ETA Until No ETA?

In 2002 Switzerland became a full member of the United Nations.  It is perhaps surprising that it took six decades from the founding of the UN for Switzerland to join.  But Swiss adherence to political neutrality is now more than two centuries old, a doctrine which is no doubt difficult to follow amidst the coalition-building and lobbying that takes place in the UN.  The track record of avoiding international conflict for more than a century, though, is a testament to Swiss dedication to neutrality.

Apparently, for some in the watch industry, avoidance of conflict ends at the border.  Also in 2002, Nicolas Hayek, the then-CEO of the Swatch Group, announced that his company would no longer supply mechanical movements to other manufacturers.

Nicolas Hayek

For years the Swatch subsidiary ETA  - Manufacture Horlogère Suisse had supplied its movements to a wide array of other watch brands.  From a business perspective this product line made little sense, Swatch was essentially enabling other brands to compete with it in the market for completed timepieces.  But at the time Hayek and others mentioned many other rationales for this change in business practice, including the fact that ETA movements were showing up in counterfeit watches and that the movement industry would become more diverse if Swatch were to exit and "make room" for others.
Approximately two weeks from when I am drafting this article, at the end of December, 2019, Swatch will have the chance to finally deliver on Hayek's decision to withdraw ETA movements from third party brands.  Why has this taken 17 years?  The answer is economics.  The Swiss government has, essentially, required Swatch to supply movements to other brands since 2002.  And this is largely a consequence of a particular sub-field of economics: antitrust.

The Watch Stream

In order to understand why Swiss authorities would control Swatch in this way it is helpful to spend some time outlining some universal principles from the field of industrial organization.  We can think of consumers as a large body of water, like an ocean.  Companies represent a tributary to this ocean, ultimately delivering finished products to consumers.  At left I offer a visual version of this notion.

  Some companies are far from consumers, working in obscurity but contributing to the finished product.  For example, mechanical watches contain synthetic rubies and a company named Djeva is a major supplier of these gemstones.  Djeva is far, far "upstream" in the production process.  Most watch buyers could not name the manufacturer of the rubies on their wrist.  Omega, on the other hand, makes the final product which consumers buy, they are as far downstream as possible.

There are a few ways in which upstream and downstream companies can be organized.  One option is that a single company operates at all points along the supply tributary.  We refer to these firms as "vertically integrated."  Such a company would manufacture its own synthetic rubies, make all the components to a mechanism, assemble the mechanism, make the case and all the other watch face components, assemble the full watch, and sell the finished product to the buyer.  "In house" movements are representative of a high degree of vertical integration.

On the other end of the spectrum would be a non-integrated supply process where each major step in the completion of a finished product is done by an independent company.  The upstream and downstream firms enter into agreements where the upstream firms sell their product to the next firm downstream.  Other things equal, a non-integrated process is more efficient in that more of a product is produced given the resources involved.  The reason for this has to do with specialization: each company is focused on a narrower array of tasks and can become extraordinarily efficient at them.  The economist Adam Smith discussed this source of efficiency in his book The Wealth of Nations in 1776.

Another economist and Nobel Laureate, Ronald Coase, pointed out that vertical integration (in house manufacturing) has certain advantages. 

Ronald Coasae

While it is less efficient and more costly to follow vertical integration, doing so allows a company to avoid contracting with other firms.  In fact, in a fully non-integrated industry the downstream firms must rely upon successful contracting among all the upstream firms.  When products are not standardized and quality is uncertain it is likely that this contracting is very expensive and prone to failure.  This year's Nobel Laureate in economics, Michael Kramer, called this an "O-Ring" production process after the seals which were associated with the in-flight explosion of NASA's space shuttle Challenger.  One small failure, such as a missing ruby delivery, can lead to catastrophe in a complex and fragile non-integrated industry.  In this case, vertical integration is actually less costly than a non-integrated process since the latter relies upon potentially inadequate, costly, and unreliable contracts.

Antitrust and industrial organization economists spend a great deal of time assessing the state of competition in an industry.  Generally speaking, very low levels of competition are socially undesirable.  Inadequate competition can result in restricted quantities and high prices.  In most countries antitrust laws and regulators attempt to evaluate whether these outcomes are taking place and identify remedies if they are.  There are almost unlimited permutations of vertical integration and competition.  For example, there could be a non-integrated industry with: 1) a monopolist (one firm) downstream selling to consumers, 2) a duopolist mid-stream (two firms) selling to the monopolist, and 3) a highly competitive upstream ecosystem populated by many firms.  It is not easy to assess the overall state of competition in such an industry.  And this is generally true when it comes to antitrust.

Movements as an "Essential Facility"

When Hayek announced the Swatch Group would stop supplying ETA movements to the wider industry, the state of competition in watches was complex.  Downstream there were many brands, but they were often owned by a single firm.  The Swatch Group owned Omega, Tissot, Swatch, Breguet, Jacques-Droz and many other brands.  The Richemont Group owned Vacheron Constantin, Jaeger LeCoutre, Lange & Sohne, Panerai, Cartier, Piaget and many others.  LVMH owned TAG Heuer and Zenith.  But these "giants" faced many competitors such as Rolex, Patek and Audemars Piguet.  The downstream industry was fairly competitive.

In contrast, upstream manufacturing of movements was highly concentrated.  ETA, owned by the Swatch group, was the principal source for the Swiss movements employed by many other brands. 

An ETA Moonphase Patent

Sellita was an alternative source but they, too, relied a great deal upon ETA.  In fact, balance springs were almost exclusively available from only one firm: Nivarox, which was also owned by the Swatch Group!  In the parlance of antitrust, Swatch Group controlled an "essential facility."  Without it, many brands would no longer be able to continue production downstream, hampering competition there and generating adverse consequences.

