Oligopolistic Competition in the UK Grocery market

The UK Grocery market is characterised by a market leader (Tesco’s) and 3 other

major firms (ASDA, Sainsbury’s, and Morrison’s); together they make up the ‘big

four’, competing in an oligopolistic setting, more specifically under Bertrand

competition. Under these conditions firms compete on price. In this situation, firms

do not have the same marginal cost (C) and as a result we have product

differentiation. If one firm sets price higher than the marginal cost (p > c), then the

other has an incentive to offer a lower price. Interestingly, supermarkets also act as

platforms in that they bring buyers (customers) and sellers (suppliers) together and

charge both a price; the sellers are charged supplier revenue and the buyers are

charged a mark-up determined by the supermarket.

Traditionally these four supermarkets have been the major players in the UK

grocery market however the industry is now undergoing a revolution on a scale

never seen before. Since 2012, market leader Tesco’s has seen it market share fall

by 1.4%1 and has also seen its profits fall for the first time since 19942. This downturn

has not only affected Tesco’s but all members of the ‘big four’, for example

Morrison’s has seen a 12% fall in relevant market share3 since 2012. Why has this

revolution begun? Well a large part of the reason is due to the emergence of

discount stores such as Aldi and Lidl, both of which have seen its relevant market

share increase by 92% and 40% respectively4 since 2012. Consumers purchasing

habits have changed; more consumers now consider price to be a major factor in

1 http://www.kantarworldpanel.com/en/grocery-market-share/great-britain/snapshot/01.03.15/05.02.12 Note calculations are accurate as of 01/03/15. 2 http://www.telegraph.co.uk/finance/newsbysector/retailandconsumer/9583264/Tesco-profits-fall-for-first-time-in-18-years.html 3 Note by relevant market share the authors mean change in market share proportionate to that firms market share in 2012. (S2015 – S2012)/S20124 Note these calculations were made by the author using data from Kantarworldpanel.com, that database was cross checked with statistica.com/statistics to check for accuracy in results.

their purchasing decisions following the global recession. Finally the emergence of

online stores selling both groceries (Ocado.com) and other non-food items

traditionally found in large supermarkets (Amazon.com) has meant large amounts of

new competition entering the market. The authors now look to identify clear

indicators of oligopolistic competition in this industry and discuss future implications.

One of the most common methods of analysing whether an industry displays

oligopolistic characteristics is to look at the four firm concentration ratios. The

economic literature generally accepts that an industry which displays a concentration

ratio of above 60% can be classified as oligopolistic5. Using data from

Kantarworldpanel.com the authors calculated the four firm concentration ratios to be

77.5% as of February 2012 and 73.5% as of March 2015. Notably both these figures

fall comfortably within the arbitrary cut-off point decreed by the economic literature.

One should bear in mind a serious drawback of simply looking at only the four-firm

concentration ratio however is that it simply aggregates the market share of the top

four firms whilst ignoring the market shares of the remaining firms in the industry. As

such one should consider concentration ratios alone to be a vague and fairly

ambiguous indicator of competition. The Herfindahl–Hirschman Index proves to be a

much more comprehensive measure for competition as it accounts for all firms in the

market and is used by many competition regulators such as the U.S. Department of

Justice (DOJ). The DOJ defines an industry as oligopolistic if it has a HHI score of

1000+, using the previous database the authors calculated a HHI score of 1769 in

2012 and 1642 in 2015, suggesting the UK grocery market is clearly oligopolistic in

structure. Imperfectly competitive competition is often seen as being inefficient,

generating a dead weight loss to society. The UK grocery market is showing signs of

5 Bade, Parkin, 2008, Essential foundations of economics, 4th ed, chapter 13.

becoming more competitive through falling HHI scores, but to what extent is the

return to groceries inflated in the UK? The authors calculated the HHI score in

France to be 1480 and 1420 in China, whilst discovering the UK’s HHI to be 13.2%

higher, clearly showing a distinct lack of competition in the UK market.

