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Stackelberg Game in the Negotiations between OEMs and Suppliers in the US Auto Industry

Image Credit: Weber (2022)

What is the Stackelberg game?

The Stackelberg game, a strategic model in economic theory, delineates the dynamics between market leaders and followers, where the leader's actions significantly influence the followers' subsequent decisions (Koirala & Laine, 2023). This concept, named after the German economist Heinrich Freiherr von Stackelberg, originates from his pivotal work 'Marktform und Gleichgewicht' (Market Structure and Equilibrium), published in 1934 (Hicks, 1935). The Stackelberg model is characterized by a sequential decision-making process, often called the leader-follower game. In this framework, the leader makes the initial move, setting the stage for the follower, who then reacts and makes the decisions sequentially. Initially rooted in economic analysis, the Stackelberg game has since found wide-ranging applications across various disciplines, including business strategy and political science, wherever a clear leader-follower dynamic is evident.

Why is it relevant to OEMs and suppliers’ negotiation?

The Stackelberg game (Esmaeili et al., 2009) can be applied to the negotiations between OEMs and suppliers by improving the negotiation power and outcomes. In the U.S. auto industry, the OEM typically takes on the role of the leader, as they have more market power and can set certain terms and conditions, such as production quantities, delivery schedules, and prices. By strategically deciding these terms, the OEM can influence the supplier's behavior and maximize its own profits. Meanwhile, suppliers acting as followers who observe the terms set by the OEM will decide the counter strategies that could benefit from the Stackelberg game by understanding the OEM's preferences and constraints before making their decisions. This can lead to more informed negotiation strategies. The suppliers could be in stronger positions to negotiate if they have stronger market positions, such as possessing unique capabilities, patents, or resources. The goal in the Stackelberg game is to find an equilibrium where all players are satisfied with the negotiated terms. This may involve multiple rounds of negotiation and adjustments. Clempner (2017) points out that a Machiavellian player conceptualizes the manipulation of social conduct considering three concepts: views, tactics, and immorality. Clempner (2017) also suggests a reinforcement learning approach that provides evidence of how people acquire Machiavellian immoral behavior, considering its principle of error-driven adjustment of cost/reward predictions. These statements mentioned above are supported by the predatory purchasing practices that OEMs intend to engage in due to their extraordinary power over suppliers (Sturgeon et al., 2008). Chen and Chen (2021) stated that the optimal pricing policies for achieving an agreement are derived from the Stackelberg game accounting for the lot sizes, in which the OEM chooses how much to order based solely on its profit structure, and then the supplier selects the production quantity best to optimize the compliance regime. The optimal lot-sizing decisions are derived from a Stackelberg game. The advantage of applying the Stackelberg game theory in the negotiations between OEMs and suppliers is the great flexibility in parameter selection and profit allocation, and by selecting the parameters properly, a win-win situation between the OEM and the supplier will be achieved.

Real Practical Examples

Example 1: Electric vehicle battery suppliers must decide how to adjust and respond to the increase in EV production by Tesla, General Motors, etc. (Breiter et al., 2022). This is the application of the Stackelberg game model: The OEM (leader) decides on a specific EV model and the supply of batteries. It sets terms for battery specifications, delivery schedule, and strong-arming the price. The battery supplier (follower) responds by investing the production capacity to meet the OEM's demands, recruiting and retaining skilled labor, negotiating the price and terms based on their capabilities, securing raw material supply, and stepping up the R&D capabilities.

Example 2: Autonomous Driving Technology Reshapes Suppliers’ R&D horizon As OEMs (leaders) plan to adopt more autonomous driving features, suppliers (followers) are reshaping their innovation capabilities to provide sensors, software, and other autonomous driving technologies. This is another example of the application of the Stackelberg game model: The OEM decides the level of technology it wants to incorporate into its vehicles and sets standards for quality, performance, and price. Suppliers of autonomous driving technology must assess whether they can meet these standards and at what cost. They might need to invest in R&D, adjust their production processes, or collaborate with other tech companies.

There are very few scenarios in which suppliers are the leaders and OEMs are the followers due to suppliers possessing special patented advanced technology, such as Advanced Driver Assistance Systems (ADAS) Technology. The suppliers, such as Mobileye or Bosch, will have the leading position in the market and negotiation table. The microchip (semiconductor) suppliers will also be in the same position.

Conclusion – win/win

Applying the Stackelberg game model offers a strategic framework for understanding and optimizing these interactions in the intricate dance of negotiations between OEMs and suppliers in the US auto industry. By recognizing leader and follower roles dynamics, OEMs and suppliers can better anticipate and respond to each other's strategies, leading to more effective and mutually beneficial outcomes. It's not just about gaining a competitive edge; it's also about fostering sustainable, collaborative relationships that drive innovation and growth in the industry. As the auto industry continues to evolve with technological advancements and shifting market demands, the principles of the Stackelberg game remain relevant, providing a lens through which to view and navigate these complex business negotiations. Ultimately, the goal is to win a single negotiation and establish a foundation for ongoing success and partnership in a rapidly changing industry landscape.

References:

Breiter, A., Horetsky, E., Linder, M., & Rettig, R. (2022, October 18). Power spike: How battery makers can respond to surging demand from EVs. McKinsey & Company. https://www.mckinsey.com/capabilities/operations/our-insights/power-spike-how-battery-makers-can-respond-to-surging-demand-from-evs

Chen, Z., & Chen, C. (2021). Price negotiation and coordination in outsourcing supply chain under yield and demand uncertainties. RAIRO-Operations Research, 55(6), 3661-3675.

Clempner, J. B. (2017). A Game Theory Model for Manipulation Based on Machiavellianism: Moral and Ethical Behavior. Journal of Artificial Societies & Social Simulation, 20(2), 4. https://doi-org.ezproxy.umgc.edu/10.18564/jasss.3301

Esmaeili, M., Aryanezhad, M. B., & Zeephongsekul, P. (2009). A game theory approach in seller–buyer supply chain. European Journal of Operational Research, 195(2), 442-448.

Hicks, J. R., (1935), Marktform und Gleichgewicht, The Economic Journal, Volume 45, Issue 178, 1 June 1935, Pages 334–336, https://doi.org/10.2307/2224643

Koirala, P., & Laine, F. (2023). Monte Carlo Optimization for Solving Multilevel Stackelberg Games.

Sturgeon, T., Van Biesebroeck, J., & Gereffi, G. (2008). Value chains, networks and clusters: Reframing the Global Automotive Industry. Journal of Economic Geography, 8(3), 297–321. https://doi.org/10.1093/jeg/lbn007

Swinney, R., & Netessine, S. (2009). Long-Term Contracts Under the Threat of Supplier Default. Manufacturing & Service Operations Management, 11(1), 109–127. https://doi-org.ezproxy.umgc.edu/10.1287/msom.1070.0199

The Economist Newspaper. (2018). Autonomous vehicles are just around the corner. The Economist. https://www.economist.com/special-report/2018/03/01/autonomous-vehicles-are-just-around-the-corner

Weber, A. (2022, December 14). Digital Technology Transforms Auto Assembly Lines. ASSEMBLY RSS. https://www.assemblymag.com/articles/97512-digital-technology-transforms-auto-assembly-lines