Competition in Retailing

Prepared for the Office of Fair Trading by London Economics

September 1997

Research paper

13

Please note. Page numbers have been removed from this PDF version of the report.

Summary
1. 2. Main findings Specific findings 2.1. The nature of retailing 2.2. A framework for assessing competition in retailing

Introduction 1. An introduction to modern UK retailing

1.1 Overview of UK retailing 1.1.1 The main retailing sectors 1.1.2 Retail expenditure by households Concentration in UK retailing 1.2.1 Economies of scale in store operations 1.2.2 Retailers and centralised distribution Technology and innovation in retailing 1.3.1 Introduction of information technology in retailing 1.3.2 Product development 1.3.3 New forms of retailing

1.2

1.3

2.

The economics of retailing

2.1 2.2 Characteristics of consumers What do retailers do? 2.2.1 Manufacturer relationships 2.2.2 Logistics 2.2.3 Consumer relationships Dimensions of competition in retailing 2.3.1 Pricing 2.3.2 Geographical location 2.3.3 Product selection

2.3

2.4 2.5

2.3.4 Level and quality of retailer service Vertical issues 2.4.1 The economics of vertical restraints Policy implications 2.5.1 Identification of competition issues 2.5.2 Preliminary analysis 2.5.3 Suggested framework

3.

Market definition
3.1 3.2 The OFT/NERA market definition methodology The nature of the retail end-product 3.2.1 An example: direct sales channels versus store-based retailing Applying the US SSNIP test to retailing 3.3.1 Retailer market definition: demand-side substitutability 3.3.2 Retailer market definition: supply-side substitutability 3.3.3 Geographical market definition at the retail level Dimensions of competition other than price Summary

3.3

3.4 3.5

4.

Barriers to entry
4.1 4.2 The OFT/LE barriers to entry methodology Absolute advantages 4.2.1 Legal and regulatory restrictions 4.2.2 Access to retail sites 4.2.3 Advertising restrictions Strategic advantages: sunk cost and economies of scale Strategic advantages: advertising, goodwill and 4.4.1 Advertising 4.4.2 Goodwill and loyalty 4.4.3 Product proliferation and retailer differentiation Capital requirements Entry impediments

4.3 4.4 differentiation

retailer

4.5 4.6

5.

Competition assessment: market structure

5.1 Market structure and market power 5.1.1 Retailers market shares 5.1.2 Measuring market power Merger case study: Kingfisher plc and Dixons Group plc 5.2.1 Assessment of market structure 5.2.2 Dimensions of competition 5.2.3 Merger issues

5.2

5.3 Merger case study: Grand Metropolitan plc and William Hill Organisation Ltd 5.3.1 Assessment of market structure 5.3.2 Dimensions of competition between bookmakers 5.3.3 Merger issues

6.

Pricing issues
6.1 6.2 6.3 6.4 Price collusion Predatory pricing Price discrimination Loss leading

7.

Vertical issues
7.1 The economics of vertical restraints 7.1.1 Efficiency motives 7.1.2 Anti-competitive motives (and effects) 7.1.3 Rent sharing motives Assessing vertical restraints Implications for recent cases

7.2 7.3

Appendix 1:

References

The views expressed in this report are those of the authors and do not necessarily reflect the views of the Office of Fair Trading Crown copyright 1997 This material may be freely reproduced except for sale or advertising purposes

Summary
The Office of Fair Trading has commissioned this study as one in a series of research reports on competition policy. The terms of reference ask whether the UK competition authorities need to follow a different approach when they are required to assess competition issues involving retailing.

1.

Main findings

Our analysis concludes firstly that competition problems are likely to be particularly prevalent in retailing, and secondly that there are significant differences between retailing and other areas of the economy, but that these differences are a matter of degree rather than exclusive to retailing. This means that, while the emphasis of competition policy will often be different in retailing, there should be no need for any major change in general competition policy methodologies. However, in the process of analysing competition policy in retailing, we have discovered certain difficulties in applying some of the existing general methodologies. This does not mean that retailing requires separate methodologies, but rather that the current general methodologies need to be amended. This leads us to recommend that: C Competition enquiries should always start with an identification of the relevant competition issues and then proceed with a preliminary analysis of demand and supply factors, particularly of the general characteristics of consumers and the dimensions of retailer competition; Market definition should ensure that the identification of the relevant market or markets serve to clarify the competition issue and that the retailer market is separately identified from the product market; and Existing approaches to vertical restraints need to be refined with respect to the increased role of retailers in their establishment and enforcement.

2.

Specific findings

2.1

The nature of retailing

Retailing is the final link between the production of a good and the end-consumer. The economic characteristics of the end-consumer are thus crucial to the economics of retailing. Typically, the end-consumer can be characterised as being: 1 Small (in the sense that the size of a given purchase forms a small part both of the consumers total expenditure and of the retailers total sales); Immobile (in the sense that they are often not able or willing to travel long distances in order to purchase the appropriate product); and Uninformed (in the sense that they often do not know which products are available where, and what prices; and they may not be able to observe product quality in advance of purchase).

The combination of these characteristics explains essentially why retailers exist. The fact that consumers purchases tend to be small means that retailers play an important role in preventing the exploitation of consumers by manufacturers: no single consumer would have any bargaining power against powerful manufacturers, whereas retailers can bargain strongly on their behalf. 1 The fact that consumers are immobile means that retailers play an important function in bringing the products to the consumers, to prevent the consumer from having to go to the product. The fact that consumers are uninformed about the availability of products, their prices, and their qualities means that retailers carry out an important service in terms of providing information and quality assurances. These characteristics also explain many aspects of retailing. For example, consumers immobility means that geographical location and one-stop shopping will be important, while their lack of information means that price visibility, product range, and reputation/quality assurances will be important. These aspects of retailing feed straight into a discussion of the nature of competition in retailing. We identify four dimensions of horizontal competition between retailers: 1 Pricing;

However, the existence of retailers may itself also be a factor allowing manufacturers to become large, and to exploit economies of scale in production.

 2 3 4

Geographical location; Product selection; and Retailer service.

These various dimensions in retailing have important consequences for competition policy, and it is crucial, when considering competition in retailing, to examine all of these dimensions.

2.2

A framework for assessing competition in retailing

Competition problems are likely to be particularly prevalent in retailing, since markets will only tend to work imperfectly when there are asymmetries in bargaining power (consumers are small), high transactions costs (consumers are immobile), information asymmetries (consumers are uninformed), or vertical restraints. Indeed, there have been numerous cases where the OFT and MMC had to look at competition in retailing. The issues typically covered include: 1 Pricing issues (including excessive pricing, discriminatory pricing, predatory pricing, and loss leading); Merger issues (for which market definition is crucial); and Vertical issues (including vertical restraints, differential discounting, and own-brand competition).

2 3

In order to analyse these various issues, we suggest the following framework: 1. 2. Identification of competition issues Preliminary analysis of retailing: C C 3. 4 5 the characteristics of consumers; and the dimensions of competition between retailers.

Market definition Barriers to entry Competition assessment: C C C market structure and merger issues; pricing issues; and vertical issues.

Identification of competition issues

We suggest that at the outset of every enquiry the competition issues are clearly identified. Each step in the assessment of competition in retailing has to be considered in the context of the specific competition issue, and cannot be dealt with in isolation. Some competition

issues (such as those resulting from a merger between retailers) are easily identified, whereas a more general complaint of excessive prices for a class of products may require an in-depth investigation of both the retailing and the wholesale/manufacturing element of the supply chain.

Preliminary analysis of retailing

We suggest one important addition to the current methodology: that every investigation should include a preliminary analysis of the specific characteristics of retailing. In some recent competition cases (e.g. Contact Lens Solution, 1993), this has been carried out very effectively, but other cases have exhibited a poor understanding of the characteristics of the retail market. Without this step, it is extremely difficult to appreciate the typical competition problems that retailing engenders. The first part of this descriptive analysis should focus on the characteristics of consumers in terms of the size and frequency of their purchase, shopping behaviour in terms of travel distance and, most importantly, the way in which consumers obtain information about prices, availability and quality of products. The second part should focus on the dimensions of competition between retailers in terms of price, geographical location, product selection, and the various types of retailer service.

Market definition
The OFT/NERA report Market Definition in UK Competition Policy effectively recommends the use of the US Small test to define relevant market. In terms of applying the SSNIP test to retailing, however, there are a number of complicating issues: a) Product markets versus retailer markets. Consumers buy a bundled good from a retailer, which consists of the product itself plus the retailers value added (in terms of retailer service, location, gatekeeper function, etc). Different retailers vary greatly in the types of retailer value-added which they provide. In enquiries that relate to the retailing of a particular product group, it is therefore important to distinguish between relevant product markets and relevant retailer markets, and to define these separately. Usually this means that the relevant product markets should be defined first, and that then the relevant retailer market should be defined with respect to thetype of retailer. Dimensions of competition. The fact that retailers compete in different ways and in different dimensions will sometimes mean that there is more than one possible definition of relevant retailer markets, depending on which aspects of retailers behaviour are being analysed. With respect to the geographic dimension this means that local markets are usually defined with reference to demand-side issues (such as price and transaction costs). But it easily may be the case that national markets are more likely to be relevant when considering certain forms of strategic

b)

behaviour (such as national pricing policies, advertising, brand reputation and purchasing). Moreover, the nature of competition across a number of potential relevant retailer markets may sometimes so affect competition between retailers that the market definition needs to be adapted to serve the focus of the competition assessment. Our general conclusion is that market definition should never take place in a vacuum. Rather, it is always important to keep in mind exactly what it is about competition that is of concern and how market definition helps us in analysing this aspect of competition. Indeed, there may be several possible market definitions, each of which is valid for looking at a particular issue.

b)

Barriers to entry

The OFT/LE report Barriers to Entry and Exit in UK Competition Policy divides barriers to entry into a number of groups. Firstly, it distinguishes between entry barriers and entry impediments: the former prevent entry, while the latter delay it. Obtaining planning permission can be an important entry impediment (especially for out-of-town retailers). The time taken to form contracts with suppliers may be another. However, the most important entry impediment in the retail sector is probably the time it takes for a new retailer to establish itself with customers, particularly if reputation is important. Secondly, within the category of entry barriers, the report distinguishes absolute cost advantages and strategic (first mover) advantages. The former include regulatory barriers to entry. For example, in some retail markets (such as pharmacies and betting shops), there are regulations restricting the number of local competitors. Similarly, for some retail products (such as contact lens solutions in 1992), there are regulations restricting the types of retailers which can sell the product. Both of these are important in protecting incumbent retailers from entry. In addition, in some retail markets, prime geographical location can be crucial, and (if this is not tradable) this may be an absolute cost advantage. Thirdly, within strategic (first mover) advantages, the report distinguishes five categories, which can be recast for the purposes of retailing as: 1 2 3 4 5 Economies of scale and scope; Advertising, goodwill, market positioning, and geographical location; Capital requirements; Vertical foreclosure and exclusion; and Predatory pricing.

The importance of economies of scale and scope as a barrier to entry depends on their size relative to the size of the market. These economies can be important because retail

markets tend to consist of a whole series of small local sub-markets. Economies of scale and scope in distribution, reputation formation, and negotiating with manufacturers, can also mean that it is difficult successfully to enter some retail markets on anything but a national level. Advertising is itself not as important a barrier to entry in retail markets as it is in product markets, but promoting retailer image in other ways can be crucial, and spending on this may result in barriers to entry. Goodwill amongst customers, meanwhile, is likely to be a very strong barrier to entry into many retail markets. The fact that consumers are small, immobile and uninformed means that they tend to face fairly large costs of switching between retailers, which can make it hard for entrants to gain sufficient market share to make entry worthwhile. In terms of market positioning, retailers can increase their portfolio of products in such a way that retailers which only provide a subset of the products cannot compete in the market, and this is an important barrier to entry. Geographical location can also act as a barrier to entry in some markets, but the importance of this is often overstated. It is not clear that capital requirements are likely to be more important in retailing than in other areas of the economy. Vertical restraints and predatory pricing are analysed in the section on competition assessment.

Competition assessment

There are three sets of issues covered in our competition assessment: 1 Market structure and merger issues: creation or strengthening of market power of retailers, measurement of market power, market shares, barriers to entry and strategic advantages; Pricing issues: price collusion between retailers, predatory pricing, price discrimination, tying/bundling, and loss leading; and Vertical issues: vertical restraints, differential discounting, and ownbrand competition.

2 3

The assessment of market shares and strategic advantages of the various retailers in the market is helpful in clarifying the degree to which market power is present. This step brings together the results from the previous steps and leads into the assessment of merger, pricing, and vertical issues. The creation or strengthening of the market power through merger is a common concern. However, the importance of local sub-markets and of non-price competition mean that merger investigations are particularly complicated in retailing. Definition of the relevant market is crucial, as is consideration of the effects of merger on all aspects of competition, and not just price. In particular, geographical location can be an important motive for merger in retailing.

Price collusion between retailers, price discrimination, tying/bundling and loss leading are all issues that are relatively common in retailing. Our report sets out the issues involved in these various pricing strategies and discusses possible remedies. Vertical restraints are very important between retailers and manufacturers. However, the form of these vertical restraints has changed over time: they are less often of the traditional general form, and more often in the form of specific agreements/contracts or direct intervention; they are also now instigated by retailers more often than has traditionally been the case. There are many efficiency and rent sharing justifications for these various forms of vertical restraint, but they may also have an important anticompetitive effect: limiting competition or preventing entry. There is unlikely to be any major concern unless they have a major negative effect on horizontal competition either upstream or downstream. Own-brand competition is also rising in importance. Because retailers have final control over promotional tools such as shelf space, they may discriminate in favour of their ownbrand products (because they receive higher margins on these). Where own-brand products are designed to resemble the brand leader, the retailers may be free-riding on manufacturers investment in brand image.

Introduction

This study is one of a series of reports commissioned and published by the Office of Fair Trading (OFT). The first two reports in this series were general studies on market definition (NERA, 1993) and on barriers to entry (by London Economics (LE), 1994). The objective of this latest study is to assess the approach currently taken by the OFT to competition issues in the retailing sector. Such a study is both timely and relevant. The economic importance of the retailing sector, and the many changes that have occurred within it, mean that this sector is a prime area for competition enquiries. In recent years, there have been numerous enquiries by the OFT and the Monopolies and Mergers Commission (MMC) into markets where retailers behaviour has been subject to complaints, or where the relevant laws oblige the OFT to consider the competition implications of certain business strategies, either of, or relating to, retailers. The principal aim of this report is to provide recommendations on the general analytical approach the OFT should take to retailing cases. In particular, it examines whether retailing has features which may require refinement of the general approach to competition inquiries. In order to meet these objectives, the report first provides a brief overview of retailing in the UK. It then examines the economic nature of retailing in some detail. Retailing activities range from the simple provision of storage and display of goods, to a complex interaction between retailers, suppliers, and consumers. The role of retailers is to overcome a number of problems that consumers would face if they had to deal directly with suppliers of goods. These problems relate to lack of bargaining power, lack of mobility and lack of information. Retailers perform this intermediary role by providing a number of value-added services, building long term relationships with consumers and suppliers. Competition between retailers is determined by the scope of these activities, and the constraints that retailers face in choosing market position, both in terms of products and geography. The report then turns to the implications for competition policy in retailing. This analysis examines three sets of methodological issues: C Market definition: covering product, retailing and geographic aspects, and considering the conclusions of the study by NERA; Barriers to entry: with a particular emphasis on applying the LE barriers to entry framework to retailing; Competition assessment: including horizontal competition between retailers, vertical relationships between retailers and upstream manufacturers, and other types of market behaviour which commonly

attract complaints. Our conclusions are based on an analysis of the OFTs current approach to retailing cases, including the review and adaptation of the approaches developed to market definition and barriers to entry in the NERA (1993) and LE (1994) papers, so that they can be applied to the retail sector. We examine the appropriate approach to competition issues in retailing with reference to examples from recent UK competition enquiries. All the cases referred to in this report are MMC case unless stated otherwise. These cases include: 1 Merger cases: Kingfisher plc and Dixons Group plc (1990), Grand Metropolitan plc and William Hill Organisation Ltd (1989), and TescoWm. Low (OFT, 1994). Excessive pricing and collusion: The Supply of Petrol (1990), Contact Lens Solutions (1993), The Supply of Recorded Music (1994), and Contraceptive Sheaths (1994). Predatory pricing and price discrimination: Contraceptive Sheaths, and Black and Decker (1989). Vertical restraints: Fine Fragrances (1993), Ice cream (1994), New Motor Cars (1992), and The Supply of Petrol (1990).

1.

An introduction to modern UK retailing

Retailing is the final link between the production of a good and the end-consumer. Retailers provide an important function for end-consumers 2 in a number of respects. On behalf of endconsumers, they select goods and they collect and store them. They also assist end-consumers in making their choices through the provision of product information and after sales service. This chapter provides a brief description of modern retailing in the UK, in order to provide evidence on some of the analytical points made in Chapter 2. The first section illustrates the relative importance of different retailing sectors with reference to some key statistics. It also includes a general overview of retail expenditure by households. The second section discusses some general aspects of the trend towards increased concentration in retailing. This trend is linked with the exploitation of economies of scale and scope in the operation of stores and the increases in efficiency of distribution and inventory management. The third section reviews, in summary form, developments of technology in retailing and innovations in retailing formats.

1.1

Overview of UK retailing

Retailing is one of the most important sectors of the UK economy in terms of its contribution to GDP. As UK GDP has increased over the last two decades, the retail (and wholesale) sector has grown in line. In 1973, the retail (and wholesale) sectors output was 39.8 billion. By 1993, this had risen to 55.4 billion (both figures expressed in 1990 prices): an average annual growth rate of nearly 1.7 per cent. 3 Figure 1 shows that retailing and wholesaling sector has accounted for around 10 to 12 per cent of the UKs GDP over the last twenty years (on average it has represented 11 per cent of GDP). This sector is particularly sensitive to the economic cycle, being hit harder than average in times of economic recession and recovering its share of UK GDP as the economy picks up. Despite the so-called retailing boom in the mid-to-late 1980s, there was not a massive increase in this sectors share of GDP. The implication is that the performance of the UKs retailing (and wholesaling) sector responds proportionately to the general economic climate in the country. 4

2 3 4

The economic characteristics of retailing are discussed in more detail in the following chapter. Data relates to retailing plus wholesaling activities, but excludes expenditure on motor cars. Whilst this may be true for the retail sector as a whole, we would expect large variations to occur between different retail markets. DIY and motor cars, for example, will be very sensitive to the economic cycle, whilst food and tobacco will be less so.

Figure 1 : Retailing, wholesaling and repairs' contribution to UK GDP

12% 10% 8% 6% 4% 2% 0% 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993

Source: CSO Blue Book; LECalculations.

1.1.1

The main retailing sectors

Food retailers are by far the largest retailing group in the UK. Table 1 shows that food retailing accounts for almost 38 per cent of UK retail sales, whilst the large grocery retailers alone account for 30 per cent of all UK retail sales. There are a relatively small number of large grocery retailers, each of which operate a large number of stores (on average the large grocers operate 113 stores each, compared to an average of 1.3 stores per retailer for the food sector as a whole), generating large per-store turnover. The top five large grocery retailers account for 48 per cent of all sales (although the actual figure will be substantially lower than

this, since these retailers also sell many non-food items). Other types of retail outlets which are important include: C Confectionery, tobacco and newsagents (CTNs) represent 7.8 per cent of total UK retail turnover. These tend to be small businesses, most retailers operating only one outlet. The top five retailers account for just 14 per cent of all sales by CTNs. Clothing retailers represent 7 per cent of total UK retail turnover. There tend to be more multiples in this sector than in CTNs, although nowhere near as many as in food retailing, with an average of 1.9 stores operated by each retailer. The top five clothing retailers represent 29 per cent of all sales in this sector. Household textiles, furniture and carpet retailers account for over 5 per cent of the UK retail market. The top five retailers in this sector account for 17 per cent of sales in this category. Again, most retailers tend to be small, with an average of 1.3 outlets operated per business. Electrical and music goods retailers make over 5 per cent of all UK retail sales. This is a relatively concentrated area of retailing, with the top five firms accounting for over 30 per cent of sales. However, many retailers are small, as is reflected by there being an average of 1.6 stores operated per retail business in this area. Other large sectors are DIY retailers (with 3.5 per cent of all retail sales) and chemists (with 3.7 per cent of all retail sales). Mixed retail businesses account for over 15 per cent of all retail sales, but include many retailers who probably do not operate in the same market. Some UK retail sales are transacted through outlets other than stores. Mail order retailing is the most important of these, and accounts for almost 3 per cent of retail sales in the UK.

1.1.2

Retail expenditure by households

Although this statistical overview illustrates the structure of the UK retailing industry, it says little about the type of retail expenditure by households in individual retail markets in the UK. This is because the data presented in Table 1.1 relates to expenditure by type of outlet, rather than by product type. This issue is addressed in Table 1-2, which shows expenditure on retail products in the UK in 1993. This table is not perfect either, since not all the categories of expenditure shown are purchased by consumers through retail outlets. Housing is the most obvious example. However, it shows clearly which items of expenditure are most important in the average UK consumers consumption pattern: C C C Food accounts for 18 per cent of expenditure; Clothing and footwear accounts for 6 per cent of expenditure; Household goods account for 8 per cent of expenditure;

C C C

Motoring expenditure accounts for 13 per cent of expenditure; Leisure goods account for 5 per cent of expenditure (of this, electrical equipment was the largest component); Leisure services represent 9 per cent of expenditure (this is a broad category including cinema, theatre, sports and other live entertainment, television licences and rental, hotel and holiday expenses and cash gifts and donations).

Table 1-1 : Retailing in the UK in 1992 (by outlets)

Total turnover m (shaded area in %) 144,135 54,488 43,221 47.9% 11,049 13.2% 3,002 52.4% 9,875 30.0% 2,643 39.0% 169 7,277 18.5% 7,512 30.7% Number of businesses 219,131 60,119 71 41,502 5,169 21,347 3,098 477 20,274 Number of outlets Gross profit margin 30.4% 25.4% 24.3% 17.0% 15.7% 44.5% 41.7% 46.4% 39.6% 86.0 5.0 13.8 1.7 Advertising expenditure m 569.7 101.1

TOTAL RETAIL TRADE FOOD RETAILERS Large grocery retailers Top 5 grocery groups as a % of total CTNs Top 5 CTN groups as a % of total OFF-LICENCES Top 5 off-licence groups. as a % of total CLOTHING RETAILERS Top 5 clothing groups as a % of total FOOTWEAR RETAILERS Top 5 footwear groups as a % of total LEATHER AND TRAVEL GOODS RETAILERS HOUSEHOLD TEXTILES, FURNITURE AND CARPET RETAILERS Top 5 household groups as a % of total ELECTRICAL AND MUSIC GOODS RETAILERS Top 5 electrical groups as a % of total

318,751 78,606 8,003 3.1% 48,554 6.4% 9,445 43.0% 40,343 9.3% 10,144 35.4% 832 26,141 2.9% 17,484 13.4%

10,887

33.3%

76.0

9,047 11,302 HARDWARE, CHINA AND FANCY GOODS RETAILERS Top 5 hardware groups as a % of total 15.4% 5.1% 5,298 77,208 5,028 DIY RETAILERS Top 5 DIY groups as a % of total 49.8% 1.2% 7,560 12,865 5,290 CHEMISTS Top 5 chemist groups as a % of total 67.2% 25.2% 5,406 9,040 2,379 BOOKSELLERS, STATIONERS AND NEWSAGENTS Top 5 books etc. groups as a % of total 16.8% 9.7% 4,774 7,259 1,735 JEWELLERS Top 5 jewellers groups as a % of total 46.3% 15.8% 7,476 9,224 1,714 TOYS, HOBBY AND SPORTS GOODS RETAILERS Top 5 toys etc. groups as a % of total 30.7% 7.5% 11,521 11,795 1,013 OTHER NON-FOOD RETAILERS 3,591 10,802 22,411 MIXED RETAIL BUSINESSES 129 295 4,171 GENERAL MAIL ORDER HOUSES 482 2,438 1,256 TV HIRE BUSINESS 948 2,430 248 OTHER HIRE OR REPAIR Source: CSO Business Monitor SDA25; Nielsen Retail Pocket Book 1995; Corporate Intelligence The Retail Rankings.

Total turnover m (shaded area in %) 1,673

Number of businesses

Number of outlets

Gross profit margin 43.6%

Advertising expenditure m

40.6% 27.6% 43.5%

69.2 19.6 1.4

42.2% 32.0% 7.2

35.0% 28.6% 48.8% 77.4% 71.5%

6.1

As we have noted, accurately splitting expenditure on products (Table 1-2) by retailer type is extremely difficult for the UK as a whole. However, such information is more readily available when considering smaller subsets of the retail market. 5

Although we have not reproduced it here, the Business Monitor does provide a table of product expenditure by type of retailer. Other references for such information include AGB, Nielsen and Verdict.

Table 1-2 : Expenditure on retail products in the UK, 1993

Average weekly household expenditure 44.85 13.24 49.96 39.53 10.43 11.95 5.59 17.40 3.02 14.38 23.05 5.69 2.36 3.88 1.92 15.44 11.04 2.72 Average weekly expenditure lower decile 11.75 9.30 20.23 18.31 1.92 2.89 2.93 3.86 0.82 3.04 6.63 1.30 0.84 0.97 0.58 5.89 2.65 0.28 Average weekly expenditure upper decile 97.93 18.49 88.79 61.34 27.45 25.68 4.87 42.67 6.60 36.07 49.93 16.18 4.36 7.23 4.57 37.86 27.02 10.80 Total UK expenditure m 54,200 16,000 60,376 47,771 12,604 14,441 6,755 21,028 3,650 17,378 27,855 6,876 2,852 4,689 2,320 18,659 13,342 3,287 Proportion of total spend % 16 5 18 14 4 4 2 6 1 5 8 2 1 1 1 6 4 1

Housing (net) Fuel, light and power Food Grocery Meals bought away from home Alcoholic drink Tobacco Clothing and footwear Footwear Clothing Household goods Furniture Floor coverings Gas and electrical appliances Stationary and paper goods Household services Personal goods and services Leather and travel goods, jewellery, watches & fancy goods Medicines and surgical goods Toilet requisites, cosmetics etc. Hairdressing, beauty treatment etc. Motoring expenditure Motor vehicles, spares and accessories Maintenance and running of motor vehicles Fares and other travel costs Leisure goods TV, video and audio equipment (not rental) Sports goods Books, newspapers, magazines and periodicals Toys and hobbies Leisure services Other Total expenditure

1.86 3.03 1.67 36.28 15.92 20.36 6.95 13.26 4.34 0.66 4.1 1.41 25.56 2.10 276.67

0.61 0.84 0.61 4.12 1.39 2.73 1.77 3.36 0.93 0.00 1.71 0.24 4.76 0.23 80.35

3.15 6.06 3.38 84.05 40.53 43.52 19.72 30.12 9.35 2.42 8.09 2.33 82.96 4.13 614.21

2,248 3,662 2,018 43,844 19,239 24,605 8,399 16,024 5,245 798 4,955 1,704 30,889 2,538 334,350

1 1 1 13 6 7 3 5 2 0 1 1 9 1 100

Source: Family Spending 1993, CSO (1994).

1.2

Concentration in UK retailing

Much is made of the increase in concentration in retailing. 6 A detailed and in-depth analysis of individual markets is necessary to establish the extent to which this is indeed the case. However, it is generally recognised from qualitative evidence that the level of concentration has risen in many UK retailing markets since the war. 7 Table 1-3 shows how concentrated a selection of individual retail markets in the UK had become by 1992. Such concentration levels have been achieved through merger and/or the organic growth of

6 7

See, for example, Institute for Public Policy Research (1995) and OFT (1985). Baden-Fuller (1985) provides a good description of how concentration in the grocery sector has changed.

leading retailers. Although both these processes have been observed in retailing, many of the leading retailers (e.g. Marks and Spencer and the leading grocery multiples) have in fact captured market share through organic growth. Baden-Fuller (1985) notes that in the grocery retail market, most of the increase in concentration arose through internal expansion of the firms already in the industry. Merger activity has played only a small part.

Table 1-3 : Concentration ratios in the UK retailing sector in 1992

The largest five enterp rise grou p s accou nted for: Turnove Share of r total % million
18,931 4,836 7,872 5,862 6,336 951 43.5 23.1 36.2 19.9 24.0 63.0

Turnover million By broad commodity group

Food Drink, confectionery and tobacco Clothing, footwear and leather goods Household goods Other non-food retail products 43,479 20,956 21,742 29,389

The largest ten enterp rise grou p s accou nted for: Turnove Share of r total % million
25,261 7,681 10,671 8,780 9,000 1,012 58.1 36.7 49.1 29.9 34.6 67.1

26,035 Hire and repair business 1,509 Source: CSO Business Monitor SDA25 (1994).

Although concentration in many of the UK retail markets has increased in recent years, competition through new entry has always been a feature. The recent entry of the discount retailers Netto and Aldi, and the warehouse clubs Costco and the Warehouse Club illustrate this point.

