Competitionin Retailing

Prepared for the Office of Fair Tradingby London Economics

September 1997 Research paper 13

Please note. Page numbers have beenremoved from this PDF version of the

report.

Summary

1. Main findings

2. Specific findings

2.1. The nature of retailing

2.2. A framework for assessing competition in retailing

Introduction

1. An introduction to modern UK retailing

1.1 Overview of UK retailing

1.1.1 The main retailing sectors

1.1.2 Retail expenditure by households

1.2 Concentration in UK retailing

1.2.1 Economies of scale in store operations

1.2.2 Retailers and centralised distribution

1.3 Technology and innovation in retailing

1.3.1 Introduction of information technology in retailing

1.3.2 Product development

1.3.3 New forms of retailing

2. The economics of retailing

2.1 Characteristics of consumers

2.2 What do retailers do?

2.2.1 Manufacturer relationships

2.2.2 Logistics

2.2.3 Consumer relationships

2.3 Dimensions of competition in retailing

2.3.1 Pricing

2.3.2 Geographical location

2.3.3 Product selection

2.3.4 Level and quality of retailer service

2.4 Vertical issues

2.4.1 The economics of vertical restraints

2.5 Policy implications

2.5.1 Identification of competition issues

2.5.2 Preliminary analysis

2.5.3 Suggested framework

3. Market definition

3.1 The OFT/NERA market definition methodology

3.2 The nature of the retail end-product

3.2.1 An example: direct sales channels versus

store-based retailing

3.3 Applying the US SSNIP test to retailing

3.3.1 Retailer market definition: demand-side substitutability

3.3.2 Retailer market definition: supply-side substitutability

3.3.3 Geographical market definition at the retail level

3.4 Dimensions of competition other than price

3.5 Summary

4. Barriers to entry

4.1 The OFT/LE barriers to entry methodology

4.2 Absolute advantages

4.2.1 Legal and regulatory restrictions

4.2.2 Access to retail sites

4.2.3 Advertising restrictions

4.3 Strategic advantages: sunk cost and economies of scale

4.4 Strategic advantages: advertising, goodwill and retailer

differentiation

4.4.1 Advertising

4.4.2 Goodwill and loyalty

4.4.3 Product proliferation and retailer differentiation

4.5 Capital requirements

4.6 Entry impediments

5. Competition assessment: market structure

5.1 Market structure and market power

5.1.1 Retailers’ market shares

5.1.2 Measuring market power

5.2 Merger case study: Kingfisher plc and Dixons Group plc

5.2.1 Assessment of market structure

5.2.2 Dimensions of competition

5.2.3 Merger issues

5.3 Merger case study: Grand Metropolitan plc and William Hill

Organisation Ltd

5.3.1 Assessment of market structure

5.3.2 Dimensions of competition between bookmakers

5.3.3 Merger issues

6. Pricing issues

6.1 Price collusion

6.2 Predatory pricing

6.3 Price discrimination

6.4 Loss leading

7. Vertical issues

7.1 The economics of vertical restraints

7.1.1 Efficiency motives

7.1.2 Anti-competitive motives (and effects)

7.1.3 Rent sharing motives

7.2 Assessing vertical restraints

7.3 Implications for recent cases

Appendix 1:

References

The views expressed in this report are those of the authors and do not necessarilyreflect the views of the Office of Fair Trading

©Crown copyright 1997This material may be freely reproduced except for sale or advertising purposes

Summary

The Office of Fair Trading has commissioned this study as one in a series of research

reports on competition policy. The terms of reference ask whether the UK competition

authorities need to follow a different approach when they are required to assess

competition issues involving retailing.

1. Main findings

Our analysis concludes firstly that competition problems are likely to be particularly

prevalent in retailing, and secondly that there are significant differences between retailing

and other areas of the economy, but that these differences are a matter of degree rather

than exclusive to retailing. This means that, while the emphasis of competition policy

will often be different in retailing, there should be no need for any major change in

general competition policy methodologies.

However, in the process of analysing competition policy in retailing, we have discovered

certain difficulties in applying some of the existing general methodologies. This does not

mean that retailing requires separate methodologies, but rather that the current general

methodologies need to be amended. This leads us to recommend that:

C Competition enquiries should always start with an identification of therelevant competition issues and then proceed with a preliminary analysis

of demand and supply factors, particularly of the general characteristics

of consumers and the dimensions of retailer competition;

C Market definition should ensure that the identification of the relevant

market or markets serve to clarify the competition issue and that the

retailer market is separately identified from the product market; and

C Existing approaches to vertical restraints need to be refined with respect

to the increased role of retailers in their establishment and enforcement.

However, the existence of retailers may itself also be a factor allowing manufacturers1

to become large, and to exploit economies of scale in production.

C 2. Specific findings

2.1 The nature of retailing

Retailing is the final link between the production of a good and the end-consumer. The

economic characteristics of the end-consumer are thus crucial to the economics of

retailing. Typically, the end-consumer can be characterised as being:

• 1 Small (in the sense that the size of a given purchase forms a small part

both of the consumer’s total expenditure and of the retailer’s total sales);

• 2 Immobile (in the sense that they are often not able or willing to travel

long distances in order to purchase the appropriate product); and

• 3 Uninformed (in the sense that they often do not know which products

are available where, and what prices; and they may not be able to

observe product quality in advance of purchase).

The combination of these characteristics explains essentially why retailers exist.

The fact that consumers’ purchases tend to be small means that retailers play an important

role in preventing the exploitation of consumers by manufacturers: no single consumer

would have any bargaining power against powerful manufacturers, whereas retailers can

bargain strongly on their behalf. 1

The fact that consumers are immobile means that retailers play an important function in

bringing the products to the consumers, to prevent the consumer from having to go to the

product.

The fact that consumers are uninformed about the availability of products, their prices,

and their qualities means that retailers carry out an important service in terms of providing

information and quality assurances.

These characteristics also explain many aspects of retailing. For example, consumers’

immobility means that geographical location and one-stop shopping will be important,

while their lack of information means that price visibility, product range, and

reputation/quality assurances will be important.

These aspects of retailing feed straight into a discussion of the nature of competition in

retailing. We identify four dimensions of horizontal competition between retailers:

• 1 Pricing;

• 2 Geographical location;

• 3 Product selection; and

• 4 Retailer service.

These various dimensions in retailing have important consequences for competition

policy, and it is crucial, when considering competition in retailing, to examine all of these

dimensions.

• 2.2 A framework for assessing competition in retailing

Competition problems are likely to be particularly prevalent in retailing, since markets

will only tend to work imperfectly when there are asymmetries in bargaining power

(consumers are small), high transactions costs (consumers are immobile), information

asymmetries (consumers are uninformed), or vertical restraints.

Indeed, there have been numerous cases where the OFT and MMC had to look at

competition in retailing. The issues typically covered include:

• 1 Pricing issues (including excessive pricing, discriminatory pricing,

predatory pricing, and loss leading);

• 2 Merger issues (for which market definition is crucial); and

• 3 Vertical issues (including vertical restraints, differential discounting, and

own-brand competition).

In order to analyse these various issues, we suggest the following framework:

1. Identification of competition issues

2. Preliminary analysis of retailing:

C the characteristics of consumers; and

C the dimensions of competition between retailers.

3. Market definition

4 Barriers to entry

5 Competition assessment:

C market structure and merger issues;

C pricing issues; and

C vertical issues.

Identification of competition issues

We suggest that at the outset of every enquiry the competition issues are clearly identified.

Each step in the assessment of competition in retailing has to be considered in the context

of the specific competition issue, and cannot be dealt with in isolation. Some competition

issues (such as those resulting from a merger between retailers) are easily identified,

whereas a more general complaint of excessive prices for a class of products may require

an in-depth investigation of both the retailing and the wholesale/manufacturing element

of the supply chain.

C Preliminary analysis of retailing

We suggest one important addition to the current methodology: that every investigation

should include a preliminary analysis of the specific characteristics of retailing. In some

recent competition cases (e.g. Contact Lens Solution, 1993), this has been carried out very

effectively, but other cases have exhibited a poor understanding of the characteristics of

the retail market. Without this step, it is extremely difficult to appreciate the typical

competition problems that retailing engenders.

The first part of this descriptive analysis should focus on the characteristics of consumers

in terms of the size and frequency of their purchase, shopping behaviour in terms of

travel distance and, most importantly, the way in which consumers obtain information

about prices, availability and quality of products.

The second part should focus on the dimensions of competition between retailers in terms

of price, geographical location, product selection, and the various types of retailer service.

Market definition

The OFT/NERA report Market Definition in UK Competition Policy effectively

recommends the use of the US Small test to define relevant market. In terms of applying

the SSNIP test to retailing, however, there are a number of complicating issues:

a) Product markets versus retailer markets. Consumers buy a bundled good from a

retailer, which consists of the product itself plus the retailer’s value added (in terms

of retailer service, location, gatekeeper function, etc). Different retailers vary

greatly in the types of retailer value-added which they provide. In enquiries that

relate to the retailing of a particular product group, it is therefore important to

distinguish between relevant product markets and relevant retailer markets, and to

define these separately. Usually this means that the relevant product markets should

be defined first, and that then the relevant retailer market should be defined with

respect to thetype of retailer.

b) Dimensions of competition. The fact that retailers compete in different ways and

in different dimensions will sometimes mean that there is more than one possible

definition of relevant retailer markets, depending on which aspects of retailers’

behaviour are being analysed. With respect to the geographic dimension this

means that local markets are usually defined with reference to demand-side issues

(such as price and transaction costs). But it easily may be the case that national

markets are more likely to be relevant when considering certain forms of strategic

behaviour (such as national pricing policies, advertising, brand reputation and

purchasing). Moreover, the nature of competition across a number of potential

relevant retailer markets may sometimes so affect competition between retailers

that the market definition needs to be adapted to serve the focus of the competition

assessment.

Our general conclusion is that market definition should never take place in a vacuum.

Rather, it is always important to keep in mind exactly what it is about competition that is

of concern and how market definition helps us in analysing this aspect of competition.

Indeed, there may be several possible market definitions, each of which is valid for

looking at a particular issue.

b) Barriers to entry

The OFT/LE report Barriers to Entry and Exit in UK Competition Policy divides barriers

to entry into a number of groups.

Firstly, it distinguishes between entry barriers and entry impediments: the former prevent

entry, while the latter delay it. Obtaining planning permission can be an important entry

impediment (especially for out-of-town retailers). The time taken to form contracts with

suppliers may be another. However, the most important entry impediment in the retail

sector is probably the time it takes for a new retailer to establish itself with customers,

particularly if reputation is important.

Secondly, within the category of entry barriers, the report distinguishes absolute cost

advantages and strategic (first mover) advantages. The former include regulatory

barriers to entry. For example, in some retail markets (such as pharmacies and betting

shops), there are regulations restricting the number of local competitors. Similarly, for

some retail products (such as contact lens solutions in 1992), there are regulations

restricting the types of retailers which can sell the product. Both of these are important

in protecting incumbent retailers from entry. In addition, in some retail markets, prime

geographical location can be crucial, and (if this is not tradable) this may be an absolute

cost advantage.

Thirdly, within strategic (first mover) advantages, the report distinguishes five categories,

which can be recast for the purposes of retailing as:

• 1 Economies of scale and scope;

• 2 Advertising, goodwill, market positioning, and geographical location;

• 3 Capital requirements;

• 4 Vertical foreclosure and exclusion; and

• 5 Predatory pricing.

The importance of economies of scale and scope as a barrier to entry depends on their

size relative to the size of the market. These economies can be important because retail

markets tend to consist of a whole series of small local sub-markets. Economies of scale

and scope in distribution, reputation formation, and negotiating with manufacturers, can

also mean that it is difficult successfully to enter some retail markets on anything but a

national level.

Advertising is itself not as important a barrier to entry in retail markets as it is in product

markets, but promoting retailer image in other ways can be crucial, and spending on this

may result in barriers to entry. Goodwill amongst customers, meanwhile, is likely to be

a very strong barrier to entry into many retail markets. The fact that consumers are small,

immobile and uninformed means that they tend to face fairly large costs of switching

between retailers, which can make it hard for entrants to gain sufficient market share to

make entry worthwhile. In terms of market positioning, retailers can increase their

portfolio of products in such a way that retailers which only provide a subset of the

products cannot compete in the market, and this is an important barrier to entry.

Geographical location can also act as a barrier to entry in some markets, but the

importance of this is often overstated.

It is not clear that capital requirements are likely to be more important in retailing than

in other areas of the economy. Vertical restraints and predatory pricing are analysed in

the section on competition assessment.

C Competition assessment

There are three sets of issues covered in our competition assessment:

• 1 Market structure and merger issues: creation or strengthening of market

power of retailers, measurement of market power, market shares, barriers

to entry and strategic advantages;

• 2 Pricing issues: price collusion between retailers, predatory pricing, price

discrimination, tying/bundling, and loss leading; and

• 3 Vertical issues: vertical restraints, differential discounting, and own-

brand competition.

The assessment of market shares and strategic advantages of the various retailers in the

market is helpful in clarifying the degree to which market power is present. This step

brings together the results from the previous steps and leads into the assessment of

merger, pricing, and vertical issues.

The creation or strengthening of the market power through merger is a common concern.

However, the importance of local sub-markets and of non-price competition mean that

merger investigations are particularly complicated in retailing. Definition of the relevant

market is crucial, as is consideration of the effects of merger on all aspects of competition,

and not just price. In particular, geographical location can be an important motive for

merger in retailing.

Price collusion between retailers, price discrimination, tying/bundling and loss leading

are all issues that are relatively common in retailing. Our report sets out the issues

involved in these various pricing strategies and discusses possible remedies.

Vertical restraints are very important between retailers and manufacturers. However, the

form of these vertical restraints has changed over time: they are less often of the

traditional general form, and more often in the form of specific agreements/contracts or

direct intervention; they are also now instigated by retailers more often than has

traditionally been the case.

There are many efficiency and rent sharing justifications for these various forms of

vertical restraint, but they may also have an important anticompetitive effect: limiting

competition or preventing entry. There is unlikely to be any major concern unless they

have a major negative effect on horizontal competition either upstream or downstream.

Own-brand competition is also rising in importance. Because retailers have final control

over promotional tools such as shelf space, they may discriminate in favour of their own-

brand products (because they receive higher margins on these). Where own-brand

products are designed to resemble the brand leader, the retailers may be free-riding on

manufacturers’ investment in brand image.

C Introduction

This study is one of a series of reports commissioned and published by the Office of Fair

Trading (OFT). The first two reports in this series were general studies on market

definition (NERA, 1993) and on barriers to entry (by London Economics (LE), 1994).

The objective of this latest study is to assess the approach currently taken by the OFT to

competition issues in the retailing sector.

Such a study is both timely and relevant. The economic importance of the retailing sector,

and the many changes that have occurred within it, mean that this sector is a prime area

for competition enquiries. In recent years, there have been numerous enquiries by the

OFT and the Monopolies and Mergers Commission (MMC) into markets where retailers’

behaviour has been subject to complaints, or where the relevant laws oblige the OFT to

consider the competition implications of certain business strategies, either of, or relating

to, retailers.

The principal aim of this report is to provide recommendations on the general analytical

approach the OFT should take to retailing cases. In particular, it examines whether

retailing has features which may require refinement of the general approach to

competition inquiries.

In order to meet these objectives, the report first provides a brief overview of retailing in

the UK. It then examines the economic nature of retailing in some detail. Retailing

activities range from the simple provision of storage and display of goods, to a complex

interaction between retailers, suppliers, and consumers. The role of retailers is to

overcome a number of problems that consumers would face if they had to deal directly

with suppliers of goods. These problems relate to lack of bargaining power, lack of

mobility and lack of information. Retailers perform this intermediary role by providing

a number of value-added services, building long term relationships with consumers and

suppliers. Competition between retailers is determined by the scope of these activities,

and the constraints that retailers face in choosing market position, both in terms of

products and geography.

The report then turns to the implications for competition policy in retailing. This analysis

examines three sets of methodological issues:

C Market definition: covering product, retailing and geographic aspects,

and considering the conclusions of the study by NERA;

C Barriers to entry: with a particular emphasis on applying the LE barriers

to entry framework to retailing;

C Competition assessment: including horizontal competition between

retailers, vertical relationships between retailers and upstream

manufacturers, and other types of market behaviour which commonly

attract complaints.

Our conclusions are based on an analysis of the OFT’s current approach to retailing cases,

including the review and adaptation of the approaches developed to market definition and

barriers to entry in the NERA (1993) and LE (1994) papers, so that they can be applied

to the retail sector.

We examine the appropriate approach to competition issues in retailing with reference to

examples from recent UK competition enquiries. All the cases referred to in this report

are MMC case unless stated otherwise. These cases include:

1 Merger cases: Kingfisher plc and Dixons Group plc (1990), Grand

Metropolitan plc and William Hill Organisation Ltd (1989), and Tesco-

Wm. Low (OFT, 1994).

2 Excessive pricing and collusion: The Supply of Petrol (1990), Contact

Lens Solutions (1993), The Supply of Recorded Music (1994), and

Contraceptive Sheaths (1994).

3 Predatory pricing and price discrimination: Contraceptive Sheaths, and

Black and Decker (1989).

4 Vertical restraints: Fine Fragrances (1993), Ice cream (1994), New

Motor Cars (1992), and The Supply of Petrol (1990).

The economic characteristics of retailing are discussed in more detail in the following chapter.2

Data relates to retailing plus wholesaling activities, but excludes expenditure on motor cars.3

Whilst this may be true for the retail sector as a whole, we would expect large variations to occur between4

different retail markets. DIY and motor cars, for example, will be very sensitive to the economic cycle,whilst food and tobacco will be less so.

1. An introduction to modern UK retailing

Retailing is the final link between the production of a good and the end-consumer. Retailersprovide an important function for end-consumers in a number of respects. On behalf of end-2

consumers, they select goods and they collect and store them. They also assist end-consumersin making their choices through the provision of product information and after sales service.

This chapter provides a brief description of modern retailing in the UK, in order to provideevidence on some of the analytical points made in Chapter 2. The first section illustrates therelative importance of different retailing sectors with reference to some key statistics. It alsoincludes a general overview of retail expenditure by households. The second sectiondiscusses some general aspects of the trend towards increased concentration in retailing. Thistrend is linked with the exploitation of economies of scale and scope in the operation of storesand the increases in efficiency of distribution and inventory management. The third sectionreviews, in summary form, developments of technology in retailing and innovations inretailing formats.

1.1 Overview of UK retailing

Retailing is one of the most important sectors of the UK economy in terms of its contributionto GDP. As UK GDP has increased over the last two decades, the retail (and wholesale)sector has grown in line. In 1973, the retail (and wholesale) sector’s output was £39.8 billion.By 1993, this had risen to £55.4 billion (both figures expressed in 1990 prices): an averageannual growth rate of nearly 1.7 per cent.3

Figure 1 shows that retailing and wholesaling sector has accounted for around 10 to 12 percent of the UK’s GDP over the last twenty years (on average it has represented 11 per cent ofGDP). This sector is particularly sensitive to the economic cycle, being hit harder thanaverage in times of economic recession and recovering its share of UK GDP as the economypicks up. Despite the so-called ‘retailing boom’ in the mid-to-late 1980s, there was not amassive increase in this sector’s share of GDP. The implication is that the performance of theUK’s retailing (and wholesaling) sector responds proportionately to the general economicclimate in the country.4

0%

2%

4%

6%

8%

10%

12%

1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993

Source: CSO Blue Book ; LECalculations.

Figure 1 : Retailing, wholesaling and repairs' contribution to UK GDP

1.1.1 The main retailing sectors

Food retailers are by far the largest retailing group in the UK. Table 1 shows that foodretailing accounts for almost 38 per cent of UK retail sales, whilst the large grocery retailersalone account for 30 per cent of all UK retail sales. There are a relatively small number oflarge grocery retailers, each of which operate a large number of stores (on average the largegrocers operate 113 stores each, compared to an average of 1.3 stores per retailer for the foodsector as a whole), generating large per-store turnover. The top five large grocery retailersaccount for 48 per cent of all sales (although the actual figure will be substantially lower than

this, since these retailers also sell many non-food items).

Other types of retail outlets which are important include:

C Confectionery, tobacco and newsagents (CTNs) represent 7.8 per cent oftotal UK retail turnover. These tend to be small businesses, most retailersoperating only one outlet. The top five retailers account for just 14 per centof all sales by CTNs.

C Clothing retailers represent 7 per cent of total UK retail turnover. There tendto be more multiples in this sector than in CTNs, although nowhere near asmany as in food retailing, with an average of 1.9 stores operated by eachretailer. The top five clothing retailers represent 29 per cent of all sales inthis sector.

C Household textiles, furniture and carpet retailers account for over 5 per centof the UK retail market. The top five retailers in this sector account for 17per cent of sales in this category. Again, most retailers tend to be small, withan average of 1.3 outlets operated per business.

C Electrical and music goods retailers make over 5 per cent of all UK retailsales. This is a relatively concentrated area of retailing, with the top fivefirms accounting for over 30 per cent of sales. However, many retailers aresmall, as is reflected by there being an average of 1.6 stores operated perretail business in this area.

C Other large sectors are DIY retailers (with 3.5 per cent of all retail sales) andchemists (with 3.7 per cent of all retail sales). Mixed retail businessesaccount for over 15 per cent of all retail sales, but include many retailers whoprobably do not operate in the same market.

C Some UK retail sales are transacted through outlets other than stores. Mailorder retailing is the most important of these, and accounts for almost 3 percent of retail sales in the UK.

1.1.2 Retail expenditure by households

Although this statistical overview illustrates the structure of the UK retailing industry, it sayslittle about the type of retail expenditure by households in individual retail markets in the UK.This is because the data presented in Table 1.1 relates to expenditure by type of outlet, ratherthan by product type. This issue is addressed in Table 1-2, which shows expenditure on retailproducts in the UK in 1993.

This table is not perfect either, since not all the categories of expenditure shown are purchasedby consumers through retail outlets. Housing is the most obvious example. However, itshows clearly which items of expenditure are most important in the average UK consumer’sconsumption pattern:

C Food accounts for 18 per cent of expenditure;

C Clothing and footwear accounts for 6 per cent of expenditure;

C Household goods account for 8 per cent of expenditure;

C Motoring expenditure accounts for 13 per cent of expenditure;

C Leisure goods account for 5 per cent of expenditure (of this, electricalequipment was the largest component);

C Leisure services represent 9 per cent of expenditure (this is a broad categoryincluding cinema, theatre, sports and other live entertainment, televisionlicences and rental, hotel and holiday expenses and cash gifts and donations).

7

Table 1-1 : Retailing in the UK in 1992 (by outlets)Total turnover Number of Number of outlets Gross profit Advertising

£ m (shaded area businesses margin expenditure £ min %)

TOTAL RETAIL TRADE 144,135 219,131 318,751 30.4% 569.7FOOD RETAILERS 54,488 60,119 78,606 25.4% Large grocery retailers 43,221 71 8,003 24.3% 101.1Top 5 grocery groups as a % of total 47.9% 3.1% CTNs 11,049 41,502 48,554 17.0% Top 5 CTN groups as a % of total 13.2% 6.4% OFF-LICENCES 3,002 5,169 9,445 15.7% 5.0Top 5 off-licence groups. as a % of total 52.4% 43.0% CLOTHING RETAILERS 9,875 21,347 40,343 44.5% 13.8Top 5 clothing groups as a % of total 30.0% 9.3% FOOTWEAR RETAILERS 2,643 3,098 10,144 41.7% 1.7Top 5 footwear groups as a % of total 39.0% 35.4% LEATHER AND TRAVEL GOODSRETAILERS

169 477 832 46.4%

HOUSEHOLD TEXTILES, FURNITUREAND CARPET RETAILERS

7,277 20,274 26,141 39.6% 86.0

Top 5 household groups as a % of total 18.5% 2.9% ELECTRICAL AND MUSIC GOODSRETAILERS

7,512 10,887 17,484 33.3% 76.0

Top 5 electrical groups as a % of total 30.7% 13.4%

Total turnover Number of Number of outlets Gross profit Advertising£ m (shaded area businesses margin expenditure £ m

in %)

8

HARDWARE, CHINA AND FANCYGOODS RETAILERS

1,673 9,047 11,302 43.6%

Top 5 hardware groups as a % of total 15.4% 5.1% DIY RETAILERS 5,028 5,298 77,208 40.6% 69.2Top 5 DIY groups as a % of total 49.8% 1.2% CHEMISTS 5,290 7,560 12,865 27.6% 19.6Top 5 chemist groups as a % of total 67.2% 25.2% BOOKSELLERS, STATIONERS ANDNEWSAGENTS

2,379 5,406 9,040 43.5% 1.4

Top 5 books etc. groups as a % of total 16.8% 9.7% JEWELLERS 1,735 4,774 7,259 42.2% Top 5 jewellers groups as a % of total 46.3% 15.8% TOYS, HOBBY AND SPORTS GOODSRETAILERS

1,714 7,476 9,224 32.0% 7.2

Top 5 toys etc. groups as a % of total 30.7% 7.5% OTHER NON-FOOD RETAILERS 1,013 11,521 11,795 35.0% MIXED RETAIL BUSINESSES 22,411 3,591 10,802 28.6% GENERAL MAIL ORDER HOUSES 4,171 129 295 48.8% TV HIRE BUSINESS 1,256 482 2,438 77.4% 6.1OTHER HIRE OR REPAIR 248 948 2,430 71.5% Source: CSO Business Monitor SDA25; Nielsen Retail Pocket Book 1995; Corporate Intelligence – The Retail Rankings.

