In a recently published article, my co-authors and I examine buyer-supplier relationships that are characterized by lock-in situations. The study uses the theoretical foundations of social exchange theory. An illustrative multinational business example from a Danish Business Group is used to demonstrate the complexities of the lock-in situation. The conjectures developed are investigated by means of a game-theoretic model. Specifically, in the analytical model we consider the situation in which the supplier who has locked in the buyer must take into account the possible creation of substitute product by the buyer.
From the supplier's point of view, this translates into the problem of determining an appropriate pricing strategy. In our conceptualization of demand, we assume that the buyer sells a product to customers and it sources an essential component for making the product from the supplier. The supplier is completely dependent on the buyer for the product. Supplier charges a price, which is a function of the level of dependence of the buyer on the supplier. In case the supplier raises the price, the buyer adds it to its own cost structure and sells the final product to the customer at a higher price. Thus, the price increase by the supplier has a negative effect on final customer demand.
The buyer invests in innovation and product development to develop a substitute component to become independent of the supplier's lock-in. We assume that the development of the substitute product would enable the buyer to adopt a pricing strategy commensurate with end market demand, instead of adopting a pricing policy that is related to the price charged by the current supplier. If the buyer succeeds in developing a substitute product, the supplier's products will not be sourced anymore. The buyer problem is to decide how much to invest in developing the substitute product based on the price charged by the supplier. Therefore, the investment intensity in innovation and product development or in the development of an alternative source is a function of the supplier's pricing strategy. The outcome of investment is uncertain and this makes the problem complex. We assume that the investments in innovation and product development do not precisely determine the time of success of developing the substitute component. The supplier is assumed to be aware of the efforts of the buyer to develop a substitute component and adopts a pricing policy that seeks to maximize its returns from the relationship.
The results derived from the analytical model serve in the development of key research propositions. These research propositions are examined by means of a behavioral experiment. One of the key insight from the study is that the supplier should lower the price with increasing demand. The buyer's optimal investment intensity also decreases with increasing demand.
Source: Narasimhan, R., Nair, A., Griffith, D., Arlbjørn, J., Bendoly, E. 2009. Lock-in situations in supply chains: Social exchange theoretic study of sourcing arrangements in power-based buyer-supplier relationship. Journal of Operations Management, Vol. 27, No. 5, 374-389.