1.2.1

Economies of scale in store operations

One reason that retailers found it beneficial to grow in size may have been to benefit from opening larger stores in order to experience economies of scale in store operation. This feature is particularly relevant to the UKs grocery retailing sector with the development of superstores (see Figure 2). This phenomenon has also occurred in other retail markets, as is clear in Table 1-4. Retailers which have increased their average store size include: C C C C C C C Clothing (Marks and Spencer, C&A etc.); Record and CD retailing (Virgin, Tower Records and HMV); Books (Dillons, Waterstones); Electrical goods (out of town Comet, Dixons and Currys stores); Hardware (with the emergence of DIY superstores); Pharmacies (Boots and Lloyds); and, Furniture and carpets (Texas, MFI, Allied).

Figure 2 : Average size of multiple grocers' stores (sq. ft.)

14,000 12,000 10,000 8,000 6,000 4,000 2,000 0 1976 1978 1980 1982 1984 1986 1988 1990 1992

Source: Institute of Grocery Distribution.

Table 1-4 : Average sales area for top ten retailers in UK retail markets Average sales area 000 sq. ft. Average annual weighted by retailers turnover growth rate 1985/6 1992/3 (%)
14.3 22.1 Grocers Furniture 15.7 21.3 Mixed goods 20.3 23.7 DIY 27.0 36.0 Music goods 1.9 3.3 Source: Corporate Intelligence - The Retail Rankings; London Economics calculations. 6.3 4.5 2.3 4.2 8.5

1.2.2

Retailers and centralised distribution

The emergence of larger retail operators has enabled the use of more efficient methods of distribution. Over time, wholesalers have more or less disappeared from many of the retail markets in the UK, with large retailers dealing directly with manufacturers. This trend has probably been greatest in the grocery retail market; between 1982 and 1992, retail turnover increased by 125 per cent8 whilst turnover from delivered wholesale trade increased by only 59 per cent.9 Moreover, the method of delivery has changed enormously as retailers have become more efficient. Before the emergence of multiple retailers, most deliveries to UK retailers were made by manufacturers or wholesalers. Such deliveries were of an assortment of products to individual retail outlets. Nowadays, manufacturers tend to deliver large amounts of a particular product in each delivery to a retailers own centralised warehouse. The retailer has, in effect, internalised the wholesaling and transportation function into its own activities. 10 The advantages of centralised warehousing include: C C C C C reduced stock levels; reduced delivery visits per store; reduction of necessary storage space in stores themselves; fewer incidents of running out of stocks and empty shelves in the outlet; and lower shrinkage.

The organisation and management of centralised distribution varies within and across retail markets. 11 Some retailers control their own transport and warehouse systems, whilst others contract these functions out to third parties. This has led to the demise of manufacturer delivery fleets and the growth of the market for contract distributor services such as Excel Logistics. Contracting out centralised warehousing and distribution releases a retailers capital and allows it to focus on its core business of retailing. 12

1.3

Technology and innovation in retailing

Retailing has undergone a radical change over the last few decades. Not only have there been changes in the size and scope of retail outlets. There have also been significant changes in the way information technology is used to reduce costs of distribution and store operation. Retailers have also become more involved in upstream production of goods, or at least have started to influence directly what suppliers manufacture. In addition, there have been new forms of retailing that bypass the traditional shop and make use of telecommunications and

8 9 10

11 12

Source: Business Monitor, CSO. Source: Institute of Grocery Distribution. Thus, referring to the analysis above, we should not be surprised to see the value added by the retailer increasing (measured by the difference between gross and net margins), while net margins have not increased as dramatically. See McKinnon (1986). Sussams (1989, 1991).

information technology to facilitate transactions with customers. 13

1.3.1

Introduction of information technology in retailing

One of the most significant advances in the technology used by retailers is the use of electronic information technology. Bar-coding and electronic scanning of products is central to this technology. There are many reasons why this improves efficiency, including: C C C C C trading along supply chains can be made paper-less and even automatic; improved information for stocking. For example, the improved information allows just-in-time (JIT) stock management systems to be employed; improved information on sales allows more efficient allocation of stores labour force; better information regarding new product development; quicker checkout throughput times, and reduced queuing. A US study 14 reported a 12 per cent increase in productivity measured by the number of items checked per labour-hour expended after scanners had been introduced; and greater financial control (e.g. in paying creditors) through improved sales information.

Many of these benefits could only have been captured after the development of large, multiple retailers.

1.3.2

Product development

The increasing quantity of data that can now be collected and collated by retailers has improved their ability to judge how consumer preferences change over time. As a method of exploiting this new information advantage, many retailers have developed stronger relationships with suppliers (this has been seen in recent years in grocery and other retailing), and have become involved in product development. Marks and Spencer (M&S) are a good example. When they develop a new line, they involve themselves not only in the factors that affect the buying and distribution of the product, but in the details of how the product is made and the source and nature of the raw materials used to make it.15 An example of this is when M&S established its own textile laboratory in 1935 and developed a relationship with ICI in order to understand the nature of the raw materials used to manufacture its products. This involvement allows M&S to influence its manufacturers in its product specification. 16 More recently, M&S were involved in

13

14 15 16

For a good survey of how technology has revolutionised the retailing industry, in a number of countries, see the Retail Survey in The Economist, March 4th, 1995. A discussion of how new technology in retailing has been adopted and exploited can be found in Hogarth-Scott and Parkinson (1994). Saleh (1988). Davies (1993). Sieff (1970).

encouraging European manufacturers to adopt the US technology that M&S had studied, in order to supply Iceberg lettuce all year round to its stores. 17 Such practices are commonplace among other major retailers in the UK. Own-brand products have high penetration in grocery retailing. Boots, the Body Shop, WH Smith, DIY stores, and Woolworth are other examples of retailers with strong own-label product lines.

1.3.3

New forms of retailing

Advances in technology are also having consequences for the nature of retailing itself. The traditional (and still by far the most popular) form of shopping is one where consumers travel to the retailer to purchase products. However, other forms of retailing, such as mail order, teleshopping and interactive television are all viable alternatives. Moreover, home shopping, especially through teleshopping and interactive television, is likely to increase as technology progresses. The current size of the home shopping market is difficult to determine, due to its diversity and the lack of recorded data. We do know, however, that the mail order market was valued at 4.2 billion in 1993, which represented about 3 per cent of total retail sales. Some of the more popular mail order items are presented in Table 1-5. Table 1-5 : The size of the mail order market in 1993 Market Total market (m) Mail order (m)
Clothing & footw ear Electrical good s Fu rnitu re & carp ets
Source: Verdict Research

Share of total (%)

9.8 6.0 4.4

22,244 10,074 7,945

2,185 570 352

Other growth areas for home shopping include recorded music, personal computers, insurance and retail banking. It is difficult to know how directly these new forms of retailing compete with more traditional retailers, not least because data on home shopping is currently not collected very rigorously. Clearly, though, any significant growth in these new forms of retailing will be detrimental to traditional retailers18 and will have considerable effects on the structure of the retail market. The relevant question, of course, is whether there will be a significant growth in these new forms of shopping. Whilst evidence from the USA suggests that there is some potential for growth, many commentators are sceptical.

17 18

Briggs (1984). Although Humphries and Samways (1990) suggest a number of advantages of home shopping for retailers.

2.

The economics of retailing

In order to assess how to deal with competition issues in retailing, it is important first to gauge the degree to which retailing is different from other areas of the economy. It is particularly important to determine whether the economic characteristics of retailing are sufficiently different to warrant a different approach by competition authorities. There are significant differences between retailing and other areas of the economy. Distinguishing factors of retailing include: The characteristics of end-consumers: they tend to be relatively small, immobile and uninformed. The dimensions of competition: particularly the importance of geographical location, product range, and retailer services/image. The form of vertical restraints: they are now less often of the traditional general form, and more often in the form of specific agreements/contract or direct intervention. They are also now instigated by retailers more often than has traditionally been the case. These factors mean that competition problems are likely to be particularly prevalent in retailing, since markets tend to work imperfectly when there are asymmetries in bargaining power (consumers are small), high transactions costs (consumers are immobile), and information asymmetries (consumers are uninformed). These differences are a matter of degree, rather than exclusive to retailing. Thus, while the emphasis of competition policy will often be different in retailing, there should be no need for any major change in general competition policy methodologies. We do, though, suggest that any competition enquiry should start with a preliminary analysis of the economic characteristics of the retail area under investigation, before commencing on the more traditional framework of market definition, examination of entry barriers and competition assessment. The first section of this chapter examines the economic characteristics of retail consumers. It considers the implications of these characteristics for the nature of competition in retailing, with reference to the relevant economic literature. The second section discusses what retailers do, and defines the scope and nature of their activities. Following from this discussion, the third and fourth sections examine in more detail the economic nature of competition in retailing: Section 2.3 deals with the dimensions of competition between retailers, whilst Section 2.4 examines vertical issues that arise from the importance of the relationship between retailers and manufacturers 19. Section 2.5 looks at the implications for policy.

19

Except w here clearly stated otherwise, we refer throughout this report to the retailers upstream supplier as a manufacturer (even though in some circumstances the direct upstream supplier may in fact be a w holesaler/ distributor). This simplification is made purely for ease of explication, and does not change the substance of the discussion.

2.1

Characteristics of consumers

Retailing is the final stage of the value chain: the point of transaction with the end-consumer. The economic characteristics of the end-consumer are thus crucial to the economics of retailing, and are responsible for the main differences between retailing and other areas of the economy. The end-consumer can be characterised as being:

Small (in the sense that the size of a given purchase forms a small part both of the consumers total expenditure and of the retailers total sales); Immobile (in the sense that they are often not able or willing to travel long distances in order to purchase the appropriate product); and Uninformed (in the sense that they often do not know which products are available where, and what prices; and they may not be able to observe product quality in advance of purchase). The combination of these characteristics essentially explains why retailers exist. The fact that consumers purchases tend to be small means that retailers play an important role in preventing the exploitation of consumers by manufacturers: no single consumer would have any bargaining power against powerful manufacturers, whereas retailers can bargain strongly on their behalf. 20
The fact that consumers are immobile means that retailers play an important function in

bringing the products from the manufacturer to the consumer. 21

The fact that consumers are uninformed about the availability of products, their prices, and

their qualities means that retailers carry out an important service in terms of providing information and quality assurances. These consumer characteristics also explain many other aspects of retailing. Customers will be attracted to a retailer which reduces the need for a consumer to visit several shops, or to spend time acquiring information. To see how retailers can do this, it is useful to consider the various kinds of costs which consumers face in addition to the simple purchase price: 1 Pure shopping (or shoe leather) costs: Even when consumers know exactly what they want, and where best to purchase it, there are costs involved in making the shopping trip, especially in terms of time and effort. These are pure shopping costs. Shopping costs have three important implications for retailing:

20

Of course, the same problem may then occur for consumers vis--vis the strong retailers. However, if there is sufficient competition between these strong retailers, then at least some of the gains from bargaining will be passed onto consumers. Note that this movement of goods allows a single manufacturing base to produce for customers in many different localities, enabling the exploitation of economies of scale in production.

21

First, the fact that consumers do not want to travel far to make purchases means that geographical location can be important, and that retail markets are often very local (for example, the importance of location can explain the existence of local convenience stores, despite the fact that they are often more expensive than their larger rivals). Moreover, the fact that mobility is increasing as car ownership rises means that geographical markets may be widening. Second, the fact that consumers do not want to travel to several different locations for each separate purchase means that retailers often cluster, or try to provide a one-stop shopping service so that consumers can buy several products in the same place. 22 This effect becomes more important as incomes rise and as more and more women work, because the average cost of time for shoppers increases. 23
Third, these shopping costs encourage home shopping, via either television or catalogues.

Search costs: When consumers are not quite sure what product they want in advance, or where the product is available at what prices, then there is an additional search cost involved in purchasing the product. Search costs can be reduced by retailers clustering together, or by their providing a one-stop shopping service. If there is a wide range of products available in one particular location, then customers will be attracted to this location. This partly explains why shops selling similar products often cluster (for example, agglomerations of car dealers and areas which specialise in clothes shops), and why some retailers specialise in offering a very wide range of relatively similar products (these retailers are sometimes called category killers). Search costs also give retailers an incentive to increase the visibility of their prices. Search costs and shopping costs together contribute to a general reluctance amongst consumers to switch from their regular retailer (they are sometimes called switching costs24 in this case). There may be other, better retailers around, but the consumer does not find it worth investigating this possibility as long as his regular retailers service does not slip too low. 25
These costs also help to explain the importance of impulse purchases. Because it is costly - if not impossible - for consumers to determine exactly what they want to purchase in advance of a shopping trip, their decisions are often highly dependent on what they happen to see.

Information on quality: Information on a products quality is often difficult to ascertain in advance

22

Messinger and Narasimhan (1992) show how shopping costs imply the existence of one-stop shopping and also local convenience stores. Note that the growing importance of one-stop shopping (larger retailers) may result in increased concentration in certain retail markets, increasing the likelihood that competition issues will arise. See Klemperer (1987, 1990). Note that habit may also play a part in the perceived costs of switching between retailers. Switching costs may be implicit (due to search costs/ habit) or explicit (due to contracts, or to formalised incentive schemes such as loyalty cards and points schemes). Both sorts of switching costs have potential consequences for competition.

23

24

25

of purchase (products for which this is true are called experience goods). 26 Because the incremental benefits are limited, consumers do not find it worthwhile overcoming asymmetric information problems by improving their own information. They are therefore willing to pay a premium for quality assurances, especially in the form of reputation for quality (brand name/image) and other forms of point-of-sale service.27 Consumer protection laws and product safety legislation also exist to overcome this information problem, as do specialist consumer magazines.
Given these costs, it is clear that geographical location, price visibility, one-stop shopping, product range, switching costs, and reputation/quality assurances are all likely to be important dimensions of competition in retailing. In section 2.3 we examine these various dimensions of competition between retailers in more detail. Before that we ask a more basic question: what do retailers actually do?

2.2

What do retailers do?

The functions of retailers can be separated into three main categories: Managing relationships with manufacturers; Managing logistics such as distribution and stock control; and Developing and sustaining customer relationships. The relative importance of these three functions will differ from one category of retailing to the other. Superior management of logistics is essential in grocery retailing where retailers have to organise efficiently and effectively the supply and distribution of over 40,000 product lines. Developing and sustaining customer relationships tends to be very important in beer retailing (through pubs). Moreover, the value-added which retailers provide in terms of carrying out these three functions will tend to be reflected in the share of economic rents28 which they receive.

2.2.1

Manufacturer relationships

In a standard market economy, the relationship between consumer and supplier is a simple one: exchange of goods or services for money. Consumers shop around between suppliers, and purchase from the one which provides the best product at the best price. The purchase of products from retailers by endconsumers resembles this standard market set-up (with the qualifications given in the previous section). However, relationships between retailers and manufacturers are generally far more complicated than this: retailers are often involved in many aspects of the supply chain, while manufacturers want to influence the way in which their products are retailed.
26

See Kay (1993) for a discussion of a typology of goods that distinguishes between experience goods and search goods; the latter can be judged in terms of quality on inspection whereas the former manifest their quality only in the process of consumption (which, for some goods such as schooling and insurance, can occur years after the original purchase). The ability of reputation to act as an indirect guarantee of quality has been modelled by, for example, Klein and Leffler (1981), Shapiro (1983) and Allen (1984). The term economic rent essentially means profit. More precisely, it is defined as an income received by the owner of a factor over and above the amount required to induce that owner to offer the factor for its present use This form of rent should not be confused with direct rents, which are paid for property or equipment.

27

28

Retailer involvement upstream

There are various reasons why retailers feel that they have to get involved in the supply chain, rather than just purchasing products on a free market. Retailers want to ensure that the products they receive are of the desired quality. 29 They can do this through inspection (quality control). However, it may be more efficient to ensure that the production process itself is properly designed so that it does not produce faulty products in the first place (quality management). In some cases, information asymmetries between retailers and manufacturers mean that retailers have to intervene in the supply process to ensure that the products consumers want are available at all. Just-in-time distribution and quick-response systems have become very important in recent years. They reduce retailers costs by minimising the stocks which retailers need to hold;30 they improve the distribution of short shelf-life products; and they improve the flexibility of retailers in coping with changes in customer demand. However, both require high levels of co-ordination between retailers and manufacturers. A retailer which wants to maintain a reputation for exclusivity may be concerned to ensure that its manufacturers do not supply other retailers (or at least not with the same products).

Together, these characteristics are often termed supply chain management. The growth of supply chain management provides one explanation for the recent shift in market power away from manufacturers and towards retailers. There is no logistical reason why manufacturers cannot be effective in supply chain management, but they tend to lack the necessary detailed sales information. Retailers are closer to endconsumers and many have developed sophisticated information systems which can facilitate supply chain management. Thus retailers have tended to absorb this role. The growth of supply chain management also explains the decline in many markets of wholesaling, since wholesalers tend to hinder co-operation between manufacturers and retailers. In other markets, wholesaling has not disappeared, but the structure of the wholesaling operation has changed. For example, newspaper wholesaling is now carried out on an exclusive basis, with publishers auctioning franchises for local wholesaling monopolies.

Manufacturer involvement downstream

While retailers are often involved in the supply chain, manufacturers are also concerned to exert control over some aspects of retailing. In particular, manufacturers are concerned that:

29

Control of product quality is especially important for goods which are not manufacturer branded, since any reduction in quality will affect the reputation of the retailer far more than that of the manufacturer. Traditionally, retailers have had to hold high levels of stocks in order to avoid out-of-stock situations, which are especially important in retailing because of the importance of wide product range.

30

 Their products are retailed in the best way; Retail staff are properly trained; and Retailers carry out the right level and type of promotion. In terms of the first, a products position within a store can be crucial. Being near the front of a store, or on the ground floor, or on shelves which are just below eye-level can all be very beneficial to a products sales. For example, Dyer (1980) found that goods displayed at the entrance to the first aisle in an outlet increased normal sales by 363 per cent. The total amount of shelf-space allotted to a product will also have an important effect on its sales. Retailers are acutely aware of the impact of a products position on its sales. They tend to place products for which this effect is likely to be highest (potential impulse purchases) in the best positions, reserving the less effective selling space for everyday necessities which will sell anyway. Allocation of shelf space has become a particularly controversial topic with the growth in own-brand goods. Because retailers make higher margins on their own-brand products, they often promote them by giving them more (and better) shelf space than is proportional to their total sales. For example, when Sainsburys introduced its Classic Cola, it is alleged to have moved Coca Cola onto the lowest shelves in its stores (much to Coca Colas chagrin). On the second point, some manufacturers pay for the training of retail staff (this is particularly common for upmarket furniture and clothes manufacturers) or even employ the retail staff themselves (as in cosmetics and perfumes).31 More often, however, manufacturers intervene in staff training less directly, by demanding certain standards of retailers, or by refusing to supply retailers who offer a sub-standard retail service. Thirdly, the effective advertising and promotion of a manufacturers products often relies on co-ordination between manufacturer and retailer. For example, media advertising is sometimes jointly paid for by retailer and manufacturer (such as television advertisements for particular LPs at particular record retailers, or for particular grocery products at particular supermarket chains). More often, the manufacturer will pay for media advertising but will expect retailers to carry out concurrent promotion within their stores (for example, by placing the product in the window or creating a large in-store display). If information were perfect and monitoring were cost-less, it might be possible for manufacturers to design contracts which specified precisely how their products should be sold, how staff should be trained, and the level and type of promotion which retailers should carry out. However, it is often easier in the face of information constraints to design incentive schemes for retailers in the form of a vertical restraint. 32 This is discussed further in Section 2.4.

2.2.2

Logistics

Logistics involve the efficient movement and storage of materials, parts, and finished inventory from suppliers, through the company and on to customers. This is more important in some retail areas than in
31

See Davies (1993, p. 89). For example, if RRPs can be used to constrain price competition between retailers, their retail margins will be higher and they will have higher incentives to promote products.

32

others. Efficient distribution and stock control is particularly crucial in fast turnover, highly perishable areas like grocery retail; it is less important in slow turnover areas, such as furniture retailing. There have been many changes in retail logistics in recent years. The increase in the average size of stores has allowed shops to exploit economies of scale; the use of electronic tagging has reduced the possibility of theft 33; and the growth in the use of credit and debit cards has changed cashing-up procedures and reduced the need to monitor employee fraud. However, two changes in particular have had crucial impacts on retailing. First, there has been a growth in centralised distribution. Before this, deliveries were generally made by manufacturers or wholesalers directly to retailers premises. Today, the norm is for delivery to be made to a retailers own or controlled central warehouse. The retailer then organises distribution from this warehouse to each store. This reduces the number of deliveries made to individual stores. In grocery retailing, for example, Moore (1991) calculates that centralised distribution reduces store deliveries from 60 a day on average to 12 or less. It also reduces the need for storage space in retail outlets (which can be converted into selling space), reduces wastage, and reduces the likelihood of products going out of stock. The second major change in retail logistics has been the advent of computerisation, and especially the use of scanning equipment in stores. Penetration of retail scanning is higher in the UK than anywhere else in Europe. Electronic point of sale (EPOS) data can be used to dramatically improve ordering systems and to support decision-making.34 The speed and efficiency of ordering is then improved by computerisation: even the smallest of companies, such as a Welsh goat farmer supplying cheese to Tesco, are now linked to retailers by computer. 35 Retail scanning data can also be an important source of revenue to retailers. Market research companies (such as Nielsen and IRI) pay a lot for such data, as do some of the large manufacturers. The revenue generated by retailers for scanning data is in fact higher in the UK than anywhere else in the world, due to the high value of the information involved and the strong bargaining power of UK retailers.

2.2.3

Consumer relationships

Above all else, retailers must respond to consumers needs and tailor their service and image accordingly. The dimensions of competition between retailers which are discussed in the next section are directly related to consumers needs. This is because consumers place value on far more than any individual product. Whilst price is obviously important, shoppers are also concerned about the rest of the retail experience. They may prefer retailers in particular geographic locations, those which stock large product portfolios, or those which provide the best retail service. It is rarely the case that consumers will visit solely those retailers which charge the lowest prices. For this reason, competition between retailers takes place on more than one dimension (non-price competition is important in this industry). The preference of consumers for things other than low prices is illustrated in Table 2-1 for grocery stores. Shoppers were asked what was the most important factor influencing their decision as to which grocery

33

Although theft still accounts for an estimated 1 to 2 per cent of retail turnover (see Davies, 1993, p. 88). Although substantially more use could be made of this information (see Lockett and Holland, 1991). See Ody and Newman (1991).

34

35

store to frequent. Over one half of the respondents claimed that convenience was crucial, with product range coming (a much lower) second and low price representing less than 15 per cent of all responses. Of course, the nature of grocery retailing means that this spread of responses will not be valid for all types of retailing. Notably, convenience (in terms of geographical location) is likely to be less important for larger purchases, or products which are bought irregularly. However, the way in which consumer preferences are formed is clear. Table 2-1 : Factors affecting the choice of grocery store Proportion of respondents Most important factor %
Convenience Product range/selection Low price Quality Cleanliness Friendly staff Handy opening hours Others Total
Source: Nielsen Household and Shopping Survey

54 14 13 9 2 1 1 6 100

Perhaps the most difficult aspect of consumer relationships to manage is that of retailer image. Davies and Brooks (1989) argue that trying to create an image for a retailer through advertising is self-defeating unless the image is already evident in the store. More important are product range and prices, store design and atmosphere, and the quality of service. In terms of store layout, high stock density can signal budget price and low stock density exclusiveness. The importance of store layout is indicated by the fact that multiple retailers will often dictate store design to individual stores to ensure uniformity of design and presentation (including shelving allowances for particular products, and sometimes even including photographs of displays). Price can also be an important signal of quality, and too many budget product lines can reduce the overall image of retailer quality. Indeed, advertising is generally less necessary for informing consumers about retailers than it is for branded products. A store front on a high street or in a shopping centre is a far more effective advertisement than any advertisement in the media, since it is seen by a far higher percentage of its target customers. Many retailers, such as Next, M&S, the Body Shop, and Waitrose have achieved strong retailer images with minimal advertising. On the other hand, advertising can play an important role in strengthening retailer image. It also interacts in a complicated way with advertising carried out by manufacturers. Where retailers sell non-branded goods, such as in clothing and furniture, retailer advertising often effectively substitutes for manufacturer advertising. Where retailers sell manufacturer-branded goods, joint manufacturer-retailer advertising campaigns are common.

2.3

Dimensions of competition in retailing

This section describes the way in which retailers compete against each other and considers the various horizontal economic and competition policy issues to which each dimension gives rise. The vertical issues which arise from the relationships between retailers and manufacturers are discussed in the next section. Retailers, like every other commercial organisation in the economy, compete by attempting to gain a competitive advantage over their rivals. This competitive advantage can manifest itself in a number of

ways: C In terms of price; retailers attempt to maximise cost efficiency and economies of scale and scope in order to reduce price. They may also exert bargaining power when dealing with manufacturers to drive down costs, or bundle products together or price discriminate to create the perception of low pricing policies. Finally, retailers may place great emphasis on their competitive pricing with claims such as never knowingly undersold. These types of strategy have been employed by John Lewis, Kwik Save and MFI. A competitive advantage in terms of geographical location can be achieved by ensuring that stores are located in the most convenient areas. This is often just a matter of being in an area first, and so having first pick of potential locations, but deliberate site foreclosure is also a possible strategy which is alleged to have been used by the large grocers and DIY chains (see Chapter 4). Product selection may be crucial in gaining an advantage over rivals. Retailers want to stock the best range of products relative to their competitors. This can be done through a good understanding of exactly what consumers want, operating large outlets so that a wide range of products can be stocked, or by strategies aimed at obtaining exclusive products (either through extensive use of own-brand or through vertical relationships with manufacturers which deny other retailers the same products). The larger record retailers, many department stores and Boots are examples of retailers who have extended their product portfolios to attract customers. Finally, the provision of high retail service relative to rivals is often a method of gaining a competitive advantage. However, improving service is generally costly and its use will be determined by the nature of competition in the market (price or non-price) and the products being retailed (some products require more point-of-sale services). High levels of customer service are thought by retailers to be important in the retail of goods as diverse as cosmetics and cars. Indeed, it is impossible to purchase some goods without the related service (i.e. there is no low service option). Retailer image is also very important, and can act as an important barrier to entry.

As with all attempts to gain a competitive advantage, the ability of others to imitate successful strategies is always a possibility.36 For this reason, the deployment of the strategies listed above (and many others) is a complex process, and many such strategies may be employed simultaneously. For example, a favourable geographical location may increase the willingness of consumers to pay and allow higher prices, whilst a higher level of retailer service will raise costs and will only be viable if the retailer can command higher prices. Vertical relationships may also affect competition in these dimensions (this is considered in Section 2.4). Further, the dynamic nature of these strategies also has to be considered: some are short term (loss leading, for example), whilst some are much longer in time scale (such as the repositioning of a retailers image). Four dimensions of competition between retailers were identified above: 1. 2. Pricing Geographical location

36

For more details on how firms may gain a competitive strategy, and some discussion of how retailers have attempted to compete, see Kay (1993).

3. 4.

Product selection (quality and range of products retailed) Level and quality of retailer service (including retailer advertising/promotion)

Sections 2.3.1 - 2.3.4 examine in more detail how the four dimensions of competition between retailers identified above may result in forms of behaviour which are of interest to the competition authorities.

2.3.1

Pricing

The price that retailers charge for their retailing activities is an implicit price. The difference between the final sales price (net of sales taxes) and the wholesale price is the gross margin that retailers receive to offset the costs they incur in carrying out the various functions described in Section 2.2. For some retailing activities, this margin can be very high, making up over 50 per cent of the final retailing price (as in jewellery stores, fashion and haute couture). This is generally true where turnover is low but there is a need to maintain a large stock or product range on the premises, or when the retailers provide high valueadded. For other retail markets, the margin may be far lower (in grocery and DIY for example). However, the customer generally neither observes nor cares about this implicit retailer price. The prices paid for goods by retailers are not visible, and any increase in gross retailer margin gets translated into final retail prices across the range of goods provided in a shop. When comparing prices, therefore, consumers can only guess whether observed price differences are due to different retailer margins. Having said that, price is nevertheless a key variable in competition between retailers, and the importance of lowering costs and achieving efficiency is as important in retailing as it is in other areas of the economy.

Retailers generally attempt to reduce costs in all of their different functions: C Manufacturer relationships: Retailers attempt to obtain products from manufacturers at the lowest possible price. Larger retailers can often achieve this more easily than smaller retailers, partly because they have a greater incentive to shop around for the best deal, and partly because they have greater bargaining power which they can exploit in their negotiations with manufacturers. Logistics: Retailers attempt to manage store and shelf space at the lowest possible cost. Large retailers may even integrate upwards into distribution in order to enhance efficiency. Customer relationships: Retailers will try to find ways of achieving good levels of customer service at the minimum cost.

