The Market of UK Supermarkets - Essay Example

The market of UK supermarkets By: This paper tests the competitiveness of UK supermarkets based on the contestability theory. The UK supermarket industry is in an oligopoly market where few industry players dominate it. In the UK, the ‘big four’ supermarkets dominate nearly 75% of the whole market. These big four supermarkets are Tesco, ASDA, Sainsbury’s, and Morrison’s. The supplies in this industry are only owned by the ‘big four’ and face little competition. Firms that wish to enter this industry experience high barriers to entry and they must be highly interdependent. Contents Abstract 2 Introduction 4 Literature Review 4 Discussion 8 Policy implications 14 Conclusion 16 References 17 Introduction Numerous studies have associated the theory of contestable markets with William Baumol. In essence, this theory suggests a market with no barriers to entry and no barriers to exit.1 In other words, zero entry and exit costs. According to this theory, for a market to be perfectly stable, relevant industry technology would be readily available to potential entrants.2 This paper aims to investigate the contestability of the UK supermarkets, focusing on Tesco, Sainsbury, Morrison’s, and Asda supermarkets Literature Review A study by Baumol noted the importance of defining terms before analyzing them.3 Therefore, in this case, contestable markets are imperfectly competitive markets in which firms face real and potential competition.4 The biggest threat in this market, as noted in a study by Faulkner is the risk of ‘hit and run entry’. According to the author of this study, new rivals bring this threat.2 The importance of this threat is that, it keeps the market operating at a competitive price and output. It brings allocative efficiency.2 A quantitative study by Faulkner highlighted the main difference between contestable and perfectly competitive markets. According to this study, one or few firms dominate contestable markets. Additionally, each industry player in this market produces a differentiated product. A study by Stone highlighted the three conditions for market contestability. These conditions are ability and legal right to use the best available technology legal freedom to enter a market and the relative absence of sunk costs.3 There are various ways of making markets more contestable as noted in a study by Giovanardi. The first way is de-regulation.4 In this method, governments have to reduce barriers to entry to markets. The second way is formulating tougher competition laws.4 These laws need to be imposed on the predatory behaviour by the existing players in the markets. The third way is changing the nature of technology.4 This will bring down entry costs and will make prices more transparent for customers. The fourth way is by introducing new business models.4 These new models will challenge the established industry players. A magnificent example is an introduction of low-cost supermarkets. A study by Lipsey discussed the various barriers to contestability. The first barrier discussed by the author is raising rivals’ costs.5 This includes vertical integration and import tariffs. The second barrier is reducing rivals’ revenues.5 This includes bundling and selling spare capacity at low prices. The last barrier discussed is cross-subsidization.5 This is using profits from one market to cut prices in another. In contestable markets, according to Stone there are lower prices due to competition, smaller profit margins, a faster pace of innovation, and are more dynamically efficient.6 The numbers of firms in these markets are not relevant. Furthermore, these markets are characterized by abnormal profits, which attract new entrants thereby driving down prices. A qualitative study by Tye noted that, contestable markets’ competition policies focus on reducing barriers to entry. That said, these potential markets in these markets are more important than actual competition.7 A study by Stone conducted a detail analysis of the way the threat of competition affect a firm’s behaviour. The author was trying to answer the question, ‘does contestability of a market affect the performance of an industry player?’ As indicated in the diagram above, contestable markets are characterized by the threat of long run entry, which has an influence on the short-run price and output decisions.8 In this type of markets, the industry players do not charge prices that would maximize their profits, but which produces more output. Normally, these processes are very low.8 There are few markets in the world that can be categories as contestable. Experts refer to these markets as an oligopoly.9 Oligopoly can be perfectly applied to the UK supermarket industry. The UK supermarket industry is characterized by few firms that dominate the market. The UK supermarket is dominated by the big four, which are Tesco, Asda, Sainsbury’s and Morrison’s.9 Discussion There was once a funny joke in economics, which when two economists find a $10 bill, none of them will pick it up because they may be beaten by the public.10 This is how efficient the UK supermarket industry operates. The UK supermarket industry is very competitive and has few industry players.10 The UK supermarket industry is believed to be an oligopoly market. Statistics in the UK indicate that the biggest supermarkets are Sainsbury’s, Morrison’s, Tesco, and Asda.10 These supermarkets are among the 20 largest retailers in Europe. Tesco is the biggest British supermarket chain. It offers a variety of products to its customers and has dominated the UK market for a very long period.11 Sainsbury’s is a large supermarket chain in the UK. It has a 17% share of the UK market based on 2014 statistics.11 This corporation offers its products through multiple channels and offers home delivery and click-and-collect services to customers. Asda is a British supermarket, which retails food, clothing, and general merchandise. It also offers financial services to its customers. Many industry experts commend Asda for being best in innovation since it was the first company to come up with a form of click and collect the partnership. Morrison’s is a large British supermarket based in Bradford. It owns more than 400 stores in the UK and offers a variety of services and goods to its customers11. According to statistics, the four supermarkets stated above dominate nearly 75% of the whole market share.11 This demonstrates an oligopoly market where few firms only own the supplies in the whole market. In other words, the supplies in the UK market are concentrated in the hands of these four supermarkets. Majority of the UK citizens prefer these four supermarkets because of their big power in the market. This is the reason the financial results of each supermarket mentioned above indicate huge profits.12 These four supermarkets benefit a lot from having the British market power. First, these supermarkets benefit from barriers to entry into the UK government. In the UK, emerging supermarkets face the challenge of getting permission for doing business. The big four supermarkets are reputable and have enormous buying power. They make it hard for fresh players to compete with them. The big four’s massive buying and selling power force suppliers to propose discounts. This enables these four supermarkets to drive their costs down. In the long run, the suppliers face a reduction in their profit margins. Furthermore, these big four supermarkets have brought about the lack of effective price competition. These supermarkets are in a position to check each others prices and choose whether or not to increase or reduce the prices. Experts in the UK markets argues that the big four supermarkets have limited actual price competition. For instance, Tesco wanted to maintain its position as a number one supermarket in the UK after Asda sliced down their prices on primary products. Tesco therefore initiated a price cutting campaign in order to keep Asda at bay.12 These big four supermarkets often involve themselves in non-price competition. In order to remain relevant in the UK market, these supermarkets allocate a lot of money to advertisements and marketing strategies.12 Apart from advertisement and marketing, these supermarkets usually enhance the quality of service, open businesses for longer hours, extended periods of warranties on products, and offer discounts on product upgrades.12 There are many situations where the ‘big four’ supermarkets engage in price leadership.13 This means that, one big supermarket, says Asda, puts other minor supermarkets in the UK under its pricing policy. The result of this is that, quantity demanded in the market is shared among the big supermarket and other minor supermarkets.13 When this big supermarket wants to ensure market monopoly, it can lock out the minor supermarkets out of the industry. This happens when the dominant supermarket prompts pricing changes that are too harsh for minor supermarkets.13 The Kinked Demand Curve can be applied to the case of the ‘big four.’15 According to a study by Dilmus (1998), this theory of oligopoly explains the nature of interdependence that exist between firms that control a market. According to this theory, firms that are dominant in markets face a downward sloping demand curve.15 However, elasticity depends on the way competitors react to changes in price and output. In the UK, these ‘big four’ often attempt to maintain a high level of profits and assume that competitors will not follow a price increase by another firm.15 In this case, demand will be elastic and rise in price will lead to decrease in total revenue. Additionally, these ‘big four’ assume that competitors may somehow match a reduction on prices by a firm to avoid loss of market share. This result to demand being inelastic and fall in