Strategic interactions amongst firms in a supply chain crucially depend on the ability to negotiate — could Vertical Integration be the key?
Of all the possible pitfalls to the global economic system that the COVID-19 pandemic has shed light on, perhaps none is more central than assuring the resilience of global supply chains. Over the last few years, several major global players such as Amazon have astutely highlighted the importance of supply chains as part of a firm’s competitive strategy to grow and capture significant market value.
In this regard, it would be highly prudent for firms to analyse, in-depth, the strategic interactions between customers and suppliers – and the ensuing effect on the firm’s asset prices. Asset Prices here refer to two related concepts: the valuation of a firm (i.e. the market value, made up of the sum of its total equity and debt holdings)and, its’ expected returns i.e. the returns on investment to shareholders.
The Upstream and Downstream of it
Despite evident knowledge of supply chains in production the finance literature has not, historically, paid much heed to strategic customer-supplier interactions – especially in their role in affecting a firm’s asset prices. Further research from the LSE blog asserts, that “because customer and supplier firms share common fundamentals, the rewards that both offer to their respective shareholders are naturally highly correlated – whether in terms of dividend payments or stock price capitalisation. However, unlike the recent literature in law, there has not been a focus on trying to explore how firms’ strategic behaviour in supply chains (such as that of Amazon or Google) plays a role in explaining asset prices.”
A rather critical aspect of a firm’s supply chain strategy is the terms of contract between the firm’s upstream and downstream suppliers: especially the terms by which upstream firms supply to downstream firms. ‘Upstream’ firms are those which lie early on in the production process, including activities such as exploration, extraction and drilling in the oil and gas industry; the obtaining of biological materials from external sources, grown in culture (or other controlled conditions) in biomanufacturing, or the preparation of intermediary goods required eventually in the production process; among several others. ‘Downstream’ processing refers to those activities that occur later on down the production line, such as in the development of a final product, or even post-production activities such as marketing.
A key aspect in supply chain optimisation is analysing the strategic interactions between these different levels of the production process. Researcher Maria Cecilia Bustamante opines: “The specificity of a firm’s inputs of production, the degree of product market competition either upstream or downstream, or the technologies that both customers and suppliers apply to produce and assemble their products, to name a few, are critical aspects affecting the negotiations between customers and suppliers over the cost and delivery of inputs of production.”
In analysing these ‘strategic interactions’, of particular interest is a firm’s ability to negotiate the various input prices involved in the various processes of the supply chain – its ‘vertical bargaining power’ – as these may prove to have direct effects on the firm’s valuation and expected returns. The firms involved in the production process, whether upstream or downstream, are severely interdependent: if one part of the supply chain wishes to expand capacity or cater to other markets, there is enough incentive for the other firms involved in the production process to invest towards growth as well.
Research has found three major noteworthy aspects in this regard: (1) firms’ ability to negotiate, i.e. their bargaining power; (2) how firms’ bargaining power in the supply chain affects their exposure to risk and (3) why larger firms such as Amazon lay stress on vertical integration.
- A firm’s ability to negotiate, i.e. its bargaining power, is grossly complementary with canonical theories of bargaining in economics. Firms with greater ‘impatience to invest’ owing to factors such as a smaller scale of production or less diversified sales have a considerably lesser degree of bargaining power in negotiating input prices in supply chains. They thereby extract a lower level of profits, and thus have lower firm value.
- In observing the effect of supply chain firms’ bargaining powers on market risk, the findings are rather interesting. Whilst it intuitively makes sense for firms with a higher profit margin to be better insulated against shocks, this holds true only in its current A more predominant effect is noted in its future operations, which are, in fact, found to be riskier.
Bustamante writes, “(this) is because firms with greater bargaining power extract a larger fraction of the expected value of all risky growth opportunities available in the supply chain. Consequently, they are more exposed to unexpected future fluctuations in the business cycle. It follows that firms with greater vertical bargaining power such as Amazon are not only more valuable, but also yield higher expected returns.”
- Further insights from the empirical research find that greater competition in supply chains, whether downstream or upstream, reduces the asset prices of larger and more diversified firms with greater vertical bargaining power. This is because larger firms extract most of its future profits through input prices, and increased competition only leads to decreasing profit margins. This is perhaps the reason why several major global firms with large supply chains, such as Amazon, are looking towards vertical integration or reducing the number of intermediary nodes of production.
Further research surrounding vertical mergers, strategic interactions in supply chains and asset prices could prove to be rather beneficial in strengthening supply chain dynamics for the future.
Reference: Bustamante, Maria Cecilia, Customer-Supplier Interactions and Expected Returns (December 1, 2020). Available at SSRN: https://ssrn.com/abstract=3300964