There are, though, some aspects of pricing that are particularly prevalent in retailing. C Differential pricing: Retail prices tend to be very visible, with secret discounts to consumers being rare (although these do occur for large purchases such as cars and houses). This may ease collusion between retailers through different retailing formats (because cheating on collusive agreements is easy to observe). On the other hand, compared with other areas of the economy, price discrimination between consumers may be relatively easy, given that resale between consumers is relatively unlikely (because individual purchases tend to be too small to justify the necessary co-ordination between consumers of different types). This price discrimination tends to be implemented either

through provision of discounts for certain (broad) consumer categories (such as students or pensioners) or by designing retail choices (such as trade-in offers, credit deals, end-ofseason sales) in such a way that different consumers choose different options. C Variable mark-ups: In retailing, more than in any other area of the economy, retailers tend to sell bundles of products (an obvious example is bulk grocery shopping done weekly) and to stock large product ranges. As was shown above, when the products being purchased are relatively cheap, a consumer will not have strong incentives to shop around for each individual product, but will prefer to go to a single multi-product retailer (onestop shopping). Under these circumstances, Bliss (1988) shows that a multi-product retailer will generally not do best by setting a common percentage mark-up on all goods, but will prefer to set higher mark-ups for products with lower elasticities of demand, and vice versa.37 Loss leading: When choosing between multi-product retailers, consumers often have only very vague ideas of the relative qualities and prices of individual products. In this case, consumers tend to choose between retailers on the basis of their reputation for good product range and general low prices. One method of gaining a reputation for general low prices under these circumstances is loss leading. By setting low prices on a number of key items, and then by promoting these products and their prices, retailers induce consumers to compare retailers on the basis of the prices of these products. Note that loss leading may or may not be predatory, in terms of driving other retailers out of the market. Upstream restrictions on price: In some retail markets, manufacturers provide a recommended retail price (RRP). 38 The use of RRPs may ease collusion between retailers, in that it provides a focal point price which it is easy to co-ordinate on. However, RRPs are certainly not sufficient for collusion, since in many markets RRPs exist but prices bear little relationship to them.39 Moreover, RRPs may also be a method of restraining prices from being too high in relatively uncompetitive retail markets. 40 Never knowingly undersold provisions: In order to reduce the need for consumers to shop around between retailers in order to find the best deal on a branded product, some retailers state that if the consumer later finds the same product cheaper elsewhere, then the difference will be refunded. The John Lewis price pledge is a well-known example. This may be an effective method of price competition, but may also facilitate collusion (there is little point in a competitor trying to undercut prices to gain market share if the price reduction will be met automatically).

37

38

39 40

The rationale for this type of behaviour is the same as that for Ramsey pricing in the tax literature (see Atkinson and Stiglitz, 1980). For books and pharmaceuticals, manufacturers are able actually to fix retail prices (through resale price maintenance), although in the case of books this practice is quickly becoming obsolete. In other markets, manufacturers are restricted by law to providing price recommendations only. Although, where this appears to be the case, it is interesting to ask why RRPs are given in the first place. Further rationales for RRPs are discussed in Section 2.4.

National pricing strategies:41 Retail chains generally consist of a number of local stores. The degree of competition facing each individual store is likely to vary, and this provides the retail chain with an incentive to price differently in each local market. However, some retail chains choose instead to set prices nationally. This is clearly costly in terms of the ability to exploit market power at a local level, but it may be beneficial for two important reasons: C There may be benefits from having a unified retailer image for the chain (so that consumers know before going into any local store that they will be getting the same price in that store as elsewhere); and The desire to exploit economies of scale in price setting, price labelling, and advertising (by advertising prices nationally).

Moreover, price competition in retailing may not be as fierce as in other areas of the economy. Even where there is no collusion, the importance of the other dimensions of competition between retailers (location, product range, retailer service) all act to restrain direct price competition between retailers. 42

2.3.2

Geographical location

Geographical location can be important in retailing. In transport based markets, this is obvious. A petrol station or car hire firm in Derby is clearly of no use to a person who wishes to travel from Brighton. More generally, the importance of shopping/search costs mean that: C When consumers are not quite sure what they want and want to be able to make comparisons among a number of different shops, retailers can attract customers by clustering together (for example, in a shopping centre or high street); 43 When consumers just need to obtain a relatively standard (undifferentiated) product as quickly and easily as possible, shops can gain customers by locating close either to peoples homes or to places that consumers are likely to be passing anyway (for example, newsagents, post offices, convenience stores, and shops in petrol stations); When consumers want to buy large loads of shopping, or bulky objects, or when they require a very wide choice of products, shops can gain customers by being large and easily accessible by car (for example, out-of-town supermarkets and large speciality stores).

The importance of geographical location means that local market power can be high and the inability to find an appropriate location can act as a barrier to entry (although the importance of this is often overstated). Moreover, the attempt to gain access to good locations may be an incentive for merger. This was

41

42 43

Note that national retail strategies are not exclusive to competition on price. Most national retailers also have national strategies on geographical location, product selection and retailer service/image, for exactly the same reasons. Price competition may also be reduced by vertical restraints, see Section 2.4. Beggs (1994) notes an interesting implication of this clustering phenomenon. Generally if one retailer raises its prices, the sales of nearby retailers will increase (as consumers switch away from the more expensive store). Consider now two shopping centres (or malls), which consumers choose between on the basis of overall average price (of goods in each mall). If a retailer in one mall raises its prices, this may actually reduce the sales of other retailers in this mall, on the grounds that it raises the average price of the mall, causing consumers to switch to the other mall.

a prime motive for the acquisition of the Scottish grocery retailer, Wm. Low, by Tesco who at the time mainly had stores in England and Wales but a brand name that probably extended into Scotland.

2.3.3

Product selection

Location in product space 44 tends to be very important in retailing. Retailers carry out a selective gatekeeper function: consumers do not have the time or ability to look at all products available from manufacturers, and they prefer retailers to carry out some selection on their behalf. Consumers then choose between retailers on the grounds of the sort of product selection they expect the retailer to have already done.

The product selection decision

In deciding where to position themselves in product space, retailers must choose: C Level and range of products, in terms of vertical characteristics:45 where to situate on the spectrum between retailing high quality products and low quality products, and whether to provide an extensive vertical range of products; Level and range of products, in terms of horizontal characteristics: which sorts of products to sell, and whether to provide a wide horizontal range of these products or instead to situate in a niche, serving only a segment of the market; and Product portfolio:46 whether to provide several different kinds of product (as in out-oftown superstores) or specialise in one kind. A narrow product portfolio indicates a specialist retailer, whilst a very wide portfolio may signal the use of a one-stop shopping strategy.

This decision will depend on the relative strengths of various different effects: C C Strategic reduction of competition: Retailers can strategically reduce direct price competition between themselves by spreading out in product space (niche marketing).47 Business stealing: By moving closer in terms of product space to a rival, each retailer thinks that it can improve its share of the market by attracting customers from its rival (in the limit, this results in clustering).

44

45

46

47

Location in product space essentially means the market positioning of the retailer in terms of the quality, type, and range of products it sells. Vertical and horizontal are economic terms which are used to distinguish two different uses of the word quality. When people distinguish between high and low quality they are usually referring to vertical quality. People generally agree about vertical quality. If most people would prefer product A to product B when both are offered at the same price, then product A is of higher vertical quality than product B. For example, a 486 computer is of higher vertical quality than a 386 computer. On the other hand, when people refer to products having different qualities (or characteristics), they are referring to horizontal quality. People generally disagree about horizontal quality. A red version of a dress is not necessarily better or worse than the same dress in blue, but they are different in terms of horizontal product differentiation: some people will prefer one and some will prefer the other. The difference between what we term product range and product portfolio roughly equates to what the literature on retailing refers to as the distinction between depth (the number of similar lines) and width (the number of dissimilar lines). (See Davies, 1993). This effect and the next were first modelled by Hotelling (1929), in the context of geographical location.

C C

Entry deterrence: It may be possible for incumbent retailers to use location in product space as a barrier to entry, by leaving no profitable niche unfilled. 48 Consumer preference for a narrow range: The more narrow the range a retailer provides, the easier it will be for consumers to make a selection (as long as the retailer provides the right range). Consumer preference for wide vertical range: When a consumer wants to buy a product but is not sure how high a quality to buy (given that better products tend to cost more), then the consumer benefits from being able to observe and choose between several products along the price-quality trade-off schedule. Thus, retailers may want to provide a wide vertical range. Consumer preference for wide horizontal range: On the other hand, when consumers know what they want in terms of vertical quality, but are less sure what they want in terms of horizontal quality, shopping costs provide an argument for maintaining a wide horizontal product range. 49 Consumer preference for wide product portfolio: In both of the above cases, products tend to be substitutes, and a retailer stocks a wide range in order to allow consumers a choice. However, retailers often prefer to stock a wide portfolio of complementary products, especially when any single product on its own would not be worth a shopping trip (for example, supermarkets and DIY stores). 50 Economies of scale and scope: For small purchases (such as tins of beans) there may simply be large economies of scale (in terms of running a store) in selling various products at once. In addition, there are fixed costs involved in dealing with a manufacturer, and thus it may be less costly to take many products from one manufacturer than to take products from various different manufacturers. Economies of scope in advertising/ establishing brand names may also encourage retailers to expand into new product areas.51

Own-brand products
Another decision that retailers need to make in terms of the product range they stock relates to the use of own-brand products. Some retailers (such as Marks & Spencer) stock only own-brand products, whilst others (such as Thresher and Tower Records) stock only branded goods. The majority of retailers,

48

49

50

51

The possibility of using product proliferation as a method of deterring entry was first analysed by Schmalensee (1978) for the case of ready-to-eat breakfast cereals. This requires, however, both that it is difficult to change positioning in product space and that there are costs involved in exiting the market. Otherwise, the threat of maintaining position in product space post-entry is not credible, and entry will not be deterred (See Judd, 1985). However, these costs also suggest benefits for niche marketing: a consumer does not want to wade through a big shop full of lots of different types of clothes, most of which will not appeal. Thus, horizontal differentiation between consumers tends to lead to various different retailers clustering together (maybe even within a single department store), rather than single retailers providing a wide product range (although there have been moves towards large single horizontally differentiated retailers, such as Shoe City). Complementary products are defined as products with a positive cross-elasticity of demand. Less formally, they are products that one is more likely to want to buy together than to substitute between. Indeed, it might be important for a retailers image simply to stock a particular product range, or for a manufacturers brand image to have its retailers supply only certain products (issues of retailer brand image are discussed in more detail in the next section).

however, lie somewhere in the middle of these extremes, stocking a number of powerful brands whilst also providing a selection of own-brand products (Sainsburys, Boots and WH Smith are examples). The retailers strategy on own-brands is a complex one. It includes decisions about the number of ownbrands to stock, and the quality of those products. Own-brands may be included in the product portfolio in order to offer the consumer a cheaper alternative to a particular branded product (this is the traditional image of own-brand goods), or they may represent the retailers attempt to compete head-to-head with the brand leader in terms of quality, image and price. The own-brand strategy chosen will be partly determined by, and will partly determine, the image of the retailer itself. If the retailer decides to sell only branded products, then the market positioning of that retailer, in terms of product portfolio and price, is highly dependent on the manufacturers whose products are stocked. If, on the other hand, the retailer also stocks own-brand products, it can differentiate itself from rival retailers by the quality and price of those products. The importance of this method of retailer differentiation can be seen from the degree of correlation between the extent of own-brand penetration and the market positioning of retailers in particular retail markets. In the grocery sector, for example, those retailers which stock the most own-brand products (Sainsburys, Tesco and Asda) are also positioned more upmarket than those which focus on branded products (Kwik Save, Aldi and Netto). The nature of this correlation is complex and causation works in two directions: C C the success of a retailer in selling own-brand products is dependent on the reputation for quality that the retailer has; and the retailers reputation for quality depends on the quality of its own-brand products (in exactly the same way that a manufacturers reputation depends on the quality of its products).

This strategy of own-brand products also has other implications for the nature of retailer image. For example, we have already noted that some retailers are able to maintain a high quality image with little advertising effort. The examples provided earlier were Marks & Spencer, Body Shop, Next and Waitrose. It is interesting to note that three of these four examples stock exclusively own-brand products.

2.3.4

Level and quality of retailer service

Simply deciding which products to retail, however, is only part of a retailers quality choice. In addition to the physical characteristics of the products chosen, the retailer has to decide how much, and what form, of retailer service to provide. There are various possible types of service that retailers can provide: C Shop ambience: Retailer service may be simply a matter of providing a clean, efficient and well designed retail environment, which makes the shopping experience more pleasurable (known sometimes as pure retailing). Measures such as rapid computer scanning at checkouts and clear sign-posting within stores come under this heading, in that they improve the whole shopping experience. Point-of-sale service: Point-of-sale customer advice and service can be very important in some types of retailing. This covers a whole host of activities, from pharmacists providing customer advice to buyers of pharmaceuticals, to sales assistants in

delicatessens cutting off exactly the amount of cheese which the consumer wants, to the provision of test drives for potential car purchasers. C After-sales service: For example, in motor cars, the provision of after-sales service is essential. Many other retailers (and especially catalogue retailers) offer a refund policy to customers who are not satisfied with the product they have purchased. However, the provision of after-sales service is less often supplied by the retailer itself, and more often supplied by the manufacturer (although the retailer may be the point of interaction between manufacturer and consumer). Product promotion: In-store promotions can be crucial to the sales of many products. Indeed, as was noted above, even the amount and type of shelf space allocated to particular products can have important effects on how well they sell. Manufacturers will often provide higher discounts to retailers who are willing to carry out in-store promotions or give their products a good store location. Manufacturers and retailers will also sometimes combine to do joint television or press advertising. Retailer image/reputation: Where product quality is not immediately observable, the image/reputation of the retailer may play an important quality assurance role. 52 For example, Harrods, as a retailer of high quality products, sends strong signals to consumers by deciding to stock a particular brand of washing machine, clothing or beauty product. The brand name Harrods thus reinforces that of the manufacturer. In the case of Marks & Spencer, the brand name of the manufacturer is totally dispensed with, and the retailer becomes the brand that certifies quality. Retailers increasingly support their own brand image through heavy (often national) advertising.

These various retailer services may affect competition in various ways. If retailer services are important, there may be a so-called free-rider problem: consumers will get the retailer service from one retailer and then go and purchase the product from another retailer which does not provide retailer service. For example, consumers may go to Debenhams, use its sales staff to help them pick out the vacuum cleaner they think is best, and then go and actually purchase the vacuum cleaner from Argos (where prices are cheaper because no retailer service is provided). Where these free-rider problems are particularly strong, they may affect the willingness of stores to provide such retailer service, which will be bad for manufacturers, retailers, and consumers. This problem is sometimes solved by vertical restraints (see Section 2.4). The importance for product sales of advertising and promotion within stores will also sometimes lead to vertical restraints. The importance of brand name can also act as a barrier to entry. In some cases, an incumbent brand will be so strong that it is almost impossible to challenge it. In other cases, however, attaining an effective rival brand name is simply a matter of spending a sufficient amount on advertising. The effectiveness of brand name as a barrier to entry will depend on the amount of advertising which is needed to enter the industry effectively relative to the profits to be gained from entering the industry (see Chapter 4 of this report). It will also depend on the transferability of retailer brand name from one retailing market into another.

2.4

Vertical issues53
52

53

There is a large body of literature dealing with brand name and its role as a signalling device to consumers; see Kay (1993). Note that, throughout this report, vertical issues are not discussed in as much detail as they properly deserve, on the grounds that they are going to be the subject of a future OFT research report.

Vertical relationships are necessarily important in retailing, since it is by nature downstream of manufacturing. Moreover, as described above, there are important interactions between manufacturing and retailing, with manufacturers having incentives to promote retailer services (including ensuring appropriate shelf space), and with retailers having incentives to intervene upstream in order to ensure quality and efficient supply. There is also significant differential discounting by manufacturers to retailers (non-linear pricing schemes). The literature on vertical restraints between manufacturers and retailers is extensive. 54 Roughly, explanations for vertical restraints can be split into three categories:

C C

Efficiency motives (as focused on above); Anticompetitive motives (promotion of collusion, deterrence of entry, or exploitation of dominance); and Economic rent sharing (the division of economic rents between manufacturers and retailers).

In many situations, all of these explanations will apply. Indeed, they often interact. For example, manufacturers will sometimes find it profitable to promote price collusion at the retail level (which is per se anticompetitive) in order to provide incentives for retailers to compete instead on promoting their products (which improves efficiency). This means that even when a vertical restraint is motivated by efficiency concerns, it may have deleterious effects on competition between retailers, in any of the dimensions of competition described above. For example: C C C Recommended resale prices can facilitate collusion between retailers, giving them incentives to compete in other dimensions, such as retailer service. Refusal to supply, exclusive dealing and full line forcing have a direct impact on retailers positioning in the product space, and can act as an entry deterrent. Territorial exclusivity will directly affect geographical location and restrict intra-brand price competition.

2.4.1

The economics of vertical restraints

There is a tendency in the economic literature to treat retailers purely as intermediaries between manufacturers and end-consumers, and to focus on situations in which manufacturers are concerned to influence the behaviour of retailers. This emphasis is a result of thinking of vertical restraints in terms of the pure product flow, as shown in the diagram below.

54

Waterson (1993) provides an excellent survey, and discusses implications for competition policy.

Manufacturers
set price w

Retailers
set mark-up r

Consumers
pay price p = w + r

In many cases, this way of thinking about vertical restraints is sufficient. In particular, it has traditionally been true that many vertical restraints have been imposed on retailers by manufacturers. The most common examples are: C C C C C C C Retail price restrictions: such as RRP and resale price maintenance (RPM); Manufacturer non-linear pricing: that is, non-linear manufacturer discount schemes such as franchise fees, quantity discounts, or differential discounts for different retailers; Quantity forcing: requiring retailers to sell minimum quantities of the manufacturer's products; Full-line forcing: requiring retailers to carry the full line of the manufacturers products; Exclusive dealing: requiring the retailer not to carry the products of competing manufacturers; Territorial exclusivity: which protects one retailer from intra-brand competition from other retailers within that territory; Refusal to supply: as a general means of enforcing the compliance of retailers with any kind of requirements set up by manufacturers, or simply as a method of constraining total sales.

However, over the last decade or so, retailers have tended to become a more important element in the overall value chain, partly at the expense of manufacturers. This change has occurred for various reasons,

including: increased retailer size and retail concentration; increased importance of retailer image, which means that own-brand products have become more competitive with branded products; increased retailer information on consumers preferences (partly as a result of scanner technology); and increased retailer command of technology. In these changed circumstances, it is useful to think of the manufacturer-retailer relationship slightly differently: as the manufacturer and retailer each supplying an essential input into the end-product which the consumer purchases (the physical product and the retailing activity). This joint input idea is shown in the Y-shaped diagram below.

Manufacturers
set price w

Retailers
set m ark-up r

Consum ers
pay price p = w + r

This diagram reflects the fact that in many ways the situation of manufacturers is symmetric with that of retailers. Firms at both levels are concerned to co-operate to provide the most appropriate mix of products and retailing activity to consumers, and to sell this at an end-price which maximises their joint profits. In general terms, vertical restraints then become straightforward to explain: C where the joint interest of manufacturers and retailers conflicts with the individual selfinterests of each, vertical restraints may be used by each level as a commitment device to ensure that the other level acts in their joint interest.

The division of the resulting joint economic rents is then the outcome of bargaining, rather than being imposed by either side. The use of vertical restraints to achieve such joint profit-maximisation in the face of divergent incentives is discussed in more detail in Chapter 7 of this report.

More generally, one implication of the shift in the balance of power towards retailers has been a growth in vertical restraints of the sort imposed on manufacturers by retailers, such as: C C C C C Exclusive supply: requiring the manufacturer not to supply competing retailers; Refusal to stock or delisting: where retailers refuse manufacturers products access to their stores; Minimum supply levels: where retailers demand minimum quantities from manufacturers (in order to prevent the manufacturer from being able to supply further retailers); Minimum advertising requirements: where retailers refuse to stock a good unless a minimum amount has been spent in advertising it. Sunk facility requirements: where retailers refuse to give manufacturers a contract for supply (especially of own-brand products) until they have sunk costs in production facilities.

Another implication is that, even where the more traditional vertical restraints are used, they may not be being used for the traditional reasons. For example, refusal to supply has traditionally been a method instigated by manufacturers for overcoming free-rider problems among retailers (as described below). However, there have been recent allegations of retailers instigating refusal to supply, by forcing manufacturers to refuse to supply certain other retailers in order to reduce the effectiveness of these other retailers as competitors. More crucially, in addition to this change in the direction of imposition of vertical restraints, it also seems that the form of vertical restraints is changing over time. Vertical restraints of the traditional form are rather blunt instruments, in that they achieve their primary aims only indirectly. For example, one common aim of vertical restraints is for manufacturers to reduce price competition between retailers, and thus to encourage them to compete in terms of service and sales promotion instead. This bluntness gives rise to an obvious question: why cant manufacturers simply contract for the optimal levels of service and sales promotion directly? The answer to this question lies in monitoring costs. Historically, retailers tended to be small and local, while manufacturers were relatively large. This meant that, although manufacturers were in a position to impose general vertical restraints such as RRP and exclusive territories, the costs of monitoring compliance with specific contract conditions were too high to be worth incurring. As retailers have grown larger, monitoring costs have become less important relative to total turnover, which has resulted in manufacturers and retailers increasingly solving divergences of incentives between them directly through the use of specific agreements and contracts and direct intervention - rather than through the more traditional vertical restraints. Indeed, the line between vertical intervention and vertical integration has become blurred: if a retailer makes the majority of the manufacturers investment and production decisions for him, then the retailer is effectively acting as if it owns the manufacturer. There is no obvious difference between this behaviour and full vertical integration in terms of implications for competition policy.55
55

In The Supply of Beer (1989), the MMC recognised that the vertical restraints between breweries and public houses are so complete that they are essentially the same as vertical integration. Waterson (1993) discusses various explanations for why full vertical integration will sometimes be favoured over vertical restraints. Generally, the choice will depend on potential economies of scale and scope, transactions costs, information asymmetries, the degree to which sunk investment is required, the importance of flexibility in vertical

In terms of retailing, therefore, it is very important to examine all the ways in which retailers and manufacturers intervene in each others behaviour, and not just the more formal vertical restraints described above. Although difficult, it is also very important to determine so far as is possible which side is instigating the vertical restraint, the motives of each side, and the effects of the vertical restraint.

2.5

Policy implications

The terms of reference for this study state that it should aim to provide a robust approach to the identification and assessment of competition in retailing. This involves asking two questions: C Is retailing different from other sectors of the economy in terms of the nature of competition between retailers and the relationship between retailers and upstream suppliers? Can the competition issues that arise be addressed using established approaches to competition policy, or do new methodologies need to be developed?

This chapter has shown that there are significant differences between retailing and other sectors of the economy. In particular, distinguishing factors of retailing relate to the characteristics of end-consumers who tend to be relatively small, immobile and uninformed, the wide range of dimensions of retailer competition, and the prevalence of vertical restraints. These differences are a matter of degree rather than exclusive to retailing, and for this reason we believe that that the emphasis of competition policy will often be different in retailing, but that there should be no need for any major change in general competition policy methodologies. We do advocate two amendments to the traditional framework for competition enquiries: C C That the relevant competition issue is clearly identified at the outset; and That the enquiry should always start with a preliminary analysis of the characteristics of consumers and the dimensions of competition between retailers, in line with the analysis outlined above.

2.5.1

Identification of competition issues

In most cases that come to the OFT or the MMC, the relevant competition issue is already given:

C C

A merger between retailers required examination by the OFT under the provisions of the Fair Trading Act 1973; A complaint by a retailer against a predatory practice by a competitor defines the competition issue to be investigated; and A complaint may refer to an exclusionary practice which is part of an agreement between a manufacturer and retailers.

There are, however, instances where the competition issues are less clear at the outset of an enquiry. The

relationships (which may be important for providing strong incentives and credible threats), and the degree to which non-integrated prices are distorted through market power.

investigations into the supply of beer, petrol or recorded music were of a more general nature where the competition concerns covered pricing issues, entry barriers and vertical restraints. Retailing of these goods was not the main focus or subject of a complaint. It is important for the discussion in the remainder of this report that the competition issue is identified as far as possible at the outset of any investigation. This may seem a trite point. However, the methodological steps discussed below cannot be seen in isolation of the relevant competition issues. For example, market definition is not of importance in itself. Market definition is a useful step in the process of identifying whether or not market power exists. We suggest that any enquiry should state the relevant competition issues before the traditional approach is pursued. For the analysis of competition in retailing, this implies that the enquiry can be categorised with reference to one of the following groups of issues:

Merger issues: 1 2 Pricing issues: 1 2 3 Price collusion between retailers is a pure retailer issue; Predatory pricing by a competing retailer is a pure retailer issue; and Excessive pricing of a class of products is not a pure retailer issue, but can be due to excessive margins at both the retailer and wholesale/manufacturer levels. This can lead to an extensive investigation of the whole value chain of a class of products. A merger between retailers will focus on a particular retailing sector; and A merger of two manufacturers may have implications for the relevant retailing sectors.

Vertical issues: 1 2 3 Restrictive vertical practices instigated by manufacturers involves retailing; Restrictive vertical practices instigated by retailers focuses on retailing; and Discriminatory pricing by an upstream supplier can be the result of market power up- or down-stream, and may lead to an investigation of both these markets.

2.5.2

Preliminary analysis

Appendix 1 of this report provides some guidance on how this preliminary analysis may be undertaken. The first step is to examine the extent to which the different consumer characteristics identified above (e.g. size of purchase, immobility, information) are important in the case being investigated. This in itself provides a better understanding of the way in which retailers do, and may, compete. However, we suggest that this is also examined separately, as a second step in the preliminary analysis. This step assesses which dimensions of competition between retailers are important (e.g. price, geographical location, product selection, retailer service), and the level at which competition takes place (e.g. at a national level or at a local level). Answering these questions will also provide insights into why particular forms of market structure exist. For example: C When purchases are small in terms of spend, consumers may be unwilling to travel far to purchase them. Thus such products will either be purchased in passing (giving rise to the importance of local newsagents and convenience stores), or at the same time as other products in a shopping trip (giving rise to multi-product shops such as supermarkets, and DIY superstores). 56 When consumers are unsure of exactly what they want, they will value a retailer which provides a wide selection (both vertically and horizontally) of different products, or a location at which many similar retailers are clustered. A good example is shoes, which tend to be sold in shops which offer a wide selection of styles and sizes, and which locate close to other such shops.

56

These types of purchase include impulse purchases (products which would not be bought unless the consumer happened to be passing).

When consumers are unsure about the horizontal aspects of the product they want to buy, but do have a preference about the vertical aspects, they will often rely on the reputation of a retailer as a guide to low or high quality merchandise. A decision to purchase a high quality bed, for example, may induce consumers to visit Harrods, whilst the demand for a cheap bed may result in a visit to a factory type shop. When consumers cannot observe quality directly, there may be a role for quality assurances, especially in the form of brand name/image, after-sales guarantees, and other forms of point-of sale service. These may be offered by the manufacturer, retailer, or both.

2.5.3

Suggested framework

Our recommendations above are based on examination of several MMC and OFT investigations. We have observed that competition enquiries often encounter problems when they do not start with a preliminary analysis of the characteristics of consumers and the dimensions of competition between retailers. This preliminary analysis is important because it both suggests potential competition problems and feeds into all of the later stages in the competition enquiry. It is crucial for market definition and can provide important insights into vertical issues and market power issues. The remaining stages of our suggested framework for competition enquiries are more traditional, leading us to recommend the following procedure: 1. 2. Identification of competition issue Preliminary analysis of retailing: C C 1. 2. 3. the characteristics of consumers; and the dimensions of competition between retailers.

Market definition Barriers to entry Competition assessment: C C C market structure; pricing issues; and vertical issues.

The following chapters discuss market definition, barriers to entry, market structure, pricing issues and vertical issues in turn.

3.

