... 102
3.5 The Empirical S t u d y ......................................................................107
3.5.1 H y p o th e se s......................................................................... 109
3.5.2 The D a t a ............................................................................ 120
3.5.3 Part I: The Case of the Missing S tra te g y ........................ 124
3.5.4 Part H: Regression R esu lts.................................................135
3.6 D iscussion......................................................................................... 150
3.7 Appendix: List of V a ria b le s .......................................................... 153
viii
4 O ptim al Contract and Spot-M arket M ix for Buyers in the
Presence o f Uncodiflable Transaction Knowledge 158
4.1 In troduction ..................................................................................... 158
4.2 Model and Notation ......................................................................164
4.3 Basic R e s u l t s ...................................................................................172
4.4 Multiple B u y ers............................................................................... 191
4.5 Summary .........................................................................................197
4.6 A p p e n d ix .........................................................................................199
5 Conclusions and Future Research Directions 212
5.1 Practical C ontributions....................................................... 213
5.2 Theoretical C o n trib u tio n s .............................................................216
5.3 Future R esearch............................................................................... 222
ix
List of Tables
3.1 Design of Analysis ............................................................................90
3.2 Descriptive S ta tis tic s ...................................................................... 123
3.3 CorrelationsT a b le l.......................................................................... 126
3.4 CorrelationsT a b le 2 .......................................................................... 127
3.7 CorrelationsT a b le o ...........................................................................130
3.8 Number of Suppliers: Main E f f e c ts ..............................................138
3.9 Number of Suppliers: U n iq u en ess................................................. 139
3.10 Defects Performance - Main E ffe c ts ..............................................145
3.11 Quality Performance - Main E ffe cts..............................................147
3.12 Performance - Learning and C odifiability.....................................149
List of Figures
*2.1 Relationship Structures as a function of Transaction Attributes 38
3.1 Time L i n e .......................................................................................... 86
3.2 Number of Suppliers vs. Annual Monetary V o lu m e ..................132
xi
Chapter 1
Introduction
With the advent of the world-wide-web (WWW) as a transaction medium
for Business-to-Business trade (B‘2B) supplier management has become the
focus of industry and research alike. This new medium, the WWW, of
fers a fundamentally different platform than any that existed before. By
drastically reducing some types of transaction costs and supplying a more
plug-and-play environment, the W WW is supposed to allow a move towards
markets, with a substantial increase in the number of participating suppliers.
Predictions of the volume of trade facilitated by the WWW are now routinely
estimated to be trillions of dollars in trade activity per annum. However, as
the past two years witnessed, this proposition is not so easily fulfilled, and it
is not clear that it can be fulfilled across all transactions domains. Indeed,
while there is substantial volume of trade over the W W W in some transac
tion categories such as steel and plastics, trade projections in other sectors
had to be lowered from their levels a year or two ago. The problem is clear.
For any progress to be made in this domain, firms have to get their suppliers
to join the exchanges, e-Marketplaces, and other such web based platforms.
Those suppliers, however, are not eager to do so for many reasons, one of
which is the fear of eroding margins due to increased competition. This and
other concerns has given rise to a renewed interest by suppliers and buyers
alike in the terms that will govern their longer-term relationships, especially
if these are to be electronically mediated. Thus, rather them reducing the
importance of relationship management, the WWW has underlined supplier
management as a key determinant of any firm in moving towards web based
procurement. This is especially true for buyer-supplier relationships for
which large idiosyncratic investments, and specifically investments in infor
mation systems, or the integration of long-term contracting and spot market
purchases are of concern. This dissertation focuses on supplier management
where these tire key underlying factors of buyer-supplier relationships. For
this context, I note specifically the central role of codifiability as a driver of
both idiosyncratic investments and resulting supplier management strategies.
In so doing, I address some of the fundamental concerns and issues behind
B2B e-commerce, its development and its future.
The rest of this chapter starts with a historical perspective on supplier
management in section 1.1. I then discuss briefly the core of this dissertation
in section 1.2 and continue with a discussion of supplier management, which
as mentioned above is my focus in this study. Section 1.3 outlines the rest
of the dissertation and summarizes the approach and results of chapters 2,
3, and 4.
1.1 H istorical P erspective
Before we put forth a theory or a model to explain some of the drivers of B2B
and its interaction with the WWW, we have to understand the challenges
faced by firms in today’s global market place. In order to do so, however,
we first have to understand the history of supplier management, since that
history shapes current practices and strategies, and therefore the challenges
faced by firms.
Around the mid eighties, Total Quality Management (TQM) had started
to influence U.S. business thinking after a 1980 special NBC program “If
Japan C an ... Why Can’t We?” brought W. Edwards Deming’s ideas to U.S.
executives (see Evans and Lindsey, 1999 for an extensive discussion of TQM).
The program highlighted Deming’s role in the development of Japanese qual
ity. By emphasizing quality, TQM pushed organizations to evaluate their
internal processes to ensure high quality. The reasoning is simple: it is more
costly to fix something than to do it correctly the first time around. How
ever, zero defects or six-sigma are not easy to achieve. Organizations had to
change complete processes and embark on continuous self-evaluation. It was
not long before this process of self-evaluation came to recognize that a key
ingredient for quality are the products, materials, and services procured from
outside. Unless those are of high quality the organizational effort towards
high quality cannot be effective. Enter supplier management. Economic
th inking at the time emphasized creating competition as opposed to estab
lishing relationships. Since quality was a driver, monitoring of quality and
thus monitoring of suppliers became key elements of supplier management.
While this trend carried on into the nineties, with the confluence with
process re-engineering, two other theories started to take root and influence
business thought. The first was Transaction Cost Economics (TCE), which
owed its early development to Williamson’s seminal book, Markets and Hi
erarchies, in 1975. In this book Williamson suggested that firm boundaries
are determined by the relative costs of conducting a transaction internally
compared to conducting it through an external source. Williamson postu
lated that firms and groups of firms (read entire value chains) choose the
least costly alternative. Thus, if it is cheaper to conduct the transaction
internally, the firm will vertically integrate and if it is cheaper to conduct it
externally the firm will procure the item from outside suppliers. However,
underlying this observation was an idea that is as critical. The idea is that
there are multiple factors determining transaction costs and as those change,
so would the organizational structures and inter-firm relationships observed.
At one extreme, firms may choose to vertically integrate, and at the other
extreme firms may choose to purchase in the spot market. Intermediate
solutions may constitute long-term relationships, small number outsourcing
among others. The TCE idea was powerful since it made the observation
that there is not one solution to supplier management strategy. Rather it
argued that efficient strategy choice depends on finding a fit between trans
action specifications and the structure of (supplier) relationships. However,
only when enough supporting empirical evidence had started to accumulate,
towards the late 80s, this idea became accepted and supplier management
w£is considered not just as quality monitoring and cost reduction but as re
quiring complex, context-based, strategy.
The second theory was Michael Porter’s value added chain approach
(Porter, 1985). Porter observed that the process by which firms add value to
a good or service consists of several subprocesses, each of which contributes
both cost Eis well as potential attributes of the product or service valued by
end customers. At the same time, each firm is a link in a value-adding
chain, which stEirts with raw materials and ends with a finished consumer
product. The more value a firm adds, the stronger its Position in the value
chain. The key to Porter’s Einalysis was to use overEill value chain margin as
the scorecEird Eind to look for opportunities across the entire value chain for
improving this scorecEird, either through reduced cost or through enhancing
those attributes of the product or service VEilued by customers. Naturally,
the first reaction by firms was to try to cut costs. When the gains from pure
cost cutting Eire exhausted, firms have to think about value adding and not
just quality and cost. Value adding, e.g. through reduced cycle time or
through improved customization of the product, requires close relationships
sind collaboration with other links in the supply chain and mainly with sup-
pliers. When such is the case, a value chain can compete with other value
chains supplying the same goods. Such very close relationships, or strategic
partnerships as they have come to be termed, are costly to establish in time
and personnel. Thus, to achieve such partnerships a firm must reduce its
supplier base and cultivate only few suppliers in each domain. As a result,
beginning in the early nineties and continuing throughout the nineties, the
trend was towards a reduction of the supplier base and a move towards close
partnerships in domains where value-added logic dictated closer relationships
between buyers and suppliers.
As a result of this type of thinking, the field of operations management
assimilated the idea of strategies focused on the entire value chain. Opera
tions management coined its own terminology, supply chain management, to
better match its operational perspective. But the idea behind supply chain
management is clearly the same as the one behind value chain management.
Firms are links in a chain leading from raw materials to consumer or in
dustrial goods. The emphasis is on linking and matching operations and
processes to facilitate a more efficient supply chain. One direct consequence
of this evolution has been the huge growth in interest in Enterprise Resource
Planning (ERP) software. In order to link outside, a firm must first link
and match its internal operations and processes. This requirement gave rise
to ERP software such as SAP’s. Given the cost and complexity of ERP
implementation, many firms stopped far short of implementing a complete
package of ERP software. However, even partial implementation, focused
on material management and production planning, has allowed firms to start
shifting their focus to external interactions with other firms and suppliers.
At the same time, the mid-nineties, the WWW had started to become
common. Firms that had invested in Electronic Data Interchange (EDI) in
the past could only do so with their big suppliers or customers or the invest
ment could not be justified. The WWW, however, offers a different type of
system. EDI is one-to-one link so that each connection requires a new in
vestment. The WWW, on the other hand, is many-to-many or one-to-many
at the least. When a third party creates an e-Marketplaces, the investment
in essence is spread over many buyers and suppliers. Furthermore, each con
nection is not unique, thus allowing for even bigger savings. Investments,
mostly in information systems (IS) are, therefore, less relationship specific.
At the same time, they are supposed to be less idiosyncratic in that the
platform should apply to multiple transaction types.
To support this evolution towards ERP-based or platform-based interac-
tions between buyers and sellers in the B2B world, a number of other data
management and sophisticated supply chain management tools were created,
including those of companies like i2 and Manugistics. The idea behind these
supply-chain software tools is to optimize the material and information flows
along the supply chain. Since, presumably, firms have reasonable control
over internal flows, and due to the common platform offered by the web,
those firms can now link and start operating as a coordinated supply chain.
Naturally, in practice this idea is far from being implemented and supply-
chain software mostly coordinates two “adjacent” firms on the supply-chain,
the standard buyer-supplier model.
W ith such opportunities, supplier management has become even more
important. A firm now has, in theory, an ability to interact seamlessly
with more suppliers across more product lines. Rather than simplify, such
ability actually complicates supplier management since now a firm cannot
look at each supplier or product in isolation and has to manage the full
matrix. The importance of matching strategy to transaction types is even
more critical since no longer can a “one approach fits all” strategy be used
successfully. More over, firms have to manage suppliers on multiple fronts.
While cost and quality are still and always will be a critical factor, firms have
to get suppliers to invest in inter-firm systems and processes of various types
in order for these firms and their supply/value chain to interact efficiently.
On the transaction level, firms have to figure out which transactions can
be conducted via electronic channels and what has to be done to facilitate
electronic transactions, from standardizing and digitizing the product offering
to agreeing on contract and transactional terms sufficiently precisely to allow
electronic order fulfillment.
1.2 Supplier M anagem ent in P erspective
Notwithstanding all of these very positive developments, and as noted ear
lier, the early growth predicted for electronic B‘2B activity did not materialize
in many sectors. In order to understand why B‘2B activity has not picked
up as fast as forecasted, we have to understand supplier management and
its interaction with the WWW. This is the primary focus of this disserta
tion. Supplier management research in the past three decades has included
multiple research questions, researched with different methodologies and has
been discussed in several disciplines, mostly in economics, management, and
operations management. In the next few paragraphs I give a short review
10
of approaches to the problem. I start with the questions asked within sup
plier management, explain the differing approaches of different disciplines
and which methodologies have been used. Broadly defined, these questions
can be divided into the following categories:
1. How many suppliers to have? This question arises from economics and
mostly compares the nature of incentives one versus multiple sources
offer. Multiple sources are considered broadly without examination
of the differences between having, for example, four or five suppliers.
This issue is usually also linked to the “Spot market vs. long term
relationship” question discussed below.
2. Make or Buy? When a firm is interested in using only a single source,
it may want to consider vertical integration. There axe advantages and
disadvantages to either make or buy decision. Sometimes the decision
to buy may be from multiple sources (vs. from a single source), but
that is not usually the case examined. The literature is concerned with
analyzing the trade-offs between make and buy strategies.
3. W hat should be the nature of relationship with suppliers? There are
many types of relationships a firm can establish with its suppliers,
11
ranging from strategic partnership bordering on vertical integration to
an opportunistic one with no commitments or any other relationship-
enhancing mechanisms. As mentioned before, this question and the
number of suppliers question are tied since to create strategic partner
ship with a supplier a firm cannot have more than a few suppliers for
the specific item in question. Often this question is posed as follows:
(a) Should a firm buy through long-term relationships or through spot
markets? Posing the question as such allows for starker differences
and for analytical modeling. Many of the •‘middle ground” con
figurations are difficult to model analytically since benefits and
costs are not clearly defined and measurable monetary value or
costs associated with alternative designs are difficult to identify.
4. How should contracts be written? As Coase (1937) and Williamson
(1975) observed, contracts may be difficult and costly to write due to
transaction costs, bounded rationality and other factors. Furthermore,
even when contracts are costless it can be still difficult or even impossi
ble to structure contracts that induce optimal behavior. The contract
literature is vast but as I show later, much has yet to be achieved. A
12
more focused question often asked is:
(a) W hat incentives should be given via contracts to suppliers? The
idea is to use specific incentives (for the transaction in question)
to align suppliers’ objectives with the buyer’s own objectives to
induce a desired behavior.
All these questions Eire tied together and answers to one affect what can be
done to Einswer others. However, anEilyzing these questions in conjunction
is often difficult, especially for analytical modeling which is the research
focus here. Each question is explored using a different level of Einalysis
and isolates different interactions among firms. In this research I try to
link these different questions, and specificEilly questions 1, 3, and 4, eis the
following outline describes.
1.3 D issertation O utline
Therefore, I start by ansdyzing the incentives problem in chapter 1. In
centives are designed once the decisions regsurding number of suppliers and
purchasing institutions and markets (spot vs. long-term) have been made.
Only when a buyer knows the way it is going to purchEise Eind how msiny
13
suppliers are to be used, can it consider the question of incentives and tailor
them appropriately. Incentive questions have been analyzed extensively in
the Principal-Agent literature, contract theory, game theory and in numer
ous other streams of literature and research paradigms, including economics,
marketing, operations, management, accounting, and law. These have also
been applied to IT investments for supply-chain improvements (Clemons and
Kleindorfer, 1993), (Wang and Seidmann, 1995). In analyzing incentives
for investments to improve supplier-buyer transactions, it is important to
reflect the impact of such investments on the cost and quality of the ulti
mate transactions leveraged by these investments. To be specific, I focus on
investments in information systems, but the same arguments developed for
IT will apply more generally. In the model developed, the buyer is able to
observe supplier investments but cannot mandate them (in the usual sense
of principal-agent modeling), in contrast to the assumption of Wang and
Seidmann (1995). Rather than rely on incentives that rely on ex post mon
etary transfers, depending on the level of the supplier investment, a different
approach is required that is compatible with the context of supplier manage
ment involving competing suppliers. The framework developed foresees two
incentive instruments, both in the hands of the buyer. The first instrument
14
is based on the natural assumption that suppliers compete for the buyer’s
business and, in the contest model developed, the “best” supplier wins the
business. Here, “best” will be defined as an observable function of the sup
plier’s investment in IT. The second instrument is that the buyer itself can
invest in the supplier, thus assuring some additional performance from the
supplier but also affecting the supplier's further incentives to invest. The
trade-offs between the cost and effectiveness of these two instruments is the
central object of the analysis.
As Williamson (1975) established, investments are a key factor in deter
mining the nature of relationships between firms. To support idiosyncratic
investments, long-term relationships have to be established. Williamson and
the whole stream of TCE that followed have tried to identify the types of
relationships likely to form as a function of several key variables, such as
complexity and frequency of transactions. I build on that insight and use
it to extend standard supplier relationship models by considering a segmen
tation of transactions as a function of transaction attributes. Chapter 2
analyzes the segmentation problem in terms of the nature of optimal incen
tives for alternative transactions, described by volume, revenues, complexity
of the buyer-supplier interactions, as well as required investment costs and
15
effectiveness.
In chapter 2 and chapter 3 transactions axe modeled as being of different
types relative to supplier capabilities. The “type variable” for new projects is
modelled as a random variable taking values in the [0,1] interval. The unit
interval represents a measure of transaction attributes on which suppliers
are measured, such as quality and cost. Supplier capabilities are located
on this same interval. The buyer cares about the distance between the
transaction and the suppliers, and chooses the supplier who is closest to the
transaction, given a preselected list of approved suppliers. Investments in
supplier capabilities, and the screening and qualification of suppliers, are
decisions undertaken before the "locations” (i.e., specific requirements) of
any new projects are known.
Such modeling provides both advantages and disadvantages in analysis.
The key advantage is, of course, the ability to incorporate and analyze spe
cific transaction attributes, such as frequency, monetary volume, variability,
and complexity, as drivers of supplier management strategy. The key disad
vantage is the need to specify functional forms more strongly. I argue that
the functional forms chosen here are reasonable on several dimensions. The
key intuitive property of these functional forms is that investments in buyer-
16
supplier compatibility improve this compatibility by providing a better fit
between future projects of the buyer and supplier capabilities. We will see
that this has profound effects on the nature of feasible and optimal incentives
and other characteristics of the supplier management problem. The analysis
of these effects, given a set of suppliers, is indeed the main contribution of
chapter 2.
The results of Chapter 2 also contribute to the theory of contests by
complementing existing literature as best exemplified by Nalebuff and Stiglitz
(1983). Existing literature has concentrated on agents’ output that is linear
in effort with risk-averse agents. In this research the assumption is that
output (here it is A* and not R(A*) since agents are chosen based on A*)
is non-linear in effort/investment and agents axe risk neutral. Nalebuff
and Stiglitiz, generalizing previous papers (e.g., Lazear and Rosen, 1981;
Holmstrom, 1982), have shown that under assumptions of linear output,
risk-neutral agents, and individual randomness effort is increasing in prize
(Theorem 2). The results in this paper axe the same. Similar to the
behavior of agents in their model, agents (suppliers) in this model invest in
order to increase their probability of winning the contract only to end up
with the same probability of winning the contract with which they started
17
(in the symmetric case, 0.5). Nalebuff and Stiglitz also showed that, under
non-linearity, a contest does not achieve first best even under risk neutrality.
Here the result is strengthened and it is shown that adding an individualistic
component will improve results under the right conditions. In doing so it
adds to the fundamental discussion of Nalebuff and Stiglitz regarding how
contests and individualistic incentive schemes compare. Lastly, Nalebuff
and Stiglitiz showed that individual randomness is required for equilibrium
to exist. In this work, individual randomness in not present and is not
required to generate interesting results since the nonconvexities identified by
Nalebuff and Stiglitz do not occur here.
In chapter 3 ,1 use the same framework and extend it in order to solve for
the optimal number of suppliers to be used for a set of transactions, the scope
of whose characteristics are defined ex ante, with individual projects realized
randomly in the fashion described above. The analysis generates testable
hypotheses about the factors that drive supplier management strategy, in
cluding investment levels, numbers of suppliers and performance for various
types of market environment and transactions characteristics. I test these
hypotheses in the empirical part of chapter 3 using data from the purchasing
department of a leading Fortune 500 chemical company.
18
A key aspect of the analysis of Chapter 3 is the identification of transac
tion knowledge codifiability as an important factor in determining supplier
management strategy, especially when e-commerce is concerned. Codifiabil
ity (Zander and Kogut, 1992) is the ability to take the knowledge embedded in
the transaction and its related processes and codify it in manuals and explicit
instructions for the purpose of communicating requirements for products or
projects involved in the transaction. Codifying transaction knowledge is
necessary for electronic interchange since only codified inputs can be trans
ferred electronically. In the context of the modeling framework of Chapter
3, codifiability (or more correctly uncodifiability of transaction knowledge)
is modeled as lack of knowledge regarding the transaction or project loca
tion on the unit interval AFTER the transaction has realized. This lack
of knowledge could apply for both buyer and suppliers. Thus, the buyer
has to form its supplier management strategy knowing it may not be able to
recognize the most able supplier without error or maybe not even at all in
the extreme case.
While knowledge codifiability has been examined in a very limited way
in the management literature (Kogut and Zander 1993; Szulanski, 2000;
Inkpen and Dinur 1998) it has not been examined as a driver for inter-firm
19
relationships, supplier management strategy and e-commerce related strate
gies. Furthermore, using codifiability for analyzing inter-firm relationships
gives rise to interesting new categories of information ‘"asymmetry” effects.
Previous models, based on moral-hazard and adverse selection, have placed
the information asymmetry on only one side of a relationship, mostly placing
the principal at a disadvantage. Uncodifiability of transaction knowledge,
however, may affect both parties similarly. In the case of new technology,
for example, it is sometimes not clear what the specifications are, how to
produce it, or how to support the development and deployment of the tech
nology. Under conditions of complete uncertainty about such requirements,
the model in Chapter 2 predicts that only one “good overall” supplier will be
used. Thus, in line with intuition, when faced with new technology develop
ment under high uncertainty on product specification, firms will employ one
supplier for externally sourced requirements. In less extreme circumstances,
increasing uncodifiability results in fewer suppliers used.
Part II of Chapter 3 is an empirical study of a leading Fortune 500 chem
ical company to examine the several hypotheses generated from this frame
work. As explained in Chapter 3, multiple reasons exist as to why a single
company is an appropriate focus for such a study at this stage of research
‘20
knowledge. The results strongly support the analytical model and the hy
pothesis that codifiability is a key driver of supplier management strategy.
These results extend the analytical model by showing that indeed, as pointed
above, it is not codifiability itself that matters, but the ability of the buyer to
communicate or transfer its transaction knowledge to its suppliers. In many
instances, the buyer in question knew the transaction and was able to codify
it but was not able to transfer that knowledge to its suppliers, who were
unable to learn the transaction well and efficiently. The result of this lack of
communicability was a decrease in the number of suppliers used, matching
the model’s prediction. Naturally, such instances represent a tremendous
improvement opportunity for the buyer.
Building on the codifiability results and insights, I examine in chapter 4
the integration of various market types for procurement. Given the centred
role of e-Marketplaces in the B2B area, the emphasis here is on the inte
gration of spot markets and long-term contract procurement choices. We
will see that codifiability is again a central aspect of the nature of this in
tegration; increased codifiability makes the good in question more amenable
on multiple dimensions to spot market transactions involving arms-length
participation by a number of buyers and sellers. Exactly how this occurs,
21
both in single supplier-buyer transactions and in market equilibrium among
competing buyers and sellers requires that we abstract from the details of
individual contracts and focus on more general types of interactions between
buyers and sellers in the markets in question. The framework developed to
analyze this problem builds on work by Wu, Kleindorfer, and Zhang (‘2000,
2001) that examines the spot vs. contracting question but in less general
settings and without treating codifiability effects.
The model developed in chapter 4 adopts the following perspective. One
or more buyers face a decision as to how to source an intermediate product
from one or more suppliers. They can do so either by setting up longer-term
contracts, with specialized suppliers, or through one-time (spot) purchases
from generalized suppliers. In the case of contracts, systems and procedures
are established ahead of time to support the execution of transactions, and
these procedures may be embodied in an exchange with restricted member
ship. In the case of generalized suppliers, procurement occurs through a
■’spot exchange", where the exchange can be either an established electronic
exchange or something as simple as the Yellow Pages.
The key difference between these types of procurement is that contract
procurement is negotiated in advance, and can accommodate virtually any
22
customization in product or delivery features desired by the buyer(s), while
generalized (or "spot”) procurement is constrained by the rules of the market,
and typically allows much less customization. The benefits of contracting
are assumed to be lower variable production and transactions cost, including
the costs of poor quality and off-spec product, and a higher probability of
order fulfillment in the face of demand volatility. Spot purchases from gen
eralized suppliers provide access to a broader competitive market, and allow
fine timing of demand and supply, but possibly at higher unit costs associated
with the poorer matching of product specifications and delivery features with
the buyer’s requirements. While these benefits favor contracting, it must be
done in advance, and sometimes well in advance, of physical delivery require
ments so that investments in capacity or customization required of suppliers
to support contract execution may face increased uncertainty relative to spot
market transactions. The trade-offs between these costs and risks depends
fundamentally on the codifiability of transactions and the volatility of de
mand. If transactions are completely codifiable, and unit costs are identical
between these two sourcing alternatives, there would be no reason (for ei
ther competing suppliers or buyers) to set up long-term contracts. But cost
differences can arise for both suppliers and buyers. I use this framework
•23
to synthesize a host of previous results on the incentives for contracting in
supply chain management.
To summarize, this dissertation examines all stages of supplier manage
ment from control, selection and screening, to the choice of long-term con
tracting and spot market mix. This dissertation has formulated a framework
allowing segmentation of supplier relations, into which a number of previous
findings have been integrated. Building on this framework, a fundamental
contribution, shown both analytically and empirically, is the role of codi
fiability as a driver of all aspects of supplier management strategy. The
analysis and results take on special importance against the significance and
growth of B2B e-commerce activity and resulting restructuring of procure
ment strategies.
24
Chapter 2
Incentives for Suppliers’
Investm ents in Information
System s
2.1 Introduction
As the World-Wide-Web (WWW) increases in importance for B‘2B transac
tions, supplier management becomes more critical for success. At the same
time, buyers’ demands from suppliers are changing. In the past, cost and
quality were the important factors driving supplier management and the key
‘25
measures of successful relationships. In a complex and global competitive
world the WWW brings about, cost and quality are not enough. Firms that
cannot create value-adding relationships with their suppliers will not be able
to compete. Given the rise of the WWW and increasing B‘2B activity, such
relationships hinge on investments in ever more complex information systems
(IS), mostly geared towards inter-firm transactions. Until several years ago,
conducting transactions via electronic channel meant doing it through an
EDI connection. Today, it means conducting it either through EDI, or
through a variety of different and new e-Marketplaces. At the same time,
supply-chain software, building on enterprise resource planning (ERP) sys
tems has emerged to offer even more competitive tools to optimize supply
chain operations.
The result is that for firms to compete successfully, they must get their
suppliers to invest in information systems of different types. While such
systems are typically highly idiosyncratic investments, they may be more or
less relationship specific, i.e. some of these investments may be useful in
general in allowing buyers or suppliers to integrate their operations with the
new realities of e-Markets. The broad purpose of all of these information
systems, whether operational, transactional, or information sharing oriented,
26
is improving interactions between buyers and suppliers along the range of
products traded between them.
In order to get suppliers to invest in such information systems, a buyer
must set up an environment conducive to supplier investments. Interestingly,
the WWW is the exact opposite of what one usually takes to be the prop
erties of an "investment inducing environment”. In particular, the W WW
stresses easy access to many suppliers, thus promising higher competition on
the supply side and therefore lower margins for suppliers. However, unless
suppliers believe they can recuperate the investment, they will not invest.
Thus, firms face a sort of catch-2‘2. They want suppliers to invest in sys
tems that by their very nature may weaken the ability of these suppliers to
recuperate these investments. This may be one of the several reasons that
B‘2B has not grown as fast as forecasted a few years back. A key objective
of this dissertation is to create a framework for designing incentives for to
motivate suppliers to invest in inter-firm IS when it is efficient to do so. In
this chapter I use the framework to analyze incentives for such investments
while in the following chapter I analyze the related question of screening and
selecting suppliers (the so-called "selection problem”), including the optimal
number of such. Thus, as we will see, the framework established allows
27
analysis of both selection and control within a single framework.
The framework developed draws upon and extends the transaction cost
economics (TCE) literature on intermediate production relationships (which
has come to be dubbed as B2B), as developed originally by (Coase, 1937)
and (Williamson, 1975). Williamson (1975, 1996) has argued in detail that
the nature of inter-firm relationships changes when various attributes of the
transaction, such as risk and frequency, change. These relationships can
vary from close partnerships with one supplier to spot market purchases in
an open market among several buyers and sellers. However, in the area of
supplier management, TCE has not been successfully formalized analytically.
This paper lays a foundation for such a formalization based on the theory of
contests (Nalebuff and Stiglitz, 1983) and Principal-Agent modeling (Holm-
strom, 1982). A buyer who is the principal has to structure incentives for
suppliers to make inter-firm, relationship strengthening, investments. The
suppliers compete on getting orders or projects from the buyer. By investing,
a supplier makes its fit with any project better. As Clemons et. al (1993)
observed, IS have such an effect. Regardless of the transaction executed
information systems should improve its efficiency and performance. In this
chapter I model this feature of IS and it is the reason why the buyer is trying
28
to incent supplier to invest in IS. Suppliers’ investments in IS improve their
performance for any given project transacted with the buyer, which in turn
improves the buyer’s revenues. Such relationship enhancing investments are
akin to establishing a strong relationship. As shown later, the buyer may
invest in the relationship as well, which is akin to selecting those suppliers it
invests with. Thus, part of the ’selection of suppliers’ problem is answered
here as well. However, due to the one-period nature of the model, this paper
does not claim to fully answer it or analyze implications of such selection.
Further work is required to build a multi-period model with more them one
buyer to analyze the full spectrum of the selection and relationships question
?ind is outside the scope of this paper.
To fully use TCE as a basis for analysis economic tools are not enough for
two reasons. The first is that economics neglects operational variables that
are important and critical for understanding relationships with suppliers.
Furthermore, in economics demand is price dependent and such a framework
applies more to market or consumer market situations. In buyer-suppliers
context, demand is generated not by suppliers’ prices but on the buyer’s side
independently of suppliers’ prices and should therefore modeled as stochas
tic, which is an Operations Management perspective. In this work I use
29
stochastic demand generated on the buyer side.
As Williamson (1975) observed, investments are a key factor in estab
lishing relationships. Wang and Seidmann (1995) explored the question of
incentives for investments in EDI but assumed suppliers must participate,
which mutes the relationship building aspect of the investment. Other mod
els based on PA have looked at cost reduction rather than investment induce
ment. As a result, this work finds that the classic solution to PA problems,
of conditional transfers, used in Wang and Seidmann (1995) as well, does not
work in this context. Rather, a more novel approach is required.
This work also contributes to the theory of contests by complementing
existing literature as best exemplified by Nalebuff and Stiglitz (1983). Ex
isting literature has concentrated on agents’ output that is linear in effort
with risk-averse agents. In this research the assumption is that output (here
it is A* and not f?(A*) since agents are chosen based on A*) is non-linear in
effort/investment and agents are risk neutral. Nalebuff and Stiglitiz, gen
eralizing previous papers (e.g., Lazear and Rosen, 1981; Holmstrom, 1982),
have shown that under assumptions of linear output, risk-neutral agents,
and individual randomness effort is increasing in prize (Theorem 2). The
results in this paper are the same. Similar to agents behavior in their model,
30
agents (suppliers) in this model invest in order to increase their probability
of winning the contract only to end up with the same probability of winning
the contract with which they started (in the symmetric case, 0.5). Nale
buff and Stiglitz also showed that, under non-linearity, a contest does not
achieve first best even under risk neutrality. Here the result is strength
ened and it is shown that adding an individualistic component will improve
results under the right conditions. In doing so it adds to the fundamental
discussion of Nalebuff and Stiglitz regarding how contests and individualis
tic incentive schemes compare. Lastly, Nalebuff and Stiglitiz showed that
individual randomness is required for equilibrium to exist. In this work,
individual randomness in not present and is not required to generate inter
esting results since the nonconvexities identified by Nalebuff and Stiglitz do
not occur here.
The rest of the paper is as follows: Section 1 discusses relationship specific
investments and long-term relationships. Section 2 discusses IS investments
in particular. Section 3 deals with supplier management and control. Sec
tion 4 surveys briefly some of the selection and control literature. In section
5 we describe the analytical model. In part I (of section 5) we analyze
the case of two asymmetric suppliers and without special incentives towards
31
investments. That creates a base model to compare to and establishes suppli
ers expected behavior with regard to investments when they are not offered
investments based incentives. In Part II I analyze investment dependent
incentive schemes for two symmetric suppliers and demonstrate the impor
tance of the type of incentives provided to suppliers. I also solve for the
optimal linear scheme, which is both a common assumption in literature and
a practical necessity for implementation.
2.2 Supplier M anagem ent: An O verview o f
the Issues
During the past decade there has been a marked and continuing trend to re
duce the number of suppliers used (Dyer 1995; McMillan 1990). In a recent
survey covering 27 U.S. industries, all but the government and transporta
tion sectors reported that in 1997 the mean decrease in number of suppliers
was 6.1%, as a percentage of the 1996 supplier base. Given the growing
economy in 1997, this decrease is quite large, especially against the backdrop
of significant previous decreases in the supplier base during the early ’90s.
At the same time, mean percentage of sales revenues procured from suppliers
32
was 35% and in some industries it reached 60% (averaged across the sampled
companies). Thus, on one hand firms are reducing their supplier base and
on the other they are outsourcing more.
As companies increasingly try to focus on core competencies, outsourcing
becomes critical for successful competition in the global marketplace. If a
firm does not manage its suppliers effectively, its operations, product quality,
time to market and overall strategy will clearly be adversely affected.
Previous research aimed at understanding supplier management and inter
firm relationships have typically concentrated on only one of the four stages
of supplier management:
1. Selection and screening. In order to ensure quality and smooth
transactions, firms have to select and screen suppliers to establish a
list of qualified suppliers.
2. R elationship formation. After suppliers have been selected and
screened, the buyer forms relationships with them. Those relation
ships may range from arm-length to strategic partnerships and al
liances. Each relationship type carries a different nature and level
of interaction.
33
3. Relationship developm ent. Once those relationships have been
formed, they have to be maintained and strengthened, especially when
they are close, long-term relationships.
4. Control and incentives. At the operational level of supplier man
agement, firms have to write contracts, establish control mechanisms,
and offer the correct incentives to supports the buyer’s goals for a given
relationship.
The thrust of the present work is to examine the challenges of integrat
ing the above stages. While these four stages are typical of most supplier
relationships, there are significant differences across industries, buyers, and
suppliers in the nature and intensity of each of these stages. A general
framework will need to represent the factors that might affect these dif
ferences. As Seshadri (1995) notes, selection and control Eire increasingly
considered as strategicEilly linked stages, but except for his theoretical paper
there is little other evidence to suggest that this notion has influenced the
research literature. SimilEirly, early on Macbeth (1987) predicted that just-
in-time and other advanced manufacturing technologies would bring about
the integration of supplier selection with long-term contracts, but very little
34
research has been accomplished until recently to examine this subject.1
Like Seshadri (1995) and Wang and Seidmann (1995), I solve simulta
neously the joint problem of screening an appropriate number of suppliers
and investing in the resulting longer-term relationships with those suppliers.
As in Seshadri (1995), I analyze the dual-sourcing problem using a contest
embedded in a principal agent problem. Seshadri examined the cost contain
ment contest between two suppliers and derives the optimal cost-plus contest.
The suppliers are drawn from several vendors through a bidding competition.
The winner of the bidding competition, the supplier with lower cost, wins a
larger share of the contract. Wang and Seidmann (1995) analyzed adoption
of EDI by suppliers find showed that EDI externalities influence the adopter
value. The reward for adopters is increased market share and sales volume.
They also show that under certain conditions the buyer may want to subsi
dize suppliers. Similar to Wang and Seidmann (1995) I analyze idiosyncratic
investments in IS by suppliers. However, unlike both Seshadri (1995) and
Wang and Seidmann (1995) in our model demand cannot be split between
lThis is not to say that the area of contracting in supply chain management has not
been a very active area of research over the past decade, e.g., Cohen and Agrawal (1999)
and many other works reviewed in the recent survey by Cachon (2001). The point here
is simply that this literature has not yet integrated the subjects of selection and control
within a unified framework.
35
suppliers. The winner gets all of the profits for any single project (of course,
the buyer may, and in our model does, distribute the benefits of projects
over time among all suppliers on the approved list) . Furthermore, while in
Wang and Seidmann (1995) suppliers are mandated to adopt EDI, suppliers
in this model invest in IS only if they find it profitable to do so. I also
explore the structure of incentives in more detail and show that certain in
centive schemes have very dysfunctional consequences. Specifically, I show
that conditional transfers, the classic solution in PA and also used by Wang
and Seidmann (1995), are not feasible for ex ante investment incentives in
supplier management. The structure of reasonable incentives is clarified in
this paper.
Concerning general frameworks for supplier management, Christy and
Grout (1994) divide the relationships and the associated theory or models
of supplier management into 4 quadrants. On one axis is process specificity
and on the other is product specificity. When product specificity is high and
process specificity is low, they argue that principal-agent models apply. In
the ’’opposite” quadrant, when product specificity is low and process speci
ficity is high, transaction cost economics and long-term contracting are ar
gued to be the suitable theoretical approach. However, in the middle ranges
36
of product and process specificity they provide no clear answer regarding
which model should be used. I am interested in exactly this middle area and
through combining transaction cost economics and a principal-agent models
I aim to develop a framework that applies to a broader range of supplier
management settings.
Arguably, the central foundation during the past decade for general frame
works for studying supplier management and inter-firm relationships derives
from transaction cost economics (TCE, see Williamson 1996). The goal of
TCE is to understand and explain the nature of supplier relations in terms
of the factors driving the nature of these relationships. Williamson (1975,
1996) argued that the key factors to consider are: risk, complexity, monetary
volume, and frequency of transactions. These factors determine, according to
Williamson, the nature of relationships and efficient mechanisms for govern
ing these. These governance mechanisms include long-term contracts, spot
markets, and other arrangements for planning and executing transactions.
The basic logic of Williamson’s approach, applied to supplier management,
is illustrated in Figure 2.1 below.
Located at the lower left corner of the transaction space in Figure 2.1, or
at low levels of risk, complexity, and impact but with high monetary volume
37
Figure 2.1: Relationship Structures as a function of Transaction A ttributes
c
o Sole Sourcing
m
Long-term Alliances
*
s
t
k
Annual $ Volume
Strategic Impact
and frequent transactions, are standardized transactions. For such transac
tions, the buyer knows the exact specifications, and products are essentially
commodities; here the emphasis is on low unit cost and low transaction costs.
The market as the trading system is the most common structure, and the
relationship is mostly adversarial. Although investments are made, these are
not relationship-specific investments, but jure geared towards lowering trans
action costs (e.g., EDI, web-based systems) and better monitoring (tracking
shipping progress, etc.).
At the extreme right upper comer, at high levels of risk, complexity, mon-
38
etary volume of transactions (a function of both S/transaction and frequency
of the transaction), and strategic impact are the very close relationships,
resulting in either vertical integration or sole sourcing with long-term con
tracting. The range of such "strategic partnerships” can itself be large.
Examples are found in automotive and high technology manufacturing. A
parts supplier may supply only one manufacturer, both because of the high
cost and complexity of designing parts and tools for a specific manufacturer
and by reason of the large strategic risks for the automotive manufacturer
(the buyer) should quality problems result. For such transactions where
relationship-specific investments are extremely high and the dollar volume
of transactions makes it worthwhile, efficient supplier management requires
that work processes be aligned, with supporting IT and organizational mech
anisms to facilitate sharing and coordinating production scheduling and ful
fillment. These requirements lead naturally to a small supplier base.
When not all the dimensions are either high or low, relationships become
more difficult to establish and analyze. For example, large engineering con
struction projects are very complex and carry high risk, both for the buyer
and the contractor. Monetary value and strategic and financial impact are
u su a lly high. However, the number of transactions is low. In this case,
39
vertical integration may not be feasible since the bought firm would lose its
ability to trade with other buyers and the number of transactions with any
one buyer is not high enough. Sole sourcing, on the other hand, is also
typically infeasible for the buyer, given the geographic dispersion of such
engineering projects. However, the buyer is still interested in relationship-
specific investments on the part of its suppliers since these allow mitigation
of the risks and complexity involved.
As these examples illustrate, at the middle ranges of the dimensions dis
cussed above, we see various structures, from alliances and strategic partner
ships to closed e-Markets. These formations are solutions spanning the mid
dle ground between market mechanisms and full integration or sole sourcing.
In the middle-ground of Figure 1, buyers would still benefit from suppliers’
making relationship-specific investments. However, providing appropriate
incentives to promote such investments is difficult. Among other factors,
relationship duration may complicate matters. Unless suppliers Eire guaran
teed a long enough relationship they will hesitate to invest since buyers can
eiIways walk away after investments have been made.
Before analyzing market structure using transaction cost economics in
em analytical model, we have to understand how idiosyncratic investments
40
are linked to selection and control. In order to benefit over the long term,
a firm has to select suppliers that can improve over time. However, such
improvements usually require idiosyncratic investments, for which suppliers
want to be compensated. To compensate suppliers for such investments,
buyers often promise suppliers who invest that they will enjoy a bigger wal
let share as an incentive. As a result, selection and control issues are fre
quently tied to relationship-specific investments. Thus, only an analytical
apparatus that includes both selection and control in conjunction with idio
syncratic investments will sufficient scope to deal with the basic issues raised
by the transaction cost economics paradigm that has come to dominate as
the foundational framework for analyzing efficient supplier management.
Williamson (1975, 1996) in his analysis of transaction cost economics es
tablished that a key to understanding market structure lies with relationship
specific investments. These investments are at the core of forming close
relationships such as alliances. However, at the same time, such invest
ments create a hold-up problem to one or both parties involved. Joksow
(1987) found that buyers and sellers make longer commitments to the terms
of future trades and count less on repeated bargaining as the importance
of relationship-specific investments increases. Therefore, in order to under-
41
stand long-term relationships, we first have to understand the mechanisms
underlying the creation of specific investments.
First, let us recall the historical trends noted above towards reduced sup
plier base. A firm that reduces its supplier base is more exposed to hold-ups
by suppliers as they become more critical to the buyer’s operation and not
as easily replaceable. To counteract such exposure, a firm has to establish
stronger relationships with its existing suppliers. Therefore, accompanying
the reduction in supplier base, we have witnessed a growth in strategic al
liances for procurement. When vertical integration is not feasible or not
desirable, such alliances serve to secure valuable resources, technologies and
knowledge and usually entail long-term relationships that allow firms to cap
italize on improved congruency and trust. The benefits to both sides are
many. Kalwani and Narayandas (1995) found that suppliers in long-term
relationships do not experience a lower sales growth than their competitors
who prefer a more transactional approach and at the same time axe able
to reduce cost through better inventory utilization. These cost reductions
are transferred to the buyers through lower prices, which implies that firms
involved in long-term relationships with their suppliers might enjoy cost ad
vantages. However, Kalwani and Narayandas (1995) also show th at supplier
42
firms in long-term relationships enjoy higher profitability by having lower
discretionary expenses such as selling, general, and administrative overhead
costs. At the same time, buyer firms in long-term relationships were found
to benefit from improved quality, process performance and continuous cost
reductions (Newman 1988; TVevelen 1987; Liker and Wu *2000).
Gassenheimer et. al. (1995) found relationship-specific investments to
be the key variable explaining differences in a supplier’s share of a buyer’s
purchases. Such investments include training, process alignment, specialized
information systems, specific equipment and other investments that are only
valuable in a specific relationship. Gassenheimer et. al. found that the
higher the supplier’s investments, the higher the share of the buyer’s wallet
they get. Similarly, Stump (1995) found specific investments to be associated
with greater purchasing concentration. This evidence suggests that suppliers
should want to invest in relationship-specific investments and that buying
firms should try to incent suppliers to invest. However, often firms do
not or cannot sign long-term contracts in advance. Thus, the question
arises: how do buyers motivate suppliers to invest in specific investments
even when future contracts are not guaranteed? This is the central focus
of the analytical framework developed below.
43
The second key issue in the framework developed is the integration of
selection and control, an issue to which I now turn. In addition to the work
of Seshadri (1995) and Wang and Seidmann (1995), discussed above, some
work on this produced in the literature on managing bidding, awarding and
control of public procurement. A key paper in this regard is Anton find Yao
(1989), who analyze a split-award model and show that it leads to collusive
behavior that in turn leads to increased prices by preventing competition.
Seshadri et. al. (1991) analyze a bidding model without collusion and find
that when the number of bidders is endogenously determined it leads to more
bidders but with higher prices. As Seshadri (1995) points out, both streams
of research into bidding, collusive or competitive, find (p. 563) that: "The
generally obtained result in the cited studies is that multiple agent selection
schemes lead to higher prices them if just one agent were selected.”
Principal-agent theory on the other hand examines contests or tourna
ments as a means for motivating suppliers. Lazear and Rosen (1981) use
rank-order tournaments as such a mechanism. Holmstrom (1982) generalizes
their mechanism through sufficient statistics analysis. In both models the
principal is faced with a hidden action problem since agents have two sources
of cost uncertainty, common and private. Using a contest, the principal is
44
able to outperform an individualized incentive scheme since the contest al
lows the principal to extract the common cost information. Extraction of
the common cost information allows the principal to extract rents from the
agents. This result depends on the common uncertainty, and as Holmstrom
(1982) observes, "competition per se is worthless” (p. 324). Only compe
tition that allows extraction of common factors supplies benefits. Nalebuff
and Stiglitz (1983) also use a contest in a slightly different way but with
comparable results. When a common source of uncertainty exits, compe
tition is mostly preferred over individualistic reward schemes as a means of
extracting the common information rents from the agents. Thus, in contrast
to the selection literature, principal-agent research finds competition to be
better than, or at least equal to, individualistic compensation schemes.
In this paper I integrate the above two streams of research and apply the
integrated model to the realm of idiosyncratic investments. I use a contest
with two suppliers but with a different structure than either that of Seshadri
(1995) or Wang and Seidmann (1995). The agents and principal face the
same common uncertainty. However, although the principal can observe the
investments made by the agents, she cannot contract on these investments
directly because of the nature of the environment in which only one of the
45
agents can execute the work. The principal, due to the uncertainty involved,
does not know ex-ante which agent is best suited for the work. Only the
winner gets ”a prize”, which is actually the payment associated with the
contract. While the promise of winning the project may be enough for agents
(suppliers) to invest, the buyer may find it useful to offer stronger, investment
specific, incentives. I find that monetary transfers, fixed or conditional, are
not enough and in effect do not change suppliers’ effective investments, since
such transfers do not affect their marginal returns. The principal (buyer)
has to invest in the relationship. In my two-stage model, such incentives are
akin to a selection of the supplier in a multi-period model since they establish
a "strong” relationship with a supplier and give that supplier some preferred
status. In the model here, this translates to higher probability of winning
a contract ceteris paribus. We show below that when the two questions
of selection and control are tied together there is no clear answer to how
many suppliers the principal (the buyer) should select. Depending on the
technology of the idiosyncratic investment and other factors, the principal
might select both, one, or none of the suppliers.
46
2.3 M odeling Framework
We assume two suppliers competing for the business of a single buyer. Sup
pliers can be asymmetric on two attributes. The first is their type or spe
cialty, which we represent by a type parameter p{, for suppliers i = 0 , 1 , where
p{ takes values on the [0,1] interval. Projects (or transactions) are assumed
to arrive stochastically and to have attributes that can also be positioned
on this same [0, 1] interval. Indeed, we think of the location of project a t
tributes as describing the ideal type supplier for that project, whereby actual
suppliers will be chosen as suppliers depending on the distance of their type
from this ideal type or project location. The details of the selection process
are described below.
We place the two suppliers on the extremes, one supplier at pQ = 0 and
one supplier at px = 1. However, having asymmetry by placing one closer
to the middle than the other would not change results in any fundamental
manner. Such asymmetry would only serve to shorten the [0,1] effective
interval over which competition for projects occurs to the interval between the
two suppliers. Any area between a supplier find the interval end is controlled
by that supplier alone and therefore does not affect the competition between
the suppliers.
47
The second source of asymmetry is a technology factor, a*. I start by
assuming technology asymmetry (qo a i) but I consider the results for the
special case of symmetry in some detail.
I begin with a simple pure contest model that does not have any specific
incentive mechanism designed to incent investments by suppliers. I limit the
analysis to two suppliers; the N-supplier case is a straightforward extension.
I consider in Chapter 3 of this dissertation the optimal number of suppli
ers, thus complementing the present analysis to solve the dual questions of
selection and control.
2.3 .1 T h e C ontest
Each supplier faces the same situation. It wants to maximize its profits
given the incentive scheme declared by the buyer. Thus, supplier i faces the
following problem:
MaxUi = T x Ti - Xi for i = 0,1 (*)

