The Structure of the Economy: Bilateral Oligopoly

DEFINITION OF A BILATERAL OLIGOPOLY

Models of market structure assume that the demand side is represented by a large number of buyers.  The structure of the market, and the assumed market outcomes, depends on the number of suppliers and how they compete.  Suppliers either post one price or exploit their knowledge of buyer categories by using price discrimination.  Despite the comments about the key role of consumers in determining economic performance, consumers are fairly passive when the discussion focuses on imperfectly-competitive industries.  But many markets are not structured this way; the buyers are not passive consumers but large corporations that do not passively accept suppliers’ prices.  Net prices are actively negotiated.  These markets are often bilateral oligopolies.

In a bilateral oligopoly the buyers are not an undifferentiated mass of consumers but rather a small number of purchasing agents or professional buyers representing large purchasers.

 

There are now a small number of large corporations on both sides of the market.  The same company could be on different sides of two bilateral oligopolistic markets.  For example, Boeing Aircraft is a major purchaser of jet engines from the three big engine producers and one of two major suppliers (with Airbus) of large commercial aircraft to a limited number of large airlines. 

THE MARKET FOR CAPITAL EQUIPMENT

Economics textbooks talk about putting inputs together in the most cost-effective way possible to produce some level of output.  But if capital goods markets are not perfectly competitive, there is no mechanism on how this is done.

Markets for capital goods and many other inputs are structured differently than the consumer products markets that are the usual examples in economics.  Capital goods, processed metals like steel and aluminum, chemicals and petrochemicals, packaging material, transportation equipment, IT hardware and software, and other inputs are often produced by large corporations in oligopolistic industries.  There are usually large economies of scale and scope compared to the size of the market.  Economies of scale producing differentiated products define the size of the market and the net price of the product for each customer.  Yet, contrary to the impression in economics textbooks that concentration leads to collusion, companies in these types of industries are very competitive, including fierce price competition.  Even duopolies, such as Coke and Pepsi or Boeing and Airbus, can be very price competitive markets.  Long-run economic profits (profits above the cost of capital) are surprisingly rare.  Outcomes in many of these industries approach the ideal outcomes as if these industries were perfectly competitive.

One of the reasons for price competition and lack of market power by large sellers is the lack of asymmetric information.  Large corporations on the buy side of the market spend a great deal of resources to be well-informed about suppliers.  Size plus market information gives them countervailing market power.  The result is a bilateral oligopoly market structure.      

DESCRIPTION OF A BILATERAL OLIGOPOLY

Many producers sell intermediate goods and capital goods to final producers and assemblers.  Final producers often sell to large wholesalers, distributors and retailers.  Even small retailers often purchase through franchisors, buying offices or big coop distributors like True Value.  In all these situations, it is professional buyers who make the buying decision.  Purchasing agents and new product committees are well-informed about their suppliers.  They demand a great deal of information about products and services from potential suppliers but do not share actual price and product information with competing suppliers.

Because they represent large customers, they have substantial market power, playing off one supplier against another.  They buy in large volume, often for their own private label, and are compensated for negotiating low prices.  In the extreme, retailers like Wal-Mart force suppliers to offer prices close to the suppliers' marginal cost, the same prices that would prevail in a perfectly-competitive market. 

In many bilateral oligopolistic markets, price is a primary consideration in the purchasing decision.  Professional buyers along the supply chain are not swayed by marketing or advertising.  Brand names are often unimportant or irrelevant in markets for raw materials, commodities, industrial products, intermediate goods, commodity chemicals, information technology, products made to buyer’s specifications, generic products, and private label products.  Price at or near marginal cost occurs when competing products are close or perfect substitutes in the eyes of the professional buyers.  When buyers view alternative sources of inputs as close substitutes, sellers can not charge a premium price based on perceived superior value.

Corporate buyers have leverage if their company is a relatively big part of the market or if producers have large economies of scale.  One implication of large economies of scale is that producers are forced to run plants at a high percent of capacity to make a profit.  Industries with large economies of scale also often have industry overcapacity so that not all companies can run their plants at full capacity.  As long as price is above marginal cost, some companies would be willing to expand output to increase profit or reduce loss.  For example, auto company purchasing agents negotiate with large suppliers from the steel, aluminum, plastics, and tire industries, all of which currently have excess capacity. 

