BUYER POWER: ECONOMIC THEORY AND ANTITRUST POLICY

Transcription

1 BUYER POWER: ECONOMIC THEORY AND ANTITRUST POLICY Zhiqi Chen ABSTRACT The objective of this paper is to survey the recent developments in economic theories ofbuyer power and using the theories as a guide to discuss how antitrust cases involving buyer power can be analysed. An important conclusion that emergesfrom this survey is that the competition effects of buyer power are quite different depending on whether it is monopsony power against powerless suppliers or countervailing buyer power against large suppliers with market power. A proposed framework of antitrust analysis is presented, and issues related to market definitions and determination of buyer power are discussed. 1. INTRODUCTION The increased concentration of retail industry in Europe and the tremendous success of big-box retailers such as Wal-Mart, Home Depot, and Staples in North America and around the world have enhanced the interest in antitrust policy issues regarding buyer power in recent years. Antitrust authorities in Europe and North America appear to be increasingly concerned about the policy implications of rising buyer power. For example, both the OECD and Research in Law and Economics, Volume 22, Copyright 2007 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: /doi: / (06)

2 18 ZHIQI CHEN the European Commission conducted studies to examine the impact of buyer power on competition (OECD, 1998; European Commission, 1999). In the United States, the Federal Trade Commission held a public workshop in 2000 to discuss enforcement policy regarding slotting allowances, a major buyer power issue in grocery retailing. 1 A more recent indication of enhanced interest in buyer power in the antitrust community is the publication of a symposium on this subject in the Antitrust Law Journal in The objective of this paper is to survey the recent developments in economic theories of buyer power and using the theories as a guide to discuss how antitrust cases involving buyer power can be analysed. Section 2 is a review of the theoretical literature on buyer power. An important conclusion that emerges from this survey is that the competition effects ofbuyer power are quite different depending on whether it is monopsony power against powerless suppliers or countervailing buyer power against large suppliers with market power. These differences can be seen from their differential effects on economic efficiency as well as from the different consequences of their interactions with downstream competition and pricing schemes. In addition, theories of buyer group are also reviewed. Section 3 is a discussion of the antitrust analysis of buyer power. Three analytical issues are discussed: market definition, determination of buyer power, and assessment of anticompetitive effects. On market definition, it is pointed out that buyer power cases often involve two levels of markets. While the definition of downstream markets can be carried out in the conventional way, the definition ofupstream markets should focus on seller side substitutability rather than buyer side substitutability. Consequently, the relevant upstream markets are not necessarily aligned with the relevant downstream markets. In other words, the set of competitors on the buyer side of the upstream markets may not be the same as the set of competitors on the seller side of the downstream markets. This last point is especially important in the determination of buyer power. In practice, a useful indicator of buyer power is a buyer's market share, i.e. the buyer's share of purchases in the suppliers' total sales in the relevant upstream market. The above discussion suggests that when calculating the buyer's share of purchase, one should include in the denominator sales to all buyers in the relevant upstream market, not just those buyers who compete with this particular buyer in the relevant downstream market. For the assessment of possible anticompetitive effects in buyer power cases, I propose an analytical framework that is grounded in economic theories, in particular the recent theoretical developments. The framework uses a classification scheme based on the state of competition in both

3 Buyer Power 19 upstream and downstream markets. Consistent with the findings from the literature survey, this framework emphasizes the distinction between countervailing power and monopsony power. 2. ECONOMIC THEORY OF BUYER POWER 2.1. Definitions There is no generally accepted definition of buyer power. Existing definitions range from the almost tautological: 2 "[B]uyer power" refers to the circumstance in which the demand side of a market is sufficiently concentrated that buyers can exercise market power over sellers (Noll, 2005, p. 589). to the convoluted: [A] retailer is defined to have buyer power if, in relation to at least one supplier, it can credibly threaten to impose a long term opportunity cost (i.e. harm or withheld benefit) which, were the threat carried out, would be significantly disproportionate to any resulting long term opportunity cost to itself (GEeD, 1998, p. 6). A more useful definition, however, can be found in an earlier report by OECD (1981, p. 10): Buying power may be defined as the situation which exists when a firm or a group of firms, either because it has a dominant position as a purchaser of a product or a service or because it has strategic or leverage advantages as a result of its size or other characteristics, is able to obtain from a supplier more favourable terms than those available to other buyers. A similar definition of buyer power is proposed by Dobson, Waterson, and Chu (1998, p. 5) who state that buyer power is exercised when "a firm or group of firms obtain from suppliers more favourable terms than those available to other buyers or would otherwise be expected under normal competitive conditions." My preferred approach is to take the conventional definition of market power, 3 invert it to refer to the power on the buyer side, and broaden it to include both monopsony power and countervailing power. To be more specific, I would define buyer power as the ability of a buyer to reduce the price profitably below a supplier's normal selling price, or more generally the ability to obtain trade terms more favourable than a supplier's normal trade terms. As will become clear from the discussion below, it is useful to distinguish two types of buyer power based on whether the supplier has market

