Bargaining power of suppliers

Each supplying industry has to be evaluated separately. The first focus should be on supplying industries that represent a large portion of total cost for the focal industry. This posting will highlight the main drivers of supplier power.

This is post eight in a series on industry analysis.


There are always several supplying industries to the focal industry. It is necessary to assess the bargaining power of each supplying industry separately, naturally with a focus on the more important supplying industries.

Industry supply chain

Price level above the ideal perfect competition price. Suppliers have power over the focal industry to the extent that they can increase prices to a higher level than would have been the case under perfect competition. Since we observe industries with imperfect competition, we will hardly ever know the counter-factual of having perfect competition. Still it is possible to make an assessment of how much the actual prices seem to deviate from the ideal perfect competition price. It is possible to try to estimate a perfect competition price. However, industry analysis takes the short-cut of looking at the underlying structural factors instead. There are two very important factors, and a number of additional factors that could be important in specific situations.

Factor 1. Concentration ratio of the supplying industry. The most important indication that the supplying industry has power is its concentration ratio. The more concentrated the supplying industry, the more power it will have over the companies in the focal industry. Concentration ratios (CRx) are typically measured as the combined sales of the largest x companies divided by total industry sales. Typically the ratio is calculated with x equal to 4, 5, or 10.

Let us look at the focal industry grocery retailing in the US. Carbonated soft drink manufacturing in the US is an example of a highly-concentrated industry supplying to the grocery retailing industry. In 2012 the top 3 carbonated soft drink firms (CR3) had a combined market share of 81.5%. In most cases the supplying industries will be more concentrated than the focal industry. The top 3 grocery retailers had a combined market share of 36.0%. From the perspective of the retailers, the soft drink manufacturers have large power. The CR10 in the grocery retailing industry is only 51.1% indicating that there are a lot of rather small grocery retailers in the US.

In developed countries an almost normal configuration is to have a fairly concentrated supplying industry and a somewhat less concentrated focal industry. Depending on the relationship between the two concentration ratios the suppliers either have high power (much higher concentration ratio) or medium power (similar concentration ratios, countervailing power). However, there are situation in which the supplying industry is not concentrated at all. In such situations the suppliers have low power. Some examples:

• Capital in developed countries. There is often a well functioning market for the supply of equity capital and debt capital. Generally, this market functions quite efficiently because there are several suppliers of capital. The market share of the top 10 suppliers of capital in the world would be less than 1%. However, there are situations in which the capital markets do not function well (e.g. in crisis situations, risk capital in developing countries). (Note: I am not talking about the banks here.)
• Unskilled and standard-skilled labour. Unskilled labour normally does not have any power because there are typically thousands of workers available. However, the situation differs drastically to the extent that trade unions can speak on behalf of the workers. If everyone agrees to pool their interests and become union members, the focal industry has only one counter-party, i.e. the trade union. The trade union will have power. Even labour with standard-skills is normally in ample supply (e.g. nurses, accountants, sales clerks, supervisor). In some situations there is a shortage of certain skills and the supply of labour cannot adjust quickly. In such a situation the skilled labour has power, but often only of a temporary nature.
• Commodities. If there are several buyers and sellers in a commodity market, the resulting price is close to a perfect competition outcome. This means that the suppliers does not have any power (e.g. grains, steel). Some commodities are traded on exchanges where there are only a few suppliers (e.g. oil,  rare earth metals). Other commodities (e.g. diamonds) are not traded on exchanges and only have a few suppliers. In such industries the market price will deviate from the perfect competition price and the suppliers will have some degree of power.

For supplying industries that do not have a very low level of concentrations, the following additional factors are important to consider.

Factor 2. Relationship specific assets. The second important indication that the supplying industry has power is the amount of relationship specific investment by the supplying industry and/or the focal industry. Relationship specific investment are investments specific to serving one specific customer or supplier. When a focal-industry has relationship specific assets, we can call it a situation of switching costs. An example of the former is locating a steel plant next to an automotive plant. Since it is expensive to transport steel, the steel plant invests in a location to serve one specific automotive plant. Almost the whole investment is relationship specific. An example of the latter is an airline that has invested in pilots and maintenance to support one kind of aircraft (either Boeing and Airbus). The relationship specific investment makes it difficult for the airline to change supplier. In many cases of outsourcing, there might be a fair amount of relationship specific assets.

Any industry that is characterised by large relationship specific assets will be vulnerable to abuse from the counter-party. In the airline example the aircraft manufacturers gain power to the extent that the airlines mostly (or exclusively) use aircraft from one manufacturer. The aircraft manufacturers themselves have very little relationship specific assets. In the steel and automotive plants example, both the steel manufacturer and the automotive manufacturer have relationships specific assets. A detailed study of the size of these investments needs to be made before the bargaining power of suppliers can be addressed.

Minor factors. The two major factors should always be considered. Additionally, all the factors listed under the force of rivalry can be used to understand the bargaining power of the suppliers. If the spotlight were on the supplying industry we would study its own rivalry in more detail (here). Thus all the factors listed under the force of rivalry can play a role. Here are a few examples:.

• If the supplying industry only represents a small portion of total costs for most its customers, it can take advantage of lack of knowledge to keep prices high. 
• Likewise, if the supplying industry has differentiated products, then the supplying industry can increase its power. 
• In other situations the focal industry (supplying industry) can credibly signal that it will engage in backward (forward) vertical integration. In such situations the supplying industry will gain (lose) power.

No one market price. The above analysis assumes that most transactions are clustered around one market price, which can deviate from the ideal perfect competition price if the suppliers have power. There might be minor variations like volume discounts, but basically there is one market price. In some industries this is not a good description of reality. Different companies in the focal firm might be able to negotiate an individual price with the supplying industry, not because they have power as a group, but because one firm might be very powerful in itself. In the above mentioned retailing example, the price charged by Coca Cola or PepsiCo can vary considerably by retailer. Walmart (number 1 with 25.1%) will have more countervailing power than Kroger (number 2 with 7.6%) or Safeway (number 3 with 3.3%). The discount is the result of bargaining between Coca Cola or Pepsi and Walmart. It is not due to the fact that it is cheaper to supply a large customer. When we assess the bargaining power of suppliers we look at the typical relationship. The median grocery retailer of the top 25 only has 0.4% of the market so it will not be able to exercise power over the carbonated soft drink manufacturers.

However, Walmart will be able to exercise power since they have 25% of the market. This is an important point to note, but it is not essential for industry analysis. Naturally, if there is a trend towards consolidation of the retailers, the median size will increase and their power will increase. The countervailing power of Walmart is naturally very important for Walmart and should be considered when its strategy is analysed.