Xj> 0
T is the average transfer suppliers receive from a given transaction . 2 is
2In the more general framework proposed in Chapter 3 we multiply the term TxT, by
the arrival rate of projects/transactions that would be enabled by the single investment Xj.
In this more general framework, the supplier is thus making investments with an eye on
cashflows generated by a stream of projects that it might thereby win. For the moment,
we focus on a single-shot contest, i.e., a single transaction.
48
supplier i’s probability of winning any given order or project, and Xi is sup
plier i’s relationship-specific investment directed towards winning this order.
Such investments might include specialized equipment, tooling or informa
tion systems. To solve the supplier’s problem, Ti has to be specified. As
noted above, we assume th at the probability of winning the order for sup
plier i is determined by the distance between the supplier’s type (p0 = 0 and
p, = 1) and the realized project characteristics p, where p is assumed to be
a uniform random variable on [0, 1]. The distance between supplier i and
the realized project type before investments effects axe taken into account is
A, := |p —p j. Supplier i’s investment is assumed to reduce the ”effective
distance” between the supplier and the project. We model the effective
distance as A f^ = Av x A/, where M : = ---- , which we term the ” tech-

1 + otiXi
nology function” with the technology factor a* determining the impact of Xi
on Mi and therefore on Aj.
Using the above notation and assumptions, To = (1— Ti) is determined
as follows:
To = Pr[Supplier 0 wins the project]
=Pr[SupplierOhasthesmallesteffectivedistance]
=Pr[|p - Pol x iV/ 0 < |p - pj| x Mi\
49
=Pr[pM0 < (1 - Pj) x Mi]
or „ Mi , Mi
=Pr[p <
(Mo + Mi) (M0 + Mi)
where the fineil equality results from the assumption that projects are drawn
from a uniform distribution. Similarly we get Ti = , . , .

(M0 + Mi)
Given To and Ti, there is a unique point p*, which divides the [0,1]
interval into two parts. To the left of p* supplier 0 wins eind to the right of
it supplier 1 wins. Substituting T* into the profit function (*), we obtain
the suppliers’ problem:

,. _ T x Mj . n , ,
MaxIIj = 7— r— - Xi t = Q, 1 j = I -1
-vt>0 M (Mi + Mj)
T h e o re m 1 For the game with profit functions Ilj, i — 1,2, there exists a
unique, Nash Equilibrium:
Xi = Max < 0, QtQj t —L\ i = o ,l j = 1 —i

I (<*« + < * j) Cti J
Proof.
Existence
Since H is concave in Xi I consider the first-order condition while ignoring
the non-negativity constraint. To simplify presentation I use the fact that

At #
d ‘ = —QiMf. The F.O.C.s are therefore:
g jl.a WM j=oa j ml-i

dxi (Mi + Mj)
50
Combining the two F.O.Cs for the two suppliers and solving for M q and Mi
results in atoMo = a i Mi and therefore,
Mi = ^Q,2+Q^ - i = 0 ,1 j = 1 - i
<Aa i T
Solving for X*:
Xi =
QiQj
t J aT T
- —1
i = 0 ,1 j = 1 - *
(a* + atj)2 at
Since I!,- is strictly concave in x* it is easily seen this implies the solution
proposed.
Uniqueness
I follow the discussion in EViedman (1986) which summarize both Gale-
Nikaido (1965) and Rosen (1965) and thus allow to show that uniqueness
follows from both those papers but through using one notation system. The
following conditions hold and can be easily verified:
1. Si, the strategy space of each player is compact and convex for each
player i. A strategy for player i is simply Xj (corresponds to As
sumption 2.1 in EViedman.)
2 . H is continuous and bounded for all strategy combinations s = (sot Si)
and Jill i (corresponds to Assumption 2.2 in EViedman.)
3. H is strictly concave in x,.(corresponds to Assumption 2.3 in EVied-
51
man.)
4. Players cannot have binding agreements (corresponds to Rule 2.1 in
Friedman.)
5. Strategy choices by the players (suppliers) axe made prior to the game
(corresponds to Rule 2.2 in Friedman.)
6 . T = (N, S, FI) is a strictly smooth game. N is the set of players, S the
strategy space and II is the set of H . (corresponds to Definition 2.13
in EViedman.)
Given the above conditions both Theorem 2.6 in FViedman which follows
the Gale-Nikaido (1965) univalence theorem and Rosen’s uniqueness theorem
are satisfied if the Jacobian of the implicit form of the best reply function is
negative quasi-definite. To show that last condition the following deriva
tions are provided:

tfU j —2 a j T M j M f
dx? (Mi 4- M j)3
FUi Q jCtjTM jM f (M j - Mj)
dxidxj (Mi + M j)3
Since the diagonal elements of the Jacobian are negative and the deter
minant | J + J 7"! is positive the Jacobian is negative quasi-definite and the
proof is complete. Q.E.D. ■
52
From Theorem 1, we see that under symmetry, Qo = = a , the solution
f T 1)
is Xi = M ax < 0 ,--------- >. Note for the symmetric case that if a T < 4 then
I 4 aj
xq = X\ = 0. Thus, the combination of project revenues and the unit im
pact of investment on buyer-supplier fit should be above a certain threshold
in order for supplier investment to occur. In other words, expected revenues
for the supplier and investment impact should be high enough to make it
profitable for suppliers to invest in information systems and other idiosyn-
cractic systems to improve supplier-buyer performance. The incentives for
supplier investment are sharpened somewhat by the nature of the prisoners’
dilemma type of competition embodied in this contest. Notwithstanding
this sharpening, if the cumulative effect on efficiency is not sufficiently high,
no investment will occur. Note that, as expected, investments increase in ex
pected revenues, T. Investments increase in the technology factor ct*, which
drives investment effectiveness in terms of improved fit. Given the declining
marginal effectiveness of investments on overall fit as well as supplier prof-

T
itability, such investments are bounded above, in the symmetric case by —.
4
Note that under symmetry, suppliers still have the same probability 0.5 of
winning the project after equilibrium investments have occurred, and thus
they are worse off than before investments occurred, having lost the invest-
53
ment. This outcome is the natural and intended consequence of the structure
of the contest set up by the Buyer to push suppliers towards processes and
technologies exhibiting better fit.
2.3.2 T he B uyer’s P rob lem
As a base model I assume the buyer is not offering any specific incentives
for suppliers’ investment. Thus, suppliers would invest only if ex-ante, they
perceive the investment to be profitable. I note that from discussions we
had with purchasing managers, firms mostly do not offer specific incentives
towards investments in information systems or other idiosyncratic invest
ments, but rather require such as the normal course of business interactions.
However, as experience for example with B‘2B related investments, suppli
ers would not necessarily invest. As Stump (1995) found, when suppliers
do make relationship specific investments, they have a higher likelihood of
winning projects or orders and both the buyer and supplier enjoy lower trans
action costs because of a decrease in repeated bargaining (Joksow, 1987).
I model investment effects as follows. Assume any given project or order
would generate some ideal revenues r on the buyer’s side. However, r can
be achieved only if the supplier matches perfectly with the project. In
54
the model, such match translates to supplier attributes or location p{ being
the same as the the project attributes or location p. Under any other
configuration of supplier location and project location there will be some
distance, A* = \p{ —p\, between the supplier and the project, which will
lower revenues achieved. I define the revenue function as R — /i(A*) =
1~—— where
1+0A *
0 6 [0,oo) is the ’impact of fit’ coefficient. For different firms, and even
for different project types within the same firm, the importance of supplier-
project fit is different. For example, when a highly strategic project such as
a new manufacturing plant is considered, the importance of supplier-project
fit is high. On the other hand, when an order of desks for employees usage is
considered, the importance of fit is very low or practically zero. Thus, when
0 = 0 , which would match the desk example, the buyer always achieves the
ideal results or revenues associated with it and therefore would not require
its suppliers to make relationship enhancing investments. As 9 increases,
the importance of fit, or A*, goes up and the only way to offset the increase
in 6 is for suppliers to invest.

r
Note that 0 < A* < 1 and therefore < R < r. Therefore, changes
1+ 0 - - °
in 0 will affect not onlv the mean but also the variance of R.
oo
I assume the following on r : r > (Q° a 0 ^ This assumption assures
a 0Qi
feasibility of prize and non-negative revenues for the buyer. Theoretically,
this assumption may not be satesfied, but then contracting does not happen.
Thus, this is a regularity condition on the relationship between r and the fit
paramteres in the model.
The buyer’s problem is to maximize profits, assuming he uses only project
based incentives or the ” prize” awarded to the winner, and is therefore:
MralIU = r ? W " r < a ’‘i)

