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Report n°2: An integrated approach to economic and social contestability in business

The recycler's dilemma overcome by creating an intangible asset: a reputation network

The above reasoning poses the first key steps in diagnosing the economic and social contestability of the historic recycling operator and how they tie together. The solution that the recycler chooses to resolve this dilemma will modify his exposure to the different forms of contestability identified thus far. It also has an impact on other mechanisms that enter into play in the economic equation.

Study of the scrap metal recycling activity has indeed spotlighted an incentive mechanism in operation among collectors. It is based on an emerging multi-lateral reputation network to which some collectors take part. This network is a social device establishing and controlling the economic reputation of the recycling operator. The effects of this network on the recycler's economic contestability cannot be ignored.

This mechanism, in which the recycler's reputation is at stake, fulfils two functions that have been discussed in the literature. Firstly, it aims to encourage the recycler to offer a price that correlates to the quality of the batch. In case of suspected failure to do this, he is likely to see a reduction in his scrap supply, whereas he is highly dependent upon a regular and reliable supply because of the just-in-time management practised in his relations with the output market. Secondly, it aims to ensure that the members of the network (1) will sanction the recycler if necessary and (2) within the network will disseminate only reliable information on the prices offered by the recycler and spread the good word about him. This second function defines certain restrictive conditions that are necessary to fulfil in order to participate in the reputation network. Suppliers who wish to belong to the network must have a sufficiently keen knowledge of the scrap grades to be capable of judging how the buyer assesses the batches. They must also be reliable in the information that they distribute within this network, whether on the prices offered or on possibly abusive or discriminatory pricing practised by the buyer.

Once in place, the reputation network acts as an intangible asset that belongs collectively to all its members. It is useful in defending the interests of these latter, but also useful to the recycler. Its actions indeed enable the recycler to eliminate the two types of market failure identified earlier. It enables him to uphold quality transactions on the input market with the members of the said network and may in return be used by the recycler to leverage and coordinate the collectors' individual efforts. This performance results from the incentives given and the information disseminated by the reputation network: the network facilitates joint scrutiny of the recycler's pricing strategy and, in the collectors' eyes, acts as an incentive to the recycler. It makes the recycler's promise to practise "fair" prices more credible, despite his superior expertise, which he might be tempted to abuse. At the same time, acquisition of the ability to evaluate the recycler's pricing strategy is directly dependent on the collectors learning by experience how a particular buyer assesses the quality of the batches proposed. This network (or intangible asset) therefore is of specific value when facing a given recycler only. Thus, while it provides guarantees and makes credible the pricing commitment, it binds those suppliers to that particular recycler and attenuates the collectors' ability to force that particular recycler to compete with a competitor. Symmetrically, since this network cannot be rapidly reconstituted with other collectors, any change in the siting of the historic operator's activities would render this specific asset obsolete. The arbitrage between re-locating and trying to hold on to his current site requires to take into account the exit barrier, or barrier to re-location. The existence of the reputation network operating between a sub-group of collectors who keep each other mutually informed, credibilises the fair pricing practices, acts as a mutual incentive forms a barrier against the entry of new recycling operators who might seek to compete with the historic operator.

Highlighting this reputation mechanism and its contribution to the smooth running of the input market and an effective and adequate supply of scrap metal enables us better to assess the recycler's economic contestability. The reputation network reduces the recycler's external contestability yet at the same time makes re-location a less interesting alternative. As a specific local asset, it tends to preserve the status quo. Also, by limiting the risk of triggering contestatory strategies (defection) by collectors against the recycler, it also avoids the threat to the social licence to operate and the subsequent intervention of public authorities on the organisation of the market, which would then multiply the number of incidents and nuisances.

Not all suppliers, however, meet the conditions required to belong to a reputation network. Not all mistrust of a recycler who may distort pricing on the basis of his superior expertise has therefore been eliminated. Yet the contribution of these "non-member" suppliers is necessary to supply the recycler's activity, just as the efforts in favour of quality are sought by these suppliers. The recycler must therefore find a remedy for this situation of exclusion, which will otherwise induce a vicious circle of protest and defection, resulting in the procurement of low quality and more hazardous supplies sanctioned by lower prices.

The recycler relies on the basic premise that most collectors discuss among themselves and compare the terms obtained individually by each on delivery and detect potential unfounded differences in the prices applied. The buyer of the recycling firm then uses accurate communication regarding the terms of transaction, principally the prices and grades of scrap, as a means to regulate the transfer of information to the suppliers, which will then serve as a basis for comparison between the suppliers among themselves. In other words, the degree of accuracy in the list of grades used to describe the batches is not homogeneous across all suppliers as a group. This variable enables the buyer to adapt the level of transparency or otherwise that he considers he should establish for some transactions. In the same way, this buyer can, during repeated transactions, halt or increase the transfer of expertise to the suppliers.

An information strategy like this on his pricing structure enables the recycler to eliminate, in turn, two beliefs that can individually trigger protest in the form of defection by collectors outside of the reputation network and cause them to reduce their collection and sorting efforts. The first belief concerns the terms for obtaining truthful prices: these would be reserved for members of the reputation network, from which some collectors are excluded. The second belief to overcome refers to the level of expertise that would be necessary to prevent any abuse of prices on the part of the buyer; indeed, some suppliers may believe that increasing their expertise is a pre-requisite if they are to obtain a truthful price; were this true, re-establish symmetry of expertise would be a necessary condition for reaching a mutually profitable transaction.