The UK Supermarket Sector Is an Oligopoly - Essay Example

?UK Supermarket Sector Is an Oligopoly Table of Contents Introduction 3 The Oligopoly Market 3 Strategic Decision in the Oligopoly Market 4 Competition Strategic Decision 5 Pricing Decision 5 Implementation Strategy 5 Barriers to Entry in Oligopoly Market 6 Collusive Oligopolies 7 7 Competitive Oligopolies 8 Oligopoly Non-Pricing Strategy 8 Oligopoly Market Share of Firms 9 The Concentration Ratio of the Oligopoly Market in the UK 10 Kinked Demand Curve Model 11 Price Leadership Model 14 Cartel’s Model 16 Price Stickiness and Game Theory Approach 18 Conclusion 20 References 21 Introduction The UK market has been growing in the supermarket segment which is considered as an important market in Europe. There are several companies operating in the supermarket segment in the UK market. Britain’s food retailing is the ‘most concentrated’ in Europe. With top five supermarket chains such as Tesco, ASDA, Sainsbury’s, Morrisons and Safeway, they control approximately 70% of all food obtained from the market. Their trade was valued approximately at ?76.78 billion in the year 2000 and had increased by 4.5% over the years (Tyler, 2011). In this study, the discussion will critically evaluate the citation that UK supermarket sector is an oligopoly. For this purpose, Tesco, Sainsbury’s, ASDA, Morrisons and Safeway will be included in the study since they are the top five supermarket chains. The Oligopoly Market According to Investopedia, “An oligopoly is much like a monopoly, in which only one company exerts control over most of a market. In an oligopoly, there are at least two firms controlling the market” (Investopedia, 2011). In the UK supermarket there are mainly three big companies that operate and control the market. These are Tesco, Sainsbury’s and ASDA. Its presence is also felt in the European market as most of the supplies of the supermarket are through these companies. The oligopoly market structure is such that there are few sellers, who control the market. Unlike the monopolistic competition, perfect competition and monopoly market, the oligopoly requires to think strategically. In oligopoly, the sellers are huge enough to have an influential affect upon the market. A seller needs to respond to its competitors’ choices, but the competitors are countering to the sellers’ choices. For instance, when Tesco responds towards the choice of Sainsbury’s, at the same time Sainsbury’s reacts to the choices of Tesco in the UK market (Ohio State University, 2000). In the oligopoly markets, there are tensions in relation to cooperation as well as self-interest in the companies such as Tesco, ASDA & Sainsbury’s in the UK. If all these companies limit their productivity, it will affect the prices that will tend to be high, but then there are possibilities of the companies to have an incentive to expand their output (Ohio State University, 2000). Strategic Decision in the Oligopoly Market The strategic decision is crucial in the case of firms that are interdependent. In the UK market’s supermarket sector Tesco, Sainsbury’s and ASDA are interdependent as they control the market in this segment. They cannot act independently; consequently they have to take into consideration the likely responses of the competitor in order to make any kind of alteration in the pricing and non-pricing activities. They develop the strategies based upon the probable reaction of the rivals (Economics Online, 2011). In the UK supermarket, Tesco, Sainsbury’s and ASDA need to decide strategically in certain aspects of the market that are listed below: Competition Strategic Decision The firms need to strategically decide whether to compete with the competitors or join together. It is tough to decide as a prediction made by the firms against the decision made by the rivals might turn out to be wrong (Economics Online, 2011). Pricing Decision The firms need to strategically decide whether to increase or decrease the price or to keep it at constant. It is difficult for the firms to decide. They generally undertake the pricing strategy that is almost similar by all the firms in the same market (Economics Online, 2011). Implementation Strategy The firms need to make a decision whether to implement a new strategy or wait for others; or be the first to implement it or see the market of others and then implement it. Deciding for the first move or second move for benefit is difficult as decision in implementing them is crucial and involves risk at higher level. To gain ‘head start profits’ generally the firms first implement the new strategy. The involvement of risk is higher, but the benefit involved in it is also greater as it is the first to implement and gain benefit. The firms implement the second move after waiting for certain period after the first move to know the strategy and then update and improve and launch them in the market in order to get maximum benefit from the first move with enhanced strategy (Economics Online, 2011). Barriers to Entry in Oligopoly Market The oligopoly market often preserves their place in the market position because it is determined that it is costly and complicated for the potential competitors to enter the market. These problems are the barriers for the entry. In the UK market, Tesco, Sainsbury’s and ASDA are operating for long period of time and they have been efficient enough in developing the market and has concentrated huge market share. If new competitors want to enter this segment of market it will be a costly affair as the market share is highly concentrated by them and the pricing decision and other decisions are highly influential in the market. For the new competitors it will become difficult to survive and compete for the long run purpose. The ‘economies of scale’ in the UK supermarket segment has already been explored by Tesco, Sainsbury’s and ASDA and they have been taking advantage from this ‘economies of scale’. If a new competitor tries to enter this market, there will be difficulties to gain ‘economies of scale’ in operations. The