Chapter 10: Creating and Capturing Value in the Value Chain
Creating and Capturing Value in the Value Chain
The focus has been on how competition among incumbent firms and the advantages they
might have over potential entrants have an impact on profitability of incumbent firms.
This chapter extends the analysis to the value chain in which the industry is embedded.
10.2 Value Creation, Value Capture, and Buyer or Supply Power
In keeping with the framework for industry analysis, we are interested in how the
characteristics of segments in the value chain and the links among them affect the
division of value (PIE). We want to identify what determines the value that the
manufacturing segment, the retailing segment, and the final consumers in this chain each
capture. The value extraction problem faced by the incumbents is to maximize the share
they are able to capture by reducing the share captured by other segments in the chain.
Broadening our perspective to include other segments of the chain also enables us to
think about value creation. By including the entire chain, we can think about the factors
that affect how much value is created. In particular, we will consider how relationships
between firms in different segments of a chain can create value.
Although it is convenient to think about value capture and value creation separately, they
are related activities. For example, if a firm has market power in its segment, the value
its chain creates and the share it captures are typically higher when all other industries in
the chain are fragmented. Often, however, pursuing capture has an adverse effect on
value creation. Because firms pursue both value capture and value creation, companies
within a chain can both compete and cooperate with each other. Value capture tends to
be adversarial; holding total value constant, we see that one segment’s gain is another
segment’s loss. Value creation, however, is often cooperative.
10.3 Capturing Value
Traditionally, a value chain is said to have suppliers “upstream” and buyers
“downstream.” This perspective is particularly appropriate for considering pricing
because the party charging a price is logically upstream to the one paying it. However,
some industries participants have a more complicated relationship. Fortunately, even
when one might argue about which segment is the supplier and which is the buyer, the
way these are assigned doesn’t affect how much value is generated or how it is
distributed among the segments. Furthermore, we usually don’t need to think about the
issues in relationships among buyers and suppliers separately because they are opposite
sides of the same coin. In any given relationship, what matters for value capture, for
example, is the relative ability of the firms to affect the transaction price.
“Value” means the value of the product to its final consumers minus the opportunity cost
of the resources required to produce it. This restates the definition of Potential Industry
Earnings (PIE), and the terms “PIE” and “value created” are used interchangeably. In
particular, although every segment in the chain typically adds something to PIE, a
segment that adds more value does not always capture more value.
“Supplier power” is the ability to capture PIE by demanding a payment in excess of
opportunity cost. “Buyer power” is the ability to capture value by demanding to pay less
than the price one is willing to pay. The key characteristic of buyer or supplier power is
the ability to affect the terms at which the parties exchange goods.
Firms producing a commodity product take the market price and other transaction terms
as given. If there is some cost asymmetry among these firms, however, the lower cost
firms will be more profitable. Competition implies that the market price will be equal to
the marginal cost of production. When there are cost differences among firms, the higher
marginal cost will determine price. To focus on buyer and supplier power, cost
differences are set aside by assuming that all firms in a segment have the same costs.
10.4 Creating Value
Competition limits buyer or supplier power.
“Supplier power” is another term for “market power in output markets.” “Buyer power”
is another term for “market power in input markets.” Because the competition within
each segment of the chain affects buyer and supplier power, the nature of competition in
all segments of the value chain affects value capture.
When there are multiple supplying industries, the analysis must be performed for each of
them. There may be spillovers from one buying industry to another. Unless the
supplying firm can prevent resale, selling to one industry in which the purchasing firms
have buying power can depress the price the firm can charge to all industries. To simplify
the analysis, assume that each layer of the value chain contains only one industry.
Value Capture without Buyer or Supplier Power
Suppose each stage (except the final consumers) in some value chain is a competitive
industry. Since a perfectly competitive firm cannot capture the value it creates, in this
case, the final consumers capture it all, even though consumers have no market power
and therefore no buyer power.
Value Capture by a Single Powerful Supplier (or Buyer)
Suppose a firm in one stage in the chain has buyer or supplier power. Because it has
significant market power, this firm can set its output price. If firms in the other stages are
competitive, competition among them drives their price to marginal cost, and the
powerful buyer can do no additional damage. Consumers, however, are worse off
because both their share of the value created and the total value created have declined.
Consumers can still capture some value even without the benefits of a competitive supply
chain. This happens because the powerful supplier is assumed to charge a single price for
its output. If, however, the company can price discriminate in some way among
Chapter 10: Creating and Capturing Value in the Value Chain
consumers who place different value on the product, it will increase the share of total
value it captures.
Strategic management scholars frequently claim a large supplier is powerful. But the
power relationship comes from a difference in market power, not a difference in size. A
firm may buy only a small share of some supplier’s output, but the supplying firm might
have no power because the industry is competitive. “Large” can mean that the supplying
firm provides an input that represents a large share of the purchasing firm’s cost.