In order to solve this maximization problem A* has to be calculated first.
Theorem 2 A t the optimal solution to the buyer’s problem, A* = (Q° ^

atoctii
for any a, and any prize T. The optimal prize maximizing the Buyer’s
expected profits is T* = - <*±*11

aoai ao£*i
Proof. A* is the expected distance between the chosen supplier and the
project and therefore A* = E min Âq^, A * ^ where A ^ is as defined
above, the ”net distance” between supplier and a project accounting for
investment effects. As shown above, there exists a unique equilibrium point,
p'. To the left of p ’ supplier 0 wins and to the right of it, supplier 1 wins.
Using this fact, the solution for A* is obtained as follows:
56
A* = E m i n ^ ^ A f ' ) =
= Pr (Supplier 0 wins) x Aq^ + Pr (Supplier 1 wins) x A ^ ^ =
= J f pModp + (1 - p) M«ip =
MqM i
(Mo + M t)
(a , 4- Qj) 2
Substituting Mi = —^ — ■£— supplies the desired result. To determine T*,
a f a jT
given A*, we note that the buyer’s problem is:
w _tt a0a xr T
Maxiih — _ . .
7* a o ctiT 4- (oio -F Q i ) ®
Since lit is concave in T, we use the F.O.C to find the maximum, which is
achieved at:
r . _ /(q, + a,)r(J _ (°. + o,)0 Q ED u
V ao<*i ttoOt
2
Corollary 1 Under symmetry a 0 = ai = 0, A* = —= and the optimal prize
al
/ 2r0 20
is T = J ------------.
V a a
From these results, we note that as the revenues for the Buyer increase,
so too does the optimal prize T*. In the symmetric case, T is convex in
q and is maximized at a = 80 jr . There is a level of impact of investment
at which transfers to suppliers provide the buyer with the highest returns
for its money. When a is too low, investments do not have enough effect
and therefore the buyer does not give as high a transfer. However, if a
57
is sufficiently high, the buyer knows the suppliers are going to invest and
therefore the buyer can and does lower its transfer payments. Below we show
the profit function that embodies this discussion. Note in the symmetric case
that T is always increasing in 9 near the origin. Thus, some attention to fit
is always appropriate in setting the level of the prize.
1
Corollary 2 A* =
/ Q0a xrd _ Q
(Qo +Oti)
Corollary 3 A* = , under symmetry. As should be, A* in-

y /0 J ri§ -6
creases in r, a , and 9.
= r _ y ( a o 4- a i ) r 0
Corollary 4 R(9)
QoQi
Given the assumption, (Q° < r aôt,gj R{9) is positive and con-
aoOi
tracting is feasible.
Corollary 5 II6 = R(9) - TT == r - 22 ^/ (Q° + Ql) rg + ^Q° + ? l)0 and given

w a 0a i a 0 a!
the assumption above it is positive.
/ 2r0 20
Corollary 6 Under symmetry: Ub = r —2 \ ------ 1---- and therefore profits
V a a
are convex in a.
58
2.3.3 In cen tives
As I observed earlier, using only project dependent transfers may not be
enough to support supplier investments. Furthermore, it may be beneficial
to the buyer to offer investment related incentives, other them T. In most
cases it is not feasible to condition T on supplier investments Xi since T in
this context represents expected revenues from a stream of future transac
tions. In the following section I analyze when it is profitable for the buyer to
offer investment related incentives, what form should these incentives take,
and how suppliers would respond to them. I examine three types of incen
tives and show the classic solution to Principal-Agent problems, conditional
transfer, does not work in this context and a more sophisticated conditional
incentive is required. The analysis is restricted to linear schemes since non
linear schemes would not be practical in this problem context and thus I
do not solve for the optimal incentive scheme. I solve only for symmetric
suppliers in order to show insights clearly. For asymmetric suppliers the
analysis does not yield qualitatively different results.
59
D irect Transfers: Fixed Transfers
The first incentive to consider is the trivial fixed transfer. However, as easily
observed, such a transfer would not change supplier investments. It would
only increase suppliers’ profits while lowering buyer’s profits.
D irect Transfers: C onditional Transfers
This is the classic solution to Principal-Agent problems. However, under this
paper’s problem it does not work. If the conditional transfer is K(Xi) the
QiOtj
analysis will show the optimal investment to be x< = --------- -a---------—T —
(ai + ctj) (1 - K )
— where K' is the derivative with respect to xt. If we assume a linear scheme
K(Xi ) = kxi it is easy to see that x, is indeed increasing in k. However, it
is essentially the same as offering the supplier a higher transfer T, but T is
solved to optimality to begin with. The main difference in this paper from
classic Principal-Agent papers is the problem here is of incenting investments
and not inducing cost reductions. In cost reduction problems the suppliers’
objective function fundamentally changes when such incentives are used due
to a change in the marginals. Such an effect does not take place when
investments are concerned. Wang and Seidmann (1995) had shown condi
tional transfers to work for inducing investments but under the assumption
60
that suppliers must participate, which allows conditional transfers to work
in their settings. However, the present work does not assume, as is realistic
in many situations, that buyers can force suppliers to invest.
Investm ents in the R elationship
Given the above analysis of transfers it is clear that for an incentive scheme to
work it should be more them a mere transfer from the buyer to its suppliers.
Indeed, where investments in relationships are concerned, a buyer can invest
in the relationship as well. Such investments translate to a better fit between
the buyer rind the specific supplier supported by such an investment. As was
shown previously, higher fit induces higher investments by suppliers.
Such a scheme, of a buyer investing in its relationship with a supplier, is
akin to the buyer selecting this supplier for long-term relationship. Given
the one-period nature of the model in this paper it is not feasible to analyze
the broader and temporal effects such investments would have and is outside
the scope of this paper.
Fixed Support
If the buyer invests a fixed amount yt- in the relationship then
Mi = --------- and yi is guaranteed and known to the suppliers in

1 + q (xi + yi)
61
advance. The analysis of suppliers’ contest does not change and the solution
is still Mq — Mi = - 7 - . Using the new we solve for Xj to get x» =

ctT
T 1
— j/f. This solution is the same solution as before except that the
4 Q
supplier now invests y* less. Clearly the buyer gains nothing and only loses
Ih. Interestingly, this scheme has the same effect as the direct fixed transfer
incentive had.
Quid Pro Quo Support
An improvement on the fixed support scheme would be to offer condi
tional support, i.e. iji = 2/»(Xj). Intuitively, such an incentive should increase
suppliers’ incentives to invest by improving fit. The trade-off for the buyer
is between the costs of the support find the benefits incurred due to a smaller
A*. As mentioned before, I concentrate on a linear scheme = 0Xi since
nonlinear schemes are not practical for implementation. As in the analy
sis under no incentives, I start with the contest and then solve the buyer’s
problem.
The C ontest
Since the analysis follows exactly the analysis for no incentives the proofs
are the same and I will only report the changes. The first change is that now
—_ a (1 4. p ) Xi_ 1 define a ’’new” technology factor a ' = a (1 + 13

uXj
62
a ia j 1
and oget X;» ------
(I — ------ r,> i = 0.1, j = 1 —i. Note that this solution is
(Q« + a i)
exactly like the asymmetric solution reported earlier but with the new factor
replacing the previous one o^. As expected, Xf increases in /3{. Note th at
now the buyer’s investment in the relationship induces higher investment by
the supported supplier(s) because the more the buyer invests, the more it
pays the supplier to invest.
The Buyer’s Problem The buyer’s profit function is now slightly dif
ferent and is:
M ax Ilfc = -— T
~ T - f3x
T.t3 1 + 0A*
with (3 = (/?o,/?i) a n d x = (x0 ,x i). However, when y(x) or (3 is optimized,
it is assumed that T is fixed or given. The reasoning is as before th at T
is a stream of payments and project dependent and therefore the buyer is
trying to optimize incentives for investment given those payments. Therefore,

(qo + a'.)
and using the solution A* = - —■,—rzr~ an<i the solution for xt the buyer’s
Qoa i ^
problem is:
n _______ a'0a [r T _______ ^ {0O+ 0 X) aoa'l m . 0 O , (3l
* Al6 _ a ' a ; r + ( a ; + Q; ) 0 ( a '+ a 'O + + a',
Theorem 3 The solution to the buyer’s problem is:
I- A> ~ = P
63
Reproduced with permission o f the copyright owner. Further reproduction prohibited without permission.
2a0 rT T 2
2. 3 is determined by the equation 7 ——-H------------ =• =
^ ( a ( l + 0 ) T + 20) 2 a (1 + /3)
2 a 0 rT T 2
0 in the region w here ------------ , —— H— > 0 and 3 = 0 outside this
(a T + 29)2 2 a
region.
3. Unique
Proof. In the appendix we show 0 Q = 0 { = 0. Therefore, the buyer’s

,, . „ a(l+ /S )rT „ /S„ . 2/3 c .
problem «: M ax II. = q ( 1 + ^ - T - -T + The f a t
2 ck0 rT T 2
derivative w.r.t. /? is -----------------------r —— H ---------r. At 0 = 0 it
( a ( l + 0 ) T + 20) 2 a(l+0)2
. 2a 6 rT T 2 . , , . - 4 a 29rT 2
is------------- s —— H— . Since the second derivative---------------------- t —
(a T + 20) 2 a (a (1 + 0 ) T + 29)
4
----------- 3 < 0 V/3, Ilf, is unimodai in /?. Thus to have a positive solution
a (1 4- 0)
for 0 the first derivative must be positive at 0 which defines the region as in
2. Then we get the solution to 0 by the equation defined in 2. Otherwise,
if at 0 = 0 the first derivative is not positive, 0 = 0 is the optimal solution.
Q.E.D. ■
2.4 D iscussion
I have demonstrated that suppliers should invest in relationship specific in
vestments to enhance the likelihood of winning projects because of their
en h a n ced relationship with the buyer. Suppliers find such investments ben-
64
eficial when their revenues from the contract are high enough, and when the
impact of the investment on the relationship is strong enough. Such in
vestments are induced by suppliers’ competition over the contract. When
suppliers enjoy asymmetric returns from such investments one may invest
while the other may not.
I have also demonstrated that a buyer has several ways to motivate sup
pliers but only one of those actually works. Contrary to practice, but in
accordance with standard principal-agent analysis, the buyer should not of
fer any type of fixed support to the supplier. However, when a buyer does
support suppliers through fixed transfers she may fail to understand that
such fixed support is not optimal. The reason is that while such support
does not change suppliers’ investments, the buyer still enjoys profits and
therefore misinterprets the investment effects. However, the buyer’s profits
are not optimal but only the same profits she would have enjoyed without
the transfer minus the transfer. When linear reward schemes are considered,
only conditioned support is optimal. Thus, the buyer should invest directly
in the relationship instead of using monetary transfers to the supplier, which
result in the supplier reducing its own investment by at least the amount
transferred to it.
65
This work also adds insight to the economic literature on contests. The
model used here has the suppliers investing despite the existence of only
environmental randomness and no individual based randomness. This result
contrasts with the classic result (theorem 4) of Nalebuff and Stiglitz (1983) in
which they prove individual randomness to be a necessary condition for effort
by the agents (suppliers in our case.) Thus, we Eire able to structure a new
type of contest where individual randomness is not required while the prize
system is still ordinal as in Nalebuff and Stiglitz (1983). This chapter offers
further insight on Nalebuff and Stiglitz’s (1983) theorem 1, which states that
some dependence between agents’ outputs is needed for the optimEil incentive
scheme not to be individualistic. Theorem 2 in this chapter states that when
suppliers are symmetric the incentives should be the sEime to both. Given
the perfect correlation between the two suppliers’ ’’output," I have proved
the complement of Nalebuff and Stiglitz (1983) theorem 1.
The model Einalyzed here applies to cases where a contract can be awEirded
to only one supplier, while most of the literature has been concerned with
contracts that can be split among suppliers (e.g. Anton and Yao 1989; Se-
shadri, 1995;Wang and SeidmEinn, 1995). The model exEimined in this paper
adds another dimension to the literature and allows a better investigation of
66
the various types of contracts. Indeed, as discussed in the introduction, con
tracts and supplier relations exhibit considerable variety in terms of the risk,
complexity, and impact they present to the buyer. A worthy goal, for future
research is to integrate the various possible models for each combination of
conditions on the above dimensions into one general framework.
As discussed in the introduction, this paper is only the first step in estab
lishing a framework for analysis of supplier management across its life-cycle.
I was able to analyze both selection and control, the two extreme phases
of the cycle, in conjunction. To analyze questions relating to long-term
relationships, multiple periods must be introduced into the model. Corre
spondingly, in order to analyze the full question of supplier selection, ” pre
ferred supplier” status, alliances and partnerships, more than two suppliers
should be assumed to exist. Combining these two extensions would allow
us to examine how long-term relationships and strategic alliances, or other
types or relationships, interact with contract structure, interorganizational
idiosyncratic and specific investments, and the nature of the transactions
and products involved. Another possible extension is to add suppliers’ pri
vate information regarding their production function. This paper’s model
generates an interesting conflict even without the use of private information.
67
Finally, I am aware of modeling limitations in this paper due to the
specific functional forms we used. However, in order to generate the insights
which are the main focus of this paper, specific functions had to be used.
Because of the model’s complexity, having a contest embedded in a principal-
agent model, generalizing the functional forms would have limited our ability
to derive meaningful results.
2.5 A ppendix A
Summery of Notations
Xi :=Relation specific investment made by the supplier.
y { —Relation specific investment, in supplier i, made by the buyer.
ai :=Technology factor determining the impact of x, and on A/,, a , > 0.
Mi : = -------- ,technologyfunction determining the impact of x, and iji

1 + OjXj
on the distance between a project and supplier i.
r —Location of a project, r is distributed uniformly on [0, lj.
p{ —Location of a supplier on the [0,1] interval.
^ := |p - Pi\
A /c f —A,-x Mi, the effective distance between a supplier and a project
68
given Xi and y,.
A* := min(Aj), the minimum of the distances between the suppliers and
the project. Supplier i, which achieved this distance is the winner.
T :=The fixed transfer or prize the buyer gives the winning supplier.
R := R( A*) the revenue function of the buyer as a function of the distance
between the winning supplier and the project.
H := Profit function of supplier i.
lib := Profit function of the buyer.
Proof, o f Theorem 1: We want to show that /30 = ,8i . For simplicity of
presentation I define
2 + 0Q + 0 X /? ,) + /? ! J D L
A = — --- , . -,i—“ -r and B ——r-— - ——— . Let Ai and B, be
Q ( 1 + A>) ( 1 + $i) a.{2 + 0 Q+ 0 X)
the first derivatives w.r.t.. to /3iof A and B respectively. Then
-1 2
Ai = ------------ 7 and Bi = --- ——-- — for i = 0,1. The buyer’s
q ( 1 + Pi) Q( 2 + P o + f a )
objective function can now be rewritten as follows:
w__ r-r _ rT _ B_T _____ 0o_________ 0i
M ax lift T + AQ a T q(1 +) 3oj +
The F.O.C. are:

dnb rT 1 (BiA - B A ) T 1 Q
80, T + A6 a (1 + f3,)2 A2 a(l+,^)2
Multiplying by a (1 + 0,)2 , equating the F.O.C for i = 0 and i = 1 and
simplifying we get:
69
(B qA — BA q) a (1 + 0 Q)2 = ( B \A —B A i) a (1 -I- A ) 2- Substituting Ao,
Ax, Bo, B\, A, and B the condition is:
1 + A) = 71 7+-A j r a a
7 - 7 - 5- 3 - and therefore, A = Pi-
1 + Pi i + Po
It is easy to check the second order conditions and as I showed in the proof
given in the body of the paper, those axe satisfied when ,P0 = fix-Q.E.D. ■
TO
Chapter 3
The Optimal Number of
Suppliers and Codifiability
3.1 Introduction
In chapter 2 of this dissertation I have analyzed the question of control
through incentives by a buyer to its supplier for idiosyncratic investments,
such as investments in Information Systems (IS). The focus of this chapter
is to solve the complementing problem of supplier selection, and it is done
via the analytical framework developed in chapter ‘2. I then examines em
pirically the hypotheses generated by the analytical model. Selection is the
71
first stage in supplier management and thus affects the nature and specifics
of later stages in the supplier management process. Supplier selection is both
a strategic and an operational decision, which makes it more complex to an
alyze. While supplier management strategy has to align with the buyer’s
overall supply-chain strategy and allow its execution, supplier management
strategy also has to satisfy operational requirements when products and ma
terials are procured.
In the new world of B2B e-commerce, when e-Marketplaces and ex
changes are increasingly becoming a medium through which to conduct trans
action, having the right supplier management strategy becomes even more
critical for firms. Even more so, buyers now must consider the right sup
plier base for supplier investments in IS. As the last two years have shown,
suppliers are highly hesitant to join e-Marketplaces and exchanges for fear
of eroding margins due to increased competition (see Helper and MacDuffie,
2001). The only successful (or partially so) exchanges are these cater to com
modities (e.g. steel) or are led by a strong buyer or consortium of buyers (e.g.
Covisint). In most other instances suppliers either do not join exchanges or
put high obstacles to prevent successful operation of the exchange in ques
tion. As an International Data Corporation study found, only 10% of 1,000
72
exchanges launched in a span of 18 months had any activity by May, ‘2001
(cited in The Economist, 5/19/2001). One potential explanation is sug
gested by the analytical framework, which shows that limiting the supplier
base (as in Covisint) is required for suppliers’ investments.
Even more critical for any electronic transaction is the issue of codi
fiability (Kogut and Zander 1992), which is the level at which a transaction
can be described by a written description and manuals. Naturally, unless a
transaction can be codified it cannot be executed electronically. However,
as this chapter shows, it is not just a requirement but also a critical and
important driver of supplier management strategy. Management literature
(Kogut and Zander, 1992 and 1993; Szulanski 1996; Inkpen and Dinur 1998)
examined codifiability in intra-firm activities and context and find it to be
an important factor in knowledge transfer. I take the idea of codifiability
and apply it in inter-firm relationships context and specifically as a driver of
supplier management strategy. The analytical model shows the extent to
which transaction codifiability may determine the optimal number of suppli
ers. As codifiability decreases, fewer suppliers can be used. The empirical
analysis extends the concept and examines transaction transferability (Szu
lanski 1996; Inkpen and Dinur 1998). Inkpen and Dinur found contextual
73
elements (e.g. culture) to be an important factor in determining transferabil
ity. In this study the focus is how transaction transferability affects supplier
management strategy and specifically how it determines the number of sup
pliers used. Therefore, both codifiability and suppliers’ ability to learn the
transaction are measured.
Operations management literature (Helper and MacDuffie, 2001)
concentrated on product standardization and complexity as a driver of sup
plier management strategy and recently B2B e-commerce strategy. Com
plexity, also identified by Williamson (1975), and standardization are indeed
important factors in supplier management. Novak and Eppinger (2001)
have found product complexity and vertical integration to be complements.
However, a key observation is that both standardization and complexity are
directly related to codifiability and transferability of transactions. The more
complex a product is, the less codifiable it is and the more difficult it is for the
supplier to learn. The more standardized a product the easier and cheaper
it is to codify. Moreover, suppliers have to invest much less in learning
since learning a product once serves all buyers who procure that product.
Therefore, I focus on codifiability and transferability as drivers and in the
empirical analysis measure them directly.
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Codifiability, when applied to inter-firm relationships, gives rise to in
teresting new categories of information “asymmetry” effects. Previous mod
els, based on moral hazard and adverse selection, have placed the information
asymmetry on only one side of a relationship, mostly placing the principal
at a disadvantage. Uncodifiability of transaction knowledge, however, may
affect both parties similarly. In the case of new technology, for example, it
is sometimes not clear what the specifications are, how to produce it, or how
to support the development and deployment of the technology. As such, it
gives rise to many questions (and outside the scope of this study) such as
what investments should be made in codification, whom should make them
(buyer or suppliers) and how codifiability level and related investments af
fect the overall industry structure. Under conditions of complete uncertainty
about such requirements, the model in this chapter predicts that only one
“good overall” supplier will be used. Thus, in line with intuition, when faced
with new technology development that implies high uncertainty on product
specification, firms will employ one supplier or develop it in house. In less
extreme circumstances, increasing uncodifiability results in fewer suppliers
used.
The selection of suppliers is an ongoing process composed of first
(0
screening suppliers in order to ensure acceptable quality, adequate capacity,
and in general to screen out (or screen in) suppliers that do not have the
capabilities to satisfy the buyers requirements on multiple dimensions. Those
suppliers who pass the screening process become part of a qualified supplier
list. The critical questions for this stage are how many suppliers to use
and which ones should be chosen to constitute the qualified suppliers list.
Previous research on these questions, especially analytical modeling, centered
on two variants of the number of suppliers question:
1. Pros and cons of multiple suppliers compared to a single source.
2. Pros and cons of dual sourcing compared to sole sourcing.
This analysis tackles the broader question of optimal number of suppli
ers for a given product and market attributes. By doing so, it takes the
Williamsonian framework of TCE a step further. TCE stipulated that dif
ferent supplier relationships configurations should exist for different product
attributes, specifically risk, complexity, monetary volume, and frequency of
transactions. This paper supplies an analytical framework to solve for the
optimal number of supplier given those factors when idiosyncratic invest
ments axe of concern.
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The second stage is selecting, usually from the pre-qualified suppliers list,
the supplier who is to supply a specific order. The process may vary and
may include an auction, request for proposal, or more screening for specific
capabilities. As explained in chapter 2, in this framework the supplier who
is best fit to execute the transaction gets selected to do so. In doing so, the
study takes a different approach and focus than auction related literature or
split-award research (Anton and Yao, 1989), which emphasizes the selection
of the most appropriate supplier or the correct way to divide the work be
tween two winning suppliers. Given the most fit supplier selection criteria,
and the assumption of uniform distribution of transactions, suppliers selected
to be on the qualified supplier list are uniformly distributed throughout the
attributes space represented by the [0, 1 ] interval. Of course, the uniform dis
tribution assumption is only for analytical tractability. The insight derived
is that buyers should select suppliers to match the distribution of attributes
of future transactions. In doing so, the buyer maximizes the expected fit be
tween the chosen supplier and project/transaction. Such a supplier selection
strategy will also balance competitive forces and likelihood of winning future
transactions (by a supplier.) For example, if the distribution of arriving
transactions for a certain product line is skewed towards high quality and
77
sophisticated engineering products, then more suppliers with those capabili
ties should be chosen and fewer of lower sophistication. The result is strong
competition in the high quality/sophisticated engineering product domain,
and as chapter 2 shows, leads to high investments in IS for competitive ad
vantage while ensuring high enough volume for each supplier. At the same
time, the lower concentration of low quality suppliers ensures that they will
have enough volume (given the lower frequency of such projects) to provide
them with an incentive to invest in idiosyncratic investments.
As shown with this example, the analytical framework developed in this
dissertation allows segmented supplier management strategy. For a differing
set of conditions, a different strategy should be used. In the empirical work
this hypothesis is examined as well as whether the factors identified in the
analytical part of this chapter are drivers of supplier management strategy
and if so, how do the supplier management strategy as determined by these
factors influences performance.
The empirical investigation had been conducted on the procurement de
partment of a leading, Fortune 500, chemical company (XChem). Specifically,
for reasons explained in detail in the empirical section of this chapter, data
collection focused on equipment purchasing. Severed findings have emerged.
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First, XChem does not have a supplier management strategy as it relates to
factors used in the analytical model. Except monetary volume, other fac
tors are not systematically considered in strategy formulation. Despite that,
when a multi-factor regression is run, the model is confirmed. Practically
all hypothesized effects are supported. Since some of those factors are well
grounded in economic theory, the ability to replicate results is important.
Indeed, even the effects of transaction knowledge codifiability and transfer
ability are strongly supported. Given the small data set of 35 observations,
such results are quite encouraging.
The model is also an optimization model, which implies that when the
suggested supplier management strategy is not followed, performance should
suffer. To examine performance related hypotheses two performance mea
sures, defects and quality, are used. These specific measures are used since
they most aptly capture the essence of suppliers’ performance in the model
and have proven time and again to be a critical, if not the most critical,
factor in determining overall performance (of the buyer in this case). While
the model’s performance is buyer’s revenues, these are not measurable in this
context. Most factors are found to affect performance through interaction
with the number-of-suppliers strategy in the hypothesized direction. The
79
one exception is suppliers’ ability to learn. It seems that rather than being
a complement of the strategy it is a substitute. While the effect may be
firm specific, it suggests that further study is required to understand the
interactions of learning and performance in supplier management.
The rest of the chapter is as follows. Section 2 introduces the model.
Section 3 analyzes under two different assumptions about information visibil
ity. Section 4 discusses codifiability and the results of incorporating it into
the model. Section 5 discusses the empirical study, describes the hypotheses
generated by the analytical model and the results. I conclude in section 6
with a discussion of both the analytical and empirical parts.
3.2 M odeling Framework
This study examines supplier management by a buyer who is interested
in its suppliers investing in intra-firm information systems. To model this
setting I use a principal-agents framework (see figure 2 in appendix A). The
suppliers (agents) compete for projects that arrive stochastically. In each
period, only one supplier can win a project. Unlike previous work (Anton
and Yao, 1989; Wang and Seidmann, 1995), split awards are not used since
80
the focus is on the selection of the optimal number of suppliers, which can
be any, and is not limited to two as in Anton and Yao. The winner takes
all assumption, however, does not prevent splitting the total volume between
multiple suppliers, which is exactly the case in this study. It crystallizes,
though, the importance of fit between a supplier and a transaction, which
would be masked under split awards. Comparing different types of trans
actions (e.g. large, complex projects such as building a new plant versus
procuring office supplies) requires that monetary volume would not have en
dogenous effects, which is the case in split awards. Furthermore, while one
can model splitting an order to two suppliers as two separate orders (of simi
lar characteristics), it is not common to observe a complex project being split
into two. Therefore, to be able to analyze across transaction characteristics
a winner takes all approach is required.
Not all projects of similar type (say, ordering a spark plug or order
ing a valve) necessarily require the same type of supplier in terms of quality,
cost and other such considerations. In order to capture that, suppliers are
modeled as distributed along the [0 , 1 ) interval, with their location, p£, rep
resenting a measure of their overall characteristics. One could consider 0
location to be low cost and low quality supplier where the T ’ location would
81
be a high cost, high quality supplier. In essence, the [0,1] interval is a
mapping of the efficient frontier and dominated suppliers are not considered.
Projects that arrive, although of similar type, may have different require
ments (e.g., high quality, fast delivery, low cost, etc.) modeled as a location,
r, on the [0, l] interval. Projects’ locations are distributed uniformly on the
[0 , 1 ] interval, with the uniform distribution assumed for analytical tractabil-
ity. When a project arrives the buyer observes the project’s location, p, and
chooses the best-fit supplier. In this model fit is measured as the Euclidean
distance, Ai, between a supplier and the project. Thus, only the two closest
suppliers actually compete on a specific project. As we have observed in
a case study and in current work reported in the empirical section of this
study, buyers often limit the final decision to a decision between two suppli
ers even if the list of possible suppliers and bidders includes more than two.
This screening stage is not modeled here but could be considered the stage in
which the buyer learns of the suppliers’ exact locations and eliminates those
that are dominated by the “n” best suppliers.
Suppliers, however, can influence their fit with projects through in
vestments. Idiosyncratic, relationship specific investments have the effect of
improving a supplier’s capabilities with regard to the transaction to which
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the investments apply. There could be two types of such idiosyncratic invest
ments. First, transaction specific investments, which are investments that
apply only to a specific type of project. Second, investments which apply
to the relationship in general and therefore are valuable to all transaction
types. Investments in intra-firm information systems are mostly of the sec
ond type (but information systems may be developed in support of specific
transactions as well). These investments improve supplier performance for
any project and not only for a specific transaction due to better coordination
between firms. In the model developed, we focus on a particular type of
transaction in the landscape. We assume that suppliers may invest, x<, in in
formation systems and therefore improve their fit, i.e. decrease the distance,
with any project that arrives of this general type. The effect of this invest
ment is Mi, and is a function of the investment, Xj. By comparing the results
derived for a specific type of transaction across the transaction landscape,
we are able to generate hypotheses about differences in efficient governance
structures that might be expected to be observed in different parts of the
landscape.
The buyer requires a certain level of investment by suppliers in order
for the relationship to achieve a minimum performance level. However, in-
83
vestments may or may not be observable to the buyer. Thus, the incentives
given by the buyer may or may not depend on the investment made. This
study analyzes both cases. Interestingly, results for the observable case still
hold under unobservability but are augmented with additional conditions.
All else being equal, the buyer would prefer more suppliers to fewer
since as the number of suppliers increases, the expected project-supplier fit,
E (A '), improves. However, each additional supplier requires a fixed cost, F,
associated with establishing the relationship. Suppliers incur relationship-
specific fixed costs as well, denoted J\. As to be expected, the Buyer has
to compensate suppliers for fi in order to enlist their participation. There
fore, the Buyer pays F directly and fi indirectly for each additional supplier.
Unless suppliers are guaranteed to at least break even in expectation, they
would not participate and therefore the buyer would not be able to execute
projects. As Wang and Seidmann (1995) observe, the buyer may need sup
pliers to participate even when they invest less than the required investment
level X i. We call that requirement a "strong participation constraint” since
it is a tighter constraint for the buyer. Alternatively, it may only need those
suppliers investing at least X \ (denoted the "weak participation constraint”).
We analyze both scenarios.
84
Next, we list all the assumptions, show the time line and supply a
summary of notation used in the development of the modeling framework.
The plan of analysis, i.e. the different combinations of assumptions analyzed,
is then described, followed by the main results with a short discussion. Since
proofs are straightforward and follow the proofs in Appendix B, we omit these
for a cleaner exposition.
3.2.1 A ssu m p tion s
• Suppliers can invest in the relationship, which makes them better
fit for any project arriving.
• Buyer and suppliers are risk neutral and maximize expected profits.
• Common knowledge - suppliers and buyer know all parameters in
volved: cost functions, locations, technology and fit parameters). They
also know that the others know ad infimum.
• Two types of supplier investments are modeled:
— Contractible
— Non-observable
85
• Codifiability - Project location may range between being perfectly ob
servable to non-observable. I concentrate on the two extreme cases for
clarity of insights.
• Suppliers’ locations: it is assumed that suppliers are chosen to be lo
cated at equal distances along the [0,1] interval. This assumption is
actually a result that can be proven in the event that the Buyer can
choose which Suppliers to include in the supplier base. This result is
shown in Appendix B for the case of two suppliers.
• Suppliers have identical cost structure and may be one of the following
two:
- Q = q(Xi) + K s f E
- C t = q(Xi) + K
3 .2.2 T im e Line
Figure 3.1: Time Line
Incentive Screening Suppliers —► Project Money

