Measuring market power

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Measuring market power

• Lecture 32
• Economics of Food Markets
• Alan Matthews

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Lecture objectives

• What methods can economists use to measure market
  power in the food industry?
• What is the evidence on the use/abuse of market
  power from empirical studies?

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Readings

• Processor power
• US Senate and Tweeten response
• Retail buyer power
• Dobson, UK Competition Commission
• Empirical studies
• Bunte, London Economics

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A priori stylised facts

• Growing concentration upstream and downstream of
  farmers
• Farmers share of consumer spending is falling
• Farm-retail price spreads are widening,
  suggesting farmers are being squeezed
• When farm prices fall, retail prices rarely
  follow, suggesting profit-taking by oligopolistic
  firms

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Farmers share of consumers spending

• Can be measured in various ways
• The marketing bill
• the difference between consumer expenditure on
  food (excluding imports, beverages and seafood)
  and the farm value.
• Reflects changes in price, product quantity,
  product mix and the quantity of marketing
  services.
• The market basket approach
• measures the changing cost of a fixed basket of
  groceries
• Cost changes solely the result of changes in
  prices

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Farmers share of the consumers euro

• Farm-retail price spread
• Used for measuring farm share of individual
  products
• Must be measured in equivalent units
• Example
• For steers, 2.5 kg of live weight yield 1 kg of
  retail beef cuts
• 2000 retail beef price 8.40/kg average all
  cuts
• 2000 steer price 1.20/kg live weight
• 2000 farm-retail price spread 5.40/kg retail
  cut
• ( 8.40 2.51.20)
• However measured, evidence that farmers share is
  falling over time

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Evolution of Danish farm retail price spreads
(Source Baker 2003)
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Interpreting changes in the farmers share

• Is a large farm-retail price spread necessarily
  bad?
• Shift in consumption patterns towards food with
  higher value added and more food
  eaten-away-from-home (marketing bill)
• Factor productivity increases more rapidly in
  agriculture than in manufacturing, let alone
  services
• Could be due to growing market power
• Latter suspicion fuelled when reductions in farm
  prices are not passed through in lower retail
  prices

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Real price of food is falling.
Source Agri-Aware website
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but Irish food prices remain high compared to
other EU countries
2003 comparative price level indices for the main
food sub-groups, EU25100 Source Eurostat
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Buyer power at retail level

• Refers to the ability of leading retail firms to
  obtain from suppliers more favourable terms than
  those available to other buyers, or which would
  otherwise be expected under normal competitive
  conditions.
• Extract discounts and obtain low prices
• Onerous contractual obligations
• Ability to shift financial risk to suppliers

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Sources of retail buyer power

• Differences in relative economic dependency,
  determined by relative sizes of contracts and
  relative switching costs
• Multi-faceted roles of retailers as they appear
  to suppliers (Dobson 2005)
• Customers, competitors and suppliers

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Examples of retail buyer power

• Depends on whether firms operate in a market or
  bargaining framework
• Demand withholding
• Adverse investment and innovation effects
• The waterbed effect
• Supply chain practices

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Supermarket practices related to relations with
suppliers
Category of practices Number of practices against the public interest
Payments for access to shelf space 4
Imposing conditions on suppliers trade with other retailers 0
Applying different standard to different suppliers 1
Imposing an unfair imbalance of risk 10
Imposing retrospective changes to contractual terms 6
Imposing charges and transferring costs to suppliers 5
Requiring suppliers to use third party suppliers nominated by the retailer 1
Source UK Competition Commission (2000)
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Measuring welfare loss of market power

• Role of demand elasticity
• What about the Posner rectangle A?

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Approaches to the empirical analysis of
farm-retail price spreads

• Structure-conduct-performance paradigm
• New empirical industrial organisation
• Time series price transmission studies

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Structure-conduct-performance studies

• Examine the cross-industry or geographic (cross
  section) or time (time series) variation in
  prices, controlling for local market cost
  variations
• Short review in London Economics Annex 5
• Market concentration measures Cn measures, HHI
  index
• Indicators of market power price-cost markup
  (Lerner index), prices, margins, profitability
• Many studies have found significant relationship
  between measures of market concentration and
  indicators of market power

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Empirical SCP studies

• Market power generates consumer welfare losses
• ..but concentration may also have positive
  effects on firm efficiency
• Vulnerable to critique that market concentration
  is correlated with profits because efficient
  (i.e. low cost) firms acquire greater market
  shares over time, not because of pricing power
• Rely on reduced form models. Firm behaviour is
  not explicitly modelled and no statistical tests
  are performed

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New empirical industrial organisation models