Another common feature of an oligopolistic industry are the high barriers to entry

which act to protect the firms within the oligopoly from new entrants. Oligopolies try

to maintain their positions in the market through having high barriers to entry as a

method of reducing competition. This results in entry for new rivals often proving too

costly and problematic. The incumbent firm can either put these barriers in place

themselves or choose to exploit the ones that exist naturally such as economies of

scale, high costs for both research and development and initial set up capital.

Artificial barriers include predatory pricing, limit pricing and brand loyalty, just to

name a few, and are beginning to become commonplace throughout industry.

Traditionally the UK grocery market has displayed high barriers to entry through the

enormous sunk cost required to build supermarkets across a country or region.

Incumbent firms can take advantage of economies of large scale production; this

deters new entrants from entering the market. Large spending on research and

development by existing firms is a sign that the new entrant needs to spend a lot

more than that to compete in the industry, with some even describing high R&D

costs as a “scare tactic”6 . Firms use predatory pricing to push prices low enough

until they force new rivals out of the market; in 2004 Tesco’s was accused of

implementing such artificial barriers by an independently run supermarket,

Proudfoot7 . Limit pricing occurs when firms set price below the marginal cost (P<

6 http://www.economicsonline.co.uk/Business_economics/Supermarkets.html7 http://www.telegraph.co.uk/finance/2875648/Proudfoot-cries-foul-at-Tescos-tactics.html

MC) and produce a large amount of output, making it difficult for the new firm to

make profit at that market price. This is best achieved by selling at a price just below

the average total costs (ATC) of potential entrants. Both brand loyalty and brand

identification are consistent features of UK Supermarkets; Tesco’s “Everyday Value”,

Asda “Smartprice”, to name a few. Brand loyalty provides consumers not only with

both a degree of familiarity, but also an element of pseudo-tribalism. The result of

this is clear in that new firms find it very hard to get customers to betray their

allegiances and move to their own new products. This again is an example of a

barrier to entry to a new firm; the new entrant is not exposed to the whole market

and therefore has little opportunity to flourish. Barriers to entry reduce the number of

new entrants into the market and reduce the chances of there being a contestable

market. That is a market in which there is freedom of entry and exit with no costs.

Another indicator of oligopolistic competition is firm interdependence; this is seen as

one of the biggest indicators of oligopolistic competition. Economic theory proposes

that firms that operate under oligopoly cannot act alone or be independent. They

have to consider the actions of their closest rivals when making pricing decisions in

the Bertrand market. When competition exists under Bertrand, firms act according to

their best response functions and make pricing decisions based on the prices of

other firms. In respect to price one might consider the UK grocery market to display

‘Stackelberg competition’ characteristics in that there is a clearly defined market

leader (Tesco’s) and other firms respond to the actions of the leader accordingly.

However unlike Stackelberg competition, firms compete on prices not quantity. In

January 2015 Tesco’s cut its prices of 380 products by an average of 25%8, as a

direct response to the actions of the market leader both Asda and Sainsbury’s

8 http://www.thegrocer.co.uk/stores/prices-and-promotions/tesco-announces-price-cuts-ahead-of-christmas-trading-results/511621.article

announced they would spend £300 million and £150 million on lowering the price of

2500 products9 respectively. These numbers are a clear indication of competing

firms responding to the actions of the market leader and as such conclusive proof

that firm interdependence exists in the UK grocery market. Note that the very fact

that firms have the ability to change its price represents some degree of imperfect

competition as perfectly competitive firms are price takers who take the market price

P=MC.

When firms are interdependent there is always scope for collusion. Collusion is a bi-

product of an oligopolistic market structure and is illegal in the UK, however this does

not mean that it does not happen. Sainsbury’s, Asda and Safeway were caught fixing

the price of dairy products in 2002-200310. Conclusive proof of collusion is incredibly

difficult to find as firms are likely to end any period of collusion if they are at risk of

being “found out”. What is particularly interesting is that a “price war” has been

triggered at times of falling market shares for all the major Supermarkets. Firms have

an objective to maximise profits and colluding firms can agree to restrict output to its

monopolistic level and earn the monopolistic profits associated with that. Each firm

earns 1nπMt or it chooses to compete and earn πCt. If the Net profit value is such that