Scheme Invest Realized Transfers
86
3.2.3 Notations
• p:= Location of a project, r is distributed uniformly on [0,1].
• pi := Location of a supplier on the [0,1] interval.
• Ai := |p —Pi\ = ~ 7 rrr^ The distance function of each supplier from the
project. jL. js the mean distance given a uniform distribution of project
location and even spacing of the suppliers along the [0 , lj interval
• Xi := Relationship-specific investment made by the supplier.
Axiom 1 • Qj := Technology factor determining the impact of x, and
tjion Mi with a,- > 0.
• Mi := M (xi) technology function determining the impact of Xi on A,-.
• := Aj x Mi, the effective distance between a supplier and a project
given Xf and yi.
• A ’ := m in (A i), the minimum of the distances between the suppliers
and the project. Supplier i, which achieved this distance is the winner.
• Ti := Transfer or prize the buyer gives the winning supplier.
87
• R := i?(A*) the revenue function of the buyer as a function of the
distance between the winning supplier and the project.
• X = Projects arrival mean rate
• N — Number of suppliers
• F = Fixed investment by the buyer
• f = fixed investment by a supplier
• Cost function:
- Ci = q {X i ) + k Va
- C i = q{Xi) + k VE*
• H ;= Profit fi unction of the buyer. Buyer optimizes profits and would
not participate unless profits are not negative.
3.3 A nalysis
We analyze the model under two major assumptions. The first assumes
investments are contractible and therefore, incentive plans and contracts can
be and are written on the investment itself. The second model assumes
88
investments are unobservable and contracts cannot written on them. How
ever, a noisy signal, the revenues resulting from investments, exists and con
tracts can be written on that signal. Interestingly, results of the contractible
investments model hold under unobservability. Additionally, under unob
servability error variance matters in determining the number of suppliers to
be used, a result that is completely new to principal agent literature.
I also analyze two types of cost functions for each of the models, one
being concave and the other convex. This is done to examine whether the
nature of the cost function determines the results. Again, all results hold.
Furthermore, we also examine two types of participation constraints, which
again examine sensitivity to modeling assumptions. As before, the model
shows robustness and results are the same.
As summarized below, our analysis has a 2 x 2 x 2 design, which is
composed of two fundamental models, each with a 2 x 2 design. Note th at
while the incentive scheme is different for contractible versus unobservable
investments, it is fundamentally the same but adjusted to take into account
the difference in assumptions. Table 3.1 below summarizes the design.
89
Version 1: Contractible Version 2: Unobservable
Case 1: Case 2:
Cost Function
C i= q iX J + K yfR C i = 9(X;) + K V A3
Strong Participation:
V1C1S / V2C1S V1C2S / V2C2S
n i(xi= x 0) = o
Weak Participation:
V1C1W / V2CIW V1C2W / V2C2W
ni(x,.= A:1) = o
£o Sd
A IV
Si if Xi>Xi
Incentive Scheme
II
So if Xi<Xi
Distance Function: A* M(JCi+ii)
f»V2 8V3
Table 3.1: Design of Analysis
Note:
1. The technology function, A/*, has an error term in order to create an
unobservable investment environment for version ‘2 of this model.
'2. Participation could be required, i.e., guaranteed, under all investment
levels, whether at Xq or X \. Alternatively, payments to suppliers could
be made that would guarantee participation only if they invest at least
X i > X q. Clearly, the former is a stronger constraint on the structure
of the design of Buyer incentive structures.
3. It turns out that strong or weak participation does not m atter for the
results since forcing the equality sign in the participation and incentive
90
compatibility constraints mutes that issue.
In this model we assume the Buyer ensures suppliers participation.
Thus, given the incentive scheme and assuming the Buyer solves the appro
priate “problem” (detailed below), suppliers invest X \. Suppliers invest at
this level, since the buyer ensures, via T), that it is the suppliers’ preferred
option.
3 .3 .1 V ersion 1: C ontractible In vestm en ts
T he B uyer’s Problem
The buyer wants to maximize profits. It has revenues f?(A*) that are a
function of the distance between the chosen, closest supplier and the arriving
project. Those revenues arrive at a rate of A. However, the buyer incur costs
N
of 52 Ti which are the average transfer costs as a result of the incentive
i=l
scheme T* it uses to incent suppliers to participate and invest in the required
information systems. The buyer also incurs fixed relationship costs of F with
each supplier it chooses. The buyer also has to make sure suppliers partici
pate and that investing is their preferred action, or incentive compatible.
Therefore, the buyer’s problem is:
91
Strong Participation (SP): A^ —C (X o) —/ > 0
Incentive Compatibility (IC): —C( Xi ) > A ^ —C ( X o)
Where T is the vector (T0,T i, ...T \r) and N is the number of suppliers
selected to have a relationship with.
Theorem 4 For the above problem and case 1 with the cost function
Ci— q{Xf) + K \f K , the solution is Ti = Si Vi with S0 = ^ and
„ N { f + Cx) ^ L , „ J -A R ^ M (X i)
Si = — The number of suppliers is given by N = . / — ---- .
A y 4(r +
Proof. If we denote Co = C (X 0) and Ct = C (X i) and solve the above
„ . N (f-h C o ) , e W (/ + C,)
constramts we get: So ------ and Si = ------ -------
A A
Given SP, suppliers pay the fixed cost / to have a relationship. Further
more, given IR, suppliers choose x* = and therefore the buyer pays
Ti = Si for all i.
After substitution of the above solution and Si the buyer’s problem is:
max lib = Ai*(A‘) - N ( f + Ci + F)

N
Substituting C j= q iX J 4 - F n/A and given A* := problem is:
max lib = AJJ(A') - N ( f + q(X i) + F) -

N
92
dA ' M (XA
Solving for the F.O.C and denoting -7 7 7 = — - we get the solution:
dJy —lDiY'*
N = (I The second order conditions are as required

V ^ f + z + ^ o) ^
and are easy to check. Q.B.D. ■
Corollary 7 A !=>■ N f Higher demand results in more suppliers used.
Corollary 8 \R&\ !=► N ] As the fit between a supplier and a project
becomes more important (stronger effect on revenues) the buyer will use more
suppliers and thus reduce the average distance.
Corollary 9 X \ f = > N [ (since M( Xi ) J, and q(X 1 ) f ) Higher required
investment implies a smaller supplier base.
Corollary 10 F f or f f ==>• N J, Higher fixed cost on either the buyer or
supplier side results in a smaller supplier base since the buyer ends up paying
both.
Corollary 11 q (X 1 ) t= ^ N I irrespective of changes in Xy as the variable
costs of investments increase the supplier base shrinks. Since the buyer has
l For this analysis to hold, cannot be a function of N. However, that is a reasonable

condition if for example, R = When A approaches 0, R approaches infinity, which
might create a problem. To solve that, R could be modeled as min{R , ^ } . This would
not change the results or analysis except to introduce an upper bar on the number of
suppliers to be chosen, which is the case for other reasons such as supplier pool, strategic
reasons, and coordination costs to name a few. Thus, we are choosing to forgo this
unnecessary complication in modeling and analysis.
93
to ensure all suppliers invest X i, it has to take into account the resulting
variable costs.
Theorem 5 When costs are as in case 2, i.e., C i= q { X() + K \ J A^,
N= —y/SXR^M(Xi) + k M 3(Xi)
V 4V 8(F + /+< *(* ,))
Proof. Following the analysis in theorem 1 but using Ci— q ( X {) + K n/A^
as a cost function generates the desired result. Q.E.D. ■
Corollaries 7-11 hold with corollary 12 below as an additional one.
Corollary 12 k f=> N f Stronger effect of A on the variable costs result
in more suppliers since more suppliers reduce A thus reducing variable costs.
Discussion
We can see that most if not all of the results are intuitive. As demand in
creases, we do expect to see more suppliers used for several reasons. First,
as demand increases, the pie is bigger, and the buyer can afford to use more
suppliers while still being able to incent them to invest in the costly in
formation system. That investment can only pay off to suppliers if their
expected share of the pie is big enough. Furthermore, considerations outside
the model, such as meeting demand volatility by having multiple suppliers to
94
ensure availability of production capacity, dictate that as demand increases
more suppliers will be used.
Sim ila rly, as the investment required increases, the supplier base size
is reduced. This reduction allows suppliers to recuperate the associated
investments. An increase in the variable costs associated with supplier’s
investments results in areduction of supplier’s expected profits, thus the buyer
has to reduce the number of suppliers it uses to ensure suppliers invest at the
required level, X%. In the case of an increase in the fixed costs associated
with the relationship on either the buyer’s or the supplier’s side, the buyer
finds that those costs weigh more than the decreasing margined benefits of
having more suppliers and thus uses fewer suppliers.
Corollary 8 is the one that is not seen in the literature and thus may
be less intuitive. It states that as the impact of supplier’s fit with a project
type on revenues is stronger, the buyer will use more suppliers. This result
seems to contradict prevalent wisdom to reduce the number of suppliers as
projects increase in strategic importance (which partially translates to in
crease in importance of supplier-project fit.) However, the analysis here is
a simple-factor sensitivity analysis with all factors (e.g. codifiability) but
the one examined being held constant. In reality, as strategic importance
95
increases, codifiability (see below for extensive discussion and analysis) be
comes lower and other factors change as well. As shown in the codifiability
section, a reduction in the codifiability level reduces the number of suppliers.
If the codifiability effect is stronger than the project-supplier fit effect, the
number of suppliers will decrease.
Corollary 12 is straightforward. Since more suppliers reduces the average
distance, as that distance has stronger effect on variable costs the number of
suppliers will increase.
As discussed above, we treat these results on two dimensions. While
these are recommendations stemming from an optimization model, we view
these as hypotheses with regard to firms’ strategy. Certainly, firms may not
behave optimally at any given point in time for many reasons. They may be
in the process of learning, they may be exhibiting bounded rationality and
not able to ” compute” optimal behavior in face of complex dynamic world.
Regardless of the reason for such suboptimal behavior, we do expect to see
performance affected in those instances. Through performance we expect
to see the two views of the model meet.
96
3.3.2 V ersion 2: U nobservable In vestm en ts
The assumption about contractibility of investments changes to:
• X i is unobservable. Furthermore, A; = -—^ with E(£i) = 0
and ci has the pdf g and cdf G.
Definition .1 R\ = ECiR ( A(X t)2
Now the incentive scheme cannot depend on x< but has to use the revenues
as a signal. Thus,
S\ if R > Ri
{ Sq i f R < R\
Definition .2 p* = p(x<) = P(Ri > R \) = P ( A f < Ai) =
= P [ M ( x i + ei) < M ( X i)] =
= P [(x< + et) > X i ] = l - G (X t - Xi)
We therefore have pi = p(Xi ) = 1 —G(0) and po = p(Xo)
Under the assumption of unobservability the SP and IC constraints change
to become probabilistic and buyer’s problem is:
m a x n 6 = AP(A*) - £ £ Ti - iV x F
TJ* t=l
2 While using ER(A{Xi) instead of R(E( A(A'i))) is not precise, it does not change the
fundamental nature of the model while allowing analytical tractability.
97
(SP) poA^ + (1 —Po)A^ —C(Xo) —/ > 0
(IC) PiA^- + (1 —Pi)A^ —C(Ao) > PoA^ + (1 —Po)Xjfr —C(X0)
T h e o re m 6 Given the buyers problem, and the case 1 cost function,
C i= q ( X{) + K \f K , the solution to the buyer's problem is:

N PoCi + P iC 0
S0 =
(pi - Po )
N f + (1
andi cSi = —
— po)C i + (1 — P \)C q
A (Pi - P o)
y 4 ( F + f + q{Xi))
P ro o f. As in Theorem 1 we solve the SP find. IC conditions and get So and
Si- Given that, we can restate the buyer’s problem as follows:
max lift = A \p\R\ + (1 -pi)Ho] - A[pi7\ + (1 - p i) T 0J - N x F =

N
= A \piRi + (1 - pi)Ro] - N ( F + f + Ci)
Again solving for the F.O.C results in:

i-X [ptMCX,) + (1 - Pi ) M( X q)]
N =
4(F + / + 9(JC0)
• Corrolaries 7-12 of Version 1 Case 1 still hold. In addition due to
uncertainty, the magnitude of X 0 influences N as follows:
C o ro lla ry 13 X 0 f=>- N ]. (since M ( X 0) I) Now the buyer has to take
into account the lower investment since she cannot know which one has been
actually invested.
98
C o ro lla ry 14 Since M { X x) < M ( X 0) [ X x > X 0J i f p x ± 0.5 , i.e. E(si) ± 0
[and assuming a distribution in which the mean=median], then we have two
cases:
1. E(Si) > 0 =*■ pi = 1 —G(0) > 0.5
If Var(ei) t [without changing E(ct)] then N f (since C(0) f and
therefore pi |)
Intuition: The LEFT tail of R xs distribution gets bigger (i.e., supplier’s
probability of reaching f?i when investing X x decreases) and therefore
the buyer hedges by having more suppliers (The buyer wants Var(£i) =
0). Thus, what we see here is a hedging strategy, by the buyer, against
the likelihood of getting sub-par results. When the expectation is for
an above par result, then higher variance results in a higher likelihood of
having a sub par result, even as the expectations stays constant. Given
that the buyer is interested not in expectations per se, but in getting
above par (i.e., above iii results), the buyer hedges by increasing the
the number of suppliers, countering the effect of the higher variance.
2. E(si) < 0 ==> pi = 1 —C(0) < 0.5
If Var( cj) f [without changing f?(cj)] then N f (since C(0) J. and
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therefore pi | )
Intuition: The RIGHT tail of R x's distribution gets bigger (i.e., sup
plier’s probability of reaching R\ when investing A-! increases) and
therefore the buyer can reduce the number of suppliers. In this case,
the buyer can reduce its hedging and use fewer suppliers. By doing
so, the buyer increases the strength of incentives to invest for the re
maining suppliers. As before, it is driven by the threshold objective
the buyer is interested in.
Theorem 7 When costs are as in case 2, Ci— q i X J -I- K y/&*,
J k M*{ X\ ) ~ y/8AflA[piM (A 1) + (1 - fb)M(Xo)]

