Tesco UK and Oligopolistic Competition - Case Study Example

ECONOMICS: OLIGOPOLY Executive summary The UK supermarket industry exhibit most if not all characteristics and behavior of oligopolistic market structure. Tesco supermarket enjoys the largest percentage of UK market with 30.9% followed closely by Sainsbury and Asda and the three occupies 63.9% of the total UK supermarket industry; hence creating oligopolistic market structure. The fact that these three supermarkets command over 60% of UK supermarket industry justifies that their products are similar and are exchanged in oligopolistic market structure. Furthermore, these firms engage in price wars and their interdependence is evident whereby if Tesco who is the price leader decreases their price the other firms follow suit to avoid the risk of losing their market share. In addition, there firms practice price collusions though tactfully. Secondly, these firms capitalize on natural as well as create artificial barriers to bar their rivals’ entry into the industry. The natural barriers include large economies of scale and scarce land resources whereas the artificial barriers include the loyalty schemes, research and development and advertising and marketing strategies. In order to maintain as well as increase their market share these firms engage in non –price competition such as creation of loyalty clubs, online shopping, home delivery services, long opening hours, after sales service and inclusion of non- food products and services in their stores. However, although oligopolists are very significant to the economy, their behavior makes them allocatively and productively inefficient. Therefore, the price leader and in this case Tesco should ensure that prices are stable to enable their consumers plan on their future expenditure. Furthermore, these firms should strive to maintain competitiveness by eliminating if possible some barriers of entry. Table of Contents ECONOMICS: OLIGOPOLY Executive summary 1 Introduction and Tesco’s background information 4 Characteristics of an oligopoly 6 Products similarity and branding 6 Price wars 7 Interdependence 9 Non-price competition 9 Advertising and marketing strategies 9 Customer loyalty 10 Other incentives 11 Online shopping and home delivery services 12 Barriers of entry 12 Collusion in UK supermarkets 15 Implications of oligopolistic competition 15 Conclusion and recommendation 17 References 18 Introduction and Tesco’s background information In UK, the food and drink retail sector is the largest and in 2003 it contributed approximately 9% of the total GDP (Harvey, 2000, p. 16). In recent years, dedicated research has been conducted in UK supermarket industry owing to the rising concerns from investors that big supermarkets are colluding to bar new entrants from the market (Lawyer and Yang, 2003, p. 119). However, is imperative to mention that UK supermarkets exhibit numerous characteristics of oligopoly than of any other market structure. This report, therefore, critically analyses Tesco Supermarket in an attempt to establish whether its characteristics and behavior concur with economics of oligopoly. Tesco operates more than 2,318 stores that are spread worldwide. However, its largest market is in UK whereby it operates under the umbrellas of Extra, Superstore, Metro and Express (Tesco, 2011, par. 6). Over the years, Tesco has expanded its products range to incorporate non-food products as well as the development of own labels (Tesco, 2011, par. 6). Tesco UK and oligopolistic competition Tesco operates in an oligopolistic market structure. An oligopolistic market structure is a situation whereby an industry is dominated by few firms whose products are closely related. According to Ismail (2008, p. 26) though the UK supermarket industry consists of several firms, only three that is Tesco, Sainsbury and Asda dominate the market; hence creating oligopolistic competition. Moreover, in oligopolistic competition there is high level of market concentration. Lawler & Yang (2003, p.119) postulate that it is important to calculate the concentration ratio to determine the extent to which the leading firms in oligopolistic competition dominate the market. According to Competition Commission in UK oligopolistic market structure occurs when the top five firms assume more than 60% of the total market in terms of demand and supply (Ismail, 2008, p.26). From the table below the top three and top five firm’s market concentration is 63.9% and 79.5% respectively. Source; Ismail (2008, p.27) Characteristics of an oligopoly To begin with, Ismail (2008,p.27) postulates that a single price or output theory cannot account for the behavior of oligopoly firms because price wars which are a common occurrence often produce unpredictable results depending on the strategies adapted by individual firms. Whereas the strategies at times might be in terms of price and produce as it is evident in highly competitive market structures, at other times oligopolists behave like pure monopolies (Ismail, 2008, p.28). Products similarity and branding Under oligopoly market structure, firms deal with similar