Information technology, incentives and the optimal number of suppliers

Buyers are transforming their relationships with suppliers. For example, instead of playing off dozens or even hundreds of competing suppliers against each other, many firms are finding it move profitable to work closely with only a small number of “partners”. In this paper we explore some causes and consequences of this transformation. We apply the economic theory of incomplete contracts to determine the optimal strategy for a buyer. Surprisingly, we find that the buyer will often maximize profits by limiting its options and reducing its own bargaining power. This may seem paradoxical in an age of cheap communications costs and aggressive competition. However, unlike earlier models which focused on coordination costs, we focus on the critical importance of providing incentives for suppliers. Our results spring from the need to make it worthwhile for suppliers to invest in “non-contractibles” like innovation, responsiveness and information sharing. Such incentives will often be stronger when the number of competing suppliers is small. The findings of the theoretical models appear to be consistent with observations from empirical research which highlight the key role of information technology in enabling this transformation