Managing Supplier Switching

To examine the potential gains from a second production source, we examine how source switching is optimally structured. The model focuses on a purchaser who manages the acquisition process, an incumbent supplier, and a potential entrant or second supplier. Because the costs of the incumbent and second source are correlated, the entrant's costs provide an informative signal about the incumbent's costs. Judicious use of this information allows the purchaser to limit the incumbent's rents. Because entry also provides an alternative source of production, however, there are important distinctions between the optimal entry policy and the optimal auditing policy. One of our findings is that it may be optimal to replace the incumbent, even when the entrant is known to have higher production costs.