resource is limited in nature. In the UK market, the companies such as Tesco, Sainsbury’s and ASDA have access to resources and have developed other alternatives of the resource. In case of new entrants, the problem of resource will be faced by the new firms and this might increase the cost of the new firm. When there will be increase in the price, firms might find difficulty in sales management. The other problem will be faced is the scarcity of resources that will make the firms instable in the long run operations. Tesco, Sainsbury’s and ASDA will apply the ‘limit pricing strategy’ in case of new entry of a firm in this sector in the UK market. They will determine low pricing strategy with high productivity level so that the new entrants cannot derive profit at that particular price. This is implemented through selling the products at a price that is just below the average total cost (ATC). This will make the potential entrants aware of the fact that profits are difficult to gain in this market. Collusive Oligopolies The important feature of the oligopoly market is the collusive model of oligopoly market. The firms attempt to plan in order to gain maximum benefit from the market that they have developed. In the collusion model of oligopoly the firms such as Tesco, Sainsbury’s and ASDA act as monopoly and derive higher profits for the long run purpose. They take the benefit of monopoly market in different perspectives such as pricing decision, supply decision and others. This increase the market share of the firms and the huge concentration of resources and power to influence the market are withheld by them. The trade association in the general form is known as the covert collusion model. In this type of model the agreements of trade are not hidden. There is openness between the firms related to the trade agreements. Usually this model is applied to avoid the exposure by regulators in the matter of fixing prices. Competitive Oligopolies In order to avoid the pricing war between Tesco, Sainsbury’s and ASDA they might apply the non-pricing competition when they are competing in the UK market. They can gain strategic benefit from the price reduction strategy. This strategy will assist the firms to gain market share and discourage the potential competition entry, but in this model the risk is that the rivals can simply decrease their prices in such response towards the market. The effect of this model is that there will be fewer gains which will lead to decrease the revenues and profits of the firm. Oligopoly Non-Pricing Strategy This approach of non-pricing strategy is applied by Tesco, Sainsbury’s and ASDA because the pricing strategy leads to critical price wars. However, this strategy of non-pricing provides the opportunity for the firms to enhance their quality of service and quality after sales service can offer extended guarantee. The sales promotion is highly dominated by Tesco, Sainsbury’s and ASDA in the UK market in the supermarket category. The buy-one-get-one-free (BOGOF) sales promotion is frequently implemented by them to gain advantage and increase the market share. There are certain loyalty schemes that are implemented in the oligopoly market by the firms in the UK supermarket. For the purpose of loyalty, Tesco has ‘Club Card’ and Sainsbury’s has ‘Nectar Card’. However, ASDA does not follow the similar pattern in loyalty cards. Different strategies are implemented by firms in terms of cost and benefit, as benefits needs to be more than the cost. There are special non-pricing strategies that differ from one firm to another within the oligopoly market, but the offerings of the products are similar in nature. Oligopoly Market Share of Firms Tesco, ASDA, Sainsbury’s, Morrisons, Somerfield, Waitrose and Iceland Foods Ltd’s market shares were 30.6%, 16.6%, 11.1%, 5.4%, 3.7% and 1.8% respectively in the UK supermarket segment in the year 2006 (BBC, 2006). This is well illustrated below in figure 1. Figure 1: Market Share of Firms in the UK Market in Supermarket Segment Source: (BBC, 2006). The Concentration Ratio of the Oligopoly Market in the UK Figure 1.1 Concentration Ratio (Ivory Research Ltd, 2011). The above figure 1.1 illustrates that the concentration ratio has improved every consecutive year from 2004 to 2008 when C4 and C5 are considered for the concentration ratios. There has been significant increase in the year 2007 and 2008 with a 9.90% of direct increase for both C4 and C5 concentration ratios. This is due to the major attributes of the momentous increase in market share of Tesco, ASDA and Sainsbury’s from 2007 to 2008 (Ivory Research Ltd, 2011). The concentrated competition between Tesco, ASDA and Sainsbury’s supermarket companies had resulted in creating new strategies and promotion campaigns which resulted in increase in the market share. This strategy had resulted to negative collision on the profit margin of largest companies in a short term. Furthermore increase in customer loyalty and revenues had resulted in increasing profitability and revenues in the long run. Kinked Demand Curve Model Kinked demand curve model was pioneered by Paul Sweezy in the year 1939 to illustrate the price rigidity that was frequently viwed in many oligopolistic models (Razani Hj & Jali, 2010). The prices in oligopoly remain stable due to lack of price competition among the firms. In Fig 2, it is illustrated that an oligopolistic selling an output of OB at a price of OA, at which point the ‘demand curve is kinked’ (Thornes, 2010). Source: (Thornes, 2010). The theory proposes that the competitors will leave their price where they are at current position if the firm increases its price above OA and this will lead to drop in its market share. The demand curve becomes elastic above the price OA, thus further increase will lead to decrease in total revenue. Below OA, demand curve is inelastic with fall in revenue due to lower price. If one firm lowers its price then others follow. Below the OA, the demand curve shows inelastic behaviour, there is price war due to which its effects are seen