Demystifying the Smiling Curve in a buyer-driven global supply chain-an O-Ring theory perspective

Abstract

This paper explores a theoretical framework about mechanism of divisions of the gains in the global supply chain by incorporating the O-Ring theory model developed by Kremer (1993) into the sequential production framework. By introducing the vertical constraint so called quantity forcing, the double marginalization problem would be eliminated under a joint-profit maximizing contract among firms in the supply chain. Motivating by the recently widely discussed concept called “smiling curve” in the management and international business literature, this paper found that the variation of average profitability along firms producing at different production stages in the supply chain illustrates the U-shaped curve depends on the nature of supply chains. (buyer driven or producer intensive). For the U-shaped curve to hold in the producer-driven supply chains, it must be the case that the firms specializing at higher value-added stages have higher market power than firms at low value-added stages. For the U-shaped curve to hold in the buyer driven supply chains, the market power of firms spanning the chain does not necessarily matter. The only thing matters is to ensure firms specializing at higher value-added stages have higher labour productivity.