Transcript Responding to Buyer Power

Strategies for Responding to
Buyer Power
MANEC 387
Economics of Strategy
David J. Bryce
David J. Bryce © 2002
Summary of Last Few Sessions
• Buyers have power relative to sellers when demand
curves are flat
• Firm demand curves are flat when many alternative
product options are available to buyer—which limits
pricing flexibility and drives down profit
• A change in price could either increase or decrease
total revenue
• A decrease in price will enhance the available
satisfaction a consumer can get from a good, while
an increase in price will decrease the available
satisfaction
David J. Bryce © 2002
The Structure of Industries
Threat of new
Entrants
Bargaining
Power of
Suppliers
Competitive
Rivalry
Threat of
Substitutes
From M. Porter, 1979, “How Competitive Forces Shape Strategy”
David J. Bryce © 2002
Bargaining
Power of
Customers
What can be done to neutralize the
bargaining power of buyers?
1.
2.
3.
4.
5.
6.
7.
Differentiate product or service so that it uniquely responds to
only certain buyer needs
Create demand for complementary goods that require your
product or service as an exclusive input
Discriminate on price among buyers—charge different buyers a
different price for your product
Narrow the options of the buyer through market consolidation or
exclusive alliances
Find new types of buyers and/or alternative uses for your product
Create switching costs for your buyers
Price at or below marginal cost and produce large quantities so
that your product floods the market and attracts loyalty,
dependence, and dominant market share; then restrict supply and
raise price (risky)
David J. Bryce © 2002
1. Differentiate Product
• Recall from last session that consumer
preferences vary
• If a firm can uniquely satisfy the preferences
of some particular group, it creates a steeper
demand curve and more flexibility in its
pricing
• By differentiating, the firm may, in effect,
create a “monopoly” within some particular
consumer segment
David J. Bryce © 2002
Example: Differentiate Product
• “Big Bertha”
Golf clubs
• Wide hitting
face and superb
balance appeal
to less proficient
golfers
David J. Bryce © 2002
p
Demand for
Big Berthastyle clubs
Demand for
all golf clubs
q
2. Create Demand for Complementary
Goods
• Complementary goods are those that work
together with other products or services to create
joint value
• Example: Sign exclusive joint agreements with
complementary product companies or create new
goods outright and then help to stimulate
demand for that good; or
• Make your good or service an exclusive input into
the production of another good or service and
create demand for that good
David J. Bryce © 2002
Example: Complementary Goods
Strategy
• Nutrasweet brand on diet colas helped to sell
more cola and create demand for Nutrasweet
• “Intel inside” campaign in which Intel’s brand is
stamped on complementary goods, thus creating
demand for those goods and selling more chips
• NextelDirect – Motorola cell phone walkie-talkie
features are valuable only in the presence of
complementary direct connect services; sell more
phones by creating demand for the walkie-talkie
service; Sell the service by creating networkexclusive phones with Motorola
David J. Bryce © 2002
3. Price Discrimination
• Price discrimination is charging a higher price to
consumers with higher willingness to pay
– First degree: price equals willingness to pay for every
consumer – firm extracts all consumer surplus
– Second degree: different prices for different quantities
– Third degree: different prices for different consumer groups
• In practice, segment consumers by elasticity of demand
– raise price for inelastic customers; lower price for
elastic customers
– Auctions, purchasing a car
– Airlines, hotels
– First adopters vs. later ones
David J. Bryce © 2002
Segmenting Customers by
Differences in Price Elasticity
David J. Bryce © 2002
The Opportunity of Consumer Surplus
• Consider the demand curve
as an ordering of consumers
from highest to lowest
willingness to pay
• Buyers to the left of market
clearing demand (Q*) paid
less than they were willing –
can we charge them more?
• Area between the demand
curve and the market
clearing price (P*) is
“consumer surplus.”
David J. Bryce © 2002
Demand
P*
Supply
Consumer
Surplus
Q*
Value of Price Discrimination:
Some Calculations
• With demand curve
Q(P)=100-P and no price
discrimination, the firm sells
70 units at $30 for $2100
revenue.
• With price discrimination, the
firm sells 30 units at $70 and
40 units at $30 for $3300
revenue.
• As long as the cost of
implementing price
discrimination is less than
$1200, profits are increased.
