Operational collaboration between rivals: The impact of cost reduction

Business rivals often collaborate on specific aspects of their operations in order to achieve cost efficiency. To better understand and manage such an operational collaboration, we formulate a multi-stage duopoly competition model to study the strategic and welfare implications of a cost-reducing cooperation between competing firms. Without any additional agreement beyond the collaborative effort in deterministic cost reduction, we characterize intuitive conditions under which there exists a unique equilibrium for the operational collaboration, where the high-cost firm inputs more effort. Furthermore, the equilibrium cost reduction would benefit both firms when they have similar costs and/or their products have small substitutability. Moreover, such a pure operational collaboration never hurts consumer surplus. We then consider the effect of facilitating agreements and find that, with a properly designed unit transfer payment, the competition may be softened so that both firms are willing to collaborate. However, consumer surplus may decrease as a consequence. Finally, we assume that firms could receive signals of some random shock on the cost reduction process and examine the resulting Bayesian game. If the random shock is on the cost reduction fraction, then firms' equilibrium efforts could be independent of the random signal. If, however, the random shock is on the effort, then we apply simplifying assumptions and use special stochastic orders to capture the impact of signal variability on firms' effort levels. Our findings provide useful managerial insights into the underlying drivers of an operational collaboration between rivals.