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David J. Bryce 2002David J. Bryce 2002

Strategies for Responding to

Buyer Power

Strategies for Responding to

Buyer Power

MANEC 387

Economics of Strategy

MANEC 387

Economics of Strategy

David J. BryceDavid J. Bryce


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Summary of LastFew SessionsSummary of LastFew Sessions Buyers have powerrelative to sellers when demand

curvesare flat

Firm demand curvesare flatwhen manyalternativeproductoptionsare available to buyerwhich limitspricing flexibilityand drives down profit

A change in price could eitherincrease or decreasetotal revenue

A decrease in price will enhance the availablesatisfaction a consumer can get froma good, whilean increase in price will decrease the availablesatisfaction

Buyers have powerrelative to sellers when demandcurvesare flat

Firm demand curvesare flatwhen manyalternativeproductoptionsare available to buyerwhich limitspricing flexibilityand drives down profit

A change in price could eitherincrease or decreasetotal revenue

A decrease in price will enhance the availablesatisfaction a consumer can get froma good, whilean increase in price will decrease the availablesatisfaction


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The Structure of IndustriesThe Structure of Industries

Competitive

Rivalry

Threat ofnew

Entrants

Bargaining

Powerof

Customers

Threat of

Substitutes

Bargaining

Powerof

Suppliers

From M. Porter, 1979, How Competitive ForcesShape Strategy


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Whatcan be done to neutralize the

bargaining power ofbuyers?

Whatcan be done to neutralize the

bargaining power ofbuyers?1. Differentiate product orservice so thatituniquelyrespondsto

only certain buyer needs

2. Create demand for complementary goods thatrequire yourproductorservice asan exclusive input

3. Discriminate on price among buyerscharge differentbuyersadifferentprice foryour product

4. Narrow the options ofthe buyer through marketconsolidation orexclusive alliances

5. Find new types ofbuyersand/oralternative uses foryour product

6. Create switching costs foryourbuyers7. Price atorbelow marginal cost and produce large quantitiesso

thatyour product floodsthe marketand attracts loyalty,dependence, and dominantmarketshare; then restrictsupplyandraise price (risky)

1. Differentiate product orservice so thatituniquelyrespondstoonly certain buyer needs

2. Create demand for complementary goods thatrequire yourproductorservice asan exclusive input

3. Discriminate on price among buyerscharge differentbuyersadifferentprice foryour product

4. Narrow the options ofthe buyer through marketconsolidation orexclusive alliances

5. Find new types ofbuyersand/oralternative uses foryour product

6. Create switching costs foryourbuyers7. Price atorbelow marginal cost and produce large quantitiesso

thatyour product floodsthe marketand attracts loyalty,dependence, and dominantmarketshare; then restrictsupplyandraise price (risky)


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1. Differentiate Product1. Differentiate Product Recall from lastsession thatconsumer

preferencesvary

Ifa firm can uniquelysatisfythe preferencesofsome particular group, itcreatesasteeperdemand curve and more flexibilityin itspricing

By differentiating, the firmmay, in effect,create a monopoly within some particularconsumersegment

Recall from lastsession thatconsumerpreferencesvary

Ifa firm can uniquelysatisfythe preferencesofsome particular group, itcreatesasteeperdemand curve and more flexibilityin itspricing

By differentiating, the firmmay, in effect,create a monopoly within some particularconsumersegment


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Example: Differentiate ProductExample: Differentiate ProductBig Bertha

Golf clubs

Wide hittingface and superbbalance appeal

to less proficientgolfers

Big BerthaGolf clubs

Wide hittingface and superbbalance appeal

to less proficientgolfers q

p

Demand forall golf clubs

Demand forBig Bertha-

style clubs


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2. Create Demand for Complementary

Goods

2. Create Demand for Complementary

Goods Complementary goodsare those thatwork

together with other products orservicesto createjointvalue

Example: Sign exclusive jointagreements withcomplementary productcompanies or create newgoods outrightand then help to stimulatedemand forthatgood; or

Make your good orservice an exclusive inputintothe production ofanother good orservice andcreate demand forthatgood

Complementary goodsare those thatworktogether with other products orservicesto create

jointvalue

Example: Sign exclusive jointagreements withcomplementary productcompanies or create newgoods outrightand then help to stimulatedemand forthatgood; or