• Focus of this literature is on the conduct of
  firms within a particular industry
• Based on structural oligopoly models by
  specifying the first-order conditions for the
  profit maximising behaviour of a single
  oligopolist
• The key behavioural parameter in this approach is
  the conjectural variation of the oligopolist
  (usually designated as ?), which measures the
  degree to which a firm takes into account its
  rivals reactions to its own output choice

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Supply of an oligopolistic firm

• Profits for firm j total revenue less variable
  costs
• Demand function
• Total supply
• Conjectural variations elasticity Percent
  change in total output for a 1 change in firm
  output
• First order condition. When ?j 0, reduces to
  the competitive outcome
• Tj/? Lerner index for oligopoly power,
  represents the degree to which a firm can set
  output price above marginal cost

Source Appelbaum, 1982
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New empirical industrial organisation models

• The expectation of a limited market response to a
  change in firm output (low ?) suggests market is
  competitive.
• Expectation of an extensive market response
  suggests presence of market power (high ?)
• Estimating the structural model allows the
  empirical data to provide information on the
  value of ?
• Given the value of ?, the size of the market
  power mark up can be calculated.

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New empirical industrial organisation models

• Weaknesses
• The estimate of market power relies crucially on
  accurate estimates of the underlying market and
  cost conditions
• Theoretically highly appealing, but complex to
  apply empirically and often requires simplifying
  assumptions

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Price transmission studies

• Concern is that reductions in farm prices are not
  passed on to consumers in form of lower retail
  prices
• Three issues
• Prices changes are not fully transmitted
• There is a time lag between the price adjustments
  at the respective stages
• There is an asymmetry in reaction between
  positive and negative price shocks.
• Imperfections in price transmission may be due to
  market power but can also be due to adjustment
  costs (relabelling prices, advertising, goodwill)

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Price transmission studies

• Traditional regression methods (regressing retail
  price on farm price) ignore time series
  properties and give biased results
• Co-integration methods are now preferred, which
  also allow for speed of adjustment and direction
  of causality to be inferred, as well as testing
  for asymmetric price responses

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London Economics case study

• Uses a variety of approaches
• Simple correlation analysis between changes in
  farm-retail price spreads and concentration
  ratios
• Reduced form SCP model linking spreads to
  concentration, controlling for other factors
• Four food products wheat products, red meat,
  poultry, fruit and vegetables drawn from nine
  countries

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Correlation coefficients are generally low,
whether spreads are measured in absolute amounts
or as a ratio of the two prices (relative
spread) Highest correlation coefficient obtained
for cereals of about 0.3 Source London
Economics 2004
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When changes in concentration are correlated with
changes in spreads, in some cases the correlation
is negative Correlation coefficients are
sensitive to the time period chosen, but even
when time period is divided, coefficients remain
low Source London Economics 2004
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Example London Economics SCP model

• Purpose is to determine the influence of changing
  concentration ratios on the farm-retail price
  spread
• Model is
• Spread f(lagged spread, SCCOSTS, CSHARE,
  LIP, EXRATE, C5, Trend)

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Example London Economics SCP model
Spread Price spread (including lagged values)
SSCOSTS Economy-wide indicator of costs sustained along the supply chain
CSHARE The share of the product used directly for human consumption in total domestic supply. This variable controls for any impact of demand and supply shifts on farm-retail spreads.
LIP Log(Intervention Price)
EXRATE Vector of exchange rates against the euro
C5 Share of food retail market accounted for by top 5 firms
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Example London Economics SCP model

• Concentration in the retail domestic market does
  not seem to have a significant impact on the
  evolution of spreads.
• Confirms conclusions from correlation analysis

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The Marion et al study of monopsony power in US
beef packing

• Tries to determine influence of packer
  concentration on cattle prices and packer margins
• Uses model
• P f (B, S, PG, R, NSD)
• Estimates using pooled cross section data from 13
  regional markets for time period 1971-1986

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The Marion et al study of monopsony power in US
beef packing
P Price of beef cattle
B Structure of regional buying markets. Packers shares of total cattle slaughtered using various concentration measures
S Structure of regional selling markets. Per cent of cattle coming from feedlots with capacity of 1000 head or more
PC Packer costs measured by three variables employee wages economies of scale binary variable if large plant existed and distribution costs, distance from major market
R Rivalry or market turbulence. Measured as change in CR between years or relative share instability
NSD National supply-demand, measured by either national prices or yearly dummies
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The Marion et al study of monopsony power in US
beef packing

• Conclusions
• Evidence that higher concentration is
  significantly related to lower cattle prices
  paid, other factors controlled for
• Relationship is less clear during period 1979-86
  when packer concentration was increasing sharply
  and there was excess capacity and considerable
  competition for supplies