in the revenues. This situation will promote the firms towards losses. The two parts of the kinked demand curve show different marginal revenue curves that is represented in figure 3. Source: (Thornes, 2010). D=AR1 is the elasticity demand curve and its corresponding marginal revenue curve is MR1, D=AR2 is inelastic demand curve and its corresponding marginal revenue curve is MR2. This directs to discontinuity between the points Z and V. If MR curve vary within this discontinuity then there is no motive for the firm to amend its output (Thornes, 2010). Figure 4.0 Positive Profits. The shaded part is the positive profit (Princeton University, 2011). Figure 4.1 Negative Profits. The shaded part is the negative profit (Princeton University, 2011). Figure 4.2 Zero Profits (Princeton University, 2011). Price Leadership Model In dominant firm ‘price leadership model’, the dominant firm (Tesco) sets merchandise price that maximises its total profits, permitting the followers (Sainsbury’s, ASDA) to trade all they desire at that price (Razani Hj & Jali, 2010). In this case, Sainsbury’s and ASDA behave as perfect competitors or price takers and Tesco acts as outstanding monopolistic supplier of the product. In this sector, Tesco sets a certain strategy such as discounting model for special occasions. This will be followed by other players in the market. The role of price leader can also transfer from one firm to another over time. Price leader is usually the dominant firm such as Tesco in the UK market. The possibility is that it could also be low-cost firm or any other firms that is accepted as indicator of transformation in industry cost and demand situations permitting price alterations (Razani Hj & Jali, 2010). Figure 5 Price Leadership Model (University of Toronto Scarborough, 2011). Marginal Revenue (MR) = Marginal Cost (MC) for this demand curve. This is accurate where Q*DF occurs. It is the capacity at this point when MR is just equal to MC for the dominant firm. The dominant firm (i.e. Tesco) will charge the profit-maximising price that is P*. When P* is recognised by Tesco, the ‘competitive fringe’ (who are price takers) will presently take this price and place P* = MC. This will offer the profit-maximising quantity Q*CF for the competitive fringe (University of Toronto Scarborough, 2011). Cartel’s Model Tesco, Sainsbury’s and ASDA cooperate among them to restrict competition in order to increase their profits. To ensure monopolistic profits, the firms restrict entrance into the UK market and certain parts of the European market. Market Sharing Cartel Model: There is agreement between the firms to segregate the markets and offer each competing firms the sole right to operate in a particular area or market (Razani Hj & Jali, 2010). Centralised Cartel Model: There is a formal agreement among the competing firms to set a monopoly price and control the level of output. It decides the profit margins that are to be shared (Razani Hj & Jali, 2010). In Cartel model, in which Tesco, Sainsbury’s and ASDA in the market will act as members and in which they will fully cooperate, act as a monopoly because the firms are performing as one large firm. This will assure profitability that in represented below in figure 6 (that looks just like a monopoly graph) Figure 6 Cartel Model of Profitability (Davidson College, 2010). In this Cartel model an oligopoly sets as a monopoly price. When the oligopolies limit the access of other firms in the market and structure as a cartel, then they enhance their profit margins through moving as cartel in the market. Oligopolies (Tesco, Sainsbury’s and ASDA) act as if they were monopolists. That has allocated output proportions to each firm (members of the cartel) so that total productivity is steady with combined profit maximisation (Rio Hondo College, 2007). Price Stickiness and Game Theory Approach Even when there is increase in the marginal cost at a larger extent, price tends to stick to its origin closely, assuming that there will be ‘soaring price elasticity of demand at any price rise’. This is represented in the below figure 7 about the stickiness of the price. Figure: 7 Price Stickiness (Economics Online, 2011). At the level of P (price) and Q (output), the revenues will be maximised. If MR and MC are added, then there is every possibility that profits will also be maximised at P. Even if MR=MC, the profits will still be maximised under the situation that MC cuts MR in its vertical section. If MC alters in the vertical section of the MR curve, price will still stick at P. Pricing strategies can be observed in game theory in terms of strategies and payoffs. There are three probable pricing strategies with different pay-offs and risks that are raise price, lower price and keeping the price constant. The preference of strategy depends upon the pay-offs, subjected to actions of competitors. Beneficial pay-off is possible with rising and lowering pricing strategy, but both can lead to losses and alteration in pricing is highly risky. Keeping the price constant might not lead to single best result but it may be least risky strategy for an oligopolistic firm. The prediction of game theory is also that there might be possibility of cartels to form due to high return. In oligopoly market this strategy reduces the uncertainties that are associated with interdependence of rivals. Conclusion In oligopoly market situation, the firms have high influential power in affecting the market through their pricing strategy and almost control the market. The firms consider their action in alteration of prices compared to others. There is huge competitiveness in the pricing war, therefore the firms operating under the oligopoly market focus upon non-pricing forms. In certain countries the oligopoly market situation is restricted but still they form strategies between the firms and act as a large firm and apply the monopolistic market strategy. Therefore, from the study it can be recognised that UK supermarket sector is an oligopoly. 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