There are a small number of producers in many markets for raw material, semi-processed goods or industrial products because of large economies of scale.  Scale economies create the "through-put problem" for suppliers.  Economies of scale are made possible by large up-front investment in fixed assets representing new technology.  Units of output have low variable cost.  But there is low average (unit) cost only if plants are run at high rates of capacity.  If producers have high fixed cost relative to variable costs and must operate plants at a high percent of capacity to make an adequate rate of return, or plant closing costs are high, then large buyers might be able to force the contract or negotiated price down close to marginal cost.

Many large manufacturers face large assemblers or retailers as major customers.  If products are viewed as homogeneous by buyers, suppliers are chosen primarily on price.  Buyers use a number of bidding and contract negotiation procedures to maximize the amount of price competition among potential suppliers.  Anyone who has ever been a sales rep or purchasing agent knows how complicated this process can be.

Much of the discussion of the Internet is a variation of this description.  Internet companies may have high development costs but the marginal cost of one more buyer on the site may be close to zero.  A common strategy is then to try to grab as much market share as quickly as possible. 

For some products, like computer hardware and systems, the part of the market where computer companies sell computer systems to large institutions contains aspects of bilateral oligopoly.  About 40% of total demand for information technology comes from large companies, about 45% from midsize to small businesses, and only about 15% from individual consumers.  Large banks and other financial companies spend over $1 billion a year on information systems.  They have tremendous market power - negotiating power - when they decide which suppliers to choose.

Buyers for assemblers and retailers typically face final consumers and competitors in their product markets.  So demand in intermediate markets is derived from the buyers' forecasts of final consumer demand.  Professional buyers are actually negotiating part of the cost of the final product for the ultimate consumer.  They have a big incentive to try for the lowest cost of inputs, which will give their company a competitive advantage in the output market and determine profit margins.  Price competition in the final goods or retail market keeps profit margins down.

Unlike other imperfectly-competitive markets, here we assume symmetric information.  We do not assume that sellers know more than buyers.  There are informed purchasing agents on the buy side who spend considerable resources to gather data on suppliers.  They develop technical expertise, force suppliers to share proprietary information, visit plants, and demand data from competing manufacturers. Sellers often lack valuable information that buyers have – the offering net prices and sales conditions of other sellers.

Large corporations can be fiercely competitive for market share and increased profit.  Competitors also want to protect proprietary information, negotiating positions and marketing strategies from each other.

Although products and services may be differentiated in the eyes of producers, in some intermediate markets the competing products may be almost undifferentiated (almost perfect substitutes) in the eyes of purchasing agents.  Tires and computers are examples.  Demand from professional buyers for each product is more elastic than assumed by the producers.  Producers misjudge the price elasticity of demand.  They offer to sell at a higher price than buyers are willing to pay.  Buyers then institute price competition by playing off one supplier against another, negating the market power of the large suppliers.  By such means as competitive or sealed bids, buyers decide mostly on the basis of price.  Final market price is indeterminate, partly dependent on negotiating skills. 

Professional buyers and purchasing agents, following the self-interest of their company, are negotiating prices on behalf of the final consumer.  This is a major source of price competition in retail markets.  If buyers have elastic demand and can negate the supplier's market power, the market price will probably be closer to the price reached in a perfectly-competitive market.

MARKET SHARE AND MARKET POWER

It is usually assumed that a large market share translates into market power, the ability of a company to charge prices substantially above marginal cost (and unit cost) and thus make above-average rates of return.  In a bilateral oligopoly market, however, large market shares of suppliers can be negated by large market shares of buyers.  In fact, if the main reason for a small number of big producers is economies of scale relative to the total size of the market, then market power typically swings over to the buyers' side.  This is especially true if there is excess capacity in the industry, a common situation in manufacturing industries with large economies of scale.

Large producers may also not have much market power if every sale is important.  This is the usually situation in transportation equipment - Boeing vs. Airbus selling jet aircraft in multi-billion dollar deals, large containerships and oil tankers, and diesel locomotives sold to the handful of railroads left in the United States or national railroads in other countries.  Other examples in large capital goods markets are electric power-generating equipment, oil rigs or large earth-moving equipment (Caterpillar vs. Komatsu).  Another possibility is large construction companies and their suppliers bidding on large construction projects.

This implies that the heart of the strategy of a company in a bilateral oligopoly is to use its purchasing power and knowledge of the market to hold down the costs of inputs purchased from outside suppliers.  This strategy is crucial if the company is to be price-competitive in its output market.  In an output market of few suppliers, the company must be price competitive if it pursues a market share strategy.  Many companies believe that increasing market share in the short run is a tactic to increase profitability in the long run.

