Product Quality Choice, Competition, and Supply Chain Design

Transcription

1 Product Qulity Choice, Competition, nd upply Chin Design Mrk E. Ferguson College of Mngement Georgi Institute of Technology 800 West Pechtree treet, NW Atlnt, GA Tel: (404) Fx: (404) tylinos (telios) Kvdis College of Mngement Georgi Institute of Technology 800 West Pechtree treet, NW Atlnt, GA Tel: (404) Fx: (404) October, 2006

2 Product Qulity Choice, Competition nd upply Chin Design. We explore the interply between product design choices nd their effect on the supply chin trnsctions. A lrge number of industril business-to-business trnsctions indictes tht product design choices, nd the definition of the overll product performnce (qulity), is relying on off the shelf stndrdized components, nd it influences the component pricing. We develop normtive model tht highlights the drivers for the different industril settings nd we consider end product mrkets with qulity sensitive heterogenous consumers (verticl differentition). We find tht depending on the industry concentrtion t the different tiers of the supply chin, the timing of the product definition by the OEM hs substntil effect on the trnscting firms pyoff, s well s on other relevnt metrics (totl supply chin profits, socil welfre). By exmining the potentil ction sequences cross the trnscting firms, we identify the incentives for ech firm to ccomplish decision erlier or lter in the strtegic interction. Interestingly, the stndrd notion of the leder dvntge in the trnsction does not hold lwys, due to the indirect effect of the component cost on the end-product mrket, through the indirect link between the product performnce nd the totl mrket served. Therefore, the OEM my benefit more from finlizing the end product specifictions bsed on known component costs. Along similr lines, the supplier my benefit from follower position in the sequence of decisions. Finlly, the severity of competition in ny of the two tiers my be diluted by specific sequence, depending on the vilble informtion t the monopolistic tier. KEYWORD: VERTICAL DIFFERENTIATION, UPPLY CHAIN TRANACTION, PRODUCT DE- IGN. Introduction The Apple ipod hs been resounding success by, prcticlly, ny finncil mesure. Its sleek design, high qulity udio, nd compct size enbled Apple to revmp the mrket for portble digitl music plyers in lte 200. After estblishing firm foothold in the mrket, ipod sles skyrocketed to 0.4 million units in 2004 nd obtined n overll mrket shre for U.. portble digitl music plyers of over 80%, mking Apple the third best performing stock in the tndrd nd Poor s 500 Index in 2004 (Guglielmo, 2004). However, the populr business press plced fr less ttention on the fct tht the originl ipod would not hve been possible without the dvent of n.8 inch miniture hrd-drive, designed nd mnufctured by Toshib Corportion.

3 The miniture hrd drive ws criticl to the originl ipod s smll size nd functionlity nd represented n estimted 50% of its totl vrible cost (hermn, 2002). Designing round this key component, Apple engineers determined the overll performnce nd the design fetures of the ipod through their focus on dimensions tht ffected the end-consumer perception, like the udio performnce, the power utiliztion, nd the product size. More specificlly, Apple mde severl criticl design choices (especilly with respect to the product size) nd shred them with Toshib s engineers before finlizing the per-unit cost for the hrd drives. At the sme time, Toshib quoted price for the hrd drives tht llowed Apple to retin the overll product (development nd mnufcturing) cost t levels tht supported their retil price trgets. Despite the fct tht Toshib enjoyed monopolistic power through their technologicl intellectul property (their bility to produce relible miniture hrd drive), they did not buse their power by demnding high profit mrgins. Insted, Toshib set price for the hrd drive tht provided them with modest profit mrgin, perhps in nticiption of lrge mrket potentil for the ipod where they would mke more money bsed on the high sles volumes. In hindsight, this ppers to hve been smrt move on Toshib s prt s the success of the ipod resulted in substntil finncil benefits for both compnies. The interply between the product design decisions nd the supply chin trnsction reltionships between n Originl Equipment Mnufcturer (OEM) nd key component supplier is certinly not unique to Apple s development of the originl ipod. In numerous other instnces, OEMs shre design specifictions with component suppliers before the component prices re set. Mny industril settings exhibit such interctions; e.g. Toyot finlized the key qulity requirements of the Prius (their first hybrid engine cr model) before negotiting with Pnsonic on the price of the rechrgeble btteries needed to mke the product work (Liker, 2004). At the sme time, we lso encounter the lterntive timing of decisions: the downstrem OEMs ccount for finlized price levels of key product component before freezing the design specifictions nd refining the key qulity dimensions of the end-product. As n exmple, PC mnufcturers wit until the core processor mnufcturers, Intel or AMD, nnounce their prices for the ltest microprocessor before determining the qulity fetures of their product offerings such s the mount of memory, hrd drive size, type of externl drives, etc. This intentionl dely llows the OEMs to djust their respective feture choices for the finl product to be in line with observed consumer price ceilings (e.g. $000 for consumer desktop computer; 2

