Food Retailers' Pricing and Marketing Strategies, with Implications for Producers

Agricultural and Resource Economics Review,  Oct 2006  by Li, Lan,  Sexton, Richard J,  Xia, Tian

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This paper examines grocery retailers' ability to influence prices charged to consumers and paid to suppliers. We discuss how retailer market power manifests itself in terms of pricing and marketing strategies by setting forth and offering evidence in support of eight "stylized facts" of retailer pricing and brand decisions. We argue that little, if any, of this behavior can be explained by a model of a competitive, price-taking retailer, but that most of the indicated behavior was also inconsistent with traditional models of market power. Finally, we discuss the impacts of aspects of this retailer behavior on the upstream farm sector.

Key Words: grocery retailer, market power, price spread, sales

(ProQuest Information and Learning: ... denotes formulae omitted.)

The relationship between commodity prices at the farm and the prices consumers pay at retail is a topic of obvious importance and longstanding interest in agricultural economics. The relationship, known as the farm-retail price spread or the marketing margin, has been studied and measured extensively through the years.1 In many cases the relationship has been depicted as a simple markup function. For example, George and King (1971) suggested that the margin, M^sub j^, for commodity j could be expressed as M^sub j^=α^sub j^ + β^sub j^ P^sup r^^sub j^, where P^sup r^^sub j^ is the price at retail of the finished product.

Grocery retailing has changed dramatically in the 35 years since the seminal George and King study. Traditional corner grocery stores have been mostly replaced by large supermarket chains, and now the dominance of the chains is being threatened by the remarkable growth of Wal-Mart as a grocery retailer (Hausman and Leibtag 2004). Further, the way grocery retailers do business has changed. Traditional terminal markets for fresh produce commodities have declined in importance and have been replaced by direct procurement from grower-shippers via contracts. Retailers through marketing contracts exercise considerable vertical market control over upstream suppliers and utilize their own store or private label brands to compete for sales with the brands they procure from independent manufacturers and shippers. Retailers also use a variety of strategies to differentiate themselves from their competitors.

The growth of large grocery retail chains, fueled in large part through a wave of mergers, has caused increasing concentration in the retail food sector. Rising concentration, in turn, has heightened concerns about retailers' ability to influence prices charged to consumers through possible exercise of oligopoly power, and prices paid to suppliers through possible exercise of oligopsony power.2

Understanding retailer market power, pricing practices, and marketing strategies is critical for many reasons. Most obvious is the impacts that retailer behavior can have on consumer and producer welfare.3 Assessment of various practices in grocery retailing, such as use of slotting fees, depends upon whether such fees have a basis in efficiency or are a manifestation of retailer market power. Further, the impacts of various policies and strategies intended to increase farm prices and incomes hinge critically upon the competitiveness of the market chain.4 For example, little is known about how the effectiveness of farm sector programs, such as mandatory commodity promotion, is enhanced or impeded by retailers' market power and the pricing strategies they utilize. If retailers respond to a commodity advertising campaign by raising retail margins to absorb any demand increase induced by the promotion, the higher sales needed to induce an increase in the producer price will not materialize. On the other hand, if retailers respond to a positive demand shock by reducing price, and some evidence supports this outcome (Warner and Barsky 1995, Chevalier, Kashyap, and Rossi 2003, and Li 2006), the effect would be to enhance the impact of the promotion.

This paper examines grocery retailers' ability to influence prices charged to consumers and paid to suppliers through exercise of oligopoly and oligopsony power. We then ask how retailer power manifests itself in terms of the pricing and marketing strategies that food retailers undertake. Specifically, we set forth eight features of retailer pricing and brand decisions that we argue are documented sufficiently to merit status as "stylized facts." The stylized facts are illustrated with results from our own work, together and with various co-authors, but in almost all cases the evidence is broader, as citations indicate. We then ask to what extent these observed practices are consistent with traditional notions of farm-retail price spreads, or, for that matter, can be explained at all by the existing economic theory. Finally, we discuss the impacts of aspects of this retailer behavior on the upstream farm sector.

Evidence on Grocery Retailer Market Power

The hypothesis that large grocery retailers possess some degree of market power in the sense of being able to influence the prices they pay to suppliers and charge to consumers rests on solid conceptual foundations. Consumers are distributed geographically and incur nontrivial transaction costs in traveling to and from stores. This condition leads to a spatial distribution of grocery stores, and gives a typical store market power over those consumers located in close proximity to the store and, hence, the ability to influence prices (Faminow and Benson 1985, Benson and Faminow 1985, Walden 1990, and Azzam 1999). Other considerations that enhance retailers' power to influence consumer prices include imperfect information among consumers (e.g., as to the prices that are being offered), and differentiation among retailers based upon the services they emphasize, advertising they conduct, and marketing strategies they pursue.5