Dynamic Explanations of Industry Structure and Performance



Dynamic Explanation of Industry Structure and Performance

Cotterill


brand tends to be a monopoly; i.e. food manufacturers
face brand level demand curves that have sufficient
slope to allow profitable pricing above marginal cost.

Retailers also have market power in the local
markets where they sell products due to high seller
concentration in such local markets (Marion et al. 1979,
Weiss, 1989, Cotterill, 1986, 1999a, Foer, 1999, Cotterill
et al., 2000). The following quote from Mark Husson, a
leading Wall Street analyst of the industry, very bluntly
states how supermarkets must continue to expand their
gross and net margins by expanding their market power.
He describes the exercise of power as the "gross-margin
miracle". Moreover his view of the manufacturers and
retailers battle for channel control squares with the
analysis presented below in this paper.

what has to happen (for stock prices to increase) is it has
to become obvious to the (stock) market that supermarket
retailers are developing pricing power inside their
marketplaces and that there is a structural kind of seismic
shift going on in this country in the whole of fast-moving
consumer-goods distribution in favor of food retailers,
because that's the only way you're going to keep gross
margin continuing to move forward.

If you can find that pricing power and define it
somehow as maybe the manufacturer or the consumer
losing power; with better organized, more rational
competition and more rational pricing, ... and if the
retailers are developing this pricing power from both
sides, along with private brands - and taking control of
categories is part of that - then I think there is still some
real internal momentum inside the group, which despite
the lack of inflation can keep this gross-margin miracle
still moving forward. (
Supermarket News, 1999)

Since food retailing is a slow growing business,
gross margin expansion via increased exercise of market
power is the only fundamental strategy available to
increase stock prices. In conclusion, we now have a
food system that is predominantly served by powerful
food manufacturers selling to powerful food retailers.
The same is true in Europe. The successive monopoly
model of the distribution channel captures the essence of
the channel coordination problem in the U.S. and in
individual European countries.

Spengler (1950) was the first to analyze the impact
of successive monopoly on channel coordination and
economic efficiency. Figure 2 can be used to explain the
problem.13
Dr is the retailers demand curve. MRr is the
corresponding retail marginal revenue curve. If we
assume, without loss of generality and for ease of

13 This analysis of double marginalization to explain formally
the role of trade promotions and private labels in the food
system was first presented in Cotterill,et al. (2000).
illustration, that the retailer has a fixed cost of retailing
and that the only variable cost is the purchase of the
product
Q, then the retailers marginal cost is the
manufacturer price,
w. Since a profit maximizing
retailer always equates marginal revenue and marginal
cost (
MRr = w) the retailers marginal revenue curve is
the demand curve for
Q at the manufacturer level. The
manufacturer therefore equates the marginal revenue of
the retailers input demand curve (
MRm) to its marginal
cost of manufacturing the product. In other words, the
manufacturer computes the marginal revenue of the
retailer’s marginal revenue, hence the name double
marginalization. In Figure 6 the profit maximizing
manufacturer offers quantity
q2 at price p1 = w, and the
profit maximizing retailer sells this quantity at price
p2.
This is the Vertical Nash, "arms length pricing," solution
of the previous section. If the two firms integrated the
new single monopolist would maximize profits by
lowering price to
p1 and selling q1. This is the fully
coordinated solution of the previous section. The
integrated firm’s total profits are greater than the profits
of the two successive monopolists.

The implications of this double marginalization
phenomena are very real for the US food marketing
system today. Food manufacturers and food retailers,
can in fact, increase their profits if they discard
independent (vertical Nash) pricing practices and talk to
each other to coordinate pricing and other terms of trade.
The vertical Stackleberg and full coordination games of
the prior section are two possibilities. The double
marginalization model predicts that vertical coordination
will increase channel profits and lower prices to
consumers. This is a very rare win-win situation in
economics, the “dismal science” of trade-offs! A shift
from 2 monopolies to 1 monopoly is good for everyone.
Another possibility that is better for farmers and
consumers but worse for the middlemen is competition
at both manufacturing and retailing. Of course, this is
the goal of public policy, including antitrust.

With this economic model one can begin to
understand strategic moves such as the efficient
consumer response (ECR) program with its everyday
low pricing (EDLP) component. ECR moves to improve
the logistical flow of products through the system, such
as just-in-time inventory management procedures, have
been successful because they reduce cost. However, one
of the largest projected savings due to the innovation of
ECR was related to the elimination of stop-go price
promotions via the establishment of everyday low prices
(EDLP) throughout the food system. EDLP has not
worked and savings due to smoother product flow
haven’t accrued. EDLP has failed in the United States
precisely because as implemented to date it has tended to

Food Marketing Policy Center Research Report No. 53

13




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