Category: Economics for Business: 8e Ch 17

An earlier post on this site described a recent row between Tesco and Unilever that erupted when Unilever attempted to raise the prices it charges Tesco for its products. Unilever justified this because its costs have increased as a result of the UK currency depreciation following the Brexit decision.

It also appears that more general concerns that the fall in the value of sterling would lead to higher retail prices were prevalent around the time that the Tesco Unilever dispute came to light. Former Sainsbury’s boss, Justin King, made clear that British shoppers should be prepared for higher prices. He also said that:

Retailers’ margins are already squeezed. So there is no room to absorb input price pressures and costs will need to be passed on. But no one wants to be the first to break cover. No business wants to be the first to blame Brexit for a rise in prices. But once someone does, there will be a flood of companies because they will all be suffering.

It is interesting to consider further why the Tesco and Unilever case was the first to make the headlines and why their dispute was resolved so quickly. In addition, what are the more general implications for the retail prices consumers will have to pay?

Arguably, Unilever saw itself as having a strong hand in negotiations with Tesco because its product portfolio includes a wide variety of must-stock brands, including Pot Noodles, Marmite and Persil, that are found in 98% of UK households..

Unilever has been criticised for using the currency devaluation as an excuse to justify charging Tesco more, since most of its products are made in the UK. However, Unilever was quick to point outthat commodities it uses in the manufacture of products are priced in US dollars, so the currency devaluation can still affect the cost of products that it manufactures in the UK. In addition, Unilever’s chief financial officer, Graeme Pitkethly, insisted that price increases due to rising costs were a normal part of doing business:

We are taking price increases in the UK. That is a normal devaluation-led cycle.

On the other hand, even if the cost increases faced by Unilever are genuine, it is interesting to speculate whether it would have been so quick to adjust its prices downwards in response to a currency appreciation. After all, a commonly observed phenomenon across a range of markets is ‘rockets and feathers’ pricing behaviour i.e. prices going up from a cost increase more quickly than they go down following an equivalent cost decrease.

Compared to Unilever, some other suppliers are likely to have less bargaining power – in particular, those competing in highly fragmented markets and those producing less branded products. In such markets the suppliers may be forced to accept cost increases. For example, almost 50% of butter and cheese consumed in the UK comes from milk sourced from EU markets. Protecting such suppliers is one of the key roles of the Grocery code of conduct that the UK competition agency has put in place.

From Tesco’s point of view it will have benefited from good publicity by doing its best to protect consumers from price hikes. Helen Dickinson, chief executive of the British Retail Consortium, said:

Retailers are firmly on the side of consumers in negotiating with suppliers and improving efficiencies in the supply chain to control the inflationary pressure that is building through the devaluation of the pound.

However, it is also clear that Tesco had its own motives for resisting increased costs for Unilever’s products. In such situations both supplier and retailer should be keen to avoid a situation where they both impose their own substantial mark-ups at each stage of the supply chain. It is well established that this creates a double mark-up and not only harms consumers, but also the supplier and retailer themselves. Instead, the firms have an incentive to use more complex contractual arrangements to solve the problem. For example, suppliers may pay slotting allowances to get a place on the retailers’ shelves in exchange for lower retail mark-ups.

It has also been claimed that cutthroat competition in the supermarket industry, especially from discounter retailers Aldi and Lidl, made Tesco particularly keen to prevent price rises. Some arguments suggest that these discounters will be best placed to benefit from the currency devaluation as they sell more own brands, have a limited range, the leanest supply chains and benefit from substantial economies of scale. On the other hand, they source more of their products from abroad and it has been suggested that:

A fall in sterling will push prices up for everyone who sources products from Europe, but Aldi and Lidl will be affected more than most.

One prediction suggests that the overall impact of the currency depreciation on food prices will be an increase of around 3%. This may be particularly worrisome given concerns that the impact will fall most heavily on benefit claimants and other low-income households.

Outside of the food industry, Mike Rake, the chairman of BT, has highlighted the fact that:

Imported mobile phones and broadband home hubs were already 10% more expensive and the cost would have to be passed on to consumers in the near future.

