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Multi-Tiered Supply Chain Risk Management

Jan 2018
Working Paper
Georg Schorpp, Feryao Erhun, Hau L. Lee
We study contracting for a three-tier supply chain consisting of a buyer, a supplier, and a sub-supplier where
disruptions of random length occur at the sub-supplier. As is common in supply chains, the buyer has a direct
relationship with the supplier but not the sub-supplier; that is, the buyer has limited supply chain visibility.
Both the supplier and the sub-supplier can reserve emergency capacity proactively to protect the supply
chain from a disruption. We study how the buyer and the supplier can guarantee that the correct level of
emergency capacity is reserved. Due to two types of ineciencies|a special form of double marginalization
and the substitution eect|the supply chain is misaligned in its decentralized form, leading to either under-
or over-reservation of emergency capacity by the sub-supplier depending on the cost structure of the supply
chain. The lack of visibility prevents the buyer from directly contracting with the sub-supplier to eliminate
these ineciencies. Yet, he can coordinate the supply chain through cascading: i.e., contracting with the
supplier (using a value-based carrot-and-stick contract), who in turn contracts with the sub-supplier (using
a cost-based carrot-and-stick or two-level wholesale price contract, depending on the cost structure of the
supply chain). Although the sub-supplier is the source of limited visibility in the supply chain and is the
party with private information, the supplier is the one that benets from this limited visibility and is the
party that receives information rent from the buyer.
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