Risk Mitigation Benefit From Backup Suppliers in thePresence of the Horizontal Fairness Concern *

ABSTRACT

The backup supply strategy is demonstrated as an effective approach to mitigating supply risk. We study a supply chain in which a leader manufacturer designs a contract to a potential backup supplier to mitigate the yield uncertainty of the primary supplier. In this context, the backup supplier may compare with the primary supplier and have horizontal fairness concerns. We model the contract design problem using a Stackelberg game and characterize the optimal decisions for the manufacturer and backup supplier, in both fairness and off-fairness settings. The theoretical results show that the leader manufacturer must sacrifice his own payoff to balance the payoffs of both suppliers. As a result, using a self-interested backup supplier is the dominating strategy, whereas using a fair-minded backup supplier is only suggested when the reliability of the primary supplier is low and the fairness concern of the backup supplier is not strong. Additionally, the backup supplier only benefits from fairness concerns when the level is not exceeding a threshold value. With regard to high fairness levels beyond this threshold, fairness concern has negative effects on the monetary payoff and even might lead to loss of the business. By conducting laboratory experiments, we provide evidence of the horizontal fairness concern from the backup supplier. Further, we show that if the primary supplier also has horizontal fairness concerns, the leader manufacturer can conditionally benefit from a promoted yield reliability due to an extra effort from the primary supplier.

Subject Areas: supply chain management, option contract, supply risk, and fairness concern.

INTRODUCTION
Backup suppliers are widely employed in industries, such as the aircraft (Chen, Zhao, & Zhou, 

2012), pharmaceutical (Chopra, 2007), and electronics (Tomlin, 2006) industries. One contracting strategy is to compensate for backup deliveries with capacity reservations, as is practiced in the following example. Toyota procures P-valves from a low-price, high-volume primary supplier, Aisin Seiki Co., and reserves in advance some capacity from a secondary flexible backup supplier, such as Somic, to protect the supply stream against possible disruptions (Sheffi, 2007).

In a setting with a manufacturer and a primary supplier plus a backup supplier, the manufacturer (he) has an established contract with a low-price primary supplier for regular supply, who is subject to yield uncertainty, and then develops an alternative contract with a reliable but expensive backup supplier (she) for contingent deliveries. Being conscious about the contingent rerouting option, the backup supplier may consider her relative payoff compared with that of the primary supplier when making decisions, which influences her behavior. As such, the manufacturer’s ability to obtain a contingent supply is uncertain because the backup supplier may not be willing to do business with him due to unfair treatment. For that reason, we are motivated to study the mitigation strategy for a manufacturer to avoid mitigating failure because of the possible fairness concern of his backup supplier by analyzing how he should contract with his backup supplier to ensure a responsive supply and, at the same time, benefit from contingent sourcing.

Real-world examples in which fairness concerns are important abound. In the Japanese automotive supply chain, automakers, notably Toyota, rely heavily on fair transaction relationships with their suppliers. As a result, suppliers are more likely to trust Japanese automakers to treat them fairly (Dyer, 1997). Another example occurred between two Chinese firms, Gome (one of the top three home appliance retailers) and Gree (the leading air conditioner manufacturer in China) in summer 2004. Gree decided to withdraw all of its products from Gome stores despite a significant loss in market share because Gree felt that Gome’s demand of additional summer promotion fees was unfair (AsiaInfo Services, 2004; Liu, Huang, Luo, &Zhao, 2012). Additionally, in 2008, Lego Group rejected Walmart Canada’s demand of price reduction to maintain a fair pricing structure in the Canadian and U.S. markets. Such rejection ended the business relationship between Lego Group and Walmart Canada (Georgiades, 2008).

Although the above anecdotes clearly illustrate the important role of fairness in firm performance, research on fairness in supply chain management has only recently attracted attention. Extant studies have shown that supply chain parties with fairness concerns make decisions deviating from the predictions provided by self-interested profit-maximization models (e.g., Loch & Wu, 2008; Cui, Raju, & Zhang, 2007; Demirag, Chen, & Li, 2010; Fehr, Klein, & Schmidt, 2007; Wu 2013; Katok, Olsen, & Pavlov, 2012; Katok & Pavlov 2013). In particular, in contract designs, a constant wholesale price can coordinate a dyadic channel when channel members are concerned about fairness (Cui et al., 2007; Demirag et al., 2010). Coordinating contracts result in inequivalent supply chain performance, although they are mathematically equivalent (Wu, 2013). The inequality-aversion model can describe the contract choice predictions rather accurately (Fehr et al., 2007). Katok, Olsen, and Pavlov (2012) consider fairness concern as the private information of supply chain partners and show that a wholesale pricing can conditionally coordinate the supply chain, despite the asymmetric information. Katok and Pavlov (2013) investigate the major factor contributing to rejections in supply chain contracts, and report that inequality aversion has the most explanatory power regarding retailers’ behavior compared to bounded rationality, and incomplete information. All these studies typically investigate dyadic settings with the fairness concern on the vertical dimension between seller and buyer.

While fairness in dyadic supplier-buyer relationships is important, triadic settings formed by one seller/buyer and two buyers/sellers are also common in practice, where horizontal fairness concerns may be induced between peers. Fairness concerns in horizontal dimensions provide a meaningful frame of reference for identifying individual firms that participate in the formation and execution of supply chain transactions. Because these participants engage in social exchanges and derive complex perceptions, an examination of horizontal fairness concern in a triadic supply chain is essential for generating additional insights on effective supply chain management.