Handout for Business 189 undergraduate course in Strategic Management
Bargaining Power of Buyers
Simon Rodan
Associate Professor
Department of Organization & Management
College of Business
San José State University
One Washington Square
San José, CA 95192-0070
e-mail: simon.rodan@sjsu.edu
Please do not quote or reproduce without the author’s prior agreement
-1One way to begin thinking about the bargaining power of buyers is to ask
how serious would it be for a firm in the industry to loose one buyer’s
business. Put another way, what proportion of a firm’s output in the
industry is bought by any one buyer. The proportion of a firm’s output a
single buyer takes could be thought of as a first order measure of
bargaining power.
The two extreme cases that represent upper and lower bounds to this
problem are when buyers spread their purchases evenly between all firms
and when buyers place all their orders with a single firm.
Buyers spread purchases evenly
Firms
Buyers
Suppose there are F firms in our industry and
B buyers to whom they sell. If all buyers are
the same size and buy equally from each firm,
then each buyer gets 1/F of what it needs
from each firm and each firm sells 1/B of its
output to each buyer.
In the example in the diagram to the right,
there are two firms and four buyers. Each
buyer gets half its inputs from each firm and
each firm sells a quarter of its product to each
buyer. Here the loss of a single buyer would
reduce out firm’s sales by 25%.
As the number of buyers, B, increases the
proportion of a single firms output sold to any
one buyer falls.
Note that the proportion of a firm’s output
sold to a single buyer is independent of the number of firms in the
industry. To illustrate this, suppose another firm enters the industry and
all buyers now purchase from that firm also. Ignoring Cournot and price
changes which apply best to fragmented markets (which this clearly isn’t),
the amount sold to each buyer falls by 33%, as does the amount sold in
total by each firm in the industry. However the proportions sold to each
buyer remain unchanged. Thus the power of a buyer in this case is
independent of the number of firms in the industry.
Buyers focus on single suppliers
Second, consider the case in which buyers ‘single source’ their inputs, that
is, they buy from single supplier rather than spreading their purchases
out across several firms. With B buyers and F firms, the number of buyers
per firm is B/F (compared to F in the previous case). If firms have B/F
buyers, then the proportion of output sold to one buyer is the reciprocal of
-2this, or F/B. Fir first thing to note here is that F/B is greater than 1/B, the
result from the first case.
In other words, when buyers single-source,
they take a larger proportion of a firm’s output
so the first case is the best-case scenario for
firms in the industry. As buyers focus their
purchases more narrowly, the proportion of a
firms output bought by each buyer rises, and
with it, buyers’ barraging power.
Firms
Buyers
The second point here is that if buyer power
increases as buyers focus their purchases, they
have an incentive to buy all they can from a
single firm rather than spread their purchases
across multiple suppliers. Of course this is a
completely intuitive result.
It’s also worth noting that here F has been
assumed to be less than B; when F = B, we
have a set of exclusively dyadic pairs or trading partners in which each
firm supplies all its output to a single buyer which symmetrically sources
all it’s requirements from one firm. When F > B, each buyer must source
from multiple suppliers, but if buyers still maximize bargaining power,
they will take all they can from a single firm which means 100% of each
firms output.
A few years ago, I was chatting with the owner of a small
metalwork shop in San Carlos. He’d just been offered a
contract to build parts for airport X-ray machines; the
buyer in the case was the Department of Homeland
Security. If he took the contract, he estimated he’d have
enough work for at least 5 years taking about 50% of his
production capacity.
Yet, at least when I talked to him, he was leaning towards
not taking the contract. This may seem strange – when
someone offers you guaranteed work for 5 years that
sounds like a gravy train.
His problem was that he knew how demanding the
government could be, and when a single customer is
providing half your business you can’t really say no. And
that could create pressure – for example if the DHS
asked for shipments to be brought forward - that would
interfere with the other half of his business. The
bargaining power of a single buyer here was likely to be so
great that he was leaning towards keeping his current
customer base of smaller clients.
So in summary, in a best
case scenario, buyer power
depends only on the
number of buyers. In the
worst case, buyer power
declines with the number
of buyers and increases
with the number of firms
in the industry.
Since
in
considering
rivalry we took into
account the effect of
increasing numbers of
firms in the industry itself,
we could think of bargain
power as being what’s not
accounted for by the
structure of our industry,
in
other
words
the
structure of the down-
-3stream buyer industry.
The last point to note here is that even when there are many firms in the
industry (see inset), small firms can still decide to diversify their customer
base if there are many potential customers. Firms get to choose scenario 1
to 2 above, and this choice applies quite generally, not only in the case of
F < B considered here. Just as a large firm will supply many small
customers a small firm can also – if it chooses to. The choice is whether to
spend a great deal of effort going after many smaller customers who will
not have very much bargaining power or one large one which will hold
your feet to the fire. The only circumstance in which firms can’t make this
choice is in a monopsony – when there are very few buyers.
Another way to think about bargaining power is to ask the question of a
transaction: “who can not afford to walk away from the deal”?
Suppose you have a duopoly (two firms) and a duopsony (two potential
customers). Here if both firms minimise their dependence on the two
customers, each will be selling half their output to a single customer.
Buyer power is high. Now suppose there are 10 firms in the industry
instead of two. Does their number of potential customers change? No.
Neither does the proportion of their product bought by each of their two
customers.
Few
buyers
Many
buyers
Few firms
High
Low
Many
firms
High
Low
Bottom line (literally): Buyer power is all about the size/number of buyers.