The Cost of Low Prices

Clement Wong


April 8th, 2012

One of the consistent comforts Australians can depend on is the competitively low prices at the big supermarkets. With Coles and Woolworths now calling a price war on fresh produce, it appears as if these giants are altruistically looking out for us, or are they?

Nary has a week gone by without melancholic economic news to bring one’s mood down. Amidst such woes, one of the consistent comforts Australians can depend on is the competitively low prices at the big supermarkets. With Coles and Woolworths now calling a price war on fresh produce, having already hammered down milk prices, it appears as if these giants are altruistically looking out for us. Blatant sarcasm aside, lowered prices must come from somewhere along the supply chain, which is certainly worth looking into.

At first consideration, one might compare the price war between Coles and Woolworths to a simple Bertrand competition between duopolists. In industrial economics, the Bertrand competition model involves players responding to one another via price, where the player with the lowest set price captures the entire market and its profits, and the competition misses out. With consistent incentives to undercut the opposition, equilibrium is established where homogenous competitors set prices equal to their marginal costs, and make no economic profits. This diehard approach to price slashing effectively brings about a combination of prices and quantities traded equivalent to that of a perfectly competitive market.

There is however, little reason to believe that this theoretical framework accurately maps onto the Australian food retail sector. For the first half of this financial year, Wesfarmers (owner of Coles) and Woolworths both reported that their food and liquor divisions had grown in their EBIT figures from the previous half (14.1% and 6.3% to $1,493.5 million and $656 million, respectively). Both competitors finding the means to grow sales and profits lends credibility to considering that they do not bear the cost of lowered prices as suggested by the Bertrand model, and so the investigation travels further downstream.

Supplier pressure has been noted as one of the possible avenues through which the supermarket giants have grown whilst deflating store prices. One form of such pressure is trading term negotiation. By leveraging their importance as the biggest clients, supermarkets can afford to make self-interested demands, leaving very little bargaining power to their smaller suppliers. This can involve agreeing to lower farm gate or wholesale prices, and more lenient credit terms on stock. Even large companies like Coca-Cola Amatil have borne scars from the push. Last year, a dispute arose between Woolworths and Coca-Cola during trading term negotiations. Macquarie Equities had noted that Coca-Cola was being squeezed to lower prices equivalent to foregoing $11 million, 1.8% of their Australian EBIT. Their inability to compromise and agree meant that Coca Cola was excluded from promotions and price specials at Woolworths during the period, whilst Woolworths lost foot-traffic by not promoting Coca-Cola’s popular products. With few suppliers able to claim to be as large and influential as Coca-Cola, trading terms for them are unlikely to fare much better.

Pressure also arises from the growing prominence of private label, or house brand, goods stocked in supermarkets. This is considered vertical integration – where firms along two successive stages of the supply chain produce in tandem to maximise joint profits. Working together mitigates the inefficiency of double marginalisation, where separate profit margins buffer both wholesale and subsequently retail prices. Instead, supermarkets have access to goods at very low costs due to cooperation with the private label manufacturer, and can sell them with a thicker margin attached whilst being price competitive with other brands. Private label goods are much more prevalent in the United States and the United Kingdom, where success stories like Tesco and Aldi suggest that there’s still much potential for growth in Australia. Both Coles and Woolworths have expressed interest in expanding the scope of their private label goods, which have thus far proven to be incredibly profitable. These goods are such moneymakers that prime shelf space in store is becoming increasingly allocated to these products. Thus other suppliers lose on two fronts against the private-label: they feel the pressure from low prices as well as a loss of valuable shelf space with which they can impact and attract the consumer.

The rationale behind pinching the suppliers to our benefit stems from mediocre consumer confidence. Consumer sentiments have been fairly steady in their decline since late 2010, dropping to 96.1 index points in March. The Australian people have been concerned about many things, including international conditions, interest rates, and unemployment. While there has been some good news on the European front, many still see uncertainty and volatility in that future. Domestically, there is also pessimism with regards to financial positions as a result of the major banks decoupling from the RBA. While the cash rate has remained steady since the start of the year, retail banks have sought to buoy profit margins and change their rates independently. Consumers that feel strapped for cash look for value, and the supermarkets are most definitely aware of this, as their investor reports highlight. To appease the customers and maintain sale volumes, low prices seem to be the only answer.

With the ACCC now breathing down their backs after claims of unfair leverage of market power, Coles and Woolworths have to tread carefully. Suppliers are wary of biting the hand that feeds them, but the offer of protection has already attracted a few of them to approach the commission. Whether the investigation yields any result, and whether regulation can be applied effectively is certainly an interesting question for the future. Are the comfortable days of battered-down prices and deflation in supermarkets numbered for us consumers? Perhaps – if the suppliers have their cries heard.

The views expressed within this article are those of the author and do not represent the views of the ESSA Committee or the Society's sponsors. Use of any content from this article should clearly attribute the work to the author and not to ESSA or its sponsors.

  • Dean Pagonis

    Great article Clement!

    Firstly, I would like to comment on the feasibility of Coles and Woolworths continually squeezing more margin out of their suppliers. There is a limit to how much they can do this – if their suppliers are pushed into making losses, they simply won’t exist in future and the supermarkets will lose these suppliers. Despite all the complaints from suppliers, they are clearly still making profits, albeit smaller ones.

    Furthermore, there is a common misconception that Coles and Woolworths have a monopoly on fresh produce, which is clearly wrong. There are a number of smaller, independent fresh produce retailers that successfully compete with the big supermarkets because their quality of produce is usually much better than their large scale counterparts. Further, other supermarkets/wholesalers such as Aldi, IGA and Costco also exist (and in some cases are thriving), which prevent Coles and Woolworths from simply increasing their fresh food prices (which they probably would if these competitors didn’t exist).

    As a side note, I would disagree with your comments on bank raising rates independently from RBA for profit margin reasons – higher funding costs overseas mean the banks need to raise their rates to maintain their pre-existing margins (you could argue that these existing margins are too large though).

  • Clement Wong

    Thanks Dean!

    You’re right – there is certainly an upper bound to profits Coles and Woolworths can extract out of their suppliers. While we won’t be seeing large suppliers like Coca-Cola nose-dive into oblivion from the squeeze, one could definitely argue whether the power wielded by the two large supermarkets is healthy. There’s also element of efficiency here too, in that suppliers that can produce at lower costs will survive while those who cannot will lose their contracts. Whether this is seen as desirable when it benefits consumers and simultaneously lines the pockets of our supermarkets is up for discussion.

    You’re also right that Coles and Woolworths don’t operate a perfect duopoly in the market. There are many consumers out there that prefer to buy locally and at IGAs, perhaps in part that they ascribe an ‘ethical price’ to the way suppliers are being treated at the bigger supermarkets. Aldi sells a lot of private-label goods and Costco has a very different sales model. It would be interesting to look into how these differences between firms affects their ability to compete, since a lot of what we study theoretically assumes firm homogeneity.

    Banks operating independently of the RBA cash rate is also something that could be further investigated. ANZ had some large layoffs recently which suggest that there is indeed pressure on their ability to maintain their operations at their historical size. Certainly not every dollar extracted from recently increasing their rates will go to cheery big wigs and fat cats. Regardless, there is still a detrimental effect on consumer sentiments.

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