Abstract: This paper investigates the decision equilibrium for duopoly manufacturers (M1 and M2) who produce vertically differentiated products and compete in the market where the customers have heterogeneous preferences for the quality of products. M2 can produce components of final products by itself, whereas M1 has to rely on the components from its rivals or other suppliers. No matter whom M1 purchases from, there is identical unit sourcing cost. The results show that M2 always agrees to supply components for M2 and M2 always selects its rivals as the supplier. However, it does not mean that cooperation certainly occurs, because M1 may be pushed out of the market by M2 under price competition. In fact, in equilibrium, competition and cooperation either coexist with or exclude each other. Specifically, when the cost parameter of the industry is small, the manufacturers cooperate with each other on component supply in upstream and fight for market share in downstream; that is, competition coexists with cooperation. When the cost parameter is large (the cost disadvantage caused by quality advantage is large), M2 either pushes M1 out of the market by setting a low price (namely, competition excluding cooperation) if M2 has a lower product quality than its rivals, or only supplies components for M1 and hands the market to its rival (namely, cooperation excluding competition) if the opposite is the case.

Key words: supply chain, competition, cooperation, quality, heterogeneous preference