Make your good orservice an exclusive inputintothe production ofanother good orservice andcreate demand forthatgood


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Example: Complementary Goods

Strategy

Example: Complementary Goods

Strategy Nutrasweetbrand on dietcolas helped to sell

more colaand create demand for Nutrasweet

Intel inside campaign in which Intelsbrand isstamped on complementary goods, thus creatingdemand forthose goodsand selling more chips

NextelDirect Motorola cell phone walkie-talkiefeaturesare valuable onlyin the presence of

complementary directconnectservices; sell morephonesby creating demand forthe walkie-talkieservice; Sell the service by creating network-exclusive phones with Motorola

Nutrasweetbrand on dietcolas helped to sellmore colaand create demand for Nutrasweet

Intel inside campaign in which Intelsbrand isstamped on complementary goods, thus creatingdemand forthose goodsand selling more chips

NextelDirect Motorola cell phone walkie-talkiefeaturesare valuable onlyin the presence of

complementary directconnectservices; sell morephonesby creating demand forthe walkie-talkieservice; Sell the service by creating network-exclusive phones with Motorola


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3. Price Discrimination3. Price Discrimination

Price discrimination is charging a higher price toconsumers with higher willingnessto pay

Firstdegree: price equals willingnessto pay for everyconsumer firm extractsall consumersurplus

Second degree: differentprices for differentquantities

Third degree: differentprices for differentconsumer groups

In practice, segmentconsumersby elasticity of demand raise price forinelastic customers; lower price forelastic customers

Auctions, purchasing a car

Airlines, hotels

Firstadoptersvs. later ones

Price discrimination is charging a higher price toconsumers with higher willingnessto pay

Firstdegree: price equals willingnessto pay for everyconsumer firm extractsall consumersurplus

Second degree: differentprices for differentquantities

Third degree: differentprices for differentconsumer groups

In practice, segmentconsumersby elasticity of demand raise price forinelastic customers; lower price forelastic customers

Auctions, purchasing a car

Airlines, hotels

Firstadoptersvs. later ones


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Segmenting Customersby

Differencesin Price Elasticity

Segmenting Customersby

Differencesin Price Elasticity


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The Opportunity of ConsumerSurplus

The Opportunity of ConsumerSurplus Considerthe demand curve

asan ordering of consumersfrom highestto lowest

willingnessto pay

Buyersto the leftofmarketclearing demand (Q*) paidlessthan they were willing

can we charge themmore? Areabetween the demand

curve and the marketclearing price (P*)is

consumersurplus.

Considerthe demand curveasan ordering of consumersfrom highestto lowest

willingnessto pay

Buyersto the leftofmarketclearing demand (Q*) paidlessthan they were willing

can we charge themmore? Areabetween the demand

curve and the marketclearing price (P*)is

consumersurplus.

Q*Q*

P*P*

DemandDemandSupply

ConsumerSurplus

ConsumerSurplus


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Value of Price Discrimination:Some Calculations

Value of Price Discrimination:Some Calculations

With demand curveQ(P)=100-P and no pricediscrimination, the firmsells70 unitsat$30 for $2100

revenue.

With price discrimination, thefirmsells 30 unitsat$70 and40 unitsat$30 for $3300

revenue. As long asthe costof

implementing pricediscrimination is lessthan$1200, profitsare increased.

With demand curveQ(P)=100-P and no pricediscrimination, the firmsells70 unitsat$30 for $2100

revenue.

With price discrimination, thefirmsells 30 unitsat$70 and40 unitsat$30 for $3300

revenue. As long asthe costof

implementing pricediscrimination is lessthan$1200, profitsare increased.

3030

7070

7070

3030

QuantityQuantity

PricePrice

Q(P)=100-PQ(P)=100-P


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Example: FirstDegree Price

Discrimination

Example: FirstDegree Price

Discrimination

Auctionstend to collectall availableconsumersurplus when there are many

bidders

Carbuying marketgenerally prices highand then bargains down to the

amountthe consumeris willing to pay

Auctionstend to collectall availableconsumersurplus when there are many

bidders

Carbuying marketgenerally prices highand then bargains down to the

amountthe consumeris willing to pay


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Example: Second Degree Price

