Pricing and ordering decisions in a supply chain with downward substitution and imperfect process yield

We consider a manufacturer sourcing from two suppliers of asymmetric component quality and producing a quality-differentiated product, namely a low- and high-quality version, with each having deterministic demand. The manufacturer adopts the existing process to produce low-quality products with components from the supplier with low component quality, and develops a new process to produce high-quality products with components from the supplier with high component quality. The new process has imperfect yield, and products that do not meet the specifications for high-quality products can substitute for low-quality products produced with the existing process. We investigate the suppliers’ price decisions and the manufacturer's ordering and production decisions in a game-theoretical model under dual sourcing. Our analyses reveal that increasing product differentiation or higher yield of high-quality products do not necessarily translate to a higher profit for the manufacturer. In light of the manufacturer's sourcing strategies, we show that sourcing from a single supplier with high- and low-quality components yields a lower profit than sourcing from one supplier with high component quality and the other with low component quality. Finally, we investigate the manufacturer's decision-making with endogenous yield rate of high-quality products. Our analyses demonstrate that the manufacturer benefits from setting the yield rate of high-quality products ahead of the suppliers’ price decisions.