V 4v/8(F + / + g(A,))
Proof. Similar analysis to the above will generate that result ■
Corrolaries 7-12 hold in this case.
D iscussion
It is interesting to note that all the results generated under the assumption
of contractibility are replicated under unobservability. This is not the usual
case in the literature. Unobservability and contractibility are often used as
alternate assumptions to generate different if not contradictory results. In
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this study, it is the fundamental nature of interaction between buyer and
suppliers that drives results regardless of whether the buyer can or cannot
contract or observe supplier investments. This claim is strengthened by the
fact that using a weak or strong participation constraint does not matter.
Under unobservability we would normally expect such differing requirements
(i.e., strong vs. weak constraints) to matter, even when the differing re
quirements do not affect results under contractibility. Under information
asymmetry regarding investments, the type of investments required to en
sure profitability would affect the results. However the exception would be
when the nature of factors examined is more fundamental than the informa
tion asymmetry involved. Such is exactly the case in this study, where the
factors examined dominate the information assymetry issue.
I also note that corollary 13 is unusual. I have not seen in the litera
ture any indication about importance of variance of measurement error to
supplier management strategy, and specifically on the number of suppliers
to use. Indeed, the standard assumption, which usually is not examined, is
that E(Si) = 0. Only when not assuming that as the default such an effect
is revealed. W hen we do so, we find that assumptions on E(si) matter!
Different results take place depending if it is positive or negative. In one
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case, when E(si) > 0, an increase in error variance forces the buyer to use
more suppliers to compensate for it. In the other case, when E(ei) < 0,
an increase in error variance allows the buyer to reduce the number of sup
pliers without losing. This result is achieved even though everyone is risk
neutral in our model. Again, as before, this shows that our model examines
fundamental interactions and can generate results that usually require risk
aversion on one of the sides, buyer or suppliers.
3.4 Codifiability
Knowledge can be more or less codifiable. Codifiability of a transaction
knowledge is the ability to take all aspects of the transaction and the required
knowledge to perform those and list it in written form (Zander and Kogut,
1995). As such, it is a critical factor in B‘2B e-commerce interactions that
are to be done through electronic channels. Unless transaction knowledge
can be codified the transaction cannot be completely executed electronically.
The less codifiable a transaction is, the less are the gains from moving to an
electronic means of transaction. As shown below, codifiability is not just
a requirement for successful electronic transactions but also affects supplier
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management strategy.
In order to make the concept more vivid, one can think about two trans
actions. The first is a buyer who is interested in buying desks. Naturally, the
buyer can specify the physical requirements and even the engineering specifi
cations such as materials if so required. Usually, the process of buying desks
in organizations is quite routine and therefore the associated procedures, ac
counting and otherwise, are quite clear and well specified. Therefore, this
type of transaction is highly, if not completely, codifiable. The second trans
action is the development of new technology. Almost by definition, the
knowledge associated with this transaction can hardly be specified, if at all.
At best, and even that may be questionable, operating specifications can be
spelled out, and maybe cost and time for development. Associated processes
are not routine and may or may not be well specified or even known. Even if
the buyer or the supplier have knowledge pertaining to this new technology, it
mostly cannot be written and communicated easily, but is embedded in peo
ple, skills, and organizational capabilities, processes, and culture. Therefore,
such a transaction is highly uncodifiable, if at all.
In this study’s model, one could think of the location of the project as
more or less accurately known . In the previous sections the project location
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was known without any error, which translates to perfect codifiability. The
buyer can figure out and explain the specifications of the project without any
error.
On the other hand, we think about a project as highly uncodifiable if it
would result in the inability of the engineers to specify requirements. That
leads to significant difficulty or impossibility of the procurement department
to match a supplier with the project without significant, informal interactions
with prospective suppliers. If the project is completely uncodifiable, it could
be translated in our model to a project with an error that masks the realiza
tion of the project location completely (below I explain how to construct tin
error term to fit the model), thus ex post the buyer is facing a project that
is distributed uniformly on the [0,1] interval. In this case, it is obvious that
the optimal number of suppliers is one, with that supplier located precisely
in the middle of the [0,1] interval. The simple reason is that more suppliers
are not going to improve the expected revenues since the expected project
fit with suppliers (the expected A in the above model) remains constant.
That happens since regardless of the project, the optimal selection criterion
is to select the middle supplier (located at 0.5). However, more suppliers
result in higher costs due to the fixed costs associated with establishing the
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relationship. One could think of those fixed costs as including search costs
as well.
Formally, we model the error term representing codifiability as follows:
r —* r + e £~U[—b, +a]3, where a + b = c < 1
b = mi n{ r, c/ 2}
a = m in{ 1 —r, c/2}
This modeling ensures that boundary effects are not present since the
error ’’bounces” from the edge and is always of the same length regardless of
where the project is located4. Note that since the buyer makes its decision
ex-ante and the error exists ex-post, it cannot use a point location but rather
a whole interval with length equal to error length.
Following the above reasoning, if the error term results in a project loca
tion that is distributed uniformly on half an interval, the optimal strategy is
to have 2 suppliers. That ensures the buyer does not have suppliers between
3Error term modeling: Assume an error of length I. A project location is then dis
tributed uniformly over a distance of I. A project that is too close to the extremes of the
[0,1] interval still gets the same distribution but it is not symmetric around its location
but takes into account the "border'’.
Example: if the error term is 0.5 than if a project falls between [0.25,0.75] we have no
problem. If the project is realized at 0.1 than the buyer (and supplier) can only know it
is distributed uniformly between [0,0.5]. This renders all projects that fall in the interval
[0,0.25] as same.
4An alternative model would have used a circle instead of a line, eliminating the problem
of boundary effects and simplifying the modeling. That would not have changed results
in any fundamental manner.
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which it cannot differentiate. If it were to choose more, the expected ex-post
distance would not decrease but the fixed costs associated with selecting more
supplier would increase. Similarly with an error of j , the optimal solution
is 3 suppliers.
Codifiability in effect puts a limit on the number of suppliers that can be
chosen (essentially by flattening the revenue curve after the relevant number
of suppliers is reached). If the optimal number is below that limit, then
codifiability doesn’t come into play in that decision. However, if the opti
mal number is above the limit, codifiability truncates it at the appropriate
number.
This result has an intuitive appeal since we would expect the number of
suppliers to be affected by the level of codifiability and in the same direction
as found here. In particular, intuitively it seems clear that the less codifiable
a project is, the less you want to go through the process of interacting with
a larger number of suppliers to explain the details of the project.
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3.5 T he Empirical Study
In order to test the above results or hypotheses, data was collected from a
leading, Fortune 500 company, which I will call XChem. The company is
a leader in the chemical industry and purchases about $15 billion worth of
products from its suppliers. The bulk of those purchases is done through
its corporate headquarters purchasing department but some of it is done
through local divisions. For severed reasons we have chosen to concentrate
on the central purchasing department. First, corporate procurement is sup
posed to have a more structured supplier management strategy compared to
local procurement departments. Second, Local divisions usually purchase as
needed and are highly constrained due to low volumes and geographical and
information limitations.
Within the corporate procurement the focus is on the equipment pur
chasing department. The other part of corporate procurement, the MRO
department has much less variability in its purchases due to the inherent
nature of the products it procures. Specifically, the MRO department pur
chases products that are highly codifiable and mostly are described either
by catalogue number or can be completely and easily specified (e.g. office
supplies). Since in the context of this work, I am first and foremost inter-
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ested in examining codifiability as a critical factor in supplier management
strategy, the absence of variance on it would prevent such examination.
Empirical research on transaction cost economics (TCE) tends to focus on
an industry and often on one firm. Many of the variables measured change in
definition dramatically from firm to firm. Furthermore, firm specific factors,
such as historical practices tend to change results strongly between firms and
more so between industries. Thus, while firm specific work suffers from the
potential limitation of insufficient generality, it allows for better understand
ing of the factors and models examined and is not without precedent. Even
when done at the industry level, previous TCE related research has concen
trated on highly concentrated industries such as the U.S. automobile or aero
space industry. Examples are Monteverde and Teece (1982) who used Ford
and GM only, Masten (1984) for the U.S. auto industry, Masten (1989) in the
aerospace industry. Novak and Eppinger (2001) examined eight auto firms
in the global industry but concentrated on the luxury-performance market
and on eight vehicles in total. As Novak and Eppinger indicate by quot
ing Joksow, measuring many of TCE variables, such as asset specificity, or
performance, is very difficult, especially when trying to compare across firms
and industries.
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While there are several studies examining TCE, none have examined an
analytical model that draws on TCE and none have looked into codifiabil
ity. Research using codifiability has a construct is new, sparse, and never
been done in the context of supplier management. Examples are Kogut and
Zander (1992), Szulanski (1996) and Inkpen and Dinur (1998). Further
more, TCE studies (e.g., Joksow, 1987, Walker and Weber, 1987, Helper and
Levine 1992)) have concentrated on examining either long-term relationship
or make versus buy decisions (Monteverde and Teece, 1982;Novak and Ep
pinger, 2001). This study’s broader question of optimal number of suppliers
combined with the complexity of measuring codifiability and transferability
of transaction knowledge between separate firms calls for concentrating on
one firm. Results, therefore, would serve to show future research as well as
to provide insightson underlying theory.
3.5.1 H yp oth eses
The model above allows us to generate severed hypotheses about how trans
action attributes affect suppliers management strategy and resulting perfor-
memce. In hypotheses H1-H6 the dependent variable is number of suppliers.
H7 takes into account the optimization nature of the model eind is therefore
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about performance as a result of following the recommended strategy as put
forth by the model and hypotheses H1-H6. The hypotheses are discussed
separately to clarify the logic, theory, and model behind each factor but this
is not to suggest any factor may be affecting results by itself. Rather, it is the
combination of factors that affects the dependent variable (Number of Sup
pliers or Performance), with each factor working in the direction suggested
by the relevant hypothesis.
A unique contribution of this study to economic and management liter
ature discussing strategy regarding supplier management is the concept of
codifiability. The model suggests that the more codifiable an item is, the
easier it is to use more suppliers and the gains from it are higher. During
the initial interviewing phase a case study about water tanks procurement
helped highlight the codifiability idea behind hypothesis 1. In the case of
water tanks, XChem has split the procurement continuum into three regions.
The two extremes had either low specifications (standard tanks) or high spec
ifications (customized tanks with well understood final requirements) and as
a result were relatively codifiable. The ” middle region” had products that
were of uncertain and unclear nature and had to be tailored as the develop
ment occurred. Thus, the middle region is relatively uncodifiable. Indeed,
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XChem’s strategy is to use one supplier per geographical region in the middle
region while using the regular multi supplier strategy in the other two. This
strategy is as predicted in my analysis.
However, codifiability by itself is not enough to allow for transfer of trans
action knowledge from buyer to supplier (Inkpen and Dinur, 1998). For suc
cessful, efficient, frictionless transfer to occur, the receiving unit (suppliers in
this context) should be able to learn it easily ( Szulanski, 1998; Inkpen and
Dinur, 1998). Therefore, I define transferability as the combination of trans
action codifiability and suppliers’ learning ability of the specific transaction.
Transferability is increasing in both codifiability and specific learning ability.
Measuring codifiability or transferability of knowledge is not an easy task.
Since, has been discussed, knowledge is embedded in people, processes, and
culture among others, each transaction, even in the same organization, may
have very different set of measures that are applicable. Measuring the actual
number and size of manuals pertaining to a specific transaction may not
reflect codifiability, because some transaction would require only few pages
for complete codification (e.g. desks), while others may require thousands of
pages and still may not be completely codified (e.g. building a new plant.)
The newness and how often the transaction is being executed would greatly
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affect the number and size of manuals associated with it. At the same time,
the inherent level of codifiability may be higher or lower but not reflected
by the number and size of manuals. Therefore, I have chosen to ask the
buyers in charge of a transaction about its level of codifiability. Since they
intimately know the transaction, they know exactly how difficult it is to
codify it and can assess all the intangibles that affect codifiability, and be
less effected (than the actual manuals) by its newness and frequency.
The hypotheses regarding codifiability are therefore:
HI: Higher transferability will results in more suppliers.
Hlb: Higher codifiability will result in more suppliers.
Hlc: Higher learning ability will result in more suppliers.
The analytical model suggests that when investments required to estab
lish a relationship (either F or fi] go up, the number of suppliers used should
become lower. While the model cannot examine the specificity of investment
as a factor5, it is specific (to buyer and commodity combined) investments
that should make a difference. Specific investments are an important part of
TCE, which postulates a similar direction. However, TCE mainly empha
5This limitation is due to the single buyer model used. However, given that the only
revenues that may cover such an investment for suppliers are derived only from this buyer,
it is akin to modeling that investment as a specific one.
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sizes the hold-up problem resulting from specific investments. As a result,
an argument could be made that the way for a buyer to countereffect the
hold-up problem is to increase the number of suppliers, thus putting more
competitive pressures. This study utilizes a different logic. A buyer trims
down its supplier base in order to incent remaining suppliers to invest in the
relationship. Therefore, hypothesis 2 is as follows:
H2a: Higher specific investments will result in fewer suppliers.
Buyers often make investments in aligning suppliers’ practices to
their own practices and invests in training of suppliers’ personnel. These are
also specific investments and thus the logic above holds.
H2b: Higher investments in practices alignment will result in fewer sup
pliers.
H2c: Higher investment in training will result in fewer suppliers.
After a relationship has been established firms have to maintain it. The
costs associated with doing so can be due to required investments in in
frastructure, continuing training, and realignment of processes as firms change.
While not paid up-front, these costs axe part of the investments in a rela
tionship modeled as F and /*. Therefore, the logic of hypothesis 2 holds.
H3: On-going costs will be negatively correlated with the number of
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suppliers.
The model shows that as volume increase more suppliers can and should
be used, all else being equal. While the revenue associated with the commodi
ties purchased cannot be measured, the actual annual transaction monetary
volume data was collected. It is reasonable to assume that on average, more
expensive inputs (i.e. higher annual transaction monetary volume) are part
of products that result in higher revenues. If this relationship holds than we
have the following hypothesis:
H 4: Monetary volume for a given transaction will be positively correlated
with more suppliers.
Related to investment specificity is the ability to substitute a supplier
and the level of the supplier uniqueness. Substituting a supplier can be
difficult due to a lack of substitutes or because of negative quality and cost
implications. While not necessarily a driver of supplier management strat
egy, it should be correlated with the number of suppliers used. Lack of
substitutability may constrain firms from having more suppliers or could be
a result of a close relationship with one or few suppliers. Similarly, sup
plier’s uniqueness should be correlated with the number of suppliers. Higher
uniqueness would either drive a firm to stick with one supplier or could result
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from having a close relationship with a supplier.
It is important to note that uniqueness and substitutability do not mea
sure the same latent attribute, and should not be colinear. A supplier may be
unique in offering some specialized equipment, but substituting it by another
supplier may not result in significant consequences. Similarly, a supplier may
be not unique, but hardly substitutable since the buyer had tied itself to this
specific supplier by aligning processes and making specific investments on its
side.
H 5: Substitutability will be positively correlated with the number of
suppliers used.
H6: Uniqueness will be negatively correlated with the number of suppli
ers used.
Finally, the model is an optimization model and thus implies that fol
lowing the recommended/hypothesized strategy should lead to higher per
formance. Specifically, the model suggests that this performance should
be along dimensions associated with a better fit between a supplier and a
project. While the overall objective is higher profits, this study cannot ex
amine it since there is no direct link between commodities purchased and
revenues generated from products using these commodities as inputs. How-
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ever, a better fit should translate to higher quality, lower defects, and better
on-time delivery, for all of which data had been collected.
H7a: When hypotheses 1-4 are being supported, higher quality results.
I will use H7al to H7a4 to indicate how H7a relates to each hypothesis.
H7b: When hypotheses 1-4 are being supported, fewer defects result. I
will use H7bl to H7b4 to indicate how H7b relates to each hypothesis.
H7c: When hypotheses 1-4 are being supported, better on-time delivery
performance results. I will use H7cl to H7c4 to indicate how H7c relates to
each hypothesis.
To further corroborate the above, the survey asks about production time
compared to other supplier of the same commodity and also compared to
production time of comparable commodities. The level of suppliers’ im
provement (for a specific commodity) and performance compared to XChem
goals had been collected as well. However, the link between these perfor
mance measures and the recommended strategy is not straightforward or
necessarily implied by the model and thus hypotheses about that link are
not constructed.
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D ata C ollection
Our d ata collection took place in three stages. The first stage included in
terviews with the purchasing director, the managers of equipment and MRO
departments, and product managers. In these interviews severed objec
tives were accomplished. First, better understanding of XChem’s specific
processes and business practices was achieved. Second, the underlying ana
lytical model was found to apply to XChem’s way of doing business in that
XChem uses a pre-qualified list of suppliers of whom they may require rela
tionship enhancing investments. Third, data sources were identified. How
ever, due to idiosyncrasies in data management processes at XChem, we were
able to retrieve only annual purchasing volume per supplier and commodity6.
To supplement this data a questionnaire was designed. XChem’s exec
utives find managers helped us in building the questionnaire and fine tun
ing questions to their firm specific vocabulary. After the questionnaire was
deemed satisfactory we pilot tested it with them. Four commodities were
chosen as representatives of different commodity types that may exist in their
purchasing mix. The questionnaire was administrated to the executive in
charge of equipment and a few product managers.
6In XChem terminology, they call products they purchase commodities.
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As we analyzed the results of the pilot, it was clear that they consider
the cost/price for one of the commodities was well below par. It was also
clear that this commodity in questions should have many suppliers on the
authorized supplier list but had only a few. This discrepancy held resulted
in subpar cost/price as compared to market price and the price they believed
they should face. The one factor that seemed odd was the fact that the
commodity was considered to be highly codifiable by the firm but suppliers
were having difficult time learning to produce it to acceptable levels. The
buyer had or could easily provide manuals, specifications lists, requirement
lists, etc. and despite this its purchasing managers knew suppliers were
having difficulty learning the commodity. The reason became clear imme
diately in a follow up interview with the equipment department manager
who attributed it to the safety requirements for that commodity. Given the
buyer’s emphasis on safety, those requirements are extensive and complicated
to learn. Thus, the solution was clear, to simplify and clarify the safety re
quirement, without lowering standards in order to make it feasible to train
suppliers easily and cheaply. Embarking on such strategy would allow the
buyer to move from a limited relatively small supplier pool to a much larger
one and would result in competitive prices.
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This shows not only the importance of codifiability, but also that codifia
bility includes multiple dimensions. It first must encompass the transaction
as a whole, and not just the product or commodity by itself. While the
product may be highly codifiable, parts of the associated transaction may be
less so, thus lowering overall codifiability. In addition, codifiability includes
not just the ability to supply manuals and such, but also the ability of the
’’other side” to understand and utilize those efficiently.
After fin alizin g the questionnaire, we conducted it via the web. The
questionnaire was put online on a secure web site. As product managers
filled and submitted it, the data was automatically downloaded to a database.
Once the process started, it took 10 days to finish. Although it is extremely
short time for such a process, we lost two commodities since one of the
managers left the division in the middle of the process and could not complete
it.
During the analysis it was found that few questions were not understood
in the way intended. Those questions were reworded and discussed with
XChem’s executives and managers who were responsible for answering them.
The questions that were misunderstood were about investments in inter-firm
systems, either by suppliers or XChem. The product managers interpreted
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the question as pertaining to procurement systems only and not to all sys
tems. These questions were re-administered and the data were then final
ized. The discussions that took place during this stage helped clarify and
contexualize the results and conclusions derived from the study.
3.5.2 T h e D a ta
The resulting data has 94 data points on the commodity-supplier unit of
analysis and 36 on the commodity unit of analysis. The reason for the
two types of unit of analysis is that some variables in the study pertain
only to the commodity and are by definition the same for all suppliers of a
given commodity while other variables may have different scores for different
suppliers of the same commodity. One commodity observation, and therefore
all of its associated commodity-supplier observations, was dropped off. This
commodity was an outlier on the general codifiability scale, but for reasons
exogenous to the transaction and therefore did not represent the study well.
The resulting data set had 35 commodity observations and 90 commodity-
supplier observations.
Table 1 below provides summary statistics for all variables based on the
35 commodity observations. Those variables that are on the commoditv-
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supplier scale would not have observable differences in mean and standard
deviation because only in very few instances did XChem’s buyers rank sup
pliers differently when supplying the same commodity. Several observations
can be made on the data.
The first is th at performance measures were truncated at a score of 6
(out of 7), except defects, which was not truncated above but truncated
below a t 2, indicating that XChem buyers are never ” fully satisfied” with
the performance the get from their suppliers. However, this is a common
result with Likert scale based questionnaires and does not indicate anything
of real importance.
The second observation is that general codifiability is ranked at 4-7 (7
being complete codifiability), while requirement and engineering codifiabil
ity were ranked between 1 or 2 (correspondingly) to 7, with 7 being com
plete. This indicated that the general measure of codifiability does not
capture the actual codifiability and its answers are more biased by subjec
tive perceptions. Requirement and engineering based questions directed the
respondents towards more observable and explicit measures and thus were
less biased. Supporting that were interviews with the managers and buyers
in XChem’s equipment procurement area who believed they "always know”
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the commodities they buy. Thus, general codifiability was not used in the
analysis.
Another observation is that XChem hardly make any investments in the
relationship. The scores for that measure ranged between 1 to 3, indicating
zero or very low investments. The complete lack of variation rendered this
variable meaningless to analyze and the XChem’s investments variable was
therefore dropped.
XChem tend to use 3 or fewer suppliers. While the mean (2.85) and
standard deviation (1.86) indicate it, examining the raw data makes it vivid.
Out of 35 observations, in seven cases XChem uses more than 5 suppliers, in
one case it uses 5 suppliers, in two cases it uses 4, and the rest have 3 or fewer
suppliers. It also highlights that XChem either uses 3 or fewer suppliers (few
in its language) or more than 5 (many in its language), indicating a tendency
for extreme strategies. As the next section discusses, it is indeed XChem
approach to its supplier management.
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Variable Mean Std Minimum Maximum
Quality 4.86 1.11 1 6
Defects 2.68 1.28 1 5
Number1 2.86 1.86 1 6
Cod 6.03 0.86 7
EngCod 5.97 1.58 7
ReqCod 6.28 1.38 1 7
Learning 5.11 2.19 1 7
Screening 3.4 1.19
ProdUnique 3.83 1.65 1 7
OrgUnique 3.77 1.61 1 7
MgmtUnique 4.31 1.49 7
GenSub 4.05 1.92 1 7
MnfqrSub 4.37 2.00 1 7
Qsub 4.57 2.06 1 7
CostSub 4.23 1.97 1 7
Practices 4.25 1.38 1 6
Training 4.26 1.38 1 6
Eqlnvest 4.08 1.56 1 7
TotalAnnualSpend2 6.35 1.49 0.1 35
EqUniqlnvst 1.51 1.27 1 6
DuPEqUniqlnvst 1.06 0.34 1 3
OnGoingCosts 2.06 1.88 1 7
Table 3.2: Descriptive Statistics
• Represents a transaction with a given supplier for a given commodity.
Measured in millions of US dollars.
• Number was ranked on a 1-6 scale with 1-5 being the actualy number
of suppliers used and 6 representing more than 5 suppliers.
3.5.3 P art I: T h e C ase o f th e M issin g S trategy
The correlation table shown below, together with knowledge of XChem’s
procurement gained during the interviews, indicate that XChem does not
have a formal supplier management strategy that links the variables this
study measured and the number of suppliers they use. As can be seen,
only two variables have a significant correlation. TotalAnnualSpend has a
0.4 correlation with BinNum at a p-value of 0.017. Learning, as our model
predicts, has a 0.326 correlation at a p-value of 0.056. However, XChem, at
the time of the study, was not aware of learning or codifiability as pertaining
to its supplier management strategy. Learning operated as a constraint
and forced XChem to limit the number of supplier it used but not as a pre
determined strategy. The total annual spend on a commodity, when high
enough, allowed XChem to increase the number of suppliers it was using.
Furthe more, as shown in the previous section, XChem either uses few
(less than 3) or many (more than 5) suppliers. Such a behavior indicate
that only a global strategy exists with regard to supplier management and
that strategy is not dependent on quantifiable parameters.
Discussions with XChem procurement executives confirmed that while
XChem does have a general supplier management strategy, they do not have
124
a systematic approach to segmenting its strategy per the factors considered
in this study. As one executive stated: ”We have a strategy in that we
make decisions on how many suppliers we should use for a commodity, but
certainly do not have any strategy that is based on quantitative analysis of
data.”
Note: In the corrleation tables below correlations are calculated on stan
dardized variables, except for BinNum, which is binary.
* = p<0.1 ** = p<0.05 *** = p<0.01
1. P=0.0161 2. p=0.056 3. p=0.1007 4. p=0.0173 5. p=0.0169
125
QualityPerf DefectsPerf BinNum
QualityPerf 1 0_4**i -0.26
DefectsPerf 0.4** 1 -0.26
BinNum -0.26 -0.26 1
AvgCod 0.18 0.06 0.01
MinCod 0.13 0.05 -0.02
Learning -0.34 -0.11 0.33*2
Screening o.l5 0.28 -0.16
AvgUnique 0.17 0.00 -0.25
MinUnique 0.1 -0.12 -0.25
AvgSub 0.26 0.24 -0.05
MinSub 0.07 0.05 0.11
Practices 0.04 0.10 0.07
Training 0.04 0.10 0.07
Eqlnvst 0.31* -0.21 -0.283
TotalAnnualSpend 0.009 -0.17 0.40**'1
EqUniqlnvst 0.01 0.08 0.09
OnGoingCost 0.13 0.03 -0.05
Table 3.3: Correlations Tablel
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AvgCod MinCod Learning Screening
QualityPerf 0.19 0.13 -0.34** 0.15
DefectsPerf 0.06 0.05 -0.11 0.28
BinNum 0.01 -0.02 0.32*2 -0.16
AvgCod 1 0.91*** -0.09 0.26
MinCod 0.91*** 1 -0.04 0.29**
Learning -0.09 -0.04 1 0.00
Screening 0.26 0.29* 0.00 1
AvgUnique -0.08 -0.11 -0.31** -0.22
MinUnique -0.19 -0.22 -0.30** -0.35**
AvgSub 0.04 0.04 -0.05 0.68***
MinSub 0.09 0.16 0.13 0.58**
Practices 0.24 0.20 0.14 0.24
Training 0.24 0.20 0.14 0.24
Eqlnvst -0.12 -0.18 -0.37** -0.33**
TotalAnnualSpend -0.28* -0.32* 0.21 -0.04
EqUniqlnvst 0.03 0.06 0.04 -0.31*
OnGoingCost -0.15 -0.11 0.03 -0.02
Table 3.4: Correlations Table2
127
AvgUnique MinUnique AvgSub MinSub
QualityPerf 0.17 0.11 0.26 0.07
DefectsPerf 0.00 -0.13 0.24 0.05
BinNum -0.25 -0.25 -0.05 0.11
AvgCod -0.08 -0.19 0.04 0.08
MinCod -0.11 -0.22 0.05 0.16
Learning -0.31* -0.30* -0.05 0.12
Screening -0.21 -0.35** 0.68*** 0.56***
AvgUnique 1 0.93*** -0.50*** -0.51
*
##
b\
0.93*** 1 -0.61***
-" I
MinUnique
O
I
AvgSub -0.50*** -0.61*** 1 0.87***
MinSub -0.51*** -0.57*** 0.87*** 1
Practices 0.00 -0.05 -0.01 -0.11
Training 0.24 -0.05 -0.01 -0.11
Eqlnvst 0.80*** 0.79*** 0.50*** -0.64***
TotalAnnualSpend -0.03 0.03 -0.08 -0.10
EqUniqlnvst -0.31* 0.43*** 0.56*** -0.46***
OnGoingCost -0.02 0.40**6 0.31* -0.39**
128
Practices Training Eqlnvst
QualityPerf 0.04 0.04 0.31*
DefectsPerf 0.10 0.10 0.20
BinNum 0.07 0.07 -0.283
AvgCod 0.24 0.24 -0.12
MinCod 0.20 0.20 -0.19
Learning 0.14 0.14 -0.37**
Screening 0.24 0.24 -0.34**
AvgUnique 0.00 0.01 0.80***
MinUnique -0.04 -0.05 0.79***
AvgSub -0.01 -0.01 -0.50***
MinSub -0.11 -0.10 -0.64***
Practices 1 -0.01
Training ^*** 1 -0.01
Eqlnvst -0.01 -0.01 1
TotalAnnualSpend 0.33** 0.33** -0.03
EqUniqlnvst 0.07 0.07 0.36**
OnGoingCost 0.44*** 0.44*** 0.34**
129
TotalAnnualSpend EqUniqlnvst OnGoingCost
QualityPerf 0.01 0.01 0.13
DefectsPerf -0.18 0.08 0.03
BinNum 0.40** 0.09 -0.05
AvgCod -0.28* 0.03 -0.15
MinCod -0.32* 0.06 -0.11
Learning -0.37** 0.04 0.03
Screening -0.33 -0.31** -0.02
AvgUnique -0.02 0.45*** 0.35**
MinUnique 0.03 0.43*** 0.40**
*—**
CO
AvgSub -0.08 -0.56*** oi
MinSub -0.10 -0.46*** -0.39**
Practices 0.33** 0.07 0.44***
Training 0.33** 0.07 0.44***
Eqlnvst -0.03 0.36** 0.40**
TotalAnnualS pend 1 0.09 0.53***
EqUniqlnvst 0.09 1 0.44***
OnGoingCost 0.53*** 0.44*** 1
130
I consider this lack of formulated strategy as making the test of the model
even more difficult and conservative. When a firm has a strategy based on
factors studied, finding a relationship between the factors and the measure
of strategy (in this case, the number of suppliers) is not surprising and may
not teach us much. However, when despite a lack of strategy, a relationship
between a factor and the number of suppliers used is found, it indicates a
strong support for the underlying model. Therefore, the relationship between
BinNum find Learning indicates a strong support to the idea of codifiability
and transferability as critical factors in supplier management. Similarly,
the correlation between TotalAnnualSpend and BinNum shows that XChem
responds strongly to what in the analytical model was called R . In this case,
R works as an enabler. The bigger the pie, the more suppliers XChem can
use without losing its power over the supplier.
However, even here the relationship is not straightforward. Prom the
scatter plot below it seems that low monetary volume does not carry any
recognizable strategy with regard to the number of suppliers used, while
relatively high monetary volume ($15 million and above) does entail using
more suppliers. It actually follows the "No Strategy” idea discussed above.
131
Figure 3.2: Number o f Suppliers vs. Annual Monetary Volume
Number 'Annual Monetary Volume
2 6
•
s 0
£ 4
O „
-t ro c
Num ber
1 , -■, - _
o
0 5 10 15 20 25 30 35 40
Annual Monatrary Volume
in $ millions
When the annual monetary volume is low, the lack of strategy shows. When
the volume is high, XChem reacts to it by spreading it over many suppliers,
because it can do so.
The framework and theory do not assume that any one factor would solely
or strongly influence the strategy, but some influence is expected. As the
regression results in the sections below show, XChem does respond to the
collection of forces resulting from the combined effect of multiple factors.
However, if XChem had a strategy or would respond to any variable in a
systematic way, then some significant correlation (between that factor and
132
number-of-suppliers alone), even if a low one, should have been present. The
reason for the lack of such one-to-one correlation is as the title suggests:
XChem does not have any systematic strategy with regard to the number of
suppliers it uses.
The premise of the framework is that a firm that does not follow the
model-based recommendations would suffer in its performance. The model
uses profits to measure performance. However, firms’ complex processes
usually prevent linking procurement of specific items to profits generated by
products using those items. Thus, performance is best measured through
quality and related measures. I have collected survey data both on quality (of
supplier for a given commodity) and on defects, as well as other performance
related measures (e.g. on-time delivery). Defects is the better measure to
use since it has higher variance (than quality). Furthermore, the data is
managers’ evaluations of suppliers. In the case of defects those evaluations
are based on a measurable (even if not systematically tracked) and relatively
clear signal. Furthermore, in the model, profits are a result of a fit between
the chosen supplier and the transaction. As the fit improves, so do profits’.
The best way to capture fit between a supplier and the transaction is the
’ in the stochastic version, profits are stochastically improving with fit.
133
quality and number of defects. Thus, defects and quality capture the essence
of the model better than any indirect measure of performance such as profits,
which might be affected by numerous other factors.
Three main observations are gained in the study of performance measures.
First, gained from discussion with the executive in charge of equipment pro
curement, is that XChem performs worse than what he would have expected.
Secondly, the factors hypothesized do correlate with performance, mostly in
the hypothesized direction. Thirdly, learning and codifiability are important
and their interaction affects performance as would be expected but the inter
action with the number of suppliers as it affects performance is surprisingly
opposite to the hypothesis. This result warrants a further study to examine
whether it is a result of XChem’s lack of strategy, an arbitrary effect due to
the nature of the data and study, or a fundamental relationship.
The rest of this chapter is as follows. First each hypothesis is examined
separately and scatter plots are provided to show the lack of one-to-one
relationship between factors and the number of suppliers. Then I present
regression results for the number of suppliers and discuss them. Lastly, I
examine performance related results and discuss these.
134
3 .5 .4 P art II: R egression R esu lts
Num ber o f Suppliers
It is evident that despite the lack of formal strategy by XChem with regard to
the variables discussed in this study, these same variables do affect its choice
of supplier base size as can be seen in Model 1 below. The coefficients, even
if not always significant due to the size of the data set, are almost always in
the right direction. Thus, the results suggest that the model is capturing
important factors and correctly analyzes these factors’ influence on supplier
management strategy .
M odel 1: M ain Effects The regression was run on the ’’small” data set,
which is limited to the 35 commodity based data points. Since the number
of suppliers is a commodity-based measure, the commodity based data set is
the one to use.
The first take from the regression results is that most of the variables have
the correct sign, even if significance, probably due to data set size, exists only
for TotalAnnualSpend and Learning. Such results serve both to show that
the empirical study concurs with previous research, which supports the study,
and to support the analytical framework as a basis for supplier management
135
analysis.
The main innovation of the framework in terms of factors that may predict
strategy and performance is the idea of transaction knowledge transferability
and its parts, codifiability and learning. The correlation table supported
learning as a significant factor and at the right direction, i.e. higher learning
on the supplier side is positively correlated with more suppliers used. The
regression results support this as well, even though learning is only bordering
on significance at a p-value of 0.102. Given the size of the data set, it
is not surprising to see significance disappear when more factors are used.
Noticeably, codifiability is not significant, even if it is in the right direction.
The more important role of learning as compared to codifiability is a direct
result of XChem’s knowledge of its own needs.
As with the correlation results, TotalAnnualSpend is found to be posi
tively correlated with BinNum and significant at the 0.05 level. As with
Learning the significance level is reduced from the correlation analysis to the
multi-factor regression. It is therefore clear that H4 is supported.
An interesting pattern appears with regard to expenses and investments
associated with a transaction. Both types of investments measures, which
axe either supplier investments in equipment that is unique to the commod-
136
ity but not to XChem (Eqlnvst) and investments that are unique to both
commodity and XChem (EqUniqlnvst) have a positive correlation with the
number of suppliers used. Such a finding contradicts the usual findings and
expected results. However, the correlation table show Eqlnvst to be neg
atively correlated with BinNum with a p-value of 0.1. Furthermore, the
correlation between the two investments measurers and measures of unique
ness and substitutability goes in the right direction, negative for the former
and positive for the later. It is therefore not clear what drives the regression
results in this case and further examination is required. Discussion with
XChem executives suggests that suppliers are not incented to make those
investments but do them on a need to basis. These investments are either
required or not. If they are a necessity to working with XChem on a spe
cific transaction, in the case of EqUniqlnvst, and the supplier finds them
worthwhile to make, those investments are made. However, XChem does
not change its strategy because such an investments had been made.
At the same time, a measure of transaction costs, OnGoingCosts, shows
up in the right direction as negative with a p-value of 0.06. Therefore, as
transaction costs go up, XChem uses fewer suppliers. The analytical model
concurred with TCE that this should be the effect and this result, therefore,
137
Parameter Estimate p-value
Intercept -1.98 0.028
MinCod 0.40 0.55
Learning 1.66 0.102
Screening -1.47 0.096
cq
r—
MinUnique 0.28
1
4
MinSub *2.07 0.16
Eqlnvst 2.1 0.3
TotalAnnualS pend 4.9 0.04
EqUniqlnvst *2.37 0.17
OnGoingCosts -4. *20 0.06
Table 3.8: Number of Suppliers: Main Effects
supports the model’s applicability.
M odel 2: H6 revisited Uniqueness shows in the right direction and sig
nificant both in the main effects model, which includes Screening and Spend,
or in an interaction model with spend alone. It is interesting to note that
average uniqueness does not hold as well in the model and has a lower co
efficient and is at a lower significance level, which suggests that the idea of
uniqueness as a constraint has some validity. Thus, H6 is supported with
this model.
138
Parameter Model i Model ii Model iii
-1.21 -0.34 -1.13
Intercept
(0.013) (0.58) (0.014)
-0.89 -0.67
Screening -
(0.11) (0.199)
-1.03 -1.49
MinUnique -
(0.041) (0.065)
-0.74
AvgUnique - -
(0.083)
1.03 2.82 0.92
TotalAnnualSpend
(0.03) (0.035) (0.04)
-2.53
MinUnique*Total - -
(0.08)
Table 3.9: Number of Suppliers: Uniqueness
A lternative Explanations
One alternative explanation, to replace the codifiability story, that could be
raised is moral hazard. It could be argued that a firm faces the possibility
of knowledge being copied by its suppliers and transferred to other buyers.
Indeed, codified knowledge is more easily copied and learned by suppliers and
competitors alike (Nonaka, ****). As Anton and Yao (***) observe, it may
be beneficial to a firm to hold back information and suffer in performance,
in order to prevent being imitated. While to my knowledge there is no
discussion of how such issues would affect the number of suppliers used, it is
logical that exposure is reduced when fewer suppliers are used. At the same
time, it is logical to argue that less codifiable transactions, thus not protected
139
by patents, would have a higher moral hazard. The reason being that for
such transactions, the knowledge is protected by its lower codifiability and
not by formal means of patents. Therefore, moral hazard related problems
should result in fewer supplier used and at the same time lower codifiability
would be observed.
The answer to this is two-fold. In this study, XChem does not have pro
prietory information regarding the commodities it purchases. Suppliers are
the ones who hold the real knowledge of the commodity. While the transac
tion may be more or less codifiable, it is not because XChem has some tacit
knowledge of the commodity itself, but rather because XChem may not know
some aspects of the transaction or the commodity. Codifying these transac
tions more would not expose XChem to moral hazard as discussed, since its
suppliers already have the technological knowledge required. Neither would
codifying related processes expose XChem to imitation by competitors since
these processes are ingrained in larger organizational processes and structures
and cannot be, and most likely should not be, copied by competitors, at least
not without major organizational changes. This point is strengthened by the
result that suppliers’ ability to learn the transaction and not codifiability was
the key driver of the number of suppliers. Given that suppliers do know the
140
technologies related to the commodities they supply to XChem it is apparent
that their inability to learn is of other attributes of the transaction. As was
pointed out, those attributes are not imitable by XChem’s competitors.
On a more general level, codifiability (or lack of) and moral hazard are
treated via different means. Lack of codifiability should suggest a firm may
use pilot projects and staged development in order to develop the codification.
An organization may use internal studies to make explicit what it tacitly
knows. It would not have a need, though, to have confidentiality related
sections in contracts, as moral hazard would require. Codifiability would be
alleviated through process related means while moral hazard would mostly
be alleviated through contractual means.
An interesting question to investigate is how the two relate and combine
to affect vertical integration. When a transaction is uncodifiable or has a
low level of codifiability it may be suggested that vertical integration would
alleviate the problem by increasing transferability. However, as empirical
evidence shows (Szulanski 1996, Dinur, 2002) transferring knowledge within
an organization is not an easy task. Currently there is not evidence that
a transfer between organizations is more difficult than a transfer within an
organization but between two different department. On the other hand, it
141
is clear that moral hazard is controlled by vertical integration. Thus, what
may be observed is that low codifiability absent of moral hazard would result
in sole sourcing (external or internal) but low codifiability combined with a
moral hazard would result in either sole sourcing with ’’strong” contracts or
more vertical integration. At the same time, high codifiability but with moral
hazard present should still result in sole sourcing with ’’strong” contracts or
in vertical integration.
Perform ance Regressions
The model generates performance related hypotheses only for interactions of
factors with the number of suppliers. However, examining main effects pro
vides insight to XChem’s performance with respect to the factor in question.
Performance regressions are done on the 90 data points set since performance
measures are given for each commodity-supplier combination8. I use the bi
nary form of ‘Number of Suppliers’ in the interaction term following the
discussion in the previous section. All other variables are standardized.
I examine measures of defects and quality since these are the measures
that best match the spirit of the model and relate the most to codifiability. I
8In effect, the number of points in the actual regression may be lower due to missing
data.
142
note when there are differences in results. Differences in signs of coefficients
should not exist theoretically and when they do, it could be a result of either
perceptions of the concepts involved or instability in the data. The cor
relation between defects and quality is 0.5 with significance level of 0.0001.
Examination of the data reveals that Quality scores are in the range of 4-6
while Defects scores have more variability. Since quality is based on subjec
tive assessment of multiple dimensions while defects is based on subjective
assessment of one dimension and “hard numbers” it is likely that the defects
measure is a better reflector of actual performance.
M ain Effects: D efects’ Performance regressions I provide both the
regression with all the variables included and then a more optimized version.
Signs do not change, only levels of significance but not substantially. Higher
score for defects means better performance on that measure (fewer defects)
and is therefore “good”.
• Codifiability and Learning both affect performance negatively (same
result as for Quality measure). The model does not predict how they
should affect performance but higher scores on either should make it
easier to manufacture the product and thus have fewer defects. How-
143
ever, if XChem is not using the correct strategy, a negative sign could
result.
• Screening affects defects related performance positively as it should.
• Specific investments, made by suppliers, affects defects related perfor
mance positively as it should.
• The more unique suppliers are, the better the performance. This result
makes sense since one expects that part of what makes suppliers unique
is a good fit with the transaction/product, thus leading to fewer defects.
• Higher Substitutability results in lower performance. That could well
be a result of the hold-up problem. Less substitutable suppliers might
be utilizing their power.
• The more XChem spends on a commodity (annual monetary volume)
the lower the performance it sees. That could be a result of the fact
that when they spend more they also use more suppliers, which might
have lower fit. Interaction effects between BinNum, TotalSpend, and
Uniquelnvest are highly insignificant and therefore prevent more in
sights into the reasons.
144
-1.98 -2.06
Intercept
(0.0001) (< .0001)
0.13 0.122
Intercept2
(0.75) (0.52)
0.72 0.78
Intercept3
(0.105) (0.03)
2.95 2.99
Intercept4
(< .0001) (< .0001)
5.09 5.33
Intercept5
(< .0001) (< .0001)
-0.49 -0.47
BinNum
(0.5) (0.38)
-0.71 -0.75
MinCod
(0.019) (0.007)
-0.22 -0.43
Learning
(0.46) (0.108)
1.34 1.46
Screening
(0.0002) (< .0001)
0.58 0.48
MinUnique
(0.14) (0.096)
-0.7 -0.92
MinSub
(0.066) (0.006)
0.06
Practices -
(0.82)
0.22
Eqlnvst -
(0.65)
-0.825 -0.71
TotalAnnualSpend
(0.033) (0.014)
-0.136
HHI -
(0.72)
0.69 0.71
EqUniqlnvst
(0.04) (0.018)
-0.005
OnGoingCosts -
(0.99)
Table 3.10: Defects Performance - Main Effects
145
M ain Effects: Q uality Regressions
• Different variables come out significant compared to defects perfor
mance results.
• Unique investments factor comes out negative. However, when Eqln-
vest, which is suppliers’ investments specific to the commodity but
not to XChem is removed unique investments changes sign (and many
other variables lose significance), which implies that the negative sign
is a result of the non XChem-specific investments picking up the effect.
• Uniqueness and Practices may be significant or not (and alternate)
depending on the model examined. Given the small data set it signals
that they could be important and would have both come out significant
in a bigger data set.
• Investments in practices alignment (by XChem) or in commodity re
lated equipment (by supplier) have the right, positive, sign.
Learning-Codifiability Interactions The best model for examining how
either codifiability or learning affects performance when interacting with the
number of suppliers should be a model that includes both measures. Indeed,
146
Intercept -21.75 <.0001
Intercept‘2 0.42 0.26
Intercept3 3.28 <.0001
Intercept4 4.91 <.0001
BinNum 0.97 0.085
Screening 1.36 <.0001
MinUnique 0.48 0.186
Practices 0.44 0.087
Eqlnvst 1.38 0.0009
TotalAnnualS pend -0.72 0.006
EqUniqlnvst -0.25 0.34
Table 3.11: Quality Performance - Main Effects
actual regression models with only either codifiability or learning (BinNum
included) are inferior to the model that includes both, confirming the notion
of transferability as the key issue.
• The interaction between learning and codifiability is significant and has
the right sign. When both agree (both high/both low) the performance
is higher than when they disagree. It is more difficult to identify the
problem and figure out the correct strategy when one is high and the
other low. Furthermore, examination of the data shows that codifi
ability tends to be high while learning tends to be low. Interviews
with XChem’s executives confirm that XChem has not paid attention
to the problem when codifiability is high. However, when codifiability
147
is low XChem is aware of the inherent problem and devotes resources
to solving it. Thus, the cumulative effect is that when codifiability is
high but learning is low performance is low, but when both are high
or both are low, performance is high. Given that low codifiability and
high learning do not happen, the positive coefficient results.
• The interaction of either with the number of suppliers is surprisingly
negative (only significant for learning). The model-based hypothesis is
that when there is high learning and high codifiability more suppliers
should be used and that would result in higher performance (and low
should go with low).
— XChem does not match the number of suppliers to learning or
codifiability levels knowingly. As discussed earlier the interaction
of codifiability and learning implies that when the two do not have
the same level more suppliers are used, a result which could be ei
ther random (small sample issue), due to the low-low outweighing
High-High combination. However, why it would imply higher per
formance when the number of suppliers do not agree with learning
or codifiability is not clear and warrants further investigation.
148
Intercept -1.42 <0.0001
Intercept2 0.52 0.091
Intercept3 0.99 0.002
Intercept4 2.88 <0.0001
Intercepts 5.13 <0.0001
BinNum -1.05 0.026
MinCod -0.29 0.36
Learning 0.25 0.38
BinNum*Learning -1.1 0.028
BinNum*MinCod -27 0.958
Learning* MinCod 0.45 0.109
Table 3.12: Performance - Learning and Codifiability
— It is also important to remember that in the main effects model,
both learning and codifiability showed as affecting performance
negatively, which was also contrary to intuition.
Thus, it shows the importance of codifiability and learning as part of
supplier management strategy but also indicates that further investigation is
required to understand the reasons behind the counter-model effect and to
examine whether it is unique to XChem or an actual pattern that contradicts
the model.
149
3.6 D iscussion
In this chapter the aim was to analyze the problem of segmented supplier
management within the context of B2B e-commerce environment when idio
syncratic investments in systems and procedures are required. Specifically,
this study used the framework established in chapter 2 to analyze that ques
tion under varying assumptions. The analytical results showed that re
gardless of assumptions on information visibility or on the cost function, the
proposed factors always influence the strategy in the same manner and as
described above. Furthermore, the idea of transaction knowledge codifiabil
ity was introduced and for the first time incorporated into a discussion about
inter firm relationships and firm boundaries. I have shown codifiability to be
a necessary and critical factor in determining supplier management strategy,
especially when electronic transactions are concerned.
This dissertation and specifically this chapter is the first to suggest that
segmented supplier management strategy is required. While TCE posits
that inter firm relationships are affected by a set of variables and other man
agement literature have supported that view, the idea of tailoring a firm’s
supplier management strategy to transaction, market, and firms’ (buyer and
suppliers) attributes have not been put forward in such a manner. The
150
analytical model of this chapter serves to formalize this concept and TCE’s
notions about the nature of relationships. Thus, the model suggests hypothe
ses about the nature of supplier management strategy as should be practiced
by ” Darwinian” firms that adapted and learned from the marketplace.
The second, empirical, part of this chapter serves to underscore this dis
sertation’s agenda. I have found the XChem’s procurement unit to have no
consistent strategy with regard to the number of suppliers it uses in the con
text of factors considered in this research. As a result XChem’s performance,
as viewed by itself and compared to its competitors, suffers. However, since
no data is tracked and kept, XChem’s ability to deduce and thus change its
behavior is extremely limited. Indeed, from my interviews with the exec
utives and managers in question, I have learned that a ’’global” strategy is
formed with the objective to lower costs either by going towards a smaller
supplier base (and thus close relationships) or towards a bigger supplier base
(and thus stronger supplier competition). As a confirming side note I will
point out that XChem has not invested in electronic systems, or any other
system, in order to foster suppliers’ investments, not even when suppliers
make such investments in order to work with XChem.
T hat said, the multi-factor regression does support the model and shows
151
that XChem responds to the suggested factors as hypothesized. Given the
lack of formal strategy (per those factors) and the small d ata set, such results
strongly support the framework and its underlying assumptions and theory.
Furthermore, the concept of transaction knowledge transferability is found to
affect supplier management strategy as hypothesized. The counter hypothe
sis finding that learning and number of suppliers are substitutes rather than
complements could well be due to XChem lack of strategy and its complete
unawareness of the issue. However, it does warrant further study to better
understand the reasons behind such effect.
Given these findings, it is clear that a cross firm and possibly cross in
dustry study is the next step. While strong implications for strategy must
await more detailed field studies and testing of the framework prposed the
results do underscore the need for segmented supplier management strategy
basedon codifiability and other transactions variables.
152
3.7 Appendix: List o f Variables
1. PricePerf: The performance in terms of price they get from suppliers.
Higher score means better performance.
2. ComProdTimePerf: The performance in terms of productions time
(compared to other commodities) they get from suppliers. Higher score
means better performance.
3. SupProdTimePerf : The performance in terms of productions time
(compared to other suppliers of the same commodity) they get from
suppliers. Higher score means better performance.
4. OnTimePerf : The performance in terms of on-time delivery they get
from suppliers. Higher score means better performance.
5. QualityPerf: The performance in terms of quality they get from sup
pliers. Higher score means better performance.
6. DefectsPerf: The performance in terms of defects rate they get from
7. ImprovePerf: The performance in terms of improvement they get from
153
8. GoalsPerf: The performance, compared to their goals, they get from
9. Number: Number of suppliers.
10. BinNum: The number of suppliers categorized as few (category = 0)
or many (category = 1). When the number of suppliers is 3 or below it
is categorized as few. When the number of suppliers is 4 or more it is
categorized as many. Since there were only 2 cases of 4 and one case of
5, and the scale was 1-6 with 6 being more than 5, this categorization
is reasonable. Furthermore, including the two observations of 4 in the
few would not change results and neither would a further inclusion of
the ‘5’. This categorization allowed much cleaner analysis due to the
nature of the data but helped only to enhance significance without
changing signs of coefficients.
11. Cod: Level of general codifiability of the commodity. Higher score
means more codifiable commodity.
12. EngCod: Level of engineering codifiability of the commodity. Higher
score means more codifiable commodity.
13. ReqCod: Level of requirements codifiability of the commodity. Higher
154
score means more codifiable commodity.
14. MinCod: The minimum of all the codifiability measures. Captures the
notion that codifiability level is dictated by the lowest of the measures
and is a constraint on increasing the number of suppliers.
15. Learning: Suppliers ability to learn the commodity. Higher score means
better ability to learn.
16. Screening: The amount of supplier screening that was required for this
commodity. Higher score means more screening.
17. ProdUnique: How unique is the supplier in terms of its production
capabilities. Higher means the supplier is more unique.
18. OrgUnique: How unique is the supplier in terms of its organizational
19. MgmtUnique: How unique is the supplier in terms of its management
‘20. MinUnique: The minimum of all the uniqueness measures. Captures
the notion that uniqueness level is dictated by the lowest of the mea
sures and is a constraint on increasing the number of suppliers.
155
21. GenSub: How easy it is to substitute the supplier. Higher scores mean
it is easier to substitute.
22. MnfqrSub: How easy it is to substitute the supplier in terms of manu
facturing consequences. Higher scores means it’s easier to substitute.
23. Qsub: How easy it is to substitute the supplier in terms of quality
consequences. Higher scores means it’s easier to substitute.
24. CostSub: How easy it is to substitute the supplier in terms of cost
consequences. Higher scores means it’s easier to substitute.
25. MinSub: The minimum of all the substitutability measures. Captures
the notion that substitutability level is dictated by the lowest of the
measures and is a constraint on increasing the number of suppliers.
26. Practices: How much XChem invested to align supplier’s business prac
tices with its procurement practices. Higher means higher investment
was required.
27. Training: How much XChem invested to train supplier’s personnel with
its procurement practices. Higher means higher investment was re
quired.
156
‘28. Eqlnvest: Level of investment by supplier in non XChem specific equip
ment to produce the specific commodity. Higher score means more was
invested.
‘29. SpendRank: Annual monetary volume of transaction between XChem
and the specific supplier, ranked. Higher means XChem transacts more.
30. HHI: Supplier concentration (internal market concentration). Higher
means more concentrated procurement. Not normalized for market
supplier pool.
31. EqUniqlnvst: Level of unique investments made by XChem to be able
to procure the specific commodity with the specific supplier. Higher
means more investments were made.
32. OnGoingCosts: Level of on going costs associated with the transaction
of the specific commodity with the specific supplier. Higher means
higher costs.
• All variables except BinNum have been standardized.
157
Chapter 4
Optimal Contract and
Spot-M arket M ix for Buyers in
th e Presence of Uncodifiable
Transaction Knowledge
4.1 Introduction
The last few years have seen an explosion in the number of e-Marketplaces,
including a variety of electronic exchanges in the B2B arena. Third party
158
solution providers (e.g., Vertical Net), infrastructure companies (e.g., Ariba,
i2), and big buyers (e.g., the Big 3-Covisint) jumped into this arena in order
to capture a share of the forecasted trillions of dollars expected to material
ize through e-trade1, overall totaling approximately 1500 different exchanges
existing at the end of 2000. As a result, B2B e-trade is vibrant in selected
areas such as steel, plastics, chemicals, and energy. However, the closing of
Chemdex and other such exchanges indicates that there may be significant
problems in establishing sustainable e-Markets for certain transactions. The
question addressed in this paper is what are likely to be the underlying factors
that affect which transactions are likely to be supportable by e-exchanges.
We focus here on a setting that allows both long-term contracting and short
term spot markets and attem pt to determine which suppliers and buyers will
participate in each of these forms of market relationship. For both types
of relationship, of course, exchanges may be valuable as a means of mediat
ing transactions. However, the form of the exchange is likely to be quite
different for transactions that are dominated by spot transactions than for
those dominated by contractual relationships. The key element we analyze
l The reader can open tiny publication by Forrester Research, Merill Lynch, PriceWa-
terhouseCoopers and the likes, to see a range of, typically very high, forecasts of expected
trade volumes in the online B2B sector.
159
that seems the fundamental determinant of which form of relationship will
dominate for a particular transaction is the codifiability of the transaction.
Kogut and Zander (1992, 1993) define codifiability as the ability to create
an explicit document detailing all aspects of a product, process or procedure,
so that this document would be understandable to relevant parties concerned
with this product, process or procedure. In the inter-firm context, codifiabil
ity is the ability of either or both of the trade partners to create a commonly
understood document listing everything about the transaction. Chapter
3 applied the codifiability concept to inter-firm transactions and the opti
mal structure of supplier relations. A central result of Chapter 3 is the
empirical corroboration that codifiability of transactions is a critical factor
determining the optimal structure of supplier relations. This paper argues
that “codifiability” is a central and defining factor for how transactions are
organized in markets, including the nature of the B2B systems, investments
and institutions that support a particular transaction.
Many factors, as identified by Williamson (1975, 1996), may determine
the contracting and management structures governing how particular trans
actions occur. The Williamsonian approach focuses primarily on the nature
of planning and investment activities preceding actual transactions. This
160
analysis builds on this, but is also concerned with the manner in which these
transactions can be integrated with an e-Commerce framework. The analyt
ical framework developed extends that of Wu, Kleindorfer and Zhang (2000,
2001) in investigating the integration of contracting and spot markets as al
ternative types of supplier relations. Consistent with recent developments in
e-Commerce, the model developed shows that certain transactions will natu
rally give rise to governance mechanisms dominated by contract, while others
will be dominated by spot purchases, and still others may use both forms of
procurement. We show that the primary factor underlying the equilibrium
outcome of transactions governance structure is codifiability, appropriately
defined in the context of the model developed.
The model developed adopts the following perspective. One or more
buyers face a decision as to how to source an intermediate product from
one or more suppliers. They can do so either by setting up longer-term
contracts, with specialized suppliers, or through one-time (spot) purchases
from generalized suppliers. In the case of contracts, systems and procedures
are established ahead of time to support the execution of transactions, and
these procedures may be embodied in an exchange with restricted member
ship. In the case of generalized suppliers, procurement occurs through a
161
“spot exchange”, where the exchange can be either an established electronic
exchange or something as simple as the Yellow Pages. The key difference be
tween these types of procurement is that contract procurement is negotiated
in advance, and can accommodate virtually any customization in product or
delivery features desired by the buyer(s), while generalized (or “spot”) pro
curement is constrained by the rules of the market, and typically allows much
less customization2. We model the underlying choice here for a single buyer
by considering the cost and timing of these competing sourcing strategies.
We assume that contracting requires time, and leads to fixed costs to estab
lish the buyer-seller systems and procedures that underlie contract execution.
The benefits of contracting are assumed to be lower variable production and
transactions cost, including the costs of poor quality and off-spec product,
and a higher probability of order fulfillment in the face of demand volatility.
Spot purchases from generalized suppliers provide access to a broader com
petitive market, and allow fine tuning of demand and supply, but possibly
2Spot markets that are run through exchanges are designed to allow a specific scope
of product features to be specified as delivery or purchase options in advance. For these
features, and these features alone, frictionless transactions are accommodated. Yellow
Pages, on the other hand, allow a much broader range of features to be negotiated, but
the Buyer has to incur search and negotiation costs. The tension between what products
are offered in various types of “spot market'’, and what investments are incurred and by
whom to standardize offerings, is rather interesting in its own right but one that we will
leave for future research. We provide below a framework for undertaking such an analysis.
162
at higher unit costs associated with the poorer matching of product speci
fications and delivery features with the buyer’s requirements. While these
benefits favor contracting, it must be done in advance, and sometimes well in
advance, of physical delivery requirements so that investments in capacity or
customization required of suppliers to support contract execution may face
increased uncertainty relative to spot market transactions. The trade-off
between these costs and risks depends fundamentally on the codifiability of
transactions and the volatility of demand. If transactions are completely
codifiable, and unit costs are identical between these two sourcing alterna
tives, there would be no reason (for either competing suppliers or buyers) to
set up long-term contracts. But cost differences can arise for both suppliers
and buyers. On the supplier side, as Helper and Sako (1995), Srinivasan et
al. (1991) and Wang and Seidmann (1995) point out, shared schedules and
EDI links can significantly reduce supplier costs by promoting better pro
duction planning through more precise requirement and delivery schedules.
On the buyer side, the advantages of contract procurement and strategic
partnerships with suppliers have been widely recognized (Walker and Weber,
1984; Helper and Seiko, 1995). On the other side, the advantages of open
and transparent markets are the underlying paradigm of modern economics.
163
However, as we note in the framework that follows, a mix of contracting and
spot purchases can have fundamental advantages over either contracting or
spot markets in isolation, and this is especially true when codifiability is less
than perfect and demand volatility is high.
The paper proceeds as follows. Section 2 outlines the mode and notations.
Section 3 provides the basic results and analysis applied to the one buyer
one supplier case. Section 4 analyzes the multiple buyers case. Section
5 summarizes and the Appendix provides proofs not included in the main
body.
4.2 M odel and N otation
Our modeling framework is based on Wu, Kleindorfer and Zhang (2001),
specialized to identical suppliers, but extended to include differences in cost
under contract and spot market procurement, as well as the inclusion of fixed
costs for establishing a contract relationship between a buyer and a supplier3.
We focus on a single buyer with options to purchase a particular intermediate
3Tlie results are easily extended to the case where Suppliers have heterogeneous cost
functions as in Wu, Kleindorfer and Zhang (2001). However, the increased notational
burden associated with doing so, when coupled with the more general problem framework
here, would mask the basic insights derived here.
164
product from multiple, identical suppliers in the contract market or from a
spot market .4 The process by which price in the spot market is determined
is not modelled here, i.e., it is exogenous to the analysis5.
We use the following notation.
N = { 1 ,... n}: Suppliers, with number of Suppliers = n
Pa: spot market price, with cumulative distribution function F(Pa) and
density function f { P a), where /x is the mean of the spot market price.
a : Additional costs to the Buyer per unit for purchases made in the spot
market, e.g. because of imperfect codifiability of the product. Given a, the
’’full spot price” to the Buyer of purchasing on the spot market is P3 + a.
/?: Suppliers’ unit capacity cost per period.
bc: Suppliers’ short-run marginal cost of providing a unit under contract
procurement.
b„: Suppliers’ short-run margined cost of providing a unit under spot
market procurement; we assume that bc < bs so that variable cost under
contract is no higher than variable cost under spot procurement. Indeed the
1Extensions to multiple buyers are also briefly discussed. They appear to be