4 In this pper, we explore the effects of the timing of the product definition decision s pproximted by the sequence of firm ctions on the product design choices long with the rmifictions on the supply chin. We explore how the timing of the finl product s design qulity choice (i.e. before or fter negotiting the price of key component) ffects its price, the performnce qulity of the finl product, nd the totl demnd served. We lso nlyze the impct on the totl (nd the pproprition of) supply chin profits. We seek to nswer our reserch questions under vrious competition regimes for the component nd the end-product mrkets. We strt with the bse cse of monopoly-supplier, monopoly-oem setting, which we use s benchmrk (i.e. single trnsction specific to its members). We then extend the model to incorporte the existence of competition in either the supplier or the OEM mrket. We ssume tht, wheres the end products cn be differentited with respect to their qulity performnce nd their price, the components provided from the upstrem mrket re stndrdized both with respect to their design nd the ssocited interfces. Yet, the components hold centrl role in the end-product functionlity nd they re necessry to produce it. till, without dditionl investment, the components by themselves re useless to the finl customer (e.g. memory chips cn not perform ny stndrd computer opertions without peripherls nd softwre drivers). Thus, when more thn one supplier possesses the technology to produce such components, the suppliers compete vi their cpcity decisions. Our ssumption, lbeit restrictive, cptures the essentil effect of upstrem competition (higher supply of components t lower prices to the OEM), nd follows from similr pst literture (Tygi 999, Corbett nd Krmrkr 200, Crr nd Krmrkr, 2005). As n extension to this literture, in our model, OEMs in the end-product mrket my compete by differentiting their offering vi the product qulity design choices, where choice of higher qulity incurs higher per unit cost. We posit tht such industril settings offer more relistic structure to nlyze nd understnd the importnt strtegic interctions. We find tht the timing t which the product definition decision (i.e. freezing the concept nd finlizing the design choices, Bhttchry et l. 998) tkes plce during the trnsction ffects the profit distribution between the supply chin members long with the totl supply chin profit. Interestingly, the stndrd notion of the decision leder, in the gme theoretic sence, does not lign with the profit outcomes. Under monopoly-supplier, monopoly-oem trnsction, the OEM benefits more from finlizing the product design fter locking in The reson for this exclusive pproch stems from our intention to isolte the effects of competition. 3

5 the component price. ymmetriclly, the supplier prefers to finlize component prices fter the OEM s design decisions nd investments re set, thus refrining from first mover dvntge. These order preferences my chnge, however, if there exists competition t either level of the supply chin. The presence of the qulity choice my mplify the severity of the upstrem competition when the component prices re set before the product design is fully determined. On the other end, competing OEMs exhibit misligned incentives to finlize their designs before the component prices re set. The lter result introduces the possibility tht Moorthy s (988) observtion tht the simultneous product introduction hs no difference to the sequentil one, my require further reserch. These results pper counterintuitive from trditionl economics perspective. They stem from the endogenous determintion of the totl mrket due to the product qulity choice nd the existence of heterogenous consumer preferences. Overll, our findings bre mngeril importnce by illustrting the indirect coupling between product design decisions nd the resulting supply chin trnsctions. In tht light, we echo Fine s (998) conjecture bout the need for mngers to consider product introduction decisions long three dimensions: product design, process design nd supply chin design. Our study builds comprehensive frmework for ssessing these interctions. In ddition, we obtin some socil welfre implictions tht my be of interest to policy mkers. The rest of the pper is orgnized s follows: in 2 we briefly review the relevnt literture. In 3 we introduce the model structure nd discuss the bsic premises. We estblish the importnce of the sequence of decisions cross the different firms in the supply chin in 4 for the monopoly-monopoly cse. In 5 we extend this nlysis to different supply chin structures (oligopoly-monopoly in 5., nd monopoly-duopoly in 5.2). We conclude our presenttion with the discussion of our results in 6. All proofs re provided in the Appendix. 2. Literture Review Economic theory hs trditionlly resoned tht in non-differentited products, price competition benefits the end-customer who enjoys the lowest prices (Bertrnd competition). At the sme time, the sme literture identifies differentition in product ttributes s driver for incresed profits mong competing compnies. Differentition hs registered in economics nd mngement in two possible forms: verticl nd horizontl differentition. Verticl differentition occurs when ll consumers pprecite eqully the reltive performnce qulity 4

6 of product but re heterogeneous in their willingness to py for given qulity (see Muss nd Rosen 978 nd Tirole 987 for discussions). A lower qulity product my ttrct consumers if offered t low enough price but ll consumers desire higher qulity for the sme price. In verticl differentition models, the concept of qulity is ssumed to be onedimensionl vrible, lthough it my consist of multiple dimensions such s durbility or technicl performnce. Horizontl differentition, in contrst, occurs when customers hve different tstes with respect to the product ttributes (Hotelling, 929). Hence, compnies introduce products with potentilly different fetures, nd shre the mrket by ttrcting those consumers tht hve tstes close to the offered product ttributes. In this pper, we focus on verticl differentition where OEMs differentite their products long commonly perceived performnce dimension. We employ the bsic structure of the verticl differentition model introduced by Moorthy (984), for monopoly setting, nd Moorthy s (988) lter extension to duopoly setting. These models ssume the existence of convex (qudrtic) cost of performnce qulity, nd tht the qulity choice determines the mximum mrket potentil for given price. We build upon Moorthy s nlysis to ccount for the opertionl detils of the OEM s cost structure: the externl component costs nd the internl investments in product performnce qulity comprise the per-unit vrible cost. In ddition, we position the product design 2 decisions within supply chin trnsction setting, nd we explicitly consider the strtegic interctions between the endproduct mrket nd its ssocited component mrket. In short, we extend the literture by opertionlizing the product design decisions (division between design investments nd component costs) nd by explicitly cpturing the strtegic interctions of the supply chin (trnsctions between the end-product nd the supplier mrket). While number of studies hve explored product differentition (nd the ssocited issues of introduction, cnnibliztion etc.), much less hs been sid bout the impct of the supplier mrkets on the end-product mrket differentition nd vice vers. Recently, Corbett nd Krmrkr (200) exmined the impct of the within-tier competitiveness on the djcent tiers of supply chin. They ssume multi-tier supply chin where ech tier dds components to obtin non-differentited end-product. Crr nd Krmrkr (2005) extend the nlysis to generl ssembly networks. In the hert of these models, firms re ssumed to be price tkers nd to compete in cpcities (Cournot competition). The totl quntity 2 From this point onwrds we tret the concepts of design performnce nd qulity choices s equivlent, nd thus we use the terms interchngebly. 5

