Vulnerable Options in Supply Chains: Effects of Supplier Competition

This paper presents valuation of inventory-reorder options in a competitive environment with defaultable suppliers. Analysis of a single period model of a supply chain with two suppliers, a retailer, and exogenous sources of defaults, leads to a number of surprising observation on the effects of the supplier credit risk and competition on the value of the deferment option, retailer’s procurement and production decisions, suppliers’ pricing decisions, and firms profits. In particular, when wholesale prices are fixed, introduction of the deferment option may benefit the supplier with longer production lead-time at the expense of the supplier with shorter production lead-time and there are conditions for the retailer’s profit to be increasing in default correlation. When wholesale prices are allowed to vary, analysis of the game between suppliers shows that introduction of the deferment option diminishes competition between suppliers and, thus, hurts the retailer if supplier defaults are highly correlated. On the other hand, retailer’s profit is increasing in supplier default correlation if the level of correlation is low.