What are the consequences of market power in supply chains?

Policy-makers understand that when firms have market power over the goods and services that they sell, consumers suffer. The consequences of market power in supply chains are less clear, but they also could harm consumers. Competition authorities are examining the research evidence.

Competition authorities in many countries, including the UK, vigorously pursue businesses that exercise market power – restricting supply to raise prices – to harm consumers. Market power higher up in supply chains, between one business and another, is less visible, and therefore harder to study.

To address this evidence gap, the Competition and Markets Authority (CMA) recently brought together experts on market power in supply chains for a UKRI-funded workshop. Across several studies, a consistent picture is starting to emerge: market power in supply chains – whether it is the seller power of upstream firms or the buyer power of downstream firms – matters for market outcomes and can potentially harm consumers.

Understanding how firms bargain with each other is crucial for both efficiency and welfare; market power in one part of the supply chain network can create distortions elsewhere. In practice, insights into how firms bargain with each other can improve our understanding of competition across the whole economy.

We still need answers to many important questions: for example, how widespread is market power in UK supply chains; and how does it influence the diffusion of productivity and cost changes through the system? How do different vertical arrangements – those between firms at different stages of the supply chain – affect the efficiency and resilience of supply chains? And what information do we need to assess quickly the likely impact of supply chain changes on consumer welfare?

How do competition authorities think about market power in input markets?

The thinking of competition authorities on input market power – where businesses can influence the price of inputs, such as raw materials or wages – has evolved over time. Initially, because it was difficult to measure, input market power was not something to which competition authorities paid much attention.

When it did appear on the radar of competition economists, the prevailing theory became that because firms with buyer power seek to lower input prices, consumers would necessarily benefit from it. But this is bad economics: firms with buyer power will often lower input prices by restricting the inputs used. This is also likely to restrict the output produced and therefore raise, not lower, prices for consumers.

For example, a chemical plant that is the biggest local employer may hire fewer workers in the knowledge that this will allow it to pay each worker a lower wage. But because it hires fewer workers, it also produces fewer chemical products, which may then raise their price overall.

More recently, certain types of vertical restraints (decisions by a firm in a supply chain not to supply certain buyers in the downstream market) have caught the attention of competition authorities. Where a firm acquires an input supplier to prevent it from selling to competitors (what is known as input foreclosure), competition authorities now recognise the harm to consumers.

Recent mergers in which input foreclosure concerns have been raised in the UK include Broadcom/VMWare (in which Broadcom, a supplier of server hardware components acquired VMWare, a producer of virtualisation software used in data centres); and Schlumberger/ChampionX (a merger between two suppliers of oilfield services and equipment).

A recent example from the European Union is Illumina/Grail (the proposed acquisition of Grail, a company developing blood-based cancer tests by Illumina, a global genomics firm), while TomTom/TeleAtlas (in which TomTom, a producer of satellite navigation devices acquired TeleAtlas, a provider of navigable digital maps) is another good (if older) example.

In labour markets specifically, competition authorities have increasingly taken action to counteract buyer power (Kariel et al, 2024). But wider input market power still needs to be better understood.

How does input market power affect quantities and prices?

While researchers have a good understanding of the harms caused by monopoly power (when there is only one seller in a market), the related concept of monopsony power (when there is only one buyer of an input) is relatively understudied.

Yet, the two types of market power are closely related and can lead to similar harms. Just as the monopoly seller of a product may have an incentive to reduce production to keep prices high, the monopsony buyer of inputs may be motivated to acquire too few inputs to keep input prices low. This leads the monopsonist to sell too little to final consumers.

The two types of market power do not cancel each other out; in fact, they are related (and competing) ills.

How does the bargaining process influence outcomes for those involved?

In markets with many firms on both sides, economists generally assume that buyers and sellers transact seamlessly at the market price. But when there are few buyers and few sellers, the two sides need to bargain with each other over prices and quantity.

A useful concept in this context is that of Nash bargaining. This is a set of efficiency and fairness elements that economists believe that any realistic bargaining outcome needs to satisfy: Pareto efficiency (allocation where no one can be made better off without someone else being made worse off); symmetry (equal outcomes); independence of irrelevant alternatives; and invariance to certain kinds of transformations that preserve the order of preferences.

Two contributions to the workshop study how input market power shapes outcomes under a variety of different bargaining protocols.

Flavio Toxvaerd (University of Cambridge) shows that monopoly power and monopsony power are related problems that can both cause inefficiencies in production. Common flat-rate contracts cause double marginalisation (that is, multiple inefficient mark-ups over the cost of production). These outcomes are akin to those under a different, common bargaining protocol: inefficient Nash bargaining with right-to-manage (where firms bargain over price and then one side can set quantity).

By contrast, another common bargaining protocol – bilaterally efficient cost-plus contracts – corresponds to efficient Nash bargaining where negotiations cover all terms of the contract (and not just wholesale prices). Traditional models of price posting and take-it-or-leave-it offers arise as special cases of Toxvaerd’s more general bargaining model. The analysis therefore gives policy-makers a common tool for understanding different bargaining arrangements that often arise in supply chains.

Rémi Avignon (French National Institute for Research on Agriculture, Food, and the Environment, INRAE) and co-authors model bilateral monopolies in which an upstream firm (the input supplier) and a downstream firm (the input user) determine wholesale prices via Nash bargaining, while the quantity is set by whatever firm has the right to manage.

In contrast to Toxvaerd’s work (where one of the firms is allocated this right from the outset), Avignon and co-authors impose what is called a short-side rule: no firm can be forced to supply or buy (as the case may be) more than their desired quantity. This assumption means that for high negotiated wholesale prices, the downstream firm chooses output; for low wholesale prices, the upstream firm does instead.

