Buyer Power and Suppliers' Incentives to Innovate

With many industries experiencing significant concentration processes during the last years, suppliers are increasingly confronted with powerful buyers. The common belief is that exertion of buyer power negatively affects the innovation decisions of suppliers. The rationale behind this view is that buyer power leads to decreasing profits of suppliers, which at the same time lowers their investment incentives.

This explanation may be too narrow as competition in the buyer market may spur suppliers' innovation incentives. We consider both the price and the technology dimension of buyer market competition. A powerful buyer confronted with strong price competition might have the incentive to demand lower prices or higher quality in order to gain a cost advantage or to differentiate away from competitors. Moreover, for suppliers exposed to powerful technologically competing buyers it may be a precondition to be innovative and to utilize knowledge spillovers from the buyer side. Then supplier and buyer need cooperation and collaboration which requires considerable investments into their relationship. In turn this leads to a stronger bargaining position for the supplier and thus increases innovation incentives.

A few empirical studies are dedicated to the analysis of buyer power and suppliers' incentives to innovate and they frequently find a negative relationship. However these studies lack an objective measure for buyer power or merely use industry measures. Furthermore the focus is by now on particular industries which are perceived to be heavily affected by concentration processes among buyers. Besides, all these studies tend to neglect the dimensions of competition in the buyer market.

We analyse the relationship between buyer power and suppliers' innovation incentives empirically in different stages of the innovation process. That includes the innovation decision and the decision on the intensity of innovation activity. We apply firm level data provided by the Mannheim Innovation Panel (MIP). Our dataset comprises 1,129 observations from German firms across manufacturing and service sectors and allows us to apply objective measures for buyer power taking account of a supplier’s economic dependency from the largest three customers and the buyers’ opportunities to switch to competing suppliers.

We find a negative effect of buyer power on a supplier’s likelihood to invest in R&D. This negative effect is mitigated by the intensity of price competition in the downstream market. In contrast, we find no evidence of buyer power to affect a supplier’s decision how much to invest in R&D directly. Instead, there is weak evidence that the effect of buyer power depends on the intensity of technology competition in the downstream market. The stronger the technology competition downstream, the lower R&D investments of a supplier confronted with a powerful buyer.

Köhler, Christian and Christian Rammer (2012), Buyer Power and Suppliers' Incentives to Innovate, ZEW Discussion Paper No. 12-058, Mannheim.