4 20 ZHIQI CHEN power. If there is perfect competition among suppliers, the normal selling price of a supplier is the competitive price. In this case, the buyer power is monopsony power. On the other hand, in a situation where the upstream market is dominated by a small number of suppliers with market power, the normal selling price is above the competitive price. In this latter case, buyer power can be called "countervailing buyer power" or simply "countervailing power.,,4 Allegations of buyer power typically involve a vertical situation where a firm or a group of firms buys goods (or services) from a supplier, uses them as inputs to produce a value-added product or service, and then sells it to consumers or firms in a downstream market. An obvious example of this kind of vertical relationships is a retailer who buys products from manufacturers and resells them to consumers. Another example, often mentioned in textbooks, is a large company located in a small, isolated town hiring local workers to produce a product sold in national or international markets. A more subtle example is automobile insurance companies whose business can be interpreted as "buying" automotive repair services, "repackaging," and reselling them in the form of insurance policies. Therefore, exercise of buyer power usually affects two levels of markets: an upstream market and a downstream market. For ease of discussion, I will refer to those firms who buy in the upstream market and sell in the downstream market as "retailers." I will call the sellers in the upstream market "suppliers," and the buyers in the downstream market "consumers." Buyer power then occurs in the upstream market, but it may affect the equilibrium in both upstream and downstream markets Economic Effects ofbuyer Power In this section, I will review the economic theories of buyer power, with an emphasis on more recent theoretical developments on this subject. 5 In what follows, I will discuss monopsony power and countervailing power separately. As will become clear later (see, in particular, Section 2.2.4), the effects of these two types of buyer power are quite different. In addition, I will also review the theories of buyer groups Effects of Monopsony Power As a starting point, consider the textbook theory of monopsony. Here, a single buyer faces a large number of competitive suppliers. In Fig. 1, the downward-sloping demand curve measures the marginal value of the good

5 Buyer Power 21 Price (w) Marginal expenditure Supply curve Demand curve z* Quantity (z) Fig. 1. The Textbook Theory of Monopsony. to the buyer, and the upward sloping supply curve measures the social cost of supplying an additional unit. Thus, socially optimal price and quantity is determined by the intersection between the demand curve and the supply curve (point A). On the other hand, the marginal expenditure (the additional cost of purchasing an extra unit) perceived by the monopsonist is higher than the supply price of the good because the monopsonist takes into consideration that an increase in quantity purchased pushes up the price. Consequently, the quantity chosen by the monopsonist (zm) is smaller than the socially optimal quantity (z*). By restricting the quantity purchased, the monopsonist succeeds in pushing the price down to w m. The loss in economic efficiency, measured by total surplus, is represented by the deadweight loss triangle ABC. The rectangle w*dcw m, on the other hand, represents a wealth transfer from the seller to the buyer. Note that the above analysis is done without reference to the competitive situation that the monopsonist might face as a seller in the downstream market. In other words, the efficiency loss identified above arises even if the monopsonist faces perfect competition in the downstream market. An imperfectly competitive downstream market changes the marginal value that the monopsonist attaches to the good, but it does not change the fact that the marginal expenditure curve perceived by the monopsonist lies above the supply curve. Consequently, the deadweight loss of monopsony exists independent of the state of competition in the downstream market.

6 22 ZHIQI CHEN It is important to recognize two assumptions in the textbook theory of monopsony. First, the supply curve is upward sloping. A monopsonist would not be able to affect the market price and thus cause efficiency loss if the supply curve were horizontal. Second, the transactions between the monopsonist and his supplier are based on a single unit price (linear pricing). If the parties are able to use more elaborate non-linear pricing schemes (e.g. two-part tariffs), there will be incentives for them to design a more efficient contract to capture the lost profit opportunity embedded in the deadweight loss. Therefore, if non-linear pricing is used, the efficiency loss of monopsony may be reduced or even eliminated. Provided that these two assumptions are satisfied, the insight from the textbook theory of monopsony is also applicable to situations of a small number oflarge buyers (oligopsony). In this regard, Clarke, Davies, Dobson, and Waterson (2002, p. 12) have identified three conditions that, in their view, "appear necessary for the exercise of buyer power: (i) the buyers contribute to a substantial portion of purchases in the market; (ii) there are barriers to entry into the buyer's market; and (iii) the supply curves are upward sloping. Under these circumstances, it is straightforward to apply the principles of oligopoly theory to model situations of oligopsony where strategic interaction occurs between a few buyers in a market." Strictly speaking, only conditions (i) and (ii) are necessary for the existence of buyer power. Condition (iii) is one of the necessary conditions for the exercise of buyer power to cause deadweight loss in the textbook model of monopsony. Indeed, Shaffer's (1991) analysis of slotting allowance and resale price maintenance provides an example where buyer power in the hands ofa small number of buyers may cause efficiency loss even if supply curves are horizontal. In Shaffer's model, duopoly retailers face competitive suppliers who have constant marginal costs and thus horizontal supply curves. Consequently, the deadweight loss analysis of the textbook model does not apply. Nevertheless, Shaffer demonstrates that the exercise of buyer power by the retailers can still cause efficiency loss. The loss arises because the retailers use their buyer power to mitigate their competition in the downstream market. To be more specific, in Shaffer's model suppliers compete to obtain shelf space at the retail level, and the instruments used to obtain shelf space are slotting allowance and resale price maintenance. Competition among suppliers gives retailers the buyer power to dictate the terms of contracts between the retailers and the suppliers. The use of slotting allowance allows the retailers to extract profits from the suppliers without depressing the unit wholesale prices, and higher wholesale prices mitigate downstream competition among the retailers. Alternatively, resale price maintenance provides a