Although we have not reproduced it here, the Business Monitor does provide a table of product expenditure5

by type of retailer. Other references for such information include AGB, Nielsen and Verdict.

As we have noted, accurately splitting expenditure on products (Table 1-2) by retailer type isextremely difficult for the UK as a whole. However, such information is more readilyavailable when considering smaller subsets of the retail market.5

See, for example, Institute for Public Policy Research (1995) and OFT (1985).6

Baden-Fuller (1985) provides a good description of how concentration in the grocery sector has changed.7

Table 1-2 : Expenditure on retail products in the UK, 1993Average Average Average Total UK Proportion ofweekly weekly weekly expenditure total spend

household expenditure expenditure £m %expenditure £ lower decile £ upper decile £

Housing (net) 44.85 11.75 97.93 54,200 16Fuel, light and power 13.24 9.30 18.49 16,000 5Food 49.96 20.23 88.79 60,376 18Grocery 39.53 18.31 61.34 47,771 14Meals bought away from 10.43 1.92 27.45 12,604 4homeAlcoholic drink 11.95 2.89 25.68 14,441 4Tobacco 5.59 2.93 4.87 6,755 2Clothing and footwear 17.40 3.86 42.67 21,028 6Footwear 3.02 0.82 6.60 3,650 1Clothing 14.38 3.04 36.07 17,378 5Household goods 23.05 6.63 49.93 27,855 8Furniture 5.69 1.30 16.18 6,876 2Floor coverings 2.36 0.84 4.36 2,852 1Gas and electrical appliances 3.88 0.97 7.23 4,689 1Stationary and paper goods 1.92 0.58 4.57 2,320 1

Household services 15.44 5.89 37.86 18,659 6Personal goods and services 11.04 2.65 27.02 13,342 4Leather and travel goods, 2.72 0.28 10.80 3,287 1jewellery, watches & fancygoodsMedicines and surgical goods 1.86 0.61 3.15 2,248 1Toilet requisites, cosmetics 3.03 0.84 6.06 3,662 1etc.Hairdressing, beauty 1.67 0.61 3.38 2,018 1treatment etc.Motoring expenditure 36.28 4.12 84.05 43,844 13Motor vehicles, spares and 15.92 1.39 40.53 19,239 6accessoriesMaintenance and running of 20.36 2.73 43.52 24,605 7motor vehiclesFares and other travel costs 6.95 1.77 19.72 8,399 3Leisure goods 13.26 3.36 30.12 16,024 5TV, video and audio 4.34 0.93 9.35 5,245 2equipment (not rental)Sports goods 0.66 0.00 2.42 798 0Books, newspapers, 4.1 1.71 8.09 4,955 1magazines and periodicalsToys and hobbies 1.41 0.24 2.33 1,704 1Leisure services 25.56 4.76 82.96 30,889 9Other 2.10 0.23 4.13 2,538 1Total expenditure 276.67 80.35 614.21 334,350 100Source: Family Spending 1993, CSO (1994).

1.2 Concentration in UK retailing

Much is made of the increase in concentration in retailing. A detailed and in-depth analysis6

of individual markets is necessary to establish the extent to which this is indeed the case.However, it is generally recognised from qualitative evidence that the level of concentrationhas risen in many UK retailing markets since the war. Table 1-3 shows how concentrated a7

selection of individual retail markets in the UK had become by 1992.

Such concentration levels have been achieved through merger and/or the organic growth of

leading retailers. Although both these processes have been observed in retailing, many of theleading retailers (e.g. Marks and Spencer and the leading grocery multiples) have in factcaptured market share through organic growth. Baden-Fuller (1985) notes that in the groceryretail market, most of the increase in concentration arose through internal expansion of thefirms already in the industry. Merger activity has played only a small part.

Table 1-3 : Concentration ratios in the UK retailing sector in 1992The largest five The largest ten

enterprise groups enterprise groupsaccounted for: accounted for:

Turnover Turnove Share of Turnove Share of£ million r total % r £ total %

£ million millionBy broad commodity groupFood 43,479 18,931 43.5 25,261 58.1Drink, confectionery andtobacco 20,956 4,836 23.1 7,681 36.7Clothing, footwear and leathergoods 21,742 7,872 36.2 10,671 49.1Household goods 29,389 5,862 19.9 8,780 29.9Other non-food retail products

26,035 6,336 24.0 9,000 34.6Hire and repair business 1,509 951 63.0 1,012 67.1Source: CSO Business Monitor SDA25 (1994).

Although concentration in many of the UK retail markets has increased in recent years,competition through new entry has always been a feature. The recent entry of the discountretailers Netto and Aldi, and the warehouse clubs Costco and the Warehouse Club illustratethis point.

1.2.1 Economies of scale in store operations

One reason that retailers found it beneficial to grow in size may have been to benefit fromopening larger stores in order to experience economies of scale in store operation. Thisfeature is particularly relevant to the UK’s grocery retailing sector with the development ofsuperstores (see Figure 2).

This phenomenon has also occurred in other retail markets, as is clear in Table 1-4. Retailerswhich have increased their average store size include:

C Clothing (Marks and Spencer, C&A etc.);

C Record and CD retailing (Virgin, Tower Records and HMV);

C Books (Dillons, Waterstones);

C Electrical goods (out of town Comet, Dixons and Curry’s stores);

C Hardware (with the emergence of DIY superstores);

C Pharmacies (Boots and Lloyds); and,

C Furniture and carpets (Texas, MFI, Allied).

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

1976 1978 1980 1982 1984 1986 1988 1990 1992

Source: Institute of Grocery Distribution.

Figure 2 : Average size of multiple grocers' stores (sq. ft.)

Table 1-4 : Average sales area for top ten retailers in UK retail marketsAverage sales area 000 sq. ft. Average annual

weighted by retailers’ turnover growth rate 1985/6 1992/3 (%)

Grocers 14.3 22.1 6.3Furniture 15.7 21.3 4.5Mixed goods 20.3 23.7 2.3DIY 27.0 36.0 4.2Music goods 1.9 3.3 8.5Source: Corporate Intelligence - The Retail Rankings; London Economics calculations.

Source: Business Monitor, CSO.8

Source: Institute of Grocery Distribution.9

Thus, referring to the analysis above, we should not be surprised to see the value added by the retailer10

increasing (measured by the difference between gross and net margins), while net margins have notincreased as dramatically.

See McKinnon (1986).11

Sussams (1989, 1991).12

1.2.2 Retailers and centralised distribution

The emergence of larger retail operators has enabled the use of more efficient methods ofdistribution. Over time, wholesalers have more or less disappeared from many of the retailmarkets in the UK, with large retailers dealing directly with manufacturers. This trend hasprobably been greatest in the grocery retail market; between 1982 and 1992, retail turnoverincreased by 125 per cent whilst turnover from delivered wholesale trade increased by only8

59 per cent.9

Moreover, the method of delivery has changed enormously as retailers have become moreefficient. Before the emergence of multiple retailers, most deliveries to UK retailers weremade by manufacturers or wholesalers. Such deliveries were of an assortment of products toindividual retail outlets. Nowadays, manufacturers tend to deliver large amounts of aparticular product in each delivery to a retailer’s own centralised warehouse. The retailer has,in effect, internalised the wholesaling and transportation function into its own activities.10

The advantages of centralised warehousing include:

C reduced stock levels;

C reduced delivery visits per store;

C reduction of necessary storage space in stores themselves;

C fewer incidents of running out of stocks and empty shelves in the outlet; and

C lower shrinkage.

The organisation and management of centralised distribution varies within and across retailmarkets. Some retailers control their own transport and warehouse systems, whilst others11

contract these functions out to third parties. This has led to the demise of manufacturerdelivery fleets and the growth of the market for contract distributor services such as ExcelLogistics. Contracting out centralised warehousing and distribution releases a retailer’s capital

and allows it to focus on its core business of retailing.12

1.3 Technology and innovation in retailing

Retailing has undergone a radical change over the last few decades. Not only have there beenchanges in the size and scope of retail outlets. There have also been significant changes inthe way information technology is used to reduce costs of distribution and store operation.Retailers have also become more involved in upstream production of goods, or at least havestarted to influence directly what suppliers manufacture. In addition, there have been newforms of retailing that bypass the traditional shop and make use of telecommunications and

For a good survey of how technology has revolutionised the retailing industry, in a number of countries,13

see the Retail Survey in The Economist, March 4th, 1995. A discussion of how new technology in retailinghas been adopted and exploited can be found in Hogarth-Scott and Parkinson (1994).

Saleh (1988).14

Davies (1993).15

Sieff (1970).16

information technology to facilitate transactions with customers.13

1.3.1 Introduction of information technology in retailing

One of the most significant advances in the technology used by retailers is the use ofelectronic information technology. Bar-coding and electronic scanning of products is centralto this technology. There are many reasons why this improves efficiency, including:

C trading along supply chains can be made paper-less and even automatic;

C improved information for stocking. For example, the improved informationallows just-in-time (JIT) stock management systems to be employed;

C improved information on sales allows more efficient allocation of stores’labour force;

C better information regarding new product development;

C quicker checkout throughput times, and reduced queuing. A US study14

reported a 12 per cent increase in productivity measured by the number ofitems checked per labour-hour expended after scanners had been introduced;and

C greater financial control (e.g. in paying creditors) through improved salesinformation.

Many of these benefits could only have been captured after the development of large, multipleretailers.

1.3.2 Product development

The increasing quantity of data that can now be collected and collated by retailers hasimproved their ability to judge how consumer preferences change over time. As a method ofexploiting this new information advantage, many retailers have developed strongerrelationships with suppliers (this has been seen in recent years in grocery and other retailing),and have become involved in product development.

Marks and Spencer (M&S) are a good example. When they develop a new line, they involvethemselves not only in the factors that affect the buying and distribution of the product, butin the details of how the product is made and the source and nature of the raw materials usedto make it. An example of this is when M&S established its own textile laboratory in 193515

and developed a relationship with ICI in order to understand the nature of the raw materialsused to manufacture its products. This involvement allows M&S to influence itsmanufacturers in its product specification. More recently, M&S were involved in16

Briggs (1984).17

Although Humphries and Samways (1990) suggest a number of advantages of home shopping for retailers.18

encouraging European manufacturers to adopt the US technology that M&S had studied, inorder to supply Iceberg lettuce all year round to its stores.17

Such practices are commonplace among other major retailers in the UK. Own-brand productshave high penetration in grocery retailing. Boots, the Body Shop, WH Smith, DIY stores, andWoolworth are other examples of retailers with strong own-label product lines.

1.3.3 New forms of retailing

Advances in technology are also having consequences for the nature of retailing itself. Thetraditional (and still by far the most popular) form of shopping is one where consumers travelto the retailer to purchase products. However, other forms of retailing, such as mail order,teleshopping and interactive television are all viable alternatives. Moreover, home shopping,especially through teleshopping and interactive television, is likely to increase as technologyprogresses.

The current size of the home shopping market is difficult to determine, due to its diversity andthe lack of recorded data. We do know, however, that the mail order market was valued at£4.2 billion in 1993, which represented about 3 per cent of total retail sales. Some of the morepopular mail order items are presented in Table 1-5.

Table 1-5 : The size of the mail order market in 1993Market Total market (£m) Mail order (£m) Share of total

(%)Clothing & footwear 22,244 2,185 9.8Electrical goods 10,074 570 6.0Furniture & carpets 7,945 352 4.4Source: Verdict Research

Other growth areas for home shopping include recorded music, personal computers, insuranceand retail banking. It is difficult to know how directly these new forms of retailing competewith more traditional retailers, not least because data on home shopping is currently notcollected very rigorously. Clearly, though, any significant growth in these new forms ofretailing will be detrimental to traditional retailers and will have considerable effects on the18

structure of the retail market. The relevant question, of course, is whether there will be asignificant growth in these new forms of shopping. Whilst evidence from the USA suggeststhat there is some potential for growth, many commentators are sceptical.

Except where clearly stated otherwise, we refer throughout this report to the retailer’s upstream supplier as a 19

manufacturer (even though in some circumstances the direct upstream supplier may in fact be awholesaler/ distributor). This simplification is made purely for ease of explication, and does not change thesubstance of the discussion.

2. The economics of retailing

In order to assess how to deal with competition issues in retailing, it is important first to gaugethe degree to which retailing is different from other areas of the economy. It is particularlyimportant to determine whether the economic characteristics of retailing are sufficientlydifferent to warrant a different approach by competition authorities.

There are significant differences between retailing and other areas of the economy.Distinguishing factors of retailing include:

The characteristics of end-consumers: they tend to be relatively small,immobile and uninformed.

The dimensions of competition: particularly the importance ofgeographical location, product range, and retailer services/image.

The form of vertical restraints: they are now less often of the traditionalgeneral form, and more often in the form of specific agreements/contractor direct intervention. They are also now instigated by retailers moreoften than has traditionally been the case.

These factors mean that competition problems are likely to be particularly prevalent inretailing, since markets tend to work imperfectly when there are asymmetries in bargainingpower (consumers are small), high transactions costs (consumers are immobile), andinformation asymmetries (consumers are uninformed).

These differences are a matter of degree, rather than exclusive to retailing. Thus, while theemphasis of competition policy will often be different in retailing, there should be no need forany major change in general competition policy methodologies. We do, though, suggest thatany competition enquiry should start with a preliminary analysis of the economiccharacteristics of the retail area under investigation, before commencing on the moretraditional framework of market definition, examination of entry barriers and competitionassessment.

The first section of this chapter examines the economic characteristics of retail consumers. Itconsiders the implications of these characteristics for the nature of competition in retailing,with reference to the relevant economic literature. The second section discusses what retailersdo, and defines the scope and nature of their activities. Following from this discussion, thethird and fourth sections examine in more detail the economic nature of competition inretailing: Section 2.3 deals with the dimensions of competition between retailers, whilstSection 2.4 examines vertical issues that arise from the importance of the relationship betweenretailers and manufacturers. Section 2.5 looks at the implications for policy.19

Of course, the same problem may then occur for consumers vis-à-vis the strong retailers. However, if there is 20

sufficient competition between these strong retailers, then at least some of the gains from bargaining will be passedonto consumers.

Note that this movement of goods allows a single manufacturing base to produce for customers in many different 21

localities, enabling the exploitation of economies of scale in production.

2.1 Characteristics of consumers

Retailing is the final stage of the value chain: the point of transaction with the end-consumer. Theeconomic characteristics of the end-consumer are thus crucial to the economics of retailing, and areresponsible for the main differences between retailing and other areas of the economy.

The end-consumer can be characterised as being:

Small (in the sense that the size of a given purchase forms a small part both of theconsumer’s total expenditure and of the retailer’s total sales);

Immobile (in the sense that they are often not able or willing to travel long distances inorder to purchase the appropriate product); and

Uninformed (in the sense that they often do not know which products are availablewhere, and what prices; and they may not be able to observe product quality in advanceof purchase).

The combination of these characteristics essentially explains why retailers exist.

The fact that consumers’ purchases tend to be small means that retailers play an importantrole in preventing the exploitation of consumers by manufacturers: no single consumerwould have any bargaining power against powerful manufacturers, whereas retailers canbargain strongly on their behalf. 20

The fact that consumers are immobile means that retailers play an important function inbringing the products from the manufacturer to the consumer.21

The fact that consumers are uninformed about the availability of products, their prices, andtheir qualities means that retailers carry out an important service in terms of providinginformation and quality assurances.

These consumer characteristics also explain many other aspects of retailing. Customers will be attractedto a retailer which reduces the need for a consumer to visit several shops, or to spend time acquiringinformation. To see how retailers can do this, it is useful to consider the various kinds of costs whichconsumers face in addition to the simple purchase price:

1 Pure shopping (or ‘shoe leather’) costs: Even when consumers know exactly what they want, andwhere best to purchase it, there are costs involved in making the shopping trip, especially in termsof time and effort. These are pure shopping costs. Shopping costs have three importantimplications for retailing:

Messinger and Narasimhan (1992) show how shopping costs imply the existence of one-stop shopping and also 22

local convenience stores.

Note that the growing importance of one-stop shopping (larger retailers) may result in increased concentration 23

in certain retail markets, increasing the likelihood that competition issues will arise.

See Klemperer (1987, 1990). 24

Note that habit may also play a part in the perceived costs of switching between retailers. Switching costs may 25

be implicit (due to search costs/ habit) or explicit (due to contracts, or to formalised incentive schemes such as‘loyalty cards’ and ‘points schemes’). Both sorts of switching costs have potential consequences for competition.

• First, the fact that consumers do not want to travel far to make purchases means thatgeographical location can be important, and that retail markets are often very local (forexample, the importance of location can explain the existence of local convenience stores,despite the fact that they are often more expensive than their larger rivals). Moreover, thefact that mobility is increasing as car ownership rises means that geographical marketsmay be widening.

• Second, the fact that consumers do not want to travel to several different locations foreach separate purchase means that retailers often cluster, or try to provide a one-stopshopping service so that consumers can buy several products in the same place. This22

effect becomes more important as incomes rise and as more and more women work,because the average ‘cost of time’ for shoppers increases. 23

• Third, these shopping costs encourage home shopping, via either television or catalogues.

2 Search costs: When consumers are not quite sure what product they want in advance, or where theproduct is available at what prices, then there is an additional ‘search’ cost involved in purchasingthe product. Search costs can be reduced by retailers clustering together, or by their providing aone-stop shopping service. If there is a wide range of products available in one particular location,then customers will be attracted to this location. This partly explains why shops selling similarproducts often cluster (for example, agglomerations of car dealers and areas which specialise inclothes shops), and why some retailers specialise in offering a very wide range of relatively similarproducts (these retailers are sometimes called category killers). Search costs also give retailers anincentive to increase the visibility of their prices.

Search costs and shopping costs together contribute to a general reluctance amongst consumers toswitch from their regular retailer (they are sometimes called switching costs in this case). There24

may be other, better retailers around, but the consumer does not find it worth investigating thispossibility as long as his regular retailer’s service does not slip too low. 25

These costs also help to explain the importance of impulse purchases. Because it is costly - if not impossible- for consumers to determine exactly what they want to purchase in advance of a shopping trip, their decisionsare often highly dependent on what they happen to see.

3 Information on quality: Information on a product’s quality is often difficult to ascertain in advance

See Kay (1993) for a discussion of a typology of goods that distinguishes between experience goods and search 26

goods; the latter can be judged in terms of quality on inspection whereas the former manifest their quality onlyin the process of consumption (which, for some goods such as schooling and insurance, can occur years after theoriginal purchase).

The ability of reputation to act as an indirect guarantee of quality has been modelled by, for example, Klein and 27

Leffler (1981), Shapiro (1983) and Allen (1984).

The term ‘economic rent’ essentially means profit. More precisely, it is defined as ‘an income received by the 28

owner of a factor over and above the amount required to induce that owner to offer the factor for its present use’This form of rent should not be confused with direct rents, which are paid for property or equipment.

of purchase (products for which this is true are called experience goods). Because the incremental26

benefits are limited, consumers do not find it worthwhile overcoming asymmetric informationproblems by improving their own information. They are therefore willing to pay a premium forquality assurances, especially in the form of reputation for quality (brand name/image) and otherforms of point-of-sale service. Consumer protection laws and product safety legislation also exist27

to overcome this information problem, as do specialist consumer magazines.

Given these costs, it is clear that geographical location, price visibility, one-stop shopping, product range, switchingcosts, and reputation/quality assurances are all likely to be important dimensions of competition in retailing.

In section 2.3 we examine these various dimensions of competition between retailers in more detail. Beforethat we ask a more basic question: what do retailers actually do?

2.2 What do retailers do?

The functions of retailers can be separated into three main categories:

Managing relationships with manufacturers;

Managing logistics such as distribution and stock control; and

Developing and sustaining customer relationships.

The relative importance of these three functions will differ from one category of retailing to the other. Superiormanagement of logistics is essential in grocery retailing where retailers have to organise efficiently and effectivelythe supply and distribution of over 40,000 product lines. Developing and sustaining customer relationships tendsto be very important in beer retailing (through pubs). Moreover, the value-added which retailers provide in termsof carrying out these three functions will tend to be reflected in the share of economic rents which they receive.28

2.2.1 Manufacturer relationships

In a standard market economy, the relationship between consumer and supplier is a simple one: exchangeof goods or services for money. Consumers shop around between suppliers, and purchase from the onewhich provides the best product at the best price. The purchase of products from retailers by end-consumers resembles this standard market set-up (with the qualifications given in the previous section).However, relationships between retailers and manufacturers are generally far more complicated than this:retailers are often involved in many aspects of the supply chain, while manufacturers want to influence theway in which their products are retailed.

Control of product quality is especially important for goods which are not manufacturer branded, since any 29

reduction in quality will affect the reputation of the retailer far more than that of the manufacturer.

Traditionally, retailers have had to hold high levels of stocks in order to avoid out-of-stock situations, which are 30

especially important in retailing because of the importance of wide product range.

Retailer involvement upstreamThere are various reasons why retailers feel that they have to get involved in the supply chain, rather thanjust purchasing products on a free market.

• Retailers want to ensure that the products they receive are of the desired quality. They29

can do this through inspection (quality control). However, it may be more efficient toensure that the production process itself is properly designed so that it does not producefaulty products in the first place (quality management).

• In some cases, information asymmetries between retailers and manufacturers mean thatretailers have to intervene in the supply process to ensure that the products consumerswant are available at all.

• Just-in-time distribution and quick-response systems have become very important inrecent years. They reduce retailers’ costs by minimising the stocks which retailers needto hold; they improve the distribution of short shelf-life products; and they improve the30

flexibility of retailers in coping with changes in customer demand. However, bothrequire high levels of co-ordination between retailers and manufacturers.

• A retailer which wants to maintain a reputation for exclusivity may be concerned toensure that its manufacturers do not supply other retailers (or at least not with the sameproducts).

Together, these characteristics are often termed supply chain management. The growth of supply chainmanagement provides one explanation for the recent shift in market power away from manufacturers andtowards retailers. There is no logistical reason why manufacturers cannot be effective in supply chainmanagement, but they tend to lack the necessary detailed sales information. Retailers are closer to end-consumers and many have developed sophisticated information systems which can facilitate supply chainmanagement. Thus retailers have tended to absorb this role.

The growth of supply chain management also explains the decline in many markets of wholesaling, sincewholesalers tend to hinder co-operation between manufacturers and retailers. In other markets,wholesaling has not disappeared, but the structure of the wholesaling operation has changed. For example,newspaper wholesaling is now carried out on an exclusive basis, with publishers auctioning franchises forlocal wholesaling monopolies.

Manufacturer involvement downstreamWhile retailers are often involved in the supply chain, manufacturers are also concerned to exert controlover some aspects of retailing. In particular, manufacturers are concerned that:

See Davies (1993, p. 89). 31

For example, if RRPs can be used to constrain price competition between retailers, their retail margins will be 32

higher and they will have higher incentives to promote products.

• Their products are retailed in the best way;

• Retail staff are properly trained; and

• Retailers carry out the right level and type of promotion.

In terms of the first, a product’s position within a store can be crucial. Being near the front of a store, oron the ground floor, or on shelves which are just below eye-level can all be very beneficial to a product’ssales. For example, Dyer (1980) found that goods displayed at the entrance to the first aisle in an outletincreased normal sales by 363 per cent. The total amount of shelf-space allotted to a product will also havean important effect on its sales. Retailers are acutely aware of the impact of a product’s position on itssales. They tend to place products for which this effect is likely to be highest (potential impulse purchases)in the best positions, reserving the less effective selling space for everyday necessities which will sellanyway.

Allocation of shelf space has become a particularly controversial topic with the growth in own-brandgoods. Because retailers make higher margins on their own-brand products, they often promote them bygiving them more (and better) shelf space than is proportional to their total sales. For example, whenSainsbury’s introduced its Classic Cola, it is alleged to have moved Coca Cola onto the lowest shelves inits stores (much to Coca Cola’s chagrin).

On the second point, some manufacturers pay for the training of retail staff (this is particularly commonfor upmarket furniture and clothes manufacturers) or even employ the retail staff themselves (as incosmetics and perfumes). More often, however, manufacturers intervene in staff training less directly,31

by demanding certain standards of retailers, or by refusing to supply retailers who offer a sub-standardretail service.