Market definition

The extent to which it is important to carry out a rigorous analysis of market definition in the retail sector will depend upon the competition problem being analysed. In particular, if the focus of a competition enquiry is upstream (a monopoly situation or merger between two suppliers), then the main reason for analysing the market structure at the retail level will be to see whether retailers are likely to bargain away any monopoly rents, or to enter into upstream supply themselves. For this, a detailed retailer market definition is unlikely to be needed. More generally, market definition at the retail level as well as the manufacturer level will be important. However, market definition in retailing tends to be more complicated than it is in manufacturing. The standard economic test for defining the relevant economic market for a given product revolves around the ability of a hypothetical monopolist to raise the price of that product by a small but significant amount, without losing so much custom to other products to make the move unprofitable. The general principle is that those substitute goods to which the consumers would switch, in the face of a price rise, should be considered part of the same economic market. When examining competition in retailing we need to consider that the physical product dimension, however, is only part of the picture. For most categories of consumer goods, the retailing activity is also very important and is a constituent part of the end-product which consumers purchase. This means that retailer markets need to be defined in terms of both dimensions: the physical product and the retailing activity. A further difficulty involved in applying the standard market definition in retailing derives from the fact that retailers compete in many different dimensions, and not just price, as described in the previous chapter. This means that to focus on price alone distorts market definition, especially if the various economies of scale and scope that are common in retailing mean that competition between retailers occurs at different levels for the different dimensions of competition (or even at different levels at the same time for a single dimension of competition). This chapter discusses these problems in some detail, and suggests some possible solutions. We suggest that it is crucial to consider in any enquiry exactly what aspect of competition is important, and in what way competition is threatened by the behaviour or merger of the firms under scrutiny. Market definition should never take place in a vacuum. Indeed, there may be several possible market definitions, each of which is valid for looking at a particular issue. Section 3.1 summarises the market definition methodology provided in the recent OFT/NERA paper. Section 3.2 comments on the nature of retail end-product, and shows that it is important to consider market definition with respect to the retailing activity involved as well as the physical product. This section also provides an example which demonstrates this point very clearly: the question of whether direct sales channels should be considered as in the same market as traditional store-based retailers. Section 3.3 considers more rigorously the implications of this for applying the OFT/NERA methodology to the retail sector, taking into account both the physical product dimension and the retailing activity dimension. Section 3.4 considers the implications for market definition and in particular geographical market definition of the fact that retailers compete in many different dimensions. Section 3.5 concludes.

3.1

The OFT/NERA market definition methodology

The OFT/NERA methodology for defining the relevant economic market is based on the US Department of Justice SSNIP test. Essentially, it defines the market by asking the following question: C Starting from prevailing price levels, what is the smallest set of goods or services and geographical area such that if the supply of these goods or services in this geographical area were to be in the hands of a single firm (or hypothetical monopolist) then they would be susceptible to a small but significant and non-transitory increase in price (or SSNIP)?

This methodology is now accepted by most competition authorities. In essence, the market definition process involves starting at the smallest possible market definition, testing whether or not a hypothetical monopolist of this market could sustain a significant price rise, and if not, widening the market slightly to include the principal products to which consumers switch and then retesting. This market widening process continues until a market is found for which the US SSNIP test is valid. There are generally two sides to this market definition approach: demand-side substitutability and supply-side substitutability. The test of demand-side substitutability looks at the expected behaviour of consumers in response to a price rise: CIf consumers are willing to substitute B for A when As price rises, then B is in the relevant market for A, because a hypothetical monopolist of A would not be able to sustain a rise in price (As price is constrained by B). 57 The test of supply-side substitutability, on the other hand, looks at the expected behaviour of suppliers in response to a price rise: CIf the suppliers of C can easily move into the relevant market for A when As price rises, then these suppliers are in the relevant market for A, because a hypothetical monopolist of A would not be able to sustain a rise in price (As price is constrained by these suppliers). 58 The OFT/NERA report also provides several tests which can be used to assess whether the hypothetical monopolist would be able to sustain a price rise. We have no theoretical concerns about this methodology, although we argue that supplyside substitutability has to be used extremely carefully in retailing. Most important is that the principle of defining markets according to the degree to which firms constrain each others competitive behaviour is followed. The OFT/NERA report itself provides an extensive discussion of how to deal with many of the more straightforward issues that arise in applying this test. However, there are three important problems with the simple US SSNIP test as a complete methodology for market definition: C
57

it is very product, as opposed to activity, based;

58

Note that A, B and C may be different products (relevant product market) or the same product in different locations (relevant geographical market). Note that the word easily is important here. Suppliers of C will only be in the relevant market for A on supply-side grounds if they strongly constrain the pricing of A, which requires that they can move into this market with minimal cost and minimal delay.

C C

it is very price, as opposed to other dimensions of competition, based; and it takes insufficient account of the strategic and competitive behaviour of companies in the face of economies of scale and scope across economic markets.

These problems are not unique to retailing, but they are particularly prevalent in this sector.

3.2

The nature of the retail end-product

As was discussed in Chapter 2, the product which is purchased by end-consumers may look physically identical to the product which is supplied by the manufacturer, but economically it is very different. When consumers purchase a product they are purchasing not only the physical product but also all of the associated retailing activity. That is, the manufacturer and the retailer supply two joint inputs as is shown in the figure below:

Manufacturers physical prod uct

(price w)

Retailers retailing activity

(price r)

End prod uct

(price p)

Because the US SSNIP test was designed with manufacturing industries in mind, it focuses on the physical product. In retailing, however, this can lead to problems. Two identical physical products may be defined as being in different retailer markets, because of differences in retail service, geographical location, product selection or other differences in competitive strategy. For example, it is entirely possible that a Kodak 36mm film as sold in Boots is in a completely different retailer market from a physically identical film sold in a small shop opposite the Houses of Parliament. Similarly, a 100g jar of Nescaf at a 24-hour corner shop may well be in a different retailer market from the same product when sold by one of the major supermarkets. Within retailing, therefore, it is important to define markets both in terms of the physical product and in terms of the associated retailing activity. However, there are many examples of UK competition enquiries which ignore the retailing activity completely. In Contact Lens Solutions (1993), the MMC focused entirely on the product market, and carried out little analysis as to whether pharmacists competed in the same retailer market as opticians, and whether if allowed to enter supermarkets and convenience stores

would be in this same market. This omission is especially surprising given that part of the aim of the study was to assess competition at the retail level. In fact, the MMCs report found that consumers tend to be tied in to particular opticians. Customers have strong loyalty to their own opticians (or pharmacists such as Boots that are linked with opticians). 59 This is for a variety of reasons: perhaps they value the service provided by such retailers, or because of habit, or a lack of information about alternatives, or because they have been tied in more explicitly through long-term customer discount schemes. Whatever the reason, this loyalty means that a small but significant price rise by the opticians is thus unlikely to result in a significant number of consumers shifting their custom to alternative retailers, and thus that the opticians constitute a distinct retailer market on their own. This suggests that simply allowing supermarkets and other retailers to supply contact lens solution may well not be enough to improve competition in this market. In addition, it is important to encourage consumer switching between retailers: through better provision of information on the possibilities of substitution between different contact lens solutions; and through a restriction on long-term customer discount schemes.

3.2.1

An example: direct sales channels versus store-based retailing

A good example of the importance of retailing activity in market definition is the question of whether direct sales channels for a particular product class are in the same retailer market as store-based retailing for that product class. Direct sales channels include: C C C C C person to person (e.g. Avon); party plan (e.g. Tupperware); clubs (e.g. Britannia Music Club, TSP Book Club); mail order (e.g. Littlewoods catalogues, magazine offers); and over the phone purchasing (from original suppliers, as by Direct Line Insurance, and many computer manufacturers).

These direct sales channels are becoming more and more important relative to traditional sales channels (stores). Thus, in many competition enquiries it is now important to examine whether these retail channels constitute distinct retailer markets from other sales channels. For example, in 1992 Britannia Music Club accounted for around 8% by value of all record sales, as was shown in The Supply of Music (1994). The MMC suggested that such direct record retailers compete in a different retailer market from high street record stores, despite the fact that the physical products being sold are identical. 60 The MMC did not, though, carry out any very rigorous analysis of the retailing activity offered by each type of retailer in order to come to this decision. To reach a more rigorous decision, we suggest that it is vital to consider both: C the transactions costs attached for the consumer of making the purchase (which must be considered part of the total cost of the purchase); and

59

60

This loyalty implies, for example, that despite being the second largest pharmacy chain in the UK, Lloyds sells little contact lens solution. Although note that these direct record retailers tend to supply only back catalogue records (records which have been out for at least around six months).

the nature of the buying decision which may render a particular channel inherently more suitable for selling certain products to certain consumers.

3.2.1.1 Consumers transactions costs of purchasing

Because end-consumers are relatively small, immobile and uninformed, they face a series of transaction costs in acquiring a product: C pure shopping (or shoe leather) costs: these are the costs of physically getting to the product. Even if they know exactly what they want to buy, consumers generally prefer not to travel far to make a purchase, nor to travel to several different locations for each separate purchase; search costs: these are the implicit costs incurred in finding out where the product is sold, where the prices are lowest, etc; and costs of acquiring information on quality: because quality is often unobservable ex ante, consumers face costs in obtaining information on quality; or alternatively they can pay to avoid the need for direct information by purchasing from retailers and manufacturers with high reputation (implicit quality assurance).

C C

Each retailing/selling method has different properties vis--vis these costs. Traditional retailing outlets (high-street shops, superstores, DIY stores, etc.) bring the product closer to the consumers and thus reduce pure shopping costs; they also offer some information and quality assurances through their product selection (gatekeeper function), shop ambience, product promotion, and retailer image/reputation, thus reducing search costs and costs of acquiring information on quality. Direct selling channels also provide a link between the production of a good and the endconsume. However, these selling channels differ substantially in the way they relate to the above mentioned consumer characteristics. C C Direct selling eliminate pure shopping costs almost entirely, because the consumer places the order directly from home. In direct sales, the contact with the product before purchase (and therefore the ability to inspect it and check its quality) varies; from none with a catalogue (the purchase is only on the basis of a photograph or a product description), to some with door-to-door sales, and full product demonstration with party plan selling. The time involved in making the purchase is also very different: while the time and effort of a shopping trip is avoided in the case of direct selling and catalogues, there is the delay/waiting time involved before actually obtaining the product. This may be up to a few weeks. The pre- and after-sale service is often different from that supplied by a traditional retailer. The product selection tends to be different. The amount of advertising may be different: mail order catalogues tend

C C C

not to do any traditional advertising as they regard their catalogue itself as their most effective promotional tool. Direct sellers also consider that they do not need advertising to launch new products, and that product line expansion is the most important factor for supporting growth. On the other hand, direct sales by suppliers (Direct Line, Dell, etc) may require large amounts of advertising in order to induce consumers to phone in and purchase.

3.2.1.2 The nature of the buying decision

Another important aspect which separates different sales channels is the nature of the buying decision. Clearly some products (e.g. the family car, a TV or even a new suit) are substantial purchases in the average consumers budget, which therefore require a degree of planning, and careful comparison of prices and quality. Other purchases rely on impulse. This is most often the case for products which have a low unit value, and/or are not strictly needed by the purchaser (so that the need or want is generated when the consumer sees the product, rather than being an item in his shopping list or even the object of a shopping trip). Sales of these products essentially depend on consumers exposure to the product, which is why bringing them directly to the consumers attention through direct sales marketing is a very effective way of operating. For example, in party plan selling, different products and functions are demonstrated in detail by the sales person. The aim is to trigger consumer needs or wants in a more targeted way than it is possible by retailing through traditional outlets. Television home shopping channels work in a similar way. Retailing through a traditional outlet, especially where there are several hundred items in the shop (or even several thousand, as in large DIYs or department stores or supermarkets) is a less effective technique for some impulse products: even where there is a latent need, this will not develop unless the customer happens to walk by the right shelf or aisle.61

3.2.1.3 Conclusions
If two forms of retailing each provide different ways of overcoming consumers transactions costs and encourage different types of buying decision, then it is very possible that there will be little demand-side substitutability between them, even if the pure physical product being retailed is identical in both. Thus, it will often be the case that direct sales channels will be considered as being a distinct retailer market.

3.3

Applying the US SSNIP test to retailing

3.3.1 Retailer market definition: demand-side substitutability

Once it is realised that retailer markets must be defined in terms of the retailing activity as well as the physical product, the US SSNIP test can be applied relatively straightforwardly, at least on the demand-side. Starting at the smallest possible market

61

As was discussed in Chapter 2, there is large evidence of the correlation between exposure to customers and sales of retail products.

definition, we ask the question of whether a hypothetical monopolist of the products and retailers included would be able to sustain a price rise. If not, we widen the market and retest. The only real difference between this approach and the approach described above is that widening the market to include end-products to which consumers switch may involve including new retailers of the same physical product, rather than (or as well as) other physical products sold by the initial retailers. To see how this process works it is useful to consider the simple example of baked beans within Sainsburys. A rise of the price of baked beans in Sainsburys would have if any two possible effects on the behaviour of current consumers: C C consumers would continue to shop at Sainsburys but switch to other products;62 or consumers would stay with baked beans but move to an alternative retailer.

If there were no significant effect on consumers behaviour at all, then it is possible to argue that baked beans within Sainsburys is a market on its own. If the first of the above effects is significant then the market should be widened to include these extra products, and then retested. If the second effect is significant then the market should be widened to include these extra retailers, and then retested. The relative size of these two effects will depend on the relative switching costs faced by consumers, and on their perceptions of the comparative advantages of different retailers. In the case of supermarkets, the costs of switching between retailers will be relatively high compared to the costs of switching between different products. Thus, at the first stage test at least, we would expect the second effect to dominate. In the case of a large purchase such as a fridge, however, it is far more likely that consumers will check out the same product in a number of different retailers, in which case a significant rise in the price of a particular fridge in Comet may well result in many consumers switching to an alternative retailer rather than an alternative fridge within Comet. Note that a market which is widened in one dimension at this first stage may well be widened in the other dimension at a later stage. In our example, it is probable that, at the first stage described above, consumers would switch to other tinned products rather than switching retailers. However, if Sainsburys were to raise the prices of all of these possible substitute products, then consumers may well start switching to alternative retailers.63 The final market definition resulting from this process will consist of a group products as sold by a group of retailers. For example, consider the case of record retailing, as was examined (somewhat cursorily) by the MMC in The Supply of Recorded Music (1994). It is possible to distinguish three main product classes and four main retailer types in record retailing, as described in the matrix below.

62

63

Note that the test here is not whether, once the consumer is inside Sainsburys, he or she will switch to other goods rather than other retailers, but whether the consumer will continue to shop at Sainsburys (but switch products) in the future. This will be especially true if the prices of these products have a signalling role in informing consumers about the overall prices of the retailer.

Chart General stores and petrol stations Specialist music retailers Niche retailers (non-classical) Niche classical retailers Yes Yes

Back catalogue/ specialist

Classical

Yes Yes

Yes

Yes

Although it is an empirical question, it is entirely possible that some of the cells in this matrix will constitute relevant retailer markets on their own. It is also possible that the three main product classes will constitute retailer markets (with all of the relevant retailers included), or that the four main retailer types will constitute retailer markets (with all of the relevant product classes included). Or the relevant market may be wide, and include all of the possible cells. One important point to note about this market definition methodology is that the definition of relevant retailer market will often depend on exactly where the definition process commences. Indeed, this is generally true of the OFT/NERA methodology for market definition: the relevant market for A can include B without the relevant market for B including A.64 In many situations, this is not a problem because it is clear from the nature of the competition problem being investigated where the market definition process should start. However, in more general investigations, it is important to consider all possible relevant market definitions which may face competition problems. For example, in the record retailing case above, it is perfectly feasible that: C when starting in the upper left hand cell of the matrix (chart records in general stores), the market definition would end up including all chart and back catalogue records and associated retailers; but when starting in the back catalogue in niche retailers cell, the only other cell to be included in the market definition would be the other back catalogue cell.65

Market shares, and other indicators of market power, may well differ greatly between these different market definitions. Thus, if a competition authority is concerned with the ability of record retailers to raise record prices generally (rather than chart records or back catalogue records in particular), it will be necessary to consider both market definitions.

Empirical testing of demand-side substitutability

Because retail products tend to be relatively small, because prices tend to be very visible, and because sales of retail goods tend to be very well covered by highly disaggregated market research data, it is generally easier to analyse demand-side substitutability between retail products empirically than it is for many other classes of products.
64

65

The OFT/NERA report discusses this intransitivity in cross-price elasticities on page 31. For a theoretical discussion of why cross-price elasticities will tend to be intransitive, except under strong restrictions on preferences, see Gravelle and Rees (1992), page 113. To put this more simply, it is perfectly feasible that back catalogue records should constrain the prices of chart records without chart records constraining the prices of back catalogue records.

On the other hand, it is often relatively hard to come to rigorous product market definition in retailing without such empirical analysis. Firstly, consumers are often attracted to stores by the range or portfolio of products they offer. This means that whilst products may be substitutes in terms of the in-store purchasing decision, they may be complements in terms of getting consumers into the store in the first place. For example, a reduced price suit in the front of a clothes shop may entice you into the store, but once inside you may well buy a rather more expensive item. Thus, the reduction in price of one item may actually increase, rather than reduce, sales of another. Secondly, the high level of substitutability between products once a consumer is in a store means that it is often very difficult to guess a priori which products will be substituted for which others in the face of relative price changes. US studies suggest that 65% of grocery decisions are made in-store. 66 That is, consumers go to the grocery store expecting to buy a certain number of meals for an approximate amount of money, but they dont decide exactly what they are going to buy until they get there and see what is on offer and at what prices. This kind of behaviour can imply wide retailer markets in terms of product classes included, with consumers switching between relatively diverse products in response to price changes.

Retailer market definition: supply-side substitutability

Supply-side substitutability needs to be used very carefully in relevant retailer market definition, and it is often over-used. On the one hand, it can lead to overly wide market definition in terms of the number of retailer types included in the retailer market. On the other, it can lead to overly wide market definition in terms of the number of product types included in the retailer market.

3.3.2.1 Supply-side substitutability by new retailers

It is easy to believe that potential supply-side substitutability by retailers currently outside the retailer market can have strong effects on retailer market definitions. It is often both quick and costless for a retailer currently not offering a particular product to transfer a few metres of retail shelving to this product in the face of price rises by other retailers. This suggests that the retailing of any given product is relatively contestable and thus that the relevant retailer market should be defined widely. However, this shelf-space substitutability argument must be used carefully. While it is true that it does not take much time or money to put a new product line onto existing shelf-space, this does not mean that it will be profitable to do so. In order to make sales on this new product line, it is not enough for a retailer to devote shelf space to the products and to price them competitively. Rather, it is important to consider the other dimensions along which retailers of goods compete. 67 Consider, for example, the retailing of fridges. While it is, in principle, possible for a record retailer to clear some space in its store to display a fridge, this would not be a profitable strategy because it is highly unlikely that anyone would buy it. In order to sell fridges it is important both to get potential fridge buyers into the store and also to get them to make a purchase. For this, retailers need, amongst other things, to have: C The right sort of image, in order to attract potential consumers in the first

66 67

See European Retail Digest, Winter 1994. As will have been analysed in the preliminary step.

place (electrical goods shops and department stores would be expected to sell fridges, convenience stores would not); C C A sufficient selection of fridges, and enough well-informed sales staff, for the consumer to feel she can make a well informed choice; and, The appropriate purchasing and distribution strategies that enable them to compete on price with existing fridge retailers.

Thus, in examining supply-side substitutability by new retailers, it is crucial to consider whether it would ever be profitable for the potential supply-side substituter to actually enter the retailer market. To do this requires an analysis of the nature of competition between retailers and an understanding of any vertical relationships that exist between current retailers and manufacturers.

3.3.2.2 Supply-side substitutability into new product classes

Where a retailer is capable of moving into retailing a particular product profitably, this retailer should be considered as competing in the relevant market for that product. That is, the potential size of the market is larger than it seems when analysing actual players only. This is relatively uncontroversial. A common mistake that is often made in market definition, however, is to assume that the other products supplied by this potential supplysubstituter should be added to the definition of the market. That is, if a supplier of product C can easily substitute into supplying product A, then not only is this supplier to be considered as being in the market for A but also product C should be included in this market. The fallacy of this argument is clear in the following (non-retail) example. Consider the case of Gillette Company and Parker Pen Holdings (1993). In this case, the MMC recognised that transferability of brand name meant that supply substitution into the refillable pens market would be easy for companies in other markets with similar brand images, such as Cartier (watches) or Yves Saint Laurent (fashion and perfume). The MMC did not in fact go so far as to say that these companies were supply-substituters, but suppose that it had. Would this have meant that the market for refillable pens should have been widened to include upmarket watches, fashion, and perfume? Surely not. This problem arises a great deal in retailing, and tends to result in retailer markets including many more product classes than is appropriate. For example, in Kingfisher plc and Dixons Groups plc (1990), the MMC spent some time discussing the boundaries of the relevant product market: for example, are brown and white electrical goods in the same market, should the market include photographic equipment, and other similar items? Indeed, the MMC eventually examined three different product markets, all of which included both white and brown goods. There was, however, no obvious reason for picking these three markets, rather than any other combination of products. Moreover, the debate over market definition abstracted from the real question under investigation, which was: would the proposed merger between Kingfisher plc and Dixons Group plc have a significant deleterious impact on competition in the supply of any of the product groups involved?

Geographical market definition at the retail level

The discussion above applies equally well to geographical market definition as to retailer

market definition. Exactly the same tests of demand-side and supply-side substitutability can be applied. It should be noted that the relative immobility of retail customers will often imply relatively local markets at the retail level. There are, however, arguments for widening geographical markets in retailing. These are discussed in the next section.

3.4

Dimensions of competition other than price

The fact that retailers compete across a range of dimensions other than just price is sometimes treated simply by adjusting prices to reflect differences between retailers in terms of retailer service, geographical location or product selection. For example, advanced econometric techniques (such as forms of hedonic pricing) can be used to incorporate the other determinants of the relevant price. The US SSNIP test can then be applied to these adjusted prices. However, such methods obscure the important fact that competition in these other dimensions may take place at a different level to price competition. This difference is particularly important in geographical market definition in retailing. The simple SSNIP test tends to lead to relatively narrow geographical market definitions. However, in terms of dimensions other than price, economies of scale and scope mean that national retail chains will tend to compete at a national, or at least regional, level rather than at a local level. Moreover, these other dimensions may have an impact on pricing behaviour also, so that pricing becomes national too. This point is exemplified very clearly in the case of Kingfisher plc and Dixons Group plc (1990). In the market for electrical goods retailing68 , there are some national multiple retailers of electrical goods, who have a number of national strategies and who compete vigorously against each other at a national level. These include Comet (Kingfisher) and Dixons and Currys (both Dixons Group). There are also a number of local retailers of electrical goods who compete only locally. In terms of the standard SSNIP test, it seems that the relevant market for electrical goods retail should be local, on the grounds that consumers do not travel far for electrical goods. That is, there are a number of narrow local markets for electrical goods retail. Price divergences between these local markets may exist if consumers fail to exploit them because of transportation or transaction costs. In addition, the SSNIP test, strictly applied, suggests that within each of these local markets the local players should not be considered as competing in the same retailer market as the national players. The reason is that the two main national players compete far more strongly against each other in terms of price than either would compete with local players. While the national players constrain the pricing of the local players, it is not true to say that at prevailing prices the local players constrain the pricing of the national players. Thus, starting from prevailing price levels a hypothetical monopolist of the national players would almost certainly raise prices by a significant amount (up to the level at which the competitive fringe of local players became a constraining force). The MMC, however, rejected both of these market definitions. Firstly, it decided that the relevant geographical market was national. The grounds for this seem to have been that in most dimensions of competition the electrical goods retailers involved Comet and Dixons/Currys compete against each other at a national level rather than at a local

68

We will not repeat our discussion here about whether or not this is an appropriate definition of the relevant retailer market.

level. They advertise both their stores and the prices of their products at a national level69 , they carry out negotiations with suppliers at a national level, and they make national decisions on shop layout, staff training, and product selection. Indeed, they even set nation-wide prices. Secondly, the MMC considered that the local players did compete in the same retailer market as the national players, presumably because price elasticities between the two types of retailers are clearly significant. Both of these MMC decisions seem reasonable, but neither would have resulted from strict use of the US SSNIP rule. In terms of the first, the OFT/ NERA report suggests that the choice of a national market as opposed to a number of narrower geographical markets can be reconciled with the traditional methodology through the continuous chain of substitution argument. This says that: if A is a substitute for B, and B is a substitute for C, then A should be considered to be in the relevant market for C, even if A is a poor substitute for C. Thus, it is legitimate to treat a chain of products as a being in a single market as long as each link in the chain is sufficiently strong to ensure that all products in the chain are bound by a common price constraint. However, while this form of reasoning may sometimes be valid, it is does not accurately describe why the MMC chose to define the relevant market as national. 70 Rather, the MMC recognised that competition between retailers takes place in many dimensions and that, due to various synergies, competition in these various dimensions may take place at various levels. In particular, in retailing generally, economies of scale and scope mean that many decisions will take place on a national basis. Moreover, there are benefits to be derived from having a national pricing policy, in terms of providing a unified retailer image and achieving effective consumer advertising. This means that the definition of the relevant geographic market will often depend on which aspects of competition are under investigation. Consider a set of competing retailers for which most major management decisions take place nationally but pricing decisions are made locally. To the extent that the competition enquiry is concerned with the ability to raise prices, then local market power will be of most concern and markets should be defined locally. However, to the extent that it is thought important to promote quality and innovation improvements in other dimensions, then competition at the national level is what matters, and the market should be defined nationally. This is what is sometimes called the strategic market (Kay, 1990b), because it takes into account the strategic behaviour of retailers, rather than simply the switching behaviour of customers. Note that if both issues are of concern, then competition should be analysed under both types of market definition. In fact, the US SSNIP test itself can sometimes give relevant strategic market rather than relevant economic market, as is shown by the second divergence between the MMC and the results of the US SSNIP test. This divergence can be explained by the fact that there are economies of scale and scope across economic markets. In this case, the national players have a far stronger negotiating position vis--vis suppliers, and can therefore achieve far lower wholesale prices than the local players. As a general rule, under most forms of competition, equilibrium prices will be much lower when two firms with low costs are competing than when a firm with low costs is

69 70

All three were at the time in the top 13 of nationally advertised names. In addition, there are problems with the chain of substitution argument. Even if the links between different sub-markets are strong, there will be a dilution effect as the market becomes wider due to the transactions and search costs incurred by customers. Substitutability may be equally strong between A and B, B and C, and C and D, but while C may be in As market (through the chain of substitution effect), D may not be (because of the dilution effect). This means that while the chain of substitution effect may give us regional markets, it is unlikely to give us national markets.

competing with a firm with higher costs. In the latter case, the firm with low costs will tend to do best by slightly undercutting the higher cost firm, and then taking the remaining difference between price and cost as profits. This simple case carries over to the case where there are several higher cost firms (a competitive fringe). When there is only one low cost firm competing with a higher cost competitive fringe, this fringe will tend to have a significant constraining effect on competitive prices. However, when there are two low cost firms competing against each other, the existence of the competitive fringe will have no effect on prices. Thus, the US SSNIP test which takes account of prevailing prices and thus strategic behaviour will place these two low cost firms in a strategic market on their own, even though the competitive fringe would have a significant constraining effect on prices if, for example, these two firms were to collude rather than compete on price (so that the relevant economic market will include the competitive fringe). In both of these cases of divergence between the MMC decisions and the US SSNIP test, there is actually a strong argument for using both types of market definition at once, even where only one dimension of competition is under examination. To the extent that strategic market definition is influenced by current behaviour, it should be borne in mind that this behaviour may well change (especially post-merger in merger cases). For example, just because pricing is currently done at the national level by the big electrical retailers does not mean that price decisions could not be delegated easily to local stores in the future. Thus an examination of the national market only may miss some important potential competition issues which may arise due to market power in the local market. Similarly, if the two large electrical retailers had just been colluding on price rather than competing then the result of the US SSNIP test would have coincided with that of the MMC. Note that the distinction between strategic and economic markets is not restricted to geographical market definition. It also bears on retailer market definition (by retailer type). For example, supermarkets compete in a number of different economic product markets with a number of different types of retailers: they compete in the bread market with bakeries, in the fish market with fishmongers, and in the markets for over-thecounter drugs and feminine hygiene products with chemists. However, economies of scope across these different product markets mean that supermarkets compete more vigorously against each other than they do against any of these other retailers. That is supermarkets may form a strategic retailer market by themselves, as well as competing in a number of different economic retailer markets.

3.5

Summary

We have argued that the standard US SSNIP test can be easily adjusted to define relevant retailer markets simply by recognising that the end-product purchased by consumers consists of two parts: the physical product and the retailing activity. The US SSNIP test can then be applied in both of these dimensions. However, because the US SSNIP test focused on price competition alone, it provides a distorted view of market definition (and particularly geographical market definition). In fact, there may be different relevant market definitions depending on which dimension of competition between retailers concerns us.

4.

Barriers to entry

As was argued in Chapter 2, the fact that consumers in retailing tend to be relatively small, immobile and ignorant, combined with the prevalence of vertical restraints, means that retail markets are likely to work only imperfectly, and thus that competition problems are likely. The detrimental effects of such competition problems will depend, however, on the size of the barriers to entry into the retail markets. If entry is easy, then the potential for retailers to exploit market imperfections will be limited. The assessment of barriers to entry in retailing is of particular importance when assessing potential mergers, since the ability of a merged retailer to exploit its increased market share will be strongly dependent on the height of barriers to entry into the market. In this chapter, we evaluate the assessment of barriers to entry in retailing by considering whether the methodology of the OFT/London Economics (LE) report on Barriers to Entry and Exit in UK Competition Policy (1994) can be applied to retailing without any major difficulties. The answer, in brief, is yes, although some of the analysis has to be recast slightly in order to fit retailing. A checklist of useful questions that might be asked is provided in Appendix 1. Application of this methodology shows that barriers to entry into retailing tend in fact to be relatively low, although entry into particular strategic markets can be a lot more difficult than entry into economic markets.