7 Buyer Power 23 means for retailers to commit contractually to higher prices in the downstream market, thus raising retailer profits by eliminating their incentives for aggressive downstream pricing. Therefore, both types of contractual provisions can raise retailer prices and profits; thus, both can have anticompetitive effects Effects of Countervailing Buyer Power The term "countervailing power" was coined by Galbraith (1952) to describe the market power developed on one side of a market as a result ofthe market power on the other side. In his controversial book American Capitalism: The Concept of Countervailing Power, Galbraith argues that economic power on one side of a market begets countervailing power on the other side. According to Galbraith, an important manifestation of countervailing power was that of large and powerful retail organizations such as the major chain stores at that time (e.g. A&P and Sears, Roebuck). By exercising countervailing power, he argues, these retailers were able to lower the prices they paid their suppliers and passed on these savings to their customers. Galbraith's thesis was controversial at the time when the book was first published (see Stigler (1954) and Hunter (1958) for critiques of Galbraith's book). But subsequently it was largely ignored for a long time, as evidenced by the fact that until late 1990s little theoretical analysis had been done on this subject. 6 In recent years, the growing dominance of powerful big-box retailers and the resulting increased concentration in retail markets have renewed the interest in the countervailing power hypothesis. Since 1996, a number ofpapers have been published that analyse the countervailing power hypothesis in formal models. They include von Ungem-Sternberg (1996), Dobson and Waterson (1997), Chen (2003), and Erutku (2005).7 The main insight from the analyses by von Ungern-Steinberg and Dobson and Waterson is that increased concentration at the retail level does not necessarily lead to lower prices for consumers; under certain conditions it may in fact lead to higher prices. von Ungem-Stemberg (1996) studies a model where a monopolist producer bargains with oligopolist retailers. Retailers offer identical services and they compete in quantity (i.e. Coumot competition). He demonstrates that a decrease in the number of retailers unambiguously leads to an increase in equilibrium consumer prices. As a point of comparison, he also studies the case where the retail market is perfectly competitive and finds that a decrease in the number of retailers leads to a reduction in equilibrium consumer prices. He concludes that

8 24 ZHIQI CHEN countervailing power can have positive effects for the consumer only if competition at the retail level is very fierce. Dobson and Waterson consider a similar model where a monopolist supplier bargains with oligopolist retailers. Different from von Ungern Sternberg, services offered by different retailers are imperfect substitutes. Consequently, in their model, a more competitive retail market manifests itself through closer substitutability of retailer services. They show that consumer prices fall and economic welfare rises with the reduction in the number of retailers only if retailer services are regarded as close substitutes. The analyses by von Ungern-Sternberg and Dobson and Waterson highlight two opposing forces of retailer consolidation on consumer prices and economic welfare. When the number of retailers is reduced, the remaining retailers gain both countervailing power against their suppliers and market power against consumers. The countervailing power over the suppliers tends to reduce wholesale prices, which can lead to lower consumer prices when there is intense competition in the retail market. On the other hand, increased market power in the retail market allows the retailers to boost their price-cost margins, which tends to push up retail prices. Which effect dominates depends greatly on the intensity of retail competition ~ the former effect is stronger when competition is intense, otherwise the latter effect dominates and consolidation leads to higher prices for consumers. The above discussion suggests that if retailer consolidation leads to higher consumer prices, it is caused by the increased market power in the retail market. In these models, retailer countervailing power by itself benefits consumers and improves economic efficiency by exerting downward pressure on wholesale and retail prices. In contrast, the analysis by Chen (2003) suggests that retailer countervailing power does not necessarily improve economic efficiency. Specifically, Chen (2003) studies the effects of countervailing power in the hands of a dominant retailer. In his model, an upstream supplier sells to a group of downstream retailers, which consists of a dominant retailer and a competitive fringe. The dominant retailer possesses countervailing power, but a fringe retailer does not. An increase in the degree of countervailing power manifests itself in the form of a larger share of the joint profits going to the dominant retailer. Using this framework, Chen demonstrates that a rise in the countervailing power possessed by the dominant retailer reduces the equilibrium price paid by consumers. This, however, comes at the expense of possible efficiency loss in the provision of retail services. As a result, economic efficiency does not always improve with the rise of countervailing

