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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Please do not quote or reproduce without the author’s prior agreement

Handout for Business 189 undergraduate course in Strategic Management

One 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

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 this, 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.

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.

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-stream 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  ................
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