7 is sold to homogenous end-customer mrket, expressed by the clssic liner demnd curve, nd it propgtes upstrem shping the price in the supplier mrkets for given number of firms competing in ech tier. They focus on the determinnts of the mrket structure (i.e. number of firms prticipting, entry decisions), demonstrting the subtle role of the totl number of competing firms to the end-product quntity nd cost. However, their ssumption on the commodity nture of the end-product (perfect substitutes) limits the generliztion of the results. We clim tht in most consumer mrkets, such degree of commoditiztion is rre, nd firms compete by differentiting their offerings. Thus, extr investment is undertken to ensure tht the product qulity is higher thn competitor, or tht the price is lower. Along similr lines, Mjumder nd rinivsn (2006) extend the multi-tier nlysis to include contrcting decisions cross members of the different tiers. They retin the commodity ssumption bout the end-product nd the intermedite components, nd they ssume single-member tiers. Their results highlight the importnt role of the leder in the supply chin, tht is, the firm which first proposes contrcts both to the upstrem nd the downstrem counterprts. In contrst, we do not focus on the forml contrcting process, given our ccount for product design choices (which to our knowledge re rrely contrcted upon, unless there is n explicit co-development greement), nd we llow for differentited end-products nd heterogenous consumer preferences. Despite the different perspective, we lso observe tht the order of decision mking plys n importnt role in the distribution of the supply chin profits. The considertion of the product performnce s decision vrible mkes this role less intuitive however. From product development stndpoint, Bhttchry et l. (998) explore the timing of the product definition during the product development process, given the lck of full knowledge bout the mrket potentil. While they model the concept definition phse in detil, they do not ccount for ny outside components required for the reliztion of the design, nd the respective impct of such trnsctions on the timing of the product definition. We consider higher level of decision mking nd explore how the timing of the product definition decision ffects the clssic supply chin trnsctions, nd the subsequent pproprition of the economic benefits. Krishnn nd Rmchdrn (2006) focus on the effect of modulr upgrdble components on the innovtion pce of industril mrkets. Wheres they ccount explicitly for the component performnce nd fetures, they do not consider the strtegic interction between the upstrem nd downstrem mrkets. Finlly, Ert et 6

8 l. (2006) nlyze the effect of the upstrem introduction decision of specilized processes or high-tech components on the end product OEM profitbility. They do not ddress the end consumer mrket in detil, nd they restrict their nlysis to the doption decisions by the OEMs. Essentilly, they do not ssume explicit differentition investments by the OEMs prt from dopting the new component. In contrst, we focus on the design choices of the OEMs nd we llow for competition both t the upstrem nd downstrem levels. In summry, we explore the impct of the supplier mrket on the downstrem competition with respect to prices nd the degree of product differentition. This setting llows us to understnd the cross tier linkges nd design decision sequences in qulity-bsed, differentited mrket. ince we choose to ddress these issues t such high level of nlysis nd decision mking, we mke simplifying ssumptions tht im to strike the right blnce between mthemticl bstrction nd the rel world phenomen. For exmple, s in Corbett nd Krmrkr (200), we do not ccount for detiled inventory policies nd/or the detils of the product development process tht would render the model intrctble nd would not necessrily reflect the strtegic firm decisions. 3. Model etup nd Assumptions Consider two-tier supply chin structure consisting of set of suppliers selling single stndrdized component to set of OEMs 3. The OEMs purchse the component from the supplier mrket, mnufcture the finl product nd subsequently sell it to mrket of endconsumers with heterogenous vlutions regrding the end-product qulity. The end-user mrket is chrcterized by the different vlutions tht consumers plce on the performnce levels of the products. Ech consumer s utility is u(θ, q, p) = θq p, where θ is the consumer s vlution of bseline product with qulity level of one, q the product qulity, nd p the product price. We ssume the consumers bseline vlutions re uniformly distributed cross the [0, ] line. This ssumption is common in the literture when the firm hs little knowledge of the overll distribution of the consumers mrket potentil. We normlize the size of the totl mrket to one 4. 3 Our results extend to ny multi-tier supply chin with the tiers 2 to n supplying non-differentited products. The derivtions follow Corbett nd Krmrkr (200). We choose to focus on the first 2 tiers s good proxy for the overll phenomenon. 4 Our results continue to hold for cses when the size of the mrket is different thn but the nottion becomes unnecessrily burdensome. 7

