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

Exhanges with the downstream market

For the recycler's customers, we need to look at the empirical evidence. The customer base generally consists of one major customer who absorbs the bulk of the scrap metal produced from processing into secondary raw material. This derives from the fact that it is large, capital-intensive organisations that use scrap metal on an industrial scale. In any one region, there are only a very limited number of these, if we exclude export opportunities. It is therefore appropriate to use a quasi-monopsony as the basic structure when looking at the relationships between the recycler and his customers.

The recycler must set his processing equipment to produce scrap metal that meets the specific requirements of his principal downstream customer, the one to whom he delivers the major part of the recycled scrap. This secondary raw material is of a specific quality. To the downstream customer feeding the electric furnace, the two important characteristics are the iron content of the recycled material and the size of its base components. As in the input market, the batches provided must be free of certain substances, particularly those that reduce the return from an electric-arc furnace or degrade the quality of the resulting metal; or that cause various types of pollution. For instance, were the secondary raw materials radioactive(28), it might contaminate the production equipment.

Whether or not the secondary raw material offered to the steel manufacturer meets the criteria depends primarily on the quality of the supply of scrap metal fed to the shredder, and hence on the recycler's skill in maintaining and coordinating supplies from his collectors. It can also vary depending on technical features of the processing equipment itself. It is technically possible to separate(29) adequately the different constituents of a piece of scrap metal while complying with the requirements for piece size by setting the mesh size of the grids(30) in the shredder.

These technical considerations mean that three factors prevent the recycler dealing with several competing downstream customers. In the first place, he must either be able to quickly reorganise the upstream collection, to deal with changes to the downstream demand, or have significant on-site storage capacity. The first condition would imply that the collectors work as an integral part of his business, and this would raise issues about their independence, and assumes that the public authorities have granted an exclusive concession to collect. The second condition is not usually compatible with a site in a residential area.

In the second place, the recycler would have to keep stopping and starting production, specifying each run for the particular customer, and each time adjusting the composition of the bales of scrap fed to the shredder(31). Thirdly, he would have to re-calibrate the processing equipment (grids in the shredder) to meet different size specifications. These different technical issues together strongly discourage the recycler from having several customers at the same time. As these constraints are known to the different operators in the branch, or at any rate to the downstream customers, the recycler is inhibited from putting ahead competition between several domestic buyers, and he would not be taken seriously if he did. Thus at first sight, a competitive alternative would be to go to the international market. However, transport costs can be an immediate disincentive, and limit sustained trading of that sort, except overheating periods on international markets. Thus the recycling operator cannot credibly threaten his downstream customer with competition, nor can he simply refuse to deliver.

As it was for the upstream market, a study of the methods of managing trading with the downstream steel manufacturers is useful in determining the recycler's economic contestability.

Once again, trading conditions in the downstream market are related to a problem of uncertainty in the quality of the goods traded. Unlike the buyer in the trading environment's input market, the buyer for the steel manufacturer has in theory the technical means to evaluate precisely the quality of the material offered by a recycling operator. However, the evaluation methods are too costly to be used systematically for each delivery.

The standard procedure used is the following. The quality of the purchased material can be measured ex-post, that is, by taking a sample of the molten metal. As deliveries from different recycling operators are mixed before they are loaded into the electric arc furnace, it is not possible to identify which of them has not complied with the required technical specifications. Thus a recycler who fails to satisfy the requirements specification for quality is not directly threatened by penalties. As in the input market, this weakness at first sight reduces the effectiveness of the incentive to respect the contractual criteria on the quality of the material supplied. The failure to respect the quality criteria may affect the quality of the semi-finished goods (the "tampering effect "), and pose a number of environmental and health risks. Again, this potential market failure illustrates a case where the recycler intentionally reduces the quality of the secondary raw material either by pure opportunism or as contestation of the exchange terms imposed by his main client. It may lead to adverse external effects on health and/or on the environment.

The incentive mechanism developed by the steel manufacturer to deal with the delivery feared to be "lorry-loads of earth" (sic) is based on visual inspection by a team of shifting reception agent (ex-ante evaluation) and on a probabilistic sanction (ex-post evaluation). When defection was observed in the previous deliveries, the steel manufacturer selects a set of batches from the same one recycler at random, and they are analysed during an independent production run(32). The effectiveness of this double strategy as an incentive depends principally (i) on the ability of the reception agents to evaluate properly the secondary raw materials delivered, and (ii) on the cost of the penalty imposed to a recycler who makes non-compliant deliveries, identified from the results of random testing. If a historic operator risks losing his principal customer, there is a significant cost in being discovered in a fraud, because he has no replacement in the short or medium term. Because he has so little technical and commercial flexibility, he will take seriously his commitment to deliver materials that comply with specifications. In this context, systematic visual inspection by the reception team and random testing of the metal obtained are strategic mechanisms that, from the steel manufacturer's point of view, provide the captive recycler with adequate incentives.

(28) The installation of control gates to measure radiation in the workplaces of recycling operators shows how seriously this risk is taken.

(29) By vacuum extraction, electromagnets, Foucault current, etc.

(30) The material can only be ejected from the interior when the piece size is sufficiently small to pass through the mesh of the grids.

(31) The crusher operator and the crane drivers loading the material into the crusher should therefore be in a position to know the steel manufacturer's precise requirements so they can change the composition of the scrap metal loaded into the crusher.

(32) In this case, only batches of material from a single supplier are used in the electric furnace, so that the quality obtained from this supplier can be clearly identified.

To compete with a historic operator, a new entrant must be able to overcome the difficulties inherent in trading goods of uncertain quality and develop a «trust by default". A "good" reputation is an intangible asset that one recycler has relative to another, or relative to a new arrival with no established reputation. It reduces the degree of external economic contestability for the historic operator. Its resultant effect on the degree of external economic contestability depends largely on the recycler's productive assets and on the horizon for commercial involvement implied by those assets. Firstly, assets connected with the site reduce the degree of external economic contestability, and secondly, the production equipment (the shredder) imposes a reasonably distant horizon for the firm's commercial involvement. These two elements also constitute an exit barrier. This situation implies that the recycler is looking for a long-term relationship in trading with his customers, and fosters the development both of a form of sanction based on a dependent relationship, and of a "good" or "bad" reputation.