straightforward.
5This price will depend on the co6ts and number of suppliers, on delivery options, on
the structure of the exchange through which spot purchases are made, and many other
factors.
165
difference b3 —bc is one measure of the lack of codifiability of the purchased
product in question. However, if adaptation on the supplier side is not
required (probably leading to a higher a on the Buyer’s side) then bc > b 3.
I: Suppliers’ required investment in specific systems and procedures in
order to participate in the contract market.
K: Suppliers’ total capacity.
Li'. Supplier i ’s posted capacity to the contract market, i € N. Li can
only be non-zero if the Supplier pays the required investment costs I ex ante.
Si: Supplier i’s reservation price per unit of capacity if the contract is
signed. Let s = (st , . . . , sn)
gii Supplier i ’s execution price per unit of output actually used from the
forward contract. Let g = (gi , . . . , gn)
Q i : Buyer’s contract market demand for Supplier i ’s output.
<7i: Buyer’s actual contract market consumption of Supplier i’s output,
where < Qi, Vi
x : Buyer’s actual spot market purchase
Dt = x + Qi- Buyer’s total consumption.
F (v,a) = CDF of full spot price P3 + a, so that F(v,a) = P r {Pa + a <
u} = F ((v —a )+,0), where F (t\0 ) is the CDF of the underlying spot price
166
p a.
G(v,a) = "effective price function” defined as
G(v,a) = E{min(Pa + a,u)} (4.1)
It is easily seen that G is an increasing concave function of (v, a) that ap
proaches fj. as v approaches oc. We refer to G as the effective price function
because if a buyer has purchased an option to buy the good in question at
execution price v, then the expected price paid for the good on the day will
be the minimum of the price of purchasing that unit under contract (at price
v) and purchasing it from the spot market (at price Ps -I- a). We denote
G ~l (-,a) as the inverse function of G(-,a) for any fixed adaptation cost a.
The reader will note the following relationship between G{v, 0) and G(v, a) :
G (v,a) = M in[v,G ((v —a)* ,Q) 4- a].
U(z): Buyer’s aggregate Willingness-To-Pay for output level z
D s(p): Buyer’s normal demand function, i.e., Ds(p) — argmaxD>Q{U (D) —
p D }, so that D,{p) = U'~l {p). [We note below assumptions on U that as
sure D* is well defined; the reader will note that one can start either from
properties of U or properties of D s since the one determines the other.]
167
D(p,a) = Ds(G- l (p,a)).
m(P3,a) is the probability that any Supplier i can find a last-minute buyer
on the spot market when the realized spot price is P3 and the adaptation
cost is a. As codifiability decreases (reflected in increasing a), one would
expect this access probability function m(P3,a) to also decrease, reflecting
the fact that decreased codifiability means greater difficulty in finding an
appropriate spot market supplier with whom the buyer can communicate
precise requirements. We will typically suppress the dependence of m on P3
and a in what follows.
Define c = s + G(b c), in which s — E {m(P3,a)(P3 + a —b3)*} is a lower
bound on the reservation fee for any Supplier i to profitably participate in
the contract market.
Let M C N be any set of Suppliers bidding in the contract market. For
every k 6 M C iV, we define the following sets depending on the Suppliers’
168
bids {s,g):
M l{ s ,g ) = {i e M\si + G(gi) < sk + G { g k)}; (4.2)
M t(s,g) = {* e M\si + G{gi) < s k + G(gk)}; (4.3)
Mk(s,g) = {i € M\si + G f a ) = sk + C( 3 fc)}; (4.4)
M£{s,g( = {i € M\ai + C(&) > sk + G{gk)}\ (4.5)
We will usually suppress the dependence of the sets M3k on {s,g) whenever
(s,g) is fixed and clear from the context.
We make the following assumptions, which we assume to hold throughout
the paper. Further discussion of these assumptions and conditions is in Wu,
Kleindorfer and Zhang (2001).
A l: In keeping with decreasing marginal utility of consumption (i.e.,
assuming the normal demand curve Daj is downward sloping), we will assume
that the Buyer’s W TP U(z) is strictly concave and increasing so that
U'{z) > 0, U"(z) < 0, for z > 0. (4.6)
Concerning A l, these are standard assumptions on the Willingness-to-
169
Pay function. EYom A l and the fact that G Ms increasing, it follows that
D{p) is monotonously decreasing.
A2: pEf^p) + 2D's(p) < 0, Vp > 0
A2 requires that the Buyer’s demand curve not be ” too convex” , so that
the gross profit function pD a(jp) is concave. Clearly, A2 is satisfied if Da
is linear or concave, since D'(p) is negative in any case. A2 is a standard
assumption in the financial economics literature (e.g., Rothschild find Stiglitz
1971).
A3 (N o Excess Capacity Condition): Let Suppliers’ offers be indexed
so that <7i < g 2 < ■■■< gn- Then the No Excess Capacity Condition is said
to hold if and only if
i
Qi[D3(gi) ° ’ *= (4.7)
i= i
This No Excess Capacity Condition implies that Buyers will not contract
for more than what they are sure they will use if they buy under contract
on the day, i.e., if Qi > 0 then Da{gi) > Y a = i Q i - P ut another way, this
condition says that if Qi > 0 then the sum of fill contracted capacity with
170
execution fees less than or equal to ft must not exceed D ,(ft). By way of jus
tification for this condition, we note that, on the day, the optimal execution
order of contracts is to use all contracts available in order of increasing ft up
to the point at which the next such execution fee exceeds Pa, satisfying all
additional demand from the spot market. Thus, if the No Excess Capacity
Condition were violated, it would mean that the Buyer had contracted for
some capacity that would guaranteed never be used on the day. This fol
lows since the Buyer would have to be willing to pay at least the execution
fee ft per unit of output in order to make use of contract capacity. This
non-optimal behavior is ruled out by the condition stated.
T he von Stackelberg Game: Supplier i bids the following information
(e.g., via an electronic bulletin board): [reservation price, execution price,
capacity]=[sit ft, Li\, i = 1 ,..., n. The Buyer decides how much Qi to re
serve from each Supplier i. Given a common knowledge distribution F(Pa, a)
of the spot price P3, given a, Suppliers and the Buyer adjust their bids and
offers until equilibrium is reached. The adjustment process and resulting
equilibrium will be described in more detail below.
Below we show that when Suppliers properly anticipate the Buyer’s de-
171
raand to their bids, [a^ gi, Lj\, i = then the contract execution
price should be set equal to the Suppliers’ variable contract cost, i.e., = bc,
with reservation fees a, determined by Suppliers to trade off the risk of under
utilized capacity against unit capacity costs. The Buyer’s optimal portfolio
is shown to follow a merit order (or greedy strategy) shopping rule, under
which contracts are signed following the index (si + G(bc)) that is an increas
ing function of both the Suppliers’ reservation fee (a*) and execution fee (bc).
Our assumption that bc < bs will be important in determining the scope of
contracting relative to spot purchasing.
4.3 Basic R esults
The problem confronting the Buyer is to choose an optimal portfolio of con
tracts from those available from the n identical, competing Suppliers. Some
of the contract offers may carry high subscription rates a* but low execution
fees These must be compared to other offers carrying lower subscription
fees but higher execution fees. Following Wu et al. (2001), we obtain the
result that the Buyer’s optimal solution is to rank contracts in increasing or
der of the index a* -fC(g»). This index reflects the cost of reserving capacity
172
at price s* plus the ccet of maintaining the option to execute the contract at
price gi rather than utilizing the spot market.
Define the Buyer’s utility as :6
n n
V (D t , q, x,4>) = U (D t ) - ^ 2 ~ Y l 9iqi ~ (Pa + a)x ' ^4'8)
i= l
where <j> = (Ps + a,Qi (i = 1 ,... ,n)) is the spot price and the vector of
contract capacities, q = (<ji,. . . , qn) is the vector of purchases under contract
from Supplier i = 1 ,... ,n, x is the amount purchased in the spot market,
and D t is the total consumption of the Buyer, so that
(4.9)
t=i
Because the Buyer’s problem in this paper is identical to the Buyer’s
problem in Wu et al. (2001), Lemma 1 and Theorem 8 below follow directly
from Wu et al. (2001).
6Note that this quasi-linear form of utility is rather standard and implies that the Buyer
is, in fact, risk neutral, since V(-) below is linear in money. The consequences of risk
aversion by the Buyer would be to encourage more contracting to avoid exposure to spot
market volatility. The assumed decreasing marginal utility in consumption (U"(z) < 0)
simply means that the Buyer’s normal demand curve D, is downward sloping, since as
noted earlier Ds — U'~l.
173
L em m a 1 Let ft = (Pa + a,Qi (i = l , . . . , n ) ) be given. W.o.Lg., assume
that Suppliers’ offers are indexed so that gi < g<i < .. . < gn. Let the Buyer’s
optimal total demand be given by the solution Drift) 1° îe following problem:
MaximizeDT,,^ V{D T,q,x,ft), (4.10)
subject to:
n
DT = x + ' ^ q i , x>0, q> 0 , DT > 0 . (4.11)
i=l
Then (under A 3 , the No Excess Capacity Condition) the solution Drift) 1°
(110)- (4-U ) is
k
Drift) = {DsiP* + a) - max{x(P, + a - gk) ^ Qi I 1 ^ k ^ n l ) +- (4.12)
i= i
and optimal purchases under contract from Supplier i = 1 ,..., n and from
the spot market are given by
n
Qiift) = QiXiPs + a - g i) , xift) = Drift) ~ ^2<nift)- (4-13)
i= I
174
where x(') *3 the. indicator function (which takes the value of 1 if its argument
is positive and 0 else).
Alternatively D t (4>) may be expressed as ) = max[Ds(Ps + o), £ f = 1 Qi],
where Supplier k = k{4>) provides the last unit of contract output to the Buyer.
Defining g0 = 0 and gn+i = oc, Supplier k is determined as the first Supplier
(in the indicated order of increasing gi) satisfying gk < P3 a < n• U
k = 0 , no contract capacity whatsoever is used.
The optimal quantities (4.13) purchased under contract from Suppliers
follow the normal "merit order” indicated by the execution fee rank order
in the Lemma. Contracts are executed in order up to the point at which
the spot price dominates any further available contracts. This implies also,
as seen in (4.13), that either all units of a contract or none are executed on
the day, depending on the spot price. We note from Lemma 1 that when
facing dual sources (spot market and contract market) for procurement, the
Buyer’s demand curve is kinked, as captured in (4.1*2). Given the definition
of G(-), we have the following Theorem 8 .
We will see immediately below that the ” price” in the contract market is
determined by the contract index s< -F C(<fc, a), which we also call Supplier’s
i’s ”bid” and we denote it by p. When there is a bid-tie among a set
175
of Suppliers M C N, then the Buyers’ demand for Supplier i’s output is
proportionally allocated to the Suppliers according to their bid capacity,
thus if pf = p, Vi e M, then Qi = D(p)[Li/X(M)\, where X( M) = Y,kcM Lk
is the total capacity bid in the contract market. For example, suppose
two Suppliers have the same bid, and their bid capacities are 40 and 60.
If the Buyer demands a total of 50 units from both Suppliers, then this
assumption indicates that the demand for Supplier I will be ’20 and the
demand for Supplier 2 will be 30. This would be the expected outcome
of a process in which random selection of Suppliers with the same bid were
undertaken, with visibility of capacity proportional to bid capacity. In the
present context, we will see that Suppliers will bid either all their capacity
into the contract market (if they have incurred the idiosyncratic investment
costs I to participate in this market) or none. Since we are dealing with
identical suppliers here, this tie-breaking assumption implies that the Buyer
will allocate contract capacity equally among all suppliers who participate in
the contract market, i.e., Qi = D(p)/nc. The results given on the demand
side below Eire not very sensitive to the manner in which bid ties cire broken,
but Supplier equilibrium conditions can be Eiffected by varying assumptions
in this regard.
176
Theorem 8 (Buyer’s Optimal Contract Portfolio):
Let (s,g ,L ) = {(si,gi, Li), i = 1 ,... ,n } , be posted bids by the Suppliers.
W.o.l.g. assume that Supplier bids are ranked in order of the index s< 4-
G(gi,a), so that Si 4- G{gu a) < s2 + G(g2,a ) < .. . < «/ 4- G (gi,a). If
G(U'(0),a ) < S i+ G (g i,a ), then the Buyer’s solution will be to setQ i = 0, Vi,
i.e., no contracting is optimal. Otherwise, Greedy Contracting in order of the
given index is optimal for the Buyer, i.e., the optimal Portfolio of contracts
has the form: Vi 6 A/*, Qi = Li; Vi 6 M£, Qi(s,g, L) = 0; and f o r i €
Qi(s,g,L) = ^ ■■■i D3( G - \ s i + G ( g i,a))) - Lf). (4.14)