9 We define the OEM mrket through three key vribles: (i) the index, i, of the OEM (i =, 2) 5 ; (ii) the corresponding finl product prices (p nd p 2 ); nd (iii) the qulity offering (q nd q 2 ), which describes the performnce qulities offered to the end-consumers. The vribles q i represent individul firm qulity choices, wheres the subscript i denotes the rnk, with respect to qulity, of the firm (q q 2 ). Thus, ech firm s totl cost is comprised of wholesle price, w, for the stndrdized component, nd the development nd mnufcturing cost of qulity c i = q 2 i. The qudrtic representtion of the totl cost follows up the extnt literture on product differentition (see Moorthy 984). The firm specific rtio w c i determines the importnce of the component cost in the overll firm cost structure. The supplier mrket sells stndrdized ( commodity ) component, i.e. component with well understood rchitecture nd technology such s memory chip or hrd disk drive. Our ssumption of homogenous bse of suppliers llows us to mintin trctbility nd to chrcterize the effects on the end product offering(s) nd the reltive mrket size. In ddition, it retins the common observtion tht more intense upstrem competition results in lower prices. Two vribles chrcterize the mrket: (i) the number of competing firms, n; nd (ii) the upstrem wholesle price w determined through mrket clering mechnism. We nlyze the interctions tht emerge cross the supply chin tiers through series of extensions of the bsic setup, which ssume different competitive conditions in ech tier. 4. The Role of the Decision equence We strt our nlysis with the bse cse of monopoly-supplier selling to monopoly- OEM (MM cse). This setting, lbeit stylized, is relevnt becuse it points out right from the beginning the importnce of the timing of the product definition on the supply chin trnsction. From modeling stndpoint, we cpture this timing through the sequence of ctions from the different decision mkers. As our results verify, the decision sequence hs significnt impct on the resulting profits, both for the entire supply chin nd the individul firms. In lter sections, we incorporte the effects of downstrem nd upstrem competition. Consider monopolist OEM who uses specific component for the end product. 5 Our effort is to explore different emerging equilibri for different structures of the two intercting mrkets. The pricing equilibri of the OEM mrket extend to multiple compnies through structures nd mechnisms described in hked nd utton (983). Yet closed form solutions for the equilibrium design choices re intrctble in settings with more thn two competing firms. A 8

10 sole supplier sells the component t wholesle price w. The component s functionl role is importnt becuse without it, there cn be no finl product. At the sme time the component cnnot perform s full product (recll the memory microchip), therefore the OEM needs to build set of fetures round the component in order for n end consumer to pprecite ny utility. Thus, the OEM determines the performnce qulity q of the product design, nd the retil price p of the end product, while incurring vrible per-unit cost of q 2 + w. Note tht in the trnsction, we ssume supplier powerful enough to void completely constrined decision (i.e. the supplier prices his/her component before the end-product price is determined 6 ). We begin by dpting, to our setting, two bsic results; the optiml decision mking of the verticlly integrted supply chin nd the optiml pricing gme of non-integrted supply chin where the performnce qulity of the end-product is exogenous (i.e. clssic tckelberg gme where the supplier sets the wholesle price). For the verticlly integrted supply chin, the OEM procures the component t the mrginl cost of the supplier, which is normlized to zero. Proposition summrizes the result. Proposition () A two-tier, verticlly integrted, supply chin offers finl product of qulity q = 2 t price of p = nd the totl profit is 3 9 πoem + π = 4. Only 08 3 totl mrket is served. (dpted from Moorthy 984) of the (b) For n exogenous qulity level of q =, two-tier, non-integrted, supply chin 3 offers finl product price of p = 5 nd the totl profit is 8 πoem + π = + 2 = Only of the totl mrket is served (dpted from the clssic tckelberg frmework). 6 Proposition () describes the decisions of n integrted supply chin where the supplier is mnged essentilly s cost center. The results re n dpttion of those by Moorthy (984) for the cse of monopolist providing single product. Proposition (b) itertes the clssic tckelberg result, where the supplier sets the component price nd reps the mjority of the supply chin profits (twice the mount of the OEM). The ltter setting confirms tht, even when the qulity is fixed to the optiml level of the integrted supply chin, the totl supply chin profits re lower thn for the verticlly integrted chin (the infmous double mrginliztion effect). The loss is ttributed to the self interest mximiztion of the 6 This ssumption ensures vible (nd more interesting from n nlysis perspective) setting. Otherwise none of the prties hs n interest in pursuing the trnsction; quick clcultion revels tht if the supplier moves lst in the gme sequence, then s/he prices very high, squeezing out ll the mrgin from the OEM nd prompting her to set p = q = 0. 9

11 firms. We recite these results s benchmrks for the subsequent nlysis nd to cquint the reder with the min insights of the previous literture. For the reminder of the pper, we focus exclusively on the non-integrted supply chin setting. We ctegorize two distinct sequences of decisions in the product development process: (i) the supplier(s) determines the component price w before the design specifictions re finlized (for exmple, gem prices in the dimond mrket determine to lrge extent the cost of the end refined jewels); (ii) the OEM(s) define the end-product design fetures (rchitecturl nd design choices tht determine the overll performnce) before the component price is set by the supplier mrket. Note, the decision sequence does not involve which supply chin member sets the wholesle price, sequence normlly ssocited with tckelberg ledership in the mrketing chnnels literture (Ingene nd Prry, 2004). We ssume the supplier lwys sets the wholesle price for her component. Thus, the trditionl notion of supply chin member becoming tckelberg leder or follower bsed on who sets the wholesle price is ignored in our setting. Insted, we focus on the order of other decisions mde during the design process such s when the supplier should set her price or when the OEM should shre the specific product design with the supplier. Figure depicts the timely differences of the two decision sequences. st ction 2 nd ction 3 rd ction equence O OEM mrket finlizes product(s) specifictions upplier mrket determines component wholesle price OEM mrket prices endproduct Time equence upplier mrket determines component wholesle price OEM mrket finlizes product(s) specifictions OEM mrket prices endproduct Time Figure : Different sequences in end-product finliztion 0