Discrimination

Example: Second Degree Price

Discrimination

Volume discountsdifferentunitpricesdepending on how much is purchased

Costco large size packaging

Buy 10 get1 free punch cards

Supersizein FastFood Wood pegsvolume discounts (see next)

Volume discountsdifferentunitpricesdepending on how much is purchased

Costco large size packaging

Buy 10 get1 free punch cards

Supersizein FastFood Wood pegsvolume discounts (see next)


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Example: Third Degree Price

Discrimination

Example: Third Degree Price

Discrimination

Airlines have a differentticketpricedepending on how long before a flighta

person books; price rises dramaticallyas flightdate approaches

Three weeks or greateradvancepurchaserstend to be private travelers

more likelyto shop on price Lastminute purchaserstend to be business

travelers with deeper pockets

Airlines have a differentticketpricedepending on how long before a flighta

person books; price rises dramaticallyas flightdate approaches

Three weeks or greateradvancepurchaserstend to be private travelers

more likelyto shop on price Lastminute purchaserstend to be business

travelers with deeper pockets


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Requirements forSuccessful Price

Discrimination

Requirements forSuccessful Price

Discrimination1. Identifyand segmentcustomer groupsby

elasticity inelastic customers are not eager toreveal their elasticity

2. Preventinelastic customers from purchasingatthe lower price

3. Preventarbitrage by elastic customers purchasing atthe lower price and reselling to inelastic

customers4. Provide premium features orservicesthat

cost lessthan the price premium(legally, youmust show cost differences to justify the pricedifferences)

1. Identifyand segmentcustomer groupsbyelasticity inelastic customers are not eager toreveal their elasticity

2. Preventinelastic customers from purchasingatthe lower price

3. Preventarbitrage by elastic customers purchasing atthe lower price and reselling to inelastic

customers4. Provide premium features orservicesthat

cost lessthan the price premium(legally, youmust show cost differences to justify the pricedifferences)


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4. Narrow the Options ofthe Buyer4. Narrow the Options ofthe Buyer Since many optionsavailable to buyers

diminishesasellers flexibility, one strategyisto limitbuyers options

How?

Buy, merge, oralign with your competitor(s),supplier(s), or customer(s)

Lobbythe governmentto impose preferentialtreatments foryour products over foreigncompetitors orto impose importrestrictions oncompetitors products

Since many optionsavailable to buyersdiminishesasellers flexibility, one strategyisto limitbuyers options

How?

Buy, merge, oralign with your competitor(s),supplier(s), or customer(s)

Lobbythe governmentto impose preferentialtreatments foryour products over foreigncompetitors orto impose importrestrictions oncompetitors products


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Example: Narrow Buyer OptionsExample: Narrow Buyer Options OPEC isthe classic case: Numeroussellers of oil who

create multilateral agreementsamong themselvestoweaken the power ofbuyers

AOL-Time Warnermerger eliminatesbuyersentertainmentalternatives for each ofTime WarnerandAOL and instead poolsall alternativesunder one roof

Fruitcooperatives consolidate the produce supply ofmany farmersto limitthe power ofbuyersto extract priceconcessions fromindividual farmers (government

sanctioned) Merck-Medco Merging with abuyer: Merckbuys Medco

to mitigate the impactof pharmacybenefitmanagement(PBM) practices on itsbusiness, effectively placing itselfincontrol ofthese practicesand neutralizing some PBMpower

OPEC isthe classic case: Numeroussellers of oil whocreate multilateral agreementsamong themselvestoweaken the power ofbuyers

AOL-Time Warnermerger eliminatesbuyersentertainmentalternatives for each ofTime WarnerandAOL and instead poolsall alternativesunder one roof

Fruitcooperatives consolidate the produce supply ofmany farmersto limitthe power ofbuyersto extract priceconcessions fromindividual farmers (government

sanctioned) Merck-Medco Merging with abuyer: Merckbuys Medco

to mitigate the impactof pharmacybenefitmanagement(PBM) practices on itsbusiness, effectively placing itselfincontrol ofthese practicesand neutralizing some PBMpower


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Example: Narrow Buyer OptionsExample: Narrow Buyer Options Korean Beefindustryin 1980s: Farmers lobbied the

governmentto reject foreign beefimports; themarketprice ofKorean beefrose to $14 per pound

USShrimping Industry: Encourage the governmentto place tarriffs on imported shrimp from China