products but adopt rigorous product branding strategies as they attempt to create product differentiation (Cooper, 2003, p.128). Mostly supermarkets in UK stocks similar grocery products owing to the fact that they obtain these food products from the same suppliers such as Kellogg’s, Bird’s eye and Heinz (Cooper, 2003, p.128). However, the top three supermarkets produce their own generic products to promote customer recognition and loyalty as shown in the chart below. In contrast, Ismail (2008, p.29) underscores that branding should not be confused with product differentiation as it is the case in monopolistic competition since such differentiation is false. This implies that most products in supermarkets are similar hence the justification that Tesco supermarket operates under oligopolistic competition. Price wars In oligopolistic competition, firms are likely to compete on price although major competition strategies are non-price based. Apparently, oligopolists compete on price each one of them hoping to become a price maker so as to attract a large market share (Heertje, 1996, p.55). In so doing, the firms engage in price wars which is a common occurrence among UK supermarkets whereas if for instance Tesco announces a range of price cuts, Asda and Sainsbury follows suit (Cooper, 2003, p.128). For instance in a previous price wars, Tesco opted for a strategy to cuts prices on selected products ranging from 3 - 25% and as a result it increased its market share by 12% within a period of eight weeks (Hollingsworth, 2004, p.631). As a result, other supermarkets followed suit to the benefit of the consumers. In oligopolistic theory, the dominant firms assumes a price leadership role and from the graph above Tesco commands 30.9% of supermarket market share in UK, hence it ability to engage in price making strategies. On the contrary, if Tesco adjusted their prices upwards the rival supermarkets would not follow suit hence the demand for its products would be relatively elastic and subsequent fall in total revenue would be evident. Heertje (1996, p.54) explains that rivals in oligopolistic competition usually adjust their prices down wards so as to defend their market share , but as a result their total revenue falls. However, in such as situation the demand is more inelastic. The two case scenarios of the effect of price increase or decreased on demand can be plotted in the demand curve below which is referred to as a kinked demand curve (Heertje, 1996, p.53). Source: http://economicsonline.co.uk/Business_economics/Oligopoly.html According to Heertje (1996, p.49) price wars are beneficial to consumers but are a great disadvantage to competing companies because the decreased profits margins following price wars threaten the survival of smaller companies. However, large firms like Tesco can survive the reduction in profits margins in the short run, since in the long run their revenues will adjust upwards as smaller firms shut down. On the other hand, the consumer is also at risk of being exploited by oligopolists especially when firms collude to increase prices concurrently and end up earning supernormal profits in the long run (Heertje, 1996, p.52). Interdependence The above situation indicates that firms in oligopolistic market structure portray an interdependence relationship whereby a firm has to consider the reaction and action of rivals before they can implement any decision (Heertje, 1996, p.48-57). This interdependent relationship underscores that firms cannot risk increasing prices without adequate knowledge that competitors will do the same since by so doing it can lose a great deal in terms of market share (Heertje, 1996, p.48-57). On the same note, the fact that in increase in price by Tesco compels the other oligopolists to follow suits indicates that none of the firms can act independent of this interdependence. Non-price competition Besides, the competition in terms of pricing, firms in oligopolistic competition can engage in other non-price strategies to be able to expand or maintain respective market share. More importantly, the kinked demand curve illustrated above indicates that oligopolistic markets experience price stickiness; therefore, firms cannot rely on pricing to boost sales revenues and subsequent profits (Heertje, 1996, p.47). According to Cooper (2003, p.130) non-price strategies are very significant in highly competitive oligopolistic competition upon which Tesco in UK operates. Advertising and marketing strategies Generally, marketing and advertising strategies plays a significant role in promoting firms’ products to its existing and potential consumers regardless of the type of market structure upon which a particular firm operates (Heertje, 1996, p.50). More importantly, the choice of marketing and advertising strategies by oligopolists is very crucial since pricing strategy might not work in their favor. Concurrently, marketing increases demand and subsequently brand loyalty is created and this is very crucial to maintain market share in oligopolistic competition (Heertje, 1996, p.48). On the same note, supermarkets in UK have distinct advertising