12 Our ctegoriztion couples two importnt determinnts of firm performnce: the product design choices (vi the determintion of the end-product performnce qulity) with the supply chin configurtions (single versus multiple suppliers, nd single versus multiple OEMs). Through this structure we pursue the 3-D product development decisions (Fine, 998). For nottionl ese, cll the two sequences nd O (corresponding to the supply chin member who mkes the first trnsction), defined respectively below: equence : upplier sets component price OEM finlizes design performnce OEM sets price equence O: OEM finlizes design performnce upplier sets component price OEM sets price For the reminder of this pper, we use the subscripts nd O to differentite our decision vribles nd prmeter vlues between the two sequences lthough we drop the subscript when convenient. The following Proposition offers the comprtive results cross both decision sequences in the monopoly-supplier, monopoly-oem setting. Proposition 2 For j {, O}, the optiml end-product qulity q, price p component price w, totl mrket sles D, supplier nd OEM profits π, π OEM, supplier profit premium nd totl supply chin profit re higher in sequence j s follows: Vrible q p w D π π OEM π π OEM π OEM + π γ = πoem π Higher in sequence O O O O Proposition 2 revels the opposing preferences cross the two firms of the supply chin. The supplier clerly prefers setting the wholesle price under full informtion with respect to the design (i.e. she prefers sequence O), wheres the OEM benefits more from finlizing the product qulity only fter the component price is determined (i.e. he prefers sequence ). At first sight, the outcome is puzzling; both members of the supply chin benefit from decision sequences tht retrct them from the power stndpoint of the first mover dvntge. Thus, the supplier enjoys higher profit despite the fct tht she gives up her first mover role, nd she chrges less for ech component (note tht w > w O). equence O is strightforwrd extension of the clssic tckelberg scenrio: the member of the supply chin tht sets the wholesle price enjoys twice the profit over the other member (see the Appendix for the exct solutions under ech sequence). The supplier pproprites more of the totl supply chin

13 profits wheres the OEM hs little control of the division of profits despite the fct tht he determines, through q, the size of the overll demnd. Thus, in sequence O, when the OEM chooses q, he determines the totl supply chin profit but cn not ffect the percentge of the totl profit he enjoys. Once the demnd curve is set (bsed on the OEM s choice of q), the decision sequence is exctly the sme s the clssic tckelberg gme described in Proposition b nd the supplier sets w to pproprite two thirds of the totl supply chin profit. The only lever vilble to the OEM lies in trying to induce higher demnd nd increse his profit. Therefore, he sets the performnce qulity nd the price reltively low; i.e. he pursues high volume but not high mrgins. The high volume strtegy dopted by the OEM, however, mkes the supplier better off. Interestingly, sequence grnts the supplier less power despite the fct tht she opertes under wholesle price ledership role. he is obliged to set the component price without full knowledge of the demnd curve, nd s result, the only lever for her to pproprite higher profits is by ensuring high mrgin (i.e. high w ), even though the ltter my induce smller demnd (which it does, s ttested by D < D O ). Concerning the OEM s strtegy, sequence grnts him the bility to retin higher shre of the totl supply chin profits when compred with sequence O (still γ < indicting tht the supplier retins the mjority of the supply chin profit). Therefore, in contrst to sequence O, the OEM pursues higher mrgins t the expense of lower volume. The extr percentge of the totl profits the OEM enjoys stems from the bility to set both the demnd nd the price under known component cost, thus reserving higher profit. In sense, the extr gin is rent the OEM pproprites due to full informtion, which dilutes the severity in the profit splitting observed when double mrginliztion tkes effect. The informtion rent effect is lso ttested by the difference in the totl supply chin profits. Compring the totl profits of both sequences to the integrted supply chin s profit in Proposition, there is bigger drop in the totl profit under sequence where the supplier determines the component price first. Thus, the supplier precommitment intensifies the loss due to the double mrginliztion effect. From mngeril stndpoint, the results dictte creful ssessment of the bility to integrte stndrdized components in the product design. Note tht the issue of intellectul property is t ply here, since we ssume sole supplier without competition (probbly protected under ptent enforcement), which permits the supplier to exploit the OEM. Yet, the OEM my relx the severity of the totl profit division losses by locking in the com- 2

