Swatch and supplying competitors

When we started this blog, I would not have expected that we would end up so many posts on luxury Swiss watches. But I like fancy watches, and the interesting stories keep coming. The most recent story comes from the New York Times (Swatch, Supplier to Rivals, Now Aims to Cut Them Off, Dec 10) and concerns a theme we have hit before, Swatch’s decision to stop supplying movements and components to other watch brands. Unless a series of lawsuits against the action stops them, the hammer drops on January 1st and Swatch can begin cutting back its supply.

Reading the article got me thinking about when it makes sense to supply competitors with components. Clearly, if the other firm’s product is a complete substitute to one’s own, one could cut off the supplier, increase one’s own volume and have the same volume with more margin. At the other extreme, if the other firm’s product is not at all a substitute, then one might as well sell to the firm. You are not directly competing so it’s just found money. So substitutability has got to matter.

This can be formalized with a simple model. Suppose that when firms A and B bring quantities Q_A and Q_B to the market, A’s goods sell at P_A = a – Q_A + b*Q_B and B’s go for  P_B = a – Q_B + b*Q_A. This is a simple variation on Cournot competition and we will assume that 0 ≤ b ≤  1 so increasing one’s quantity impacts one’s own price more than it increases one’s rival’s. As b goes from 0 to 1, the products become closer substitutes with the limits corresponding to two separate monopolies and two firms producing the same commodity.

That parts pretty standard. The twist here is that we will assume that firm A can produce a complete unit at cost C_A while firm B needs to buy a component from A and then incurs cost C_B. Suppose that A sells the component at cost W_C and that it costs A C_C to make the component.

Assume that A sets the wholesale price for the component and then the two firms set their retail quantity. The question is whether A would let B sell in the market. Firm A could just keep its competitor out by raising the price of the component. Note that this is essentially the problem faced by small Swiss watch brands, who claim that they will essentially be forced from the market if Swatch cuts them off.

“A lot of companies will cease to exist while Swatch, the monopoly operator, will simply get stronger,” said Peter Stas, the Dutch co-owner of Frédérique Constant, an independent watch company in Geneva that is one of the plaintiffs.

So what should A do? It turns out that both the level of substitutability and the relative costs matter. A is willing to supply B if B’s “total” cost of C_B + C_C is low enough. Low enough here means relative to A’s cost of a complete unit and the size of the market a. As b goes to one, we need that C_B + C_C < C_A. That is, A can mark up the components it sells to B and still have B expand the market at a rate it couldn’t afford to. If B’s costs are low enough, A might let him have a lower total cost of production.

So how does this match up with the Swatch story? As the article points out, Swatch’s willingness to supply components has made entering the Swiss watch market very cheap.

“Thanks to Swatch, “there is no other industry with such cheap entry costs,” said Jean-Claude Biver, who spent 12 years on Swatch’s executive committee before becoming chairman of Hublot, which is now part of LVMH Moët Hennessy Louis Vuitton, the world’s largest luxury goods company and one of Swatch’s main rivals.

Hublot has been using Swatch components, but since 2007 it has invested 40 million francs to develop its own manufacturing capacity. It is on track to ensure that 75 percent of its revenue will come from watches made entirely in-house within three years, compared with 37 percent now.

But, Mr. Biver acknowledged, “the example of Hublot isn’t valid for everybody because you have to have a certain critical mass to justify such a heavy and long-term investment.” Hublot makes 29,000 watches a year, sold at an average of $27,000 each.

Go here for a video on Hublot’s factory.

At the other extreme from Hublot, check out Xetum, a firm that markets its products as designed in California but built in Switzerland. It acknowledges using ETA, i.e., Swatch movements. (I should add that I would love to own either a Xetum or one of Hublot’s Big Bang watches.)

So from Swatch’s point of view, there are a lot of competitors but Swatch probably has lower costs simply because of its scale. Outside of the movement, one would expect that costs in a given category are going to be similar across firms. Part of what differentiates fancy watches are the materials used in the case etc. A gold watch is going to be more expensive than a steel one, and despite Swatch’s size, it isn’t going to move the world price of gold. Combine that with increased competition at pretty much every price point, it starts to make a lot of sense that Swatch would want to send smaller brands packing.