9 Buyer Power 25 power. Furthermore, the presence of fringe competition is crucial for countervailing power to benefit consumers. Erutku (2005) modifies Chen's (2003) model by considering a situation where a national retailer competes with a local retailer in each geographic market. National retailer possesses countervailing power against a monopoly supplier, which allows it to get a discount off the list price set by the supplier. A local retailer, on the other hand, does not have any counter Yailing power and thus pays the list price. Services offered by the national retailer and local retailer are imperfect substitutes. Erutku shows that when forced to offer a larger discount to the national retailer, the supplier may raise the list price, which would push up the retail prices of local retailers. This occurs when the national retailer's countervailing power is relatively small. If its countervailing power is relatively large, on the other hand, both wholesale list price and retailer prices fall. An increase in the degree of competition between retailers makes the latter situation more likely. The price of the national retailer, on the other hand, falls monotonically with its.:ountervailing power. Therefore, Erutku's analysis identifies a situation where countervailing power of a large retailer may benefit some consumers but hurt other consumers. All of the analyses reviewed so far focus on the effects of countervailing power on prices. However, price effect may not be the only consequence of retailer countervailing power. In particular, concerns have been expressed about the possible longer term effect on product variety and innovation. This has been the subject of analysis in a number of recent working papers, including Chen (2004), Inderst and Shaffer (2004), and Inderst and Wey 12005). Chen (2004) studies a monopoly supplier's choice ofproduct diversity and how that choice is affected by retailer countervailing power. He shows that the number of products produced by the monopolist is lower than that of the constrained social optimum. Retailer countervailing power lowers consumer prices but reduces product diversity. Consequently, it alleviates the distortions in prices but exacerbates the distortions in product diversity. In Chen's model, the former is outweighed by the latter. Therefore, Chen's analysis demonstrates that retailer countervailing power can cause reduction in the number of products available to consumers, and the efficiency loss.:aused by this reduction may be large enough to lower aggregate economic welfare. A welfare trade-off between lower consumer price and reduced product Jiversity can also be found in Inderst and Shaffer's (2004) analysis ofretailer :nergers. In their model, there are two suppliers selling differentiated

10 26 ZHIQI CHEN products to two retail outlets. They show that following a merger that gives a single retailer control over both outlets, the retailer may want to enhance its buyer power vis-a-vis the suppliers by delisting a product and committing to a "single-sourcing" purchasing strategy.s Anticipating further concentration in the retail industry, suppliers will strategically choose to produce less differentiated products, which further reduces product diversity. Inderst and Wey (2005) identify a mechanism through which increased retailer countervailing power can improve economic efficiency by strengthening a supplier's incentives to reduce production costs. 9 In their model, a single supplier sells to competing intermediaries (e.g. retailers) who operate in many separate markets. As an alternative to purchasing from this supplier. a retailer can develop its own supply channel at a cost. A large retailer is able to spread this cost over a larger number of units, which strengthens the retailer's bargaining position against the supplier. On the other hand, a reduction in the supplier's marginal cost of production, brought about by the investment in innovation, improves the supplier's bargaining position against a retailer, because a lower marginal cost will lead to lower per-unit purchasing prices for all supplied firms and, consequently, a retailer that chooses to switch to another source of supply will be more at a disadvantage vis-a-vis its competitors. Therefore, the supplier can counter the strengthening bargaining position of a larger retailer by making more investment in innovation to engineer a larger reduction in its cost. An increase in retailer countervailing power, then, strengthens the supplier's incentives to reduce costs Buyer Groups Buyer power issues can also arise from buyer groups. If a buyer group is formed solely for the purpose of gaining market power over the group's suppliers, the effects of such buyer power can be analysed in more or less the same way as in the case of a single buyer. The small literature on buyer groups (Mathewson & Winter, 1997; Dana, 2003) is mainly concerned with the incentives to form buyer groups. According to Mathewson and Winter (1997), buyer groups can form in response to a market inefficiency caused by monopolistic competition, namely the failure of monopolistically competitive markets to achieve the optimal trade-off between lower costs and greater variety or availability ofproducts. They start with the proposition that a monopolistically competitive equilibrium can lead to an excessive number of firms or product variety, selling at excessive prices. They demonstrate that this property of monopolistically competitive markets is enough to generate the incentive for buyers

