Could Tesco’s “Price Promise” be anti-competitive?

For a few years, Tesco has been operating what it calls its “Price Promise”, in which it states that “[w]hen you shop at Tesco, we’ll check your basket against the prices at Asda, Sainsbury’s and Morrisons. If your comparable grocery shopping would have been cheaper there, we’ll give you a voucher for the difference (up to £10)” (see Tesco’s website).

In other words, Tesco is promising to match any lower price charged by a rival. This is precisely what the economic literature refers to as a “price-matching guarantee” (PMG) – one firm promises to match the price of a rival firm should it transpire that the customer could have obtained a lower price at that rival firm.

At first glance, this appears to be uncontroversially beneficial to consumers – they are guaranteed to receive the best possible price wherever they shop, such that they can save on “search costs” (essentially, time and money spent searching for the cheapest price) while at the same time obtaining the cheapest price.

However, this simple assessment fails to take into account the incentive of PMGs on the retailers themselves. If one retailer is considering decreasing its price, it will determine whether or not doing so would be profitable by weighing the decrease in margin per unit sold it would obtain against the increase in sales it would make (via enticing additional customers to purchase the product at the lower price). If its rivals do not have a PMG in place, then the price cut would result in consumers switching from rival retailers such that the price cut might be profitable. On the other hand, if rivals have PMGs in place, then the price cut might not be profitable as consumers have no incentive to switch to the cheaper retailer – they can just tell their current retailer that they have found a cheaper price elsewhere and be refunded the difference. Hence, if rivals have PMGs, then an individual retailer would experience a reduced increase in sales subsequent to a price cut, thereby decreasing that retailer’s incentives to cut prices in the first place. As such, PMGs could harm consumers by maintaining an “artificially” high level of retail prices.

Indeed, the findings in economic literature are generally inconclusive (An excellent non-technical summary of the literature is available here). Some results (see here) suggest that PMGs can act as a credible commitment by a retailer to keep prices low – a retailer making a price guarantee is effectively signalling to consumers that they will do everything they can to keep prices low because they know that if they do not, then consumers will be able to claim money back from them. In this way, PMGs could help competition by making consumers aware of alternatives that charge a lower price than their current provider.

However, other findings (see here) suggest that the incentive effect described above outweighs all other factors, such that the presence of PMGs leads to higher retail prices. In this way, PMGs could hinder competition because they reduce the potential profitability of a price cut by any one retailer (since, if a single retailer were to decrease price, it knows that its rival with a PMG will automatically match it anyway, so the retailer contemplating a price cut would gain fewer customers than it would if its rival did not match its price).

As such, there is a potential that Tesco’s Price Promise is anti-competitive, but it is difficult to reach a definitive conclusion.

Milk prices in the UK: Subsidies and their impact

There has been more than a little recent commotion regarding the prices that supermarkets and milk processing firms pay dairy farmers for supplying their milk. Indeed, the BBC has reported that some farmers have paraded cows through aisles in certain supermarkets, block-bought all the milk no a supermarket’s shelves, or simply blockaded a supermarket (see here, here, and here).

The motivation underlying these protests appears to stem from small dairy farms (such as those operated by “family farmers”) being unable to make a profit at the prices that supermarkets and milk processing firms are willing to pay for their milk. The Guardian mentions farmers’ claims that their break-even level (i.e. the level above which they start to make a profit) is 30p per litre, but that farmers are only paid about 24p per litre, resulting in a loss of 6p per litre (see here).

This has lead to protests that farmers should be paid more for their milk. However, these protests do not appear to have considered the impact of this price increase on the overall efficiency of milk production. Presumably, the larger milk farms (i.e. those run on a large scale, rather than by individual households) are able to make a reasonable profit at the prevailing price – this profit can be considered a “reward” for those farms making the best use of their resources to produce at as low a cost as possible.

On the other hand, if small dairy farms cannot produce at a cost lower than the price they receive, ordinarily they would go out of business because they are too inefficient to compete with their rivals. This is a standard economic process of obtaining “productive efficiency” – i.e. that all goods are produced at the lowest possible price.

If small dairy farms are (effectively) subsidised via the supermarkets paying a higher price, that would keep them in business, but at what cost? First, the production of milk would not be using the most efficient resources available to it. Instead, inefficient farms would be encouraged to remain in business producing milk when those resources (the people working on the farm, the equipment used, and the land itself) could be put to a more productive use. Moreover, farms that would be able to become more efficient if they had the incentive to do so (i.e. were receiving a lower price) would no longer need to make the necessary investments that would make them more efficient. In other words, subsidising small dairy farmers has the potential to harm the overall efficiency and productivity of the economy, both in the short-term and in the long-run. In other words, the reduction in efficiency and productivity would result in the UK’s GDP being lower than otherwise had the resources tied-up in the inefficient milk farms been put to other, more productive use.

Second, the fact that supermarkets are paying a higher price for their milk means that their costs have increased – it is plausible that these costs could be passed on to consumers in the form of higher milk prices. As milk is a staple product, any increase in the price of milk is likely to affect a large number of consumers, so the effective subsidising of small dairy farms has the potential to cause wide-ranging effects across the whole economy. In particular, if consumers need to pay more for their milk, they would have less disposable income to spend on other products, resulting in a decrease in demand. However, given that any increase in the price of milk is likely to be small, the magnitude of this effect may well be negligible.

Third, any increase in the price of milk paid to farms (to the extent that the price of milk is not negotiated on a bilateral basis) means that those farms that are already efficient merely serves to increase the profits of these farms. It is somewhat surprising that this aspect of an increase in milk prices has not received more attention, particularly if one has ethical qualms regarding policies that increase the profits of international firms.

Obviously, weighed against these points are any potential benefits that arise from the continued existence of small dairy farms. Perhaps benefits are derived from their impact on the countryside and/or the local communities in which they operate. I am not in a position to elucidate on these potential benefits, but the “cons” of any increase in the price of milk via an effective subsidy certainly need to be taken into account.

A nice, non-controversial topic to start off!