David J. Bryce © 2002
Price
Q(P)=100-P
70
30
30
70
Quantity
Example: First Degree Price
Discrimination
• Auctions tend to collect all available
consumer surplus when there are many
bidders
• Car buying market generally prices high
and then “bargains” down to the
amount the consumer is willing to pay
David J. Bryce © 2002
Example: Second Degree Price
Discrimination
• Volume discounts—different unit prices
depending on how much is purchased
– Costco “large size” packaging
– Buy 10 get 1 free punch cards
– “Supersize” in Fast Food
– Wood pegs volume discounts (see next)
David J. Bryce © 2002
David J. Bryce © 2002
Example: Third Degree Price
Discrimination
• Airlines have a different ticket price
depending on how long before a flight a
person books; price rises dramatically
as flight date approaches
– Three weeks or greater advance
purchasers tend to be private travelers
more likely to shop on price
– Last minute purchasers tend to be business
travelers with deeper pockets
David J. Bryce © 2002
Requirements for Successful Price
Discrimination
1. Identify and segment customer groups by
elasticity – inelastic customers are not eager to
reveal their elasticity
2. Prevent inelastic customers from purchasing
at the lower price
3. Prevent arbitrage by elastic customers –
purchasing at the lower price and reselling to inelastic
customers
4. Provide premium features or services that
cost less than the price premium (legally, you
must show cost differences to justify the price
differences)
David J. Bryce © 2002
4. Narrow the Options of the Buyer
• Since many options available to buyers
diminishes a seller’s flexibility, one strategy is
to limit buyer’s options
• How?
– Buy, merge, or align with your competitor(s),
supplier(s), or customer(s)
– Lobby the government to impose preferential
treatments for your products over foreign
competitors or to impose import restrictions on
competitor’s products
David J. Bryce © 2002
Example: Narrow Buyer Options
• OPEC is the classic case: Numerous sellers of oil who
create multilateral agreements among themselves to
weaken the power of buyers
• AOL-Time Warner merger – eliminates buyer’s
entertainment alternatives for each of Time Warner and
AOL and instead pools all alternatives under one “roof”
• Fruit cooperatives – consolidate the produce supply of
many farmers to limit the power of buyers to extract price
concessions from individual farmers (government
sanctioned)
• Merck-Medco – Merging with a buyer: Merck buys Medco
to mitigate the impact of pharmacy benefit management
(PBM) practices on its business, effectively placing itself in
control of these practices and neutralizing some PBM
power
David J. Bryce © 2002
Example: Narrow Buyer Options
• Korean Beef industry in 1980s: Farmers lobbied the
government to reject foreign beef imports; the
market price of Korean beef rose to $14 per pound
• US Shrimping Industry: Encourage the government
to place tarriffs on imported shrimp from China
David J. Bryce © 2002
5. Find New Types of Buyers
• Find alternative uses for your product
that are fundamentally new or different;
i.e. they appeal to an entirely new
customer group
• This reduces the total influence that any
one group of customers has in the
business and thus reduces their power
David J. Bryce © 2002
Examples
• Synthetic diamonds used in drill bits are
now applied in artificial joints
– New entry into drill bits was giving power
to buyers
– New medical device customers (for artificial
joints) reduce the effects of drill bit
customer power
David J. Bryce © 2002
6. Switching costs
• By creating costs to switch from your
product to another, you lock-in buyers
to repeated purchases and lower their
power
• The price of a potential alternative
product must then be lower than the
price of your product plus the switching
cost
David J. Bryce © 2002
Examples
• Ink for Inkjet printers—customers are locked into ink
cartridge types based on their printer purchase;
therefore, manufacturers price cartridges high since
they have a monopoly in their type of ink cartridge
• Games for Nintendo—Same effect as for ink; once
the game console is purchased, customers are locked
into Nintendo games; the high prices for games
demonstrate this fact
• Cell phone companies impose a contract period of a
year (minimum) and impose a high cost for early
withdrawal
• We will study more about the theory of lock-in and
switching costs in a later session
David J. Bryce © 2002
7. Play the Demand Game
1.
Price at or below marginal cost (your cost must be
lower than competitors) and produce large
quantities, essentially foregoing profit in early
periods
Your product attracts loyalty, dependence, and
dominant market share; competitors leave the
market
Then restrict supply and raise price
2.
3.
–
–
Risky if loyalty and dependence does not develop or if this
loyalty is based only on price
Works best in the presence of consumer switching costs
and/or in standards races
David J. Bryce © 2002
Examples: Play the Demand Game
• Microsoft operating systems pricing strategy;
MSDOS, Windows (succeeded)
• Similar pricing strategy for Netscape (failed),
Adobe Acrobat (succeeded), others
• Honda’s US entry strategy in motorcycles
(succeeded)
• Hyundai’s US entry strategy in automobiles
(failed)
Note: Success or Failure in terms of after-the-fact market share
David J. Bryce © 2002