11 Buyer Power 27 collectively (or for a large subset of buyers) to offer a subset of sellers the right to their exclusive business in exchange for lower prices. The formation of such a buyer group benefits buyers inside the coalition. However, those consumers and firms outside the group may be made worse off. Outside consumers may face higher prices and fewer suppliers, and outside firms may face a smaller customer base. Dana (2003) suggests that buyer groups can be used as a commitment device in the negotiation with suppliers. He argues that a buyer group can create buyer power by committing to buy exclusively from a single supplier who offers the lowest price. When buyers with heterogenous preferences form such a buyer group, they induce the suppliers to compete more aggressively. Thus, a buyer group makes its members better off by intensifying price competition among suppliers. While some members of the group end up consuming the product they value less, the expected benefit of increased price competition exceeds the expected cost of consuming the wrong product. The incentives to form buyer groups and the effects of these groups analysed in these two papers can also be viewed as the incentives for and the effects of a merger among buyers. Indeed, there is some parallel between Dana's analysis of buyer groups and that of retailer mergers by Inderst and Shaffer (2004). This lends support to the earlier claim that in many instances analysis of a buyer group can be done in more or less the same way as in the case of a single buyer. There are situations, however, where buyer groups may raise unique competition issues. By definition, a buyer group involves coordination in the purchase decisions of the buyers. Typically, coordination takes place in the choice of suppliers and negotiation of prices. However, if coordination also extends to the quantity purchased by each member and this quantity has a direct impact on the member's output level in a downstream market, the buyer group could be used as a way to enforce collusion in the downstream market. Even in the absence of quantity coordination, one has to consider the potential facilitating effects because a buyer group reduces the variation in input costs among its members. Tacit collusion is easier to achieve when competitors have similar input costs. Therefore, in situations where members of a buyer group collectively account for a significant portion of the downstream market, the buyer group could be used as an instrument to facilitate downstream collusion. On the other hand, there are also situations where the formation of a buyer group may have nothing to do with the creation or exercise of market power. Consider a situation where there are economies of scale in the

12 28 ZHIQI CHEN supplier's distribution technology so that the average cost of processing a large purchase order is lower than that of a small order. In such a situation. a supplier may choose to offer volume discounts to encourage large purchase orders. Smaller buyers then may find it beneficial to pool their purchase orders so that they can receive the volume discounts. 1O A buyer group in such a situation is a way to exploit the efficiency gains associated with economies of scale in distribution technology Comments It is clear from the above literature review that the effects of buyer power are quite different depending on whether it is monopsony power against competitive suppliers or it is countervailing power against suppliers with market power. These differences can be seen in the following three areas. (1) The effects on economic efficiency. Generally speaking, exercise of monopsony power causes efficiency loss. With monopsony power, the best possible scenario is that the supplier and the retailer are able to use efficient contracts to avoid any deadweight loss, but even here monopsony power will not provide any benefits to final consumers. Countervailing power, on the other hand, is more likely to benefit consumers. Whether countervailing power improves economic efficiency will depend on the specific situations. and the analyses reviewed here are useful for identifying conditions under which it does. (2) The role of downstream competition. Deadweight loss of monopsony exists even if there is intense competition in the downstream market. On the other hand, the welfare effects of countervailing power depend critically on the state ofcompetition in the downstream market. A common theme in this literature (von Ungern-Sternberg, 1996; Dobson & Waterson, 1997; Chen, 2003; Erutku, 2005) is that consumers are more likely to benefit from countervailing power and consequently welfare is more likely to improve when there is intense competition in the downstream market. (3) The role of linear and non-linear pricing. In the textbook theory of monopsony, the use of linear pricing (a single unit price) plays a critical role in the welfare consequence of monopsony. In that model, the use of nonlinear pricing would reduce or even eliminate the deadweight loss of monopsony. By contrast, countervailing power is more likely to benefit consumers when linear prices are used (see, for example, Inderst & Shaffer. 2004; Erutku, 2005). With linear prices, the exercise of countervailing power will necessarily lead to lower wholesale prices, and lower wholesale prices usually translate into lower consumer prices. The use of non-linear prices. on the other hand, makes it possible for a supplier and a retailer to

13 Buyer Power 29 reallocate their joint profits without affecting the wholesale prices. Consequently, non-linear pricing may allow the firms to insulate the retail prices from the effects of a shift in market power. The above discussion suggests that it is important to distinguish between monopsony power and countervailing buyer power in the antitrust analysis of buyer power. 3. ANTITRUST POLICY AND BUYER POWER Analysis of an antitrust case usually consists of at least three parts: market definition, determination of market power, and assessment of anticompetitive effects. In what follows, I discuss each of these three parts for cases involving buyer power. The focus of this discussion is on areas where buyer power requires a somewhat different treatment from conventional market power Market Definition Buyer power cases often involve two levels of markets, which may require that market definitions be done for both the upstream markets and the downstream markets. The definition of downstream markets can be carried out in the conventional way (i.e. using the hypothetical monopolist test) since a retailer is a seller in the downstream markets. The definition of upstream markets, in which the alleged buyer power resides, requires more discussion because it is done from the buyer side as opposed to the seller side. In principle, the approach to market definition from the buyer side should be symmetric to the approach to market definition from the seller side. Therefore, I would mirror the hypothetical monopolist test used in merger reviews 11 and describe the approach to market definition from the buyer side as follows: A relevant market is defined as the smallest group ofproducts and the smallest geographic area in which a sole profit-maximizing buyer (a "hypothetical monopsonist") would impose and sustain a significant and non-transitory price decrease below its normal level. 12 Accordingly, market definition from the buyer side should focus on seller side substitutability, that is the ability by a seller to find alternative buyers. In this regard, an important factor to consider is the supplier's switching costs. When confronted by a retailer demanding lower than normal prices, a supplier may want to sell its product to an alternative retailer. This option,

