The Power of Suppliers
MANEC 387
Economics of Strategy
David J. Bryce
David Bryce © 1996-2002
Adapted from Baye © 2002
The Structure of Industries
Threat of new
Entrants
Bargaining
Power of
Suppliers
Competitive
Rivalry
Threat of
Substitutes
From M. Porter, 1979, “How Competitive Forces Shape Strategy”
David Bryce © 1996-2002
Adapted from Baye © 2002
Bargaining
Power of
Customers
Market Supply Curve
• The supply curve shows the amount of a
good that will be produced at alternative
prices.
• Law of Supply
– The supply curve is upward sloping
Price
S0
Quantity
David Bryce © 1996-2002
Adapted from Baye © 2002
What Shifts Supply?
•
•
•
•
•
•
Input prices
Technology or government regulations
Number of firms
Substitutes in production
Taxes
Producer expectations
David Bryce © 1996-2002
Adapted from Baye © 2002
The Supply Function
• An equation representing the supply curve:
QxS = f(Px , PR ,W, H,)
–
–
–
–
–
QxS = quantity supplied of good X.
Px = price of good X.
PR = price of a related good
W = price of inputs (e.g., wages)
H = other variable affecting supply
David Bryce © 1996-2002
Adapted from Baye © 2002
Change in Quantity Supplied
Price
A to B: Increase in quantity supplied
S0
B
20
A
10
David Bryce © 1996-2002
Adapted from Baye © 2002
5
10
Quantity
Change in Supply
S0 to S1: Increase in supply
Price
S0
S1
8
6
5
David Bryce © 1996-2002
Adapted from Baye © 2002
7
Quantity
Producer Surplus
• The amount producers receive in excess of the
amount necessary to induce them to produce the
good.
Price
S0
P*
Producer
Surplus
Q*
David Bryce © 1996-2002
Adapted from Baye © 2002
Quantity
Market Equilibrium
• Balancing supply and
demand
QxS = Qxd
• Steady-state
David Bryce © 1996-2002
Adapted from Baye © 2002
If price is too low…
Price
S
7
6
5
D
Shortage
12 - 6 = 6
6
David Bryce © 1996-2002
Adapted from Baye © 2002
12
Quantity
If price is too high…
Surplus
14 - 6 = 8
Price
S
9
8
7
D
6
David Bryce © 1996-2002
Adapted from Baye © 2002
8
14
Quantity
Applications of Demand and
Supply Analysis
• Event: The WSJ reports that the prices of PC
components are expected to fall by 5-8
percent over the next six months.
• Scenario 1: You manage a small firm that
manufactures PCs.
• Scenario 2: You manage a small software
company.
David Bryce © 1996-2002
Adapted from Baye © 2002
Scenario 1: Implications for a
Small PC Maker
• What happens to your business? Do
prices rise or fall? Are profits likely to
rise or fall?
David Bryce © 1996-2002
Adapted from Baye © 2002
Big Picture: Impact of decline in
component prices on PC market
Price
of
PCs
S
S*
P0
P*
D
Q0
David Bryce © 1996-2002
Adapted from Baye © 2002
Q*
Quantity of PC’s
Scenario 2: Software Maker
• More complicated chain of reasoning to arrive
at the “Big Picture”
• Step 1: Use analysis like that in Scenario 1 to
deduce that lower component prices will lead
to
– a lower equilibrium price for computers
– a greater number of computers sold.
• Step 2: How will these changes affect the
“Big Picture” in the software market?
