Horizontal sourcing in a differentiated industry: To commit or not to commit

This work studies horizontal sourcing in a supply chain where a supplier competes with a buyer in a differentiated downstream market. Both firms have in-house production capabilities for a key component required to make the end products, but the supplier has a cost advantage. The buyer may make in-house or buy from the supplier through committed or noncommitted sourcing. Under committed sourcing, the buyer must commit to an order quantity before downstream competition starts, whereas under noncommitted sourcing, the order quantity decision is deferred after downstream competition has settled. I show that horizontal sourcing can occur, as long as the supplier has a cost advantage, and the timing of sourcing quantity commitments has important competitive implications. Committed sourcing does not reduce consumer surplus, and it can increase firm profits and consumer surplus when the supplier’s cost advantage is sufficiently large, and the sourcing price is moderate. In contrast, noncommitted sourcing separates the sourcing price from downstream competition, weakening the supplier’s cost advantage and potentially reducing consumer surplus when the sourcing price is high. Furthermore, noncommitted sourcing yields higher social welfare. When sourcing terms are determined through Nash bargaining, noncommitted sourcing arises in equilibrium. However, when the sourcing terms are the results of a Stackelberg game, both firms prefer noncommitted sourcing when the supplier’s cost advantage is large relative to product differentiation or when the profit margin of the component market is high.