Competition and Diversification Effects in Supply Chains with Credit Risk∗†

We study the effects of credit risk in a supply chain where one retailer deals with competing risky suppliers who may default during their production lead-times. The suppliers, who compete for business with the retailer by establishing wholesale prices, are leaders in a Stackelberg game with the retailer. The retailer, facing uncertain future demand, chooses order quantities while weighing the benefits of procuring from the cheapest supplier against the advantages of reducing credit risk through diversification. If the wholesale prices were exogenous, the retailer would benefit by choosing suppliers that had low default correlations. However, when prices are endogenous, low supplier default correlations dampens competition among the suppliers, increasing the equilibrium wholesale prices. We show that the retailer prefers suppliers with highly correlated default events. In contrast, the suppliers and the channel prefer defaults that are negatively correlated.