Thirdly, the effective advertising and promotion of a manufacturer’s products often relies on co-ordinationbetween manufacturer and retailer. For example, media advertising is sometimes jointly paid for by retailerand manufacturer (such as television advertisements for particular LPs at particular record retailers, or forparticular grocery products at particular supermarket chains). More often, the manufacturer will pay formedia advertising but will expect retailers to carry out concurrent promotion within their stores (forexample, by placing the product in the window or creating a large in-store display).

If information were perfect and monitoring were cost-less, it might be possible for manufacturers to designcontracts which specified precisely how their products should be sold, how staff should be trained, and thelevel and type of promotion which retailers should carry out. However, it is often easier in the face ofinformation constraints to design incentive schemes for retailers in the form of a vertical restraint. This32

is discussed further in Section 2.4.

2.2.2 Logistics

Logistics involve the efficient movement and storage of materials, parts, and finished inventory fromsuppliers, through the company and on to customers. This is more important in some retail areas than in

Although theft still accounts for an estimated 1 to 2 per cent of retail turnover (see Davies, 1993, p. 88). 33

Although substantially more use could be made of this information (see Lockett and Holland, 1991). 34

See Ody and Newman (1991). 35

others. Efficient distribution and stock control is particularly crucial in fast turnover, highly perishableareas like grocery retail; it is less important in slow turnover areas, such as furniture retailing.

There have been many changes in retail logistics in recent years. The increase in the average size of storeshas allowed shops to exploit economies of scale; the use of electronic tagging has reduced the possibilityof theft ; and the growth in the use of credit and debit cards has changed cashing-up procedures and33

reduced the need to monitor employee fraud.

However, two changes in particular have had crucial impacts on retailing. First, there has been a growthin centralised distribution. Before this, deliveries were generally made by manufacturers or wholesalersdirectly to retailers’ premises. Today, the norm is for delivery to be made to a retailer’s own or controlledcentral warehouse. The retailer then organises distribution from this warehouse to each store. This reducesthe number of deliveries made to individual stores. In grocery retailing, for example, Moore (1991)calculates that centralised distribution reduces store deliveries from 60 a day on average to 12 or less. Italso reduces the need for storage space in retail outlets (which can be converted into selling space), reduceswastage, and reduces the likelihood of products going out of stock.

The second major change in retail logistics has been the advent of computerisation, and especially the useof scanning equipment in stores. Penetration of retail scanning is higher in the UK than anywhere else inEurope. Electronic point of sale (EPOS) data can be used to dramatically improve ordering systems andto support decision-making. The speed and efficiency of ordering is then improved by computerisation:34

even the smallest of companies, such as a Welsh goat farmer supplying cheese to Tesco, are now linkedto retailers by computer. 35

Retail scanning data can also be an important source of revenue to retailers. Market research companies(such as Nielsen and IRI) pay a lot for such data, as do some of the large manufacturers. The revenuegenerated by retailers for scanning data is in fact higher in the UK than anywhere else in the world, dueto the high value of the information involved and the strong bargaining power of UK retailers.

2.2.3 Consumer relationships

Above all else, retailers must respond to consumers’ needs and tailor their service and image accordingly.The dimensions of competition between retailers which are discussed in the next section are directly relatedto consumers’ needs. This is because consumers place value on far more than any individual product.Whilst price is obviously important, shoppers are also concerned about the rest of the retail experience.They may prefer retailers in particular geographic locations, those which stock large product portfolios,or those which provide the best retail service. It is rarely the case that consumers will visit solely thoseretailers which charge the lowest prices. For this reason, competition between retailers takes place on morethan one dimension (non-price competition is important in this industry).

The preference of consumers for things other than low prices is illustrated in Table 2-1 for grocery stores.Shoppers were asked what was the most important factor influencing their decision as to which grocery

store to frequent. Over one half of the respondents claimed that convenience was crucial, with productrange coming (a much lower) second and low price representing less than 15 per cent of all responses. Ofcourse, the nature of grocery retailing means that this spread of responses will not be valid for all types ofretailing. Notably, convenience (in terms of geographical location) is likely to be less important for largerpurchases, or products which are bought irregularly. However, the way in which consumer preferencesare formed is clear.

Table 2-1 : Factors affecting the choice of grocery storeMost important factor Proportion of respondents

%Convenience 54Product range/selection 14Low price 13Quality 9Cleanliness 2Friendly staff 1Handy opening hours 1Others 6Total 100

Source: Nielsen Household and Shopping Survey

Perhaps the most difficult aspect of consumer relationships to manage is that of retailer image. Davies andBrooks (1989) argue that trying to create an image for a retailer through advertising is self-defeating unlessthe image is already evident in the store. More important are product range and prices, store design andatmosphere, and the quality of service. In terms of store layout, high stock density can signal budget priceand low stock density exclusiveness. The importance of store layout is indicated by the fact that multipleretailers will often dictate store design to individual stores to ensure uniformity of design and presentation(including shelving allowances for particular products, and sometimes even including photographs ofdisplays). Price can also be an important signal of quality, and too many ‘budget’ product lines can reducethe overall image of retailer quality.

Indeed, advertising is generally less necessary for informing consumers about retailers than it is for brandedproducts. A store front on a high street or in a shopping centre is a far more effective advertisement thanany advertisement in the media, since it is seen by a far higher percentage of its target customers. Manyretailers, such as Next, M&S, the Body Shop, and Waitrose have achieved strong retailer images withminimal advertising. On the other hand, advertising can play an important role in strengthening retailerimage. It also interacts in a complicated way with advertising carried out by manufacturers. Whereretailers sell non-branded goods, such as in clothing and furniture, retailer advertising often effectivelysubstitutes for manufacturer advertising. Where retailers sell manufacturer-branded goods, jointmanufacturer-retailer advertising campaigns are common.

2.3 Dimensions of competition in retailing

This section describes the way in which retailers compete against each other and considers the varioushorizontal economic and competition policy issues to which each dimension gives rise. The vertical issueswhich arise from the relationships between retailers and manufacturers are discussed in the next section.

Retailers, like every other commercial organisation in the economy, compete by attempting to gain acompetitive advantage over their rivals. This competitive advantage can manifest itself in a number of

For more details on how firms may gain a competitive strategy, and some discussion of how retailers have36

attempted to compete, see Kay (1993).

ways:

C In terms of price; retailers attempt to maximise cost efficiency and economies of scale andscope in order to reduce price. They may also exert bargaining power when dealing withmanufacturers to drive down costs, or bundle products together or price discriminate tocreate the perception of low pricing policies. Finally, retailers may place great emphasison their competitive pricing with claims such as ‘never knowingly undersold’. Thesetypes of strategy have been employed by John Lewis, Kwik Save and MFI.

C A competitive advantage in terms of geographical location can be achieved by ensuringthat stores are located in the most convenient areas. This is often just a matter of beingin an area first, and so having first pick of potential locations, but deliberate siteforeclosure is also a possible strategy which is alleged to have been used by the largegrocers and DIY chains (see Chapter 4).

C Product selection may be crucial in gaining an advantage over rivals. Retailers want tostock the best range of products relative to their competitors. This can be done througha good understanding of exactly what consumers want, operating large outlets so that awide range of products can be stocked, or by strategies aimed at obtaining exclusiveproducts (either through extensive use of own-brand or through vertical relationships withmanufacturers which deny other retailers the same products). The larger record retailers,many department stores and Boots are examples of retailers who have extended theirproduct portfolios to attract customers.

C Finally, the provision of high retail service relative to rivals is often a method of gaininga competitive advantage. However, improving service is generally costly and its use willbe determined by the nature of competition in the market (price or non-price) and theproducts being retailed (some products require more point-of-sale services). High levelsof customer service are thought by retailers to be important in the retail of goods asdiverse as cosmetics and cars. Indeed, it is impossible to purchase some goods withoutthe related service (i.e. there is no ‘low service’ option). Retailer image is also veryimportant, and can act as an important barrier to entry.

As with all attempts to gain a competitive advantage, the ability of others to imitate successful strategiesis always a possibility. For this reason, the deployment of the strategies listed above (and many others)36

is a complex process, and many such strategies may be employed simultaneously. For example, afavourable geographical location may increase the willingness of consumers to pay and allow higher prices,whilst a higher level of retailer service will raise costs and will only be viable if the retailer can commandhigher prices. Vertical relationships may also affect competition in these dimensions (this is consideredin Section 2.4). Further, the dynamic nature of these strategies also has to be considered: some are shortterm (loss leading, for example), whilst some are much longer in time scale (such as the repositioning ofa retailer’s image).

Four dimensions of competition between retailers were identified above:

1. Pricing

2. Geographical location

3. Product selection (quality and range of products retailed)

4. Level and quality of retailer service (including retailer advertising/promotion)

Sections 2.3.1 - 2.3.4 examine in more detail how the four dimensions of competition between retailersidentified above may result in forms of behaviour which are of interest to the competition authorities.

2.3.1 Pricing

The price that retailers charge for their retailing activities is an implicit price. The difference between thefinal sales price (net of sales taxes) and the wholesale price is the gross margin that retailers receive tooffset the costs they incur in carrying out the various functions described in Section 2.2. For some retailingactivities, this margin can be very high, making up over 50 per cent of the final retailing price (as injewellery stores, fashion and haute couture). This is generally true where turnover is low but there is aneed to maintain a large stock or product range on the premises, or when the retailers provide high value-added. For other retail markets, the margin may be far lower (in grocery and DIY for example).

However, the customer generally neither observes nor cares about this implicit retailer price. The pricespaid for goods by retailers are not visible, and any increase in gross retailer margin gets translated into finalretail prices across the range of goods provided in a shop. When comparing prices, therefore, consumerscan only guess whether observed price differences are due to different retailer margins.

Having said that, price is nevertheless a key variable in competition between retailers, and the importanceof lowering costs and achieving efficiency is as important in retailing as it is in other areas of the economy.

Retailers generally attempt to reduce costs in all of their different functions:

C Manufacturer relationships: Retailers attempt to obtain products from manufacturers atthe lowest possible price. Larger retailers can often achieve this more easily than smallerretailers, partly because they have a greater incentive to shop around for the best deal, andpartly because they have greater bargaining power which they can exploit in theirnegotiations with manufacturers.

C Logistics: Retailers attempt to manage store and shelf space at the lowest possible cost.Large retailers may even integrate upwards into distribution in order to enhanceefficiency.

C Customer relationships: Retailers will try to find ways of achieving good levels ofcustomer service at the minimum cost.

There are, though, some aspects of pricing that are particularly prevalent in retailing.

C Differential pricing: Retail prices tend to be very visible, with secret discounts toconsumers being rare (although these do occur for large purchases such as cars andhouses). This may ease collusion between retailers through different retailing formats(because cheating on collusive agreements is easy to observe). On the other hand,compared with other areas of the economy, price discrimination between consumers maybe relatively easy, given that resale between consumers is relatively unlikely (becauseindividual purchases tend to be too small to justify the necessary co-ordination betweenconsumers of different types). This price discrimination tends to be implemented either

The rationale for this type of behaviour is the same as that for Ramsey pricing in the tax literature (see37

Atkinson and Stiglitz, 1980). For books and pharmaceuticals, manufacturers are able actually to fix retail prices (through resale price38

maintenance), although in the case of books this practice is quickly becoming obsolete. In other markets,manufacturers are restricted by law to providing price recommendations only.

Although, where this appears to be the case, it is interesting to ask why RRPs are given in the first place.39

Further rationales for RRPs are discussed in Section 2.4.40

through provision of discounts for certain (broad) consumer categories (such as studentsor pensioners) or by designing retail choices (such as trade-in offers, credit deals, end-of-season sales) in such a way that different consumers choose different options.

C Variable mark-ups: In retailing, more than in any other area of the economy, retailerstend to sell bundles of products (an obvious example is bulk grocery shopping doneweekly) and to stock large product ranges. As was shown above, when the products beingpurchased are relatively cheap, a consumer will not have strong incentives to shop aroundfor each individual product, but will prefer to go to a single multi-product retailer (one-stop shopping). Under these circumstances, Bliss (1988) shows that a multi-productretailer will generally not do best by setting a common percentage mark-up on all goods,but will prefer to set higher mark-ups for products with lower elasticities of demand, andvice versa.37

C Loss leading: When choosing between multi-product retailers, consumers often have onlyvery vague ideas of the relative qualities and prices of individual products. In this case,consumers tend to choose between retailers on the basis of their reputation for goodproduct range and general low prices. One method of gaining a reputation for general lowprices under these circumstances is loss leading. By setting low prices on a number ofkey items, and then by promoting these products and their prices, retailers induceconsumers to compare retailers on the basis of the prices of these products. Note that lossleading may or may not be predatory, in terms of driving other retailers out of the market.

C Upstream restrictions on price: In some retail markets, manufacturers provide arecommended retail price (RRP). The use of RRPs may ease collusion between38

retailers, in that it provides a focal point price which it is easy to co-ordinate on.However, RRPs are certainly not sufficient for collusion, since in many markets RRPsexist but prices bear little relationship to them. Moreover, RRPs may also be a method39

of restraining prices from being too high in relatively uncompetitive retail markets.40

C ‘Never knowingly undersold’ provisions: In order to reduce the need for consumers toshop around between retailers in order to find the best deal on a branded product, someretailers state that if the consumer later finds the same product cheaper elsewhere, thenthe difference will be refunded. The John Lewis price pledge is a well-known example.This may be an effective method of price competition, but may also facilitate collusion(there is little point in a competitor trying to undercut prices to gain market share if theprice reduction will be met automatically).

Note that national retail strategies are not exclusive to competition on price. Most national retailers also41

have national strategies on geographical location, product selection and retailer service/image, for exactlythe same reasons.

Price competition may also be reduced by vertical restraints, see Section 2.4.42

Beggs (1994) notes an interesting implication of this clustering phenomenon. Generally if one retailer43

raises its prices, the sales of nearby retailers will increase (as consumers switch away from the moreexpensive store). Consider now two shopping centres (or malls), which consumers choose between on thebasis of overall average price (of goods in each mall). If a retailer in one mall raises its prices, this mayactually reduce the sales of other retailers in this mall, on the grounds that it raises the average price of themall, causing consumers to switch to the other mall.

C National pricing strategies: Retail chains generally consist of a number of local stores.41

The degree of competition facing each individual store is likely to vary, and this providesthe retail chain with an incentive to price differently in each local market. However, someretail chains choose instead to set prices nationally. This is clearly costly in terms of theability to exploit market power at a local level, but it may be beneficial for two importantreasons:

C There may be benefits from having a unified retailer image for the chain (so thatconsumers know before going into any local store that they will be getting the sameprice in that store as elsewhere); and

C The desire to exploit economies of scale in price setting, price labelling, andadvertising (by advertising prices nationally).

Moreover, price competition in retailing may not be as fierce as in other areas of the economy. Even wherethere is no collusion, the importance of the other dimensions of competition between retailers (location,product range, retailer service) all act to restrain direct price competition between retailers.42

2.3.2 Geographical location

Geographical location can be important in retailing. In transport based markets, this is obvious. A petrolstation or car hire firm in Derby is clearly of no use to a person who wishes to travel from Brighton. Moregenerally, the importance of shopping/search costs mean that:

C When consumers are not quite sure what they want and want to be able to makecomparisons among a number of different shops, retailers can attract customers byclustering together (for example, in a shopping centre or high street);43

C When consumers just need to obtain a relatively standard (undifferentiated) product asquickly and easily as possible, shops can gain customers by locating close either topeople’s homes or to places that consumers are likely to be passing anyway (for example,newsagents, post offices, convenience stores, and shops in petrol stations);

C When consumers want to buy large loads of shopping, or bulky objects, or when theyrequire a very wide choice of products, shops can gain customers by being large andeasily accessible by car (for example, out-of-town supermarkets and large specialitystores).

The importance of geographical location means that local market power can be high and the inability tofind an appropriate location can act as a barrier to entry (although the importance of this is often over-stated). Moreover, the attempt to gain access to good locations may be an incentive for merger. This was

Location in ‘product space’ essentially means the market positioning of the retailer in terms of the quality,44

type, and range of products it sells.‘Vertical’ and ‘horizontal’ are economic terms which are used to distinguish two different uses of the word45

quality. When people distinguish between high and low quality they are usually referring to verticalquality. People generally agree about vertical quality. If most people would prefer product A to productB when both are offered at the same price, then product A is of higher vertical quality than product B. Forexample, a 486 computer is of higher vertical quality than a 386 computer. On the other hand, when peoplerefer to products having different qualities (or characteristics), they are referring to horizontal quality.People generally disagree about horizontal quality. A red version of a dress is not necessarily better orworse than the same dress in blue, but they are different in terms of horizontal product differentiation: somepeople will prefer one and some will prefer the other.

The difference between what we term product range and product portfolio roughly equates to what the46

literature on retailing refers to as the distinction between depth (the number of similar lines) and width (thenumber of dissimilar lines). (See Davies, 1993).

This effect and the next were first modelled by Hotelling (1929), in the context of geographical location.47

a prime motive for the acquisition of the Scottish grocery retailer, Wm. Low, by Tesco who at the timemainly had stores in England and Wales but a brand name that probably extended into Scotland.

2.3.3 Product selection

Location in product space tends to be very important in retailing. Retailers carry out a selective44

gatekeeper function: consumers do not have the time or ability to look at all products available frommanufacturers, and they prefer retailers to carry out some selection on their behalf. Consumers then choosebetween retailers on the grounds of the sort of product selection they expect the retailer to have alreadydone.

The product selection decision

In deciding where to position themselves in product space, retailers must choose:

C Level and range of products, in terms of vertical characteristics: where to situate on45

the spectrum between retailing high quality products and low quality products, andwhether to provide an extensive vertical range of products;

C Level and range of products, in terms of horizontal characteristics: which sorts of

products to sell, and whether to provide a wide horizontal range of these products orinstead to situate in a niche, serving only a segment of the market; and

C Product portfolio: whether to provide several different kinds of product (as in out-of-46

town superstores) or specialise in one kind. A narrow product portfolio indicates aspecialist retailer, whilst a very wide portfolio may signal the use of a one-stop shoppingstrategy.

This decision will depend on the relative strengths of various different effects:

C Strategic reduction of competition: Retailers can strategically reduce direct pricecompetition between themselves by spreading out in product space (niche marketing).47

C Business stealing: By moving closer in terms of product space to a rival, each retailerthinks that it can improve its share of the market by attracting customers from its rival (inthe limit, this results in clustering).

The possibility of using product proliferation as a method of deterring entry was first analysed by48

Schmalensee (1978) for the case of ready-to-eat breakfast cereals. This requires, however, both that it isdifficult to change positioning in product space and that there are costs involved in exiting the market.Otherwise, the threat of maintaining position in product space post-entry is not credible, and entry will notbe deterred (See Judd, 1985).

However, these costs also suggest benefits for niche marketing: a consumer does not want to wade through49

a big shop full of lots of different types of clothes, most of which will not appeal. Thus, horizontaldifferentiation between consumers tends to lead to various different retailers clustering together (maybeeven within a single department store), rather than single retailers providing a wide product range (althoughthere have been moves towards large single horizontally differentiated retailers, such as Shoe City).

Complementary products are defined as products with a positive cross-elasticity of demand. Less formally,50

they are products that one is more likely to want to buy together than to substitute between. Indeed, it might be important for a retailer’s image simply to stock a particular product range, or for a51

manufacturer’s brand image to have its retailers supply only certain products (issues of retailer brand imageare discussed in more detail in the next section).

C Entry deterrence: It may be possible for incumbent retailers to use location in productspace as a barrier to entry, by leaving no profitable niche unfilled.48

C Consumer preference for a narrow range: The more narrow the range a retailerprovides, the easier it will be for consumers to make a selection (as long as the retailerprovides the right range).

C Consumer preference for wide vertical range: When a consumer wants to buy a productbut is not sure how high a quality to buy (given that better products tend to cost more),then the consumer benefits from being able to observe and choose between severalproducts along the price-quality trade-off schedule. Thus, retailers may want to providea wide vertical range.

C Consumer preference for wide horizontal range: On the other hand, when consumersknow what they want in terms of vertical quality, but are less sure what they want in termsof horizontal quality, shopping costs provide an argument for maintaining a widehorizontal product range.49

C Consumer preference for wide product portfolio: In both of the above cases, productstend to be substitutes, and a retailer stocks a wide range in order to allow consumers achoice. However, retailers often prefer to stock a wide portfolio of complementaryproducts, especially when any single product on its own would not be worth a shoppingtrip (for example, supermarkets and DIY stores).50

C Economies of scale and scope: For small purchases (such as tins of beans) there maysimply be large economies of scale (in terms of running a store) in selling variousproducts at once. In addition, there are fixed costs involved in dealing with amanufacturer, and thus it may be less costly to take many products from one manufacturerthan to take products from various different manufacturers. Economies of scope inadvertising/ establishing brand names may also encourage retailers to expand into newproduct areas.51

Own-brand products

Another decision that retailers need to make in terms of the product range they stock relates to the use ofown-brand products. Some retailers (such as Marks & Spencer) stock only own-brand products, whilstothers (such as Thresher and Tower Records) stock only branded goods. The majority of retailers,

however, lie somewhere in the middle of these extremes, stocking a number of powerful brands whilst alsoproviding a selection of own-brand products (Sainsbury’s, Boots and WH Smith are examples).

The retailer’s strategy on own-brands is a complex one. It includes decisions about the number of own-brands to stock, and the quality of those products. Own-brands may be included in the product portfolioin order to offer the consumer a cheaper alternative to a particular branded product (this is the traditionalimage of own-brand goods), or they may represent the retailer’s attempt to compete head-to-head with thebrand leader in terms of quality, image and price.

The own-brand strategy chosen will be partly determined by, and will partly determine, the image of theretailer itself. If the retailer decides to sell only branded products, then the market positioning of thatretailer, in terms of product portfolio and price, is highly dependent on the manufacturers whose productsare stocked. If, on the other hand, the retailer also stocks own-brand products, it can differentiate itselffrom rival retailers by the quality and price of those products.

The importance of this method of retailer differentiation can be seen from the degree of correlationbetween the extent of own-brand penetration and the market positioning of retailers in particular retailmarkets. In the grocery sector, for example, those retailers which stock the most own-brand products(Sainsbury’s, Tesco and Asda) are also positioned more upmarket than those which focus on brandedproducts (Kwik Save, Aldi and Netto). The nature of this correlation is complex and causation works intwo directions:

C the success of a retailer in selling own-brand products is dependent on the reputation forquality that the retailer has; and

C the retailer’s reputation for quality depends on the quality of its own-brand products (inexactly the same way that a manufacturer’s reputation depends on the quality of itsproducts).

This strategy of own-brand products also has other implications for the nature of retailer image. Forexample, we have already noted that some retailers are able to maintain a high quality image with littleadvertising effort. The examples provided earlier were Marks & Spencer, Body Shop, Next and Waitrose.It is interesting to note that three of these four examples stock exclusively own-brand products.

2.3.4 Level and quality of retailer service

Simply deciding which products to retail, however, is only part of a retailer’s quality choice. In additionto the physical characteristics of the products chosen, the retailer has to decide how much, and what form,of retailer service to provide.

There are various possible types of service that retailers can provide:

C Shop ambience: Retailer service may be simply a matter of providing a clean, efficientand well designed retail environment, which makes the shopping experience morepleasurable (known sometimes as ‘pure’ retailing). Measures such as rapid computerscanning at checkouts and clear sign-posting within stores come under this heading, inthat they improve the whole shopping experience.

C Point-of-sale service: Point-of-sale customer advice and service can be very important insome types of retailing. This covers a whole host of activities, from pharmacistsproviding customer advice to buyers of pharmaceuticals, to sales assistants in

There is a large body of literature dealing with brand name and its role as a signalling device to consumers;52

see Kay (1993). Note that, throughout this report, vertical issues are not discussed in as much detail as they properly53

deserve, on the grounds that they are going to be the subject of a future OFT research report.

delicatessens cutting off exactly the amount of cheese which the consumer wants, to theprovision of test drives for potential car purchasers.

C After-sales service: For example, in motor cars, the provision of after-sales service isessential. Many other retailers (and especially catalogue retailers) offer a refund policyto customers who are not satisfied with the product they have purchased. However, theprovision of after-sales service is less often supplied by the retailer itself, and more oftensupplied by the manufacturer (although the retailer may be the point of interactionbetween manufacturer and consumer).

C Product promotion: In-store promotions can be crucial to the sales of many products.Indeed, as was noted above, even the amount and type of shelf space allocated toparticular products can have important effects on how well they sell. Manufacturers willoften provide higher discounts to retailers who are willing to carry out in-store promotionsor give their products a good store location. Manufacturers and retailers will alsosometimes combine to do joint television or press advertising.

C Retailer image/reputation: Where product quality is not immediately observable, theimage/reputation of the retailer may play an important quality assurance role. For52

example, Harrods, as a retailer of high quality products, sends strong signals to consumersby deciding to stock a particular brand of washing machine, clothing or beauty product.The brand name Harrods thus reinforces that of the manufacturer. In the case of Marks& Spencer, the brand name of the manufacturer is totally dispensed with, and the retailerbecomes the brand that certifies quality. Retailers increasingly support their own brandimage through heavy (often national) advertising.