4.1

The OFT/LE barriers to entry methodology

The OFT/LE report divides barriers to entry into a number of groups. Firstly, it distinguishes between: C C Entry barriers (which prevent entry); and Entry impediments (which delay entry).

Within the category of entry barriers, the report distinguishes between: C C Absolute advantages; and Strategic (first mover) advantages. 71

Within strategic (first mover) advantages, the OFT/LE report distinguishes five categories. These can be recast for the purposes of retailing as: C C C Economies of scale and scope; Advertising, goodwill, product/retailer differentiation Capital requirements;

71

Bain (1956) thought it appropriate to distinguish between blockaded and deterred entry. Blockaded entry occurs where the incumbents behave exactly as they would if there were no threat of entry, but where, even so, the market is not attractive to entrants. Deterred entry, by contrast, involves the incumbent retailers modifying their behaviour in order to thwart entry. We do not follow this distinction.

C C

Vertical foreclosure and exclusion; and Predatory pricing.

Altogether, therefore, the report distinguishes seven categories of entry barriers/impediments, each of which must be examined in any competition enquiry.72 For the purposes of this study, predatory pricing and vertical issues are in fact considered in Chapter 5, under the heading of competition assessment.73 The current chapter discusses the likely importance of the other five categories for competition in retailing.

4.2

Absolute advantages

Absolute advantages are advantages which cannot easily be replicated by entrants, and which are not readily tradable.74 Often, they are costs which must be borne by the entrant, but which are not borne by incumbents (Stigler, 1968). 75 Examples include most legal and regulatory restrictions, and exclusive or superior access by an incumbent firm to necessary inputs, such as geographical location, advertising, copyrights, patents, and trademarks. Copyrights, patents and trademarks are likely to be relatively unimportant in retailing. However, legal and regulatory restrictions, access to retail sites, and restrictions on advertising, can be significant barriers to entry. Legal and regulatory restrictions The most important absolute advantages in retailing are likely to be legal and regulatory barriers to entry. Quality and safety issues are very important in retailing, due to the information problems faced by consumers. If these are regulated directly (so that only retailers which provide some minimum given quality can enter the market) then the regulation will not constitute an entry barrier. However, quality and safety are sometimes regulated indirectly, through regulating the type or number of retailers that can enter the market. In this case, efficient entry may be prevented.

Quality and safety regulations

Quality and safety regulations are generally fairly easy to observe, although it may be harder to gauge their importance as barriers to entry, and the appropriate trade off between preventing entry and ensuring product quality/safety. It should be noted, though, that as quality and safety regulations become more Euro-centralised, this will become less of an issue for the UK competition authorities. Barriers to entry will tend to be reduced when only one approval process is required for all of Europe. It will also be more difficult to find remedies which the UK can unilaterally enforce.

72

73

74

75

The OFT/LE report also provides a seven step method of analysing entry barriers, which groups together three of the above categories (economies of scale and scope; advertising, goodwill and market positioning; and capital requirements). However, for the purposes of the current report, we choose to keep these various categories separate. Even though these issues could be covered here as behaviour aimed either at deterring entry or inducing exit of rivals. The importance of tradability is clear. If a licence is necessary for functioning in a market, but there is an efficient market for these licences, then there is no barrier to entry. This point was made by Gilbert (1989). Cost asymmetries due to the superior efficiency of incumbents should not be included in this category.

Regulations on retailer types allowed to enter

In Contact Lens Solutions (1993), the MMC examined anti-competitive consequences of the regulation which dictated that only opticians and pharmacies were allowed to sell CLS. The reasoning behind this regulation was that misuse by consumers of CLS could be extremely damaging, and thus that CLS should only be available in outlets which could provide good consumer information on the use of CLS, and especially on the compatibility of different types of CLS with different types of lenses. In this case, the MMC decided that these consumer information problems were not serious enough to justify the anti-competitive effects of the regulation, which was allowing retailers and manufacturers to raise prices and profits to uncompetitive levels. The regulation was thus abolished, allowing entry into the market by other possible retail competitors, such as supermarkets and convenience stores. However, this case shows an important danger inherent in analysing barriers to entry: viz. that removing one barrier to entry will not always result in free entry, but rather that other barriers to entry will then reveal themselves. In this case: C Firstly, as mentioned in the previous chapter, it is not clear that a significant number of consumers will switch to these other types of retailer, even if they are allowed to enter. Consumers prefer to use retailers that are linked with opticians, either because they value the service provided by such retailers, or because of habit/lack of information about alternatives, or because they have been tied in more explicitly (through recommendations of own-brand CLS, or through long-term customer discount schemes). Secondly, even under the regulated system, some manufacturers had opted to distribute exclusively through opticians outlets. If the market were opened up to new types of retailer, it is not clear that manufacturers would choose to supply them. The MMC did not examine this possibility.

Regulations on retailer numbers

In addition, in some retail markets (such as pharmacies and betting shops), there are regulations restricting the number of local competitors, and where retailing licences are not tradable between retailers. This is the case for both pharmacies and betting shops, and acts as an important barrier to entry into these retail markets. 76 In Grand Metropolitan plc and William Hill Organisation Ltd (1989), the MMC was concerned with the absence of price competition and the existence of a number of legislative barriers to entry (licences) and barriers to competition at the local level (advertising). The MMC judged that the crucial problem would be a reduction in competition in offcourse betting at a local level, and thus that Grand Metropolitan should be required to divest certain betting offices: wherever there are former Mecca and William Hill betting offices within a quarter of a mile of each other, and where there are no other betting offices within a quarter of a mile of one of these offices. This would involve around 20

76

Indeed, the difficulty of entering the pharmacy market has led Sainsburys to invite Boots (which does have pharmacy licences) to set up pharmacies within its stores (rather than Sainsburys setting up its own pharmacies).

disposals, mostly in London. Indeed, the MMC found that the licensing system acts as a very major entry barrier into this market. Operators of a betting shop require a bookmakers permit or betting agency permit. A betting office licence is also required for individual premises. Licences are granted by a Committee of Licensing Magistrates in each local Petty Sessional Division (PSD) (licensing boards in the case of Scotland). Among the grounds on which applications for a betting office licence may be refused (see paragraph 3.3) is that the licence would be inexpedient having regard to the demand in the locality, and the number of offices available to meet that demand. There is no provision in the legislation for granting licenses in order to stimulate competition. 77 The licensing system provides an incumbent in a local market with absolute advantages. No entrant can obtain a licence unless there is sufficient evidence that there is a clear need. Licences cannot be traded.

4.2.2 Access to retail sites

In some retail markets such as supermarket retailing, prime geographical location can also be important. In principal, if this location is not tradable, it may constitute an absolute cost advantage, and act as a barrier to entry. However, it is hard to think of situations in which retail sites would not be tradable except where location is tied up with legal restrictions such as planning permission. For this reason, we believe that the importance of geographical location as an entry barrier in retailing is often over-stated, except where planning permission is difficult to obtain. In this case, though, retail sites can be crucial for entry. Carroll, Pandian and Thomas (1994) note that this is becoming an important issue in the out-of-town retail market as the number of potential sites for superstores is declining due to planning permission becoming more and more difficult to obtain. There have even been reports of the major retailing multiples buying up out-of-town sites well in advance of using them, in order to pre-empt potential entry. 78 Access to retail sites was an issue in Kingfisher plc and Dixons Group plc (1990). In this case, the MMC considered that the growth of out-of-town electrical goods retailing may be limited in some areas by local council planning restrictions. These may prevent (or at least impede) entry by further out-of-town stores, giving the retailers that have established themselves already in such locations a degree of market power (particularly if planning permission is specific to one retailer and cannot be transferred easily to another).

77 78

See 6.13 in the MMC report. Moreover, if this behaviour drives up the price of sites remaining on the market, it provides incumbents with an additional cost advantage over entrants, potentially acting as an additional entry barrier.

In fact, the MMC rejected the proposed merger on the grounds that the merger between the two main national chain of retailers of electrical goods would substantially lessen competition in electrical goods retail. However, given that consumers tend to shop around before buying electrical goods, it is not obvious that out-of-town retailers should be considered as being in a different market from high street retailers. And if they are in the same market, difficulty of entry into out-of-town retailing does not equate with difficulty of entry into the electrical goods retail market. Advertising restrictions Advertising restrictions are another important entry barrier into the betting industry, as was examined in Grand Metropolitan plc and William Hill Organisation Ltd. The restrictions on site specific advertising are detrimental to small bookmakers. The disadvantages for potential entrants are amplified as advertising is instrumental in achieving awareness among punters of a new betting service or bookmaker. An entrant must rely on location in a high street to create awareness in his customers if site specific advertising is not possible. If these advertising restrictions were removed, then location would lose its pivotal position as the primary dimension of competition between betting shops. Entry on a large scale, however, can be supported by advertising. Nevertheless, the cost of penetrating a market that already exhibits considerable barriers to entry (licensing laws and restrictions of location choice) can be considered to be high.

4.3

Strategic advantages: sunk cost and economies of scale

Economies of scale and scope in retailing are rather different from those which exist in production, but they can act as barriers to entry in exactly the same way. As the OFT/LE paper discusses, this requires that investments79 are sunk. The basic idea here is that, if investments are not sunk, an incumbent retailer faces a pre-commitment problem: it wants ex ante to threaten to compete vigorously to maintain its current sales levels after entry, in order to make entry seem unprofitable; but ex post, in the face of actual entry, it may have an incentive to accept lower sales and not to fight. Fixed costs (economies of scale) per se are not enough to commit the incumbent to behaving aggressively post-entry (shops can be sold, for example). If, however, these costs are sunk, the story changes. Because the costs are sunk, and not recoupable, it may be profitable, even ex post, for the incumbent to fight to maintain sales, and this means that entry can be deterred. Examples of economies of scale and scope which may act as barriers to entry in retailing include: C Economies of scope in floor space: The importance of one-stop shopping has increased the importance to retailers in some markets of stocking wide product ranges, which generally requires significant floor space.80 Economies of scale in logistics: There are many of these, from minimum delivery orders, to the ability to use sales staff efficiently, and to the ability to reduce inventories (as a proportion of turnover). Economies of scope in distribution: For some sorts of retailing

79 80

In, for example, floor space, distribution networks, store networks, and advertising. This has contributed to the trend towards larger stores in general (especially in out-of town locations), and has no doubt been a crucial factor in the increasing concentration of the grocery retail market in particular.

(especially where fast and efficient delivery is crucial as with fresh foods and newspapers), it is important for retailers to control their own distribution networks. There may be significant sunk costs and economies of scale in establishing distribution systems. However, once a distribution system is set up, it can supply extra stores and extra products at minimal incremental cost. C Economies of scope due to store networks: In some retail markets, consumers prefer to buy from chain stores, on the grounds that they know what to expect81 and sometimes because they can exchange inappropriate purchases (and gift tokens) elsewhere in the country. Economies of scale due to retailer bargaining power: Larger retailers may be able to obtain better deals from upstream manufacturers than smaller retailers can.

In order to assess whether economies of scale and scope of these sorts provide a barrier to entry into any particular retail market, it is first necessary to determine the degree to which costs are sunk, which will in turn determine what would happen post-entry. In Kingfisher plc and Dixons Group plc (1990), for example, the MMC evaluated the costs in entering the electrical goods retail market from scratch. However, many of the fixed costs concerned would not be sunk: retail property and stock can be sold relatively easily, or transferred to other products. After determining the extent to which fixed costs are sunk, it is necessary to compare these sunk costs with the size of the retailer market. In this regard, retailing has two very important characteristics. On the one hand, the importance of geographical location means that many economic markets are relatively local, and thus fairly small. Thus, sunk costs need not be especially high in order to restrict entry. In fact, the sunk costs involved in setting up a single local retailer tend to be relatively low, and entry is relatively easy at the local level. On the other hand, economies of scale and scope mean that many strategic markets are national (or at least regional), covering a number of local economic markets. Strategic retailer markets may also include a number of different economic product markets. The sunk costs involved in entering these strategic markets may be extremely high. For example, in Kingfisher plc and Dixons Group plc, the MMC recommended against the proposed merger, arguing that, despite apparently easy entry at a local level, no newcomer is likely to penetrate the strategic market to the extent necessary for them to become an effective competitor to the merged company, due to the economies of scale and scope which the large national players enjoy.

4.4

Strategic advantages: advertising, goodwill and retailer differentiation

The sunk costs involved in advertising, goodwill, and retailer differentiation provide a further source of barriers to entry in retailing, which work by shrinking the residual demand that a potential entrant would face, or by raising the sunk costs of entry. For example, in Kingfisher plc and Dixons Group plc (1990), the MMC considered that

81

Chain stores tend to have strong retailer images, which are partly a result of standardising the retail environment and retailer services provided in each particular shop.

the sunk cost involved in establishing a retailer brand name that can compete effectively with the incumbent multiples may be an important barrier to entry into the national strategic market, allowing potential abuse of market power. Indeed, at the time of the report, the incumbent multiples had very high retailer brand names supported by heavy advertising (Dixons, Currys and Comet were said to belong to the top 13 nationally advertised names). The LE/OFT paper on Barriers to Entry distinguishes between advertising, goodwill and loyalty, and product proliferation and retailer differentiation. We review each of these in turn.

4.4.1 Advertising
As we argued in Chapter 2, advertising per se is not as important a means of promoting image in retail markets as it is in product markets, partly because a store front on a high street or in a shopping centre is a far more effective advertisement than any advertisement in the media, since it is seen by a far higher percentage of its target customers. Indeed, many retailers, such as Next, Marks & Spencer, Body Shop and Waitrose have achieved strong retailer images with minimal advertising. Thus, in general, while advertising is often essential in building image for manufacturers products, it tends to be far less relevant to the formation of retailer image, and so advertising is likely to be far less important (although not negligible) as a barrier to entry in retail markets than it is in product markets. This does not mean that retailer image is not important. In many retail markets, it is crucial. But retailer image can be promoted in other generally less costly ways than above-the-line advertising. Rather, the most important factors in promoting retailer image are product range and prices, store design and atmosphere, and the quality of service. These may act as barriers to entry, but given that they are part and parcel of the retailing activity, they are unlikely to keep out any retailers that stand to be successful. The need to acquire a strong retailer image may deter some types of entry more easily than others. Firstly, economies of scale in advertising mean that, in those retail markets where advertising is important, effective small-scale entry may be difficult, with entry only possible by large entrants which can exploit these economies of scale, and which have sufficient capital to carry out large advertising campaigns. For example, in The Supply of Recorded Music (1994), the MMC found that retailer image and brand name are very important for the larger record retail chains. HMV, Our Price, Tower and Virgin have established strong brand names that are heavily supported by promotion and advertising (often co-operative advertising with record companies for particular records). The importance of brand name may well act as an entry barrier to non-niche independents which attempt to compete directly against the full range multiples, but which are unable to invest in the advertising necessary to win significant market share.82 Secondly, while the need to achieve a strong retailer image can clearly be a strong barrier to pure new entry, it may not prevent entry into a retail market by retailers from other markets, which already have a strong brand name in those markets (as long as the brand

82

Although the successful recent entry of Tower Records and other US retailers (under the Sam Goody brand) suggest that this entry barrier is not that high.

name is appropriate to the new market and is transferable).83 A good example here is the move by Marks & Spencer into financial services, which was possible because of Marks & Spencers high quality retailer image. Indeed, strong retailer brand name can also allow them to enter into upstream product markets, as direct competition against branded manufacturers. Goodwill and loyalty Goodwill and consumer loyalty can be important barriers to entry into many retail markets. The key concept here is that of switching costs.84 The fact that consumers are small, immobile and uninformed means that they tend to face fairly large costs of switching between retailers, and these costs serve to lock in customers to their current retailers. Even if two retailers are identical ex ante (indeed they may be two branches of the same chain), so that new buyers find them equally attractive, the existence of switching costs will make moving from one retailer to another unattractive ex post. Switching costs can provide a strong competitive advantage for pioneering retailers which essentially create their own niche (such as the Body Shop or the Sock Shop). A pioneering retailer needs to persuade consumers to buy its products instead of spending their money on marginal consumption. Later entrants have to persuade consumers to try their products instead of spending their money on the incumbents products. Because consumers generally prefer the incumbent retailers products to their marginal consumption, it is harder to persuade consumers to switch away from the former than from the latter, and this can deter entry. 85 However, the effect of switching costs on entry is more general than this. In order to enter the market, or expand market share, a retailer must not only match the price offer of the consumers current retailer, but they must also compensate consumers for their switching costs (which can be large). In effect, this creates an additional sunk cost of entry. Switching costs cover a number of different costs which consumers may face in changing from one retailer to another. Some of these costs are natural in the sense that may stem from the desire not to travel, the familiarity with a particular stores layout, or from the accumulated goodwill of the retailer. Alternatively, they can be strategic in the sense that they are based on free gift schemes, customer loyalty cards or bundling. In either case, they can be important barriers to entry. To the extent that switching costs are natural, there may be little that the competition authorities can do to reduce them. Indeed, it is anyway not obvious that it would be desirable to reduce such switching costs, for example if they are simply a result of opening up a new market or due to customer loyalty that has been earned over a number of years through superior service. Explicit switching costs such as free gift schemes (e.g.

83

Carroll, Pandian and Thomas (1994) provide a good description of how it may be easier to enter markets from one direction from another in this way. Indeed this possibility applies to other dimensions of competition other than brand name. The geographical location of supermarkets and consumers shopping behaviour helps them to sell petrol; the geographical location of petrol forecourt shops enables them to sell CDs; the well-known characteristics of the clothing at Next aided them in their entry into the home shopping market; and the product portfolio of Dixons makes the sales of computers (both hardware and software) easier. See Klemperer (1987, 1990). See Schmalensee (1982). In addition, for a model in which asymmetric information about quality combined with moral hazard can act as a barrier to new entry, see Farrell (1986).

84 85

air miles and the Esso collection) and customer loyalty cards (provided by B&Q and, more recently, Tesco) might be more easy to remedy. However, not all such schemes act as barriers to entry. If the schemes provide equally good value per point collected, for both small and large gifts, then there is no real lockin problem; there is nothing to stop a customer cashing in his points and moving to an alternative retailer. Many such schemes, though, offer disproportionate rewards for larger numbers of points collected. This has the effect of making it costly to cash in points early, and thus makes it harder to persuade consumers to switch to a new retailer.

4.4.3 Product proliferation and retailer differentiation

Product proliferation does not act as a barrier to entry in retail markets in quite the same way as it does in product markets. In product markets, this involves incumbent firms filling up product space in such a way that there is insufficient room for a rival to enter and prosper sufficiently to recover its sunk entry costs. 86 In retail markets, however, it involves increasing the portfolio of products offered for sale in such a way that retailers which only provide a subset of the products cannot compete in the market (that is, the sunk costs of competing in the market are increased). Since economies of scope in retailing are often high (see above), such extensions to the product portfolio may not be costly for incumbents and may act as effective barriers to entry. More similar to the traditional product proliferation story is the possibility of filling up retail space in such a way that there is insufficient room for a rival retailer to enter. However, this will be possible only if these characteristics are difficult to change in the face of entry (which will be more likely in some markets than in others). In order to see whether this is in fact the case, it is useful to ask the following questions.

4.5

Capital requirements

There is some debate about whether capital requirements really constitute barriers to entry. However, they can certainly be important in hindering/ slowing entry. To the extent that large incumbent multiple retailers are able to raise capital more easily than subsequent entrants, this may be important. However, it is not clear that capital market imperfections are particularly problematic in the retail sector. Entry impediments Entry impediments are any factors which delay the process of entry into a market without increasing the (sunk) costs of entry, or creating an asymmetry between incumbents and entrants. They are not entry barriers, but they may be important to antitrust decisions, because they influence the amount of time that incumbents may exercise market power before entry occurs. Good examples of entry impediments are licensing, certification or product registration requirements which involve little or no actual costs, but take significant amounts of time to satisfy. Other examples include the time required to obtain contracts (i.e. where the markets products are sold via long-term contracts) or gain a market share large enough to significantly influence the behaviour of incumbents.

86

As long as product withdrawal costs are sufficiently high. See Schmalensee (1978) and Judd (1985).

Certification requirements are only important in a few retail markets (pharmacies, for example). Planning permission may be more important as an entry impediment (especially for out-of-town building). However, the most important entry impediment in the retail sector is probably the time it takes for a new retailer to establish itself with customers, particularly if reputation is important.

5.

Competition assessment: market structure

The previous two chapters considered market definition and entry barriers, and examined the degree to which existing approaches as outlined in two recent OFT reports can be applied to retailing. This chapter commences our discussion of how to assess competition. In line with our approach in Chapter 2, we suggest that the competition assessment distinguishes three sets of issues: C Market structure and merger issues: market shares, the measurement of market power, the threat of potential competition, and the nature of competition across markets. Pricing issues: excessive pricing, price collusion between retailers, predatory pricing, price discrimination, and loss leading. Vertical issues: vertical restraints, differential discounting, and own-brand competition.

C C

This chapter discusses the first of these. Pricing issues are examined in Chapter 6, and vertical issues in Chapter 7.

5.1

Market structure and market power

Assessment of market structure in retailing is important in providing a picture of the actual and potential market power of retailers. Structural analysis of market power is particularly important in merger cases, but it also serves to support the analysis of pricing and vertical issues which follows. For example, we argue in Chapter 7 that if there is no market power problem, then vertical restraints will generally not be anti-competitive.

5.1.1 Retailers market shares

The obvious first step in the assessment of market structure and market power is the examination of the retailers in the market and their market shares. In terms of retailers market shares, concentration levels will clearly be very different depending on how the market is defined. However, even at the national level using fairly broad retail categories, many retail markets are fairly concentrated, as shown in Table 5-1.

Table 5-1 : Concentration in retailing, 1994 Product group

Share of top 5 retail groups in total national turnover of product group %

67.2 52.4 49.8 47.9 46.3 39.0 30.7 30.0

Chem ists Off-licences DIY Grocery Jew ellery Footw ear Electrical ap p liances and m u sical good s Clothing
Source: AGB, Nielsen and London Economics.

Traditionally, merger cases especially have focused very heavily on market shares, and on how market concentration would change post-merger. However, it is inappropriate to infer market power from market concentration data alone. High market shares are neither necessary nor sufficient to infer the existence of market power. An increase in market share post-merger is only an imperfect guide to whether the market power of the merged retailer will be higher than that of the two individual retailers, and the extent to which this will affect the competitive choices made by the retailer(s). In fact, it is important to examine the market shares of all the retailers in the market, and not just the retailers whose behaviour is under investigation. As is shown below, the relative sizes of the different players will affect the nature of competition in the market.

5.1.2 Measuring market power

In order to assess market power, it is important to try to measure the extent of market power. A number of indicators can be used. As well as examining the underlying factors which determine the nature of competition in a market and the ability of retailers to exploit market power, it is also useful to examine competition more directly. The factors and indicators to be examined include: C C C C C The number of retailers in the market; The dimensions of competition between retailers; The elasticity of demand facing individual retailers; The relevant cost structures of competing retailers; and The threat of potential competition, and the nature of competition across markets.

The number of retailers in the market

In most simple models of competition, it is true that prices and profits will fall as the number of players increases, and total sales volume will increase. For example, in a simple Cournot87 game with equal sized players, a linear demand curve and zero costs, equilibrium price, total market sales volume and total market profits will be as shown below:

87

In a Cournot game, players compete in quantities. Each player chooses that quantity that will maximise his profits, given the quantities supplied by the other players. Equilibrium occurs where no player could do any better, given what the other players are doing.

Table 5-2: Simple Cournot equilibrium results Market Equilibrium Total market sales Number of players shares price (% of volume (% of
monopoly price) monopoly sales)

Total market profits (% of

monopoly profits)

1 2 3 4 5 6 7 8 9 10 50 100

100 50 33 25 20 17 14 13 11 10 2 1

100 67 50 40 33 29 25 22 20 18 4 2

100 133 150 160 167 171 175 178 180 182 196 198

100 89 75 64 56 49 44 40 36 33 8 4

This simple example provides a theoretical justification for the idea that few retailers with high market shares will result in high prices and profits. More usually, however, there will be various different sizes of retailers in a market, and the market shares of others will affect the degree to which any given retailer can exploit its market power. For example, suppose that the top retailer in the market has 40 per cent of the market. The nature of competition (in all dimensions) will be very different if there are 60 other players, with 1 per cent of the market each, than if there are two other players with 30 per cent of the market each. The dimensions of competition between retailers As well as prices and quantities, retailers also compete on geographical location, product selection, and retailer service. These will tend to reduce the direct competition on price, and thus may increase the prices that are observed in some retailer markets. More significantly, different retailers sometimes compete in different ways within the same market. Some will try to find particularly good geographical locations, others will try to provide better retailer service and product selection, while others will try to offer lower prices. It is difficult to model such differentiated competition in multi-dimensional space, but it is clear that the resulting equilibria will be far more complex than those in the simple Cournot model described above. The results of the preliminary analysis suggested in Chapter 2 can be used to support the assessment of competition. In the preliminary analysis, we propose to identify how retailers compete across the four dimensions: pricing; geographical location; product selection (quality and range); level and quality of retailer service.

5.1.2.3 The elasticity of demand facing individual retailers

Even where market shares are high, price competition will be intense if cross-price elasticities between retailers are high. The most extreme example of this is the simple undifferentiated Bertrand model, in which players compete head-to-head on price. In this simple model, it is assumed that all consumers purchase from the player who charges the least. Because there is

so much to gain from undercutting, the equilibrium in this model involves price falling to equal cost, and zero profits being made, even where there are just two players. In the real world, it is rare to find markets where all consumers readily switch to the lowest cost retailer. However, as long as there is sufficient switching by marginal consumers, similar results will hold. The reason is straightforward. A 5 per cent increase in price will provide a retailer will increased profits on those consumers which it keeps, but that retailer will lose all the profits it is currently making on those consumers which switch to another retailer. There is clearly a trade-off here, but it does not take much switching for the second effect to outweigh the first and make price rises unlikely, whatever the retailers current market share.88 The history of market behaviour can be helpful in assessing this. There are two relatively sophisticated methods of analysis which may be readily applied in competition cases, as long as sufficient market data is available. 89 These are based on observing a retailers (or a markets) price and output responses to changes in its economic environment, and in particular to variations in (i) costs and (ii) the elasticity of demand. i) Residual demand estimation is carried out by isolating incidents when a retailer has a unilateral incentive to raise price, because of changes in its costs which are not reflected by changes in the costs of other retailers. If, in such situations, the retailer successfully increases its price, then it has market power (i.e. an ability to act independently of its competitors). Where market power is present, a reduction in demand elasticity should result in an increase in prices. Thus a retailer that has market power can be distinguished from retailers that do not, by observing their relative responses to variations in the elasticity of demand.

ii)

While these techniques are generally rather difficult to apply, due to the large amount of data required, they are more likely to be workable in retailing than in many other sectors of the economy. Retail sales are generally well covered by market research, and for retailer markets in which EPOS scanning is now common, information on sales is more or less perfect, and can be highly disaggregated. Profitability is also often used as a measure of market power. However, this must be done very carefully. On the one hand, retailers with market power will often prefer to function inefficiently rather than increasing efficiency and thus profits. Thus, market power may not result in high profits. On the other hand, one retailers high profitability may simply be due to that retailers superior efficiency or market positioning, rather than any market power.

5.1.2.4 The relative cost structures of competing retailers

The ability of any retailer to exploit market power will be strongly affected by the cost structure and capacity of competing retailers. As a general rule, a competing retailer with lower costs will have a far greater constraining effect on price than a competing retailer with higher costs. Thus, if there are economies of scale so that larger retailers have lower costs than smaller retailers, prices will tend to be lower in a market with two large retailers, than in a market with one large retailer and a large number of smaller retailers.

88

89

In fact, the negative effect on profits will be greater the greater the difference between price and marginal cost, since this is the profit margin that will be foregone from consumers switching. Thus, in markets where fixed costs are high and marginal costs are low (so that price will be significantly higher than marginal cost at any long run equilibrium), even a little consumer switching will make price rises unlikely. For a summary, see Baker and Bresnahan (1992).

The ability of any retailer to exploit its market power will also depend on the capacity of other retailers to fulfil demand quickly with minimal need for increased investment. The consumer switching described in the previous section will only occur if there are alternative retailers with sufficient capacity to satisfy this demand. Otherwise, consumers will be stuck with their current retailer and are capable of being exploited. Another method of assessing the market power of retailers (at least in terms of their relations with manufacturers) is to examine the differentiation in prices paid by retailers to manufacturers. Price differentiation by manufacturers may be a result of trying to exploit market power by charging higher prices to retailers with less elastic demand. In retailing, however, it is more often due to retailers exploiting their market power in their negotiations with manufacturers.