It is therefore clear that the currency devaluation has the potential to create substantial tensions in the supply-chain agreements across a range of markets. The impact on the firms involved and on consumers will depend upon a wide range of factors, including the competitiveness of the markets, the nature of the firms involved and their bargaining power. Furthermore, evidence from an earlier currency depreciation in Latin America makes clear that the price elasticity of demand will be another factor that determines the impact price rises have.

Finally, it is also worth noting that a potential flip side of the currency depreciation is a boost for UK exports. However, it has been suggested that the manufacturing potential to take advantage of this in the UK is limited. In addition, even the manufacturing that does take place, for example in the car industry, often relies on components imported from abroad.

Articles

The Brexiteers’ Marmite conspiracy theories exposed their utter ignorance of how markets really work Independent, Ben Chu (16/10/16)
Tesco price dispute sends Unilever brand perceptions tumbling Marketing Week, Leonie Roderick (17/10/16)
Unilever and Tesco both benefit from their price row, but Brexit will bring more pain Marketing Week, Mark Ritson (19/10/16)
Why the Tesco v Unilever feud was good for British business campaign, Helen Edwards (20/10/16)

Questions

  1. What are some of the factors that affect a supplier’s bargaining power?
  2. How might the discount retailers respond to the currency devaluation?
  3. Use the figures from Latin America in the article cited above to calculate the price elasticity of demand.
  4. Explain why the price elasticity of demand is an important determinant of the effect of a price rise.
  5. Can you think of other examples of markets that may be particularly prone to price rises following a currency depreciation?

A row erupted in mid-October between Tesco, the UK’s biggest supermarket, and Unilever, the Anglo-Dutch company. Unilever is the world’s largest consumer goods manufacturer with many well-known brands, including home care products, personal care products and food and drink. Unilever, which manufactures many of its products abroad and uses many ingredients from abroad in those manufactured in the UK, wanted to charge supermarkets 10% more for its products. It blamed the 16% fall in the value of sterling since the referendum in June (see the blog Sterling’s slide).

Tesco refused to pay the increase and so Unilever halted deliveries of over 200 items. As a result, several major brands became unavailable on the Tesco website. The dispute was dubbed ‘Marmitegate’, after one of Unilever’s products.

This is a classic case of power on both sides of the market: a powerful oligopolist, Unilever, facing a powerful oligopsonist, Tesco. With rising costs for Unilever resulting from the falling pound, either Unilever had to absorb the costs, or Tesco had to be prepared to pay the higher prices demanded by Unilever, passing some or all of them onto customers, or there had to be a compromise, with the prices Tesco pays to Unilever rising, but by less than 10%. A compromise was indeed reached on 13 October, with different price increases for each of Unilever’s products depending on how much of the costs are in foreign currencies. Precise details of the deal remained secret.

An interesting dynamic in the dispute was that Tesco and Unilever were acting as ‘champions’ for retailers and suppliers respectively. Other supermarkets were also facing price rises by Unilever. Their reactions were likely to depend on what Tesco did. Similarly, other suppliers were facing rising costs because of the falling pound. Their reactions might depend on how successful Unilever was in passing on its cost increases to retailers.

This example of ‘countervailing power’, or ‘bilateral oligopoly’, helps to illustrate just how much the consumer can gain when a powerful seller is confronted by a powerful buyer. The battle was been likened to that between two ‘gorillas’ of the industry. Its ramifications throughout industry will be interesting.

Podcasts and Webcasts
Tesco-Unilever row: Can unique shop explain ‘Marmitegate’? BBC News, Dougal Shaw (13/10/16)
Tesco, Unilever in Brexit price clash Reuters, David Pollard (13/10/16)
Brexit price-rise warning to shoppers BBC News, Simon Jack (10/10/16)
Tesco in Brexit Pricing Spat With Unilever Wall Street Journal (13/10/16)
Tesco battles Unilever over prices Financial Times on YouTube (14/10/16)
Tesco vs Unilever: Who won? ITV News, Joel Hills (14/10/16)

