Product Quality Choice, Competition, and Supply Chain Design

Abstract

We explore the interplay between product design choices and their effect on the supply chain transactions. A large number of industrial business-to-business transactions indicates that product design choices, and the definition of the overall product performance (quality), is relying on "off the shelf" standardized components, and it influences the component pricing.

We develop a normative model that highlights the drivers for the different industrial settings and we consider end product markets with quality sensitive heterogenous consumers (vertical differentiation). We find that depending on the industry concentration at the different tiers of the supply chain, the timing of the product definition by the OEM has a substantial effect on the transacting firms payoff, as well as on other relevant metrics (total supply chain profits, social welfare). By examining the potential action sequences across the transacting firms, we identify the incentives for each firm to accomplish a decision earlier or later in the strategic interaction. Interestingly, the standard notion of the "leader" advantage in the transaction does not hold always, due to the indirect effect of the component cost on the end-product market, through the indirect link between the product performance and the total market served. Therefore, the OEM may benefit more from finalizing the end product specifications based on known component costs. Along similar lines, the supplier may benefit from a "follower" position in the sequence of decisions. Finally, the severity of competition in any of the two tiers may be diluted by a specific sequence, depending on the available nformation at the monopolistic tier.