David Bryce © 1996-2002Adapted from Baye © 2002
David Bryce © 1996-2002Adapted from Baye © 2002
The Power of SuppliersThe Power of Suppliers
MANEC 387Economics of Strategy
MANEC 387Economics of Strategy
David J. BryceDavid J. Bryce
David Bryce © 1996-2002Adapted from Baye © 2002
David Bryce © 1996-2002Adapted from Baye © 2002
The Structure of IndustriesThe Structure of Industries
Competitive Rivalry
Threat of newEntrants
BargainingPower of
Customers
Threat ofSubstitutes
BargainingPower of Suppliers
From M. Porter, 1979, “How Competitive Forces Shape Strategy”
David Bryce © 1996-2002Adapted from Baye © 2002
David Bryce © 1996-2002Adapted from Baye © 2002
Market Supply CurveMarket 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
S0
David Bryce © 1996-2002Adapted from Baye © 2002
David Bryce © 1996-2002Adapted from Baye © 2002
What Shifts Supply?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
David Bryce © 1996-2002Adapted from Baye © 2002
David Bryce © 1996-2002Adapted from Baye © 2002
The Supply FunctionThe 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
• 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 © 1996-2002Adapted from Baye © 2002
David Bryce © 1996-2002Adapted from Baye © 2002
Change in Quantity SuppliedChange in Quantity Supplied
Price
Quantity
S0
20
10
B
A
5 10
A to B: Increase in quantity supplied
David Bryce © 1996-2002Adapted from Baye © 2002
David Bryce © 1996-2002Adapted from Baye © 2002
Price
Quantity
S0
S1
8
5 7
S0 to S1: Increase in supply
Change in SupplyChange in Supply
6
David Bryce © 1996-2002Adapted from Baye © 2002
David Bryce © 1996-2002Adapted from Baye © 2002
Producer SurplusProducer Surplus
• The amount producers receive in excess of the amount necessary to induce them to produce the good.
• The amount producers receive in excess of the amount necessary to induce them to produce the good.
Price
Quantity
S0
Producer Surplus
Q*
P*
David Bryce © 1996-2002Adapted from Baye © 2002
David Bryce © 1996-2002Adapted from Baye © 2002
Market EquilibriumMarket Equilibrium
• Balancing supply and demand
QxS = Qx
d
• Steady-state
• Balancing supply and demand
QxS = Qx
d
• Steady-state
David Bryce © 1996-2002Adapted from Baye © 2002
David Bryce © 1996-2002Adapted from Baye © 2002
Price
Quantity
S
D
5
6 12
Shortage12 - 6 = 6
6
If price is too low…If price is too low…
7
David Bryce © 1996-2002Adapted from Baye © 2002
David Bryce © 1996-2002Adapted from Baye © 2002
Price
Quantity
S
D
9
14
Surplus14 - 6 = 8
6
8
8
If price is too high…If price is too high…
7
David Bryce © 1996-2002Adapted from Baye © 2002
David Bryce © 1996-2002Adapted from Baye © 2002
Applications of Demand and Supply AnalysisApplications 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 © 1996-2002Adapted from Baye © 2002
David Bryce © 1996-2002Adapted from Baye © 2002
Scenario 1: Implications for a Small PC MakerScenario 1: Implications for a Small PC Maker
• What happens to your business? Do prices rise or fall? Are profits likely to rise or fall?
• What happens to your business? Do prices rise or fall? Are profits likely to rise or fall?
David Bryce © 1996-2002Adapted from Baye © 2002
David Bryce © 1996-2002Adapted from Baye © 2002
Priceof
PCs
Quantity of PC’s
S
D
S*
P0
P*
Q0 Q*
Big Picture: Impact of decline in component prices on PC marketBig Picture: Impact of decline in component prices on PC market
David Bryce © 1996-2002Adapted from Baye © 2002
David Bryce © 1996-2002Adapted from Baye © 2002
Scenario 2: Software MakerScenario 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?
David Bryce © 1996-2002Adapted from Baye © 2002
David Bryce © 1996-2002Adapted from Baye © 2002
Priceof Software
Quantity ofSoftware
S
D
Q0
D*
P1
Q1
Big Picture: Impact of lower PC prices on the software marketBig Picture: Impact of lower PC prices on the software market
P0
David Bryce © 1996-2002Adapted from Baye © 2002
David Bryce © 1996-2002Adapted from Baye © 2002
Suppliers and PerformanceSuppliers 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
David Bryce © 1996-2002Adapted from Baye © 2002
David Bryce © 1996-2002Adapted from Baye © 2002
The Power of SuppliersThe 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
David Bryce © 1996-2002Adapted from Baye © 2002
David Bryce © 1996-2002Adapted from Baye © 2002
Manager’s RoleManager’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$100
80 80
OutputOutput
CostsCosts
BB
AA
TC(Q)TC(Q)
David Bryce © 1996-2002Adapted from Baye © 2002
David Bryce © 1996-2002Adapted from Baye © 2002
Methods of Procuring InputsMethods 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.
David Bryce © 1996-2002Adapted from Baye © 2002
David Bryce © 1996-2002Adapted from Baye © 2002
Key Features of Procurement MethodsKey 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
David Bryce © 1996-2002Adapted from Baye © 2002
David Bryce © 1996-2002Adapted from Baye © 2002
Transaction CostsTransaction 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
David Bryce © 1996-2002Adapted from Baye © 2002
David Bryce © 1996-2002Adapted from Baye © 2002
Specialized InvestmentsSpecialized 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”
David Bryce © 1996-2002Adapted from Baye © 2002
David Bryce © 1996-2002Adapted from Baye © 2002
The Problem of HoldupThe Problem of Holdup
David Bryce © 1996-2002Adapted from Baye © 2002
David Bryce © 1996-2002Adapted from Baye © 2002
Specialized Investments and Contract LengthSpecialized Investments and Contract Length
MCMC
L0L0
$$
Contract LengthContract LengthL
1
L1
MB1MB1
Longer ContractLonger Contract
Due to greater need for specialized
investments
Due to greater need for specialized
investmentsMB0MB0
David Bryce © 1996-2002Adapted from Baye © 2002
David Bryce © 1996-2002Adapted from Baye © 2002
Optimal Input ProcurementOptimal Input Procurement
Substantial specialized investments relative to contracting
costs?
Spot ExchangeNoNo
Complex contracting
environment relative to costs of
integration?
YesYes
Vertical Integration
Vertical Integration
YesYesNoNo
ContractContract
David Bryce © 1996-2002Adapted from Baye © 2002
David Bryce © 1996-2002Adapted from Baye © 2002
Suppliers of Labor & ManagementProblems of the Agency Relationship
Suppliers of Labor & ManagementProblems 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
David Bryce © 1996-2002Adapted from Baye © 2002
David Bryce © 1996-2002Adapted from Baye © 2002
The Principal-Agent ProblemThe 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
David Bryce © 1996-2002Adapted from Baye © 2002
David Bryce © 1996-2002Adapted from Baye © 2002
Solving the Problem Between Managers and WorkersSolving 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
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