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Sourcing through intermediaries

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We study firms that repeatedly source products or services from external suppliers. Due to changes in exchange rates, tariffs, transportation costs, etc., the lowest-cost supplier changes frequently. Further, sourcing creates opportunities for self-interested behaviour that reduces supply chain profits - this "decentralization inefficiency" could arise due to non-contractible actions such as investments in inventory or capacity, following environmental or social norms, leakage of proprietary information, unobservable efforts, etc. Inspired by the phenomenal rise of sourcing intermediaries such as Li and Fung Ltd., we compare two sourcing structures in this context: 1) Direct Sourcing, where firms deal with the suppliers directly, and, 2) Mediated Sourcing, where an intermediary consolidates demand from multiple firms and sources for each of these firms. We model each structure as an infinitely repeated dynamic game with random states. Our analysis illustrates that sourcing through an intermediary reduces the supplier-side incentives for self-interested, inefficient behaviour by limiting the immediate gains from such behaviour and by providing more long-term sourcing business in its absence. Each of these advantages arises out of the intermediary's costminimizing allocation of business among suppliers that is better distributed or more egalitarian than that of any individual buyer. This implies that it is more lucrative for an intermediary than a direct buyer to provide sufficient levels of business to more suppliers over the long run and to limit exposure in any sourcing period to a suppliers' self-interested behaviour. Our analysis illustrates that procurement through intermediaries is most beneficial when there is an intermediate level of inefficiency and the suppliers are, on average, equally preferred or when the inefficiency is high and one supplier has an advantage over the other supplier.

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