Articles

Tesco removes Marmite and other Unilever brands in price row BBC News (13/10/16)
Marmite Brexit Shortage ‘Just The Beginning’ Of ‘Gorilla’ Grocery Battle As Pound Slumps Huffington Post, Louise Ridley (13/10/16)
Unilever sales increase despite dozens of its brands being removed from Tesco shelves Independent, Ben Chapman (13/10/16)
Tesco-Unilever price row: Why pound value slump has caused Marmite to disappear from shelves Independent, Zlata Rodionova (13/10/16)
Tesco pulls Marmite from online store amid Brexit price row with Unilever The Telegraph, Peter Dominiczak, Steven Swinford and Ashley Armstrong (13/10/16)
Tesco runs short on Marmite and household brands in price row with Unilever The Guardian, Sarah Butler (13/10/16)
Tesco pulls products over plunging pound Financial Times, Mark Vandevelde, Scheherazade Daneshkhu and Paul McClean (13/10/16)
Brexit means…higher prices The Economist, Buttonwood’s notebook (13/10/16)
Tesco, Unilever settle prices row after pound’s Brexit dive Reuters, James Davey and Martinne Geller (14/10/16)

Questions

  1. To what extent can Tesco and Unilever be seen a price leaders of their respective market segments?
  2. What would you advise other supermarkets to do over their pricing decisions when faced with increased prices from suppliers, and why?
  3. What would you advise manufacturers of other consumer goods sold in supermarkets to do in the light of the Tesco/Unilever dispute, and why?
  4. What determines the price elasticity of demand for branded products, such as Marmite, Persil, Dove soap, Hellmann’s mayonnaise, PG Tips tea and Wall’s ice cream?
  5. What factors will determine in the end just how much extra the consumer pays when supermarkets are faced with demands for higher prices from major suppliers?
  6. Give some other examples of firms in industries where there is a high degree of countervailing power.
  7. What are the macroeconomic implications of a depreciating exchange rate?
  8. If, over the long term, the pound remained 16% below its level in June 2016, would you expect the consumer prices index in the long term to be approximately 16% higher than it would have been if the pound had not depreciated? Explain why or why not.

According to the BBC’s Joe Lynam, “Britain has the most competitive and dynamic retail environment in the world, which attracts shoppers globally.” It is perhaps this fact which may save BHS, with new owners being attracted by such an opportunity. BHS is soon expected to file for administration, with debts of more than £1.3 billion and having failed to secure the loan needed to keep it afloat. If this company collapses, it will bring an end to the life of an 88 year old giant.

The British retail scene has certainly changed over the past decade, with names such as Woolworths and Comet disappearing – could BHS be the next casualty of the changing retail climate? In the world of retail, tastes change quickly and those stores who fail to change with the times are the ones that suffer. One of the factors behind the downfall of BHS is the ‘dated’ nature of its stores and fashions. As clothing outlets such as Zara, Oasis and Next have continued to change with the times, commentators suggest that BHS continues with a trading offer from the 1980s. With the online shopping trend, many household names adapted their strategy, but BHS failed to do so and the second chance that BHS asked the public for when Sir Philip Green, its former owner, sold BHS in 2015 hasn’t materialised.

With administrators ready to be brought in and thousands of jobs hanging in the balance, the administrators will be looking at methods to attract funding, new owners or so-called ‘cherry pickers’ who may be interested in buying up the more profitable stores. Some of their stores remain in prime locations and deliver a tidy profit and it is perhaps these gems, together with the tradition that British Home Stores brings that may yet see the company saved. The outcome for BHS will not only affect the jobs of its employees, but will affect the pensions of thousands of workers. The BHS pension fund currently has a deficit of £576 million and so the Pension Protection Fund will have to look closely at the situation before thinking about issues a contribution notice to those connected with the fund.

A deal was on the cards last week, with BHS owner Dominic Chappell in talks with Mike Ashley’s Sports Direct, but the high debts and pensions deficit appears to have deterred this deal. The failing fortunes of BHS have now come back to haunt former owner, Sir Philip Green, who in March 2015, sold the business for just £1. Sir Philip may return to save the day, but the options for this once giant of the British high street are rather limited. The following articles consider the fortunes of BHS.