These various retailer services may affect competition in various ways. If retailer services are important,there may be a so-called ‘free-rider’ problem: consumers will get the retailer service from one retailer andthen go and purchase the product from another retailer which does not provide retailer service. Forexample, consumers may go to Debenhams, use its sales staff to help them pick out the vacuum cleanerthey think is best, and then go and actually purchase the vacuum cleaner from Argos (where prices arecheaper because no retailer service is provided). Where these free-rider problems are particularly strong,they may affect the willingness of stores to provide such retailer service, which will be bad formanufacturers, retailers, and consumers. This problem is sometimes solved by vertical restraints (seeSection 2.4). The importance for product sales of advertising and promotion within stores will alsosometimes lead to vertical restraints.

The importance of brand name can also act as a barrier to entry. In some cases, an incumbent brand willbe so strong that it is almost impossible to challenge it. In other cases, however, attaining an effective rivalbrand name is simply a matter of spending a sufficient amount on advertising. The effectiveness of brandname as a barrier to entry will depend on the amount of advertising which is needed to enter the industryeffectively relative to the profits to be gained from entering the industry (see Chapter 4 of this report). Itwill also depend on the transferability of retailer brand name from one retailing market into another.

2.4 Vertical issues 53

Waterson (1993) provides an excellent survey, and discusses implications for competition policy.54

Vertical relationships are necessarily important in retailing, since it is by nature downstream ofmanufacturing. Moreover, as described above, there are important interactions between manufacturingand retailing, with manufacturers having incentives to promote retailer services (including ensuringappropriate shelf space), and with retailers having incentives to intervene upstream in order to ensurequality and efficient supply. There is also significant differential discounting by manufacturers to retailers(non-linear pricing schemes).

The literature on vertical restraints between manufacturers and retailers is extensive. Roughly,54

explanations for vertical restraints can be split into three categories:

• Efficiency motives (as focused on above);

C Anticompetitive motives (promotion of collusion, deterrence of entry, or exploitation ofdominance); and

C Economic rent sharing (the division of economic rents between manufacturers andretailers).

In many situations, all of these explanations will apply. Indeed, they often interact. For example,manufacturers will sometimes find it profitable to promote price collusion at the retail level (which is perse anticompetitive) in order to provide incentives for retailers to compete instead on promoting theirproducts (which improves efficiency). This means that even when a vertical restraint is motivated byefficiency concerns, it may have deleterious effects on competition between retailers, in any of thedimensions of competition described above. For example:

C Recommended resale prices can facilitate collusion between retailers, giving themincentives to compete in other dimensions, such as retailer service.

C Refusal to supply, exclusive dealing and full line forcing have a direct impact on retailers’positioning in the product space, and can act as an entry deterrent.

C Territorial exclusivity will directly affect geographical location and restrict intra-brandprice competition.

2.4.1 The economics of vertical restraints

There is a tendency in the economic literature to treat retailers purely as intermediaries betweenmanufacturers and end-consumers, and to focus on situations in which manufacturers are concerned toinfluence the behaviour of retailers. This emphasis is a result of thinking of vertical restraints in terms ofthe pure product flow, as shown in the diagram below.

Manufacturersset price w

Retailersset mark-up r

Consumerspay price p = w + r

In many cases, this way of thinking about vertical restraints is sufficient. In particular, it has traditionallybeen true that many vertical restraints have been imposed on retailers by manufacturers. The mostcommon examples are:

C Retail price restrictions: such as RRP and resale price maintenance (RPM);

C Manufacturer non-linear pricing: that is, non-linear manufacturer discount schemessuch as franchise fees, quantity discounts, or differential discounts for different retailers;

C Quantity forcing: requiring retailers to sell minimum quantities of the manufacturer'sproducts;

C Full-line forcing : requiring retailers to carry the full line of the manufacturer’s products;

C Exclusive dealing: requiring the retailer not to carry the products of competingmanufacturers;

C Territorial exclusivity: which protects one retailer from intra-brand competition fromother retailers within that territory;

C Refusal to supply: as a general means of enforcing the compliance of retailers with anykind of requirements set up by manufacturers, or simply as a method of constraining totalsales.

However, over the last decade or so, retailers have tended to become a more important element in theoverall value chain, partly at the expense of manufacturers. This change has occurred for various reasons,

Manufacturersset price w

Retailersset mark-up r

Consumerspay price p = w + r

including: increased retailer size and retail concentration; increased importance of retailer image, whichmeans that own-brand products have become more competitive with branded products; increased retailerinformation on consumers’ preferences (partly as a result of scanner technology); and increased retailercommand of technology.

In these changed circumstances, it is useful to think of the manufacturer-retailer relationship slightlydifferently: as the manufacturer and retailer each supplying an essential input into the end-product whichthe consumer purchases (the physical product and the retailing activity). This joint input idea is shown inthe Y-shaped diagram below.

This diagram reflects the fact that in many ways the situation of manufacturers is symmetric with that ofretailers. Firms at both levels are concerned to co-operate to provide the most appropriate mix of productsand retailing activity to consumers, and to sell this at an end-price which maximises their joint profits. Ingeneral terms, vertical restraints then become straightforward to explain:

C where the joint interest of manufacturers and retailers conflicts with the individual self-interests of each, vertical restraints may be used by each level as a commitment device toensure that the other level acts in their joint interest.

The division of the resulting joint economic rents is then the outcome of bargaining, rather than beingimposed by either side.

The use of vertical restraints to achieve such joint profit-maximisation in the face of divergent incentivesis discussed in more detail in Chapter 7 of this report.

In The Supply of Beer (1989), the MMC recognised that the vertical restraints between breweries and public55

houses are so complete that they are essentially the same as vertical integration. Waterson (1993) discussesvarious explanations for why full vertical integration will sometimes be favoured over vertical restraints.Generally, the choice will depend on potential economies of scale and scope, transactions costs, informationasymmetries, the degree to which sunk investment is required, the importance of flexibility in vertical

More generally, one implication of the shift in the balance of power towards retailers has been a growthin vertical restraints of the sort imposed on manufacturers by retailers, such as:

C Exclusive supply: requiring the manufacturer not to supply competing retailers;

C Refusal to stock or ‘delisting’: where retailers refuse manufacturers’ products access totheir stores;

C Minimum supply levels: where retailers demand minimum quantities from manufacturers(in order to prevent the manufacturer from being able to supply further retailers);

C Minimum advertising requirements: where retailers refuse to stock a good unless aminimum amount has been spent in advertising it.

C Sunk facility requirements: where retailers refuse to give manufacturers a contract forsupply (especially of own-brand products) until they have sunk costs in productionfacilities.

Another implication is that, even where the more traditional vertical restraints are used, they may not bebeing used for the traditional reasons. For example, refusal to supply has traditionally been a methodinstigated by manufacturers for overcoming free-rider problems among retailers (as described below).However, there have been recent allegations of retailers instigating refusal to supply, by forcingmanufacturers to refuse to supply certain other retailers in order to reduce the effectiveness of these otherretailers as competitors.

More crucially, in addition to this change in the direction of imposition of vertical restraints, it also seemsthat the form of vertical restraints is changing over time. Vertical restraints of the traditional form arerather blunt instruments, in that they achieve their primary aims only indirectly. For example, one commonaim of vertical restraints is for manufacturers to reduce price competition between retailers, and thus toencourage them to compete in terms of service and sales promotion instead. This bluntness gives rise toan obvious question: why can’t manufacturers simply contract for the optimal levels of service and salespromotion directly?

The answer to this question lies in monitoring costs. Historically, retailers tended to be small and local,while manufacturers were relatively large. This meant that, although manufacturers were in a position toimpose general vertical restraints such as RRP and exclusive territories, the costs of monitoring compliancewith specific contract conditions were too high to be worth incurring.

As retailers have grown larger, monitoring costs have become less important relative to total turnover,which has resulted in manufacturers and retailers increasingly solving divergences of incentives betweenthem directly – through the use of specific agreements and contracts and direct intervention - rather thanthrough the more traditional vertical restraints. Indeed, the line between vertical intervention and verticalintegration has become blurred: if a retailer makes the majority of the manufacturer’s investment andproduction decisions for him, then the retailer is effectively acting as if it owns the manufacturer. Thereis no obvious difference between this behaviour and full vertical integration in terms of implications forcompetition policy. 55

relationships (which may be important for providing strong incentives and credible threats), and the degreeto which non-integrated prices are distorted through market power.

In terms of retailing, therefore, it is very important to examine all the ways in which retailers andmanufacturers intervene in each other’s behaviour, and not just the more formal vertical restraintsdescribed above. Although difficult, it is also very important to determine so far as is possible which sideis instigating the vertical restraint, the motives of each side, and the effects of the vertical restraint.

2.5 Policy implications

The terms of reference for this study state that it should aim to provide a robust approach to theidentification and assessment of competition in retailing. This involves asking two questions:

C Is retailing different from other sectors of the economy in terms of the nature ofcompetition between retailers and the relationship between retailers and upstreamsuppliers?

C Can the competition issues that arise be addressed using established approaches tocompetition policy, or do new methodologies need to be developed?

This chapter has shown that there are significant differences between retailing and other sectors of theeconomy. In particular, distinguishing factors of retailing relate to the characteristics of end-consumerswho tend to be relatively small, immobile and uninformed, the wide range of dimensions of retailercompetition, and the prevalence of vertical restraints.

These differences are a matter of degree rather than exclusive to retailing, and for this reason we believethat that the emphasis of competition policy will often be different in retailing, but that there should be noneed for any major change in general competition policy methodologies.

We do advocate two amendments to the traditional framework for competition enquiries:

C That the relevant competition issue is clearly identified at the outset; and

C That the enquiry should always start with a preliminary analysis of the characteristics ofconsumers and the dimensions of competition between retailers, in line with the analysisoutlined above.

2.5.1 Identification of competition issues

In most cases that come to the OFT or the MMC, the relevant competition issue is already given:

• A merger between retailers required examination by the OFT under the provisions of theFair Trading Act 1973;

C A complaint by a retailer against a predatory practice by a competitor defines thecompetition issue to be investigated; and

C A complaint may refer to an exclusionary practice which is part of an agreement betweena manufacturer and retailers.

There are, however, instances where the competition issues are less clear at the outset of an enquiry. The

investigations into the supply of beer, petrol or recorded music were of a more general nature where thecompetition concerns covered pricing issues, entry barriers and vertical restraints. Retailing of these goodswas not the main focus or subject of a complaint.

It is important for the discussion in the remainder of this report that the competition issue is identified asfar as possible at the outset of any investigation. This may seem a trite point. However, themethodological steps discussed below cannot be seen in isolation of the relevant competition issues. Forexample, market definition is not of importance in itself. Market definition is a useful step in the processof identifying whether or not market power exists.

We suggest that any enquiry should state the relevant competition issues before the traditional approachis pursued. For the analysis of competition in retailing, this implies that the enquiry can be categorisedwith reference to one of the following groups of issues:

These types of purchase include impulse purchases (products which would not be bought unless the56

consumer happened to be passing).

Merger issues:

• 1 A merger between retailers will focus on a particular retailing sector; and

• 2 A merger of two manufacturers may have implications for the relevant retailing sectors.

Pricing issues:

• 1 Price collusion between retailers is a pure retailer issue;

• 2 Predatory pricing by a competing retailer is a pure retailer issue; and

• 3 Excessive pricing of a class of products is not a pure retailer issue, but can be due toexcessive margins at both the retailer and wholesale/manufacturer levels. This can leadto an extensive investigation of the whole value chain of a class of products.

Vertical issues:

• 1 Restrictive vertical practices instigated by manufacturers involves retailing;

• 2 Restrictive vertical practices instigated by retailers focuses on retailing; and

• 3 Discriminatory pricing by an upstream supplier can be the result of market power up- ordown-stream, and may lead to an investigation of both these markets.

2.5.2 Preliminary analysis

Appendix 1 of this report provides some guidance on how this preliminary analysis may be undertaken.The first step is to examine the extent to which the different consumer characteristics identified above (e.g.size of purchase, immobility, information) are important in the case being investigated. This in itselfprovides a better understanding of the way in which retailers do, and may, compete. However, we suggestthat this is also examined separately, as a second step in the preliminary analysis. This step assesses whichdimensions of competition between retailers are important (e.g. price, geographical location, productselection, retailer service), and the level at which competition takes place (e.g. at a national level or at alocal level).

Answering these questions will also provide insights into why particular forms of market structure exist.For example:

C When purchases are small in terms of spend, consumers may be unwilling to travel far topurchase them. Thus such products will either be purchased in passing (giving rise to theimportance of local newsagents and convenience stores), or at the same time as otherproducts in a shopping trip (giving rise to multi-product shops such as supermarkets, andDIY superstores).56

C When consumers are unsure of exactly what they want, they will value a retailer whichprovides a wide selection (both vertically and horizontally) of different products, or alocation at which many similar retailers are clustered. A good example is shoes, whichtend to be sold in shops which offer a wide selection of styles and sizes, and which locateclose to other such shops.

C When consumers are unsure about the horizontal aspects of the product they want to buy,but do have a preference about the vertical aspects, they will often rely on the reputationof a retailer as a guide to low or high quality merchandise. A decision to purchase a highquality bed, for example, may induce consumers to visit Harrods, whilst the demand fora cheap bed may result in a visit to a factory type shop.

C When consumers cannot observe quality directly, there may be a role for qualityassurances, especially in the form of brand name/image, after-sales guarantees, and otherforms of point-of sale service. These may be offered by the manufacturer, retailer, orboth.

2.5.3 Suggested framework

Our recommendations above are based on examination of several MMC and OFT investigations. We haveobserved that competition enquiries often encounter problems when they do not start with a preliminaryanalysis of the characteristics of consumers and the dimensions of competition between retailers. Thispreliminary analysis is important because it both suggests potential competition problems and feeds intoall of the later stages in the competition enquiry. It is crucial for market definition and can provideimportant insights into vertical issues and market power issues.

The remaining stages of our suggested framework for competition enquiries are more traditional, leadingus to recommend the following procedure:

1. Identification of competition issue

2. Preliminary analysis of retailing:

C the characteristics of consumers; and

C the dimensions of competition between retailers.

1. Market definition

2. Barriers to entry

3. Competition assessment:

C market structure;

C pricing issues; and

C vertical issues.

The following chapters discuss market definition, barriers to entry, market structure, pricing issues andvertical issues in turn.

3. Market definition

The extent to which it is important to carry out a rigorous analysis of market definitionin the retail sector will depend upon the competition problem being analysed. Inparticular, if the focus of a competition enquiry is upstream (a monopoly situation ormerger between two suppliers), then the main reason for analysing the market structureat the retail level will be to see whether retailers are likely to bargain away any monopolyrents, or to enter into upstream supply themselves. For this, a detailed retailer marketdefinition is unlikely to be needed.

More generally, market definition at the retail level as well as the manufacturer level willbe important. However, market definition in retailing tends to be more complicated thanit is in manufacturing. The standard economic test for defining the ‘relevant economicmarket’ for a given product revolves around the ability of a ‘hypothetical monopolist’ toraise the price of that product by a small but significant amount, without losing so muchcustom to other products to make the move unprofitable. The general principle is thatthose substitute goods to which the consumers would switch, in the face of a price rise,should be considered part of the same economic market.

When examining competition in retailing we need to consider that the ‘physical product’dimension, however, is only part of the picture. For most categories of consumer goods,the retailing activity is also very important and is a constituent part of the end-productwhich consumers purchase. This means that retailer markets need to be defined in termsof both dimensions: the physical product and the retailing activity.

A further difficulty involved in applying the standard market definition in retailing derivesfrom the fact that retailers compete in many different dimensions, and not just price, asdescribed in the previous chapter. This means that to focus on price alone distorts marketdefinition, especially if the various economies of scale and scope that are common inretailing mean that competition between retailers occurs at different levels for the differentdimensions of competition (or even at different levels at the same time for a singledimension of competition).

This chapter discusses these problems in some detail, and suggests some possiblesolutions. We suggest that it is crucial to consider in any enquiry exactly what aspect ofcompetition is important, and in what way competition is threatened by the behaviour ormerger of the firms under scrutiny. Market definition should never take place in avacuum. Indeed, there may be several possible market definitions, each of which is validfor looking at a particular issue.

Section 3.1 summarises the market definition methodology provided in the recentOFT/NERA paper. Section 3.2 comments on the nature of retail end-product, and showsthat it is important to consider market definition with respect to the retailing activityinvolved as well as the physical product. This section also provides an example whichdemonstrates this point very clearly: the question of whether direct sales channels shouldbe considered as in the same market as traditional store-based retailers. Section 3.3considers more rigorously the implications of this for applying the OFT/NERAmethodology to the retail sector, taking into account both the physical product dimensionand the retailing activity dimension. Section 3.4 considers the implications for marketdefinition – and in particular geographical market definition – of the fact that retailerscompete in many different dimensions. Section 3.5 concludes.

Note that A, B and C may be different products (relevant product market) or the same product in57

different locations (relevant geographical market). Note that the word ‘easily’ is important here. Suppliers of C will only be in the relevant market for58

A on supply-side grounds if they strongly constrain the pricing of A, which requires that they canmove into this market with minimal cost and minimal delay.

3.1 The OFT/NERA market definition methodology

The OFT/NERA methodology for defining the relevant economic market is based on theUS Department of Justice SSNIP test. Essentially, it defines the market by asking thefollowing question:

C Starting from prevailing price levels, what is the smallest set of goods orservices and geographical area such that if the supply of these goods orservices in this geographical area were to be in the hands of a single firm(or ‘hypothetical monopolist’) then they would be susceptible to a ‘smallbut significant and non-transitory increase in price’ (or SSNIP)?

This methodology is now accepted by most competition authorities. In essence, themarket definition process involves starting at the smallest possible market definition,testing whether or not a hypothetical monopolist of this market could sustain a significantprice rise, and if not, widening the market slightly to include the principal products towhich consumers switch and then retesting. This market widening process continues untila market is found for which the US SSNIP test is valid.

There are generally two sides to this market definition approach: demand-sidesubstitutability and supply-side substitutability. The test of demand-side substitutabilitylooks at the expected behaviour of consumers in response to a price rise:

CIf consumers are willing to substitute B for A when A’sprice rises, then B is in the relevant market for A, because ahypothetical monopolist of A would not be able to sustain a risein price (A’s price is constrained by B). 57

The test of supply-side substitutability, on the other hand, looks at the expected behaviourof suppliers in response to a price rise:

CIf the suppliers of C can easily move into the relevantmarket for A when A’s price rises, then these suppliers are in therelevant market for A, because a hypothetical monopolist of Awould not be able to sustain a rise in price (A’s price isconstrained by these suppliers).58

The OFT/NERA report also provides several tests which can be used to assess whetherthe hypothetical monopolist would be able to sustain a price rise.

We have no theoretical concerns about this methodology, although we argue that supply-side substitutability has to be used extremely carefully in retailing. Most important is thatthe principle of defining markets according to the degree to which firms constrain eachother’s competitive behaviour is followed. The OFT/NERA report itself provides anextensive discussion of how to deal with many of the more straightforward issues thatarise in applying this test.

However, there are three important problems with the simple US SSNIP test as a completemethodology for market definition:

C it is very product, as opposed to activity, based;

Manufacturer’sphysical product

(price w)

Retailer’sretailing activity

(price r)

End product(price p)

C it is very price, as opposed to other dimensions of competition, based;and

C it takes insufficient account of the strategic and competitive behaviourof companies in the face of economies of scale and scope acrosseconomic markets.

These problems are not unique to retailing, but they are particularly prevalent in thissector.

3.2 The nature of the retail end-product

As was discussed in Chapter 2, the product which is purchased by end-consumers maylook physically identical to the product which is supplied by the manufacturer, buteconomically it is very different. When consumers purchase a product they arepurchasing not only the physical product but also all of the associated retailing activity.That is, the manufacturer and the retailer supply two joint inputs as is shown in the figurebelow:

Because the US SSNIP test was designed with manufacturing industries in mind, itfocuses on the physical product. In retailing, however, this can lead to problems. Twoidentical physical products may be defined as being in different retailer markets, becauseof differences in retail service, geographical location, product selection or otherdifferences in competitive strategy. For example, it is entirely possible that a Kodak36mm film as sold in Boots is in a completely different retailer market from a physicallyidentical film sold in a small shop opposite the Houses of Parliament. Similarly, a 100gjar of Nescafé at a 24-hour corner shop may well be in a different retailer market from thesame product when sold by one of the major supermarkets.

Within retailing, therefore, it is important to define markets both in terms of the physicalproduct and in terms of the associated retailing activity. However, there are manyexamples of UK competition enquiries which ignore the retailing activity completely. InContact Lens Solutions (1993), the MMC focused entirely on the product market, andcarried out little analysis as to whether pharmacists competed in the same retailer marketas opticians, and whether – if allowed to enter – supermarkets and convenience stores

This loyalty implies, for example, that despite being the second largest pharmacy chain in the UK,59

Lloyds sells little contact lens solution. Although note that these direct record retailers tend to supply only back catalogue records (records60

which have been out for at least around six months).

would be in this same market. This omission is especially surprising given that part ofthe aim of the study was to assess competition at the retail level.

In fact, the MMC’s report found that consumers tend to be tied in to particular opticians.Customers have strong loyalty to their own opticians (or pharmacists such as Boots thatare linked with opticians). This is for a variety of reasons: perhaps they value the59

service provided by such retailers, or because of habit, or a lack of information aboutalternatives, or because they have been tied in more explicitly through long-term customerdiscount schemes. Whatever the reason, this loyalty means that a small but significantprice rise by the opticians is thus unlikely to result in a significant number of consumersshifting their custom to alternative retailers, and thus that the opticians constitute a distinctretailer market on their own. This suggests that simply allowing supermarkets and otherretailers to supply contact lens solution may well not be enough to improve competitionin this market. In addition, it is important to encourage consumer switching betweenretailers: through better provision of information on the possibilities of substitutionbetween different contact lens solutions; and through a restriction on long-term customerdiscount schemes.

3.2.1 An example: direct sales channels versus store-based retailing

A good example of the importance of retailing activity in market definition is the questionof whether direct sales channels for a particular product class are in the same retailermarket as store-based retailing for that product class. Direct sales channels include:

C person to person (e.g. Avon);

C party plan (e.g. Tupperware);

C clubs (e.g. Britannia Music Club, TSP Book Club);

C mail order (e.g. Littlewoods catalogues, magazine offers); and

C over the phone purchasing (from original suppliers, as by Direct LineInsurance, and many computer manufacturers).

These direct sales channels are becoming more and more important relative to traditionalsales channels (stores). Thus, in many competition enquiries it is now important toexamine whether these retail channels constitute distinct retailer markets from other saleschannels. For example, in 1992 Britannia Music Club accounted for around 8% by valueof all record sales, as was shown in The Supply of Music (1994). The MMC suggestedthat such direct record retailers compete in a different retailer market from high streetrecord stores, despite the fact that the physical products being sold are identical.60

The MMC did not, though, carry out any very rigorous analysis of the retailing activityoffered by each type of retailer in order to come to this decision. To reach a morerigorous decision, we suggest that it is vital to consider both:

C the transactions costs attached for the consumer of making the purchase(which must be considered part of the total cost of the purchase); and

C the nature of the buying decision which may render a particular channelinherently more suitable for selling certain products to certainconsumers.

3.2.1.1Consumers’ transactions costs of purchasing

Because end-consumers are relatively small, immobile and uninformed, they face a seriesof transaction costs in acquiring a product:

C pure shopping (or ‘shoe leather’) costs: these are the costs of physicallygetting to the product. Even if they know exactly what they want to buy,consumers generally prefer not to travel far to make a purchase, nor totravel to several different locations for each separate purchase;

C search costs: these are the implicit costs incurred in finding out wherethe product is sold, where the prices are lowest, etc; and

C costs of acquiring information on quality: because quality is oftenunobservable ex ante, consumers face costs in obtaining information onquality; or alternatively they can pay to avoid the need for directinformation by purchasing from retailers and manufacturers with highreputation (implicit ‘quality assurance’).

Each retailing/selling method has different properties vis-à-vis these costs.

Traditional retailing outlets (high-street shops, superstores, DIY stores, etc.) bring theproduct closer to the consumers and thus reduce pure shopping costs; they also offer someinformation and quality assurances through their product selection (‘gatekeeper’function), shop ambience, product promotion, and retailer image/reputation, thus reducingsearch costs and costs of acquiring information on quality.

Direct selling channels also provide a link between the production of a good and the end-consume. However, these selling channels differ substantially in the way they relate tothe above mentioned consumer characteristics.

C Direct selling eliminate pure shopping costs almost entirely, because theconsumer places the order directly from home.

C In direct sales, the contact with the product before purchase (andtherefore the ability to inspect it and check its quality) varies; from nonewith a catalogue (the purchase is only on the basis of a photograph or aproduct description), to some with door-to-door sales, and full productdemonstration with party plan selling.

