Volume 35, Number 1, September 2017

Answers

Supermarkets’ market power: ‘stack ‘em high, and sell ‘em low’

Jon Guest

This resource provides answers to the questions set in the article on supermarkets,
on pp. 18–21 of the September 2017 issue of Economic Review.

Question 1

What are economies of scope? How do they differ from economies of scale?

Economies of scope are factors that generate cost savings when one firm produces two or more products together rather than different firms producing them separately. It is difficult to illustrate economies of scope with a diagram so it is often explained by using a formula similar to the one below:

TC(Qx, Qy) < TC(Qx, 0) + TC(0, Qy)

This illustrates that the cost of producing two goods (x and y) together is cheaper than the costs of producing them separately.

One factor that might generate economies of scope is when the factor inputs used in the production and sale of one good can also be used in the production and sale of other goods. This sharing in the use of these inputs across a range of products means that they can be used more intensely and so productivity increases. This leads to a reduction in the average costs of producing each good. One example is where the administrative systems in a company’s head office can be used to support the production of more than one good. Another example is where a firm extends the use of a popular brand into different products/markets, e.g. the launch of Mars and Snickers ice creams, Apple producing mobile phones, tablets and computers.

Economies of scale exist when average costs fall as a firm expands its production of a single good. Economies of scope exist when average costs fall as a firm increases the number of different goods it produces.

Question 2

Another way of measuring market power is to use a concentration ratio. Calculate the four-firm concentration ratio for supermarkets using the data in Table 1. What are the advantages of using the Herfindahl index?

The four-firm concentration ratio measures the combined market shares of the four largest firms in the market. Therefore the four-firm concentration ratio is calculated in the supermarket example in the following way:

28.1 + 16.5 + 15.6 + 10.9 = 71.1

The relative size of the largest firms is likely to influence the degree of market power. Take the following two examples:

1  The four largest supermarkets each have a market share of 20%.

2  The largest supermarket has a market share of 65% while the next three largest supermarkets each have a market share of 5%.

In each of these two examples the four-firm concentration ratio is 80% and so is not informative about the differences in market structure. The Herfindahl index will account for these differences.

1  In the first example, the Herfindahl index is 0.22 + 0.22 + 0.22 + 0.22 = 0.16.

2  In the second example, the Herfindahl index is 0.652 + 0.052 + 0.052 + 0.052 = 0.43.

The larger figure for the second example clearly indicates that this market structure is more concentrated.

Question 3

Following concerns about the buying power of the supermarkets, the government introduced the Groceries Supply Code of Practice (GSCOP) in 2009. Outline some of the obligations this places on supermarkets when dealing with suppliers.

Under the GSCOP Supermarkets can no longer:

·  adjust the terms of a supply agreement retrospectively

·  make late payments to suppliers for groceries delivered, i.e. payments must be made in accordance with conditions specified in the supply agreement

·  require suppliers to make payments towards the retailer’s costs of the following unless it is clearly specified in supply agreements:

·  artwork or packaging design

·  consumer or market research

·  the opening or refurbishing of a store

·  hospitality for the retailer’s staff

·  require suppliers to make payments towards the costs of wastage unless it is due in some way to their negligence

·  require suppliers to make payments towards the costs of shrinkage, i.e. stock that gets lost or stolen

·  require suppliers to make payments in order to secure better positioning or an increase in the allocation of shelf space within a store unless such payments are made in relation to a specific promotion

Question 4

In 2013 the government appointed a ‘Groceries Code Adjudicator’ to make sure supermarkets were complying with the GSCOP. Using news articles, find some cases that have been investigated by the adjudicator.

Some cases include:

·  In January 2016, the GCA concluded that Tesco had not been complying with the code by delaying the payment of money to suppliers in order to improve its own financial position.

·  In June 2016, the GCA concluded that Morrisons had not been complying with the code by requiring suppliers to make lump-sum payments even though no mention was made about the requirement for these payments in the supply contracts. In other words, Morrisons adjusted the terms of its supply agreements retrospectively.

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