L‘ seui
where h € { 1 ,..., n} is any Supplier (there may be more than one in the case
of tied bids) with the largest value of the index Si + G(gi) satisfying
sh + G(gfl, a ) < G ( U ' ( Y , L i )) ( 4 -15)
The structure of the optimal portfolio captured in Theorem 1 is relatively
simple. It calls for the Buyer to rank all offers in terms of a single index
Si + G(gi,a ) and then to pull off as much capacity as allowed by Supplier
i, proceeding in rank order of the contract index until the marginal W TP
177
is exceeded by the contract index. Since G (and therefore G -1) is strictly
increasing (G'(x, a) = 1 —F(x, a) > 0), and since by concavity (see A l) Da is
(strictly) decreasing, and therefor Qi is decreasing in the contract index for all
i = 1 ,n. Before W TP is exceeded, the Buyer takes all capacity offered
by Suppliers from whom it contracts. Of course, W TP may be exceeded with
the first Supplier and the Buyer may, in fact, sign no contracts whatsoever
(if G(C/'(0),a) < si + G(gi,a)).
We now turn to the Suppliers’ optimal bidding strategies for («<,<&, Li).
We assume throughout that Suppliers are risk neutral and maximize expected
profits from both contracting and spot markets .7 We assume throughout
that Suppliers face stringent penalties for non-performance under contract so
that they will, in fact, post no more than Li < K as available capacity and
that they will set prices (si, 5 i) so that contracted amounts will not exceed
Li.
Lem ma 2 (Optimal Suppliers*Bidding Capacity): Li(Li-K) = 0, Vi.
7If Suppliers were risk-averse, th e tradeoffs becom e m ore interesting. O n th e one h and,
th e co n tra ct m arket would allow lower variable costs an d som e hedge against th e volatility
o f sp o t prices. However, to take advantage o f these benefits, th e Supplier would have to
invest I in fixed system s costs in o rd er to p articip a te in th e co n tract m arket. T h e outcom e
of th is tradeoff could go eith er way in th e presence o f risk aversion. We follow sta n d a rd
finance th eo ry here in assum ing th a t Suppliers, except for issues o f financial distress an d
bankruptcy, a re risk neutral.
178
Thus, if a Supplier chooses to participate in the contract market, then the
Supplier will offer its entire capacity K in this market.
Proof. The profit of Supplier i is given by
IL(sf, Li, P3) = SiQi + M i “ (PiK + bcqi)+
+ (P3 + a - b3)+m(P3,a )( K - qi) - I x( Li )
= SiQi + (gi - bc)qi - (P3 -f a - b3) f m(P3, a)?,—
- f c K + (P3 + a - b3) v m(P3, a ) K - I X(U) ,
where, from Lemma 1, q, = Qi x(Pj _ 3 i)- Ekpected profit is therefore given
by
EIL(si,gi, Li) = SiQi + (gt ~ bc)( 1 - F(ffi,a))Q i+
+ (K-Q i) f
Jb.
(v —b3)m((v —a)+,a )d F (v ,a )+
+ Q iX ( 9i ~ b 3) [ (v - b 3) m ( ( v - a ) + , a ) d F ( v , a ) - 0 i K - I x ( L i ). (4.16)
Jb.
Supplier i’s problem is to maximize its overall profit from both the contract
market and the spot market by deciding how much to bid (Li) into the
contract market, i.e. MaXg,igtiLi EIL(st, r/it Li). Assuming Qi > 0 , bidding a
179
larger capacity into the contract market relaxes the constraint region (since
Qi < Li is required). Thus, if the Supplier chooses to participate in the
contract market at all (i.e., Sj, <7, and Li are chosen such that Qi > 0 ), then
setting L\ = K cannot decrease Supplier i’s profit. □ ■
Lem ma 3 (Optimal Execution Fee Bids by Suppliers): g'= bc, Vi.
Proof. Prom Theorem 1, we know that the Buyer’s optimalcontract
Q i(s,g) will remain unchanged as long as Si + G(gi,a) remains constant. To
prove the Lemma, we therefore show that for any fixed value of s* 4- G(gi, a),
the optimal solution for gi is bc. To see this, note that along any iso-quant
of Si + G (g i,a ) = c, we must have:
dgi = ~ agi
^ L = ~ ( 1 - F ( S i ’ o ) ) - ( 4 1 7 )
Thus, assuming a constant level of contract capacity Qi(s,g) along the iso
quant Si + G(gi,a) = c, we compute from (4.17) and (4.16) that
dEiii dETii „ „ li
~(9i - bc)f{gi, a)Qi, g{ < b3,
-{(1 - m(gi,a))gi + (bs - bc)\f(gi} a)Qu gt > bs.
180
where /(•) is the probability distribution density of spot market price, given
a. Prom this, m(gi, a) < 1 and b3 > bc, we see that E H is increasing for
gi < bc and decreasing for g3 > bc. Therefore, the F.O.C. implies gi = bc. □
■
Lemma 3 establishes that E H is a strongly unimodal function along any
bid iso-quant of Si -I- G(gi,a) = c for which Qi > 0 (except in the degenerate
cases where m(<fc, a) = 1 or a) = 0 ), with a global maximum at gt = bc
(unique except in the noted degenerate cases). Thus, we will refer to gi = bc
as a g-dominant bidding strategy for Suppliers, since it is optimal no m atter
what total effective bid is made, i.e., no m atter what the value of st +G(gi, a)
is. The rationale for Lemma 3 is that there is a trade-off for Suppliers
between charging higher a* and higher gt. Charging higher gi erodes the
options value (recall the contract index 3i + G(gi,a)) of the benefit Buyers
see from contracting more quickly than the marginal benefits associated with
increases in The lowest level for gi, namely bc, the price associated with
contract production, is therefore the result. Note that it is the contract
market cost rather than the spot market cost that determines the execution
fee in the contract market. In particular if codifiability decreases and this
is manifested in a significant difference between b3 and bc, then there will
181
be greater advantages to contracting. These must be balanced against the
fixed costs of supplier screening and the costs of establishing systems and
procedures to allow contracting. The next Lemma establishes the necessary
conditions for contracting to be feasible.
L em m a 4 (Conditions fo r Supplier Participation in the Contract
Market): Let gi = bc, Vi. Then a necessary and sufficient condition for any
Supplier i to participate in the contract market is the following:
(Si - E {m (P3,a)(P , + a - bs)*})Qi > /*(£*). (4.18)
Proof. Since gi = bc, the expected profit of Supplier i is given from (4.16)
as
E l U s i , bc, K ) = (Si - E {m (P „ a)(Ps + a - 6 ,) +})(?<+
+ (E {m (P „a)(P . + a - 6 ,) + } - ft] )K - I X(Li). (4.19)
We see from (4.10) that no contracting (Qi = 0) would be preferable to any
positive contract unless expected contract revenues axe superior (per unit of
capacity committed) to the expected revenues available on the spot market,
182
i.e., (4.18) must hold. □ ■
The rationale for Lemma 4 is that the Supplier does not want to make any
less per unit of capacity than it could by committing to sell its capacity into
the spot market (although access to the spot market is imperfect and occurs
on the day only with probability m(P3,a)). Equating the two possibilities,
taking into account the fixed cost of contract market participation spread
over the contract quantity Qi, leads to Lemma 4. Note that the Supplier is
not concerned in this break even analysis with whether or not they actually
sell the contracted units, since the execution price for these is bc, equal to his
unit contract production cost. Recall that we are dealing with the short-run
problem here in which capacities are not variable, so that negative profits
are indeed possible if investments are sunk and capital costs sufficiently high
relative to what the contract and spot market will bear.
The implications of codifiability Me present in Lemma 4 in severed ways.
First, of course, as I increeises because of difficulties in codifying the systems
and procedures for contracting, then participation in the contract market
is clearly negatively impacted. On the other hemd, for the same reason,
the difference in cost b, —bc between spot and contract procurement may
increase as well. To clarify the effect, fix bc. The increase in 6 a over
183
bc would reflect the increased cost, to the supplier, of meeting the Buyer’s
requirements. The result, therefore, of lower codifiability, would be to lower
the supplier’s threshold for participation in the contract market. Thus, we
see that as codifiability decreases, there is a trade-off between contracting
and spot market transactions from the supplier perspective. Note also that
decreasing codifiability on the buyer side will also likely imply that m(P3, a)
will decrease, which, together with increased sourcing cost P3 + a, makes the
spot market a less viable alternative to contracting for Buyers.
We are now in a position to derive market equilibrium prices in the short
term contract market. Several definitions of market equilibrium might be
used. The approach we take is to assume that Suppliers all know the to
ted demand function of the Buyer, consistent with sophisticated Suppliers
and well-developed markets. This assumption is explicit here in that Sup
pliers’ expected profit functions depend on the anticipated Buyer demand
functions Qi(s, g, L) as derived from Theorem 8 . Suppliers adjust their bids
until they achieve a Nash equilibrium in this market. Since there are fixed
costs (namely I) for Suppliers, there are several possibilities for defining the
”industry equilibrium”. We follow the Wilson approach to this problem .8
8See the extended discussion of industry equilibrium in the presence of fixed costs in
Baumol, Panzar and Willig (1989).
184
Under this approach, Suppliers enter as long as, at equilibrium, they all
make positive profits in the contract market, i.e., as long as (4.18) holds at
the resulting (symmetric) Nash equilibrium to their contract pricing game.
In a bit more detail, the normal form game of interest is as follows. The
players are the Suppliers. The strategies are the triples {(s’, <?*, L’) \ i =
1,..., n} and the utility functions of the players are the expected profit func
tions (4.10). For m y fixed set M C N of Suppliers bidding into the contract
market, the game just described is played to equilibrium. We show below
that this equilibrium, if it exists, is symmetric and unique. We call such
a contract market equilibrium for fixed M simply an equilibrium or an M-
equilibrium if we wish to emphasize the set M involved. Additional suppliers
enter the contract market if and only if they are to do so profitably. Since
Suppliers have identical co6 t and profit structures, there Eire multiple equilib
ria in terms of Supplier identities, but all of these will have the saime number
of Suppliers participating in the contract market and (as we will show) at the
same price. We characterize below the equilibrium number nc < n of Sup
pliers that can be supported in the contract market. After demonstrating
the conditions for existence of a Wilson equilibrium, we will investigate how
nc varies as a function of problem pcirameters, including factors reflecting
185
codifiability.
Noting th e definition
a = E {m (P „ a)(Ps + a - 6 S) + } (4.20)
we have, from (4.10), the following profit functions (in the short run, i.e.,
neglecting adjustments in capacity):
Etri(s> 6 , K ) = [* - slQiis, bc,K ) + \ s - f t] K - /*(£*). (4.21)
We are interested in short-term pricing strategies satisfying Lemmas 1-4.
From Theorem 8 , for such strategies, the only interesting parameter is the
“price” index. From Lemma 4 and Theorem 8 , we know that pi = Si +
G(bc,a) > c with c = s + G ( b c,a) with s. Using this notation, we can express
the profit functions for Suppliers (given in general by (4.10)) in the following
form:
Etu(p) = [pi - c]Qi(p) + [c - 0 - G(bc,a )\K - I X(Lt), (4.22)
where, for any vector of bids p — (pi, Qi(p) = Qi(s,bc, K ) is given
186
by our Theorem 8 . We will characterize contract equilibria of interest in
p- vector space.
For notational simplicity, define D{z) = D s(G~l (z, a)), Vz > 0. As noted
previously. From Theorem 8 find Lemma 2, we have:
K, D (P*) > EieA/2
Q *(p )= ( K / YlicM* K )(D(pk) - *0- * < 0 (l* ) <
0 , D(pk) <
D efinition .3 For any potential equilibrium set M C N and any k 6 M,
define f k{pk) = {pk - c){D(pk) - £ <eWo A"), where = A/ \ {fc} and where
Pk — sk + G(bc).
L em m a 5 If there exists an equilibrium, then it must be symmetric for all
Suppliers providing positive capacity in the contract market. That is, every
equilibrium p must be of the form Pi = x, Vi € M C N , where Qi(p) > 0,:
i € M and Qi(p) = 0,: i 6 N \ M.
P ro o f. Take any supposed equilibrium p and let M be the subset of Sup
pliers at this equilibrium supplying positive capacity in the contract market.
Suppose that the equilibrium p is not symmetric, so that pi = M infe | i 6
M } < Max {pi | i 6 M} = p 2 , and such that Qi > 0 and Q i > 0. Then, as an
equilibrium strategy for player 1 , pi must be a best response, and moreover
187
Q i = K . But consider the new bid for player 1: p/x = (pi 4 -p 2 ) / 2 which
is now strictly greater than pi and strictly less than p 2 - Now Q\ = K still
obtains, but clearly profits are strictly higher for player 1 at p'1 than at p\,
keeping all other players’ strategies fixed at their equilibrium values. Thus,
the original p-vector cannot have been an equilibrium. This contradiction
obtains as long as the lowest bid is lower than the highest bid for Suppliers
in M. □ ■
Given Lemma 5, we know that if there is an M-equilibrium price, it is
unique. We will see immediately below that this price must be such that
every Supplier bidding into the contract market contracts all of its capacity
there. To state our main theorem, define the price p ( M ) as the contract
price that would drive the Buyer to exactly exhaust capacity available from
Suppliers in M in the contract market, i.e.,
D( p (M)) = ' £ k = \M \K, (4.23)

ieM
We first state the main Theorem covering the case in which M is non
singleton, reserving for Corollary 16 the case in which M is singleton.
T heorem 9 (Equilibrium Conditions): Let K , p *, M be any M-equilibrium,
188
where M C N is the equilibrium set of all Suppliers having positive capac
ity contracts, i.e., Qi(pm) > 0 ,i € M and Qk(p *) = 0, Ar € N \ M . If
s+ G (bc) > G(U'( 0)), then no Supplier will participate in the contract market.
Assume M is non-singleton such that |A/| > 1 and s + G(bc,a) < G(U'(0)).
Then the necessary and sufficient conditions for an M-equilibrium p* to exist
are
C l: p* = p(M)
C2: < 0 if pk > p \ where f k(pk) is defined as f k{pk) = ipk -

OPk
c)[D{pk) - £ ,.6Mo K \ = (pk - c)[D{pk) - (|A/1 - 1)K\, where A/° = M \ {*}
and
C3: p* > s + G(bc, a).
For such an M-equilibrium to be a Wilson equilibrium, the following ad
ditional condition must be satisfied:
C4: p{M) > -j? + s + G{bc,a) > p (M + {i}), Vi e N \ M
P ro o f. See Appendix. □ ■
Condition C l, noted as the “symmetric condition” in Lemma 5, says that
in the short-term equilibrium, for any Supplier “in the money”, i.e., for any
k £ M, its entire capacity will be contracted in the forward market. Condi
tion C2 might seem a bit technical to begin with, but it is a standard regu-
189
laxity assumption on the demand function D to assure quasi-concavity of the
profit function in prices. See, for example, Friedman (1988) for a discussion
of this and stronger regularity conditions typically imposed in price-based
equilibrium analysis. Ours is a special case of the Friedman (1988) assump
tion for the behavior of the profit function. In Friedman (1988), it is assumed
to be strictly concave, here we only require the function to be non-increasing
to the right of the equilibrium price p, where p > argmax fk(Pk)-
Corollary 15 (Short-Term vSLFE for Single-Element Equilibrium
Group): The necessary and sufficient conditions for a single-Supplier equi
librium p to exist are (i) : p = \la x {p 11, x 11} > c, where pu as the solution
to Maximize/!(pi) = (pi —c)D(p\), a n d x 11 as the solution to D(x") = K \,
and (i i ) : p < c < G(U'(Q),a).
Theorem 10 (Computation of set M ): M can be computed in the fol
lowing way.
(i) Let h be the smallest integer that satisfies
G (U \{h - 1)K)) < c = s + G{bc, a). (4.24)
/ V
(ii) For any k e M, if ——— < 0 when pk > p m, then M is an equilibrium

OPk
190
group M ; otherwise, there does not exist any equilibrium subset of N .
Proof. EYom (i) of Theorem 2 we have D(p) = £ ieAf K, which is
equivalent to Ds(G~1(p,a)) = U'~l (G~l (p,a)) = 5Zt€M A', therefore p =
G(U'(Yli=i K ), a). Prom (tii) of Theorem 2 , we know that Vfc 6 H \ A/,p <
ck, since Supplier h does not belong to M , we have p < C/, = a* + G(bh).
Hence we obtain G(U'($2iZi K)) < Ch = £h + G(bh), and identify set M.
If every member in this set passes the test of condition (ii) of Theorem 2,
then it satisfies all necessary conditions of theorem 2 ; thus it is the unique
equilibrium group M. □ ■
4.4 M ultiple Buyers
Now we consider multiple Suppliers and multiple Buyers and derive the most
general results in this paper. These results will be seen to follow very
closely the structure of previous results, so we will spare the reader the full
development of the arguments. However, the assumption that a all buyers
face the same codifiability related costs a, which translates to a common shift
to P3, is required.
Prom the point of view of a particular Buyer, the existence of other Buyers
191
does not affect its own demand. Thus, on the day, each Buyer’s problem
remains the same as in the Multi-Supplier-Single-Buyer case. Hence the
following Lemma 6 is a direct consequence of Lemma 1.
L em m a 6 Let <f>j = (P3, Q tj (i = 1 , . . . , / ) ) , j € {1,..., J } be given, where
Qij is contracted capacity by Buyer j with Supplier i. Define Buyer j ’s de
mand function Dj(4>j) as the solution to Maximize{Vj(Dj,qj,Xj,<$>j) |Dj >
Q,qj > 0, Xj > 0}, where and Xj are purchases by Buyer j under contract
and from the spot market, respectively, and where
i i
Vj( Dj,Qj, xj , ) = Uj(Dj) —^ "SiQij —^ ' giQij ~ B3Xj. (4.25)
1=1 i=i
Then Dfifyf), qij and Xj are given by Lemma 1 (with obvious adjustments
for the subscripts j).
Although the presence of other Buyers will not affect the structure of de
mand, a key issue when multiple Buyers are present is who will have prece
dence for the more preferable Suppliers (those for which the shopping index
Si -(- G(gi) is lowest). As we note below, this will not be an issue in equi
librium, since just as in Theorem 9, so too here the shopping index of all
Suppliers in the money will be set equal to the “market index”. But clearly
192
the operation of the market can depend on how competing Buyers are allo
cated among Suppliers. We follow the standard economic assumption that
whenever two or more Buyers compete for the same Supplier contract, the
Buyer with the highest W TP will be the Buyer awarded the Supplier’s ca
pacity, at least up to the point at which some other Buyer does not have a
higher W TP [For a discussion of W TP and other rationing mechanisms un
der conditions of excess demand, see Crew and Kleindorfer (1986).] Under
this allocation procedure, the Supplier offering capacity at (s,-,#) will sell
just as much as he would to a single Buyer with aggregate demand equal to
the sum of the demands of all the Buyers. Thus, the consequence of this
standard economic allocation procedure is the following Corollary.
C o ro lla ry 16 (Buyer’s Optimal Consumption Portfolio): Given the
demand functions Daj(p),p > 0, j = 1 , . . . , J, define the aggregate Retail de
mand as Ds(p) = YlJj=i D*j(p) an(l aggregate marginal WTP as U'fiQj) =
D “ 1 (Qj), Qj > 0 . Greedy Contracting is optimal for every Buyer j , as spec
ified in Theorem 1, in the sense that Buyers will pick off contracts from Sup
pliers offered to them in the order of the Shopping Index Si+G(<7<). Moreover,
if Buyers are offered contracts in order of their WTP, then total demand for
each Supplier i will be the same as when the Supplier faces a single Buyer
193
with demand D s(p) and marginal WTP U'(z) = D3 l (z).
In a similar fashion, Lemmas 2, 3 and 4 in the previous sections hold since
the Suppliers’ problems all remain the same, where now Qi is to be under
stood as aggregate supply to all Buyers by Supplier i. In particular, from
Lemma '2 and Lemma 3, Li = K and gi = bc continue to be, respectively,
dominating and ^-dominating strategies for the Suppliers. Most importantly,
Corollary 16 implies that the game among Suppliers, and its equilibria fol
lowing the von Stackelberg model assumed here, is given by Theorem 9, with
aggregate Retail demand, as specified in Corollary 16, with the inverse ag
gregate marginal W TP specified by U~l (z) = Ds(z). The remaining logic
of Theorem 9 and its proof are then identical. The result is the following.
C orollary 17 (von Stackelberg Leader-Follower Equilibrium (vSLFE)
fo r the Multi-Buyer, Multi-Supplier Case): Consider the Multi-Buyer,
Multi-Supplier Case in which competing demands by Buyers for a particu
lar Supplier are allocated in order of Buyer WTP. For this case, the condi
tions for the existence of a vSLFE to the Multi-Buyer, Multi-Supplier Case
{{s ’,g ,, L‘) | i = 1,...,/} are identical to those specified in Theorem 2, with
D(p) = Ds(G~l (p)), where Ds(p) is given in Corollary 18.
194
Thus, under the assumption that competing Buyer demands for the same
Supplier contract are rationed in order of Buyer WTP, the solution to the
general network case is solved. This general solution results from using
the demand and equilibrium contracting building blocks of Buyer contract
demand and of the market equilibrium results for the Multi-Supplier, Single-
Buyer case. The equilibrium characterized in both Theorem 9 and Corollary
19 has important prescriptive properties that should be mentioned in con
cluding our discussion. The 5 -strategy is 5 -dominant for the contract capac
ity provided, the capacity strategy is a dominant strategy, and the s-strategy
is the transparent outcome of the pivot Supplier h who is the price setter in
the contract market. Whether this equilibrium is stable or has other impor
tant properties behaviorally than the dominance properties noted remains to
be seen through further theoretical and experimented work. The key m atter
to note here is that once the game is understood to be completely specified
in terms of the shopping index s*+C( 6 c), considerable degrees of freedom axe
removed from the problem. Most importantly, the above results establish
this index as the critical focal point for rational strategies for a particular
Supplier, whatever strategies are played by other Suppliers.
195
C o ro lla ry 18 An increase in a, the uncodifiability costs associated with spot-
market procurement and incurred by the buyer, would shift demand towards
the contract market, without changing the nature of equilibrium or the allo
cation of demands to suppliers. However, such a shift may lower overall
demand and result in some suppliers driven out of the market.
As uncodifiability and therefore a increases, it amounts to an increase
in the spot market price. Such an increase raises the effective price and
therefore reduces total demand. While the basic allocation mechanism for
awarding contracts does not change and suppliers "win” contracts according
to their index, the effect of increased spot prices shows up in two ways. First,
suppliers cannot sell the same amount of excess capacity in the spot market.
Second, last-minute demand fulfillment for buyers is also higher. The result
is that both the number of suppliers participating in the contract market
is reduced and the overall level of demand supplied by the contract market
relative to the spot market increases. These results suggest that for less
codifiable items we would see more contracting and fewer suppliers, which is
precisely what the theory of chapter 3 suggests from a different perspective,
and of course also what we corroborated empirically in chapter 3.
196
4.5 Sum mary
This chapter has provided a general solution to the Multi-Supplier, Multi-
Buyer supply chain contracting problem for non-storable goods. The key
question addressed is the structure of the optimal portfolios of contracting
and spot market transactions for these Suppliers and Buyers, and the pricing
thereof in market equilibrium and how transaction knowledge uncodifiabil
ity affects these. The framework developed by Wu, Kleindorfer and Zhang
(2 0 0 1 ) is generalized here to the case when contracts and spot markets have
different unit production costs. Furthermore, costs associated with less than
perfect codifiability of transaction knowledge are incorporated and their ef
fects analyzed. These costs may be incurred on the suppliers’ side, the
buyer side, or both. The issue of codifiability is critical for electronic chan
nels based transactions as shown in Chapter 3. In so far as contracts are
less (then spot market transactions) negotiated and executed electronically,
codifiability may be an important determinant of B2B e-commerce activity.
I show that when Suppliers properly anticipate demands to their bids,
then a 3 -dominant strategy for the contract execution price is to truthfully
reveal the Suppliers’ variable cost, with reservation fees determined by Sup
pliers to trade off the risk of under utilized capacity against unit capacity
197
costs. I further show that lower codifiability may result in a shift, under
certain conditions, towards contracts.
This solution has important applications in a number of industrial and
service sector contexts where capital intensity and non-storability are essen
tial characteristics of supply chain operations. Non-storability (including
cases of JIT delivery) is important to our analysis as is the implicit assump
tion throughout of capital intensity of the production process. Absent either
of these and inventory or rapid scale-up of production would be suitable sub
stitutes for long-term contracting or spot market purchases.
A number of future research topics Eire evident. It would be interesting
to explore the opportunities for both mEirket reseEirch and Supplier/Buyer
contracting support systems based on these results in sectors of interest. As
noted, on the theoretical side, severed areeis Eire potentially interesting. Con
cerning the present model, analyzing how investments in information systems
may change the balemce between contracts and spot markets would be highly
useful. It would even be more interesting to examine how such investments
may interact with investments in codification of trsmsaction knowledge and
the relationship between the two types of investment (i.e., information sys
tems Eind codification). As was noted at the beginning of this dissertation,
198
90% of the presently existing e-exchanges and marketplaces do not have any
transactions. As this dissertation showed, an important factor behind it
may well be the uncodifiability of may types of transactions that were sup
posed to take place through those exchanges. The investigation proposed
would help suggest some answers to how and when to make investments
towards creating e-exchanges and marketplaces, which already see trade of
several hundred billions dollars and is expected to reach several trillions in
few years. Such solutions may foster a more rapid, less wasteful, process
towards a more optimal B2B e-commerce market structure.
4.6 A ppendix
P r o o f o f L em m a 1
Take tiny i = 1 , . . . , / and any fixed total demand D t • Contract purchases
will be in order of increasing execution fees gi as long as < Pa. We can
therefore assume that, for any I < i, all capacity under contract I will be
used prior to taking any output under contract i.
Now let fc > 0 be the Supplier providing the last unit of contract output,
so that k satisfies gk < Ps < gk+1 - Under A 3 (the No Excess Capacity
199
Condition), the Buyer will never contract for more than needed, so that
for every k = 1 , Qk = 0 unless 53*=1 Qi < Da(gk) or equivalently,
since Da = U'~l , gk < Qi)- Thus, on the day, depending on the
spot market price, the Buyer faces only the following two cases under which
qk > 0 and qi = 0 for i > k:
1. 9 t< P .< u \Y L x Q i)>
2
• . gk< v ,(Y!LiQi)<P-
Using the fact that Supplier k provides the last unit of contract capacity,
we have = Qi for i < k, qt = 0 for i > k and qk < Qk. Thus, noting that
Pa > max{5 0 , • • •, <7*}, we obtain the following expression for Buyer’s utility
V after substituting the derived expressions for optimal qrf and x = Di — ^3 Qi
as functions of D r -‘
V {D t , q (D r ), x (D t ) , <i>)
i t 1
= U { D t ) ~ 5 3 *iQi ~ ^ S i Q i ” p *(D t ~ 5Z *)
t=l t=l t=l
1 * —1
= U ( D t ) - p aD T - 5 3 SiQi + 5 3 ( p * - Si)Qi
t=l i=l
fc-1
+ (P , - 9k) rn in [DT - 5 3 Q i ’ Q*\- (4 -26 )
i=i
•200
To determine Dr{<t>) we need to maximize this concave function V ( D t, q, x, <t>)
over D t > 0. We do this in two steps. In step I (which corresponds to case
1 above), we solve this problem where the minimum is the second quantity
in the [•] in (4.26). This leads directly to Dt(4>) = Da(Pa). In step 2 (which
corresponds to case 2 above), we solve this problem where the minimum is
the first quantity in the [•] in (4.26), i.e., subject to D t < 52?= i Qk- Since in
any case gk < C/'(52?=i Q*)> this leads to DT(4>) = 52?= i Qi- Combining these
two cases, shows the validity of the alternative characterization of Dt(4>) in
the statement of Lemma 1. The characterization (4.12) is easily seen to be
equivalent to this, so that Lemma 1 follows. □
P roof o f Theorem 8
The reader should keep in mind in this proof that the order assumed in
this Theorem, implied by non-decreasing values of the index 4-G(gi), may
be a different order them the order assumed in Lemma 1 in terms of non
decreasing values of g*.
Assume sj + G(gi) < G(U'(Q)) since otherwise the Buyer is not willing
to pay the effective price of even the lowest cost Supplier (i.e., otherwise the
Buyer will have no incentive to accept any contracts). We first note that since
3{ + G(gi) is non-decreasing in i (by assumption) and since G(U' ( 52!=! £/))
201
is non-increasing in i (by the properties of G and U'), then if Supplier h has
the largest value of the index + C(gt) satisfying (4.15), then every i < h
will also satisfy the following condition:
i
Si + G{gi) < sm + C(5 m ) < C { V { Z W h (4-27)
i=i
with the left inequality following from the assumed ordering in terms of the
shopping index. For suppose the right inequality in (4.27) did not hold at
some i < h. Then again by the ordering of the index and the monotonicity
of U' and G, we would have:
t /> -1
+ G(gh) > ai+l + G(gi+1) > C ( t / '( E Ll» * G (U' ( 5 2 L'))’ (4/28)
i=i i=i
contradicting the definition of h in (4.15). We note, in particular, from
(4.27) and the monotony of G that the optimal Qi, * = 1 , . . . , /, given in the
Theorem statement satisfy the No Excess Capacity Condition.
Now for any 4> = (Pa,Si,gi,Qi (i = 1 , . . . , / ) ) , we can substitute the
optimal contract and spot purchases and x from Lemma 1 to obtain the
202
following simplified form of the Buyer’s utility (4.8) as a function of 0
/ i
V(<(>) = U(D t {4>)) - PsD t {4>) ~ Y , s& + " * ) +^ > (4-29)
i=l t=l
where Dx(0) is given by (4.12). Define EV(Q) as the expected value w.r.t.
Pa of V(4>)- Clearlythere exists an optimal solution to the problem of max
imizing the EV{Q) since V{4>) iscontinuous in its arguments and we can,
w.o.Lg., restrict attention to the compact set of non-negative contract levels
Qi for which the No Excess Capacity Condition is satisfied. To characterize
the optimal contract amounts, we derive F.O.C.S by considering the deriva
tives of V(4>) for a fixed realization of P3 and then take the expected values
of these derivatives w.r.t. Pa.
From (4.29) we obtain for any i 6 {1, ... , / } that
= (U'(DtW ) - - * + ( a - S i )*, (4.30)
where D t {4>) is given by (4.12). We wish to evaluate dDr(4>)/dQ{.
Let k be the index of the Supplier with the highest execution fee for which
contract capacity is non-zero, i.e. g-k = max{<fc | 1 < i < I;Q i > 0}. Then
203
the following relation holds for any k such th at Qk > 0:
I k
9k<9k< tf'E ^ U' ( Z <&)• (4-31)