slogans in an attempt to increase customer loyalty and also to attract new customers with an aim of expanding customer base . Each year Tesco, Asda and Sainsbury sets aside some amount of money to run advertisements and sometimes the cost impacts negatively to the firms’ profits especially if a positive return in marketing investment is not realized since these firms end up spending millions of pounds (Hollingsworth, 2004, p.634).According to Heertje (1996, p.49) a promotional campaign is only profitable if the extra sales revenues exceeds the input cost of advertising. However, he underscores that it is not easy to calculate how much a specific campaign yields in terms of increased sales. Needless to say, more often than not persuasive advertising leads to a positive increase in demand and Tesco has capitalized on this aspect to maintain her market share in UK supermarket industry and henceforth maximize her profitability (Tesco, 2011, par. 8). Customer loyalty As epitomized above, oligopolists are unlikely to gain any price advantage either by lowering or increasing their products prices, therefore, they must strive to win customer loyalty through customer rewards (Cooper, 2003, p.132). For instance, the three oligopolists’ supermarkets in UK have introduced customer loyalty cards whereby card holders earn points every time they shop at these supermarkets (Cooper, 2003, p.133). More importantly, Tesco ClubCard has been very successful in retaining their customers and as a result their market share in UK has remained almost constant as well as their increasing profitability (Tesco, 2011, par. 8). Other incentives Moreover, Tesco and the other oligopolists have extended their opening hours and most branches operate on a 24hr basis in an attempt to attract more customers as well as allow their existing customers to shop at their convenience (Cooper, 2003, p.128). More importantly, the three oligopolists have realized that majority of customers would be satisfied if they could conduct their business under one roof, besides shopping. For this reason, the UK supermarkets have diversified their services by including pharmacies, banks, petrol stations and so on within their premises. Each of the supermarkets strives to modify these extra services so that they can appear unique to the customers. However, it is important to note that such services require a huge capital base hence the small and emerging supermarkets are at an unfair advantage and as a result the oligopolistic competition is heightened (Cooper, 2003, p.128) . Online shopping and home delivery services Furthermore, as a strategy to improve their customers’ convenience the three supermarkets have introduced online shopping and home delivery services (Cooper, 2003, p.128). Apparently, Tesco is the ultimate leader in this category and their customers are able to order a wide range of products ranging from food and drinks to books at the comfort of their homes. It is imperative to note that, the home delivery services are free and also customers do not lose the special offers that are present during physical shopping (Tesco, 2011, par. 8). Similarly, in an attempt to retain their competitive edge, Asda and Sainsbury have followed in the footsteps of Tesco by increasing their home delivery services although they are still lagging behind in terms of geographical coverage. According to Hollingsworth (2004, p.632) non-price strategies increase product differentiation and the resultant customer loyalty makes the demand curve to be less elastic. This implies that the firms can raise their prices in future without the risk of losing their market share owing to the fact that their customers are already loyal. Unfortunately, other supermarkets in UK do not offer home delivery services mainly because of the costs involved. Barriers of entry Barriers to entry are also characteristics of oligopoly whereby the dominant forms impose artificial or capitalize on natural barriers to discourage other competitors from joining the market (Hollingsworth, 2004, p.632). The natural barriers include economies of scale and in the case of UK the cost of starting up a supermarket as well as maintaining the high standards set by the oligopolists is too large, hence most investors shy away from venturing in this business (Howe, 1998, p. 212). More importantly, Tesco which has the highest number of stores has occupied almost every available space that interested investors are likely to set up competitive stores, thus Tesco has deliberately made the land resources very scarce (Howe, 1998, p. 214). In addition, the oligopolists through non-price strategies such as advertising and marketing have further increased the set-up costs that deter initial market entry owing to the fact that sunk costs delay the possibility of making any profit in the short run such that if any firm attempts entry they are likely to close down in the long run (Howe, 1998, p. 216). Moreover, Tesco spends a considerable amount of its profits on research and development to be able to establish what their existing and potential customer’s preferences. This sets the bar too