14 ponent prices before his design is finlized. Higher stndrdiztion in the end-product, s proxied through the inclusion of the off-the-shelf component, seems to come t socil cost however, s the inclusion of the independent supplier drives the end-product cost higher, rendering the end mrket size smller with fewer consumers served. There is n dditionl interesting insight reveled from our nlysis: the qulity-quntity trde-off in the socil welfre. We explicitly stte it in Proposition 3. Proposition 3 Assume tht the indifferent consumer between buying or not buying is of type θ j for sequence j {O, }. There is threshold consumer type θ such tht the individul consumer preferences for ech sequence re s follows: Mrket segments (0, θ O ) (θ O, θ ) (θ, θ) ( θ, ) equence with higher u(θ) None O O While sequence O results in higher portion of the consumers stisfied (higher quntity), segment of the very sensitive to qulity consumers obtins higher utility from sequence. till, this high end segment, in combintion with the higher qulity offering (despite the lso high price) is enough to chnge the result with respect to the verge enjoyed consumer utility (i.e. 0 u (θ)dθ > 0 u O(θ)dθ), indicting tht, on verge, the consumers enjoy higher utility under sequence. This lst result describes the impct on consumer utility. It revels tht wheres sequence O stisfies more consumers, sequence stisfies them better. In fct, the high-end consumers benefit substntilly from sequence becuse it enforces higher qulity product, thus providing them with more utility. This result does not directly trnslte into n bsolute preference for sequence from socil welfre perspective. Answers to the question is providing more customers with mrgin improvement in consumer utility better thn substntilly incresing the utility of few customers? reltes more to public policy economics nd is beyond the scope of our study. 5. The Role of Competition In this section we deprt from the bse-cse restriction of monopolistic mrkets in either the upstrem or the downstrem industries in the supply chin. As we introduce competition t the different tiers of the supply chin, we retin our focus on the timing of the product definition. 3

15 5. The cse of upstrem competition (OM cse) Assume the technology to produce the stndrdized upstrem component is not subject to IP restrictions, llowing its production by n supplier firms who compete in terms of their cpcity ( l Cournot). This underlying ssumption finds immedite ppliction in industril settings where the upstrem mrket supplies commodity rw products (e.g. silicon, milk, corn, steel etc.) without low concentrtion, nd it offers resonble pproximtion for more generl settings where there is mild competition (i.e. less hrsh thn Bertrnd) t the component tier of the supply chin 7. As in the previous section, we ctegorize our nlysis with respect to the timing of the design decision. equence represents industril settings where the supplier mrket, lbeit competitive, determines the component price before the performnce nd design qulity decisions re mde by the OEM. In sequence O the OEM invests nd finlizes the product design detils prior to receiving component price from the suppliers. In such setting, the OEM gurntees mjor volume for the suppliers (pproximted through the monopoly downstrem cse), therefore he cn proceed with the product definition without finl upstrem price; i.e. energy monopolies in Europen countries. As before, the monopolist OEM chooses the qulity offering q nd the price p. The upstrem mrket supplies the common component t mrket clering price w. Assuming mrket clering mechnism llows trctbility while retining the essentil fetures of competition: lower prices resulting from higher quntities of components. It lso llows us to pproximte the competition intensity through the number of supplying firms. In the Appendix, we derive the optiml decisions for generl mrket structures (n = 2, 3,... ) but in the min text we report on the opposite ends of the spectrum: in the presence of n upstrem duopoly nd the perfect competition cse with n extremely lrge (n ) number of suppliers. As the number of suppliers pproches, the results converge to the integrted supply chin results of Proposition, since the upstrem mrket ends up competing solely on price. Let πi represent the sum of the suppliers profits for i = 2,...n where n (2, 3,... ). Proposition 4 compres the non-integrted supply chin s optiml solutions for ech vrible under the monopoly-supplier, monopoly-oem (M M) setting versus the oligopoly-supplier, monopoly-oem setting (OM). These results re independent of the design sequence nd of the number of suppliers. 7 Note tht in the event the upstrem competition is in prices the resulting optiml choices coincide with the results of Proposition (). 4

16 Proposition 4 The presence of upstrem competition introduces unidirectionl effect, independent of the timing of the product definition or the number of suppliers: Vrible p w D π i π OEM π OEM + πi Lrger under setting MM 8 MM OM MM OM OM As expected, the upstrem competition lters the blnce nd shifts profits wy from the supplier mrket to the downstrem monopolist OEM. The shift is unidirectionly independent of the sequence for the component price, end-product price, nd totl demnd served. However, we show in the Appendix tht the end product qulity decreses (in order to increse the overll sles) only in sequence. Hence, the OEM is ble to tke dvntge of the supplier competition nd reduce the qulity only when the component price is set beforehnd. This is direct consequence of the informtion vilbility. In the event of setting the product qulity before knowing the component price (sequence O), the OEM retins the sme qulity level s in the upstrem monopoly cse to ensure the suppliers do not exploit the opportunity nd retin their high prices. With respect to the double mrginliztion effect, the totl supply chin profit increses under the cse of upstrem competition. As competition intensifies upstrem (n ), the mrginl profit on ech component decreses llowing the OEM to ct s n integrted mnufcturer. Proposition 5 compres the effect of the product definition timing in the presence of duopoly suppliers. Proposition 5 For n = 2 nd j {, O}, the optiml end-product qulity q, price p component price w, mrket size D, supplier nd OEM profits π, π OEM, supplier profit premium nd totl supply chin profit re higher in sequence j s follows: Vrible q p w D π i π OEM π OEM πi π OEM + πi γ Higher in sequence O O O O Proposition 5 compres the qulity offering, the socil welfre, nd the profits of the supply chin members, cross the two sequences. equence O extends the originl tckelberg frmework for competitive suppliers. Under the presence of competition, the upstrem mrket is severely penlized s ttested by Proposition 4. As expected, the OEM pproprites the biggest shre of the totl supply chin profit under both sequences since he defines the overll demnd by setting q nd, t the sme time, enjoys lower prices due to the upstrem competition (for the detiled clcultions plese refer to the Appendix). As opposed to the 5

