Countervailing Power and Upstream Innovation

We challenge the view that the presence of powerful buyers stifles suppliers’ incentives to innovate. Following Katz (1987), we model countervailing (or buyer) power as the ability of, in particular, large buyers to substitute away from a given supplier. We employ a bargaining framework and find that the presence of larger and more powerful buyers increases a supplier’s incentives to reduce marginal costs. We identify two main forces. First, we show that while the supplier’s total profits decrease in the presence of larger buyers, the supplier can extract a larger fraction of any incremental profits. Second, we find that by lowering its own marginal costs a supplier can reduce the value of buyers’ outside options and that this effect is also stronger if there are fewer but larger buyers.