Bargaining Power of Suppliers: Aggregation Of Supply

BARGAINING POWER OF SUPPLIER •Bargaining power is the ability to influence the setting of prices. •The more concentrated and controlled the supply, the more power it wields against the market. •Monopolistics or quasi-monopolistic suppliers will use their power to extract better terms (higher profit margins or ) at the expense of the market. •In a truly competitive market, no one supplier can set the prices. Aggregation of Supply •Suppliers can group to wield more bargaining power. •This aggregation can take different shapes. •Cartels try to influence prices to their own advantage.

In most developed countries cartels are illegal. •Sometimes suppliers have secret collusion agreements that are difficult to prosecute. •In most developed countries, a watchdog is responsible to protect well functioning markets from excessive supply aggregation. •Cartels, like monopolists, will prefer higher prices (i. e. higher profit margins) at lower quantity, thus choosing a point on the supply curve that will not supply for all the buyers that would buy at the lower free market price. Examples Industries facing powerful suppliers: The PC making industry faces the almost monopolistic power of operating system supplier. Microsoft has abused its power a number of times and had to be reined in by competition watchdogs all over the world. •Industries using diamonds, such as jewelry and electronics, face the huge power of DeBeers, that takes advantage of the supply concentration to achive dominant market share Industries facing weak suppliers: •Food processors can buy agricultural produce from many, weak small and medium farmers. •Retail stores can fill their shelves with many competing products from different producers. Airlines face a duopoly of two equally powerful competitors (like Airbus and Boeing in the aviation industry). Although they are both big and powerful, the threat of substitution is enough to keep their power at bay. BARGAINING POWER OF BUYER •Bargaining power is the ability to influence the setting of prices. •Monopsonistic or quasi-monopsonistic buyers will use their power to extract better terms (higher profit margins or ) at the expense of the market. •In a truly competitive market, no one buyer can set the prices. Instead they are set by supply and demand. Prices are set by supply and demand and the market reaches the Pareto-optimal point where the highest possible number of buyers are satisfied at a price that still allow for the supplier to be profitable. Supply and Demand •The supply curve is the relationship between price and supplied quantity. Normally, the higher the price, the higher the supplied quantity as more supplier will be interested to produce and sell at a higher price. •The demand curve is the relationship between price and demanded quantity. Normally, the lower the price, the higher the demanded quantity as buyers will be willing to buy more at a lower price. In a truly competitive market, supply and demand meet at the price where the supplied quantity equals the demanded quantity. •If supplied quantity is higher, price will fall. •If demanded quantity is higher, price will raise. Examples Industries facing powerful buyers: •Defense contractors have a limited set of politically motivated buyers (governments). •Sub contractors to car makers have a limited set of potential clients, each commanding a large share of their market. Industries facing weak buyers: •Retailers face individual consumers with little or no power at all. BARRIERS TO ENTRY Barriers to entry are obstacles on the way of potential new entrant to enter the market and compete with the incumbents. * The difficulties of entering a market can shelter the incumbents against new entrants. * Incumbents’ profits are potentially higher than in a truly competitive market, at the expenses of their suppliers and buyers. * The higher the barriers to entry, the more power in the hand of the incumbents. The two most important barriers to entry are: * Capital requirements * Government policy and regulations There are plenty of other potential barriers that might scare new entrants away: * Proprietary products and knowledge Access to inputs and distribution * Economies of scale and other cost advantages * Switching costs and brand identity Examples Industries with high barriers of entry: * Car making: high upfront capital investment in manufacturing equipment; compliance with safety and emission rules and regulation, access to parts suppliers, development of a network of car dealerships, big marketing campaign to establish a new car brand with consumers. * Mining: access to inputs restricted through natural distribution and government licenses, very specific/proprietary exploration knowledge, big investment in machinery.

Industries with low barriers of entry: * Computer Hardware retailing: everybody can start a home-based mail order business for computer parts. It takes little government permits, wholesaler are open for every reseller, there is no need to keep large stock, information is freely available on the internet. * Photography Services: little initial capital investment, no regulation, no economies of scale (the limiting factors are the photographer’s time and his geographical location). BARRIERS TO EXIT •Barriers to exit are obstacles to market players who realize that they will not turn a profit and would like to quit the market. The difficulties of exiting a market can force a player to keep competing as the least bad alternative. •The increased competition affects negatively the other incumbents. •Incumbents’ profits are potentially lower than in a truly competitive market, to the advantage of buyers. The most important barrier to exit is the lack of alternative, more profitable use of the assets in which the business has already invested. The costs of producing a product or service can be roughly split into fixed and variable costs. •Fixed costs represent the up front investment in machinery and other assets needed to produce the product or service. Variable costs represent the additional per unit costs, labor and material. From an economic perspective, it makes sense to produce and sell an additional unit of product or service if the revenue generated covers at least for the variable costs. What is left beyond covering variable costs is a contribution to reduce the loss on the assets. Examples Industries with high barriers to exit: •Wireless Telecom: the production of an additional minute of wireless call costs virtually nothing, most costs being up front investment in expensive equipment deployment. Air Travel: adding a passenger to a scheduled airplane cost just a little bit of kerosene, as opposed to the huge cost of idle airplanes. Industries with low barriers to exit: •Retail: inventory can be moved to more profitable markets or liquidated. •Personal care services: labor is the most important price factor for these services. THREAT OF SUBSTITUTION •On a free market, buyers have the choice if there is a viable alternative. •Substitute source. The exactly same product is sourced by two or more distributors. •Full substitute products are products from different manufacturers that fulfill the exact same purpose.

