Improving Supplier Yield under Knowledge Spillover

We study the effect of knowledge spillover on OEM manufacturers’ efforts to improve suppliers’ process yield. The OEM manufacturers compete with imperfectly substitutable products, and they share a common component supplier whose production process is subject to random output due to variations in quality or production yield. We characterize the manufacturers’ equilibrium improvement efforts and provide managerial insights on market characteristics that influence the manufacturers’ equilibrium improvement efforts. With spillover effect, each manufacturer’s feasible strategy set of improvement effort is dependent on the strategy adopted by its competitor, and the set of joint feasible strategies is not a lattice. As such, the existence of equilibrium on improvement effort is not guaranteed. Nevertheless, we are able to characterize sufficient conditions for the existence of the manufacturers’ equilibrium improvement efforts with a surrogate game. From a managerial point of view, we find that, contrary to common wisdom, spillover effect often brings favorable improvement to the manufacturers’ expected profits, regardless of whether the manufacturers are asymmetric or symmetric. We also find that manufacturers’ improvement efforts typically decline in market competition or market uncertainty, although, paradoxically, both manufacturers benefit from increased spillover effect.