Around the world, owners of essential facilities are carefully monitored by antitrust authorities in order to ensure that consumers are not harmed by abusive practices.  The Swiss Cartel Act (251 Federal Act of 6 October 1995 on Cartels and other Restraints of Competition) came into play when Hayek made his announcement.  Chapter 2, Section 1 (Unlawful Restraints of Competition), Article 7 (Unlawful practices by dominant undertakings) states, "1. Dominant undertakings behave unlawfully if they, by abusing their position in the market, hinder other undertakings from starting or continuing to compete, or disadvantage trading partners. 2. The following behaviour is in particular considered unlawful: a. any refusal to deal (e.g. refusal to supply or to purchase goods); ...".

Upon learning of Hayek's announcement, two firms, Jacquet SA and Sellita Watch Co SA requested that the Swiss Competition Commission, Weko, initiate an investigation into whether Swatch's refusal to sell movements was admissible under Article 7 of the Cartel Act.  These two firms were  located slightly more downstream than ETA.  They bought ETA movements and conducted various adjustments, including assembly, before selling those movements to brands.  Weko obliged and began their investigation.  My summary of this moment in time is drawn from a translation of Weko's publication "Recht und Politik des Wettbewerbs 2005-1."  I offer a translation of the portion pertaining to ETA (beginning on p. 128) here.

The Swiss regulator imposed a preliminary injunction on ETA which allowed only a 15% reduction in supply and capped the price increase for movements.  Simultaneously, questionnaires were sent to ETA downstream clients  as part of an investigation.  The regulator reported that ETA produced 75% of all mechanical movements in Switzerland while Rolex produced another 15%.  The remaining manufacturers produced only 10%.  It is important to note, though, that Rolex and others were not generally in the business of selling movements to third parties.  For this reason the 25% "competitive fringe" did not offer much competition to ETA, practically speaking.  If one eliminated movement production for in-house purposes then ETA had a 95% market share.

Further, Weko found that there were high barriers to entry.  Designing a movement requires a great deal of time and testing.  Errors in design and /or manufacturing are only revealed after long periods of use.  The Swiss authority anticipated that meaningful alternatives to ETA  would be available before 2011.  The end result of the investigation was an agreement that ETA would not engage in further supply reductions until 2008.  Then, in 2009, ETA could supply 50% of the prior year's volume, in 2010 25% of the prior year's volume, and in 2011 it could withdraw supply entirely.

As this date approached Swatch announced, again, that it would withdraw supply of movements.  And, again, Weko launched another investigation and imposed a preliminary injunction to preserve availability of ETA movements.  My summary of what follows comes from a translation of the Weko publication "Untersuchung 32-0224 gemäss Art. 27 KG betreffend
Swatch Group Lieferstopp" which can be downloaded here.  The investigation found that ETA still had control of an essential facility for the  industry and also that many manufacturers were low on movement inventory.  They had not placed orders for adequate movements, in the short run, as a consequence of the Great Recession.  In light of these conclusions, Weko imposed a new arrangement: Swatch would continue to supply movements, in decreasing amounts, through 2019, at which point there would no longer be an obligation to sell to third parties.

What's Next?

It is natural to wonder what might happen in 2020 and beyond as a consequence of Weko's injunction ending. In particular, what can we expect should Swatch decide to deliver on its long-standing goal to remove ETA movements from the market?  It is quite clear that there will be many downstream effects.  I offer a standard market analysis of the situation in the graph below. 

Should Swatch's withdrawal of movements mean that others, such as Sellita, can not fill the gap then the supply curve for mechanical Swiss watches will eventually shift left from S to S' because fewer movements are available.  This will create a shortage of watches.  Keep in mind that we are already dealing with shortage of certain watches, such as steel sports models.  So the situation will get worse.

The shortage will further drive up prices and consumers will scale back on their purchases, perhaps opting for a smart watch instead (or perhaps some of the models using Japanese movements).  Equilibrium prices will rise form P* to P** and quantities purchased will decline from Q* to Q**.  The total social benefit created by the Swiss watch industry, i. e. total surplus, will shrink from the triangle abc to the triangle ade (for more on the notion of surplus please see my earlier article).  A departure of Swatch from the movement market is a bad outcome, from a social perspective.  However, there may be a silver lining for collectors in that the rising prices mean that the secondary market value of their collection would likely increase since preowned watches are now relatively more desirable!

Can we expect to see this occur?  In the short run, perhaps not.  Disappearance of ETA movements from the market has been telegraphed for more almost two decades.  Most downstream brands have anticipated this development and planned accordingly by: 1) finding alternative sources, 2) developing their own movements, and / or 3) ordering a "stockpile" for future production.  There are estimates that some brands have stocked two years worth of ETA movements.  And it is true that ETA is no longer an essential facility, estimates are that they supplied approximately 500,000 movements this past year while Sellita supplied 1.2 million.  So the impact may be cushioned.

However, there is late-breaking news out of Switzerland which increases the odds of some type of major disruption.  As reported by Tony Traina at Rescapement, there are strengthening rumors that the Swiss competition authority, now called Comco, may actually BAN Swatch from selling movements in 2020.  There is a great deal of befuddlement when it comes to this move because it increases the likelihood that watches will grow more expensive and the Swiss watch market will perform more poorly.  However, it may be that Comco simply wants to eliminate uncertainty from the market and views Sellita as a stable major supplier of movements for the industry.  This will hasten standardization on the new supplier's ebauches, with ancillary efficiencies in tooling and servicing. And on December 19, 2019, Comco confirmed that for "technical" (or "factual") reasons ETA movement delivery has been "temporarily" suspended.

It is clear, though, that we are in for some type of change when it comes to brands relying upon third parties for movements.  The nature of that change, and its full implications, will only be revealed with the passage of time.