Retail rip-off – what the milk market should teach us about regulating the marketplace

Dairy farmers are back in the news; the processors who buy their production to sell on to supermarkets and food manufacturers want to push through a substantial price reduction that will see most farmers getting paid well below their cost of production.   Clearly this is not sustainable; if the processors succeed many farmers will be forced out of business, inter alia increasing our trade deficit in dairy products despite our having one of the world’s best climates for it.

To the extent that imports are involved I would bet a substantial amount that they are driven by lower welfare standards overseas and/or devious transfer pricing schemes whereby most of the profit ‘just happens’ (/sarc) to arise in subsidiary companies based in tax havens that provide a ‘service’ but never actually handle the milk at all.   Clearly, this is enormously beneficial to those involved but, equally clearly, it’s not in the public interest.

The problem is not that milk is ‘too cheap’.  Rather it is because well over 100% of the profit in the industry that should be equitably spread through the supply chain has been appropriated by the buyers.  (It’s over 100% since the farmers’ loss adds to the buyers’ profits).   They are able to do this because the supermarkets at the top of the food chain have the power to dictate terms so forming an effective oligopsony as described in an earlier post.   This has enabled them to pump up gross margins year by year; they rip off consumers while pretending to be their friend.

On the figures provided by the BBC adjusted to a single litre (and which are consistent with the time series included in my earlier post – see above link) supermarket make a gross profit of around 15 pence/litre which is nearly 30% of the selling price.   The BBC lamely ducks the issue of how much of this makes it to the bottom line as net profit but we can make a reasonable guess.  Logistics, store overheads etc. will all be minimal as it’s handled in bulk and sales are predictable.  Also we know (earlier post) that in the mid 1990s supermarkets got by on gross margins of only 1 or 2 pence.  So we can be very sure that the vast majority of the gross profit translates into net profit meaning that the supermarkets are achieving a ‘economic rent’ (roughly the excess profit above what they would get in a genuinely free market) of at least 12 pence per litre or around 25% of the selling price.

That is HUGE; if the margins on other goods are broadly similar (and I think many are) then this is a big part of the cost of living – especially for those on limited incomes.

So what is to be done?  If you are a plutocrat then nothing; for everyone else reducing prices raised by oligopoly is an even bigger prize than increasing personal allowances for the low paid.   Getting retail right also has a very direct bearing on other issues including Clone Towns and Mary Portas’ Review of the future of high streets.  But what can be done?

Any solution must start from the fact that the core issue is an imbalance of power.  So, for instance, suggestions that producers should differentiate their product miss the point – some limited differentiation around the edges may be possible but milk is fundamentally a commodity product.  Ditto an ombudsman or Food Market Regulator: having someone looking over the supermarkets shoulder, so to speak, may lead to limited interventions but it leaves the bad dynamics in place.

The first thing to say is that size is a problem in itself.  Retailing is a complex and demanding business but not exactly rocket science.  Nor does it require global companies with the resources required to design a new jetliner or get a new drug to market.   But it does benefit from economies of scale – largely (though not entirely) because the bigger you are the easier it is to bully producers – which means that the big get bigger and the small go extinct unless they can hang on in some niche.   Therefore left to its own devices a retail sector will evolve into an oligopoly where a small handful of large firms, all with similar cost structures, dominates the market.  In effect, regulation of the marketplace becomes privatised for the benefit of the biggest participants and freedom to evolve without limit in response to the market’s internal dynamics eventually ends in a market that is neither free nor fair.

So, the first conclusion is that the size of retailers should be limited.  This could be done in several ways, for instance by legislating that retailers must divest operations above a market share of, say, 20% in any one local authority area or 5% nationally.

The other way that retailing has traditionally been regulated is by mandating an equal price at either the wholesale level (US practice) or the retail level (UK practice).

The US Robinson-Patman Act  (and see also here) prohibited price discrimination by, in simple terms, requiring that the same price and other terms be given to all purchasers of goods for resale except insofar as the cost of supply is genuinely different.  The effect is to put all retailers on a level playing field with respect to their purchases.   The most obvious consequence is that large and small retailers can coexist which means that they are all kept honest by competitive pressure; many corner stores would think themselves in heaven to get ADSA’s margins and would gladly undercut them to increase sales – provided they could buy competitively!  A less obvious consequence is that producers who depend in large part on selling to retailers are not under the bully pressure that has characterised the UK in recent years; there is no particular advantage for a strong retailer to beat them into the ground as the retailer gets no advantage from so doing – any lower cost they negotiate has to be given equally to other retailers.  Another result is that it helps maintain a reservoir of small firms – and small firms are almost always the most innovative.

One of Reagan’s first actions on becoming President was to eviscerate enforcement of antitrust (i.e. anti monopoly) legislation to allow brute force to rule in the marketplace.   The fallout from this has been one of the biggest drivers in the subsequent growth of inequality.

In the UK regulation was accomplished by Retail Price Maintenance (RPM) until the 1964 Resale Prices Act which made most such agreements illegal.  (Libertarians ought to – but mostly don’t as far as I know – object to the RPA’s  flouting of privity of contract.)   RPM put the onus on producers to set competitive prices vis-a-vis their rivals while helping preserve a diverse retail scene but large retailers can still get better terms.  Absent RPM producers have no control over price which compromises their marketing and puts most on the back foot.   Interestingly, RPM survived for books until 1995 since when its demise has helped drive a huge concentration in retailing matched by a corresponding defensive concentration in publishing despite which most publishers are over a barrel, held to ransom by the few surviving retailers.

So, we face a stark choice; if we want a competitive market in goods we have to legislate to create and maintain a competitive marketplace.  If we don’t restore effective competition in the marketplace we can’t have a properly functioning market in goods.

 

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