17 monopoly-monopoly setting, things get even worse for the supplier mrket under sequence. Given tht the competing suppliers fce n unknown demnd (no credible commitment by the OEM), they intensify their competition under sequence to ensure tht, for ny potentil demnd curve, they will t lest enjoy high sles volume (chieved through lower component prices). The OEM on the other hnd, experiences lower component price under sequence without ny commitment to set for the overll demnd, hence he exploits the resulting competition even more nd obtins higher rent pproprition, s the γ index shows. Thus, the supplier mrket is better off under sequence O, exctly becuse they retin the bility to determine the end-product price under known nd committed demnd curve. Agin, the informtion vilbility benefits the second mover in the trnsction. From mngeril stndpoint, our result confirms the observtions bout severe competition in generic commoditized component mrkets, such s the recent price competition in the microprocessor mrket between Intel nd AMD (Dunn, 2006). The result is lso in line with the conjectures of the technology mngement literture (Bldwin nd Clrk, 2000) concerning the impct of different rchitectures (integrtble versus modulr) on the industry structure. Modulr rchitectures require stndrdized interfces, rendering the component mrkets more commoditized (since ny upstrem component is good enough s long s it dheres to the interfce stndrds), therefore they intensify within tier competition. 5.2 The cse of downstrem competition (MO cse) Our finl cse is setting where sole supplier offers stndrdized component to two competing OEMs tht my differentite their offering both in price nd performnce qulity. This supply chin structure represents industril settings where the upstrem mrket is dominted by single supplier (potentilly holding lw enforced ptents on the component technology), but the downstrem mrket is competitive with respect to the preferences of the end consumers. As in the previous cses, we explicitly consider the product definition timing nd distinguish between the two different sequences nd O. The OEMs choose the qulity offerings q i nd the prices p i (i =, 2). The upstrem supplier prices the component used by both OEMs t w. We restrict the downstrem competitors to two firms, due to the intrctbility to obtin closed form solutions even for this simple cse (this intrctbility is not peculirity of our setting but generlly cclimed difficulty; for more on this see the originl work by Moorthy 988). Lemm presents the end-product pricing s function of the competing qulity levels nd the supplier s component price. 6

18 Lemm The end-product pricing equilibrium is p 2 (q 2, q, w) = 2q2 q 2+3w+2q 2 2q +q 2 2 4q 2 q if q 2 > q q2 2 + w if q 2 = q 2q q2 2+2q w+wq 2 +q 2 q 2+q 2q q2 2 4q q 2 if q 2 < q () Through Lemm, it becomes pprent the two competing OEMs re obliged to differentite their products in terms of qulity becuse in the event of the sme qulity, they both mke zero profit (they set their prices equl to their mrginl cost, well known result of the Bertrnd competition structure). Note lso tht the end-product pricing decisions re independent of the sequence of decision mking since the end-product price is chosen lst in both sequences. The Lemm indictes seprting equilibri where one firm chooses low qulity nd the other firm chooses high qulity (indicted by subscripts L nd H respectively). The existence of two symmetric equilibri follows directly from Moorthy 988, s the following Corollry sttes. Corollry In both sequences nd O, there exist two symmetric equilibri for the OEM mrket: (q, p ) nd (q 2, p 2) such tht q = q L nd q 2 = q H (2) As in the originl work of Moorthy (988), we derive the optiml qulity levels numericlly for given vlues of the qulity investment cost. By minimizing the sum of the squred differences, we determine the best fitting curves q (), q 2 () to the clculted numericl vlues (results re provided in the Appendix). In Proposition 6, we compre the effect of the decision sequence in the presence of duopoly OEMs. Then, in Proposition 7, we discuss the effects of upstrem versus downstrem competition on the overll supply chin performnce nd the socil welfre. Proposition 6 For two OEMs nd j {, O}, the optiml product performnce qulities q H,j, q L,j, the corresponding end-product prices p H,j, p L,j, the component price w j, the mrket size D H,j, D L,j the supplier nd OEM profits π j nd the totl supply chin profit re higher in sequence j s follows:, π OEM, π OEM, the supplier profit premium H,j L,j π OEM i Vrible qh ql p H p L w DH DL π πh OEM πl OEM equence O O O O O 7 π OEM i + π