For example Kellog’s corn flakes and generic brand corn flakes. •Partial substitues are products that only partially substitute each other. A holiday in Venice is not exactly the same as a holiday in Amsterdam, even though they are both cities and they both feature channels. Protecting against substitution •Distributors may try to protect themselves against substitution with exclusive distribution agreements. Buyers circumvent them with so called grey market imports. •Producers may try to protect their products with strong branding, trade marks, patents and other psychological and legal barriers against substitutes. Another way to protect from substitution is to make the products incompatible with competing products. An example are the different lens systems for SLR cameras. •In general, protectionism against substitutes is bad for the consumer/buyer and good for the seller. Examples Products/services facing a strong threat of substitution: •Washing powder. A dozen of brands sitting on the shelves and waiting for consumers to pick them up. Consumer will often pick up the one that is on special on shopping day. •Retail Outlets. Don’t like Wal*Mart? Shop at Carrefour. Products/services facing a weak threat of substitution: •Oil.

Although alternative forms of energy are being studied and introduced, most engines today run on gasoline. Gasoline can not be replaced that quickly on a large scale. •Pharmaceuticals in the short term, because they are protected by patents. In the long term, generics can dent their market share and profits. ( http://www. photopla. net/wwp0503/substitutes. php) Barriers To Entry Barriers to entry are designed to block potential entrants from entering a market profitably. They seek to protect the monopoly power of existing (incumbent) firms in an industry and therefore maintain supernormal (monopoly) profits in the long run.

Barriers to entry have the effect of making a market less contestable The economist Joseph Stigler defined an entry barrier as “A cost of producing (at some or every rate of output) which must be borne by a firm which seeks to enter an industry but is not borne by firms already in the industry” This emphasises the asymmetry in costs between the incumbent firm (already inside the market) and the potential entrant. If the existing businesses have managed to exploit some of the economies of scale that are available to firms in a particular industry, they have developed a cost advantage over potential entrants.

They might use this advantage to cut prices if and when new suppliers enter the market, moving away from short run profit maximisation objectives – but designed to inflict losses on new firms and protect their market position in the long run. EXAMPLES OF BARRIERS TO ENTRY Patents Giving the firm the legal protection to produce a patented product for a number of years (see below) Limit Pricing Firms may adopt predatory pricing policies by lowering prices to a level that would force any new entrants to operate at a loss Cost advantages

Lower costs, perhaps through experience of being in the market for some time, allows the existing monopolist to cut prices and win price wars Advertising and marketing Developing consumer loyalty by establishing branded products can make successful entry into the market by new firms much more expensive. This is particularly important in markets such as cosmetics, confectionery and the motor car industry. Research and Development expenditure Heavy spending on research and development can act as a strong deterrent to potential entrants to an industry.

Clearly much R spending goes on developing new products (see patents above) but there are also important spill-over effects which allow firms to improve their production processes and reduce unit costs. This makes the existing firms more competitive in the market and gives them a structural advantage over potential rival firms. Presence of sunk costs Some industries have very high start-up costs or a high ratio of fixed to variable costs. Some of these costs might be unrecoverable if an entrant opts to leave the market. This acts as a disincentive to enter the industry.

International trade restrictions Trade restrictions such as tariffs and quotas should also be considered as a barrier to the entry of international competition in protected domestic markets. Sunk Costs Sunk Costs are costs that cannot be recovered if a businesses decides to leave an industry Examples include: ” Capital inputs that are specific to a particular industry and which have little or no resale value ” Money spent on advertising / marketing / research which cannot be carried forward into another market or industry When sunk costs are high, a market becomes less contestable.

High sunk costs (including exit costs) act as a barrier to entry of new firms (they risk making huge losses if they decide to leave a market). A good example of substantial sunk costs occurred in 2001 when British Telecom announced it was scrapping its loss-making joint venture with US telecoms firm AT. The closure was estimated to lead to the loss of 2,300 jobs – almost 40% of Concert’s workforce. And, it will cost BT $2bn (? 1. 4bn) in impairment charges and restructuring costs, and AT&T $5. 3bn.