Korean Beefindustryin 1980s: Farmers lobbied thegovernmentto reject foreign beefimports; themarketprice ofKorean beefrose to $14 per pound

USShrimping Industry: Encourage the governmentto place tarriffs on imported shrimp from China


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5. Find NewT

ypes ofBuyers5. Find NewT

ypes ofBuyers Find alternative uses foryour product

thatare fundamentally new or different;

i.e. theyappeal to an entirely newcustomer group

Thisreducesthe total influence thatany

one group of customers hasin thebusinessand thusreducestheir power

Find alternative uses foryour productthatare fundamentally new or different;

i.e. theyappeal to an entirely newcustomer group

Thisreducesthe total influence thatany

one group of customers hasin thebusinessand thusreducestheir power


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ExamplesExamples Synthetic diamondsused in drill bitsare

now applied in artificial joints

New entryinto drill bits was giving powerto buyers

New medical device customers (forartificial

joints)reduce the effects of drill bitcustomer power

Synthetic diamondsused in drill bitsarenow applied in artificial joints

New entryinto drill bits was giving powerto buyers

New medical device customers (forartificial

joints)reduce the effects of drill bitcustomer power


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6. Switching costs6. Switching costs By creating coststo switch fromyour

productto another, you lock-in buyers

to repeated purchasesand lowertheirpower

The price ofa potential alternative

productmustthen be lowerthan theprice ofyour product plusthe switchingcost

By creating coststo switch fromyourproductto another, you lock-in buyers

to repeated purchasesand lowertheirpower

The price ofa potential alternative

productmustthen be lowerthan theprice ofyour product plusthe switchingcost


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ExamplesExamples Ink for Inkjetprinterscustomersare locked into ink

cartridge typesbased on their printer purchase;therefore, manufacturers price cartridges high sincethey have amonopolyin theirtype ofink cartridge

Games for NintendoSame effectas forink; oncethe game console is purchased, customersare lockedinto Nintendo games; the high prices for gamesdemonstrate this fact

Cell phone companiesimpose a contractperiod ofayear (minimum)and impose a high cost for earlywithdrawal

We will studymore aboutthe theory of lock-in andswitching costsin a latersession

Ink for Inkjetprinterscustomersare locked into inkcartridge typesbased on their printer purchase;therefore, manufacturers price cartridges high sincethey have amonopolyin theirtype ofink cartridge

Games for NintendoSame effectas forink; oncethe game console is purchased, customersare lockedinto Nintendo games; the high prices for gamesdemonstrate this fact

Cell phone companiesimpose a contractperiod ofayear (minimum)and impose a high cost for earlywithdrawal

We will studymore aboutthe theory of lock-in andswitching costsin a latersession


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7. Playthe Demand Game7. Playthe Demand Game1. Price atorbelow marginal cost (your costmustbe

lowerthan competitors)and produce largequantities, essentially foregoing profitin earlyperiods

2. Your productattracts loyalty, dependence, anddominantmarketshare; competitors leave themarket

3. Then restrictsupplyand raise price

Riskyif loyaltyand dependence does notdevelop orifthisloyaltyisbased only on price

Worksbestin the presence of consumerswitching costsand/orin standardsraces

1. Price atorbelow marginal cost (your costmustbelowerthan competitors)and produce largequantities, essentially foregoing profitin earlyperiods

2. Your productattracts loyalty, dependence, anddominantmarketshare; competitors leave themarket

3. Then restrictsupplyand raise price

Riskyif loyaltyand dependence does notdevelop orifthisloyaltyisbased only on price

Worksbestin the presence of consumerswitching costsand/orin standardsraces


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Examples: Playthe Demand GameExamples: Playthe Demand Game

Microsoftoperating systems pricing strategy;MSDOS, Windows (succeeded)

Similar pricing strategy for Netscape (failed),Adobe Acrobat(succeeded), others

HondasUS entrystrategyin motorcycles

(succeeded) HyundaisUS entrystrategyin automobiles

(failed)

Microsoftoperating systems pricing strategy;MSDOS, Windows (succeeded)

Similar pricing strategy for Netscape (failed),Adobe Acrobat(succeeded), others

HondasUS entrystrategyin motorcycles

(succeeded) HyundaisUS entrystrategyin automobiles

(failed)

Note: Success or Failure in terms ofafter-the-factmarketshare

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