Effects of Correlated Defaults in Supply Chains

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. Although, in general, the timing of the retailer-to-suppliers payments is important, we identify a family of wholesale pricing policies for which, in equilibrium, the suppliers and the retailer are indifferent between up-front and on-delivery payment schedules. Our analysis reveals that the equilibrium firms’ profits decline as default risk increases. Furthermore, the decline rates for firms in different echelons of the supply chain depend on the shape of the demand distribution. If the wholesale prices were fixed, the retailer would benefit from the decreasing correlation of the defaults. However, if prices are endogenous to the model, the decreasing defaults’ correlation alters the nature of the competition among the suppliers and lowers the equilibrium wholesale prices. We show that, in equilibrium, the retailer prefers suppliers with positively correlated default events. In contrast, the suppliers and the supply chain prefer defaults that are negatively correlated.