C The time involved in making the purchase is also very different: whilethe time and effort of a shopping trip is avoided in the case of directselling and catalogues, there is the delay/waiting time involved beforeactually obtaining the product. This may be up to a few weeks.

C The pre- and after-sale service is often different from that supplied by atraditional retailer.

C The product selection tends to be different.

C The amount of advertising may be different: mail order catalogues tend

As was discussed in Chapter 2, there is large evidence of the correlation between exposure to61

customers and sales of retail products.

not to do any traditional advertising as they regard their catalogue itselfas their most effective promotional tool. Direct sellers also consider thatthey do not need advertising to launch new products, and that productline expansion is the most important factor for supporting growth. Onthe other hand, direct sales by suppliers (Direct Line, Dell, etc) mayrequire large amounts of advertising in order to induce consumers tophone in and purchase.

3.2.1.2The nature of the buying decision

Another important aspect which separates different sales channels is the nature of thebuying decision. Clearly some products (e.g. the family car, a TV or even a new suit) aresubstantial purchases in the average consumer’s budget, which therefore require a degreeof planning, and careful comparison of prices and quality. Other purchases rely onimpulse. This is most often the case for products which have a low unit value, and/or arenot strictly needed by the purchaser (so that the ‘need’ or ‘want’ is generated when theconsumer sees the product, rather than being an item in his shopping list or even theobject of a shopping trip).

Sales of these products essentially depend on consumers’ ‘exposure’ to the product,which is why bringing them directly to the consumer’s attention through direct salesmarketing is a very effective way of operating. For example, in party plan selling,different products and functions are demonstrated in detail by the sales person. The aimis to trigger consumer needs or wants in a more targeted way than it is possible byretailing through traditional outlets. Television home shopping channels work in a similarway.

Retailing through a traditional outlet, especially where there are several hundred items inthe shop (or even several thousand, as in large DIYs or department stores orsupermarkets) is a less effective technique for some impulse products: even where thereis a ‘latent’ need, this will not develop unless the customer happens to walk by the rightshelf or aisle.61

3.2.1.3Conclusions

If two forms of retailing each provide different ways of overcoming consumers’transactions costs and encourage different types of buying decision, then it is verypossible that there will be little demand-side substitutability between them, even if thepure physical product being retailed is identical in both. Thus, it will often be the casethat direct sales channels will be considered as being a distinct retailer market.

3.3 Applying the US SSNIP test to retailing

3.3.1 Retailer market definition: demand-side substitutability

Once it is realised that retailer markets must be defined in terms of the retailing activityas well as the physical product, the US SSNIP test can be applied relativelystraightforwardly, at least on the demand-side. Starting at the smallest possible market

Note that the test here is not whether, once the consumer is inside Sainsbury’s, he or she will switch62

to other goods rather than other retailers, but whether the consumer will continue to shop atSainsbury’s (but switch products) in the future.

This will be especially true if the prices of these products have a signalling role in informing63

consumers about the overall prices of the retailer.

definition, we ask the question of whether a hypothetical monopolist of the products andretailers included would be able to sustain a price rise. If not, we widen the market andretest.

The only real difference between this approach and the approach described above is thatwidening the market to include end-products to which consumers switch may involveincluding new retailers of the same physical product, rather than (or as well as) otherphysical products sold by the initial retailers.

To see how this process works it is useful to consider the simple example of baked beanswithin Sainsbury’s. A rise of the price of baked beans in Sainsbury’s would have – if any– two possible effects on the behaviour of current consumers:

C consumers would continue to shop at Sainsbury’s but switch to otherproducts; or62

C consumers would stay with baked beans but move to an alternativeretailer.

If there were no significant effect on consumers’ behaviour at all, then it is possible toargue that baked beans within Sainsbury’s is a market on its own. If the first of the aboveeffects is significant then the market should be widened to include these extra products,and then retested. If the second effect is significant then the market should be widenedto include these extra retailers, and then retested.

The relative size of these two effects will depend on the relative switching costs faced byconsumers, and on their perceptions of the comparative advantages of different retailers.In the case of supermarkets, the costs of switching between retailers will be relatively highcompared to the costs of switching between different products. Thus, at the first stage testat least, we would expect the second effect to dominate. In the case of a large purchasesuch as a fridge, however, it is far more likely that consumers will check out the sameproduct in a number of different retailers, in which case a significant rise in the price ofa particular fridge in Comet may well result in many consumers switching to analternative retailer rather than an alternative fridge within Comet.

Note that a market which is widened in one dimension at this first stage may well bewidened in the other dimension at a later stage. In our example, it is probable that, at thefirst stage described above, consumers would switch to other tinned products rather thanswitching retailers. However, if Sainsbury’s were to raise the prices of all of thesepossible substitute products, then consumers may well start switching to alternativeretailers. 63

The final market definition resulting from this process will consist of a group products assold by a group of retailers. For example, consider the case of record retailing, as wasexamined (somewhat cursorily) by the MMC in The Supply of Recorded Music (1994).It is possible to distinguish three main product classes and four main retailer types inrecord retailing, as described in the matrix below.

The OFT/NERA report discusses this intransitivity in cross-price elasticities on page 31. For a64

theoretical discussion of why cross-price elasticities will tend to be intransitive, except under strongrestrictions on preferences, see Gravelle and Rees (1992), page 113.

To put this more simply, it is perfectly feasible that back catalogue records should constrain the prices65

of chart records without chart records constraining the prices of back catalogue records.

Chart Back catalogue/ Classicalspecialist

General stores and petrol YesstationsSpecialist music retailers Yes Yes YesNiche retailers Yes(non-classical)Niche classical retailers Yes

Although it is an empirical question, it is entirely possible that some of the cells in thismatrix will constitute relevant retailer markets on their own. It is also possible that thethree main product classes will constitute retailer markets (with all of the relevant retailersincluded), or that the four main retailer types will constitute retailer markets (with all ofthe relevant product classes included). Or the relevant market may be wide, and includeall of the possible cells.

One important point to note about this market definition methodology is that thedefinition of relevant retailer market will often depend on exactly where the definitionprocess commences. Indeed, this is generally true of the OFT/NERA methodology formarket definition: the relevant market for A can include B without the relevant market forB including A.64

In many situations, this is not a problem because it is clear from the nature of thecompetition problem being investigated where the market definition process should start.However, in more general investigations, it is important to consider all possible relevantmarket definitions which may face competition problems.

For example, in the record retailing case above, it is perfectly feasible that:

C when starting in the upper left hand cell of the matrix (‘chart records ingeneral stores’), the market definition would end up including all chartand back catalogue records and associated retailers; but

C when starting in the ‘back catalogue in niche retailers’ cell, the onlyother cell to be included in the market definition would be the other backcatalogue cell.65

Market shares, and other indicators of market power, may well differ greatly betweenthese different market definitions. Thus, if a competition authority is concerned with theability of record retailers to raise record prices generally (rather than chart records or backcatalogue records in particular), it will be necessary to consider both market definitions.

Empirical testing of demand-side substitutability

Because retail products tend to be relatively small, because prices tend to be very visible,and because sales of retail goods tend to be very well covered by highly disaggregatedmarket research data, it is generally easier to analyse demand-side substitutability betweenretail products empirically than it is for many other classes of products.

See European Retail Digest, Winter 1994.66

As will have been analysed in the preliminary step.67

On the other hand, it is often relatively hard to come to rigorous product market definitionin retailing without such empirical analysis. Firstly, consumers are often attracted tostores by the range or portfolio of products they offer. This means that whilst productsmay be substitutes in terms of the in-store purchasing decision, they may be complementsin terms of getting consumers into the store in the first place. For example, a reducedprice suit in the front of a clothes shop may entice you into the store, but once inside youmay well buy a rather more expensive item. Thus, the reduction in price of one item mayactually increase, rather than reduce, sales of another.

Secondly, the high level of substitutability between products once a consumer is in a storemeans that it is often very difficult to guess a priori which products will be substitutedfor which others in the face of relative price changes. US studies suggest that 65% ofgrocery decisions are made in-store. That is, consumers go to the grocery store66

expecting to buy a certain number of meals for an approximate amount of money, but theydon’t decide exactly what they are going to buy until they get there and see what is onoffer and at what prices. This kind of behaviour can imply wide retailer markets in termsof product classes included, with consumers switching between relatively diverse productsin response to price changes.

Retailer market definition: supply-side substitutability

Supply-side substitutability needs to be used very carefully in relevant retailer marketdefinition, and it is often over-used. On the one hand, it can lead to overly wide marketdefinition in terms of the number of retailer types included in the retailer market. On theother, it can lead to overly wide market definition in terms of the number of product typesincluded in the retailer market.

3.3.2.1Supply-side substitutability by new retailers

It is easy to believe that potential supply-side substitutability by retailers currently outsidethe retailer market can have strong effects on retailer market definitions. It is often bothquick and costless for a retailer currently not offering a particular product to transfer a fewmetres of retail shelving to this product in the face of price rises by other retailers. Thissuggests that the retailing of any given product is relatively contestable and thus that therelevant retailer market should be defined widely.

However, this shelf-space substitutability argument must be used carefully. While it istrue that it does not take much time or money to put a new product line onto existingshelf-space, this does not mean that it will be profitable to do so. In order to make saleson this new product line, it is not enough for a retailer to devote shelf space to theproducts and to price them competitively. Rather, it is important to consider the otherdimensions along which retailers of goods compete. 67

Consider, for example, the retailing of fridges. While it is, in principle, possible for arecord retailer to clear some space in its store to display a fridge, this would not be aprofitable strategy because it is highly unlikely that anyone would buy it. In order to sellfridges it is important both to get potential fridge buyers into the store and also to get themto make a purchase. For this, retailers need, amongst other things, to have:

C The right sort of image, in order to attract potential consumers in the first

place (electrical goods shops and department stores would be expectedto sell fridges, convenience stores would not);

C A sufficient selection of fridges, and enough well-informed sales staff,for the consumer to feel she can make a well informed choice; and,

C The appropriate purchasing and distribution strategies that enable themto compete on price with existing fridge retailers.

Thus, in examining supply-side substitutability by new retailers, it is crucial to considerwhether it would ever be profitable for the potential supply-side substituter to actuallyenter the retailer market. To do this requires an analysis of the nature of competitionbetween retailers and an understanding of any vertical relationships that exist betweencurrent retailers and manufacturers.

3.3.2.2Supply-side substitutability into new product classes

Where a retailer is capable of moving into retailing a particular product profitably, thisretailer should be considered as competing in the relevant market for that product. Thatis, the potential size of the market is larger than it seems when analysing actual playersonly.

This is relatively uncontroversial. A common mistake that is often made in marketdefinition, however, is to assume that the other products supplied by this potential supply-substituter should be added to the definition of the market. That is, if a supplier ofproduct C can easily substitute into supplying product A, then not only is this supplier tobe considered as being in the market for A but also product C should be included in thismarket.

The fallacy of this argument is clear in the following (non-retail) example. Consider thecase of Gillette Company and Parker Pen Holdings (1993). In this case, the MMCrecognised that transferability of brand name meant that supply substitution into the‘refillable’ pens market would be easy for companies in other markets with similar brandimages, such as Cartier (watches) or Yves Saint Laurent (fashion and perfume). TheMMC did not in fact go so far as to say that these companies were supply-substituters, butsuppose that it had. Would this have meant that the market for refillable pens should havebeen widened to include upmarket watches, fashion, and perfume? Surely not.

This problem arises a great deal in retailing, and tends to result in retailer marketsincluding many more product classes than is appropriate. For example, in Kingfisher plcand Dixons Groups plc (1990), the MMC spent some time discussing the boundaries ofthe relevant product market: for example, are brown and white electrical goods in thesame market, should the market include photographic equipment, and other similar items?Indeed, the MMC eventually examined three different product markets, all of whichincluded both white and brown goods. There was, however, no obvious reason forpicking these three markets, rather than any other combination of products. Moreover,the debate over market definition abstracted from the real question under investigation,which was: would the proposed merger between Kingfisher plc and Dixons Group plchave a significant deleterious impact on competition in the supply of any of the productgroups involved?

Geographical market definition at the retail level

The discussion above applies equally well to geographical market definition as to retailer

We will not repeat our discussion here about whether or not this is an appropriate definition of the68

relevant retailer market.

market definition. Exactly the same tests of demand-side and supply-side substitutabilitycan be applied.

It should be noted that the relative immobility of retail customers will often implyrelatively local markets at the retail level. There are, however, arguments for wideninggeographical markets in retailing. These are discussed in the next section.

3.4 Dimensions of competition other than price

The fact that retailers compete across a range of dimensions other than just price issometimes treated simply by adjusting prices to reflect differences between retailers interms of retailer service, geographical location or product selection. For example,advanced econometric techniques (such as forms of hedonic pricing) can be used toincorporate the other determinants of the relevant price. The US SSNIP test can then beapplied to these adjusted prices.

However, such methods obscure the important fact that competition in these otherdimensions may take place at a different level to price competition. This difference isparticularly important in geographical market definition in retailing. The simple SSNIPtest tends to lead to relatively narrow geographical market definitions. However, in termsof dimensions other than price, economies of scale and scope mean that national retailchains will tend to compete at a national, or at least regional, level rather than at a locallevel. Moreover, these other dimensions may have an impact on pricing behaviour also,so that pricing becomes national too.

This point is exemplified very clearly in the case of Kingfisher plc and Dixons Group plc(1990). In the ‘market’ for electrical goods retailing , there are some national multiple68

retailers of electrical goods, who have a number of national strategies and who competevigorously against each other at a national level. These include Comet (Kingfisher) andDixons and Curry’s (both Dixons Group). There are also a number of local retailers ofelectrical goods who compete only locally. In terms of the standard SSNIP test, it seemsthat the relevant market for electrical goods retail should be local, on the grounds thatconsumers do not travel far for electrical goods. That is, there are a number of narrowlocal markets for electrical goods retail. Price divergence’s between these local marketsmay exist if consumers fail to exploit them because of transportation or transaction costs.

In addition, the SSNIP test, strictly applied, suggests that within each of these localmarkets the local players should not be considered as competing in the same retailermarket as the national players. The reason is that the two main national players competefar more strongly against each other in terms of price than either would compete withlocal players. While the national players constrain the pricing of the local players, it isnot true to say that – at prevailing prices – the local players constrain the pricing of thenational players. Thus, starting from prevailing price levels a hypothetical monopolist ofthe national players would almost certainly raise prices by a significant amount (up to thelevel at which the competitive fringe of local players became a constraining force).

The MMC, however, rejected both of these market definitions. Firstly, it decided that therelevant geographical market was national. The grounds for this seem to have been thatin most dimensions of competition the electrical goods retailers involved – Comet andDixons/Curry’s – compete against each other at a national level rather than at a local

All three were at the time in the top 13 of nationally advertised names.69

In addition, there are problems with the chain of substitution argument. Even if the links between70

different sub-markets are strong, there will be a dilution effect as the market becomes wider due to thetransactions and search costs incurred by customers. Substitutability may be equally strong betweenA and B, B and C, and C and D, but while C may be in A’s market (through the chain of substitutioneffect), D may not be (because of the dilution effect). This means that while the chain of substitutioneffect may give us regional markets, it is unlikely to give us national markets.

level. They advertise both their stores and the prices of their products at a national level ,69

they carry out negotiations with suppliers at a national level, and they make nationaldecisions on shop layout, staff training, and product selection. Indeed, they even setnation-wide prices. Secondly, the MMC considered that the local players did compete inthe same retailer market as the national players, presumably because price elasticitiesbetween the two types of retailers are clearly significant.

Both of these MMC decisions seem reasonable, but neither would have resulted fromstrict use of the US SSNIP rule. In terms of the first, the OFT/ NERA report suggests thatthe choice of a national market as opposed to a number of narrower geographical marketscan be reconciled with the traditional methodology through the ‘continuous chain ofsubstitution’ argument. This says that: if A is a substitute for B, and B is a substitute forC, then A should be considered to be in the relevant market for C, even if A is a poorsubstitute for C. Thus, it is legitimate to treat a chain of products as a being in a singlemarket as long as each link in the chain is sufficiently strong to ensure that all productsin the chain are bound by a common price constraint.

However, while this form of reasoning may sometimes be valid, it is does not accuratelydescribe why the MMC chose to define the relevant market as national. Rather, the70

MMC recognised that competition between retailers takes place in many dimensions andthat, due to various synergies, competition in these various dimensions may take place atvarious levels. In particular, in retailing generally, economies of scale and scope meanthat many decisions will take place on a national basis. Moreover, there are benefits tobe derived from having a national pricing policy, in terms of providing a unified retailerimage and achieving effective consumer advertising.

This means that the definition of the relevant geographic market will often depend onwhich aspects of competition are under investigation. Consider a set of competingretailers for which most major management decisions take place nationally but pricingdecisions are made locally. To the extent that the competition enquiry is concerned withthe ability to raise prices, then local market power will be of most concern and marketsshould be defined locally. However, to the extent that it is thought important to promotequality and innovation improvements in other dimensions, then competition at thenational level is what matters, and the market should be defined nationally. This is whatis sometimes called the strategic market (Kay, 1990b), because it takes into account thestrategic behaviour of retailers, rather than simply the switching behaviour of customers.Note that if both issues are of concern, then competition should be analysed under bothtypes of market definition.

In fact, the US SSNIP test itself can sometimes give relevant strategic market rather thanrelevant economic market, as is shown by the second divergence between the MMC andthe results of the US SSNIP test. This divergence can be explained by the fact that thereare economies of scale and scope across economic markets. In this case, the nationalplayers have a far stronger negotiating position vis-à-vis suppliers, and can thereforeachieve far lower wholesale prices than the local players.

As a general rule, under most forms of competition, equilibrium prices will be muchlower when two firms with low costs are competing than when a firm with low costs is

competing with a firm with higher costs. In the latter case, the firm with low costs willtend to do best by slightly undercutting the higher cost firm, and then taking theremaining difference between price and cost as profits.

This simple case carries over to the case where there are several higher cost firms (acompetitive fringe). When there is only one low cost firm competing with a higher costcompetitive fringe, this fringe will tend to have a significant constraining effect oncompetitive prices. However, when there are two low cost firms competing against eachother, the existence of the competitive fringe will have no effect on prices. Thus, the USSSNIP test – which takes account of prevailing prices and thus strategic behaviour – willplace these two low cost firms in a strategic market on their own, even though thecompetitive fringe would have a significant constraining effect on prices if, for example,these two firms were to collude rather than compete on price (so that the relevanteconomic market will include the competitive fringe).

In both of these cases of divergence between the MMC decisions and the US SSNIP test,there is actually a strong argument for using both types of market definition at once, evenwhere only one dimension of competition is under examination. To the extent thatstrategic market definition is influenced by current behaviour, it should be borne in mindthat this behaviour may well change (especially post-merger in merger cases). Forexample, just because pricing is currently done at the national level by the big electricalretailers does not mean that price decisions could not be delegated easily to local storesin the future. Thus an examination of the national market only may miss some importantpotential competition issues which may arise due to market power in the local market.Similarly, if the two large electrical retailers had just been colluding on price rather thancompeting then the result of the US SSNIP test would have coincided with that of theMMC.

Note that the distinction between strategic and economic markets is not restricted togeographical market definition. It also bears on retailer market definition (by retailertype). For example, supermarkets compete in a number of different economic productmarkets with a number of different types of retailers: they compete in the bread marketwith bakeries, in the fish market with fishmongers, and in the markets for over-the-counter drugs and feminine hygiene products with chemists. However, economies ofscope across these different product markets mean that supermarkets compete morevigorously against each other than they do against any of these other retailers. That issupermarkets may form a strategic retailer market by themselves, as well as competingin a number of different economic retailer markets.

3.5 Summary

We have argued that the standard US SSNIP test can be easily adjusted to define relevantretailer markets simply by recognising that the ‘end-product’ purchased by consumersconsists of two parts: the physical product and the retailing activity. The US SSNIP testcan then be applied in both of these dimensions.

However, because the US SSNIP test focused on price competition alone, it provides adistorted view of market definition (and particularly geographical market definition). Infact, there may be different relevant market definitions depending on which dimensionof competition between retailers concerns us.

Bain (1956) thought it appropriate to distinguish between blockaded and deterred entry. Blockaded71

entry occurs where the incumbents behave exactly as they would if there were no threat of entry, butwhere, even so, the market is not attractive to entrants. Deterred entry, by contrast, involves theincumbent retailers modifying their behaviour in order to thwart entry. We do not follow thisdistinction.

4. Barriers to entry

As was argued in Chapter 2, the fact that consumers in retailing tend to be relativelysmall, immobile and ignorant, combined with the prevalence of vertical restraints, meansthat retail markets are likely to work only imperfectly, and thus that competition problemsare likely.

The detrimental effects of such competition problems will depend, however, on the sizeof the barriers to entry into the retail markets. If entry is easy, then the potential forretailers to exploit market imperfections will be limited. The assessment of barriers toentry in retailing is of particular importance when assessing potential mergers, since theability of a merged retailer to exploit its increased market share will be strongly dependenton the height of barriers to entry into the market.

In this chapter, we evaluate the assessment of barriers to entry in retailing by consideringwhether the methodology of the OFT/London Economics (LE) report on Barriers to Entryand Exit in UK Competition Policy (1994) can be applied to retailing without any majordifficulties. The answer, in brief, is yes, although some of the analysis has to be recastslightly in order to fit retailing. A checklist of useful questions that might be asked isprovided in Appendix 1.

Application of this methodology shows that barriers to entry into retailing tend in fact tobe relatively low, although entry into particular strategic markets can be a lot moredifficult than entry into economic markets.

4.1 The OFT/LE barriers to entry methodology

The OFT/LE report divides barriers to entry into a number of groups. Firstly, itdistinguishes between:

C Entry barriers (which prevent entry); and

C Entry impediments (which delay entry).

Within the category of entry barriers, the report distinguishes between:

C Absolute advantages; and

C Strategic (first mover) advantages. 71

Within strategic (first mover) advantages, the OFT/LE report distinguishes fivecategories. These can be recast for the purposes of retailing as:

C Economies of scale and scope;

C Advertising, goodwill, product/retailer differentiation

C Capital requirements;

The OFT/LE report also provides a seven step method of analysing entry barriers, which groups72

together three of the above categories (economies of scale and scope; advertising, goodwill and marketpositioning; and capital requirements). However, for the purposes of the current report, we chooseto keep these various categories separate.

Even though these issues could be covered here as behaviour aimed either at deterring entry or73

inducing exit of rivals. The importance of tradability is clear. If a licence is necessary for functioning in a market, but there74

is an efficient market for these licences, then there is no barrier to entry. This point was made byGilbert (1989).

Cost asymmetries due to the superior efficiency of incumbents should not be included in this category.75

C Vertical foreclosure and exclusion; and

C Predatory pricing.

Altogether, therefore, the report distinguishes seven categories of entrybarriers/impediments, each of which must be examined in any competition enquiry. For72

the purposes of this study, predatory pricing and vertical issues are in fact considered inChapter 5, under the heading of competition assessment. The current chapter discusses73

the likely importance of the other five categories for competition in retailing.

4.2 Absolute advantages

Absolute advantages are advantages which cannot easily be replicated by entrants, andwhich are not readily tradable. Often, they are costs which must be borne by the entrant,74

but which are not borne by incumbents (Stigler, 1968). Examples include most legal75

and regulatory restrictions, and exclusive or superior access by an incumbent firm tonecessary inputs, such as geographical location, advertising, copyrights, patents, andtrademarks.

Copyrights, patents and trademarks are likely to be relatively unimportant in retailing.However, legal and regulatory restrictions, access to retail sites, and restrictions onadvertising, can be significant barriers to entry.

Legal and regulatory restrictions

The most important absolute advantages in retailing are likely to be legal and regulatorybarriers to entry. Quality and safety issues are very important in retailing, due to theinformation problems faced by consumers. If these are regulated directly (so that onlyretailers which provide some minimum given quality can enter the market) then theregulation will not constitute an entry barrier. However, quality and safety are sometimesregulated indirectly, through regulating the type or number of retailers that can enter themarket. In this case, efficient entry may be prevented.

Quality and safety regulations

Quality and safety regulations are generally fairly easy to observe, although it may beharder to gauge their importance as barriers to entry, and the appropriate trade offbetween preventing entry and ensuring product quality/safety. It should be noted, though,that as quality and safety regulations become more Euro-centralised, this will become lessof an issue for the UK competition authorities. Barriers to entry will tend to be reducedwhen only one approval process is required for all of Europe. It will also be more difficultto find remedies which the UK can unilaterally enforce.

Indeed, the difficulty of entering the pharmacy market has led Sainsbury’s to invite Boots (which does76

have pharmacy licences) to set up pharmacies within its stores (rather than Sainsbury’s setting up itsown pharmacies).

Regulations on retailer types allowed to enter

In Contact Lens Solutions (1993), the MMC examined anti-competitive consequences ofthe regulation which dictated that only opticians and pharmacies were allowed to sellCLS. The reasoning behind this regulation was that misuse by consumers of CLS couldbe extremely damaging, and thus that CLS should only be available in outlets which couldprovide good consumer information on the use of CLS, and especially on thecompatibility of different types of CLS with different types of lenses.