Potential competition and the nature of competition

The principle source of potential competition is from companies currently outside the market. Thus, the size of barriers to entry can have an important impact on the intensity of competition in a market. However in highly innovative and dynamic markets, potential competition can also arise from within the market. As a rule, barriers to entry increase the degree to which it is possible to translate market shares into market power. At the limit, in a contestable market, where it is possible to enter without cost and immediately, without provoking immediate retaliation from the incumbent retailers, even a monopolist will be unable to price above cost without losing its market to hit and run entry. Although the concept of a contestable market would appear to be of limited practical value, it nevertheless serves to emphasise the point that entry conditions play an important role in determining the degree to which market power can be exercised, and the importance of potential, as well as actual, competition in constraining the action of firms in a market. Collusion between retailers is also difficult when entry is easy. In markets that are increasing or changing quickly, market share can be a particularly poor indicator of market power. In such cases, a large market share at any point in time may result from a recent innovation or new product which captured a large amount of the market, but which will soon either be copied by the other players (who will then claw back market share), or will be surpassed by a further innovation or new product (and the new innovator will then win the large market share instead). In either of these cases, we should see market shares fluctuating greatly over time (or falling fast in the case of a growing market). This provides a good description of many areas of the economy. An example which was recently examined by the MMC is the film industry, where the success of a single film can dramatically increase market share in one year. It is not clear, however, that this will often be a valid argument in retailing. Finally, it is worth examining the nature of competition across markets, especially if a relatively narrow approach is taken to market definition.

Merger case study: Kingfisher plc and Dixons Group plc

In order to illustrate the steps involved in assessing market structure and market power issues in retailing we discuss two merger cases. Here we discuss the merger reference to the MMC in Kingfisher plc and Dixons Group plc (1990). In 5.3 we discuss the merger between Grand Metropolitan and William Hill (1989). Each case is examined under three headings:

C C C

Assessment of market structure; Dimension of competition; and Merger issues.

In Kingfisher-Dixons Group, the MMC rejected the proposed merger on the grounds that the merger between the two main national chains of retailers of electrical goods would substantially lessen competition in electrical goods retail. Electrical goods comprise both white goods (refrigerators, washing machines, etc.) and brown goods (TV sets, VCRs, hi-fi, etc.), together with small domestic appliances such as toasters and kettles. This case is well known for its controversial assessment of the relevant market and competition between national chains of multiple retailers. The MMC report contains a note of dissent by one of the members of the panel. Dixons Group plc was incorporated in 1937. In early years, the company focused on retailing photographic equipment, and in 1960s and 1970s diversified into electronic equipment. In 1984, Dixons Group acquired Currys. At the time of the reference Dixons and Currys still traded under separate names, but formed part of a single management structure, called DSG Dixons Stores Group. In 1988-89, Dixons Stores turnover was 1,755 million, and its operating profit was 82 million. Outlets trading as Dixons are high-street outlets, mostly selling brown goods. Currys stores, a significant proportion of which are out-of-town, sell white goods, small electrical appliances, and a selection of brown goods. Kingfisher plc was created in 1982 through the successful buy-out of the general retailer Woolworth (UK), which also owned the DIY retailer B&Q. The company has since acquired several retailers of electrical appliances: Comet, Ultimate, Connect and Laskys, almost all the stores of which now trade under the name Comet. Kingfisher also acquired the drugstore retailer Superdrug and, at the time of the report, was the 4th largest non-food/drink retailer in the UK, with more than 2,000 stores, and 57,000 employees. Its turnover in 1989-90 was 2,910 million, and its operating profit was 246 million. Comet (which accounts for 95 per cent of Kingfishers sales of white and brown goods, domestic electrical appliances, and photo equipment) had a turnover in 1989-90 of 519 million, and operating profits of 18 million.

Assessment of market structure

In terms of entire UK electrical goods sales 90, DSG had a market share of around 17 per cent in 1989, while Comet had a market share of around 9 per cent, and Rumbelows had a market share of 5 per cent. In addition, there were about 5,000 independent electrical retailers, mostly small and family-owned. The independents sector accounted for 20 per cent of all electrical sales (down from 23 per cent in 1985). The electricity showrooms had a share of 13 per cent, mostly of large white goods. Department stores accounted for 6 per cent of sales (down from 8 per cent in 1985). General retailers (e.g. Boots) had a share of 17 per cent, and mail order had a share of 7 per cent. The merged retailer would have had around 26 per cent market share. This market share is hardly enough to bestow potential market power. Moreover, faced with strong competition from other electrical goods retailers, any market power would not be abused and would not be deleterious for welfare. We argue above in Chapter 3, however, that the national multiples are in a strategic market of their own, and that, to an extent, their behaviour is not constrained by retailers outside this strategic market. Within this strategic market, the merged firm would clearly have more like 84 per cent of the market, and prices would be likely to rise until the

90

Using the MMCs market definition A (see above).

point at which local retailers would start to constrain them. Separating out total UK sales into different types of retailer activity changes this situation slightly. For smaller domestic appliances, where the market share of the merged retailer would be fairly low (around 13 per cent) and general retailers are very strong, there is unlikely to be major problem. Moreover, in terms of major white goods, the merged retailer would face a fair amount of competition from the electricity showrooms (fairly large retailers with high reputation, who also get good discounts from suppliers), and lesser competition from local independents. In terms of all other electrical goods, however, the combined market share of the merged retailer would be well over 30 per cent, and the main competition would be Rumbelows, niche retailers, small local independents and general retailers, none of which are likely to constrain the behaviour of the merged firm to any great extent (Rumbelows because it was already in some financial difficulty, and the others because they either compete in essentially different markets or because they receive so much worse terms from suppliers than the merged retailer would).

5.2.2 Dimensions of competition

The MMC report illustrates very clearly that electrical goods retailers compete across all of the dimensions that we identify in Chapter 2. Price Pricing strategies are the most important element of competition in electrical goods retailing. The surveys presented in the MMC report support this view; and frequent references are made to a period of tough price competition between the two parties to the proposed merger (Kingfisher and DSG). These two leading retail groups in fact act as price leaders, setting price levels at the national level which are largely followed by the large number of independents and small chains of multiple retailers. Two surveys cited by the MMC showed that there was indeed considerable price uniformity across retailers, both in local shopping areas, and nationally, reflecting strong price competition.

5.2.2.2 Geographical location

Because purchases of electrical retail goods tend to be quite large, geographical location is less important than easy access. High street retailers have the benefit that consumers can easily pop in and look around. However, many consumers (if they have cars) will also look at out-oftown stores. These have the advantage that they have lower property costs (and can thus charge lower prices and/or provide a wider selection in larger outlets) and that goods can be more easily transported home from these outlets (due to easy car access). Indeed, out-of-town shopping is becoming more important, particularly for white goods. Out-of-town sales were said to have risen from 11 per cent to 18 per cent of the market between 1985 and 1990.

5.2.2.3 Product selection

Product portfolio can vary enormously in electrical goods retailing. Small domestic appliances can be found in small shops as well as in larger outlets where they are only a small part of a large selection of electrical goods. Appendix 2.3 of the report shows the overlap of products sold by Currys and Dixons shops which are both in the DSG, and specialise in white and brown goods respectively. This diagram is reproduced below.

In addition, to product portfolio, product range is very important. This is a major difference between different kinds of electrical goods retailers. For example, computer specialists and photographic equipment specialists will have a far greater depth of choice than a Dixons store will tend to have. Similarly, Comet and Currys out-of-town stores and the electricity showrooms of the Regional Electricity Companies (RECs) will tend to provide a far wider choice within each category of white good than department stores or other general retailers have.

5.2.2.4 Retailer service

Quality of service is important. The role of the retailer in providing information and advice to consumers is less important for smaller purchases, but can be crucial for larger products (such as computers and white goods). In addition, after-sales service is an important dimension of competition, especially for brown goods (manufacturers tend to carry out aftersales service on white goods). Warranties are also very important (for larger durable goods), and the role of warranties is key to understanding pricing issues. Some retailers, it was argued in the report, do not make any return from the sale of electrical goods but only from the associated sale of warranties. Overlap of products sold by Currys and Dixons
Washing m achines Freezers Vacu u m cleaners Coffee m akers Televisions Vid eo Record ers Satellite d ishes Cam eras Binocu lars Lenses Dryers Cookers Irons Dishw ashers Microw aves Kettles Refrigerators H eating Toasters

Rad io cassettes Personal hi-fis Car au d io Cam cord ers H om e com p u ters Electronic gam es

H i-fi system s Telep hones Keyboard s Personal organisers Fax m achines

Retailers also compete through advertising and promotion, through which they aim to inform consumers that they offer quality and a good selection of products in the appropriate price range. A retailer who does not get his message to his customers will not be viable. The retailer needs a very visible shop window (prime high street location) and/or high levels of media advertising. This aspect of competition derives directly from the fact that consumers are not initially well informed about availability, relative prices and product quality. The fact that the major multiple retailers use national advertising and pricing policies as part of their competitive strategy is very important for market definition.

5.2.3 Merger issues

The MMC felt that the merger would lead to a significant reduction in competition in electrical retailing, and would as a consequence lead to higher prices. We have a lot of sympathy with this view, which concurs with the results of our analysis of the strategic competition across different economic markets. As discussed above, the MMC decided that the relevant geographical market was national, on the grounds that the electrical goods retailers involved Dixons, Currys and Comet all set

national prices, and advertised both their stores and the prices of their products at a national level. We agree with the MMC that the national market is of key importance for the analysis of competition between the strategic groups in this industry (although it is also important to examine the effects of the merger on competition at the local level). In terms of the relevant retail market, the effects of the merger would depend on which market is being examined. For small domestic appliances, the effect would be negligible. In terms of large white goods, the increase in concentration would be substantial (each of the merging parties has roughly equal market shares in large white goods), but pricing would be strongly constrained by the electricity showrooms. For all other electrical goods, the increase in concentration would be less strong (DSG is already almost three times as strong on these as Comet), but there is little direct competition which might constrain the resulting pricing behaviour of the merged entity. In terms of product selection, the MMC concluded that the total range might well fall postmerger, on the grounds that the two retail chains would no longer need to compete in terms of product range. On the other hand, it is possible that the effect of reduced competition might be to differentiate the retailers more strongly in terms of product range, resulting in better choice for customers. Further analysis would have been required to resolve this question. In terms of entry barriers, the MMC rejected the argument put by Kingfisher that entry into the market was easy, and that this fact would constrain the pricing policy of the merged company. Although there were a large number of competitors, the MMC argued that history does not support the view that newcomers would succeed in penetrating the market to the extent necessary for them to become an effective competitor to the merged company, nor that other multiple chains [....] would expand into electrical retailing to any great extent. The new entrants could also be deterred by the cost and complexity of providing after-sales service. We are not entirely convinced by this, and further analysis of entry barriers (at both the local and the national level) would have been useful. For example, it could be argued that the merger would provoke entry by another competitor, or at least a significant increase in advertising and promotion by Rumbelows or other smaller multiple retailers.

Merger case study: Grand Metropolitan plc and William Hill Organisation Ltd In this case study, we evaluate the proposed merger between Grand Metropolitan plc and William Hill Organisation Limited. This merger, between two of the four largest chains of bookmakers, raised a number of important competition issues. The MMC considered the merger to operate against the public interest unless a number of recommendations were accepted. The chief concern of the MMC was with the absence of price competition and the existence of a number of legislative barriers to entry (licences) and barriers to competition at the local level (restrictions on advertising). The MMC judged that the crucial problem would be a reduction in competition in off-course betting at a local level, and thus that Grand Met should be required to divest certain betting

offices: wherever there are former Mecca and William Hill betting offices within a quarter of a mile of each other, and where there are no other betting offices within a quarter of a mile of one of these offices. This would involve around 20 disposals, mostly in London. The MMC was also concerned with a number of arrangements in the industry that involved the big four chains of betting shops: C C C Provision of racecourse information through SIS, which is partly owned by bookmakers and the Racecourse Association; Organisation of greyhound races through subsidiaries of bookmakers; and Laying off with on-course bookmakers and thus influencing the starting price.

However, it did not recommend any changes with respect to these arrangements.

5.3.1 Assessment of market structure

There are around 6,000 bookmakers. The big four operate 35.7 per cent of betting shops and account for 60 per cent of turnover. This is a fairly concentrated industry when measured at the national level. The merger is between numbers 2 and 4 in the industry to create the second largest chain after Ladbrokes. Entry barriers are significant due to the regulatory restrictions that require a license to operate a betting shop, constrain the free choice of location, and restrict advertising that states the address of an individual betting shop. Dimensions of competition between bookmakers Bookmakers offer odds on the likelihood of an event occurring. They will offer odds taking into account the perceptions of punters. If several/many punters believe an event will occur with a greater degree of probability than the bookmaker indicates through his quoted odds, they will place a bet at fixed odds. Bookmakers, when taking bets at different odds, always try to balance their books so that they are not unduly exposed to risk and are guaranteed a margin.

5.3.2.1 Price
It is frequently believed that prices offered by betting shops are uniform throughout the country. While this is largely true, it is not completely true. C C C Ante-post prices can vary considerably (although these comprise only 2 per cent of bets). Deductions for multiple bets are sometimes discounted. Maximum limits, which in effect worsen the odds for big winners, differ from one betting shop to another.

The observation that starting prices (SPs) are uniform is correct. Deductions are also uniform. While the former may be the outcome of the market process, the latter is a convention built around the tax and levy system.

5.3.2.2 Geographical location

Geographic location is extremely important. Regular punters, especially, do not want to travel far to place a bet, and convenience is thus vital. Out-of-town bookmakers would have no customers. For credit betting, location plays no major role as all betting is done on the telephone. Location is only important in credit betting when is comes to assessing the creditworthiness of punters. Such information may be more easily available on a local basis.

5.3.2.3 Product selection

Selection of products is less important. There are some opportunities to offer more imaginative bets, but for the standard event (e.g. the 2.30 at Kempton) the products are pretty much the same.

5.3.2.4 Retailer service

Point of sale service in betting shops matters: the ambience, the running commentary, and the pictures from SIS, etc., are all very important to the enjoyment of betting. Until recently, legislative restrictions made it difficult to improve the ambience and attractiveness of betting shops. Advertising and promotion are highly regulated in this industry. Government regulations do not permit an individual betting shop to advertise its address. Only corporate advertising is permitted. This perverse regulation is probably one of the chief reasons for the high degree of concentration in this market. Any small bookmaker who wants to promote his services and find ways to communicate a new or improved service is seriously hampered in how he may do so. A small bookmaker relies entirely on word-of-mouth promotion and his local reputation. Larger bookmakers, who operate chains of betting shops, will find it easier to promote their activities and establish a brand name through general advertising (i.e. without putting in the addresses of their individual betting shops) or sponsorship of races. The sunk cost of taking out advertising space in the national racing press, for example, can be recovered across a large number of betting shops. Therefore the incentive to operate chains of betting shops that can benefit from advertising is considerable and, in our view, is a determining factor of the structure of the betting industry, which has become increasingly concentrated.

5.3.3 Merger issues

As the market is characterised by absolute entry barriers at the local level (in the form of licences) and by advertising restrictions that make entry on a small scale difficult, any increase in market share by members of the strategic group of national chains of bookmakers may well translate into increased market power. In addition, the market is not characterised by price competition between betting shops, as most bets are done on a starting price basis, which governs all SP bets in the country. There are some limited elements of price competition in that maximum winnings differ between companies and because deductions for multiple bets are often granted. On the other hand, the high visibility of prices in the betting market significantly constrains independent market behaviour. The betting market is easy to collude in, given the local structure and existence of absolute entry barriers. Indeed, the uniform level of deductions, while justified by tax and levies, can

easily be interpreted as a collusive arrangement. Straightforward application of tax would lead to a 8.8 per cent tax for all forms of betting. For horse race betting there is another 1.0 per cent of levy that needs to be collected. For other forms of betting where no levy applies, there is still a 10 per cent deduction. Why? Similarly, credit betting attracts a lower level of levy. Running a centralised credit operation is not obviously more expensive than running a betting shop in the High Street. On the contrary, it may well be cheaper. So why are deductions the same everywhere? These concerns are not new. In 1986, the industry was subject to a referral to the Restrictive Practices Court. This case related to a collusive agreement to restrict shop opening hours for shops operating in the same street and to agreements between the big four to co-ordinate shop closures. The adverse finding led to recommendations designed to increase competition between local betting shops, and are a clear indication that concerns over collusive practices are justified. The findings of the MMC that the merger of Grand Met and William Hill bookmakers would create a number of local monopoly situations appear to be justified in the light of the observations made above. The question is whether the MMC went far enough when recommending the divestment of 20 betting shops in areas where the two bookmakers had outlets within a quarter of a mile of each other. The existence of barriers to entry at the local level as well as at the national level, where the two chains of bookmakers compete in terms of advertising and promotion, would suggest an even closer scrutiny of the merger in terms of its negative impact on competition.

CHAINMACRO() to have. Similarly, Comet and Currys out-of-town stores and the electricity showrooms of the Regional Electricity Companies (RECs) will tend to provide a far wider choice within each category of white good than department stores or other general retailers have.

5.2.2.4 Retailer service

Quality of service is important. The role of the retailer in providing information and advice to consumers is less important for smaller purchases, but can be crucial for larger products (such as computers and white goods). In addition, after-sales service is an important dimension of competition, especially for brown goods (manufacturers tend to carry out aftersales service on white goods). Warranties are also very important (for larger durable goods), and the role of warranties is key to understanding pricing issues. Some retailers, it was argued in the report, do not make any return from the sale of electrical goods but only from the associated sale of warranties. Overlap of products sold by Currys and Dixons

Washing m achines Dryers Dishw ashers Refrigerators Freezers Cookers Microw aves H eating Vacu u m cleaners Irons Kettles Toasters Coffee m akers

Televisions Rad io cassettes H i-fi system s

Vid eo Record ers Personal hi-fis Telep hones

Satellite d ishes Car au d io Keyboard s

Cam eras Cam cord ers Personal organisers

Binocu lars H om e com p u ters Fax m achines

Lenses Electronic gam es

Retailers also compete through advertising and promotion, through which they aim to inform consumers that they offer quality and a good selection of products in the appropriate price range. A retailer who does not get his message to his customers will not be viable. The retailer needs a very visible shop window (prime high street location) and/or high levels of media advertising. This aspect of competition derives directly from the fact that consumers are not initially well informed about availability, relative prices and product quality. The fact that the major multiple retailers use national advertising and pricing policies as part of their competitive strategy is very important for market definition.

5.2.3 Merger issues

The MMC felt that the merger would lead to a significant reduction in competition in electrical retailing, and would as a consequence lead to higher prices. We have a lot of sympathy with this view, which concurs with the results of our analysis of the strategic competition across different economic markets. As discussed above, the MMC decided that the relevant geographical market was national, on the grounds that the electrical goods retailers involved Dixons, Currys and Comet all set national prices, and advertised both their stores and the prices of their products at a national level. We agree with the MMC that the national market is of key importance for the analysis of competition between the strategic groups in this industry (although it is also important to examine the effects of the merger on competition at the local level). In terms of the relevant retail market, the effects of the merger would depend on which market is being examined. For small domestic appliances, the effect would be negligible. In terms of large white goods, the increase in concentration would be substantial (each of the merging parties has roughly equal market shares in large white goods), but pricing would be strongly constrained by the electricity showrooms. For all other electrical goods, the increase in concentration would be less strong (DSG is already almost three times as strong on these as Comet), but there is little direct competition which might constrain the resulting pricing behaviour of the merged entity. In terms of product selection, the MMC concluded that the total range might well fall postmerger, on the grounds that the two retail chains would no longer need to compete in terms of product range. On the other hand, it is possible that the effect of reduced competition might be to differentiate the retailers more strongly in terms of product range, resulting in better choice for customers. Further analysis would have been required to resolve this question. In terms of entry barriers, the MMC rejected the argument put by Kingfisher that entry into the market was easy, and that this fact would constrain the pricing policy of the merged company. Although there were a large number of competitors, the MMC argued that history does not support the view that newcomers would succeed in penetrating the market to the extent necessary for them to become an effective competitor to the merged company, nor that other multiple chains [....] would expand into electrical retailing to any great extent. The new entrants could also be deterred by the cost and complexity of providing after-sales service. We are not entirely convinced by this, and further analysis of entry barriers (at both the local and the national level) would have been useful. For example, it could be argued that the merger would provoke entry by another competitor, or at least a significant increase in advertising and promotion by Rumbelows or other smaller multiple retailers.

Merger case study: Grand Metropolitan plc and William Hill Organisation Ltd In this case study, we evaluate the proposed merger between Grand Metropolitan plc and William Hill Organisation Limited. This merger, between two of the four largest chains of bookmakers, raised a number of important competition issues. The MMC considered the merger to operate against the public interest unless a number of recommendations were accepted. The chief concern of the MMC was with the absence of price competition and the existence of a number of legislative barriers to entry (licences) and barriers to competition at the local level (restrictions on advertising). The MMC judged that the crucial problem would be a reduction in competition in off-course betting at a local level, and thus that Grand Met should be required to divest certain betting offices: wherever there are former Mecca and William Hill betting offices within a quarter of a mile of each other, and where there are no other betting offices within a quarter of a mile of one of these offices. This would involve around 20 disposals, mostly in London. The MMC was also concerned with a number of arrangements in the industry that involved the big four chains of betting shops: C C C Provision of racecourse information through SIS, which is partly owned by bookmakers and the Racecourse Association; Organisation of greyhound races through subsidiaries of bookmakers; and Laying off with on-course bookmakers and thus influencing the starting price.

However, it did not recommend any changes with respect to these arrangements.

5.3.1 Assessment of market structure

There are around 6,000 bookmakers. The big four operate 35.7 per cent of betting shops and account for 60 per cent of turnover. This is a fairly concentrated industry when measured at the national level. The merger is between numbers 2 and 4 in the industry to create the second largest chain after Ladbrokes. Entry barriers are significant due to the regulatory restrictions that require a license to operate a betting shop, constrain the free choice of location, and restrict advertising that states the address of an individual betting shop. Dimensions of competition between bookmakers Bookmakers offer odds on the likelihood of an event occurring. They will offer odds taking into account the perceptions of punters. If several/many punters believe an event will occur with a greater degree of probability than the bookmaker indicates through his quoted odds, they will place a bet at fixed odds. Bookmakers, when taking bets at different odds, always try to balance their books so that they are not unduly exposed to risk and are guaranteed a margin.

5.3.2.1 Price
It is frequently believed that prices offered by betting shops are uniform throughout the country. While this is largely true, it is not completely true. C C C Ante-post prices can vary considerably (although these comprise only 2 per cent of bets). Deductions for multiple bets are sometimes discounted. Maximum limits, which in effect worsen the odds for big winners, differ from one betting shop to another.

The observation that starting prices (SPs) are uniform is correct. Deductions are also uniform. While the former may be the outcome of the market process, the latter is a convention built around the tax and levy system.

5.3.2.2 Geographical location

Geographic location is extremely important. Regular punters, especially, do not want to travel far to place a bet, and convenience is thus vital. Out-of-town bookmakers would have no customers. For credit betting, location plays no major role as all betting is done on the telephone. Location is only important in credit betting when is comes to assessing the creditworthiness of punters. Such information may be more easily available on a local basis.

5.3.2.3 Product selection

Selection of products is less important. There are some opportunities to offer more imaginative bets, but for the standard event (e.g. the 2.30 at Kempton) the products are pretty much the same.

5.3.2.4 Retailer service

Point of sale service in betting shops matters: the ambience, the running commentary, and the pictures from SIS, etc., are all very important to the enjoyment of betting. Until recently, legislative restrictions made it difficult to improve the ambience and attractiveness of betting shops. Advertising and promotion are highly regulated in this industry. Government regulations do not permit an individual betting shop to advertise its address. Only corporate advertising is permitted. This perverse regulation is probably one of the chief reasons for the high degree of concentration in this market. Any small bookmaker who wants to promote his services and find ways to communicate a new or improved service is seriously hampered in how he may do so. A small bookmaker relies entirely on word-of-mouth promotion and his local reputation. Larger bookmakers, who operate chains of betting shops, will find it easier to promote their activities and establish a brand name through general advertising (i.e. without putting in the addresses of their individual betting shops) or sponsorship of races. The sunk cost of taking out advertising space in the national racing press, for example, can be recovered across a large number of betting shops. Therefore the incentive to operate chains of betting shops that can

benefit from advertising is considerable and, in our view, is a determining factor of the structure of the betting industry, which has become increasingly concentrated.

5.3.3 Merger issues

As the market is characterised by absolute entry barriers at the local level (in the form of licences) and by advertising restrictions that make entry on a small scale difficult, any increase in market share by members of the strategic group of national chains of bookmakers may well translate into increased market power. In addition, the market is not characterised by price competition between betting shops, as most bets are done on a starting price basis, which governs all SP bets in the country. There are some limited elements of price competition in that maximum winnings differ between companies and because deductions for multiple bets are often granted. On the other hand, the high visibility of prices in the betting market significantly constrains independent market behaviour. The betting market is easy to collude in, given the local structure and existence of absolute entry barriers. Indeed, the uniform level of deductions, while justified by tax and levies, can easily be interpreted as a collusive arrangement. Straightforward application of tax would lead to a 8.8 per cent tax for all forms of betting. For horse race betting there is another 1.0 per cent of levy that needs to be collected. For other forms of betting where no levy applies, there is still a 10 per cent deduction. Why? Similarly, credit betting attracts a lower level of levy. Running a centralised credit operation is not obviously more expensive than running a betting shop in the High Street. On the contrary, it may well be cheaper. So why are deductions the same everywhere? These concerns are not new. In 1986, the industry was subject to a referral to the Restrictive Practices Court. This case related to a collusive agreement to restrict shop opening hours for shops operating in the same street and to agreements between the big four to co-ordinate shop closures. The adverse finding led to recommendations designed to increase competition between local betting shops, and are a clear indication that concerns over collusive practices are justified. The findings of the MMC that the merger of Grand Met and William Hill bookmakers would create a number of local monopoly situations appear to be justified in the light of the observations made above. The question is whether the MMC went far enough when recommending the divestment of 20 betting shops in areas where the two bookmakers had outlets within a quarter of a mile of each other. The existence of barriers to entry at the local level as well as at the national level, where the two chains of bookmakers compete in terms of advertising and promotion, would suggest an even closer scrutiny of the merger in terms of its negative impact on competition.

6.

Pricing issues

Pricing issues figure prominently in competition cases involving retailing. Apart from the classic cases of monopolistic and collusive pricing, there are issues to do with predatory pricing and discriminatory pricing. In some cases, pricing issues are directly linked with vertical issues: loss leading may be met by refusal to supply on the part of manufacturers; Recommended Retail Price (RRP) may be a method of facilitating collusion amongst retailers. This section examines: C C C C Price collusion; Predatory pricing; Price discrimination and tying/bundling; and Loss leading.

Suggested checklists of questions that might be asked are given in Appendix 1 to this report.

