Optimal Service-Based Competition with Heterogeneous Suppliers. Working Paper

We investigate how a competition can be designed to maximize expected profit for a buyer who wishes to allocate demand among a diverse set of suppliers when his profit is dependent on the supplier’s service levels. The candidate suppliers are heterogeneous in their capacities and cost structures, and compete for shares of the buyer’s demand based on their promised service levels. To characterize the optimal competition, we first identify a family of allocation functions that are service maximizing, meaning they can intensify the competition to a point where each supplier provides its maximum feasible service level and the outcome of the competition is a predefined set of demand shares. We show that using a service maximizing allocation function is a necessary condition for solving the buyer’s problem. We then characterize the optimal demand allocation set and, when they are endogenous, the optimal procurement prices. When both demand allocation and procurement prices can be chosen by the buyer, we find that the competition also maximizes supply chain profit. Through a set of numerical examples, we show that the benefit of using this optimal competition design, including its specified demand allocation function and suggested procurement prices, can be significant