Although a supplier with supplier power will charge a higher price for the same input
than a supplier who does not have supplier power (and therefore will have a larger share
of cost), cost share is irrelevant to market power. Even though an input represents a
significant share of the cost of a product, if the industry is competitive, firms have no
Value Capture When Buyers and Suppliers Are Powerful
More commonly, firms in several stages in a value chain have at least some buyer or
supplier power. As a result, more than one stage of firms shares the value captured.
When, more than one stage of the chain has firms with some power, two kinds of effects
come into play: double marginalization and bargaining over transaction price.
Suppose stage 1 is competitive and stage 2 is a monopoly, but stage 3 is a niche market.
Firms in stage 3 have some supplier power but no buyer power. Each niche firm has
some supplier power because it has some customers for whom purchasing from another
distributor is not a good substitute.
Because the first stage remains competitive, the monopolist’s buyer power is still
unimportant, and (stage 3) its supplier power still enables it to capture some value. Its
buyers also have some supplier power, which affects the share the monopolist can
extract. However, each firm in stage 3 will add a greater markup; its supplier power will
allow it to add a positive price-cost margin on top of the margin our monopolist creates.
These two margins are the source of the name “double marginalization.”
In this case, two industries are now capturing some of the value. As a result, the share
the monopolist captures has declined. The decline in share also implies that imperfect
competition in another stage will adversely affect the absolute amount of value the
monopolist captures. Firms prefer to have market power in their own industries to
mitigate the effects of competition on value capture. Firms also prefer their buyers to
have no supplier power.
Bargaining between Powerful Buyers and Suppliers
When a powerful supplier faces a powerful buyer. Both the supplier and the buyer can
influence the terms at which they transact. Whether a firm can capture a larger share
depends on its bargaining position. A firm’s bargaining position arises from the details
of the bargaining situation. The firms will bargain over the transaction price, and each
will probably capture some of the value. There are three common characteristics of
bargaining between two firms.
• First, both parties want the transaction to go forward. More generally, there are gains
from trade when some buyer values the product more than the seller does.
• Second, the final price cannot be one that makes either firm worse off than it would
be if the transaction did not go through. This is why the firm’s alternatives set the
price range: The buyer will pay no more than the increase in value that owning the
product will allow it to realize, and the supplier will not accept less than its
incremental cost of supply.
• Finally, the negotiated price reflects the relative bargaining power of the two firms.
Outside option value as a primary determinant of bargaining power, but other factors
can also come into play.
Negotiating skill can also affect bargaining power.
Whatever the precise outcome, a supplying firm with supplier power would prefer that its
buyers have no power. As with double marginalization, power elsewhere in the chain
reduces the value that the powerful incumbent firms can capture.
Reducing Power in Other Stages
Because competition among buyers or suppliers is the most important weapon against
supplier or buyer power, any strategy that encourages increased competition in other
stages can be profit enhancing. Vertical integration could mitigate the power of other
stages. In principle, the credible threat of vertical integration should suffice. To make
the threat of competition credible, a company can pursue a strategy of “tapered”
integration; it builds some capacity in another stage but not enough to serve its entire
demand for inputs or to handle its entire output.
If, however, bringing the activity in-house involves important scale or learning
economies, the firm may find the in-house operation much less efficient than the outside
alternative. Because in-house production is often at a competitive disadvantage to supply
by another stage, encouraging independent competitors is usually a better alternative.
Qualifying multiple suppliers, or ensuring that potential suppliers could easily be
qualified, reduces supplier power. Even if a firm has a favorite supplier, maintaining a
second source of supply lessens that supplier’s ability to threaten the firm and enables it
to capture more PIE. In some settings, holding an auction for inputs not only invites
firms to prove that they are qualified, but it may also induce competition more effectively
than negotiating with the suppliers separately.
The firm also might benefit by maintaining flexibility about the inputs it uses in its
production process if the supplier of one of those inputs has significant market power.
Firms can create tremendous value by working closely with their buyers and suppliers.
However, a cooperative working relationship to maximize value creation is not always
easy. Managers responsible for crafting and maintaining relationships with other firms
have to design a relationship that coordinates resource acquisition and deployment across
Chapter 10: Creating and Capturing Value in the Value Chain
firm boundaries. Since both firms want to capture value, their managers have divergent
interests. The organizational design problem is to construct a relationship that best
addresses the coordination and incentive problems to maximize the value created and
captured through the relationship.
Interfirm relationships can take many forms – vertical integration is at one extreme and
market transactions are at the other. Between these two extremes, are various “relational
contracts.” Relational contracts differ in duration scope, and complexity. Joint ventures
usually involve formation of a third entity and are complex contracts with substantial
scope and relatively long duration. A supply contract may be much simpler, more limited
in scope, and of various durations.
A manager thinking of setting up a relational contract needs to understand specifically
how the relationship will create value. Why will transacting within a relational contract
make the firm better off than it would be with a simple market transaction? The costs of
the relationships are often under-estimated. When a unit is on its own in the market, its
profitability and revenues become signals of its performance and quality. When a unit is
embedded in a complex relational contract, getting clear indicators of performance and
quality are much harder.