(=1 1=1
The first inequality follows since g-k is the maximum execution fee for non
zero callable capacity. The middle inequality is essentially equivalent to the
No Excess Capacity Condition since, by definition of k, Qi = 0 Vi > k, so that
Ilf=i Qi = Hi=i Qi- The final inequality in (4.31) follows since U' = D ~x is
monotone decreasing.
Prom Lemma 1 we know that DT{4>) = max(Da(P3), £ f = 1 Qi), where k is
the last contract executed given <p. Thus, D t {4>) depends on Qt if and only if,
for some k > i , £ f = 1 Qi < DS(P„) and gk < Ps < g k n • Using the Non Excess
Capacity Condition, we further note that if Qk > 0 , then D3(gi) > 52?= i Qi-
We conclude from this and (4.31) that
dDrifi) 1 iff 3 A: with Qk > 0 and & < 0 * < U'{Ya =i Q‘) <
dQi
0 e ls e .
204
B ut, given the definition of k and (4.31), this is equivalent to the following:
d D rtt) 1 iff i < k and U ' { Z L i Qi ) < ft-

dQi
0 else.
We also note from (4.31) that precisely when d D r if y /d Q i = 1, we have
Dt {4>) = J2i= i Qi* s™ce ^ f t > ^(52?= i Qt) f°r any * ^ * with Qk > 0 , then
f t > U 'iH U iQ i)- Thus, substituting DT(<j>) = Y^Li Qi ^ interchanging
expectation and differentiation, we finally obtain from (4.30)
= r ( V ( £ q i ) - P.)dF(P.) + / “ (ft - g,)dF(P.) -

Ju'G :lt=lQ,) ^ hi
(4.34)
Since G(p) = Etmintp.P,]} = E {P , - (P3 - p )+}, the first two terms
in this expression reduce to G(U'(Yli= l Qi)) — E {P ,} and E {P a} — G(gi),
respectively, yielding
^ P = C ( y ' ( ^ Q , ) ) - ( » i + C te))- (4.33)
Now note that since the first term is independent of i in (4.35), d E V /d Q i
is monotonic decreasing in s, + CQfc). Thus, if for some k 6 {1,...,/},
205
dE V /dQ k > 0 , then dE V /d Q i > 0 for any i such that Si+G(gi) < Sk+G(gk).
Finally, note that for the contract with the maximum such index, say h, with
Q h > 0, we must have dEV/dQ-h > 0 with inequality unless Q-h = L-h. It
follows that every contract with a value of the index s{ 4 - G(gi) no greater
than h will have dE V /d Q i > 0 so that for such contracts Qi = Li. From
this, we see that, in fact, h = h as defined in (4.15). The Theorem follows.
□
Proof o f Theorem 9
We first note that if the assumption Min{ci|i 6 5} < G(U'(Q)) is not satis
fied, then there would be no positive contract equilibrium since, as noted in
Theorem 8 , in this case no Supplier would be able offer a profitable contract
that would attract non-zero Buyer demand.
Sufficiency. First we show that if there is a set M that satisfies (i) and
(ii), then VA: € M, the optimal contract price for k is to charge Pk — P
as computed via (i). Furthermore, denote p.* as the price vector of other
players in set M. Given p_* = p, k has no incentive to either decrease or
increase its price pk from p.
Case (a): Choose any k € A/, and suppose, pk < p. We see immediately
that all A;’s capacity will be used, i.e., Qk(pk,P-k) = Kk, that gives him
206
a profit of Eiric(pk,p-k) = (Pk — ck)Kk- By definition, we have E 7T*(p) =
(p - ck)D (P)z * * k ' by (*)» we Set D(p) = 5ZieAf K , therefore, Ett*(p) =
(p —Ck)Kk■ Thus we obtain
E 7rk(Pk,P-k) = {pk ~ ck) K k < ( p - ck) K k = Eirk(p), (4.36)
which shows that Supplier k has no incentive to decrease its price given that
other players are charging p.
Case (6 ): Choose any A: € M, and suppose, pk > p. Since pk > p and
from (i ) we have D{p) = YUzm K , since the demand function D(-) is strictly
decreasing, we get D{pk,p - k) < D{p) = 5ZieAf K, therefore, Supplier fc’s
capacity cannot be fully used, i.e., Qk{pk) < Kk- We see,
limPJk~.pEnk{pk,P-k) = { p ~ ck)Qk{p) = (p - ck) K k = E/rfc(p). (4.37)
If we take limits on both sides of equation (4.36), we get
limp*~pE'rfc(Pfc,P-fc) = (p ~ ck) K k = Eirfc(p). (4.38)
207
Hence, Effk(j>k,P-k) is continuous at p. Since Pk > p, we have
E7Tk{pk,P-k) = fk(Pk,P-k) = {Pk~ Ck)Qk{Pk,P-k) =
= (Pk ~ ck)(D(pk,p-k) (4-39)
Take derivatives of w.r.t. pk in the above equation, we have
dfk{Pk,P-k)
g- nt_
= D f e .p_- O, y - ,, +, , - \&D(pk,P-k)
C„)----- g - -----
ieiW® y
yi / \ . i \dQk(jPkiP-k)
= Qk(j>k,P-k) + (Pfc —Cfc) jr- .
0Pk
From (ii), we have f'k(pk) < 0 if Pk > p, we obtain
d^k(Pk,p-k) d f k(pk,p-k)
< 0. (4.40)
dpk dpk
We conclude that, E n k(j)k,P-k) = fk(j>k,P-k) decreases if pk > p. Hence
Supplier k has no incentive to increase its price given other players’ charge
P-k = P-
Condition C 3 insures that no one outside group M would have any in
centive to charge a price < p, since doing so will lead to negative profits by
208
Lemma 4.
N ecessity. Assume there exists an equilibrium set, M, of positive contract
Suppliers. By Lemma 5, we can further assume all Suppliers in M charge an
identical price p. Consider any Supplier k 6 M, since M is sin equilibrium,
k has no incentive to deviate from the equilibrium price p. That is to say, if
we fix other Suppliers’ strategy at p, k does not want to decrease or increase
his contract price pk. We discuss these two cases accordingly.
Case (a): Supplier k does not want to decrease its price by charging pk <
p. If he decreases his price, then he would either extract all the demand from
the Buyer by being the first and last unit provider (Qk(Pk,P-k) = D(pk,p_k)),
leaving nothing for other Suppliers in A/, or still be able to sell all its capacity
(Qk(Pk,P-k) = Kk)- Clearly he has incentive to do so in the former case, since
Kk
limpk-.pEx k(pk,p-k) = ( p - ck)D (p ,p -k) > ( p - ck)D (p ,p -k) = =
luieM K
= Eirk(p ,p -k).
The fact that he does not decrease his price indicates that the latter is true,
209
i.e., Qk(Pk,P-k) = Kk, and Eirk(pk,P-k) < Etfk(p,P-k)- Therefore
Ettjk(pk,P-k) = (Pk~ ck) K k < E j k{p,P-k) = (p ~ Ck)D(p,p-k )-^ —

Isiex'r K
(4.41)
If we let pk —* p on both sides of the above equation, we obtain, Kk <
D{p,p-k) r K or equivalently, D(jp) > £ igJV> K .
Case (6 ): Supplier fc does not want to increase price by charging pk > p-
If he increases his price, then he would either be able to sell all its capacity
(QkiPk,P-k ) = Kk) or fulfill the residual demand from other Suppliers in
group M at Qk{pk,P-k) = D{pk,P k) - E ieAio K > 0. Clearly he has incen
tive to do so in the former case since he enjoys more profit by increasing his
price and selling the same output, the fact that he does not increase price
indicates that the latter is true, i.e., Qk{pk,p~k) = D{pk,P-k ) — E j eA/o K ,
and Eirk{pk,p-k) < Enk(p,P-k)- Therefore
Eirk{pk,P-k) = {Pk ~ ck)[D(pk,P k) “ 5 Z < E?rk{p,p-k) =

ieiw°
= (p - ct )0 ( p ,p -t ) Kk . (4.42)
If we let pk —* p in both side of the above equation, we obtain, D{p,p-k) —
210
£ . ^
K ^ ^(p.p-0 r ^ i c or «iuivalently>d(P’P-‘) i ^ f ^ £*«« k ,
or D(p) < £ t6Ay /C.
If we combine the results of case (a) and case (6), we obtain C l in the
Theorem 9, i.e., D(jp) = YlieM ^ - Furthermore, the above reasoning shows
that E7rfc(p*,p_fc) is continuous at p, and decreases if p* > p, so that it
is straightforward to obtain C2. Condition C 3 holds since if 3 j € 5 \
A/,p > cj, the Supplier j has an incentive to join in M , which contradicts
our assumption that M is an equilibrium group. □
‘211
Chapter 5
Conclusions and Future
Research D irections
This dissertation has achieved multiple interrelated objectives, both on the
theoretical front and on the practiced side. While the practical and theoretical
aspects of this research are highly interlinked, I present these contributions
separately. I start with a discussion of the practiced implications in section
1 and continue with a discussion of the theoretical innovations and contri
butions to existing knowledge put forward in this dissertation. I conclude in
section 2 with a discussion of future reseeuch directions and cheillenges.
212
5.1 P ractical C ontributions
First, as suggested in the introduction, this dissertation provides insights and
a deeper understanding of the nature of supplier management in the impor
tant context of B2B e-commerce, especially when significant investments in
information systems are required. Chapter 2 showed that traditional incen
tive systems would not work when such investments are required and offered
an alternative incentive mechanism that is shown to incent suppliers to make
investments when these are efficient. The incentive system offered, namely
buyer’s matching investments in the relationship and supporting systems, is
easily implemented and has an intuitive appeal to firms who are interested
in close relationships with their suppliers. Chapter 3 complements this by
showing what the optimal supplier base should be in the same context, using
the same framework put forward in chapter 2. Thus, chapter 2 and chapter 3
combine to provide insights on implantable solutions for the linked questions
of supplier selection and control.
Even more important is the idea of segmented supplier management that
underlies the framework offered in chapter 2 and 3. Managers and firms,
as became evident in the empirical study, which is part of chapter 3, are
educated to form an overall supplier management approach. That approach
213
may be one of creating close, long-term relationships with a small number
of suppliers or of operating in a more adversarial mode with a larger num
ber of suppliers. However, as the results of Chapter 2 and 3 show, supplier
management strategy should be segmented according to the combination of
product and market attributes, as well as the context in which the strategy
takes place; hence, segmented supplier management strategy. As the empir
ical results show, the factors put forward by the framework affect supplier
management strategy and more importantly, combine with the strategy to
affect performance. The advent of the Internet as a B2B activity platform
only serves to accentuate the performance implications of not following such a
strategy since the tensions between spot-markets and contracts only increase
when technology improves one or the other or both.
Indeed, out of chapter 3 an important factor for B2B e-commerce arises,
the codifiability of transaction knowledge. Codifiability, which is at some
level a necessary condition for electronic transactions, is found in this disser
tation to be a critical factor in determining supplier management strategy. I
find that the higher the codifiability, the more suppliers can and should be
used and thus electronic trading (i.e., e-Marketplaces and exchanges and not
EDI) becomes a more viable and appropriate mechanism. This result cor-
214
roborates what is evident in the marketplace; that the only e-Marketplaces
and exchanges that have any transactions are those that deal with highly
codifiable transactions (e.g., steel, plastics, office products and MRO). The
emphasis is on transaction codifiability and not product codifiability since
even if the product itself may be highly codifiable, business process and pro
cedures associated with it may make the overall transaction less codifiable.
The issue of codifiability as a driver and factor of B2B e-commerce activ
ity and associated supplier management strategy has enormous implications
for the economy, the marketplace, and firms. If the codifiability thesis, put
forward by chapter 3’s analytical model and results and corroborated in the
empirical analysis, is true, then many firms would have to reconsider their
B2B e-commerce strategy. The implications are significant both for would
be trading firms (i.e., buyers and suppliers at all levels) and for the whole set
of firms that create the B2B e-commerce infrastructure (e.g., SAP, Ariba, i2,
Vertical Net, Covisint.)
Chapter 4 complements Chapter 2 and 3 by examining how codifiability
affects the mix of contracts and spot-market transaction buyers would choose.
Corroborating and complementing Chapter 3’s codifiability results, chapter
4 show codifiability to be a driver of the contracts and spot-market mix. It
215
is shown that, in general, as codifiability improves, spot-markets become a
more attractive option. Such a result has, again, important implications for
firms considering the nature of such a mix, especially when technology brings
the issue to the forefront and may alter the balance in the relative merits of
contracts and spot markets.
Given the forecasted future size of B2B e-commerce trading activity
(which may be as large as $4 trillion within the next few years according to
some industry pundits), the insights and results discussed above may carry
significant economic impact. While further research has to be conducted to
fully support these results, the empirical research and anecdotal observations
of the developing B‘2B e-commerce space, suggest that these results hold and
may be of fundamental importance for practice.
5.2 T heoretical C ontributions
This dissertation provides numerous theoretical contributions, from funda
mental and basic to more topic specific. Given the detailed discussions in
the preceding chapters, I limit the discussion in this chapter to the more
fundamental and consequential contributions, even when topic-specific con-
216
tributions may be significant.
By uniting several research streams, ideas and modeling approaches, from
economics, operations management, and management, it became feasible to
put forward an analytical framework to investigate the idea of segmented sup
plier management strategy. Previous research such as transaction cost eco
nomics (TCE), agency theory, and supplier management, identified drivers
of both supplier management strategy and market configurations. Thus,
TCE, as the major proponent of such an approach, showed which factors
may determine market structure and inter-firm relationships. At the same
time, the management and operations management literature focused on sup
plier management strategy (e.g., Helper and Sako, 1995). This dissertation
suggests that the two should be combined, resulting in segmented supplier
management strategy. The basic approach to segmentation is this. Each
transaction is categorized according to levels of a set of factors identified to
matter, including unit value of transactions and aggregate level of same. The
buyer then determines a number of segment-specific strategies, including the
size of the supplier base, investments in this base and appropriate procure
ment incentives. The resulting segment-specific strategies unite the economic
t hinking of market Darwinism determining efficient configurations with the
217
management approach to proactively choosing optimal configurations and
investments.
Notably, the segmented supplier management strategy study presented
here is grounded in an analytical framework. Previous attempts at analyti
cally modeling TCE have not succeeded because the pure economic modeling
mechanisms (e.g., game theory, principal agent modeling, industrial organi
zation modeling) do not offer enough detailed information. This detailed
transaction information is required in order to analyze the interdependency
between transaction and market structure. By combining economic modeling
tools (principal-agent and game theory) with the operations management em
phasis on the details of the transaction, the framework developed in Chapters
2 and 3 provides a workable and realistic framework for developing insights
on the optimal segmented supplier management strategy.
In doing so, Chapters 2 and 3 solve the dual question of selection and
control of suppliers. Such analysis have been conducted only once before
(Seshadri, 1995) at a lower level of complexity. As Seshadri notes and Chap
ters 2 and 3 show, the two questions are linked and influence each other.
Chapter 2 and 3 demonstrate that both the supplier base size (selection)
and the type of incentives given (control) influence suppliers’ decisions about
218
investments in inter-firm information systems and associated systems and
infrastructure. If both the supplier base size strategy and incentives given
by the buyer do not concur, the result would be contradictory forces (on
the supplier to invest) and some degree of inefficiency. Thus, the analytical
model of Chapters 2 and 3 allow analysis of the selection and control ques
tions within the same framework but segmented according to transaction and
market attributes rather them according to a one-strategy-fits-all approach.
In Chapter 3 I introduce the idea of transaction knowledge codifiability
as a factor in supplier management and inter-firm relationships. Codifiability
had been discussed previously in both economics and the management liter
ature (Pelikan 1979; Kogut and Zander 1992) but in intra-firm context and
transfers. This dissertation uses codifiability to analyze inter-firm transac
tions and specifically supplier management. The analytical part of Chapter 3
show that codifiability is a critical factor in determining supplier management
strategy. Codifiability determines the range of strategic options available to
the buyer. The higher the codifiability, the greater the range.
The idea of transaction knowledge codifiability allows a new type of infor
mation deficiency m odel. Game theory and principal-agent models assume
one or more of the players (alternatively, principal or agents) may lack some
219
of information the other player(s) have. Codifiability, however, suggest a new
model in which both sides lack the same type of information since this lack
is embedded in the transaction itself. Less then a perfectly codifiable trans
action implies all participants face the same type of information deficiency
or lack. The ability to place the information deficiency on the transaction
itself provides an ability to conduct richer and more complex analysis of in
teractions between transaction participants and seem to be a methodological
innovation.
To complete the analytical investigation conducted in Chapters 2 and 3,
Chapter 3 examines the question of optimal mix of contracts and spot-market
transactions when transactions are not perfectly codifiable. To do so, I utilize
a framework developed by Wu, Kleindorfer and Zhang (2001). I generalize
their model by allowing differing production costs between contracts and spot
markets and introducing codifiability-related cost effects. Lack of codifiabil
ity is found to shift buyers’ demand towards contracts and may even lower
overall demand and thus trade, resulting in some suppliers being driven out
of the market. This result corroborates Chapter 3’s result that showed lack
of codifiability to reduce the number of suppliers selected. Thus, codifiability
is shown to be a driver of both the supplier base size as well as the nature
220
and intensity of contracting.
Last, but certainly not least, an empirical study was conducted to examine
Chapter’s 3 results (hypotheses). While studies of TCE and related theories
have been conducted in the past, only a few empirical studies exist and
these have been primarily directed towards examining the nature of contracts
signed and not their relationship to supplier base and supplier management
issues. Furthermore, the empirical study examined the concept of transaction
codifiability and transferability, which has not received much attention in the
empirical literature until now. Despite a small data set of 35 or 90 data points
the model’s hypotheses are strongly confirmed. Specifically, the concept of
codifiability is shown to be a factor in both supplier management strategy
and related performance. These results are striking since it is also shown
that the firm in question does not follow any pre-conceived strategy based
on the model’s factors, except for the trading volume. However, the study
replicates results concerning certain classic variables and corroborates for the
present study the nature of their influence on supplier management strategy.
The consistency of these findings with multiple past studies thus provides
additional corroboration of the empirical study’s validity.
In conclusion, this dissertation has provided multiple theoretical contribu-
221
tions. These contributions include foremost the introduction of new concepts
into existing research streams and a comprehensive and supporting analytical
framework. The results for supplier management strategy in the unfolding
era of B2B e-Commerce could be significant, and taken together they seem
to provide a fertile ground for future research in multiple directions.
5.3 Future Research
While many future research directions are possible, I highlight only a few
that are more fundamental and constitute a significant examination of this
dissertation’s models and results.
First, given the strong results of the empirical study, a larger, less firm
specific study is required. The study, which would preferably be a cross
industry study, would serve to examine whether the results are firm specific,
industry specific, or indeed more general. Given the nature of XChem’s lack
of supplier management strategy as pertaining to the factors examined, the
results and hypotheses must be confirmed in other settings. Lessons learned
in this study will be utilized to enhance such a study, both in broad concept
as well as in the definition of survey instruments and measures.
222
Secondly, a codifiability based information model could be developed.
Such a model would serve to enrich the study of interactions among trans
acting entities (players, firms). Building a general model in which informa
tion deficiency is placed on the transaction rather than on one of the players
would enhance and complete existing information based models and can be
used to examine various types of situations and their implications for mar
kets, exchanges and supporting systems.
Thirdly, the framework developed in Chapter 2 uses some specific func
tional forms, some of which are generalized in Chapter 3. While the complex
ity of the model may limits the ability to generalize functions and still get
meaningful significant results, it is important to determine the robustness of
the results obtained to more general assumptions on these functions.
Fourthly, the framework of Chapter 2 and 3 can be expanded to examine
even a broader range of factors. By extending the framework to multiple
buyers and/or multiple suppliers, issues such as transaction specificity and
its effects could be studied. This would also allow examination of result
ing market structure, thus fully combining the management and economics
approaches. The latter are mostly interested in a bird’s eye view of the mar
ket to examine equilibrium based market structure and the former is more
223
concerned with the implications for firms’ strategies. When multiple buyers
and suppliers are part of the model, both the participants strategy can be
analyzed and the resulting structure. Futher more, with such a construct,
the important factor of switching costs and its interaction with codifiability
could be examined. High codifiability should reduce switching costs and
thus allow even a stronger tendency to use markets than was shown in this
research. On the other hand, high switching costs may result in longer-term
relationships, which would result in higher transferability of knowledge from
one partner to the other, but not to other partners. It is not clear how
performance would be affected, and it offers an exciting venue for research.
Finally, Chapter 4’s framework could be used to investigate how invest
ments in information systems affect the balance between contracts and spot-
market transactions. Specifically, such investments may affect and interact
with transaction codifiability, which has been shown to drive the mix of con
tracts and spot-markets.
These future directions seem to indicate, together, the promise of a fruit
ful and deep research program that may provide both an inspiration to its
author and continuing contributions of practical relevance in improving sup
plier management in industry.
224
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Operations and Information Management

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to my wife, Adva Dinur-Levi

material and especially his invaluable assistance on the empirical part. I

the Operations and Information Department at The Wharton School. I am

highly indebted to my wife, Adva Dinur-Levi, who throughout my studies

this dissertation would not be as it is. More them anyone, I am forever

indebted and thankful to my advisor, Paul Kleindorfer for his multi-faceted

support, guidance, knowledge, and wisdom, which have carried me through­

and omissions are solely my responsibility. This dissertation was supported

in part by the Institute of Supply Management (ISM, formerly NAPM).

B2B e-commerce requires substantial investments by suppliers and buyers

in information systems find related infrastructure. As has become evident re­

those is expected to reach trillions of dollars. However, more than 90% of

salient of is fear of margin erosion. In order to analyze supplier management

strategy in this context I build an analytical framework. This framework

allows analysis of both the selection and control questions. In Chapter 2

the questions of incentives (control) for suppliers’ investments in informa­

tion systems is solved, while in Chapter 3 I analyze the question of how

emerges an important factor in determining strategy, namely the codifiabil­

ity of transaction knowledge. Codifiability, some level of which is necessary

for electronically mediated transactions, is shown to determine how many

plication to inter-firm relationships is novel. To examine the framework and

the hypotheses generated in Chapter 3, an empirical study on a procurement

department of a leading chemical firm is performed. I find that the model

is strongly supported and that codifiability and transferability of transac­

tion knowledge are important factors in determining supplier management

strategy and performance. Building on these findings, chapter 4 uses an

spot-market procurement. I find lower codifiability to shift the mix towards

contracts, which allow an orderly negotiation process on the details of the

transaction, thus strengthening Chapter 3’s results. Details of the resulting

market equilibrium arising from various degrees of codifiability are presented

as one important implication of this modeling framework.

1.1 Historical Perspective.................................................................... 3

1.2 Supplier Management in P e rs p e c tiv e ........................................ 10

1.3 Dissertation O u t l i n e .................................................................... 13

2 Incentives for Suppliers’ Investm ents in Information System s 25

2.2 Supplier Management:An Overview of the Issu es.......................... 32

2.3 Modeling Fram ew ork........................................................................ 47

2.3.1 The C o n te st........................................................................ 48

2.3.2 The Buyer’s P ro b le m ............................................................54

2.3.3 In c e n tiv es........................................................................... 59

3 T he O ptim al Num ber o f Suppliers and Codifiability 71

3.1 Introduction ........................................................................................71

3.2 Modeling F ram ew ork....................................................................... 80

3.2.2 Time L in e ..............................................................................86

3.2.3 N o ta tio n s ..............................................................................87

3.3.1 Version 1: Contractible Investm ents.................................. 91

3.3.2 Version 2: Unobservable In v e stm e n ts ................................97

3.4 C odifiability..................................................................................... 102

3.5 The Empirical S t u d y ......................................................................107

3.5.1 H y p o th e se s......................................................................... 109

3.5.2 The D a t a ............................................................................ 120

3.5.3 Part I: The Case of the Missing S tra te g y ........................ 124

support, guidance, knowledge, and wisdom, which have carried me through

in information systems find related infrastructure. As has become evident re

the questions of incentives (control) for suppliers’ investments in informa

emerges an important factor in determining strategy, namely the codifiabil

is strongly supported and that codifiability and transferability of transac

while there is substantial volume of trade over the W W W in some transac

which large idiosyncratic investments, and specifically investments in infor

The program highlighted Deming’s role in the development of Japanese qual

th inking at the time emphasized creating competition as opposed to estab

compared to conducting it through an external source. Williamson postu