14 30 ZHIQI CHE~ however, may not be a profitable one ifit faces significant switching costs, in which case, the alternative retailer has to be excluded from the relevant upstream market. Note that the relevant upstream markets defined using the hypothetical monopsonist test are not necessarily aligned with the relevant downstream markets defined using the hypothetical monopolist test. In other words, the relevant upstream markets and the relevant downstream markets could be quite different in terms of the products being included, or the geographic areas being covered, or both. For example, imagine a buyer power case where a supermarket chain is accused ofabusing buyer power against, say. a toothpaste manufacturer. At the downstream level, the relevant product market may be defined as the one-stop shopping of grocery products, and accordingly, the geographic market is likely to be local. The competitors in a downstream market are supermarket chains operating in a particular geographic area. At the upstream level, on the other hand, the relevant product market, defined from the buyer's side, is likely to be the wholesale purchase of toothpaste. The relevant geographic market will be national if the wholesale purchases are done at the national level. Competitors included on the buyer side of the upstream market may be all the supermarket chains operating in different parts of the country as well as other types of retailers (e.g. pharmacies) that also purchase and resell toothpaste. In such a case. there is significant asymmetry between the relevant upstream markets and relevant downstream markets Existence ofbuyer Power Before assessing its impact, one should first determine whether a retailer in fact possesses any buyer power. One should not presume that a retailer has buyer power simply because it is large in size relative to its supplier. A large retailer may not be able to obtain below-normal prices from a supplier if it has to compete aggressively against other retailers for the supplier"s products. The key to the existence of buyer power, therefore, is not the relative size, but whether there is vigorous competition, either actual or potential, for the supplier's products. To gauge whether there is actual competition for the suppliers' products. one can start with a calculation of the retailer's share of purchases in the relevant upstream market. Note from the toothpaste example that the other buyers in this upstream market do not necessarily compete with this retailer in the relevant downstream market. Therefore, one should take care to

15 Buyer Power 31 include the sales to all buyers in the relevant upstream market, not just those buyers who compete with the retailer in the relevant downstream market. It has been pointed out (Kirkwood, 2005, p. 637) that while a dominant share of purchases in the relevant market may be necessary for the exercise of monopsony power, such dominance is not required for a buyer to exert countervailing power. Kirkwood (2005, pp ) lists a number of instances where countervailing power had been exerted even though the buyers had neither a very large share of purchases nor a dominant share. Therefore, a very large share of purchases is not a necessary condition for the existence of buyer power. Neither is it a sufficient condition. One must also consider the barriers to entry into the buyer side of the upstream market. If high barriers to entry exist, an incumbent retailer may not have to worry too much about the possibility of its suppliers being bid away by a new retailer offering higher prices. Note, again from the toothpaste example, that the new retailer does not have to be a competitor in the incumbent's downstream market Competition Effects Dobson et al. (1998) have proposed an approach to analysing the competition effects of buyer power, framed around five questions (see Table 1).13 Questions 1-3 are designed to determine the existence of market power in the hands of suppliers and buyers. Depending on the answers to these questions, the effects of buyer power can be different. For example, "if the buyer power is against relatively powerless suppliers then there are concerns about abuse of monopsony power, which might include a detrimental effect on producer (suppliers') surplus and the long-term viability of suppliers. On the other hand, if buyer power is linked with significant seller power at the upstream level then it is more likely that the existence or enhancement of buyer power is beneficial, that is buyer power may have a socially beneficial countervailing effect by negating the detrimental effects of upstream.seller power" (Dobson et ai., 1998, p. 31). Through Question 4 Dobson et ai. propose to examine buyers' market behaviour, with a focus on buyerinduced vertical restraints that are potentially anticompetitive. Finally, Question 5 considers the underlying economic conditions in production! distribution in order to determine whether there is an efficiency reason for the presence of buyer power. As this approach was developed in 1998 (or ~rlier), it did not have the benefit of the insights generated by theoretical developments since then.

16 32 ZHIQI CHEN Table 1. Analytical Framework in Dobson et al. (1998). Question 1. Is there significant buyer power? If not, the considerations of buyer power are not relevant. (By 'significant power' is meant the ability to have material effect on prices set or negotiated, on quantities exchanged, or on the viability of traders at one or more stages ofthe production/distribution cycle.) 2. Is the buyer power against relatively powerless suppliers? If so, it is more likely that buyer power has policy implications. (In contrast, if buyer power is linked with significant seller power at the upstream stage then it is more likely that the existence or enhancement of buyer power is beneficial.) 3. Does the buyer itself have significant selling power? If so, then buyer power may serve as a means of strategically enhancing seller power in the downstream market raising potentially adverse effects 4. Does the buyer attempt to constrain its suppliers' other actions? If so, such an arrangement should be treated with suspicion 5. Are there significant productive efficiency gains associated with buyer power? If so, then there may be an efficiency justification for the presence of buyer power Relevant Evidence Significant proportion of the product as a whole purchased by this firm Significant arrangement of terms of purchase by this firm (e.g. upfront fees for distributing a product, such as slotting allowances) Absence of evidence that suppliers dictate terms of sale Low seller concentration in the upstream market Normal means of assessing seller power (in the downstream market) Evidence of exclusive supply requirements, specific custom designs or arrangements, idiosyncratic specification, etc. Pecuniary or other economies of scale indicating 'natural' monopsony tendency (i.e. average costs lowered by buying being undertaken by a single party) Here, I present an analytical framework of buyer power that is more firmly grounded in the economic theories of buyer power, in particular recent theoretical developments in this area. Instead of a series of questions. this approach uses a classification scheme based directly on the state of competition in both the upstream market and the downstream market. This framework is summarized in Table 2. As can be seen from the table. the state of competition in the upstream market is classified into three situations: (i) the retailer in question is a competitive buyer, (ii) the retailer has monopsony power, and (iii) the retailer has countervailing buyer power. 14 Meanwhile, the condition in the downstream market is divided into two cases: (a) the retailers are competitive sellers and (b) the retailers have

