Capacity Games in Assembly Systems with Uncertain Demand

Yunzeng Wang
Weatherhead School of Management
Case Western Reserve University
yxw36@weatherhead.cwru.edu

Yigal Gerchak
Tel Aviv University

Consider an assembly firm who needs multiple components each produced by a different supplier. In order to produce the components and assemble the final product, firms involved need to first build up their individual production capacities.  The firms have an incentive scheme (contract) to induce a “proper” capacity build-up. The key parameters of the contract are a set of transfer prices the assembler pays each supplier for a unit of its component. We consider two scenarios as for how the terms of the contract are determined and study their corresponding equilibrium capacity decisions and channel performance. The first is one where the assembler sets up the transfer prices. The second scenario is for the suppliers to simultaneously choose the prices each wants to charge. We first characterize the optimal capacity decision when the system is centralized, and then derive the decentralized equilibrium system capacity under each of the two game settings. We show that system structure/parameters heavily affect decentralized channel performance. However, the specific ways by which a parameter affects the performance under the two game settings dramatically differ from each other. The analyses then allow us to draw important, managerial implications on managing decentralized assembly systems.