BHS seeks Sports Direct lifeline as it heads for collapse The Guardian, Graham Ruddick (24/04/16)
BHS expected to file for administration on Monday BBC News (25/04/16)
Thousands of BHS workers face anxious wait amid administration fears The Telegraph (25/04/16)
BHS administration: ‘Imminent bankruptcy’ puts 11,000 jobs at risk Independent, Peter Yeung (25/04/16)
Up to 11,000 jobs face the axe as BHS is expected to announce collapse of chain after efforts to find rescuer failed Mail Online, Neil Craven (24/04/16)
BHS nears collapse putting 11,000 jobs at risk Sky News (25/04/16)
BHS set to file for administration after sales talks fail Financial Times, Murad Ahmed (25/04/16)

Questions

  1. Using a demand and supply diagram, can you explain some of the factors that have contributed to the difficult position that BHS finds itself in?
  2. Now, can you use a diagram showing revenues and profits and explain the current position of BHS?
  3. What type of market structure does BHS operate in? Can this be used to explain why it is in its current position?
  4. How has the company failed in adapting its business strategy to the changing times?
  5. Looking back at the history of BHS, can you apply the product life cycle to this store?
  6. If another company is considering purchasing BHS, or at least some of its stores, what key information will it need and what might make it likely to go ahead with such a purchase?

A number of famous Business Schools in the UK and US such as MIT Sloan, NYU Stern and Imperial College have launched new programmes in business analytics. These courses have been nicknamed ‘Big Data finishing school’. Why might qualifications in this area be highly valued by firms?

Employees who have the skills to collect and process Big Data might help firms to successfully implement a pricing strategy that approaches first-degree price discrimination.

First-degree price discrimination is where the seller of a product is able to charge each consumer the maximum price he or she is prepared to pay for each unit of the product. Successfully implementing this type of pricing strategy could enable a firm to make more revenue. It might also lead to an increase in economic efficiency. However, the strategy might be opposed on equity grounds.

In reality, perfect price discrimination is more of a theoretical benchmark than a viable pricing strategy. Discovering the maximum amount each of its customers is willing to pay is an impossible task for a firm.

It may be possible for some sellers to implement a person-specific pricing strategy that approaches first-degree price discrimination. Firms may not be able to charge each customer the maximum amount they are willing to pay but they may be able to charge different prices that reflect customers’ different valuations of the product.

How could a firm go about predicting how much each of its customers is willing to pay? Traditionally smaller sellers might try to ‘size up’ a customer through individual observation and negotiation. The clothes people wear, the cars they drive and their ethnicity/nationality might indicate something about their income. Second-hand car dealers and stall-holders often haggle with customers in an attempt to personalise pricing. The starting point of these negotiations will often be influenced by the visual observations made by the seller.

The problem with this approach is that observation and negotiation is a time-consuming process. The extra costs involved might be greater than the extra revenue generated. This might be especially true for firms that sell a large volume of products. Just imagine how long it would take to shop at a supermarket if each customer had to haggle with a member of staff over each item in their supermarket trolley!! There is also the problem of designing compensation contracts for sales staff that provide appropriate incentives.

However the rise of e-commerce may lead to a very different trading environment. Whenever people use their smart phones, laptops and tablets to purchase goods, they are providing huge amounts of information (perhaps unconsciously) to the seller. This is known as Big Data. If this information can be effectively collected and processed then it could be used by the seller to predict different customers’ willingness to pay.

Some of this Big Data provides information similar to that observed by sellers in traditional off-line transactions. However, instead of visual clues observed by a salesperson, the firm is able to collect and process far greater quantities of information from the devices that people use.

For example, the Internet Protocol (IP) address could be used to identify the geographical location of the customer: i.e. do they live in a relatively affluent or socially deprived area? The operating system and browser might also indicate something about a buyer’s income and willingness to pay. The travel website, Orbitz, found that Apple users were 40 per cent more likely to book four or five star hotel rooms than customers who used Windows.

Perhaps the most controversial element to Big Data is the large amount of individual-level information that exists about the behaviour of customers. In particular, browsing histories can be used to find out (a) what types of goods people have viewed (b) how long they typically spend on-line and (c) their previous purchase history. This behavioural information might accurately predict price sensitivity and was never available in off-line transactions.

Interestingly, there has been very little evidence to date that firms are implementing personalised pricing on the internet. One possible explanation is that effective techniques to process the mass of available information have not been fully developed. This would help to explain the growth in business analytics courses offered by universities. PricewaterhouseCoopers recently announced its aim to recruit one thousand more data scientists over the next two years.