In this case, the MMC decided that these consumer information problems were notserious enough to justify the anti-competitive effects of the regulation, which wasallowing retailers and manufacturers to raise prices and profits to uncompetitive levels.The regulation was thus abolished, allowing entry into the market by other possible retailcompetitors, such as supermarkets and convenience stores.

However, this case shows an important danger inherent in analysing barriers to entry: viz.that removing one barrier to entry will not always result in free entry, but rather that otherbarriers to entry will then reveal themselves. In this case:

C Firstly, as mentioned in the previous chapter, it is not clear that asignificant number of consumers will switch to these other types ofretailer, even if they are allowed to enter. Consumers prefer to useretailers that are linked with opticians, either because they value theservice provided by such retailers, or because of habit/lack ofinformation about alternatives, or because they have been tied in moreexplicitly (through recommendations of own-brand CLS, or throughlong-term customer discount schemes).

C Secondly, even under the regulated system, some manufacturers hadopted to distribute exclusively through opticians’ outlets. If the marketwere opened up to new types of retailer, it is not clear that manufacturerswould choose to supply them. The MMC did not examine thispossibility.

Regulations on retailer numbers

In addition, in some retail markets (such as pharmacies and betting shops), there areregulations restricting the number of local competitors, and where retailing licences arenot tradable between retailers. This is the case for both pharmacies and betting shops, andacts as an important barrier to entry into these retail markets. 76

In Grand Metropolitan plc and William Hill Organisation Ltd (1989), the MMC wasconcerned with the absence of price competition and the existence of a number oflegislative barriers to entry (licences) and barriers to competition at the local level(advertising).

The MMC judged that the crucial problem would be a reduction in competition in off-course betting at a local level, and thus that Grand Metropolitan should be required todivest certain betting offices: wherever there are former Mecca and William Hill bettingoffices within a quarter of a mile of each other, and where there are no other bettingoffices within a quarter of a mile of one of these offices. This would involve around 20

See §6.13 in the MMC report.77

Moreover, if this behaviour drives up the price of sites remaining on the market, it provides78

incumbents with an additional cost advantage over entrants, potentially acting as an additional entrybarrier.

disposals, mostly in London.

Indeed, the MMC found that the licensing system acts as a very major entry barrier intothis market.

“Operators of a betting shop require abookmaker’s permit or betting agency permit.A betting office licence is also required forindividual premises. Licences are granted by aCommittee of Licensing Magistrates in eachlocal Petty Sessional Division (PSD) (licensingboards in the case of Scotland). Among thegrounds on which applications for a bettingoffice licence may be refused (see paragraph3.3) is that the licence would be inexpedienthaving regard to the demand in the locality, andthe number of offices available to meet thatdemand. There is no provision in thelegislation for granting licenses in order tostimulate competition.”77

The licensing system provides an incumbent in a local market with absolute advantages.No entrant can obtain a licence unless there is sufficient evidence that there is a clearneed. Licences cannot be traded.

4.2.2 Access to retail sites

In some retail markets such as supermarket retailing, prime geographical location can alsobe important. In principal, if this location is not tradable, it may constitute an absolutecost advantage, and act as a barrier to entry. However, it is hard to think of situations inwhich retail sites would not be tradable except where location is tied up with legalrestrictions such as planning permission.

For this reason, we believe that the importance of geographical location as an entry barrierin retailing is often over-stated, except where planning permission is difficult to obtain.In this case, though, retail sites can be crucial for entry. Carroll, Pandian and Thomas(1994) note that this is becoming an important issue in the out-of-town retail market asthe number of potential sites for superstores is declining due to planning permissionbecoming more and more difficult to obtain. There have even been reports of the majorretailing multiples buying up out-of-town sites well in advance of using them, in order topre-empt potential entry.78

Access to retail sites was an issue in Kingfisher plc and Dixons Group plc (1990). In thiscase, the MMC considered that the growth of out-of-town electrical goods retailing maybe limited in some areas by local council planning restrictions. These may prevent (or atleast impede) entry by further out-of-town stores, giving the retailers that have establishedthemselves already in such locations a degree of market power (particularly if planningpermission is specific to one retailer and cannot be transferred easily to another).

In, for example, floor space, distribution networks, store networks, and advertising.79

This has contributed to the trend towards larger stores in general (especially in out-of town locations),80

and has no doubt been a crucial factor in the increasing concentration of the grocery retail market inparticular.

In fact, the MMC rejected the proposed merger on the grounds that the merger betweenthe two main national chain of retailers of electrical goods would substantially lessencompetition in electrical goods retail. However, given that consumers tend to shoparound before buying electrical goods, it is not obvious that out-of-town retailers shouldbe considered as being in a different market from high street retailers. And if they are inthe same market, difficulty of entry into out-of-town retailing does not equate withdifficulty of entry into the electrical goods retail market.

Advertising restrictions

Advertising restrictions are another important entry barrier into the betting industry, aswas examined in Grand Metropolitan plc and William Hill Organisation Ltd. Therestrictions on site specific advertising are detrimental to small bookmakers. Thedisadvantages for potential entrants are amplified as advertising is instrumental inachieving awareness among punters of a new betting service or bookmaker. An entrantmust rely on location in a high street to create awareness in his customers if site specificadvertising is not possible. If these advertising restrictions were removed, then locationwould lose its pivotal position as the primary dimension of competition between bettingshops. Entry on a large scale, however, can be supported by advertising. Nevertheless,the cost of penetrating a market that already exhibits considerable barriers to entry(licensing laws and restrictions of location choice) can be considered to be high.

4.3 Strategic advantages: sunk cost and economies of scale

Economies of scale and scope in retailing are rather different from those which exist inproduction, but they can act as barriers to entry in exactly the same way. As the OFT/LEpaper discusses, this requires that investments are sunk. The basic idea here is that, if79

investments are not sunk, an incumbent retailer faces a pre-commitment problem: it wantsex ante to threaten to compete vigorously to maintain its current sales levels after entry,in order to make entry seem unprofitable; but ex post, in the face of actual entry, it mayhave an incentive to accept lower sales and not to fight. Fixed costs (economies of scale)per se are not enough to commit the incumbent to behaving aggressively post-entry (shopscan be sold, for example). If, however, these costs are sunk, the story changes. Becausethe costs are sunk, and not recoupable, it may be profitable, even ex post, for theincumbent to fight to maintain sales, and this means that entry can be deterred.

Examples of economies of scale and scope which may act as barriers to entry in retailinginclude:

C Economies of scope in floor space: The importance of one-stopshopping has increased the importance to retailers in some markets ofstocking wide product ranges, which generally requires significant floorspace.80

C Economies of scale in logistics: There are many of these, fromminimum delivery orders, to the ability to use sales staff efficiently, andto the ability to reduce inventories (as a proportion of turnover).

C Economies of scope in distribution: For some sorts of retailing

Chain stores tend to have strong retailer images, which are partly a result of standardising the retail81

environment and retailer services provided in each particular shop.

(especially where fast and efficient delivery is crucial as with fresh foodsand newspapers), it is important for retailers to control their owndistribution networks. There may be significant sunk costs andeconomies of scale in establishing distribution systems. However, oncea distribution system is set up, it can supply extra stores and extraproducts at minimal incremental cost.

C Economies of scope due to store networks: In some retail markets,consumers prefer to buy from chain stores, on the grounds that theyknow what to expect and sometimes because they can exchange81

inappropriate purchases (and gift tokens) elsewhere in the country.

C Economies of scale due to retailer bargaining power: Larger retailersmay be able to obtain better deals from upstream manufacturers thansmaller retailers can.

In order to assess whether economies of scale and scope of these sorts provide a barrierto entry into any particular retail market, it is first necessary to determine the degree towhich costs are sunk, which will in turn determine what would happen post-entry. InKingfisher plc and Dixons Group plc (1990), for example, the MMC evaluated the costsin entering the electrical goods retail market from scratch. However, many of the fixedcosts concerned would not be sunk: retail property and stock can be sold relatively easily,or transferred to other products.

After determining the extent to which fixed costs are sunk, it is necessary to comparethese sunk costs with the size of the retailer market. In this regard, retailing has two veryimportant characteristics.

On the one hand, the importance of geographical location means that many economicmarkets are relatively local, and thus fairly small. Thus, sunk costs need not be especiallyhigh in order to restrict entry. In fact, the sunk costs involved in setting up a single localretailer tend to be relatively low, and entry is relatively easy at the local level.

On the other hand, economies of scale and scope mean that many strategic markets arenational (or at least regional), covering a number of local economic markets. Strategicretailer markets may also include a number of different economic product markets. Thesunk costs involved in entering these strategic markets may be extremely high. Forexample, in Kingfisher plc and Dixons Group plc, the MMC recommended against theproposed merger, arguing that, despite apparently easy entry at a local level, no newcomeris likely to penetrate the strategic market to the extent necessary for them to become aneffective competitor to the merged company, due to the economies of scale and scopewhich the large national players enjoy.

4.4 Strategic advantages: advertising, goodwill and retailerdifferentiation

The sunk costs involved in advertising, goodwill, and retailer differentiation provide afurther source of barriers to entry in retailing, which work by shrinking the residualdemand that a potential entrant would face, or by raising the sunk costs of entry.

For example, in Kingfisher plc and Dixons Group plc (1990), the MMC considered that

Although the successful recent entry of Tower Records and other US retailers (under the Sam Goody82

brand) suggest that this entry barrier is not that high.

the sunk cost involved in establishing a retailer brand name that can compete effectivelywith the incumbent multiples may be an important barrier to entry into the nationalstrategic market, allowing potential abuse of market power. Indeed, at the time of thereport, the incumbent multiples had very high retailer brand names supported by heavyadvertising (Dixons, Currys and Comet were said to belong to the top 13 nationallyadvertised names).

The LE/OFT paper on Barriers to Entry distinguishes between advertising, goodwill andloyalty, and product proliferation and retailer differentiation. We review each of these inturn.

4.4.1 Advertising

As we argued in Chapter 2, advertising per se is not as important a means of promotingimage in retail markets as it is in product markets, partly because a store front on a highstreet or in a shopping centre is a far more effective advertisement than any advertisementin the media, since it is seen by a far higher percentage of its target customers. Indeed,many retailers, such as Next, Marks & Spencer, Body Shop and Waitrose have achievedstrong retailer images with minimal advertising. Thus, in general, while advertising isoften essential in building image for manufacturers’ products, it tends to be far lessrelevant to the formation of retailer image, and so advertising is likely to be far lessimportant (although not negligible) as a barrier to entry in retail markets than it is inproduct markets.

This does not mean that retailer image is not important. In many retail markets, it iscrucial. But retailer image can be promoted in other – generally less costly – ways thanabove-the-line advertising. Rather, the most important factors in promoting retailer imageare product range and prices, store design and atmosphere, and the quality of service.These may act as barriers to entry, but given that they are part and parcel of the retailingactivity, they are unlikely to keep out any retailers that stand to be successful.

The need to acquire a strong retailer image may deter some types of entry more easily thanothers. Firstly, economies of scale in advertising mean that, in those retail markets whereadvertising is important, effective small-scale entry may be difficult, with entry onlypossible by large entrants which can exploit these economies of scale, and which havesufficient capital to carry out large advertising campaigns.

For example, in The Supply of Recorded Music (1994), the MMC found that retailerimage and brand name are very important for the larger record retail chains. HMV, OurPrice, Tower and Virgin have established strong brand names that are heavily supportedby promotion and advertising (often co-operative advertising with record companies forparticular records). The importance of brand name may well act as an entry barrier tonon-niche independents which attempt to compete directly against the full rangemultiples, but which are unable to invest in the advertising necessary to win significantmarket share.82

Secondly, while the need to achieve a strong retailer image can clearly be a strong barrierto pure new entry, it may not prevent entry into a retail market by retailers from othermarkets, which already have a strong brand name in those markets (as long as the brand

Carroll, Pandian and Thomas (1994) provide a good description of how it may be easier to enter83

markets from one direction from another in this way. Indeed this possibility applies to otherdimensions of competition other than brand name. The geographical location of supermarkets andconsumers’ shopping behaviour helps them to sell petrol; the geographical location of petrol forecourtshops enables them to sell CDs; the well-known characteristics of the clothing at Next aided them intheir entry into the home shopping market; and the product portfolio of Dixons makes the sales ofcomputers (both hardware and software) easier.

See Klemperer (1987, 1990).84

See Schmalensee (1982). In addition, for a model in which asymmetric information about quality85

combined with moral hazard can act as a barrier to new entry, see Farrell (1986).

name is appropriate to the new market and is transferable). A good example here is the83

move by Marks & Spencer into financial services, which was possible because of Marks& Spencer’s high quality retailer image.

Indeed, strong retailer brand name can also allow them to enter into upstream productmarkets, as direct competition against branded manufacturers.

Goodwill and loyalty

Goodwill and consumer loyalty can be important barriers to entry into many retailmarkets. The key concept here is that of switching costs. The fact that consumers are84

small, immobile and uninformed means that they tend to face fairly large costs ofswitching between retailers, and these costs serve to ‘lock in’ customers to their currentretailers. Even if two retailers are identical ex ante (indeed they may be two branches ofthe same chain), so that new buyers find them equally attractive, the existence ofswitching costs will make moving from one retailer to another unattractive ex post.

Switching costs can provide a strong competitive advantage for pioneering retailers whichessentially create their own niche (such as the Body Shop or the Sock Shop). Apioneering retailer needs to persuade consumers to buy its products instead of spendingtheir money on marginal consumption. Later entrants have to persuade consumers to trytheir products instead of spending their money on the incumbents’ products. Becauseconsumers generally prefer the incumbent retailer’s products to their marginalconsumption, it is harder to persuade consumers to switch away from the former thanfrom the latter, and this can deter entry. 85

However, the effect of switching costs on entry is more general than this. In order to enterthe market, or expand market share, a retailer must not only match the price offer of theconsumers’ current retailer, but they must also compensate consumers for their switchingcosts (which can be large). In effect, this creates an additional sunk cost of entry.

Switching costs cover a number of different costs which consumers may face in changingfrom one retailer to another. Some of these costs are natural in the sense that may stemfrom the desire not to travel, the familiarity with a particular store’s layout, or from theaccumulated goodwill of the retailer. Alternatively, they can be strategic in the sense thatthey are based on free gift schemes, customer loyalty cards or bundling. In either case,they can be important barriers to entry.

To the extent that switching costs are natural, there may be little that the competitionauthorities can do to reduce them. Indeed, it is anyway not obvious that it would bedesirable to reduce such switching costs, for example if they are simply a result ofopening up a new market or due to customer loyalty that has been earned over a numberof years through superior service. Explicit switching costs such as free gift schemes (e.g.

As long as product withdrawal costs are sufficiently high. See Schmalensee (1978) and Judd (1985).86

air miles and the Esso collection) and customer loyalty cards (provided by B&Q and,more recently, Tesco) might be more easy to remedy.

However, not all such schemes act as barriers to entry. If the schemes provide equallygood value per “point” collected, for both small and large gifts, then there is no real lock-in problem; there is nothing to stop a customer cashing in his points and moving to analternative retailer. Many such schemes, though, offer disproportionate rewards for largernumbers of points collected. This has the effect of making it costly to “cash in” pointsearly, and thus makes it harder to persuade consumers to switch to a new retailer.

4.4.3 Product proliferation and retailer differentiation

Product proliferation does not act as a barrier to entry in retail markets in quite the sameway as it does in product markets. In product markets, this involves incumbent firmsfilling up product space in such a way that there is insufficient room for a rival to enterand prosper sufficiently to recover its sunk entry costs. In retail markets, however, it86

involves increasing the portfolio of products offered for sale in such a way that retailerswhich only provide a subset of the products cannot compete in the market (that is, thesunk costs of competing in the market are increased). Since economies of scope inretailing are often high (see above), such extensions to the product portfolio may not becostly for incumbents and may act as effective barriers to entry.

More similar to the traditional product proliferation story is the possibility of filling upretail space in such a way that there is insufficient room for a rival retailer to enter.However, this will be possible only if these characteristics are difficult to change in theface of entry (which will be more likely in some markets than in others). In order to seewhether this is in fact the case, it is useful to ask the following questions.

4.5 Capital requirements

There is some debate about whether capital requirements really constitute barriers toentry. However, they can certainly be important in hindering/ slowing entry. To theextent that large incumbent multiple retailers are able to raise capital more easily thansubsequent entrants, this may be important. However, it is not clear that capital marketimperfections are particularly problematic in the retail sector.

Entry impediments

Entry impediments are any factors which delay the process of entry into a market withoutincreasing the (sunk) costs of entry, or creating an asymmetry between incumbents andentrants. They are not entry barriers, but they may be important to antitrust decisions,because they influence the amount of time that incumbents may exercise market powerbefore entry occurs.

Good examples of entry impediments are licensing, certification or product registrationrequirements which involve little or no actual costs, but take significant amounts of timeto satisfy. Other examples include the time required to obtain contracts (i.e. where themarket’s products are sold via long-term contracts) or gain a market share large enoughto significantly influence the behaviour of incumbents.

Certification requirements are only important in a few retail markets (pharmacies, forexample). Planning permission may be more important as an entry impediment(especially for out-of-town building). However, the most important entry impediment inthe retail sector is probably the time it takes for a new retailer to establish itself withcustomers, particularly if reputation is important.

5. Competition assessment: market structure

The previous two chapters considered market definition and entry barriers, and examined thedegree to which existing approaches – as outlined in two recent OFT reports – can be appliedto retailing.

This chapter commences our discussion of how to assess competition. In line with ourapproach in Chapter 2, we suggest that the competition assessment distinguishes three sets ofissues:

C Market structure and merger issues: market shares, the measurement ofmarket power, the threat of potential competition, and the nature ofcompetition across markets.

C Pricing issues: excessive pricing, price collusion between retailers, predatorypricing, price discrimination, and loss leading.

C Vertical issues: vertical restraints, differential discounting, and own-brandcompetition.

This chapter discusses the first of these. Pricing issues are examined in Chapter 6, and verticalissues in Chapter 7.

5.1 Market structure and market power

Assessment of market structure in retailing is important in providing a picture of the actual andpotential market power of retailers. Structural analysis of market power is particularlyimportant in merger cases, but it also serves to support the analysis of pricing and verticalissues which follows. For example, we argue in Chapter 7 that if there is no market powerproblem, then vertical restraints will generally not be anti-competitive.

5.1.1 Retailers’ market shares

The obvious first step in the assessment of market structure and market power is theexamination of the retailers in the market and their market shares.

In terms of retailers’ market shares, concentration levels will clearly be very differentdepending on how the market is defined. However, even at the national level using fairlybroad retail categories, many retail markets are fairly concentrated, as shown in Table 5-1.

In a Cournot game, players compete in quantities. Each player chooses that quantity that will maximise87

his profits, given the quantities supplied by the other players. Equilibrium occurs where no player coulddo any better, given what the other players are doing.

Table 5-1 : Concentration in retailing, 1994Product group Share of top 5 retail groups in total

national turnover of product group

%Chemists 67.2Off-licences 52.4DIY 49.8Grocery 47.9Jewellery 46.3Footwear 39.0Electrical appliances and musical goods 30.7Clothing 30.0Source: AGB, Nielsen and London Economics.

Traditionally, merger cases especially have focused very heavily on market shares, and on howmarket concentration would change post-merger. However, it is inappropriate to infer marketpower from market concentration data alone. High market shares are neither necessary norsufficient to infer the existence of market power. An increase in market share post-merger isonly an imperfect guide to whether the market power of the merged retailer will be higher thanthat of the two individual retailers, and the extent to which this will affect the competitivechoices made by the retailer(s).

In fact, it is important to examine the market shares of all the retailers in the market, and notjust the retailers whose behaviour is under investigation. As is shown below, the relative sizesof the different players will affect the nature of competition in the market.

5.1.2 Measuring market power

In order to assess market power, it is important to try to measure the extent of market power.A number of indicators can be used. As well as examining the underlying factors whichdetermine the nature of competition in a market and the ability of retailers to exploit marketpower, it is also useful to examine competition more directly. The factors and indicators tobe examined include:

C The number of retailers in the market;

C The dimensions of competition between retailers;

C The elasticity of demand facing individual retailers;

C The relevant cost structures of competing retailers; and

C The threat of potential competition, and the nature of competition acrossmarkets.

The number of retailers in the market

In most simple models of competition, it is true that prices and profits will fall as the numberof players increases, and total sales volume will increase. For example, in a simple Cournot87

game with equal sized players, a linear demand curve and zero costs, equilibrium price, totalmarket sales volume and total market profits will be as shown below:

Table 5-2: Simple Cournot equilibrium resultsNumber of Market Equilibrium Total market sales Total market

players shares price (% of volume (% of profits (% ofmonopoly price) monopoly sales) monopoly profits)

1 100 100 100 1002 50 67 133 893 33 50 150 754 25 40 160 645 20 33 167 566 17 29 171 497 14 25 175 448 13 22 178 409 11 20 180 3610 10 18 182 3350 2 4 196 8100 1 2 198 4

This simple example provides a theoretical justification for the idea that few retailers with highmarket shares will result in high prices and profits.

More usually, however, there will be various different sizes of retailers in a market, and themarket shares of others will affect the degree to which any given retailer can exploit its marketpower. For example, suppose that the top retailer in the market has 40 per cent of the market.The nature of competition (in all dimensions) will be very different if there are 60 otherplayers, with 1 per cent of the market each, than if there are two other players with 30 per centof the market each.

The dimensions of competition between retailers

As well as prices and quantities, retailers also compete on geographical location, productselection, and retailer service. These will tend to reduce the direct competition on price, andthus may increase the prices that are observed in some retailer markets.

More significantly, different retailers sometimes compete in different ways within the samemarket. Some will try to find particularly good geographical locations, others will try toprovide better retailer service and product selection, while others will try to offer lower prices.It is difficult to model such differentiated competition in multi-dimensional space, but it isclear that the resulting equilibria will be far more complex than those in the simple Cournotmodel described above.

The results of the preliminary analysis suggested in Chapter 2 can be used to support theassessment of competition. In the preliminary analysis, we propose to identify how retailerscompete across the four dimensions: pricing; geographical location; product selection (qualityand range); level and quality of retailer service.

5.1.2.3The elasticity of demand facing individual retailers

Even where market shares are high, price competition will be intense if cross-price elasticitiesbetween retailers are high. The most extreme example of this is the simple undifferentiatedBertrand model, in which players compete head-to-head on price. In this simple model, it isassumed that all consumers purchase from the player who charges the least. Because there is

In fact, the negative effect on profits will be greater the greater the difference between price and marginal88

cost, since this is the profit margin that will be foregone from consumers’ switching. Thus, in marketswhere fixed costs are high and marginal costs are low (so that price will be significantly higher thanmarginal cost at any long run equilibrium), even a little consumer switching will make price rises unlikely.

For a summary, see Baker and Bresnahan (1992).89

so much to gain from undercutting, the equilibrium in this model involves price falling toequal cost, and zero profits being made, even where there are just two players.

In the real world, it is rare to find markets where all consumers readily switch to the lowestcost retailer. However, as long as there is sufficient switching by marginal consumers, similarresults will hold. The reason is straightforward. A 5 per cent increase in price will providea retailer will increased profits on those consumers which it keeps, but that retailer will loseall the profits it is currently making on those consumers which switch to another retailer.There is clearly a trade-off here, but it does not take much switching for the second effect tooutweigh the first and make price rises unlikely, whatever the retailer’s current market share.88

The history of market behaviour can be helpful in assessing this. There are two relativelysophisticated methods of analysis which may be readily applied in competition cases, as longas sufficient market data is available. These are based on observing a retailer’s (or a89

market’s) price and output responses to changes in its economic environment, and in particularto variations in (i) costs and (ii) the elasticity of demand.

i) Residual demand estimation is carried out by isolating incidents when a retailerhas a unilateral incentive to raise price, because of changes in its costs whichare not reflected by changes in the costs of other retailers. If, in such situations,the retailer successfully increases its price, then it has market power (i.e. anability to act independently of its competitors).

ii) Where market power is present, a reduction in demand elasticity should resultin an increase in prices. Thus a retailer that has market power can bedistinguished from retailers that do not, by observing their relative responsesto variations in the elasticity of demand.

While these techniques are generally rather difficult to apply, due to the large amount of datarequired, they are more likely to be workable in retailing than in many other sectors of theeconomy. Retail sales are generally well covered by market research, and for retailer marketsin which EPOS scanning is now common, information on sales is more or less perfect, and canbe highly disaggregated.

Profitability is also often used as a measure of market power. However, this must be donevery carefully. On the one hand, retailers with market power will often prefer to functioninefficiently rather than increasing efficiency and thus profits. Thus, market power may notresult in high profits. On the other hand, one retailer’s high profitability may simply be dueto that retailer’s superior efficiency or market positioning, rather than any market power.