17 Buyer Power 33 Table 2. A Framework to Analyse the Competition Effects of Buyer Power. Upstream Market Competitive Monopsony Power Countervailing Buyers Buyer Power Competitive No buyer power If linear prices are Buyer power will sellers issue when used, efciency likely benet markets are in loss is likely consumers in equilibrium the short run If non-linear prices Buyer power may are used, have potential efciency loss is long-run effects less likely but on product the issue of variety and wealth transfer innovation in remains the upstream market, and on the state of competition in the downstream Downstream market market Market power No buyer power Efciency loss is Efciency loss is issue when possible even if possible in both markets are in non-linearprices short run and equilibrium are used long run There are more potential competition problems than in the case of competitive downstream market market power over consumers. The discussion below is organized based on the state of competition in the upstream market A Competitive Buyer If there is a large number of small buyers in the upstream market, buyer power does not exist when the market is in equilibrium. If there is no buyer pvwer in this case, why include it in this analytical framework? The reason is

18 34 ZHIQI CHEN that there may be situations where occasional changes on the demand or supply side shift the balance ofpower in favour ofsome retailers in the short run, which may lead to complaints about anticompetitive buyer power. For example, changes in consumer tastes may lead to a permanent decrease in the demand for a product. The excess capacity caused by the drop in demand may trigger a price war among suppliers as they struggle to stay alive. This may confer buyer power on some retailers in the short run. The buyer power, however, evaporates in the long run as some suppliers are forced to exit and the number of suppliers in the market reaches its new equilibrium level. Similarly, advances in technology that enlarge the efficient scale of production may reduce the number of suppliers needed in a market and, as existing suppliers fight for survival, confer buyer power to some retailers in the transition period. However, as long as a reasonably large number of buyers remain in the upstream market, this kind of short-run buyer power is unlikely to raise competition concerns. Note that the above discussion is applicable whether a retailer has market power in a downstream market or not. Market power in a downstream market could raise competition policy issues of its own. But that is not the subject of analysis in this paper Monopsony Power Monopsony power arises when a retailer possesses market power against a competitive supplier. As has been discussed in Section 2, monopsony power against competitive suppliers can cause deadweight loss both in the case where the downstream market is competitive and in the case where the retailer has market power in the downstream market. This is particularly the case where a linear pricing scheme is used in the contracts between the retailer and its supplier, in which case, the deadweight loss caused by monopsony power is independent of the state of competition in the downstream market. The effects of monopsony power are more ambiguous when a non-linear pricing scheme is used. In the case of competitive downstream market, the use ofnon-linear pricing may reduce or eliminate the deadweight loss arising from monopsony power, although monopsony power still causes wealth transfer from the supplier to the retailer. However, the effects of monopsony power may not be as benign in the case where the retailer has market power in the downstream market. In such a situation, as Shaffer (2001) shows, oligopolistic retailers with monopsony power can use non-linear pricing as an instrument to lessen competition in the downstream market.

19 Buyer Power Countervailing Buyer Power The analysis tends to be more complex when buyer power is exercised against sellers with market power. Depending on the state of competition in the downstream market, a range of scenarios is possible. For example, exercise of countervailing power could benefit consumers in the short run but not long run, benefit consumers in both short run and long run but at the cost of efficiency on the production side, or harm consumers and cause efficiency losses in both short run and long run, just to name a few possibilities. 15 Therefore, the subsequent discussion in this subsection is organi 'zed based on the state of competition in the downstream market. The Retailer Faces Intense Competition in the Downstream Market. In this case, exercise of countervailing power by a large retailer is likely to benefit consumers, at least in the short run. This is the scenario that has often been put forward in the discussion of buyer power in popular press. Buyer power in the upstream market allows a large retailer to obtain lower prices from its suppliers, but intense competition in the downstream market forces the retailer to pass on at least a portion of the cost savings to consumers. Beneficial effects to consumer do not necessarily mean that exercise of countervailing buyer power is always free of efficiency loss. As Chen (2003) shows, increased retailer countervailing power by a dominant retailer, while benefiting consumers by reducing the prices they pay, can cause efficient loss on the production side. The reason is that exercise of buyer power by one retailer will typically cause redistribution of retailing business in the downstream market. Given that this redistribution of business is based on the retailers' buyer power (or the lack of) in the upstream market rather than on their productive efficiency in the downstream market, it tends to result in distortions in downstream production. Furthermore, one must consider the effects of countervailing power in the long run. A question of particular interest is, can the intensity of competition in the downstream market be maintained in the long run? Or, to put it in a slightly different way, will the competition in the downstream market be lessened as a result of exercise ofcountervailing buyer power? In this regard, it may be useful to consider the relative strengths of the competing retailers in the upstream market. If most retailers have approximately the same amount of buyer power against their suppliers, it is unlikely that one of the retailers will be able to use the cost advantage obtained from the exercise of buyer power to squeeze out most of its rivals in the downstream market. In such a situation, it is likely that most of the existing competitors in the

