Bargaining power of buyers

A pre-condition for bargaining power is that the buyers are price-sensitive. This post will look into the structural factors that make a buyer price sensitive. As a result, corporate buyers can have low to high bargaining power, while consumers can only have low and medium bargaining power.

This is post seven in a series on industry analysis.




Before looking into the specific relationship between the focal industry and its buyers, let me provide some context. The focal industry is situated in a a flow of products or services. In this flow, both suppliers and buyers can potentially have bargaining power over the focal industry (see figure). This post is focused on the bargaining power of the buying industries.

It is important to assess the bargaining power of buyers over one or two complete business cycles. At the bottom of the business cycle, buyers can have considerable temporary power. In the severe downturns of 2001-02 and 2008-09, airlines had more bargaining power over Airbus and Boeing because the aircraft manufacturers had free capacity and cancellations in their order pipeline. However, such situations are temporary and should not be taken as an indication of a stable amount of bargaining power of buyers.

The following factors will create increase the bargaining power of buyers.

Buyer concentration ratio. The buyer concentration ratio is the single most important determinant of price sensitivity. Industries with high buyer concentration will almost always have price sensitive buyers, since the potential savings associated with a price reduction are large. If individual buyers represent a sizable portion of total purchases from the focal industry, they have the ability to influence the price through negotiation. Some buyers might be slow to realise their bargaining power, but with time it is very likely that they will learn and exercise that power.

Concentration ratios are defined as the combined sales of the largest x companies divided by total industry sales. (Typically the ratio is calculated with x equal to 4, 8, 20, or 50 in the US or 5, 10, 20, 50 in Europe - don't ask me why.) A more sophisticated measure is the Herfindahl index, but the different measures are normally highly correlated.

The analyst has a choice between considering each buying industry separately or considering them jointly. The former approach will provide a more nuanced analysis. If the latter approach is used, it should be noted that the buyer concentration ratio is the concentration across all the different buying industries or industry segments.This is different from the buying industry concentration ratio (see figure). However, if the focal industry is only selling to one buying industry, the relevant measure of concentration is identical to the buying industry concentration ratio. Independent producers of pulp will for instance only sell their product to the the paper manufacturing industry. However, if the focal industry is selling to more than one industry, the relevant measure is the buyer concentration ratio across all industries buying from the focal industry (e.g. copying machines are sold to all industries).

The concentration ratio can vary between different geographical markets. The cement industry in Mexico has mostly small customers, while the cement industry in the US deals mostly with large construction companies. The US customers have more bargaining power than the Mexican customers have.

Product adds unique value to buyer. This is typically the case for differentiated products. Differentiation could refer to product characteristics, reliability of the supplying company, image created through advertising, etc. Corporate buyers often prefer products that have more reliability or provide better after sales service. This is particularly important when the product is critical for the performance of the buyer's products. Consumers are more interested in particular product features or a certain image attached to the product. The buyer loses bargaining power when a particular differentiated product is perceived as being superior to its competitors.

Low transparency of information among buyers. If the buyers are not fully aware of the price levels in the industry, their lack of knowledge will be taken advantage of by the focal industry. This can happen for a corporate buyer when the volume purchased is small. Because the purchase manager spends most of his time on big purchases, he might lack information concerning the prevailing price level for the specific smaller product.

One way for corporate buyers to improve their information about price levels is tapered integration. This involves backward integration into focal industry, but only for a smaller portion of the required purchases. Such behaviour will send a signal to the focal industry that the buyer is serious about lowering his purchase costs and it will make cost information more transparent.

Consumers will often lack the required information to make informed decisions. Lack of information or unwillingness to process innovation dulls their price-sensitivity. For instance, most consumers will not have knowledge about the way the financial industry charges for their service. Many consumers will be less price sensitive when they have an emotional attachment to the product, e.g. Starbucks coffee or funeral services at inflated prices. In many cases it is difficult for consumers to assess the quality of the product, even after its purchase. In such situations, consumers often buy expensive products in the hope that they will be better.

Price sensitivity of the buying industry's customers. The price sensitivity of buyers is also affected by the price sensitivity of the buyers' customers. A common approach is for the focal industry to influence the buyers' customers directly by differentiating their products (e.g. marketing, design, innovation). If the end-customer has a preference for a certain brand, the intermediate buyer will be less price sensitive when dealing with the focal industry. Naturally, the buyers can try to use a similar strategy to enhance their bargaining power over the focal industry. A manufacturer of over-the-counter pain killers and do advertising targeted to the consumer. However, the pharmacies can try to strengthen its bargaining power over their suppliers by providing recommendations to the consumer.

Captive buyer. Both corporate buyers and consumers that have invested in relationship specific assets will have lower price sensitivity. An airline that buys both Airbus and Boeing aircraft will have more power because they have invested in relationship specific assets relating to both manufacturers (e.g. pilots, maintenance routines) compared to an airline that always buys Boeing.

Finally I would like to bring up a different aspect of bargaining power of buyers. In most buying industries there exists various kinds of buyers. It is possible to make one assessment for each buying industry segment. Coca Cola in the US is for instance meeting very concentrated buyers in the supermarket industry segment, but much more fragmented buyers in the convenience store segment. This level of analysis of the bargaining power of buyers is important for companies when they are setting or changing their business-unit strategies.