6.1

Price collusion

In Contact Lens Solutions (1993) the MMC concluded that the existence of RRPs enabled price co-ordination: Boots priced at RRPs, and this provided a shelter for others to do the same (indeed there was even some evidence of Boots forcing others to do the same). In Contraceptive Sheaths (1994), a similar case, there were two sets of RRPs: one set for small pharmacists and another (lower) set for larger customers. The aim of this was considered to be to improve the ease of collusion at the retail level, by allowing for a degree of heterogeneity amongst retailers. This in fact was successful for a long period, although collusion had broken down just before the MMC report, leading the MMC to conclude that RRPs, while anti-competitive in aim, were not anti-competitive in effect. 84 In The Supply of Recorded Music (1994), usually referred to as the CD enquiry, the DGFT made a referral to the MMC following a long standing campaign over the level of pricing of CDs in the UK when compared to the level of prices in the US. A House of Commons Select Committee found that prices of CDs in the UK were between 20-50 per cent higher and that record companies were abusing the right to stop parallel imports to maintain excessive prices. The MMC enquiry established that these allegations did not hold up to detailed scrutiny and cleared the record companies of any allegations of anticompetitive practices. While the main focus of the enquiry was centred on record companies, there were some lines of enquiry that dealt with the behaviour of record shops and other retailers of recorded music. These cases show that collusion is a relatively common worry in retailing enquiries. When collusion is explicit, there will often be documentation available which can be used as evidence. For example, in recent years, several explicit cartels have been discovered in the UK, particularly in the building materials sector. There have been few retailing cases in recent decades in which explicit collusion was even suspected, let alone found: in the case of The Supply of Petrol (1990), the UK retail market appeared to be protected from competitive pressures in some regions and locations, but no evidence of explicit

84

RRPs ease collusion, but are not sufficient for it. This may explain why, in Contact Lens Solutions, the MMC advocated structural changes to increase competition, rather than a ban on the use of RRP.

collusion could be discovered. Most UK competition policy enquiries into collusion are in fact concerned with implicit (or tacit) collusion, where explicit documentation is unlikely to be found and inference of collusion is more difficult.85 The Contact Lens Solutions reference to the MMC, for example, was initiated not least because of pricing issues that led to suspicions of implicit collusion. Implicit collusion is often considered especially likely in retailing. The main difficulty involved in maintaining a collusive set-up is that the various parties to it have incentives to cheat: given that some retailers are charging the high collusive price, it will be beneficial for any individual retailer to lower its price and steal market share from the others. In order to prevent this from happening, collusion will generally require both that cheating is observable and that a punishment scheme for cheating retailers (such as a price war) can be imposed and is damaging enough to deter cheating. Retailers must also somehow agree a price on which to collude without any explicit communication. For these reasons, collusion between parties will be easier when: C C C C The number of colluding retailers is small (so that co-ordination is easier); One or two retailers take on the role of price leader (again so that coordination is easier); Cheating on the collusive agreement is easy to observe (so that punishments can be carried out appropriately and swiftly); and There is some focal point price on which retailers can tacitly agree to collude.86

From this, we can deduce that some characteristics of retailing may be favourable to collusion between retailers, since: C The importance of one-stop shopping and the use of certain vertical restraints will both tend to reduce the number of retailers in the market, which improves their chances of effective collusion; In many retail markets there are just one or two clear market leaders, which may enable price leadership; In some markets, prices tend to be very visible (no secret discounts),

C C

85

86

Explicit and implicit collusion have been extensively analysed in the economic literature. They are perhaps best covered in Scherer (1980), Salop (1986), Schmalensee and Willig (1989), and Carlton and Perloff (1994, Chapters 6 and 7). A relevant case study can be found in Kwoka and White eds. (1994), Chapter 7 The Ethyl Case (1984) by G A Hay. A further problem with collusion is that, while colluding retailers would like to threaten ex ante to punish any cheating retailer, it may not be optimal ex post for them to do so. This is similar to the predatory pricing story described below, where an incumbent retailer wants to threaten ex ante to fight any entrant, but where it may not be optimal ex post for it to do so. The theoretical solution to the collusion problem is slightly different, though. Kreps et al (1982) show that collusion is sustainable in many situations as long as there is a small possibility that players are crazy (or congenitally nice), in that they would never cheat on a collusive situation even when it is profitable for them to do so. In this case, all the players try to signal that they are crazy in this way and collusion succeeds.

which means that detecting cheating on price is easy; 87 and C The use of recommended resale price (RRP) provides a focal point price on which retailers can collude (so that RRP in fact approximates RPM).

On the other hand, when competition is multi-dimensional, as in retailing, the nature of cheating may be complex and less easily observable. For example, a cheating retailer may not decide to cut price but to increase the quality of its services, a change which is harder to assess than a straight price change. Moreover, as a general rule, implicit collusion is only possible if there are effective entry barriers into the market. If there is a high likelihood of entry, then it very difficult to coordinate collusive agreement between all the actual and potential parties. If there are no significant barriers to entry into a retail market, there is therefore little reason to expect collusion. In order to assess whether or not there is implicit collusion in a retail market, we recommend a three step procedure. Step 1 involves examining the height of any entry barriers into the market.88 Generally, while the existence of entry barriers does not imply collusion, collusion can only be as effective as entry barriers are high. Step 2 involves determining whether there are any aspects of the retailer market and retailing practices that may facilitate implicit collusion among retailers. Step 3 involves looking at market price data and assessing whether there is any plausible explanation for the observed pricing behaviour, other than the existence of price collusion, and whether retailers would have sufficient incentives not to cheat on the collusive price. This three step procedure is discussed in more detail in Appendix 1.

6.2

Predatory pricing89

The idea behind predatory pricing is that a reduction of price in the short run will drive competing retailers out of the market, or discourage the entry of new retailers, and that this will in the long run allow incumbent retailers to charge higher prices than they would have been able to in the presence of greater competition. In Contraceptive Sheaths (1994), there were two potential cases of predatory pricing by the London Rubber Company (who own the Durex brand): its pricing to the NHS and its commission rates to major site owners for vending machines. The MMC argued that, because entry into both of these sectors is relatively easy, pricing could not be predatory. The OFT has also recently considered a complaint that various Regional Electricity Companies (RECs) were engaged in predatory pricing in their electrical retailing businesses. Specifically, it was claimed that the RECs were offering unprofitable credit terms to their customers financed by excessive profits from their electricity supply business. The DGFT concluded that no action should be taken, since the RECs share of the national market was too small for a predatory strategy to be feasible. Predatory pricing may be particularly difficult to detect in retailing, given that

87

88

89

For example, the use of large price boards outside petrol stations make it easier for local competitors to observe each others price changes at short notice. Immediate reactions to these price changes will frustrate any attempt to lower prices and attract customers away from competitors. Thus, price competition is unlikely to emerge. While we covered entry barriers above, we feel that it is important to reconsider them here, given that entry barriers tend to be crucial for implicit collusion. This section examines pure predatory pricing. The related issue of loss-leading is examined in a later section.

manufacturers provide differential discounts to retailers. This means that, if they want to, larger retailers may be able to drive smaller retailers out of the retail market without even making losses (although the retailer may not be achieving maximum profit margins). This means that a price-cost test of the sort suggested by Areeda and Turner (1975) will generally be of little use in identifying predatory pricing. 90 Moreover, even if pricing results in exit, it is sometimes difficult to discern whether it is really predatory, to the extent that it only drives out small and inefficient retailers. Indeed, low prices are a prime virtue of the competitive process and these small retailers might be driven out even without deliberate predatory pricing. For example, if there are two large retailers which both receive large discounts from manufacturers, and a competitive fringe of small retailers which do not, vigorous price competition between the two large retailers may have the effect of driving the small retailers out the market even without having this aim. Thus, in order to analyse predatory pricing in retailing, it is important to determine whether retailers are being driven out of the market as part of a natural process of rationalisation (shaking out the inefficient), or whether pricing is designed strategically with this aim. For example, supermarkets have recently been accused of trying to deliberately price specialist bakeries out of the market. It may well be the case that, as consumers tend to use supermarkets to an ever greater extent, there is no longer a role for local bakeries. However, it is also possible that this is not the case that there is still a role for local bakeries but that supermarkets are deliberately trying to force them out of the market through predatory pricing. In order to test for this possibility, it is important to ask the following two questions: C C Does the behaviour of the alleged predator deviate from its short run profit maximising behaviour in any way? Would predatory pricing in fact be a rational strategy? 91

If these questions can both be answered positively, then it provides fairly strong although not conclusive evidence of predation. The first of these questions is both difficult to answer and on its own is too easy a test for predation, in that it would class too many actions as predatory. The second test is more stringent. Predatory pricing is only a rational strategy if it will in the long run allow incumbent retailers to charge higher prices than they would have been able to in the presence of greater competition. However, it is not clear why rivals should leave the market in the short run if they realise that prices will rise again in the long run.92 Likewise, although an incumbent may want to threaten ex ante to price low in the face of new entry, in order to deter it, it will usually be profitable ex post for it raise price in the face of actual entry, unless it has some further motive for not doing so.

90

91

92

A further difficulty with applying price-cost tests in retailing is that, as Bliss (1988) shows, a multiproduct retailer will generally not do best by setting a fixed percentage mark-up, but will prefer to set higher mark-ups for products with lower elasticities of demand, and vice versa (the rationale for this type of behaviour is the same as that for Ramsey pricing in the tax literature). This means that, for a given product, it is not clear that price would lie above average variable costs, even in the absence of predatory pricing (this issue is considered in more detail below, under the heading of loss leading). The lack of such a rationale for predatory pricing was one of the principal criticisms levelled at the OFTs investigation into local bus services by Utton (1990). In Contraceptive Sheaths, for example, the London Rubber Company argued that its pricing to the NHS market could not be predatory, on the grounds that there were no barriers to entry, and thus that if it were to raise its price (to try and capture the gains from predatory pricing), it would lose market share dramatically.

Predatory pricing can, however, be a rational, and credible, entry deterrence strategy in at least two circumstances: C Imperfect capital markets: If capital markets are imperfect, there may be asymmetries between retailers in terms of access to funds, and these can be exacerbated by predatory pricing.93 In particular, smaller retailers may find it hard to raise funds in order to cover its short run losses, and so may not be able to last until prices eventually increase. Asymmetric information: When there is some asymmetric information between retailers, it may be possible for an incumbent retailer to use predatory pricing in the short run to build a reputation for aggressive predatory behaviour94, or to signal that it has low costs95.

In addition, predatory pricing will generally only be rational if there are sunk costs of exit or entry: if entry and exit are costless, then bakeries could simply exit the market for as long as predatory pricing lasted and then re-enter as soon as prices rose.

6.3

Price discrimination

When different types of consumer differ in their average willingness to pay for a good, and when resale between consumers is unlikely, it may be profitable for a retailer to charge different prices to the different consumer types, or maybe to bundle different products and services.96 Price discrimination is likely to be relatively common in retailing. One of the most important requirements for effective price discrimination is that resale between consumers will be minimal. Compared to other sectors, resale is relatively unlikely amongst retail consumers (because individual purchases tend to be too small to justify the necessary coordination between consumers of different types). This tends to ease price discrimination. Moreover, although retailers almost never have detailed information on the willingness to pay of any particular customer, they can still discriminate between broad consumer categories. For example, national retailers may charge higher prices in more affluent areas97, and retailers may provide discounts for regular customers, or students, or senior citizens.

93 94

95 96

See Bolton and Scharfstein (1990) and Tirole (1988) (pages 378-379). See Kreps and Wilson (1982) and Milgrom and Roberts (1982). It can be shown that even a tiny possibility that the incumbent might be aggressive by nature can make it rational for incumbents of all types to fight entry to deter future entrants. See Roberts (1986). Bundling, tying, and the provision of discounts are essentially forms of price discrimination, and are all effectively covered under this heading. For example, products may be offered at reduced price if sold as part of a bundle with other products, so that consumers who buy product A can purchase product B at a reduced price, or consumers who purchase product B must purchase product A at a higher price. Products being sold complete with warranties are an example of the latter form of bundling. Note that Whinston (1990) defines tying thus: A company engages in tying when it makes the sale or price of one of its products conditional upon the purchaser also buying some other product from it. The only difference between tying and bundling appears to be that bundling specifies quantities of both products (i.e. a bundle or package) as well as prices. Bundling of products is probably more common than tying in retailing. In the Supply of Beer case, the MMC noted large variations in the prices of beer between different regions of the UK.

97

Price discrimination is often relatively easy to observe. 98 However, the welfare effects are usually very difficult to judge. Price discrimination can have important negative effects. There is a consumption inefficiency due to unexploited opportunities for further trade. There is also a transfer of rents from consumers to retailers (as a result of the exploitation of market power).99 For example, in The Supply of Beer (1989), the MMC concluded that the large variations in the prices of beer between different regions of the UK were an attempt to maximise monopoly profits and were against the public interest. Perhaps the most important negative effect of price discrimination, though, is that it may be used to foreclose market segments. For example, if a large multi-product retailer supplies two product market segments, and if it faces competition in only one of these segments from retailers which only supply this segment, then it may choose to price low in the competitive market segment in order to drive out the competition in this segment (so that entry by a retailer only becomes feasible if it enters both segments). Another example is provided by the case of Contact Lens Solutions (1993). The MMC noted that the opticians recommendation of a CLS care system was typically followed by the wearer throughout the life of the lenses. Opticians thus both recommended and sold solutions, implying a potential conflict of interest. This tying of opticians services together with CLS resulted in insufficient cost advice being provided by opticians (both in terms of choices between CLS and in terms of the decision to wear lenses in the first place). In particular, those retailers who have own-brands (Boots, Dolland & Aitchison, and Specsavers) tended to recommend these own-brands, where appropriate, giving their products a strong advantage, and effectively foreclosing the market to other potential retailers. On the other hand, there are also important benefits of price discrimination. In particular, it can result in higher total sales (more consumers being served) than would be the case under uniform pricing.100 Indeed, it can even allow totally new markets to open up. For example, In Contraceptive Sheaths (1994), the MMC argued that price discrimination between the NHS market and the retailer/vending machine market was beneficial, on the grounds that the result of stopping price discrimination would be to bring NHS prices up to those elsewhere (which might result in this market closing altogether), rather than to reduce prices elsewhere. For tying, bundling and other forms of discounting, there is a further benefit: there are often economies of scale or scope in bundling products. For example, the fixed costs

98

99

100

Note, though, that when differential prices are due to supply-side differences (such as differences in property costs in different areas), this is not price discrimination. Price discrimination is always driven by demand-side side differences. In simple economic terms, this transfer of rents is welfare neutral, but it less likely to be neutral on political grounds. This can be shown in a simple example. Suppose that a product costs 10 to develop, and that there are two potential purchasers which value the product at 4 and 7 respectively. It is clearly optimal that the product should be developed (since the gains exceed the costs), and that price discrimination between the two purchasers will allow this. However, neither purchaser could afford for the product to be developed on his own, and if price is constrained to be the same for each purchaser, then the most that will go towards the products development is 8, which is not enough. Thus price discrimination can allow greater sales than would otherwise occur (in fact in this example, a whole market opens up: more usually the market will just expand). Bundling can work in a similar way. Suppose that there are now two products A and B both of which cost 10 to develop, and that one purchaser is willing to pay 4 for A and 7 for B while the second purchaser is willing to pay 7 for A and 4 for B. If the products must be sold separately at a uniform price, neither product will be developed, for the reason given above. However, if a bundle of the two products together can be offered to the purchasers, each would be willing to pay 11 for the bundle, which would cover the development costs.

involved in retailing mean that when more is sold, the average cost per unit sold falls. Thus, a discount related to the amount that a consumer spends is both justified by the cost structure and can allow better exploitation of resources. Products may also be bundled together to save the consumers time and effort. The benefit of package holidays, for example, is that it reduces the number of separate choices which the consumers need to make, while allowing certain economies to be achieved by the holiday providers. From the point of view of competition policy, it is often difficult to weigh up the costs and benefits of price discrimination, tying/bundling and discounting. It is clear that if price discrimination does not result in higher total sales or lower average costs, then it cannot be socially beneficial. Thus, if there are potential rivals which could easily enter the lower priced market segment if price discrimination by the incumbent retailer were prevented, then there will be no serious reduction in welfare from disallowing price discrimination. If in addition, it is thought that these potential rivals are being kept out of the market by price discrimination, there may even be a positive social gain from disallowing price discrimination. More generally, however, we may observe both increased sales and entry deterrence, in which case it is difficult to weigh up the pros and cons. The European Commission takes an extremely strong line on any form of price discrimination by a dominant firm, but in the UK and the US, the competition authorities are rather more lenient and are willing to weigh up the possible costs and benefits.

6.4

Loss leading

In retailing, more than in any other area of the economy, retailers tend to sell bundles of products and to stock large product ranges. When the products being purchased are relatively cheap, a consumer will not have strong incentives to shop around for each individual product, but will prefer to go to a single retailer which he knows will stock the desired products at reasonable prices. For some products, consumers may know exactly which retailer provides the best product at the best price. More generally, however, consumers have only very vague ideas of the relative qualities and prices of individual products, and in this case consumers tend to choose between retailers on the basis of their reputation for good product range and general low prices. Loss leading is effectively a method of gaining a reputation for general low prices under these circumstances. While consumers cannot compare the prices of every product sold by a multi-product retailer, they may be able to compare a limited number of product prices, and will infer from these limited price comparisons how the retailers prices compare more generally. By reducing the prices of particular products and then promoting/advertising these products and their prices, retailers encourage consumers to use these low price products to make their price comparisons with other retailers. 101 Loss leading as a purely promotional exercise does not require retailer market power and does not give rise to competition problems in the short term. The only problem in this case is that loss leading may distort consumers purchase decisions to the extent that it does not signal general price levels correctly. 102 In the longer term, however, loss leading may have destructive effects at both the retailer and the manufacturer levels (and
101

102

Note that loss leading does not necessarily mean that the retailer charges a price which is below what it pays for the product. It just means that the price is set (for promotional purposes) less high than would otherwise be the case (that is, the contribution of the product to the retailers fixed costs is lower than it would otherwise be). For example, stores which are generally more expensive may be better able to afford more dramatic price-cut promotions than generally cheaper stores.

especially if loss leading is being used for predatory as well as for promotional purposes103). These effects have led manufacturers to refuse to supply products to loss leading retailers. The destructive effects of long-term loss leading at the retailer level are straightforward. Retailers which provide a wide product range can cover any losses made through loss leading through increased sales on the rest of their range. Smaller retailers, though, which only provide a small part of the product range of the loss leading retailers, may be unable to match the loss leading price (for what might be one of their most important products), and may thus be driven out of the market, or at least put at a competitive disadvantage. It is less easy to see why manufacturers would object to loss leading using their products. Simple economics suggests that, for a given manufacturer price, manufacturers will do best when retailers sell as many of their products as possible. Loss leading and promotion by the retailer would thus be expected to raise manufacturer profits, rather than reduce them, at least in the short term. In the longer term, though loss leading may be destructive for manufacturers for three main reasons. C Switching of supplier: If smaller retailers cannot make an acceptable mark-up on the manufacturers product, they may switch to an alternative supplier which can provide them with a better mark-up, which will act to reduce manufacturers sales. Moreover, if there are economies of scale in distribution, the reduction in the number of outlets may make the current distribution network inefficient. Price as a signal of quality: When consumers are not sure about the quality of a good, its price may act as a signal to them of its quality. 104 If a low price signals low quality (as it is likely to, if it is not just a short run promotional price), then the image of the manufacturers product will be adversely affected by the loss leading. 105 Lack of incentives for retailer promotion: The retailers that carry out the loss leading clearly have incentives also to promote the product. However, other retailers, whose mark-ups are reduced by the loss leading, will be unwilling to engage in promotion of the product, and may have incentives to give it reduced (or less advantageous) shelf space.

These arguments seem to have been accepted. Indeed, Section 13 of the Resale Prices Act (1976) provides for a supplier to lawfully withhold supplies of goods from a retailer if he has reasonable cause to believe that the retailer has been using them as loss leaders.

103

104

That is, if loss leading is being used to drive out other retailers which cannot match the loss leading price, or at least to make them switch to a supplier of a less popular brand. See Milgrom and Roberts (1986). Their model shows that there are in fact two signalling effects of price. A low price may signal high quality, because only a high quality manufacturer would be able to extract enough consumer surplus in later periods to cover the cost of the initial low price. On the other hand, a low price may also signal low quality, due to the fact that low quality costs less to manufacture. This model sits well with the idea that in the short term low price may signal high quality, but that in the longer term it may signal low quality. In Black and Decker, the MMC rejected the argument that loss leading results in a lowering of brand image, on the grounds that manufacturers products would not be any use as promotional tools if their brand image were damaged, and thus that retailers have an incentive to maintain this brand image. However, this argument is flawed: the retailer can always switch to an alternative brand for its promotion, and anyway the manufacturer will have far more to gain from maintaining its brand image than will any given retailer.

105

This has meant that the focus of UK competition authorities has turned away from discussion about whether the above arguments hold true in any particular case, and towards the difficulty of assessing whether loss leading is actually occurring. When the retailers price for a product is less than the retailer actually paid for the product, there seems little doubt that loss leading is occurring. It is difficult to think of any justification for making an actual loss on a product unless it results in increased sales of products with positive price-cost mark-ups. 106 When a retailers price is at or above what the retailer paid for the product, however, the situation is less clear for three reasons. First, Bliss (1988) shows that a multi-product retailer will generally not do best by setting a fixed percentage mark-up, but will prefer to set higher mark-ups for products with lower elasticities of demand, and vice versa. The products which are supposedly chosen for loss leading tend to have high demand elasticities. Indeed, if consumers were relatively unresponsive to price (low demand elasticity), the product would be of little use as a loss leader. Blisss theory thus suggests that these products would tend to have low mark-ups anyway, even in the absence of loss leading. Second, the products which are supposedly chosen for loss leading tend to have strong manufacturer brand names. This means that manufacturers of these products are in stronger bargaining positions with retailers than are the manufacturers of weaker brands (or own-brand products), and thus retailers will tend to receive a lower share of total rents for these products (resulting in reduced retailer mark-ups). Third, the products which are supposedly chosen for loss leading tend to be relatively fast-selling products. This means that the costs of shelf space and inventory costs per unit sold are lower than for more slow-selling items, which again means that stores can afford to set lower mark-ups. These arguments show that it is very hard to distinguish between loss leading and the normal pricing of a high-elasticity, strongly-branded, fast-selling product. In addition, the cost structures and cost allocation systems of different retailers can vary substantially, so that any simple percentage mark-up test for loss leading which is valid for one retailer is unlikely to be valid for another. Moreover, the use of a general rule of this type is tantamount to RPM, which the Resale Prices Act specifically outlawed. All of these problems arose in the case of Black and Decker (1989). The MMC examined whether Black and Decker (B & D), whose power tools and workbenches had been used as loss leaders by certain large DIY retailers, was justified in refusing to supply any retailers whose gross retail margin was under 12.5 per cent. The MMC rejected the argument that loss leading results is a lowering of brand image, on the grounds that B & D products would not be any use as promotional tools if B & Ds brand image were damaged, and thus retailers have an incentive to maintain the brand image. The MMC was more convinced by the possible detrimental effects of loss leading on competition, and allowed that refusal to supply was an acceptable response by manufacturers. However, the use of any general rule for loss leading (such as the 12.5 per cent rule) was outlawed because of the problems associated with looking at gross margins.

106

The only other justification for selling a product at a loss in the short term is that it might attract new sellers to the product in the long term (when retail margins will again be positive). In this case, however, it is unlikely that the manufacturer would object.

7.

Vertical issues

UK competition authorities have dealt with numerous cases involving vertical restraints and relations between upstream suppliers and retailers. These covered various forms of vertical restraint, including: C C C Refusal to supply: Fine Fragrances (1993) Full line forcing: New Motor Cars (1992) Exclusivity arrangements: New Motor Cars (1992), Ice Cream (1994), and Contraceptive Sheaths (1994)

In addition, several cases have examined the importance of the countervailing market power of strong retailers when facing manufacturers. Examples include Kingfisher plc and Dixons Group plc (1990), and Contact Lens Solutions (1993). In this chapter, we give a brief description of the economics of vertical restraints in retailing. We then examine implications for the assessment of vertical issues.

7.1

The economics of vertical restraints

As stated in Chapter 2, the aim of vertical restraints is to maximise the joint profits of retailers and manufacturers in the face of divergent self-interest, or to share out these joint profits between the two levels. Indeed, it is generally assumed that retailers and manufacturers accept vertical restraints voluntarily (other than unilateral restraints such as refusal to supply or refusal to stock), and thus no individual vertical restraint will be ever imposed which is detrimental to either the manufacturer or retailer involved. 107 In some cases, the joint interest of manufacturers and retailers will correspond with that of consumers. For example, where vertical restraints aim to improve levels of retailer service, or to ensure high product quality, consumers may benefit. These are efficiency reasons for vertical restraints. However, in other cases, vertical relationships can be anticompetitive and harmful to consumers. For example, if the aim of vertical restraints is simply to maximise joint profits by raising end-prices to monopoly levels, say, or by preventing entry by potential competitors, consumers will lose out. The following subsections examine three main explanations for vertical restraints, which apply whatever the form of the vertical restraint: Efficiency motives; anti-competitive motives; and economic rent sharing.

7.1.1 Efficiency motives

Vertical restraints may be useful for overcoming divergent incentives: C C between manufacturers and retailers; between retailers;

107

Although note that Rasmusen et al (1991) show how vertical restraints may be individually beneficial but jointly detrimental: while each individual retailer does better through accepting the vertical restraint, all retailers collectively do worse than they would if none accepted the restraint.

between manufacturers;

7.1.1.1 Divergent incentives between manufacturers and retailers

Co-operation between manufacturer and retailer can be crucial for providing customers with the right products and the right levels and types of retailing activity, at the right sorts of prices. More generally, co-ordination between the two levels can be vital for maximising their joint profits. However, as was discussed above, the individual selfinterest of manufacturer and retailer can sometimes conflict with this joint interest. Vertical restraints can help solve this. A simple example of this is the issue of double marginalisation. When the manufacturer is selling at a price higher than marginal cost, it wants to sell as many units as possible. Under perfect competition in retailing, prices will be competed down to their competitive level, and output will be maximised, benefiting the manufacturer. However, when retailers have some market power, they may be able to set price above the competitive level, which reduces sales and so reduces the profits of the manufacturer. Because the retailers do not take this reduction in profit into account, prices in this situation will be higher than is in the joint interest of manufacturer and retailers. Vertical restraints such as quantity forcing, quantity discounts and recommended retail price can alleviate this problem, raising joint profits for retailers and manufacturers and also improving consumer welfare. This case is one where manufacturer and retailer have diverging incentives concerning pricing. The same story applies when they have diverging incentives on other aspects such as product quality and retailer service.108 For example, as long as manufacturer and retailer both stand to gain from any increase in the quality or promotion of the manufacturers product, then neither will individually have incentives to do the jointly profit maximising amount of quality improvement or promotion. General vertical restraints can help to solve such problems indirectly. For example, vertical restraints can reduce direct price competition, and so encourage competition on quality and promotion instead. However, when retailers and manufacturers are large enough to make monitoring compliance worthwhile, this problem is more often solved through more direct vertical constraints: from minimum promotion requirements and deals whereby the costs of advertising will be split between manufacturer and retailer according to the benefits each expect to receive from it, to direct intervention by the retailer in the upstream production process or by the manufacturer in the retailing process.

7.1.1.2 Divergent incentives between retailers

Promotional services provided by retailers on the behalf of manufacturers cannot be
108

For example, suppose that the manufacturer is selling at a price higher than marginal cost (making a profit A on each unit), and thus wants to sell as many units as possible. Retailers can increase the number of units sold by carrying out store promotions, or by giving the product superior shelf space or location within the store. In the absence of vertical restraints, the retailer will receive only the retail margin r on each extra unit sold, whereas the total joint profit on each is (r + A). The retailer will thus carry out too little sales promotion for joint profit maximisation. A further, and rather different, rationale for manufacturers use of vertical restraints is based on the fact that retailers may locate further apart than is optimal from a manufacturer's point of view, in order to reduce price competition between them (an idea which is drawn from Hotelling, 1929). Vertical restraints such as RRP can then be used to soften price competition between retailers and so encourage them to locate closer together. This rationale for vertical restraints is given in Mathewson and Winter (1986).

separately charged for and are therefore vulnerable to free-riding. Suppose that there were to exist car dealers which do not provide test drives and which can therefore afford to charge lower prices. In principle, consumers could then test drive a car at a car dealer which provides test drives, and then go and purchase the car from a cheaper car dealer which does not. In practice, this would not be a sustainable situation, because the car dealer which provides test drives would go out of business. Thus, in this simple example, if car dealers which do not provide test drives are allowed to exist, the eventual outcome will be that no car dealers provide test drives, and total car sales will be reduced (reducing the joint profits of manufacturer and retailers, and also damaging consumer welfare). Refusal to supply can solve this problem directly: the manufacturer can simply refuse to supply its product to any retailer which does not provide the appropriate retailing activities. Full line forcing can be a useful way of ensuring that retailers do not free-ride in terms of product range. Resale price maintenance can alleviate the problem by reducing the ability of retailers which do not provide the appropriate level of retailing activity to steal customers from those who do (this argument has been used in the case of books). Territorial exclusivity, meanwhile, can reduce the problem by reducing the ease with which consumers can switch between retailers.

Divergent incentives between manufacturers

Again, it is important to remember that many vertical issues are in fact symmetric between retailers and manufacturers. Suppose that there are various brands of a product, and that advertising any particular brand has positive spill-over effects on the other brands. In this situation, free-riding between manufacturers will result in too little advertising, which is damaging for both retailers and manufacturers. Exclusive dealing can alleviate this problem indirectly, but again direct intervention is more likely to be used as a solution.

7.1.2 Anti-competitive motives (and effects)

Not all vertical restraints are motivated by efficiency improvements, and even those that are may have anti-competitive effects. In terms of competition between retailers, where manufacturers have a choice, and where there are no efficiency gains to be made, manufacturers will tend to prefer more competition at the retail level rather than less. The reason is straightforward: for given manufacturer price, the manufacturer wants to sell as many products as possible, which is done when retail margins are as low as possible. This point has been used to argue that manufacturers would never want to ease collusion or even limit competition between retailers, except for efficiency reasons. In a traditional situation, where large manufacturers with high market power face small retailers with little market power, this argument may hold true. However, if retailers are large and have significant market power, as is now the case in many UK retail markets, there may be other, anti-competitive, reasons why manufacturers seek to promote collusion at the retail level. Suppose that there are a number of manufacturers who are competing for the custom of retailers. If one manufacturer is willing to facilitate collusion between retailers, through the use of RRP for example, then retailers will be more willing to stock that manufacturers product. Thus, competition between manufacturers for retail outlets may end up being in terms of the degree to which they are willing to restrict competition between retailers.