David Bryce © 1996-2002
Adapted from Baye © 2002
Big Picture: Impact of lower PC prices
on the software market
Price
of Software
S
P1
P0
D*
D
Q0 Q1
David Bryce © 1996-2002
Adapted from Baye © 2002
Quantity of
Software
Suppliers and Performance
• Firms incur costs as they use inputs to produce
outputs
• Suppliers are our sources of inputs
–
–
–
–
Materials
Technology/Equipment
Labor
Management
• Suppliers have power to raise our input costs
through the strength of their bargaining power
David Bryce © 1996-2002
Adapted from Baye © 2002
The Power of Suppliers
Suppliers have bargaining power over firms when:
• Supplier’s products are highly differentiated
• Suppliers are not threatened by substitutes
• Suppliers threaten forward vertical integration
• Supplier’s products are a large fraction of a firm’s final
costs
• Firms in an industry are relatively unimportant
customers of the supplier – low purchasing volumes, high
switching costs, supplier product important to quality of product
David Bryce © 1996-2002
Adapted from Baye © 2002
Manager’s Role
• Procure inputs in the
least cost manner
• Provide incentives for
workers to put forth
effort
• Failure to accomplish
this results in a point
like B
David Bryce © 1996-2002
Adapted from Baye © 2002
Costs
TC(Q)
B
$100
80
A
Q
Output
Methods of Procuring Inputs
• Spot Exchange
– When the buyer and seller of an input meet,
exchange, and then go their separate ways.
• Contracts
– A legal document that creates an extended
relationship between a buyer and a seller.
• Vertical Integration
– When a firm shuns other suppliers and chooses to
produce an input internally.
David Bryce © 1996-2002
Adapted from Baye © 2002
Key Features of Procurement Methods
• Spot Exchange
– Specialization, avoids contracting costs, avoids
costs of vertical integration.
– Possible “hold-up problem”
• Contracting
– Specialization, reduces opportunism, avoids
skimping on specialized investments
– Costly in complex environments
• Vertical Integration
– Reduces opportunism, avoids contracting costs
– Lost specialization, organizational costs
David Bryce © 1996-2002
Adapted from Baye © 2002
Transaction Costs
• Costs of acquiring an input over and above
the amount paid to the input supplier –
includes:
– Search costs
– Negotiation costs
– Other required investments or expenditures
David Bryce © 1996-2002
Adapted from Baye © 2002
Specialized Investments
• Investments in “specific assets” made to allow
two parties to exchange
• Specific assets have little or no value outside of
the exchange relationship
–
–
–
–
Site specificity
Physical-asset specificity
Dedicated assets
Human capital
• Lead to higher transaction costs and the
problem of “holdup”
David Bryce © 1996-2002
Adapted from Baye © 2002
The Problem of Holdup
David Bryce © 1996-2002
Adapted from Baye © 2002
Specialized Investments
and Contract Length
MC
$
MB1
Due to greater need
for specialized
investments
MB0
Longer Contract
L0
David Bryce © 1996-2002
Adapted from Baye © 2002
L1
Contract
Length
Optimal Input Procurement
Spot Exchange
Substantial
specialized
investments
relative to
contracting
costs?
No
Yes
Complex contracting
environment relative
to costs of
integration?
No
Contract
David Bryce © 1996-2002
Adapted from Baye © 2002
Yes
Vertical Integration
Suppliers of Labor & Management
Problems of the Agency Relationship
• Agency relations exist when a “principal”
delegates binding decision-making authority
to an “agent” – e.g., stockholders delegate to
executives; managers delegate employees
• Agency problems arise when
– Agent has different incentives than the principal
– It is costly to monitor the agent’s behavior
• Agency theory designs governance
mechanisms to align the incentives of the
principal and the agent
David Bryce © 1996-2002
Adapted from Baye © 2002
The Principal-Agent Problem
• Occurs when the principal cannot observe the
effort of the agent
– Example: Shareholders (principal) cannot observe
the effort of the manager (agent)
– Example: Manager (principal) cannot observe the
effort of workers (agents)
• Problem – principal cannot determine whether a
bad outcome was the result of the agent’s low
effort or due to bad luck
David Bryce © 1996-2002
Adapted from Baye © 2002
Solving the Problem Between
Managers and Workers
•
•
•
•
•
•
•
Profit sharing
Revenue sharing
Employee stock options
Piece rates
Commissions
Bonuses
Time clocks and spot checks
David Bryce © 1996-2002
Adapted from Baye © 2002