5.1.2.4The relative cost structures of competing retailers

The ability of any retailer to exploit market power will be strongly affected by the coststructure and capacity of competing retailers. As a general rule, a competing retailer withlower costs will have a far greater constraining effect on price than a competing retailer withhigher costs. Thus, if there are economies of scale so that larger retailers have lower costs thansmaller retailers, prices will tend to be lower in a market with two large retailers, than in amarket with one large retailer and a large number of smaller retailers.

The ability of any retailer to exploit its market power will also depend on the capacity of otherretailers to fulfil demand quickly with minimal need for increased investment. The consumerswitching described in the previous section will only occur if there are alternative retailers withsufficient capacity to satisfy this demand. Otherwise, consumers will be stuck with theircurrent retailer and are capable of being exploited.

Another method of assessing the market power of retailers (at least in terms of their relationswith manufacturers) is to examine the differentiation in prices paid by retailers tomanufacturers. Price differentiation by manufacturers may be a result of trying to exploitmarket power by charging higher prices to retailers with less elastic demand. In retailing,however, it is more often due to retailers exploiting their market power in their negotiationswith manufacturers.

Potential competition and the nature of competition

The principle source of potential competition is from companies currently outside the market.Thus, the size of barriers to entry can have an important impact on the intensity of competitionin a market. However in highly innovative and dynamic markets, potential competition canalso arise from within the market.

As a rule, barriers to entry increase the degree to which it is possible to translate market sharesinto market power. At the limit, in a contestable market, where it is possible to enter withoutcost and immediately, without provoking immediate retaliation from the incumbent retailers,even a monopolist will be unable to price above cost without losing its market to “hit and run”entry. Although the concept of a contestable market would appear to be of limited practicalvalue, it nevertheless serves to emphasise the point that entry conditions play an important rolein determining the degree to which market power can be exercised, and the importance ofpotential, as well as actual, competition in constraining the action of firms in a market.Collusion between retailers is also difficult when entry is easy.

In markets that are increasing or changing quickly, market share can be a particularly poorindicator of market power. In such cases, a large market share at any point in time may resultfrom a recent innovation or new product which captured a large amount of the market, butwhich will soon either be copied by the other players (who will then claw back market share),or will be surpassed by a further innovation or new product (and the new innovator will thenwin the large market share instead).

In either of these cases, we should see market shares fluctuating greatly over time (or fallingfast in the case of a growing market). This provides a good description of many areas of theeconomy. An example which was recently examined by the MMC is the film industry, wherethe success of a single film can dramatically increase market share in one year. It is not clear,however, that this will often be a valid argument in retailing.

Finally, it is worth examining the nature of competition across markets, especially if arelatively narrow approach is taken to market definition.

Merger case study: Kingfisher plc and Dixons Group plc

In order to illustrate the steps involved in assessing market structure and market power issuesin retailing we discuss two merger cases. Here we discuss the merger reference to the MMCin Kingfisher plc and Dixons Group plc (1990). In 5.3 we discuss the merger between GrandMetropolitan and William Hill (1989). Each case is examined under three headings:

Using the MMC’s market definition A (see above).90

C Assessment of market structure;

C Dimension of competition; and

C Merger issues.

In Kingfisher-Dixons Group, the MMC rejected the proposed merger on the grounds that themerger between the two main national chains of retailers of electrical goods wouldsubstantially lessen competition in electrical goods retail. Electrical goods comprise bothwhite goods (refrigerators, washing machines, etc.) and brown goods (TV sets, VCRs, hi-fi,etc.), together with small domestic appliances such as toasters and kettles. This case is wellknown for its controversial assessment of the relevant market and competition betweennational chains of multiple retailers. The MMC report contains a note of dissent by one of themembers of the panel.

Dixons Group plc was incorporated in 1937. In early years, the company focused on retailingphotographic equipment, and in 1960s and 1970s diversified into electronic equipment. In1984, Dixons Group acquired Currys. At the time of the reference Dixons and Currys stilltraded under separate names, but formed part of a single management structure, called DSG– Dixons Stores Group. In 1988-89, Dixons Stores’ turnover was £1,755 million, and itsoperating profit was £82 million. Outlets trading as Dixons are high-street outlets, mostlyselling brown goods. Currys stores, a significant proportion of which are out-of-town, sellwhite goods, small electrical appliances, and a selection of brown goods.

Kingfisher plc was created in 1982 through the successful buy-out of the general retailerWoolworth (UK), which also owned the DIY retailer B&Q. The company has since acquiredseveral retailers of electrical appliances: Comet, Ultimate, Connect and Laskys, almost all thestores of which now trade under the name Comet. Kingfisher also acquired the drugstoreretailer Superdrug and, at the time of the report, was the 4th largest non-food/drink retailer inthe UK, with more than 2,000 stores, and 57,000 employees. Its turnover in 1989-90 was£2,910 million, and its operating profit was £246 million. Comet (which accounts for 95 percent of Kingfisher’s sales of white and brown goods, domestic electrical appliances, and photoequipment) had a turnover in 1989-90 of £519 million, and operating profits of £18 million.

Assessment of market structure

In terms of entire UK electrical goods sales , DSG had a market share of around 17 per cent90

in 1989, while Comet had a market share of around 9 per cent, and Rumbelows had a marketshare of 5 per cent. In addition, there were about 5,000 independent electrical retailers, mostlysmall and family-owned. The independents sector accounted for 20 per cent of all electricalsales (down from 23 per cent in 1985). The electricity showrooms had a share of 13 per cent,mostly of large white goods. Department stores accounted for 6 per cent of sales (down from8 per cent in 1985). General retailers (e.g. Boots) had a share of 17 per cent, and mail orderhad a share of 7 per cent.

The merged retailer would have had around 26 per cent market share. This market share ishardly enough to bestow potential market power. Moreover, faced with strong competitionfrom other electrical goods retailers, any market power would not be abused and would notbe deleterious for welfare. We argue above in Chapter 3, however, that the national multiplesare in a strategic market of their own, and that, to an extent, their behaviour is not constrainedby retailers outside this strategic market. Within this strategic market, the merged firm wouldclearly have more like 84 per cent of the market, and prices would be likely to rise until the

point at which local retailers would start to constrain them.

Separating out total UK sales into different types of retailer activity changes this situationslightly. For smaller domestic appliances, where the market share of the merged retailer wouldbe fairly low (around 13 per cent) and general retailers are very strong, there is unlikely to bemajor problem. Moreover, in terms of major white goods, the merged retailer would face afair amount of competition from the electricity showrooms (fairly large retailers with highreputation, who also get good discounts from suppliers), and lesser competition from localindependents. In terms of all other electrical goods, however, the combined market share ofthe merged retailer would be well over 30 per cent, and the main ‘competition’ would beRumbelows, niche retailers, small local independents and general retailers, none of which arelikely to constrain the behaviour of the merged firm to any great extent (Rumbelows becauseit was already in some financial difficulty, and the others because they either compete inessentially different markets or because they receive so much worse terms from suppliers thanthe merged retailer would).

5.2.2 Dimensions of competition

The MMC report illustrates very clearly that electrical goods retailers compete across all of thedimensions that we identify in Chapter 2.

Price

Pricing strategies are the most important element of competition in electrical goods retailing.The surveys presented in the MMC report support this view; and frequent references are madeto a period of tough price competition between the two parties to the proposed merger(Kingfisher and DSG). These two leading retail groups in fact act as price leaders, settingprice levels at the national level which are largely followed by the large number ofindependents and small chains of multiple retailers.

Two surveys cited by the MMC showed that there was indeed considerable price uniformityacross retailers, both in local shopping areas, and nationally, reflecting strong pricecompetition.

5.2.2.2Geographical location

Because purchases of electrical retail goods tend to be quite large, geographical location is lessimportant than easy access. High street retailers have the benefit that consumers can easilypop in and look around. However, many consumers (if they have cars) will also look at out-of-town stores. These have the advantage that they have lower property costs (and can thuscharge lower prices and/or provide a wider selection in larger outlets) and that goods can bemore easily transported home from these outlets (due to easy car access). Indeed, out-of-townshopping is becoming more important, particularly for white goods. Out-of-town sales weresaid to have risen from 11 per cent to 18 per cent of the market between 1985 and 1990.

5.2.2.3Product selection

Product portfolio can vary enormously in electrical goods retailing. Small domestic appliancescan be found in small shops as well as in larger outlets where they are only a small part of alarge selection of electrical goods. Appendix 2.3 of the report shows the overlap of productssold by Currys and Dixons shops which are both in the DSG, and specialise in white andbrown goods respectively. This diagram is reproduced below.

In addition, to product portfolio, product range is very important. This is a major differencebetween different kinds of electrical goods retailers. For example, computer specialists andphotographic equipment specialists will have a far greater depth of choice than a Dixons storewill tend to have. Similarly, Comet and Currys out-of-town stores and the electricityshowrooms of the Regional Electricity Companies (RECs) will tend to provide a far widerchoice within each category of white good than department stores or other general retailershave.

5.2.2.4Retailer service

Quality of service is important. The role of the retailer in providing information and adviceto consumers is less important for smaller purchases, but can be crucial for larger products(such as computers and white goods). In addition, after-sales service is an importantdimension of competition, especially for brown goods (manufacturers tend to carry out after-sales service on white goods). Warranties are also very important (for larger durable goods),and the role of warranties is key to understanding pricing issues. Some retailers, it was arguedin the report, do not make any return from the sale of electrical goods but only from theassociated sale of warranties.

Overlap of products sold by Currys and Dixons

Washing Dryers Dishwashers RefrigeratorsmachinesFreezers Cookers Microwaves Heating

Vacuum cleaners Irons Kettles ToastersCoffee makers

Televisions Radio cassettes Hi-fi systemsVideo Recorders Personal hi-fis TelephonesSatellite d ishes Car audio Keyboards

Cameras Camcorders Personal organisersBinoculars Home computers Fax machines

Lenses Electronic games

Retailers also compete through advertising and promotion, through which they aim to informconsumers that they offer quality and a good selection of products in the appropriate pricerange. A retailer who does not get his message to his customers will not be viable. Theretailer needs a very visible shop window (prime high street location) and/or high levels ofmedia advertising. This aspect of competition derives directly from the fact that consumersare not initially well informed about availability, relative prices and product quality. The factthat the major multiple retailers use national advertising and pricing policies as part of theircompetitive strategy is very important for market definition.

5.2.3Merger issues

The MMC felt that the merger would lead to a significant reduction in competition in electricalretailing, and would as a consequence lead to higher prices. We have a lot of sympathy withthis view, which concurs with the results of our analysis of the strategic competition acrossdifferent economic markets.

As discussed above, the MMC decided that the relevant geographical market was national, onthe grounds that the electrical goods retailers involved – Dixons, Currys and Comet – all set

national prices, and advertised both their stores and the prices of their products at a nationallevel. We agree with the MMC that the national market is of key importance for the analysisof competition between the strategic groups in this industry (although it is also important toexamine the effects of the merger on competition at the local level).

In terms of the relevant retail market, the effects of the merger would depend on which marketis being examined. For small domestic appliances, the effect would be negligible. In termsof large white goods, the increase in concentration would be substantial (each of the mergingparties has roughly equal market shares in large white goods), but pricing would be stronglyconstrained by the electricity showrooms. For all other electrical goods, the increase inconcentration would be less strong (DSG is already almost three times as strong on these asComet), but there is little direct competition which might constrain the resulting pricingbehaviour of the merged entity.

In terms of product selection, the MMC concluded that the total range might well fall post-merger, on the grounds that the two retail chains would no longer need to compete in termsof product range. On the other hand, it is possible that the effect of reduced competition mightbe to differentiate the retailers more strongly in terms of product range, resulting in betterchoice for customers. Further analysis would have been required to resolve this question.

In terms of entry barriers, the MMC rejected the argument put by Kingfisher that entry intothe market was easy, and that this fact would constrain the pricing policy of the mergedcompany. Although there were a large number of competitors, the MMC argued that

“history does not support the view that newcomerswould succeed in penetrating the market to theextent necessary for them to become an effectivecompetitor to the merged company, nor that othermultiple chains [....] would expand into electricalretailing to any great extent. The new entrantscould also be deterred by the cost and complexityof providing after-sales service.”

We are not entirely convinced by this, and further analysis of entry barriers (at both the localand the national level) would have been useful. For example, it could be argued that themerger would provoke entry by another competitor, or at least a significant increase inadvertising and promotion by Rumbelows or other smaller multiple retailers.

Merger case study: Grand Metropolitan plc and William Hill Organisation Ltd

In this case study, we evaluate the proposed merger between Grand Metropolitan plc andWilliam Hill Organisation Limited. This merger, between two of the four largest chains ofbookmakers, raised a number of important competition issues. The MMC considered themerger to operate against the public interest unless a number of recommendations wereaccepted.

The chief concern of the MMC was with the absence of price competition and the existenceof a number of legislative barriers to entry (licences) and barriers to competition at the locallevel (restrictions on advertising).

The MMC judged that the crucial problem would be a reduction in competition in off-coursebetting at a local level, and thus that Grand Met should be required to divest certain betting

offices: wherever there are former Mecca and William Hill betting offices within a quarter ofa mile of each other, and where there are no other betting offices within a quarter of a mile ofone of these offices. This would involve around 20 disposals, mostly in London.

The MMC was also concerned with a number of arrangements in the industry that involvedthe big four chains of betting shops:

C Provision of racecourse information through SIS, which is partly owned bybookmakers and the Racecourse Association;

C Organisation of greyhound races through subsidiaries of bookmakers; and

C Laying off with on-course bookmakers and thus influencing the startingprice.

However, it did not recommend any changes with respect to these arrangements.

5.3.1 Assessment of market structure

There are around 6,000 bookmakers. The ‘big four’ operate 35.7 per cent of betting shopsand account for 60 per cent of turnover. This is a fairly concentrated industry when measuredat the national level. The merger is between numbers 2 and 4 in the industry to create thesecond largest chain after Ladbrokes.

Entry barriers are significant due to the regulatory restrictions that require a license to operatea betting shop, constrain the free choice of location, and restrict advertising that states theaddress of an individual betting shop.

Dimensions of competition between bookmakers

Bookmakers offer odds on the likelihood of an event occurring. They will offer odds takinginto account the perceptions of punters. If several/many punters believe an event will occurwith a greater degree of probability than the bookmaker indicates through his quoted odds,they will place a bet at fixed odds. Bookmakers, when taking bets at different odds, alwaystry to balance their books so that they are not unduly exposed to risk and are guaranteed amargin.

5.3.2.1Price

It is frequently believed that prices offered by betting shops are uniform throughout thecountry. While this is largely true, it is not completely true.

C Ante-post prices can vary considerably (although these comprise only 2 percent of bets).

C Deductions for multiple bets are sometimes discounted.

C Maximum limits, which in effect worsen the odds for big winners, differfrom one betting shop to another.

The observation that starting prices (SPs) are uniform is correct. Deductions are also uniform.While the former may be the outcome of the market process, the latter is a convention builtaround the tax and levy system.

5.3.2.2Geographical location

Geographic location is extremely important. Regular punters, especially, do not want to travelfar to place a bet, and convenience is thus vital. Out-of-town bookmakers would have nocustomers. For credit betting, location plays no major role as all betting is done on thetelephone. Location is only important in credit betting when is comes to assessing the credit-worthiness of punters. Such information may be more easily available on a local basis.

5.3.2.3Product selection

Selection of products is less important. There are some opportunities to offer moreimaginative bets, but for the standard event (e.g. the 2.30 at Kempton) the products are prettymuch the same.

5.3.2.4Retailer service

Point of sale service in betting shops matters: the ambience, the running commentary, and thepictures from SIS, etc., are all very important to the enjoyment of betting. Until recently,legislative restrictions made it difficult to improve the ambience and attractiveness of bettingshops.

Advertising and promotion are highly regulated in this industry. Government regulations donot permit an individual betting shop to advertise its address. Only corporate advertising ispermitted. This perverse regulation is probably one of the chief reasons for the high degreeof concentration in this market. Any small bookmaker who wants to promote his services andfind ways to communicate a new or improved service is seriously hampered in how he maydo so. A small bookmaker relies entirely on word-of-mouth promotion and his localreputation.

Larger bookmakers, who operate chains of betting shops, will find it easier to promote theiractivities and establish a brand name through general advertising (i.e. without putting in theaddresses of their individual betting shops) or sponsorship of races. The sunk cost of takingout advertising space in the national racing press, for example, can be recovered across a largenumber of betting shops. Therefore the incentive to operate chains of betting shops that canbenefit from advertising is considerable and, in our view, is a determining factor of thestructure of the betting industry, which has become increasingly concentrated.

5.3.3 Merger issues

As the market is characterised by absolute entry barriers at the local level (in the form oflicences) and by advertising restrictions that make entry on a small scale difficult, any increasein market share by members of the strategic group of national chains of bookmakers may welltranslate into increased market power.

In addition, the market is not characterised by price competition between betting shops, asmost bets are done on a starting price basis, which governs all SP bets in the country. Thereare some limited elements of price competition in that maximum winnings differ betweencompanies and because deductions for multiple bets are often granted. On the other hand, thehigh visibility of prices in the betting market significantly constrains independent marketbehaviour.

The betting market is easy to collude in, given the local structure and existence of absoluteentry barriers. Indeed, the uniform level of deductions, while justified by tax and levies, can

easily be interpreted as a collusive arrangement. Straightforward application of tax wouldlead to a 8.8 per cent tax for all forms of betting. For horse race betting there is another 1.0per cent of levy that needs to be collected. For other forms of betting where no levy applies,there is still a 10 per cent deduction. Why?

Similarly, credit betting attracts a lower level of levy. Running a centralised credit operationis not obviously more expensive than running a betting shop in the High Street. On thecontrary, it may well be cheaper. So why are deductions the same everywhere?

These concerns are not new. In 1986, the industry was subject to a referral to the RestrictivePractices Court. This case related to a collusive agreement to restrict shop opening hours forshops operating in the same street and to agreements between the big four to co-ordinate shopclosures. The adverse finding led to recommendations designed to increase competitionbetween local betting shops, and are a clear indication that concerns over collusive practicesare justified.

The findings of the MMC that the merger of Grand Met and William Hill bookmakers wouldcreate a number of local monopoly situations appear to be justified in the light of theobservations made above. The question is whether the MMC went far enough whenrecommending the divestment of 20 betting shops in areas where the two bookmakers hadoutlets within a quarter of a mile of each other. The existence of barriers to entry at the locallevel as well as at the national level, where the two chains of bookmakers compete in termsof advertising and promotion, would suggest an even closer scrutiny of the merger in termsof its negative impact on competition.

CHAINMACRO() to have. Similarly, Comet and Currys out-of-town stores and the electricityshowrooms of the Regional Electricity Companies (RECs) will tend to provide a far widerchoice within each category of white good than department stores or other general retailershave.

5.2.2.4Retailer service

Quality of service is important. The role of the retailer in providing information and adviceto consumers is less important for smaller purchases, but can be crucial for larger products(such as computers and white goods). In addition, after-sales service is an importantdimension of competition, especially for brown goods (manufacturers tend to carry out after-sales service on white goods). Warranties are also very important (for larger durable goods),and the role of warranties is key to understanding pricing issues. Some retailers, it was arguedin the report, do not make any return from the sale of electrical goods but only from theassociated sale of warranties.

Overlap of products sold by Currys and Dixons

Washing machines

Dryers

Dishwashers

Refrigerators

Freezers

Cookers

Microwaves

Heating

Vacuum cleaners

Irons

Kettles

Toasters

Coffee makers

Televisions

Radio cassettes

Hi-fi systems

Video Recorders

Personal hi-fis

Telephones

Satellite d ishes

Car audio

Keyboards

Cameras

Camcorders

Personal organisers

Binoculars

Home computers

Fax machines

Lenses

Electronic games

Retailers also compete through advertising and promotion, through which they aim to informconsumers that they offer quality and a good selection of products in the appropriate pricerange. A retailer who does not get his message to his customers will not be viable. Theretailer needs a very visible shop window (prime high street location) and/or high levels ofmedia advertising. This aspect of competition derives directly from the fact that consumersare not initially well informed about availability, relative prices and product quality. The factthat the major multiple retailers use national advertising and pricing policies as part of theircompetitive strategy is very important for market definition.

5.2.3 Merger issues

The MMC felt that the merger would lead to a significant reduction in competition in electricalretailing, and would as a consequence lead to higher prices. We have a lot of sympathy withthis view, which concurs with the results of our analysis of the strategic competition acrossdifferent economic markets.

As discussed above, the MMC decided that the relevant geographical market was national, onthe grounds that the electrical goods retailers involved – Dixons, Currys and Comet – all setnational prices, and advertised both their stores and the prices of their products at a nationallevel. We agree with the MMC that the national market is of key importance for the analysisof competition between the strategic groups in this industry (although it is also important toexamine the effects of the merger on competition at the local level).

In terms of the relevant retail market, the effects of the merger would depend on which marketis being examined. For small domestic appliances, the effect would be negligible. In termsof large white goods, the increase in concentration would be substantial (each of the mergingparties has roughly equal market shares in large white goods), but pricing would be stronglyconstrained by the electricity showrooms. For all other electrical goods, the increase inconcentration would be less strong (DSG is already almost three times as strong on these asComet), but there is little direct competition which might constrain the resulting pricingbehaviour of the merged entity.

In terms of product selection, the MMC concluded that the total range might well fall post-merger, on the grounds that the two retail chains would no longer need to compete in termsof product range. On the other hand, it is possible that the effect of reduced competition mightbe to differentiate the retailers more strongly in terms of product range, resulting in betterchoice for customers. Further analysis would have been required to resolve this question.

In terms of entry barriers, the MMC rejected the argument put by Kingfisher that entry intothe market was easy, and that this fact would constrain the pricing policy of the mergedcompany. Although there were a large number of competitors, the MMC argued that

“history does not support the view that newcomerswould succeed in penetrating the market to theextent necessary for them to become an effectivecompetitor to the merged company, nor that othermultiple chains [....] would expand into electricalretailing to any great extent. The new entrantscould also be deterred by the cost and complexityof providing after-sales service.”

We are not entirely convinced by this, and further analysis of entry barriers (at both the localand the national level) would have been useful. For example, it could be argued that themerger would provoke entry by another competitor, or at least a significant increase inadvertising and promotion by Rumbelows or other smaller multiple retailers.

Merger case study: Grand Metropolitan plc and William Hill Organisation Ltd

In this case study, we evaluate the proposed merger between Grand Metropolitan plc andWilliam Hill Organisation Limited. This merger, between two of the four largest chains ofbookmakers, raised a number of important competition issues. The MMC considered themerger to operate against the public interest unless a number of recommendations wereaccepted.

The chief concern of the MMC was with the absence of price competition and the existenceof a number of legislative barriers to entry (licences) and barriers to competition at the locallevel (restrictions on advertising).

The MMC judged that the crucial problem would be a reduction in competition in off-coursebetting at a local level, and thus that Grand Met should be required to divest certain bettingoffices: wherever there are former Mecca and William Hill betting offices within a quarter ofa mile of each other, and where there are no other betting offices within a quarter of a mile ofone of these offices. This would involve around 20 disposals, mostly in London.

The MMC was also concerned with a number of arrangements in the industry that involvedthe big four chains of betting shops:

C Provision of racecourse information through SIS, which is partly owned bybookmakers and the Racecourse Association;

C Organisation of greyhound races through subsidiaries of bookmakers; and

C Laying off with on-course bookmakers and thus influencing the startingprice.

However, it did not recommend any changes with respect to these arrangements.

5.3.1 Assessment of market structure

There are around 6,000 bookmakers. The ‘big four’ operate 35.7 per cent of betting shops andaccount for 60 per cent of turnover. This is a fairly concentrated industry when measured atthe national level. The merger is between numbers 2 and 4 in the industry to create the secondlargest chain after Ladbrokes.

Entry barriers are significant due to the regulatory restrictions that require a license to operatea betting shop, constrain the free choice of location, and restrict advertising that states theaddress of an individual betting shop.

Dimensions of competition between bookmakers

Bookmakers offer odds on the likelihood of an event occurring. They will offer odds takinginto account the perceptions of punters. If several/many punters believe an event will occurwith a greater degree of probability than the bookmaker indicates through his quoted odds,they will place a bet at fixed odds. Bookmakers, when taking bets at different odds, alwaystry to balance their books so that they are not unduly exposed to risk and are guaranteed amargin.

5.3.2.1Price

It is frequently believed that prices offered by betting shops are uniform throughout thecountry. While this is largely true, it is not completely true.

C Ante-post prices can vary considerably (although these comprise only 2 percent of bets).

C Deductions for multiple bets are sometimes discounted.

C Maximum limits, which in effect worsen the odds for big winners, differfrom one betting shop to another.

The observation that starting prices (SPs) are uniform is correct. Deductions are also uniform.While the former may be the outcome of the market process, the latter is a convention builtaround the tax and levy system.