As well as anti-competitively restricting competition between retailers, vertical restraints may be used by a retailer to improve its competitive advantage vis--vis its rivals. For example, a retailer who requires exclusive supply (or encourages manufacturers to refuse to supply its competitors) can gain a competitive advantage in terms of product selection, and a manufacturer will be willing to fulfil this requirement if the retailer has sufficiently high market power. At the extreme, this use of vertical restraints may even prevent the entry of new competitors into the retail market by preventing access to the necessary products. Economists of the Chicago school 109 dispute this entry prevention point. They argue that vertical restraints and integration should not be a concern of antitrust policy because they are always motivated by considerations of efficiency, and any antitrust problems simply result from a lack of horizontal competition. For example, with respect to refusal to supply, the Chicago argument was that it is always more profitable for an incumbent monopolist manufacturer to provide access to key inputs to a more efficient rival at monopoly prices than to attempt to foreclose a potentially competitive market by refusing to supply. Hence refusal to supply would occur only if it were in the interests of productive efficiency. However, more sophisticated recent economic analyses have shown that, except in some special cases, foreclosure and exclusion through vertical restraints are both possible and rational. For example, analysis by Bolton and Whinston (1991, 1993) and Hart and Tirole (1990) provides formal and quite general conditions under which refusal to supply can be a rational and credible policy. Nevertheless, these papers still suggest that foreclosure effects are more likely to occur where one of the markets (manufacturer or retailer) is highly concentrated.

7.1.3 Rent sharing motives

Various vertical devices can be used to adjust the shares of economic rents received by manufacturers and retailers, including franchise fees, quantity discounting, or more general forms of discounting. The relative sharing of economic rents between retailers and manufacturers will depend on their relative bargaining power, which will in turn depend on their relative sizes, their relative contributions to value-added, and the intensity of competition at each level. Although rent sharing per se is not anti-competitive, it can have important anticompetitive consequences, especially when different retailers receive significantly different discounts. There are two reasons for this: C C differential discounting may be used to prevent discounts from manufacturers being passed onto consumers; and it may be used to prevent entry/induce exit at the retail level.

The first of these will depend on the form of competition that exists between retailers. If, for example, retail prices are constrained downwards by the unit costs of the highest cost retailer, then all retailers with lower unit costs than this marginal retailer will make profits. The total profits of the retail sector will thus be equal to the shaded area in the figure below. The more unequal the differential discounting between retailers, the higher the profits that accrue to this sector.

109

For examples of the Chicago school view, see Bork (1978) or Posner (1976, 1979).

pe rc i

Rilpft e ris to a uct no it s s

Rileindoeagsu e r oefdr s dot t s r r c inicn a e s (nagitct) ics u o r inn s e s

A more extreme example is that where the retail market is characterised by one large retailer (which receives large discounts) and a competitive fringe (which receives none).110 In this case, higher discounts to the large retailer are unlikely to get passed onto consumers, but instead will be taken as economic rents. Secondly, differential discounting may induce exit from the retail market. Consider the retail market just described with one large retailer and a competitive fringe. If the large retailer were instead to pass on some of its increased discount to consumers, it may well force the competitive fringe out of the market, since they are unable to compete with these new low prices. This may or may not be detrimental to consumer welfare: the benefits of lower prices would have to be weighed up against the reduction in consumer choice. However, if exit from the market is easier than entry into it, there is a serious risk that, after driving out the competitive fringe, the large retailer will be able to raise prices again. However, differential discounting will not always have such deleterious consequences. If price competition between retailers is sufficiently strong, then increased discounts will at least to some extent be passed onto consumers. Indeed, price competition provides part of the motivation for retailers trying to achieve higher discounts: the retailer which achieves the highest discounts will have a competitive advantage in terms of price competition.

110

This roughly describes the pharmacy retail market.

Thus, when retailers use their countervailing market power to negotiate for higher discounts from manufacturers and then compete these increased discounts away in price competition, they carry out a beneficial function from the point of view of consumers, in terms of reducing end-prices. This beneficial function of retailers was noted in the MMC and OFT reports on discounts to retailers (1981,1985) which argued that as long as there is sufficient competition at the retail level then increased discounts to retailers are a good thing.

7.2

Assessing vertical restraints

We showed in Chapter 2 that the form of vertical restraints has changed over time. Vertical restraints of the traditional form are rather blunt instruments, in that they achieve their primary aims only indirectly. The reason for using these indirect methods lies in monitoring costs. Historically, retailers tended to be small and local, while manufacturers were relatively large. This meant that, although manufacturers were in a position to impose general vertical restraints such as RRP and exclusive territories, the costs of monitoring compliance with specific contract conditions were too high to be worth incurring. As retailers have grown larger, two changes have been seen in the form of vertical restraints. First, monitoring costs have become less important relative to total turnover, which has resulted in manufacturers and retailers increasingly solving divergences of incentives between them more directly, through the use of specific agreements and contracts, and direct intervention, rather than through the more traditional vertical restraints. Indeed, the line between vertical intervention and vertical integration has been becoming more and more blurred: if a retailer makes most of the manufacturers investment and production decisions for him, then the retailer is effectively acting as the manufacturer, and there is no obvious difference between this and full vertical integration in terms of implications for competition policy. Second, it has become more common that retailers want to have some control over what manufacturers are doing, rather than vice versa, than was traditionally the case. Indeed, even where these traditional vertical restraints are used, they may not be being used for the traditional reasons. For example, refusal to supply is known as a method which can be instigated by manufacturers for overcoming free-rider problems among retailers. However, there have been recent allegations of retailers instigating refusal to supply, by forcing manufacturers to refuse to supply certain other retailers in order to reduce the effectiveness of these other retailers as competitors. In terms of competition policy in retailing, it is thus very important to examine all the ways in which retailers and manufacturers intervene in each others behaviour, and not just to examine the more traditional vertical restraints, such as RRP and refusal to supply. It is also very important to discover: which side instigated the restraint; C C C C C whether the other side accepted it willingly; whether any other retailers or manufacturers object; what the aims of the restraint seem to be; what the effects of the restraint are; and how much each side stands to gain from it.

The first three of these questions may be possible to answer through interviews. In terms of aims and effects, we have also distinguished three possible motives for vertical restraints: efficiency, anti-competitive, and economic rent sharing. a)Efficiency: When the incentives of retailers and manufacturers diverge (perhaps because they each receive only a share of economic rents, or perhaps because they have different information), vertical restraints can align their incentives. This will generally benefit both sides, and it will also often benefit consumers. These are efficiency motives for vertical restraints. b)Anti-competitive: Chapter 2 discussed various ways in which vertical restraints can be used purely anti-competitively, either to limit competition or to deter entry. c)Rent sharing: Franchise fees, quantity discounting, and general differential discounting are all methods of sharing economic rents between manufacturers and retailers. Own-brand products can also be an effective means of extracting manufacturers economic rents. This categorisation gives rises to a four step methodology for dealing with vertical issues. Step 1 examines whether the manufacturing and retail markets are competitive. If both are, then vertical restraints will not generally require intervention by competition. Step 2 examines whether the vertical restraint can be explained by efficiency gains or economic rent sharing. if not, they are likely to be anti-competitive. Step 3 looks at whether the restraint has any effects on horizontal competition. If not, there unlikely to be an anti-competitive effect. Finally Step 4 attempts to weigh up any positive efficiency or rent sharing effects against any negative effects on competition. This four step methodology is described in more detail in Appendix 1. The final step is generally only carried out by the MMC. The OFT will pass cases on to the MMC only if they fail Steps 1 to 3. Note that the suggested methodology says nothing about the form of vertical restraints, but rather focuses on their aims and effects. The idea that the form vertical restraints take is relatively unimportant was made famous by Mathewson and Winter (1986), who showed that various pairs of vertical restraints could be perfect substitutes. 111

7.3

Implications for recent cases

Vertical restraints
The MMC has generally been relatively lax on vertical restraints, giving a lot of weight to the positive efficiency effects. In Fine Fragrances (1993), the MMC accepted the argument that in order to maintain the high brand image of their products, perfume suppliers were justified in refusal to supply to Superdrug and Tesco, on the grounds that these retailers would have no positive impact on brand image themselves and would simply free-ride on the contributions to brand

111

In fact, this alleged equivalence of different kinds of vertical restraints holds only under very special circumstances. If, for example, uncertainty is introduced, then the insurance effects of different vertical restrictions have to be considered, and the risk preferences of manufacturers and retailers matter. However, the general point that the form of vertical restraints is unimportant holds true from the point of view of competition policy.

image made by current retailers. There was also however a clear anti-competitive effect that had to be weighed against this, and the OFT was correct to refer the case to the MMC. In New Motor Cars (1992), there were a variety of vertical restraints imposed on car dealers by manufacturers. In this case the MMC again had to weigh up the positive efficiency effects of the restraints and the negative anti-competitive effects. In fact, it is possible to argue that the MMC did not take a hard enough line in this case: C Car dealers objected that they were forced to take a suppliers whole range, when only parts of the range sold well. The MMC concluded that the forcing of the suppliers complete product range was acceptable, as an important and necessary part of the suppliers sales system. The use of exclusive territories was examined. Again the MMC the practice to continue, on the grounds that it was necessary to allow car dealers a sufficient margin to maintain their high standards. Car dealers objected that they that they were restricted from holding dealerships from competing suppliers. The MMC decided that restrictions on dealers holding competing dealerships at the same site were essential to ensure that the suppliers marque were sold effectively

In fact, one of the few recommendations that the MMC made in this case was rather peculiar. It recommended that competing dealerships at separate locations should be allowed, on the grounds that this would allow dealers to become bigger and thus to exert more negotiating power against the manufacturers. However, given that this would if anything reduce competition at the retail level, it is not at all clear that any benefits of this increased negotiating power would be passed onto consumers. In Ice Cream (1994), the two main suppliers of impulse ice cream (Birds Eye Walls Ltd and Nestl td) provided freezers to retailers free, on the condition that no other brand of ice cream was stocked in these freezers. The MMC decided that this practice did not act as a major barrier to entry, on the grounds that retailers could always terminate the agreement and acquire their own freezer (in which case they would also receive their ice cream more cheaply), or they could add a second freezer where space permitted (this was thought to be possible in around 80% of outlets). In fact, application of Step 2 might have helped in the case of Ice Cream (1994). The MMC decided in this case that the anti-competitive effects of freezer exclusivity were not strong enough to require intervention. However, they did not show any significant efficiency benefits which might have justified this vertical restraint. The MMC was more critical of vertical restraints in Contraceptive Sheaths (1994). The London Rubber Company had arrangements with at least three major chemists to stock only Durex condoms. Two of these said that they had decided to stop stocking Mates anyway, due to low sales, and the third said that it would soon have done so, so that behaviour was actually unchanged. However, Mates claimed to find the delistings puzzling and said that it had been far harder to sell Mates to these stores than seemed normal. The MMC decided that these agreements increased barriers to entry and required LRC to cease them.

Countervailing market power

The issue of the countervailing market power of grocery retailers was discussed directly

by the MMC in Discounts to Retailers (1981) and by the OFT in Competition and Retailing (1985). Both studies concluded that the practice of granting discriminatory discounts was part and parcel of developments which had been beneficial to competition and to the consumer, and that the general effect of the practice on the public interest over the recent past had not been harmful: Despite some further increase in concentration in grocery retailing since the MMCs report, competition in this sector is evidently still very strong, and in general lower buying prices have been passed on to the benefit of consumers. (OFT, 1985) It was emphasised however that this conclusion would remain valid only as long as there continued to be effective competition among both suppliers and retailers. This is not the case in all retailer markets, however. The issue of the bargaining power of big retailers arose in Kingfisher plc and Dixons Group plc (1990). A merger between these two groups would have formed a huge electrical goods retail group with a great deal of bargaining power, and an ability to get very high discounts from suppliers. Kingfisher suggested that this would not have anti-competitive effects, but that instead suppliers would be forced to grant to all retailers any improved terms. The MMC felt, though, that suppliers would instead seek to restore their own margins by selling to smaller retailers at higher prices or on less advantageous terms than would otherwise rule. Similarly, in Contact Lens Solutions, the big discounts given by suppliers to the larger retailers were not being passed onto consumers. Rather they just constituted a transfer of economic rents from suppliers to retailers.

Appendix 1

LE recommended checklists

As discussed in the main body of the report, we recommend a five stage approach to competition enquiries in retailing. 1. identification of competition issues 2. preliminary analysis of retailing: C C the characteristics of consumers the dimensions of competition between retailers

1. market definition 2. barriers to entry 3. competition assessment: C C C market structure pricing issues vertical issues

This Appendix provides checklists of questions for stages 2 to 5 that it is useful to ask under each of these stages (other than market definition and market structure).

Preliminary analysis of retailing

The characteristics of consumers
One of the characteristics of retail markets is that end-consumers tend to be relatively: C C C small (in the sense that the size of a given purchase forms a small part both of a consumers total expenditure and of the retailers total sales); immobile (in the sense that they are often not able or willing to travel long distances in order to purchase the appropriate product); and uninformed (the costs of becoming fully informed about each of the products and prices available in the market are too high for many consumers profitably to undertake).

In order to discover which of these characteristics are important in a given case, it is useful to ask the following questions: C C C How frequently do different consumers groups purchase the product, and do they tend to purchase it from the same retailer? How big is an individual purchase (relative to the average wage, and in terms of the average turnover of the retailer)? Do consumers generally make the purchase independently of other purchases, or are they likely to include it in a shopping trip. If the latter, how large is the average shopping trip?

Where do consumers tend to shop for the product in question (close to home/work, in town centres, in out-of-town retail sites, through mailorder, at home over the telephone), and why? How well informed are consumers about the product: i. ii. in terms of what prices are available where in the market; in terms of the range of products available in the market;

iii. in terms of which retailers sell which products; and iv. in terms of the quality and characteristics of products? C If consumers are informed about the product and market: i. ii. how do they get this information; how hard is it to collect;

iii. is it provided freely; and iv. are published reports available (such as Which? reports) or is reputation crucial?

Dimensions of competition between retailers

In Chapter 2, we separated out four dimensions of competition in retailing. 1. 2. 3. 4. price geographical location product selection (the gatekeeper function) level and quality of retailer service (including advertising and promotion)

In order to assess which of these four dimensions are important in any particular enquiry, and the level at which competition takes place (for example, is competition in price carried out at a national level, with national pricing policies, or at a local level), it is useful to ask some of the questions presented below: 112

a)

Price levels and costs

C C C How wide a range of margins and final retail prices for apparently similar products can be observed? Do manufacturers set RRPs, and are these generally followed? Do any particular kinds of retailers tend to sell apparently similar products at lower (or higher) prices than others?

112

Note that many of these questions will recur later in this chapter, since they may tell us about barriers to entry and other aspects of market behaviour, as well as dimensions of competition.

C C C C C C

Are consumers price responsive? What factors tend to influence retailing costs? Are mark-ups the same (in percentage terms) for all products sold by the retailer(s)? Is there a stable relationship between retail prices and manufacturer/wholesale prices? Are retailers integrated upstream into either distribution or manufacture, and is this mainly for efficiency reasons? Are prices set nationally or locally? (the existence of national price lists or mark-up structures would be evidence of the former 113, as would national advertising which included price information) Is there any evidence of price wars, and are these local or national? Is there evidence of prices remaining sticky, in the face of cost changes? Is there evidence of price leadership by larger retailers (either in terms of raising price to above the competitive level, or in terms of competing price down to below levels that would otherwise be chosen by smaller retailers)? Is there any evidence of retailers selling a product at a price which is lower than (i) the cost of that product to other retailers, or (ii) the cost of that product to itself? What sort of discounting occurs in the market? Is it simple price cutting or are price cuts hidden in other offers (such as three for the price of two offers, for example)?

C C C

b)

Geographical location
C C C C C C Do retailers of similar goods tend to cluster, or spread out in geographical space? How high are property costs as a proportion of total retailing costs? What are the differentials between rents (or imputed rents) in different retail sites? Is there any evidence of retailers buying up sites well in advance of using them? Are retail chains concentrated in particular regions of the country or spread across the country? Do consumers tend to walk to purchase the product, so that location

113

Although in some industries you get national price lists but local discounting, so that prices are not effectively set nation-wide.

close to offices/homes is very important? C Do they tend to drive, so that parking space is very important, often resulting in location out-of-town?

c)

Product selection (the gatekeeper function of retailers)

C C In national chains, is product range chosen locally or nationally? Do retailers tend to focus on selling similar products (e.g. hi-fi shops and clothes shops), or do they tend to sell many different types of products (e.g. supermarkets)? Do retailers tend to sell products which differ horizontally (e.g. clothes shops) or vertically (e.g. hi-fis)? Has there been a trend in the market toward greater product range? Do retailers tend to cluster, or spread out in product space? Are there specialists which focus on one particular section of the product range (niche operators)? If so, how successful are they? Are there any vertical restraints restricting in any way the product range stocked (such as full-line forcing or refusal to supply)? Do retailers engage in bundling or tying of products (for example three for the price of two offers and free with ... offers)?

C C C C C C

d)

Retailer service, including advertising and promotion

C C C C C C How important are staff costs relative to product costs? Are point of sales services important to consumers? How important to consumers are quality assurances/reputation? Can the products in the market be bought via mail-order? If so, what proportion of total sales are via mail-order? Are there any kinds of quality certification or compensation schemes? How strong are the brand names of the products, how strong are the brand names of the retailers, and which tends to be more important? (consumer brand awareness surveys may be useful here) Do retailers supply own-brand versions of brand-name products? If own-brand versions are offered, what share of the total market do they account for and do they compete at all levels of quality or just the lower quality end of the market? How large a share advertising/promotion? of total retail costs consists of

C C

C C

Are retail advertising campaigns national or local? Do they contain price information or product range information?

Barriers to entry
The following lists of questions can be helpful for assessing barriers to entry.

Legal and regulatory restrictions

C are there any legal and regulatory restrictions to entry into the retail market, in terms of quality and safety regulations, restrictions on retailer type, restrictions on retailer numbers, or restrictions on advertising?

Access to retail sites

C C C C C C C How high are property costs as a proportion of total costs? What are the differentials between rents (or imputed rents) in different retail sites? Are there major obstacles to obtaining planning permission for new sites. Is planning permission transferable? Is there any evidence of retailers buying up sites well in advance of using them? How important is geographical location for consumers choices between retailers? How important a barrier to entry do retailers consider access to retail sites to be? How strongly are consumers choices between retailers affected by geographical location/availability of parking facilities?

Economies of scale and scope

In order to examine the importance of sunk costs as a barrier to entry, two sets of questions can be asked. The first set examines the cost structure of the incumbent(s). C C C How large are the various economies of scale and scope in retailing (i) at a store level, and (ii) at a national level? How high are retailers current sales, and how large is the total potential market (i) at a store level, and (ii) at a national level? What is proportion of investment in these economies is sunk (i) at a store level, and (ii) at a national level? (For example, how costly would it be to scale down retail operations, or even exit the market?) How sunk are these costs (short-term or long-term)? (For example,

if there is a vibrant market in out-of-town retail sites, the costs of increased floor space may be easy to recoup. On the other hand, it may be less easy to sell off a highly retailer-specific distribution network). The second set attempts to gauge more directly what would happen post-entry C C C What is the nature and what are the instruments of market competition (see the preliminary analysis)? How has the market reacted to entry in the past (in terms of price wars, accommodation, and collusion)? How has the market reacted to exit in the past (in terms of price increases, output reductions, and the re-establishment of stable or collusive pricing strategies)?

Advertising and promotion

In order to assess how important advertising and promotion are as barriers to entry in a particular retail market, we can ask the following questions. C C How important are advertising and promotion by incumbents (in terms of total costs, for example)? How strong are the incumbent retailers brand names, in terms of consumer awareness? (Information on this may be available through consumer surveys) How much initial advertising and promotion was carried out by previous entrants to the market? How important are information asymmetries between consumers and retailers (that is, how strongly are seller reputation and reliability valued by consumers)? Is reputation capital (retailer brand image) transferable between retail markets (allowing entry from one retail market into another)? Has there been a history of this type of entry?

C C

Goodwill and loyalty

In order to assess the importance of switching costs as a barrier to entry, it is thus worth asking the following questions. C C C Do consumers tend to shop around, or do they tend to stick to the same retailer(s)? And if the latter, why? Do consumers have good information about all the retailers in the relevant market, or would they have to search? Do retailers try artificially to create customer loyalty through points schemes of some sort? And if so, are the reward schemes linear, or do they offer disproportionate rewards for larger numbers of points collected?

Customer loyalty/goodwill will again be a greater barrier to entry from some directions than from others. For example, goodwill may difficult to build up from scratch, but may be easily transferable from one retail market into another.

Product proliferation and retailer differentiation

The following questions may be useful in assessing these issues. C C C C Are retailers in the market highly differentiated? How costly would it be for an incumbent retailer to remove itself, or one of its products, from the market entirely? How costly would it be for an incumbent retailer to change the market positioning of itself or one of its products? Has there been a history of such repositioning and how successful has it been?

Competition assessment
Pricing issues 1. Price collusion
In order to assess whether or not there is implicit collusion in a retail market, we recommend a three step procedure. Step 1 involves re-examining the height of any entry barriers into the market. Generally, while the existence of entry barriers does not imply collusion, collusion can only be as effective as entry barriers are high. Step 2 involves determining whether there are any practices that may facilitate collusion among retailers. In order to detect practices which facilitate collusion in a particular retail market, the following kind of questions might be useful. C C C C Are there few enough retailers for co-ordination to be feasible? Are there one or two clear market leaders? Are their prices clearly visible to competitors? Do retailers follow RRPs? Is price competition important (collusion on prices is more difficult if retailers compete through the other strategic dimensions such as quality of services and product portfolio)? Are prices displayed prominently? (this would ease detection of cheating) Are retailer percentage mark-ups fixed across different products? (it may be easier for retailers to collude on a single percentage mark-up than to co-ordinate on a whole series of different prices for different

C C

products) C Do any retailers promise to never knowingly be undersold? (this may stop any competitor from engaging in price competition, for fear of an immediate reaction that would cancel out any advantage that the price cut might have yielded).

Evidence of such practices is obviously not sufficient to infer price collusion. Indeed, in many cases (such as the never knowingly undersold offer), they may be an instrument of price competition. However, the absence of any such practices might lead one to deduce that collusion is unlikely (without needing to progress to Step 3). Step 3 involves looking at market price data and asking the following questions: a) Is there any plausible explanation for the observed price behaviour, other than the existence of price collusion? If we were observing collusion, would retailers have sufficient incentives not to cheat on the collusive price (that is, are there credible punishment strategies that would make it optimal for them not to cheat in the short run)?

b)

In terms of answering question (a), a traditional method of detecting collusion was to test for price parallelism and high profits. Price parallelism may be equally a result of competition, but profitability should be low. The timing of price changes relative to cost changes may also be important: under competition prices should change immediately, whereas under collusion they may be sticky. 114 Evidence of price leadership is stronger, and was used by the MMC enquiry into White Salt. 115 But it is often difficult to find conclusive evidence on this, unless the parties are honest about it, partly because it can be hard to show statistically that one retailers price choice causes the price choices of others in any way,116 and partly because the identity of the price leader often changes over time. Evidence of different pricing regimes may be stronger: this would be more difficult to explain other than a result of price collusion combined with periodic breakdowns in price collusion.117 Answering question (b) is more complicated, and is likely to require information on costs as well as on prices. The key question is whether there exist possible threats of punishment in the face of cheating that would be credible. Recent economic theory has focused on the issue of renegotiation proofness: if cheating happens, will retailers have an incentive ex post to carry out the punishment or would they prefer to renegotiate the implicit contract? This suggests that collusion will only be successful in a particular market under fairly stringent conditions on market and retailer-specific parameters. 118

114

115 116 117

118

One reason for sticky pricing under collusion is that it takes time for retailers to co-ordinate on a new price. A second reason is that, in the absence of full information, a retailer may not know whether a given change in costs is common to all retailers in the market or specific to it. To the extent that the retailer thinks that the change is specific to it, then it will not want to change its price in case the change is though to be an act of cheating by other retailers (leading to a price war). Thus collusive prices may not move until retailers have ascertained that there has been a change in common costs. For an interesting analysis of the Salt duopoly case, see Rees (1993a). The use of Granger causality tests can help to alleviate this problem. Green and Porter (1984) show why, in the presence of a degree of asymmetric information between colluding firms about demand and supply conditions, we would expect to see co-operation over prices may then be punctuated by occasional price wars, or breakdowns in co-operation. See Rees (1993b) for a summary of some of the possible punishment strategies and their credibility.

Step 3 is difficult to apply. This means that it is often difficult to make a strong argument for the existence of price collusion, especially when there is no available documentary evidence. Moreover, even if retailers do seem to be colluding, it is not clear how such collusion can be remedied, especially since fines are not possible in the UK.

2. Predatory pricing
In order to test for predatory pricing it is important to ask the following two questions: 1. Does the behaviour of the alleged predator deviate from its short run profit maximising behaviour in any way? Would predatory pricing in fact be a rational strategy? 119

2.

For this, the following questions may be useful steps: C What sort of retailers are being driven out of the market (in terms of how big they are, what market segments they compete in, whether they are vertically integrated)? What are relative cost structures of incumbents and exiters. How high are the sunk costs of exit? How high are the sunk costs of entry (both for current exiters and for other kinds of entrants)? Are the exiters constrained by capital requirements? What are the expectations of exiters (and other potential future entrants) about the level of incumbents costs and the likelihood of aggressive behaviour by the incumbent in the future?

C C C C C

3. Price discrimination
In order to judge whether price discrimination (of whatever form) is on balance beneficial or detrimental to welfare, the following questions may be useful: C C Are there potential competitors into the lower price market segment? Is the cost structure of the incumbent such that it recoups most of its fixed costs in the uncompeted markets, so that, in a market where it faces competitors, it only needs to cover the incremental costs of serving that market? Do consumers benefit in terms of time and effort from any bundling of products? If the incumbent were to be forced to charge an identical price in each market, what would the profit-maximising price be, and would this result in the closure of either market? (this would require relatively sophisticated analysis of the retailers cost structure and demand

C C

119

The lack of such a rationale for predatory pricing was one of the principal criticisms levelled at the OFTs investigation into local bus services by Utton (1990).

conditions)

4. Loss leading
We agree with the MMC decision that general tests of loss leading (of the 12.5% mark-up type) should be outlawed. However, the MMC did not make clear how one might test for loss leading in any specific case. We suggest that the best way of doing this is firstly to examine whether the particular retailer is setting the price of a particular product with a purpose other than making a profit on the sale of that product, and secondly to determine whether we actually observe any of the supposed harmful effects of loss leading for manufacturers: C C C Switching of supplier; Price as a signal of quality; and Lack of incentives for retailer promotion. 120

Only if this can be shown, should refusal to supply ever be allowed. It also important that the manufacturer only threaten the instigator(s) of the loss leading with refusal to supply. If the manufacturer refuses to supply retailers which are merely following the price leadership of others (in order to maintain sales), then it will not cure the loss leading and will harm exactly those retailers which are anyway put most at risk by the loss leading. For this reason, we suggest a further condition that must be satisfied before refusal to supply is allowed: the retailer must be promoting the low price in some way and must have the lowest (or joint lowest) price of any retailer.

Vertical issues
We suggest a four step methodology for dealing with vertical issues: Step 1: Anti-competitive effects are more likely to be present where one of the markets (manufacturer or retailer) is highly concentrated, and unlikely to be present where both markets are competitive. Thus, if both the manufacturing and retail markets are competitive, vertical restraints will not generally require intervention by competition authorities (no need to progress to Step 2). Step 2: If there is no explanation for a vertical restraint in terms of significant efficiency gains or rent sharing, then it is almost certainly anti-competitive (if effective), and needs addressing (no need to progress to Step 3). 121 Step 3: As Kay (1990) and Waterson (1993) point out, vertical restraints are rarely detrimental to welfare unless they have adverse effects on horizontal competition. Thus, where a vertical restraint has no effects on horizontal competition, then we can presume that its motivation is efficiency that it is beneficial (no need to

120

121

Evidence about loss of image can be gained from consumer surveys, and evidence on why retailers switched to other suppliers can be gained by interviewing some such retailers. This step might have helped in the case of Ice Cream (1994). The MMC decided in this case that the anticompetitive effects of freezer exclusivity were not strong enough to require intervention. However, they did not show any significant efficiency benefits which might have justified this vertical restraint .

progress to Step 4).122 Step 4: Steps 1 to 3 enable us to separate out some vertical restraints as being either definitely bad or definitely not bad for consumers. However, many other vertical restraints will remain: vertical restraints which do have adverse effects on horizontal competition (in any dimension), but which also have significant efficiency gains or rent sharing benefits. In such situations, vertical restraints must be examined on a case by case basis, the aim being to weigh up the positive efficiency or rent sharing effects against the negative effects on competition. Note that the above four step methodology does not focus at all on the form of vertical restraints, but rather on their aims and effects.

122

Note that it is important to look for adverse effects on all dimensions of horizontal competition, and not just price competition.

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