Another possible explanation is that firms fear a backlash from customers who are deeply opposed to this type of pricing. In a widely cited survey of consumers, 91% of the respondents believed that first-degree price discrimination was unfair.

Articles

Big data is coming for your purchase history – to charge you more money The Guardian, Anna Bernasek and DT Mongan (29/5/15)
Big data is an economic justice issue, not just a Privacy Problem The Huffington Post, Nathan Newman (16/5/15)
MIT’s $75,000 Big Data finishing school (and its many rivals) Financial Times, Adam Jones (20/3/16)
The Government’s consumer data watchdog New York Times, Natasha Singer (23/5/2015)
The economics of big data and differential pricing The Whitehouse blog, Jason Furman, Tim Simcoe (6/2/2015)

Questions

  1. Explain the difference between first- and third-degree price discrimination.
  2. Using an appropriate diagram, explain why perfect price discrimination might result in an economically more efficient outcome than uniform pricing.
  3. Draw a diagram to illustrate how a policy of first-degree price discrimination could lead to greater revenue but lower profits for a firm.
  4. Why would it be so difficult for a firm to discover the maximum amount each of its customers was willing to pay?
  5. Explain how the large amount of information on the individual behaviour of customers (so-called Big Data) could be used to predict differences in their willingness to pay.
  6. What factors might prevent a firm from successfully implementing a policy of personalised pricing?

Recent reports in the media have included headlines such as “Sexist surcharge” and “Pink premium?” Various claims have been made that women pay significantly higher prices for similar products than men.

The Times newspaper recently published the results from an investigation it carried out on the prices of hundreds of similar products that were marketed at both men and women. The study found that those products marketed at women cost 37% more on average than similar versions that were marketed at men. Examples included:

Disposable razors: Tesco priced a packet of five of its own-brand disposable razors for women at £1. The key characteristic that targeted the razors at female customers was the colour – they were pink. For the same price, a packet targeted at male customers (i.e. they were blue) contained 10 disposable razors.
Ballpoint pens: Staples priced a packet of five pastel-coloured Bic pens marketed ‘for her’ at £2.99. A packet of five Bic pens that were not in the ‘for her’ range (i.e. they had transparent barrels) were priced at £1.98.
Scooters: Argos increased the price of a child’s scooter by £5 if it was pink instead of blue.

Maria Miller, the chair of the Women and Equalities Select Committee, stated that:

“It is unacceptable that women face higher costs for the same product just because they are targeted at women. Retailers have got to explain why they do this.”

A more detailed study carried out by New York City’s Department of Consumer Affairs was published in December 2015. Average prices were collected for 794 individual items across 5 different industries. The key findings were that products marketed at women were

7 per cent more for toys and accessories
4 per cent more for children’s clothing
8 per cent more for adult clothing
13 per cent more for personal care products
8 per cent more for health products

Interestingly whereas the investigation in the UK only found examples of women paying higher prices than men, the New York study found some goods where the price was higher for men.

Reports in the media have claimed that this is clear evidence of price discrimination. Although this is likely to be true, it is impossible to say for certain without more detailed information on costs.

For example, when referring to the higher price for the razors marketed at women in the UK study, Richard Hyman, an analyst at RAH Advisory, stated that:

“the packaging will be different and they will sell fewer so it could be to do with the volume”

If economies of scale and the different costs of packaging can fully account for the difference in prices between the razors then it is not an example of price discrimination.

Articles

The sexist surcharge – how women get ripped off on the high street The Guardian 19/01/16
Women paying more than men for everyday products The Independent 19/01/16
Price differences for men and women ‘astonishing’ BBC 19/01/16
Pink premium? There are greater problems The Guardian 24/01/16
Being a women costs more than being a man CNBC 23/12/15

Questions

  1. Define price discrimination.
  2. Outline and explain the three different categories of price discrimination.
  3. Could a situation where a firms charges all of its customers the same price for a good or service ever be classed as an example of price discrimination?
  4. A firm with market power may still not be able to successfully implement a policy of price discrimination. Explain why.
  5. Under what circumstances could price discrimination improve allocative efficiency?