20 36 ZHIQI CHE~ downstream market will survive, and hence effective competition wi1llikely remain in the long run. If, on the other hand, buyer power is concentrated in the hands of one or two dominant retailers, competition problems may arise in the long run when a significant number of smaller retailers are forced oui of the downstream market and, as a result, the dominant retailers acquire significant seller power in the downstream market. Finally, one must consider the long-run effects of countervailing power on product variety and, more generally, on investment in innovation by upstream suppliers. Recall from the discussion in Section 2 that the theoretical predictions on this subject are rather mixed. Depending on the circumstances, retailer countervailing power can cause distortions in product variety that outweighs the benefits of lower consumer prices (Chen. 2004), or strengthen suppliers' incentive to invest in innovation (Inderst & Wey,2005). The Retailer Possesses Market Power in the Downstream Market. In this case, the retailer possesses market power in both upstream and downstream markets, and countervailing buyer power is most likely to cause competition problems. Broadly speaking, competition problems may arise from two directions. First, the exercise of buyer power itself may cause harm to consumers and deadweight loss in the economy. Insufficient competition in the downstream market means that a retailer with buyer power will not be compelled to pass on the cost savings to consumers. On the contrary, it may find it advantageous to raise the purchase prices it pays the suppliers and extract profits from the suppliers in the form of lump-sum payments such as slotting allowances. In an oligopolistic retail market with insufficient price competition, a commitment to higher purchase prices by a retailer will push up its own retail prices, and encourage other retailers to raise prices (Shaffer. 1991).16 Second, a retailer may abuse the dominant position conferred by its buyer power in an attempt to eliminate or stifle competition in the downstream market. Such abuse of dominant position may take the form of pressuring suppliers into not supplying certain competitors of the retailer: imposing market restrictions, such as exclusive dealing, on suppliers; or raising rival's costs by artificially bidding up the suppliers' prices. The possible anticompetitive effects of these practices can be analysed in the same way as conventional abuse of dominance cases.

21 Buyer Power CONCLUSIONS An important observation from the literature survey is that the competition effects of buyer power are quite different depending on whether it is monopsony power against competitive suppliers or it is countervailing power against suppliers with market power. Generally speaking, exercise of monopsony power causes efficiency loss. With monopsony power the best possible scenario is that the supplier and the retailer are able to use efficient contracts to avoid any deadweight loss; but even here monopsony power will not provide any benefits to final consumers. Countervailing power, on the other hand, has a better chance to benefit consumers. Whether countervailing power improves economic efficiency will depend on the specific situations, in particular the state of competition in the downstream market. Consistent with this observation, the analytical framework of buyer power proposed in this paper uses a classification scheme that is based on the state of competition in both upstream and downstream markets and emphasizes the distinction between monopsony power and countervailing buyer power. NOTES 1. Shaffer (1991, p. 12) defines slotting allowance as "fees paid by manufacturers to obtain retail patronage. They may be cash gifts or payments in kind, such as cases offree goods. Either way, their salient characteristic is that the fee paid does not vary with subsequent retailer sales." 2. This definition conveys virtually no information as it does not specify what market power means in this context. It is equivalent to defining monopoly power (seller power) as the "exercise of market power by a seller." 3. Market power or monopoly power is usually defined as the ability of a firm to set prices profitably above competitive levels. See, for example, Carlton and Perloff 12005, p. 783) and Viscusi, Harrington. and Vernon (2005, p. 294). 4. This approach is similar to the one in Kirkwood (2005), which makes a distinction between monopsony power and bargaining power based on the way buyer power is exercised. Monopsony power is exerted through the reduction in the quantity purchased, while bargaining power "is the power to obtain a concession from another party by threatening to impose a cost, or withdraw a benefit, if the party does not grant the concession" (Kirkwood, 2005, pp ). Kirkwood also observes that normally bargaining power can be exercised only in markets where a seller has market power. Therefore, there is little substantive difference between the bargaining power in Kirkwood (2005) and the countervailing power defined here. 5. Surveys of older literature can be found in Blair and Harrison (1993) and Clarke et al. (2002).