When there are a small number of well-informed buyers, they can constantly and effectively monitor the market.  They will be especially sensitive to any attempts by suppliers to attempt collusion since the buyers' companies are the immediate victims of supplier collusion.  Buyers may find it hard to pass on high input costs to their oligopolistic customers.  Buyers and purchasing agents can initiate "cheating", that is, price competition among suppliers.  This is one reason for the small amount of overt or even tacit collusion in U.S. industry. 

Even in a duopolistic retail market like that of cola, Coke and Pepsi compete for market share.  Supermarkets can often negotiate lower prices with one company in exchange for more shelf space and greater volume purchases.  This puts pressure on the other company to match the lower price.

DUAL MARKETS:  SELLING INTO RETAIL AND BILATERAL OLIGOPOLISTIC INSTITUTIONAL MARKETS

Corporate buyers are in a strong position if the same product, such as tires or personal computers, is sold in both retail and industrial markets.  Institutional buyers initiate a form of price discrimination, demanding lower prices than the wholesale prices to the retail market.  Price discrimination here works in favor of buyers if sellers are forced by competition or excess capacity to offer lower prices to large, well-informed corporate customers in the original equipment market.

Only part of the total market, the industrial part, has to be price-sensitive - sheets sold to industrial users, tires to car manufacturers, cola bought by fast food chains, personal computers bought by corporate buyers. 

BILATERAL OLIGOPOLY AND VERTICAL INTEGRATION

Being a buyer in a bilateral oligopoly is a good reason why an assembler or retailer should not integrate backwards (backwards vertical integration).  In the short run, the market is characterized by fierce price competition.  In the long run, a company does not want to get locked into one development path based on one type of technology.  The examples of what happened to IBM (fell behind Intel in microprocessors), U.S. Steel (did not adopt minimill technology) and General Motors (lack of innovation, inefficient internal coordination), all depending almost entirely on in-house research and development, caution against vertical integration.  Of course, large corporate buyers in intermediate markets can threaten to produce some of the inputs themselves.  Given the dynamics of bilateral oligopolies, this may not be a credible threat.

 

INDUSTRY STRUCTURE AND INTERNAL CORPORATE ORGANIZATION

This brings up the issue of the relationship between industry structure and internal organization.  Companies that recognize they are in a bilateral oligopoly may be less likely to have a fully-developed divisional structure.  The reasons could be a small marketing function (supply side), since advertising and promotion have limited effect on professional buyers, or a small product development function (buy side).  The result could be a simpler management structure.  Supplier firms will tend to be production-oriented, not market-oriented.  Many of the functions of a self-contained division are not necessary or are performed elsewhere (by customers, by suppliers, or by specialized capital goods companies) or jointly with customers. 

An important determinant of the internal structure of a firm will be the transaction costs to the firm as a buyer of inputs.  If transaction costs are low, possibly because of accumulated knowledge of the market, the firm will have low purchasing costs.  Internal coordination costs between purchasing and production, and related inventory costs, may be low if the purchaser can impose “just-in-time” delivery schedules on suppliers.  Also, net transaction costs may be low if the cost of accumulating knowledge about suppliers translates into lower prices for a large volume of inputs.

CONCLUSION

It is hard to find a market or industry, no matter how narrowly or broadly defined, that is not an oligopoly or tending to oligopoly.  These industries are usually part of a supply chain, most of which are structured as bilateral oligopolies.  This limits the market power of large corporations and constrains profit margins.

As discussed in the post on Baldwin Locomotives, producers of complicated products like transportation systems, supplying large transportation companies,  tend to be in bilateral oligopoly markets.  Many health care markets are becoming bilateral oligopolies, mostly through mergers and acquisitions. As one side of the market becomes more concentrated, companies on the other side combine as a defensive strategy.  
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This post is also an economics tutorial. For more economic tutorials, alternatives to chapters in standard textbooks, click on Pages.

For examples of bilateral oligopoly, see The New York Times Discovers Bilateral Oligopoly.

For a historical example of a bilateral oligopoly, see Baldwin Locomotive. 

For a modern example, see Markets and Large Companies:  A Case Study of Parker Hannifin

For a list of all posts and economic tutorials, see Guide to Posts and Pages.