19 Proposition 6 highlights the conflicting incentives cross the competing OEMs. The low qulity OEM benefits more from sequence O where he defines his product qulity before knowing the supplier s component price. In contrst, the high qulity OEM prefers knowing in dvnce the component price. The difference stems from similr logic s in the duopoly suppliers cse. A predetermined component cost (sequence ) essentilly restricts the overll mrket by inflting the overll product costs. Thus, the component price determines the totl mrket size, incresing the competition mong the OEMs trying to differentite themselves in given mrket. With smller totl mrket, the low qulity OEM is obliged to increse his qulity nd price to retin n cceptble level of profits, thus reducing his mrket size. The severity of the competition mong the OEMs is lso ttested by the mgnitude of the product differentition (i.e. q H q L ), which is smller in sequence. This is lso seen through the totl supply chin profits. Once competition intensifies, the totl profit in the supply chin declines. Note however, the different effect of the locus of competition on the totl supply chin profits: When the competition tkes plce in the supplier mrket, the mximum totl supply chin profits re ttined under sequence. Here, the sme result is chieved when the OEMs set their qulities first (sequence O). The underlying phenomenon is the sme lthough it mnifests itself differently. In either cse, when the competing prties commit to their decisions with less informtion, the competition mong them intensifies, benefiting the other supply chin tier. In the second cse (OEMs competing), higher intensity implies tht qulities re set higher nd tht fewer consumers buy, but t higher mrgin. Finlly, due to the stronger OEM competition, sequence O results in higher totl demnd D H + D L. From the supplier s perspective, her preferred choice of the design sequence chnges when there is competition t the OEM level. For the MM nd OM cses, the supplier(s) prefers full knowledge of the product design before setting the component price (sequence O). With duopoly competition mong the OEMs however (the MO cse), she prefers to set the component price before the OEMs set their qulities (sequence ). To see why, consider the MM bse cse If the supplier moves first in this scenrio, she must price the component low so the OEM will invest in lrge enough qulity level nd price the end-product low enough to ensure sufficient demnd. When there is competition t the OEM level however, the OEMs lredy hve n incentive to differentite their products (through their price nd qulity choices) s much s possible. Thus, the supplier cn price the component higher nd still enjoy the benefits of lrge end-product demnd. Thus, volume-bsed strtegy 8

20 becomes ttrctive. The mngeril tke wy once more emphsizes the component nture. tndrdized components with fixed prices render differentition less ttrctive device for profit pproprition, nd the OEMs compete more intensively. Especilly for components with ptented technologies, the impct on product differentition results in socil welfre loss, potentilly opening up mrket spce for dditionl competitors (since lrger prt of the totl demnd remins unstisified). Proposition 7 compres the duopoly-supplier, monopoly-oem structure with the monopolysupplier, duopoly-oem structure. Proposition 7 The component cost (w ), the totl demnd served (D ), nd the totl supply chin profits re higher under the MO cse thn the OM cse. These results hold under both design sequences. Proposition 7 compres the key indices cross the two competition scenrios. When compiled together, the results revel n interesting insight: despite the fct tht the endproduct demnd increses (signling lower on verge prices) nd the component price is higher under the M O cse, the totl supply chin profits re lso higher. The increse is driven by the existence of verticl differentition which llows the OEMs to retin (on verge) some of the vlue even though they py higher prices to the monopoly-supplier upstrem. Thus, verticl differentition downstrem dilutes the upstrem monopoly power, llowing higher rent pproprition. From socil welfre stndpoint, when components re commodities but end-products re qulity differentited, it is better to llow monopolies t the supplier level thn t the OEM level (t lest in terms of totl demnd served). 6. Conclusions nd Discussion In this pper, we provide normtive perspective on erlier conjectures in the literture bout the potentil interdependence between product design decisions nd supply chin trnsctions (Fine 998). We consider the strtegic interply between the upstrem supplier mrket nd the downstrem end-product mrket given tht (i) the end customers vlue qulity heterogeneously, nd (ii) the product design requires stndrdized component to offer complete functionlity. In such setting, the OEM(s) must decide on the product design fetures by tking into ccount the entire product rchitecture (i.e. component sourcing, or 9

21 IP component integrtion) nd the timing of the ssocited decisions (before or fter the prices hve been set for the components). There cn be two possible times for this decision, which we proxy through the sequence of ctions tking plce during our gme theoretic bstrction of the phenomenon. In the first sequence, the supplier mrket defines the component price before the downstrem firm(s) finlize the product design specifictions (i.e. the performnce qulity level) of the end-product. In the second sequence, the downstrem OEM(s) determines the product design detils (through irreversible investments in product development nd resources) before the supplier mrket sets the component price. The OEM s choice of the end-product qulity influences the resulting mrket potentil (nd differentites the product offerings in the cse of competing OEMs) t cost tht is incresing in the level of qulity. The supplier s choice of the component price influences the OEM s totl mrginl cost, nd subsequently, the end-product price, thus indirectly determining the supplier s demnd. We explore how the timing of the product design definition influences the component wholesle pricing, the product performnce qulity, the finl selling price of the end-product, nd profits for both the supplier, OEM, nd the totl supply chin. We extend our nlysis to ccount for competitive settings within the different tiers in the supply chin. From the outset, our model offers comprehensive frmework for identifying the interctions between the product design definition nd the trnsction structure cross the supply chin tiers. To our knowledge, no other study hs concurrently nlyzed both design relted decisions nd supply chin strtegic interctions, the ltter considered within nd cross tiers. till, s in ny normtive model, our results should be viewed with cution when trnslting them into mngeril ctions. Our gol is not to offer decision support system but rther to provide directionl insights s to the impct on specific decision vribles. We find the timing of the design definition ffects the profits of the supply chin members in mngerilly relevnt wys. The stndrd notion of the decision leder, in the gme theoretic sense, does not lwys lign with the pyoff outcomes. Under monopoly-supplier, monopoly-oem setting, the OEM benefits from defining the product qulity before the component price is set by the supplier. ymmetriclly, the supplier prefers to finlize component prices fter the OEM s design decisions nd investments re set, thus lso refrining from leder dvntge. These timing preferences my chnge however, if there is competition t either tier of the supply chin. Thus, in monopoly-supplier, duopoly-oem setting, the supplier nd the OEM producing the high qulity product benefit more from fixed upfront 20