BUYER POWER: ECONOMIC
THEORY AND ANTITRUST POLICY
Zhiqi Chen
ABSTRACT
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. An important
conclusion that emerges from 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, 17-40
Copyright © 2007 by Elsevier Ltd.
All rights of reprOduction in any form reserved
ISSN: 0193-5895/doi:10.1016/50193-5895(06)22002-5
17
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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 2005.
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 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. 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 of upstream 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
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
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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.
2.2. Economic Effects of Buyer 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.
2.2.1. 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
Buyer Power
21
Marginal
expenditure
Price (w)
Supply curve
Demand curve
z*
Fig. 1.
Quantity (z)
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 wm . 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.
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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 of a 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
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.
2.2.2. 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 of the
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 of papers
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
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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 UngernSternberg, 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
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 counterYailing 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 of product 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
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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.
2.2.3. 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 of products.
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
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
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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.
2.2.4. 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 of competition 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
29
Buyer Power
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.
3.1. 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,
ZHIQI
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CHE~
however, may not be a profitable one if it 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 of abusing 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.
3.2. Existence of Buyer 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
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. 642-644) 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.
3.3. 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.
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 of the 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
Buyer Power
Table 2.
33
A Framework to Analyse the Competition Effects of Buyer
Power.
Upstream Market
Competitive
Buyers
Competitive
sellers
No buyer power
issue when
markets are in
equilibrium
Monopsony Power
Countervailing
Buyer Power
If linear prices are
used, efciency
loss is likely
Buyer power will
likely benet
consumers in
the short run
Buyer power may
have potential
long-run effects
on product
variety and
innovation in
the upstream
market, and on
the state of
competition in
the downstream
market
Efciency loss is
possible in both
short run and
long run
There are more
potential
competition
problems than
in the case of
competitive
downstream
market
If non-linear prices
are used,
efciency loss is
less likely but
the issue of
wealth transfer
remains
Downstream
market
Market power
No buyer power
issue when
markets are in
equilibrium
Efciency loss is
possible even if
non-linear prices
are used
market power over consumers. The discussion below is organized based on
the state of competition in the upstream market.
3.3.1. 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
34
ZHIQI CHEN
that there may be situations where occasional changes on the demand or
supply side shift the balance of power in favour of some 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.
3.3.2. 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 of non-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.
Buyer Power
35
3.3.3. 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 of countervailing 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
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.
37
Buyer Power
4. 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. 638-639). 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).
38
ZHIQI CHEN
6. To the best of my knowledge, the only theoretical analysis during this period is
Veendorp (1987), in which numerical examples are presented to illustrate the point
that while countervailing power may lead to lower consumer prices, it does not
necessarily improve economic efficiency.
7. In a related paper, Snyder (1996) develops a model where a price-taking buyer
accumulates backlogs of unfilled orders for the purpose of weakening tacit collusion
among sellers and obtaining lower prices. While the buyer in his model can be
interpreted as a downstream firm that buys an intermediate input and converts it into
a final product, the model's assumption of constant buyer valuation of the input
amounts to assuming that the downstream firm faces a fixed price in the downstream
market. Therefore, by design the firm's countervailing power in this model has no
impact on the consumer price in the downstream market.
8. The source of buyer power identified here is reminiscent of that of a buyer
group in Dana (2003). See Section 2.2.3 for discussion on buyer groups.
9. The same kind of arguments can also be found in an earlier paper by Inderst
and Wey (2004).
10. For this to occur, it must be the case that the cost of aggregating small orders
by the buyer group is lower than the cost of performing the same task by the
supplier.
11. See, for example, Section 1.0 of the Horizontal Merger Guidelines in the US, or
paragraph 3.4 of the Merger Enforcement Guidelines in Canada.
12. Recall from the discussion in Section 2.1 that the normal selling price is the
competitive price if there is perfect competition among suppliers, but it is above the
competitive price if the upstream market is dominated by suppliers with market
power.
13. The same approach is presented in Clarke et al. (2002).
14. Note that a multi-product retailer may be in more than one of these situations
simultaneously. It may deal with suppliers with little market power (e.g. a small
vegetable farmer) for some products, and large suppliers with monopoly power
(e.g. the Coca Cola Co.) for other products.
15. Related to this, Kirkwood (2005, pp. 647-651) lists five ways in which
non-cost justified discrimination as a result of the exercise of countervailing power
can harm consumers. The discussion below touches on these five ways in various
details.
16. In practice, however, such occurrence may not be very common. Based on his
personal experience at FTC, Kirkwood (2005, p. 647) observes that in most of the
investigations involving large buyers, the exercise of buyer power led to lower perunit prices from suppliers (in addition to lump-sum payments such as slotting
allowances) and some of the savings were passed on to consumers.
ACKNOWLEDGMENTS
For comments and discussions I thank Andy Baziliauskas, Tim Brennan,
Alan Gunderson, John Kirkwood, Roger Ware, and Thomas Ross.
Buyer Power
39
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