NPVt(1nπMt) > NPVt(πCt) for all firms then all firms continue to collude. Firms cannot

observe the output of other colluding firms and as such they form trigger strategies. If

firm 1’s trigger strategy is activated then firm 1 immediately exits collusion for t

periods where tϵ [1,∞]. As firms can’t observe the output of its rivals it is common

practice for firms to base their trigger strategies on market share, that is if all firms

agree to restrict output but if one firm chooses to cheat then it sells QCheat of product j

9 http://www.theguardian.com/business/2015/jan/06/asda-supermarket-price-war-resurgence-tesco10 http://news.bbc.co.uk/1/hi/business/7132108.stm

at the monopoly price PM where Qcheat > QCollude. As such its revenues and subsequent

market share increases by a greater amount than if the firm had stuck to the

collusive agreement. All firms can observe the market share of others at the end of

the period and as such design trigger strategies based on their own market shares; if

it sees a fall in its own market share then firm 1 knows firm 2 has cheated and ends

collusion, thus causing prices to fall to their competitive level. If we assume that the

‘big four’ Supermarkets pre 2012 had trigger strategies based on their own market

share then all have seen market share fall and as such we have seen any collusion

end and prices have fallen from Monopoly to Bertrand levels. One important note

that the reader should make is that falling market shares and falling prices does not

conclusively prove that firms have exited a period of collusion, it is merely what we

would expect to see if firms had colluded, as such we must accept the notation that

firms in the UK grocery market have the ability to collude even if we can’t

conclusively prove it has happened and as such is another indicator towards

oligopolistic competition.

Earlier we mentioned the notion of product differentiation (PD) as an oligopolistic tool

used by UK supermarkets and it would be foolish to overlook its potential power. PD

is a method used by the majority of large companies as an attempt to distinguish

their product from other competitor’s substitutes. One prime example of PD in

general takes place in the soft drinks market, with companies such as Coca Cola,

PepsiCo and Snapple all offering similar products. Their differentiation exists in the

form of taste but there are many other ways in which firms can attempt to create its

own unique stamp in an attempt to increase market share. If we accept that the

overall aim of PD is to “distinguish a product or service from others, to make it more

attractive to a particular market”11 then we can begin to look how it affects the UK

supermarket oligopoly. Uniqueness then is what firm’s desire, something to set them

away from the norm and make them appear more desirable to customers. One

example of PD, which actually links back to the idea of brand loyalty discussed

earlier, is the introduction of ‘loyalty cards’ offered by these firms. Tesco ‘Clubcard

Points’ and Sainsbury’s ‘Nectar Points’ all act as methods of trying differentiate from

other supermarkets, offering incentives to customers who repeatedly shop with them

in an attempt to increase market share. Again, as mentioned earlier the availability of

various ‘budget ranges’ such as Sainsbury’s ‘Basics’ and Asda’s ‘Smart Price’ further

this effect, allowing a consumer to identify with a specific chosen brand. It is not

purely just through products that PD can be an effective tool however, what we are

beginning to see more and more across the UK is the use of facilities offered by a

supermarket as a way of drawing in customers. No longer just a market for

groceries, an ever increasing number of companies offer facilities such as in-store

pharmacies and even associate petrol stations for potential customers. As of 2012,

Tesco had 493 of their supermarkets offering petrol stations outside, supplying

15.5% of all consumer fuel in the UK. More than this, over 45% of all petrol sold

across the UK comes from pumps stationed in supermarkets. This facility based form

of PD is one becoming more and more common across the UK and is working only

to further increase the oligopolistic nature of the UK grocery market.12

Whilst over recent years the supposed ‘big four’ have seemingly begun to lose their

grip slightly on what was previously a completely dominant oligopoly, this can merely

be seen as a bump in the road. Whilst firms such as Aldi and LIDL continue to

11 https://www.boundless.com/economics/textbooks/boundless-economics-textbook/oligopoly-13/prerequisites-of-oligopoly-76/product-differentiation-289-12386/12 http://www.telegraph.co.uk/finance/newsbysector/retailandconsumer/9207714/Supermarkets-now-sell-almost-half-of-all-petrol-sold-in-UK.html

increase their market share, eventually we will reach an equilibrium in which a UK

supermarket oligopoly still exists with the same market control, only this time there

may simply be a couple more players involved.

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