This means small changes in the relative bargaining power of firms can lead to sudden changes of outcomes, as there is a regime switch where output is determined first along the demand function and then along the supply function.

Does the wider structure of supply networks also matter?

Matteo Bizzarri (University of Napoli Federico II) presented work on how prices form in production networks in which supply chains are potentially very complicated (rather than the simple upstream-downstream set-up that economists usually study).

His aim is to find alternative ways to understand settings in which market power is shared by both sides of the input markets. He departs from the two standard approaches, namely price posting (or its extension to top-down vertical oligopoly) and bilateral bargaining (or its extension to multilateral bargaining using what is known as the Nash-in-Nash approach: Nash bargaining embedded in a Nash equilibrium).

Instead, he considers price formation in which firms post menus of prices: selling firms compete in supply functions, while buying firms compete in demand functions. Using this new approach, Bizzarri shows that market power across the wider network can determine outcomes in a particular market.

Matt Elliott (University of Cambridge) and co-authors look at market power in supply chains using the framework of network theory. They are interested in how to identify bottleneck firms – those that have market power because they occupy nodes in the production network that, when removed, cause the economy to fail to meet final consumer demand.

They show that the existence of such firms is closely related to how competitive the economy is and derive algorithms for identifying such bottleneck firms in the data.

How much do these mechanisms matter in practice?

Michael Rubens (University of California, Los Angeles) and Mert Demirer (Massachusetts Institute of Technology) start from a model of bilateral monopoly in which an upstream firm and a downstream firm determine wholesale prices via Nash bargaining, as in the model developed by Avignon and co-authors.

Their approach differs in two main respects. Most researchers assume that firms first agree wholesale prices and only then agree on output. In contrast, Rubens and Demirer assume that firms determine output and prices simultaneously. To be able to solve this model, they appeal to the notion of Nash-in-Nash and assume that prices must fall between the marginal cost of the upstream firm and the marginal revenue of the downstream firm.

This creates a overall picture similar to that presented by Avignon and co-authors, in which outcomes can change drastically as the relative bargaining power between the two firms changes. Rubens and Demirer then estimate the model for three empirical settings across energy, agricultural and labour markets to show the insights it can yield when we have data of varying comprehensiveness. In practice, this approach demonstrates that relative bargaining weights, and as a result quantity and price outcomes, vary widely across settings and markets, suggesting the need for more industry-specific evidence.

Monica Morlacco (University of Southern California) and co-authors study a bilateral monopoly setting in the context of international trade, in which a domestic (downstream) firm sources its inputs from a foreign (upstream) firm. The firms negotiate over wholesale prices using Nash bargaining.

In contrast to the other research presented at the workshop, they employ a much richer production technology with additional inputs and non-linear demand for final goods. This allows them to take their model to data on Colombian importers. Ignoring market power in supply chains has important policy-relevant effects: for example, Morlacco and co-authors argue that failing to account for market power in supply chains leads to overestimation of the increase in market power over their period of study in conventional approaches.

How does input market power play out in labour markets?

The one area of input market power for which there are good data and evidence is labour market power (firms’ ability to set wages and working conditions).

For the UK, the CMA has recently summarised the extent and consequences of labour market power, arguing that even though labour market power has not increased in the UK (unlike in the United States), it can still have significant costs for affected workers.

The report documents labour market institutions that change the nature of labour market bargaining, such as non-compete agreements (contract clauses that prevent employees from moving to a direct competitor), collective bargaining and the gig economy.

At the workshop, Volke Nocke (University of Mannheim) and Heski Bar-Isaac (University of Toronto) considered how firms may use acquisitions to gain control of key workers and by doing so, exploit the resulting market power in the labour market.

A key question they address is why firms use acquisitions to gain access to workers, rather than to hire the same workers directly. They show that under direct hiring, the acquiring firm must compensate workers in order to give them incentives to move away from a valued existing job. In contrast, in an acquisition, this option is removed and so some of the supra-normal returns can be expropriated by the acquiring firm and the target firm’s shareholders.

What aspects of market power in supply chains do we need to understand better?

In the opening presentation of the workshop, Jakob Schneebacher (CMA) surveyed the importance of input market power in current policy and existing empirical evidence on the topic.

His overview highlights three lessons: first, that understanding input market power is crucial for many aspects of policy design (from better understanding of competition policy to creating an industrial strategy); second, that the bargaining process differs from setting to setting, creating a need for much more empirical evidence; and finally, that the boundaries of the firm are blurred in many vertical arrangements, which means that policy-makers need to understand long-term relational arrangements as well as traditional spot market transactions.

Schneebacher outlines four areas for the research community to investigate further to help policy-makers: better measurement; breaking down the boundaries between economic fields of research with different approaches to supply chains (such as trade or organisational economics); extensions to existing models to capture dynamic relationships better; and how to assess the welfare impacts of changes to input market power.

In addition, policy-makers need much better evidence on where market power sits in UK supply chains, how this has changed over time, and how it affects the propagation of productivity improvements throughout the UK economy. As part of its growth programme, the CMA Microeconomics Unit has announced an upcoming report to provide new evidence on these topics.

Where can I find out more?

CMA-UKRI workshop into market power in supply chains: research from a range of leading scholars into market power in supply chains.
Bilateral monopoly revisited: Price formation, efficiency and countervailing powers: Flavio Toxvaerd summarises a wide range of bilateral monopoly theories in a single theoretical model.
Market power in input markets: Theory and evidence from French manufacturing: Monica Morlacco presents new evidence on widespread input market power among French manufacturing firms.
Competition policy and labour market power: New evidence and open questions: Joel Kariel and co-authors survey competition enforcement in labour markets, new UK evidence on labour market power and open questions for competition authorities.
The state of UK competition report 2024: CMA research into how competition is working across the UK economy.