high for new investors since without research and development new firms are unlikely to satisfy customer needs hence their markets share will remain very low and they may forced out of the market in the long run (Lawyer & Yang, 2003, p. 121) . Secondly, oligopolists can impose artificial barriers to deter new entrants from the market and UK supermarkets have been accused of this habit. As explained elsewhere in the paper oligopolists are likely to engage in price wars whereby one firms decides to lower their products prices in order to attract more customers. On the other hand, pricing can be used to push rivals out of the market whereby a large firm deliberately lowers the price and since the small firms are unable to hold for long at zero profits, they opt out of the business (Howe, 1998, p. 221). Closely related predatory pricing is what Hollingsworth ( 2004,p.630) refers to as limit pricing whereby existing firms set prices below output levels thus rival entrants are unable to make profits at that price. Moreover, limit pricing implies that the set price is below average total costs hence new entrants are scared off before they even venture into the market. Knowledge about the market is very crucial for new and existing firms to be able to retain a competitive edge. However, Tesco having been in the market for many years have an undue advantage over new entrants since they have superior knowledge about the marker either through research and development or practice, therefore, the lack of superior knowledge by rivals is an artificial barrier that discourages entry (Hollingsworth, 2004, p.629) . As stated above, product branding and creation of customer loyalty scheme is a successful non-price strategy that is utilized by oligopolists to defend and accelerate their market share. However, such strategies can also act as barriers to entry. For instance, Tesco UK has created and maintained a strong brand image and more importantly is the customer loyalty scheme through ClubCard(Lawyer & Yang, 2003, p. 121) . This strategy makes its very difficult for any new entrant to gain considerable market share that would guarantee profits, hence the rivals prefer to stay away from this industry. Hollingsworth (2004, p.629-638) elucidates that oligopolists can take part in predatory acquisitions in order to increase their market share advantage. However, in UK though Tesco have taken part in some acquisition, they are always kept in check by Competition Commission to ensure that acquisitions and mergers do not hinder competition (Lawyer & Yang, 2003, p. 121) Collusion in UK supermarkets More often than not oligopolists enter into collusions either overt or covert to ensure they maintain their status quo in the market (Howe, 1998, p. 214). However, since collusions are discouraged through market regulations, oligopolists usually in tacit collusion. For instance, in UK supermarket industry Tesco is tacitly recognized as the price leader and in line with the oligopoly behavior any change in price will compel the other supermarkets follow the same route (Lawyer & Yang, 2003, p. 121). However, as explained above, this will attract undue advantage to small firms who are unable to operate at low output levels. Implications of oligopolistic competition Although oligopolies are significant to a country’s economy because of their ability to generate the biggest share of national income, if left unwatched they impact negatively on the consumer (Hollingsworth, 2004, p.632). To begin with, the fact that oligopolisits are highly concentrated leaves the consumer with little or no choice but to purchase the firms products. Secondly, since the high barriers of entry discourage competition the firms can collude to charge high prices to the disadvantage of the consumers (Hollingsworth, 2004, p.634). According to Howe (1998, p. 219) oligopolists have been regarded as inefficeint in terms of allocation and productivity as shown in the figure below. Source: http://economicsonline.co.uk/Business_economics/Oligopoly.html Conclusion and recommendation In conclusion, Tesco UK operates under an oligopolistic market structure. However, despite the disadvantage associated with oligopolies supermarkets in UK can still increase their competitive behavior by eliminating the artificial barriers of entry mainly by charging reasonable prices for their goods. More importantly, the firms can use the research and development strategy to the consumers advantage whereby through innovations and development of new products the consumer end up gaining instead of using it to bar entry of new entrants (Harvey,2000,17). Finally, Tesco being the price leader can ensure that prices remain stable rather than fuelling price wars among the major supermarkets. Price stability will be advantageous for the consumers since they are able to budget for their future expenditure. References Cooper, D. 2003. Findings from theCompetition Commission's inquiry into supermarkets. Journal of Agricultural Economics, 54(1), 127-143. Harvey, M. 2000. Innovation and competition in UK supermarkets. 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