CIAO DATE: 8/01

Is Collective Purchasing Good or Bad for the Economy?

James K. Glassman
Kevin A. Hassett

On The Issues

February 2001

American Enterprise Institute for Public Policy Research

Advances in information technology are allowing consumers to bargain as a single buyer and drive prices down. Such arrangements may provide an effective counterweight to monopolies and other powerful sellers.

Even as the new economy breeds new strains of monopolies or near-monopolies like Microsoft or America Online, it is also breeding their opposite—an arrangement that economists call "monopsony."

While monopolies have always been with us, it's only recently that the somewhat dusty notion of monopsony has popped up on the public-policy radar, primarily because of Covisint, the automotive exchange. Its recent monopsony-tinged brush with the Federal Trade Commission and European regulators brings several questions to mind: Is monopsony a bad thing? Should it be squashed by regulators? And how will it change the way business is done?

More to the point, what is monopsony?

Simply put, monopsony is the opposite of monopoly. Where a monopoly is a single seller and lots of buyers, a monopsony is a single buyer and lots of sellers. In both cases, there's a lopsided balance of power: Monopolists can gouge buyers by forcing them to accept higher prices while monopsonists can exploit sellers by forcing them to accept lower prices.

The classic example of a monopsony is an isolated nineteenth century New England town with just one employer—say, a big textile manufacturer. The company is the only buyer of labor in a town with abundant sellers of labor. Since workers have nowhere else to turn for jobs, they have to accept low wages.

In modern times, monopsonies are rare. Unless sellers are stuck in a single, small market (as they were before transportation and communication developed in the twentieth century), they have abundant potential customers.

 

The Increasing Power of Buyers

But the Internet is changing the nature of buyers. Since they can share information quickly in a digital world, these buyers can create what's called "aggregate demand." In other words, they can combine into one big buyer, with enormous power to extract concessions from sellers.

Right now, examples of demand aggregation seem almost trivial, but that situation will soon change. Consider MobShop.com, which lets consumers join with others to become mass buyers. On offer recently, for example, was an AcerPower 8600 computer with a suggested retail price of $2,405. If one to five consumers register to buy the machine, the price would drop to $2,049; with between six and fifteen buyers, the price would fall to $1,999.95, and so on. The more buyers, the lower the price.

Mercata.com uses the same approach, selling items such as phone calling cards (10,000 buyers signed up) and rebates on Buicks. "It's a win-win situation," says Tom Van Horn, Mercata's founder. "It's a win for buyers because they get volume discounts, and it's a win for sellers because they sell a lot."

But win-win is not the only possible outcome. An exchange like Mercata could turn some sellers into big losers. We asked Van Horn to imagine that millions of potential buyers signed up on a Mercata-like site—just about everyone who wants to buy a PDA. What would happen if this "one big buyer" demanded a price of $100 for a $400 Palm? "I suppose I could imagine that," he answered. Now, imagine that Palm won't sell at that price, so the one big buyer simply turns to another supplier—Hewlett-Packard or Handspring. With that kind of power, buyers could drive prices so low that the profit margin of the firm that offers the best deal would be eliminated and its competitors would be driven out of business.

Of course, this is only a thought experiment. As with selling cartels like OPEC, this Palm-buying cartel could be broken if some buyers decided not to hold out. But our point is that technology is changing the patterns of buying and selling, and information-sharing puts a lot more power into buyers' hands.

The power of monopsony will be felt more quickly in the business-to-business world. The online exchange Covisint, for example, links five automakers (together accounting for about half of all worldwide production) with perhaps eventually as many as 8,000 suppliers. While the FTC voted on September 11 to allow Covisint to move forward, it continues to keep a close eye on it. The big question is whether the automakers will get together as one big buyer and pressure suppliers to either cut prices to the bone or have no one to sell to. Covisint spokesman Dan Jankowski says the exchange does not intend to allow the automakers to aggregate their purchases. In other words, Ford and GM won't be able to enter a joint bid for antilock brakes or rear-view mirrors. We'll see.

Down the road, it seems inevitable that the automakers will use their combined buying power to cut costs. The only restraint on such actions would be trustbusting. And Covisint is not the only such exchange. MyAircraft.com, set up by Honeywell (soon to be part of General Electric) and United Technologies, received FTC approval in 2000, and there will be more to come.

Even if Covisint and its brethren do become monopsonies, why is that a bad thing? The automakers, acting as one big buyer, will be able to buy their parts more cheaply and pass the savings—at least part of the savings—to the customer. Isn't the point of antitrust regulation to help consumers by making quality goods and services cheap and, even more important, abundant?

Certainly, but the problem with monopsony is the same as with monopoly—not so much prices as output. A monopolist typically earns more by withholding supply and driving up prices. Likewise, a monopsonist typically earns more by withholding demand to drive prices down.

And yet, no matter how you slice it, when you drive prices down, you also drive supply down. It's no fun producing more stuff if you know that you won't get a decent price for it. Unlike the "invisible hand" of the marketplace, which helps to find the right balance of supply and demand, monopsony gives the demand side a thumb on the scales.

So should regulators crack down on incipient monopsonists and kill them in the cradle? Probably not. As Microsoft's success so readily demonstrates, the new economy has a remarkable propensity to foster huge market shares for first-movers—or simply for best-movers. Monopsony can provide a counterweight to those advantages—a way for decentralized buyers to keep powerful sellers from getting out of control.

We're under no illusions about monopoly and monopsony balancing each other perfectly, of course. The moral here is that regulators should go slowly in acting against apparent monopolies and apparent monopsonies alike. Things are changing fast. We know, for example, that Internet monopolies are different from old-economy monopolies since the marginal cost of making many digital products is close to zero. So there's no reason to limit supply, as the old-economy monopolists did. In fact, there is good reason to boost supply in order to create broader networks on which to sell more goods. This, of course, makes regulating monopolies a slightly more complex proposition.

 

Balancing the Power of Monopolies

Just as digital production methods and networks are fostering different kinds of monopolies, so too might digital communications methods and networks foster a different kind of monopsony. At last, buyers can talk to each other in real time and aggregate their demand.

It's easy, then, to imagine a digital monopsony being a more benign force than a New England textile mill. Against the mill, the only countervailing power was a union—sellers of labor, trying to create their own monopoly and threatening to withhold their product unless they get their price.

But imagine that a half-dozen computer makers decided to band together as one big buyer. Just the possibility of their acting in concert would tend to lower the prices charged by near-monopolist software companies and chipmakers. Market forces will provide a natural balancing mechanism. If a monopolist gouges its customers, then there will be a much stronger incentive for them to form a monopsony.

In other words, when customers of a monopoly coalesce to bargain as a single buyer, it may—sometimes—be good for society and the economy. A monopoly raises prices to maximize profits, and consumers respond to the higher prices by purchasing fewer goods—an unhappy result. If, on the other hand, consumers work together as one big buyer and say to the monopoly, "If you don't give us a price we like, we will collectively shun your product," then the monopoly will be forced to lower its price. As the digital world makes markets more fluid, monopsony may do a better job of regulating monopoly than the FTC ever could.

 

James K. Glassman is a resident fellow at AEI. Kevin A. Hassett is a resident scholar at AEI. An earlier version of this article appeared in the December 11, 2000, issue of the Industry Standard.