1. David Bryce © 1996-2002 Adapted from Baye © 2002 The Power of Suppliers MANEC 387 Economics of Strategy MANEC 387 Economics of Strategy David J. Bryce

2. David Bryce © 1996-2002 Adapted from Baye © 2002 The Structure of Industries Competitive Rivalry Threat of new Entrants Bargaining Power of Customers Threat of Substitutes Bargaining Power of Suppliers From M. Porter, 1979, “How Competitive Forces Shape Strategy”

3. David Bryce © 1996-2002 Adapted from Baye © 2002 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 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 Quantity S0S0

4. 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 Input prices Technology or government regulations Number of firms Substitutes in production Taxes Producer expectations

5. David Bryce © 1996-2002 Adapted from Baye © 2002 The Supply Function An equation representing the supply curve: Q x S = f(P x, P R,W, H,) –Q x S = quantity supplied of good X. –P x = price of good X. –P R = price of a related good –W = price of inputs (e.g., wages) –H = other variable affecting supply An equation representing the supply curve: Q x S = f(P x, P R,W, H,) –Q x S = quantity supplied of good X. –P x = price of good X. –P R = price of a related good –W = price of inputs (e.g., wages) –H = other variable affecting supply

6. David Bryce © 1996-2002 Adapted from Baye © 2002 Change in Quantity Supplied Price Quantity S0S0 20 10 B A 5 A to B: Increase in quantity supplied

7. David Bryce © 1996-2002 Adapted from Baye © 2002 Price Quantity S0S0 S1S1 8 5 7 S 0 to S 1 : Increase in supply Change in Supply 6

8. David Bryce © 1996-2002 Adapted from Baye © 2002 Producer Surplus The amount producers receive in excess of the amount necessary to induce them to produce the good. Price Quantity S0S0 Producer Surplus Q*Q* P*P*

9. David Bryce © 1996-2002 Adapted from Baye © 2002 Market Equilibrium Balancing supply and demand Q x S = Q x d Steady-state Balancing supply and demand Q x S = Q x d Steady-state

10. David Bryce © 1996-2002 Adapted from Baye © 2002 Price Quantity S D 5 6 12 Shortage 12 - 6 = 6 6 If price is too low… 7

11. David Bryce © 1996-2002 Adapted from Baye © 2002 Price Quantity S D 9 14 Surplus 14 - 6 = 8 6 8 8 If price is too high… 7

12. David Bryce © 1996-2002 Adapted from Baye © 2002 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. 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.

13. 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?

14. David Bryce © 1996-2002 Adapted from Baye © 2002 Price of PCs Quantity of PC’s S D S* P0P0 P* Q0Q0 Q* Big Picture: Impact of decline in component prices on PC market

15. David Bryce © 1996-2002 Adapted from Baye © 2002 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? 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?

16. David Bryce © 1996-2002 Adapted from Baye © 2002 Price of Software Quantity of Software S D Q0Q0 D* P1P1 Q 1 Big Picture: Impact of lower PC prices on the software market P0P0

17. David Bryce © 1996-2002 Adapted from Baye © 2002 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 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

18. 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 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

19. 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 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 $100 80 Output Costs B B A A TC(Q) Q Q

20. David Bryce © 1996-2002 Adapted from Baye © 2002 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. 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.

21. 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 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

22. 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 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

23. 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” 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”

24. David Bryce © 1996-2002 Adapted from Baye © 2002 The Problem of Holdup

25. David Bryce © 1996-2002 Adapted from Baye © 2002 Specialized Investments and Contract Length MC L0L0 L0L0 $ $ Contract Length L1L1 L1L1 MB 1 Longer Contract Due to greater need for specialized investments MB 0

26. David Bryce © 1996-2002 Adapted from Baye © 2002 Optimal Input Procurement Substantial specialized investments relative to contracting costs? Spot Exchange No Complex contracting environment relative to costs of integration? Yes Vertical Integration Yes No Contract

27. David Bryce © 1996-2002 Adapted from Baye © 2002 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 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

28. 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 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

29. 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 Profit sharing Revenue sharing Employee stock options Piece rates Commissions Bonuses Time clocks and spot checks