Many managers have a bias toward exerting control and thus, often think vertical
integration is the best solution. Vertical integration – or any relational contract between
firms in the value chain – does not solve all the existing problems and usually creates
Opportunities for Creating Value: The Coordination Problem
Generally, vertical relationships can add value by reducing transaction costs. Most
transactions are repeated so relationships can create value by encouraging companies to
make investments that are valuable only if the relationship continues. Investments of this
type are called relationship-specific investments because they are assets that are more
valuable within an ongoing relationship than they are outside it.
Relationship-specific investments have two general characteristics:
• They create value so both parties in the relationship want to make the investment.
• The value they create is specific to the relationship (i.e., they are less valuable outside
The combined effect of these two characteristics is that such investments create the
potential for “hold-up” (i.e., ex ante expropriation of the value created) by either party.
This implies that firms will not make the investment – and not create the value – without
Contracting to Create Value: The Incentive Problem
The hold-up problem exists because the incentives of the two firms are not aligned. Both
want the investment made because it creates value, but once one firm makes the
investment, the other has an incentive to capture as much of the value as possible. As
with other incentive problems, the appropriate contract can solve the hold-up problem.
However, a contract that protects both firms must anticipate all contingencies and would
be difficult, if not impossible, to write. Thus, except in the simple cases, formal contracts
that govern a relationship are incomplete. Unanticipated event often occur, especially as
the duration, scope, or complexity of the relationship increases.
One way to avoid the hold-up problem is to focus on the long-term gain from the
relationship. Firms in a relationship will make relationship-specific investments as long
as the gain from continuing the relationship is greater than the gain from exploiting the
opportunity for hold-up.
Another way to avoid the hold-up problem is implicit contracts (i.e., accepted ways of
dealing with issues) based on trust. Trustworthy behavior can reduce transaction costs by
reducing risk. Agreements sustained by an atmosphere of trust encourage firms to refrain
from constantly assessing the tangible perceived benefits and costs. A firm with a
reputation for trustworthy behavior can contract with others more easily.
It is one thing to say that “an atmosphere of trust” can be beneficial; it is another to create
and maintain that atmosphere. What supports this kind of relationship between firms? A
societal context where legitimacy rests on goodwill and reciprocity and commitment to
resolve problem are valued would promote an atmosphere of trust. Some have argued
that the Japanese culture fits this description, but that the individualistic values of
Western culture do not. However, adoption of these kinds of relationships in the U.S.
and Europe challenge these assertions.
Implicit contracts can develop between firms, but are difficult to develop and maintain.
Trust is central to these relationships, and trust takes time to develop. Implicit contracts
go through three phases:
• In Phase I, the pre-conditions for initiating the relationship are established (e.g.,
reputation of managers and firms for trustworthiness).
• In Phase II, the parties to the relationship enter a trail period during which rules
and procedures are established, clear expectations are formed, and some initial
level of trust and feeling of reciprocity is built.
• In Phase III, there is a key transition of level of operational integration (i.e., the
relationship becomes an integral part of each firm’s operations) and strategic
integration (i.e., the relationship is a central asset in their strategic objectives).
Implicit contracts do not negate the need for explicit contracts. Explicit contracts are
necessarily incomplete and imperfect, but they ensure both parties agree to certain terms
and provide essential protection at the beginning of a relationship. Explicit contracts are
important also because the firms’ interests may change over time effecting the balance
between benefits and costs of taking temporary advantage of their partner. Both explicit
and implicit contracts are useful ways to alter and to end the relationship.
Appendix: Price Discrimination
Chapter 10: Creating and Capturing Value in the Value Chain
Offering every buyer the same price limits a powerful supplier’s ability to capture value.
The seller could extract more value if it could charge a higher price the price inelastic
buyer and a lower price to the price elastic buyer. To do this, the seller needs:
• To distinguish between those willing to pay a higher price and a lower price.
• To be able to charge different prices.
• To prevent resale of its product.
Focus in the appendix is on the case where a powerful supplier faces buyers who have no
power. A total absence of buyer power is not necessary for price discrimination, but
allows the bargaining problem to be set aside.
Ideally, a firm would like to perfectly price discriminate, that is, be able to charge each
buyer a price exactly equal to her willingness to pay for the product. But the information
requirements are so high that perfect price discrimination is rare.
Firms have many ways to adjust its product and price offerings to achieve some price
• Finding an observable characteristic (e.g., quality consciousness) that is a rough
proxy for buyers’ valuations and offer different prices or products based on that
• Constructing purchasing requirements (e.g., discount coupons) that get consumers to
self-sort according to their willingness to pay.
• Tying a primary durable good priced at or near cost with complementary consumable
goods priced to extract value based on usage (e.g., deskjet printers and ink cartridges)
• Bundling two or more goods tha...
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