price will lead to a reduction of total revenue.16 Another theory that can be applied to the case of the ‘big four’ is the game theory. This theory is very useful in understanding the oligopolistic nature of the UK supermarket sector. Based on this theory, experts argue that developing supermarkets in the UK are suffering because of increasing monophony power of the ‘big four’ supermarkets.16 Aldi and Lidl had risen by 2012, thereby halting the rise of the big four. This caused the reduction of the 4-firm concentration from 75% to 62.3%16. However, the ‘big four’ supermarkets have caused a decline in independent retailers in the UK.16 Policy implications There are various ways that the government has attempted to curb supermarket powers in the UK. Recently, the UK government chose an adjudicator rather than an ombudsman for watching over supermarkets’ activities.17 The watchdog was supposed to name and shame supermarkets that unfairly use their market powers against suppliers.17 There have been public outcries from economists in the UK who demand proper regulation of the big four supermarkets. According to these economists, the British people require genuine level of competition.17 Despite the eye-catching advertisements by these supermarkets, they are not the cheapest shopping option for customers.18 There are some situations where these supermarkets engage in dubious marketing practices. Additionally, according to statistics, once a big supermarket is opened in the UK, approximately 300 jobs are lost.18 Meanwhile, these big four supermarkets have failed to implement living wage policies for the lowly paid employees despite the senior employees being paid handsomely. Therefore, there is a need for the government to create rules and frameworks that will guide on how the supermarkets operate.18 There are a number of ways in which the government rules affect these supermarkets. For instance, the economic policy has implications on how these supermarkets operate in the UK. Because of their high-profit margins, the government takes advantage of this and taxes a lot of money from these corporations.19 These supermarkets then pass some of this tax to consumers, thereby charging higher prices. Additionally, the economic policy of the UK government requires the state to determine the level of interest rates charged on businesses. Since these supermarkets are big corporations, the government often charges higher interest rates on them than other businesses in the UK.19 An increase in interest rates causes rise in the costs of business of borrowing money, causing customers to reduce expenditure. In the end, the business suffers from the fall in sales.19 Another policy implication can arise from legal changes effected by the government.20 Normally, the government is responsible for all the laws governing the land. Therefore, it is not wrong for the government to regularly changing the laws in line with its political policies. For instance, recently the government passed legislation that required all businesses in the UK to cater for the disabled by building ramps in their buildings. Somehow, this is an additional cost to the business, and these costs will be passed on to the consumers.20 Conclusion This paper has discussed the theory of contestability followed by a primary analysis of UK’s big four supermarkets. From this study, it is evident that the UK supermarket industry is explained as an oligopoly market. Tesco, ASDA, Morrison’s, and Sainsbury’s dominate this industry in the UK. The big four’s powers have enabled them dominate suppliers and fix price levels by driving prices down. Therefore, it can be concluded that it is very hard for new entrants to enter UK’s supermarket business because of the existing product niches. References Baumol, W. J. Contestable Markets and the Theory of Industry Structure. London: Harcourt Brace Jovanovich, 1998. Bennett, N. "How best can the government curb supermarkets power." The Guardian, 2012. Bergh, R. European Competition Law and Economics: A Comparative Perspective. London: Intersentia nv, 2001. Drexl, J. Research Handbook on Intellectual Property and Competition Law. New York: Edward Elgar Publishing, 2010. Faulkner, R. LiveEcon Microeconomics 2007. New York: Interactyx Ltd, 2007. Giovanardi, M. Evaluating the UK Supermarket Industry: A Critical Analysis of Its Strategies, Management Practices and Trends. London: University of Sheffield, 2002. Gomes, E. 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Edexcel A2 Economics Unit 4 - Industrial Economics Digital Textbook. New York: Tutor2u Limited, 2012. Sioshansi, F. P. Electricity Market Reform: An International Perspective. Chicago: Elsevier, 2006. Stone, M. A. Fundamentals of Marketing. New York: Routledge, 2007. Tye, W. B. The Theory of Contestable Markets: Applications to Regulatory and Antitrust Problems in the Rail Industry. Greenwood Press, 1990. Read More