5.3.2.2Geographical location

Geographic location is extremely important. Regular punters, especially, do not want to travelfar to place a bet, and convenience is thus vital. Out-of-town bookmakers would have nocustomers. For credit betting, location plays no major role as all betting is done on thetelephone. Location is only important in credit betting when is comes to assessing the credit-worthiness of punters. Such information may be more easily available on a local basis.

5.3.2.3Product selection

Selection of products is less important. There are some opportunities to offer moreimaginative bets, but for the standard event (e.g. the 2.30 at Kempton) the products are prettymuch the same.

5.3.2.4Retailer service

Point of sale service in betting shops matters: the ambience, the running commentary, and thepictures from SIS, etc., are all very important to the enjoyment of betting. Until recently,legislative restrictions made it difficult to improve the ambience and attractiveness of bettingshops.

Advertising and promotion are highly regulated in this industry. Government regulations donot permit an individual betting shop to advertise its address. Only corporate advertising ispermitted. This perverse regulation is probably one of the chief reasons for the high degreeof concentration in this market. Any small bookmaker who wants to promote his services andfind ways to communicate a new or improved service is seriously hampered in how he maydo so. A small bookmaker relies entirely on word-of-mouth promotion and his localreputation.

Larger bookmakers, who operate chains of betting shops, will find it easier to promote theiractivities and establish a brand name through general advertising (i.e. without putting in theaddresses of their individual betting shops) or sponsorship of races. The sunk cost of takingout advertising space in the national racing press, for example, can be recovered across a largenumber of betting shops. Therefore the incentive to operate chains of betting shops that can

benefit from advertising is considerable and, in our view, is a determining factor of thestructure of the betting industry, which has become increasingly concentrated.

5.3.3 Merger issues

As the market is characterised by absolute entry barriers at the local level (in the form oflicences) and by advertising restrictions that make entry on a small scale difficult, any increasein market share by members of the strategic group of national chains of bookmakers may welltranslate into increased market power.

In addition, the market is not characterised by price competition between betting shops, asmost bets are done on a starting price basis, which governs all SP bets in the country. Thereare some limited elements of price competition in that maximum winnings differ betweencompanies and because deductions for multiple bets are often granted. On the other hand, thehigh visibility of prices in the betting market significantly constrains independent marketbehaviour.

The betting market is easy to collude in, given the local structure and existence of absoluteentry barriers. Indeed, the uniform level of deductions, while justified by tax and levies, caneasily be interpreted as a collusive arrangement. Straightforward application of tax would leadto a 8.8 per cent tax for all forms of betting. For horse race betting there is another 1.0 percent of levy that needs to be collected. For other forms of betting where no levy applies, thereis still a 10 per cent deduction. Why?

Similarly, credit betting attracts a lower level of levy. Running a centralised credit operationis not obviously more expensive than running a betting shop in the High Street. On thecontrary, it may well be cheaper. So why are deductions the same everywhere?

These concerns are not new. In 1986, the industry was subject to a referral to the RestrictivePractices Court. This case related to a collusive agreement to restrict shop opening hours forshops operating in the same street and to agreements between the big four to co-ordinate shopclosures. The adverse finding led to recommendations designed to increase competitionbetween local betting shops, and are a clear indication that concerns over collusive practicesare justified.

The findings of the MMC that the merger of Grand Met and William Hill bookmakers wouldcreate a number of local monopoly situations appear to be justified in the light of theobservations made above. The question is whether the MMC went far enough whenrecommending the divestment of 20 betting shops in areas where the two bookmakers hadoutlets within a quarter of a mile of each other. The existence of barriers to entry at the locallevel as well as at the national level, where the two chains of bookmakers compete in termsof advertising and promotion, would suggest an even closer scrutiny of the merger in termsof its negative impact on competition.

RRPs ease collusion, but are not sufficient for it. This may explain why, in Contact Lens Solutions,84

the MMC advocated structural changes to increase competition, rather than a ban on the use of RRP.

6. Pricing issues

Pricing issues figure prominently in competition cases involving retailing. Apart from theclassic cases of monopolistic and collusive pricing, there are issues to do with predatorypricing and discriminatory pricing. In some cases, pricing issues are directly linked withvertical issues: loss leading may be met by refusal to supply on the part of manufacturers;Recommended Retail Price (RRP) may be a method of facilitating collusion amongstretailers. This section examines:

C Price collusion;

C Predatory pricing;

C Price discrimination and tying/bundling; and

C Loss leading.

Suggested checklists of questions that might be asked are given in Appendix 1 to thisreport.

6.1 Price collusion

In Contact Lens Solutions (1993) the MMC concluded that the existence of RRPs enabledprice co-ordination: Boots priced at RRPs, and this provided a shelter for others to do thesame (indeed there was even some evidence of Boots forcing others to do the same).

In Contraceptive Sheaths (1994), a similar case, there were two sets of RRPs: one set forsmall pharmacists and another (lower) set for larger customers. The aim of this wasconsidered to be to improve the ease of collusion at the retail level, by allowing for adegree of heterogeneity amongst retailers. This in fact was successful for a long period,although collusion had broken down just before the MMC report, leading the MMC toconclude that RRPs, while anti-competitive in aim, were not anti-competitive in effect.84

In The Supply of Recorded Music (1994), usually referred to as the CD enquiry, theDGFT made a referral to the MMC following a long standing campaign over the level ofpricing of CDs in the UK when compared to the level of prices in the US. A House ofCommons Select Committee found that prices of CDs in the UK were between 20-50 percent higher and that record companies were abusing the right to stop parallel imports tomaintain excessive prices. The MMC enquiry established that these allegations did nothold up to detailed scrutiny and cleared the record companies of any allegations of anti-competitive practices. While the main focus of the enquiry was centred on recordcompanies, there were some lines of enquiry that dealt with the behaviour of record shopsand other retailers of recorded music.

These cases show that collusion is a relatively common worry in retailing enquiries.When collusion is explicit, there will often be documentation available which can be usedas evidence. For example, in recent years, several explicit cartels have been discoveredin the UK, particularly in the building materials sector. There have been few retailingcases in recent decades in which explicit collusion was even suspected, let alone found:in the case of The Supply of Petrol (1990), the UK retail market appeared to be protectedfrom competitive pressures in some regions and locations, but no evidence of explicit

Explicit and implicit collusion have been extensively analysed in the economic literature. They are85

perhaps best covered in Scherer (1980), Salop (1986), Schmalensee and Willig (1989), and Carltonand Perloff (1994, Chapters 6 and 7). A relevant case study can be found in Kwoka and White eds.(1994), Chapter 7 “The Ethyl Case” (1984) by G A Hay.

A further problem with collusion is that, while colluding retailers would like to threaten ex ante to86

punish any cheating retailer, it may not be optimal ex post for them to do so. This is similar to thepredatory pricing story described below, where an incumbent retailer wants to threaten ex ante to fightany entrant, but where it may not be optimal ex post for it to do so. The theoretical solution to thecollusion problem is slightly different, though. Kreps et al (1982) show that collusion is sustainablein many situations as long as there is a small possibility that players are crazy (or congenitally nice),in that they would never cheat on a collusive situation even when it is profitable for them to do so.In this case, all the players try to signal that they are crazy in this way and collusion succeeds.

collusion could be discovered.

Most UK competition policy enquiries into collusion are in fact concerned with implicit(or tacit) collusion, where explicit documentation is unlikely to be found and inferenceof collusion is more difficult. The Contact Lens Solutions reference to the MMC, for85

example, was initiated not least because of pricing issues that led to suspicions of implicitcollusion.

Implicit collusion is often considered especially likely in retailing. The main difficultyinvolved in maintaining a collusive set-up is that the various parties to it have incentivesto cheat: given that some retailers are charging the high collusive price, it will bebeneficial for any individual retailer to lower its price and steal market share from theothers. In order to prevent this from happening, collusion will generally require both thatcheating is observable and that a punishment scheme for cheating retailers (such as a pricewar) can be imposed and is damaging enough to deter cheating. Retailers must alsosomehow agree a price on which to collude without any explicit communication.

For these reasons, collusion between parties will be easier when:

C The number of colluding retailers is small (so that co-ordination iseasier);

C One or two retailers take on the role of price leader (again so that co-ordination is easier);

C Cheating on the collusive agreement is easy to observe (so thatpunishments can be carried out appropriately and swiftly); and

C There is some focal point price on which retailers can tacitly agree tocollude.86

From this, we can deduce that some characteristics of retailing may be favourable tocollusion between retailers, since:

C The importance of one-stop shopping and the use of certain verticalrestraints will both tend to reduce the number of retailers in the market,which improves their chances of effective collusion;

C In many retail markets there are just one or two clear market leaders,which may enable price leadership;

C In some markets, prices tend to be very visible (no secret discounts),

For example, the use of large price boards outside petrol stations make it easier for local competitors87

to observe each other’s price changes at short notice. Immediate reactions to these price changes willfrustrate any attempt to lower prices and attract customers away from competitors. Thus, pricecompetition is unlikely to emerge.

While we covered entry barriers above, we feel that it is important to reconsider them here, given that88

entry barriers tend to be crucial for implicit collusion. This section examines pure predatory pricing. The related issue of loss-leading is examined in a later89

section.

which means that detecting cheating on price is easy; and87

C The use of recommended resale price (RRP) provides a focal point priceon which retailers can collude (so that RRP in fact approximates RPM).

On the other hand, when competition is multi-dimensional, as in retailing, the nature ofcheating may be complex and less easily observable. For example, a cheating retailer maynot decide to cut price but to increase the quality of its services, a change which is harderto assess than a straight price change.

Moreover, as a general rule, implicit collusion is only possible if there are effective entrybarriers into the market. If there is a high likelihood of entry, then it very difficult to co-ordinate collusive agreement between all the actual and potential parties. If there are nosignificant barriers to entry into a retail market, there is therefore little reason to expectcollusion.

In order to assess whether or not there is implicit collusion in a retail market, werecommend a three step procedure. Step 1 involves examining the height of any entrybarriers into the market. Generally, while the existence of entry barriers does not imply88

collusion, collusion can only be as effective as entry barriers are high. Step 2 involvesdetermining whether there are any aspects of the retailer market and retailing practicesthat may facilitate implicit collusion among retailers. Step 3 involves looking at marketprice data and assessing whether there is any plausible explanation for the observedpricing behaviour, other than the existence of price collusion, and whether retailers wouldhave sufficient incentives not to cheat on the collusive price. This three step procedureis discussed in more detail in Appendix 1.

6.2 Predatory pricing 89

The idea behind predatory pricing is that a reduction of price in the short run will drivecompeting retailers out of the market, or discourage the entry of new retailers, and thatthis will in the long run allow incumbent retailers to charge higher prices than they wouldhave been able to in the presence of greater competition.

In Contraceptive Sheaths (1994), there were two potential cases of predatory pricing bythe London Rubber Company (who own the Durex brand): its pricing to the NHS and itscommission rates to major site owners for vending machines. The MMC argued that,because entry into both of these sectors is relatively easy, pricing could not be predatory.

The OFT has also recently considered a complaint that various Regional ElectricityCompanies (RECs) were engaged in predatory pricing in their electrical retailingbusinesses. Specifically, it was claimed that the RECs were offering unprofitable creditterms to their customers financed by excessive profits from their electricity supplybusiness. The DGFT concluded that no action should be taken, since the RECs’ share ofthe national market was too small for a predatory strategy to be feasible.

Predatory pricing may be particularly difficult to detect in retailing, given that

A further difficulty with applying price-cost tests in retailing is that, as Bliss (1988) shows, a multi-90

product retailer will generally not do best by setting a fixed percentage mark-up, but will prefer to sethigher mark-ups for products with lower elasticities of demand, and vice versa (the rationale for thistype of behaviour is the same as that for Ramsey pricing in the tax literature). This means that, for agiven product, it is not clear that price would lie above average variable costs, even in the absence ofpredatory pricing (this issue is considered in more detail below, under the heading of loss leading).

The lack of such a rationale for predatory pricing was one of the principal criticisms levelled at the91

OFT’s investigation into local bus services by Utton (1990). In Contraceptive Sheaths, for example, the London Rubber Company argued that its pricing to the92

NHS market could not be predatory, on the grounds that there were no barriers to entry, and thus thatif it were to raise its price (to try and capture the gains from predatory pricing), it would lose marketshare dramatically.

manufacturers provide differential discounts to retailers. This means that, if they want to,larger retailers may be able to drive smaller retailers out of the retail market without evenmaking losses (although the retailer may not be achieving maximum profit margins). Thismeans that a price-cost test of the sort suggested by Areeda and Turner (1975) willgenerally be of little use in identifying predatory pricing.90

Moreover, even if pricing results in exit, it is sometimes difficult to discern whether it isreally predatory, to the extent that it only drives out small and inefficient retailers. Indeed,low prices are a prime virtue of the competitive process and these small retailers mightbe driven out even without deliberate predatory pricing. For example, if there are twolarge retailers which both receive large discounts from manufacturers, and a competitivefringe of small retailers which do not, vigorous price competition between the two largeretailers may have the effect of driving the small retailers out the market even withouthaving this aim.

Thus, in order to analyse predatory pricing in retailing, it is important to determinewhether retailers are being driven out of the market as part of a natural process ofrationalisation (shaking out the inefficient), or whether pricing is designed strategicallywith this aim. For example, supermarkets have recently been accused of trying todeliberately price specialist bakeries out of the market. It may well be the case that, asconsumers tend to use supermarkets to an ever greater extent, there is no longer a role forlocal bakeries. However, it is also possible that this is not the case – that there is still arole for local bakeries – but that supermarkets are deliberately trying to force them out ofthe market through predatory pricing.

In order to test for this possibility, it is important to ask the following two questions:

C Does the behaviour of the alleged predator deviate from its short runprofit maximising behaviour in any way?

C Would predatory pricing in fact be a rational strategy?91

If these questions can both be answered positively, then it provides fairly strong –although not conclusive – evidence of predation. The first of these questions is bothdifficult to answer and on its own is too ‘easy’ a test for predation, in that it would classtoo many actions as predatory. The second test is more stringent. Predatory pricing isonly a rational strategy if it will in the long run allow incumbent retailers to charge higherprices than they would have been able to in the presence of greater competition.However, it is not clear why rivals should leave the market in the short run if they realisethat prices will rise again in the long run. Likewise, although an incumbent may want92

to threaten ex ante to price low in the face of new entry, in order to deter it, it will usuallybe profitable ex post for it raise price in the face of actual entry, unless it has some furthermotive for not doing so.

See Bolton and Scharfstein (1990) and Tirole (1988) (pages 378-379). 93

See Kreps and Wilson (1982) and Milgrom and Roberts (1982). It can be shown that even a tiny94

possibility that the incumbent might be aggressive by nature can make it rational for incumbents ofall types to fight entry to deter future entrants.

See Roberts (1986).95

Bundling, tying, and the provision of discounts are essentially forms of price discrimination, and are96

all effectively covered under this heading. For example, products may be offered at reduced price ifsold as part of a bundle with other products, so that consumers who buy product A can purchaseproduct B at a reduced price, or consumers who purchase product B must purchase product A at ahigher price. Products being sold complete with warranties are an example of the latter form ofbundling.

Note that Whinston (1990) defines tying thus: “A company engages in tying when it makes the saleor price of one of its products conditional upon the purchaser also buying some other product fromit”. The only difference between tying and bundling appears to be that bundling specifies quantitiesof both products (i.e. a bundle or package) as well as prices. Bundling of products is probably morecommon than tying in retailing.

In the Supply of Beer case, the MMC noted large variations in the prices of beer between different97

regions of the UK.

Predatory pricing can, however, be a rational, and credible, entry deterrence strategy inat least two circumstances:

C Imperfect capital markets: If capital markets are imperfect, there maybe asymmetries between retailers in terms of access to funds, and thesecan be exacerbated by predatory pricing. In particular, smaller retailers93

may find it hard to raise funds in order to cover its short run losses, andso may not be able to last until prices eventually increase.

C Asymmetric information: When there is some asymmetric informationbetween retailers, it may be possible for an incumbent retailer to usepredatory pricing in the short run to build a reputation for aggressivepredatory behaviour, or to signal that it has low costs .94 95

In addition, predatory pricing will generally only be rational if there are sunk costs of exitor entry: if entry and exit are costless, then bakeries could simply exit the market for aslong as predatory pricing lasted and then re-enter as soon as prices rose.

6.3 Price discrimination

When different types of consumer differ in their average willingness to pay for a good,and when resale between consumers is unlikely, it may be profitable for a retailer tocharge different prices to the different consumer types, or maybe to bundle differentproducts and services. 96

Price discrimination is likely to be relatively common in retailing. One of the mostimportant requirements for effective price discrimination is that resale between consumerswill be minimal. Compared to other sectors, resale is relatively unlikely amongst retailconsumers (because individual purchases tend to be too small to justify the necessary co-ordination between consumers of different types). This tends to ease price discrimination.Moreover, although retailers almost never have detailed information on the willingnessto pay of any particular customer, they can still discriminate between broad consumercategories. For example, national retailers may charge higher prices in more affluentareas , and retailers may provide discounts for regular customers, or students, or senior97

citizens.

Note, though, that when differential prices are due to supply-side differences (such as differences in98

property costs in different areas), this is not price discrimination. Price discrimination is always drivenby demand-side side differences.

In simple economic terms, this transfer of rents is welfare neutral, but it less likely to be neutral on99

political grounds. This can be shown in a simple example. Suppose that a product costs 10 to develop, and that there100

are two potential purchasers which value the product at 4 and 7 respectively. It is clearly optimal thatthe product should be developed (since the gains exceed the costs), and that price discriminationbetween the two purchasers will allow this. However, neither purchaser could afford for the productto be developed on his own, and if price is constrained to be the same for each purchaser, then themost that will go towards the product’s development is 8, which is not enough. Thus pricediscrimination can allow greater sales than would otherwise occur (in fact in this example, a wholemarket opens up: more usually the market will just expand).

Bundling can work in a similar way. Suppose that there are now two products A and B both of whichcost 10 to develop, and that one purchaser is willing to pay 4 for A and 7 for B while the secondpurchaser is willing to pay 7 for A and 4 for B. If the products must be sold separately at a uniformprice, neither product will be developed, for the reason given above. However, if a bundle of the twoproducts together can be offered to the purchasers, each would be willing to pay 11 for the bundle,which would cover the development costs.

Price discrimination is often relatively easy to observe. However, the welfare effects are98

usually very difficult to judge. Price discrimination can have important negative effects.There is a consumption inefficiency due to unexploited opportunities for further trade.There is also a transfer of rents from consumers to retailers (as a result of the exploitationof market power). For example, in The Supply of Beer (1989), the MMC concluded that99

the large variations in the prices of beer between different regions of the UK were anattempt to maximise monopoly profits and were against the public interest.

Perhaps the most important negative effect of price discrimination, though, is that it maybe used to foreclose market segments. For example, if a large multi-product retailersupplies two product market segments, and if it faces competition in only one of thesesegments from retailers which only supply this segment, then it may choose to price lowin the competitive market segment in order to drive out the competition in this segment(so that entry by a retailer only becomes feasible if it enters both segments).

Another example is provided by the case of Contact Lens Solutions (1993). The MMCnoted that the optician’s recommendation of a CLS care system was typically followedby the wearer throughout the life of the lenses. Opticians thus both recommended andsold solutions, implying a potential conflict of interest. This tying of opticians’ servicestogether with CLS resulted in insufficient cost advice being provided by opticians (bothin terms of choices between CLS and in terms of the decision to wear lenses in the firstplace). In particular, those retailers who have own-brands (Boots, Dolland & Aitchison,and Specsavers) tended to recommend these own-brands, where appropriate, giving theirproducts a strong advantage, and effectively foreclosing the market to other potentialretailers.

On the other hand, there are also important benefits of price discrimination. In particular,it can result in higher total sales (more consumers being served) than would be the caseunder uniform pricing. Indeed, it can even allow totally new markets to open up. For100

example, In Contraceptive Sheaths (1994), the MMC argued that price discriminationbetween the NHS market and the retailer/vending machine market was beneficial, on thegrounds that the result of stopping price discrimination would be to bring NHS prices upto those elsewhere (which might result in this market closing altogether), rather than toreduce prices elsewhere.

For tying, bundling and other forms of discounting, there is a further benefit: there areoften economies of scale or scope in bundling products. For example, the fixed costs

Note that loss leading does not necessarily mean that the retailer charges a price which is below what101

it pays for the product. It just means that the price is set (for promotional purposes) less high thanwould otherwise be the case (that is, the contribution of the product to the retailer’s fixed costs islower than it would otherwise be).For example, stores which are generally more expensive may be better able to afford more dramatic102

price-cut promotions than generally cheaper stores.

involved in retailing mean that when more is sold, the average cost per unit sold falls.Thus, a discount related to the amount that a consumer spends is both justified by the coststructure and can allow better exploitation of resources. Products may also be bundledtogether to save the consumers time and effort. The benefit of package holidays, forexample, is that it reduces the number of separate choices which the consumers need tomake, while allowing certain economies to be achieved by the holiday providers.

From the point of view of competition policy, it is often difficult to weigh up the costs andbenefits of price discrimination, tying/bundling and discounting. It is clear that if pricediscrimination does not result in higher total sales or lower average costs, then it cannotbe socially beneficial. Thus, if there are potential rivals which could easily enter thelower priced market segment if price discrimination by the incumbent retailer wereprevented, then there will be no serious reduction in welfare from disallowing pricediscrimination. If in addition, it is thought that these potential rivals are being kept outof the market by price discrimination, there may even be a positive social gain fromdisallowing price discrimination.

More generally, however, we may observe both increased sales and entry deterrence, inwhich case it is difficult to weigh up the pros and cons. The European Commission takesan extremely strong line on any form of price discrimination by a dominant firm, but inthe UK and the US, the competition authorities are rather more lenient and are willing toweigh up the possible costs and benefits.

6.4 Loss leading

In retailing, more than in any other area of the economy, retailers tend to sell bundles ofproducts and to stock large product ranges. When the products being purchased arerelatively cheap, a consumer will not have strong incentives to shop around for eachindividual product, but will prefer to go to a single retailer which he knows will stock thedesired products at reasonable prices. For some products, consumers may know exactlywhich retailer provides the best product at the best price. More generally, however,consumers have only very vague ideas of the relative qualities and prices of individualproducts, and in this case consumers tend to choose between retailers on the basis of theirreputation for good product range and general low prices.

Loss leading is effectively a method of gaining a reputation for general low prices underthese circumstances. While consumers cannot compare the prices of every product soldby a multi-product retailer, they may be able to compare a limited number of productprices, and will infer from these limited price comparisons how the retailers’ pricescompare more generally. By reducing the prices of particular products and thenpromoting/advertising these products and their prices, retailers encourage consumers touse these low price products to make their price comparisons with other retailers. 101

Loss leading as a purely promotional exercise does not require retailer market power anddoes not give rise to competition problems in the short term. The only problem in thiscase is that loss leading may distort consumers’ purchase decisions to the extent that itdoes not signal general price levels correctly. In the longer term, however, loss leading102

may have destructive effects at both the retailer and the manufacturer levels (and

That is, if loss leading is being used to drive out other retailers which cannot match the loss leading103

price, or at least to make them switch to a supplier of a less popular brand. See Milgrom and Roberts (1986). Their model shows that there are in fact two signalling effects of104

price. A low price may signal high quality, because only a high quality manufacturer would be ableto extract enough consumer surplus in later periods to cover the cost of the initial low price. On theother hand, a low price may also signal low quality, due to the fact that low quality costs less tomanufacture.

This model sits well with the idea that in the short term low price may signal high quality, but that inthe longer term it may signal low quality.

In Black and Decker, the MMC rejected the argument that loss leading results in a lowering of brand105

image, on the grounds that manufacturer’s products would not be any use as promotional tools if theirbrand image were damaged, and thus that retailers have an incentive to maintain this brand image.However, this argument is flawed: the retailer can always switch to an alternative brand for itspromotion, and anyway the manufacturer will have far more to gain from maintaining its brand imagethan will any given retailer.

especially if loss leading is being used for predatory as well as for promotionalpurposes ). These effects have led manufacturers to refuse to supply products to loss103

leading retailers.

The destructive effects of long-term loss leading at the retailer level are straightforward.Retailers which provide a wide product range can cover any losses made through lossleading through increased sales on the rest of their range. Smaller retailers, though, whichonly provide a small part of the product range of the loss leading retailers, may be unableto match the loss leading price (for what might be one of their most important products),and may thus be driven out of the market, or at least put at a competitive disadvantage.

It is less easy to see why manufacturers would object to loss leading using their products.Simple economics suggests that, for a given manufacturer price, manufacturers will dobest when retailers sell as many of their products as possible. Loss leading and promotionby the retailer would thus be expected to raise manufacturer profits, rather than reducethem, at least in the short term. In the longer term, though loss leading may be destructivefor manufacturers for three main reasons.

C Switching of supplier: If smaller retailers cannot make an acceptablemark-up on the manufacturer’s product, they may switch to analternative supplier which can provide them with a better mark-up,which will act to reduce manufacturer’s sales. Moreover, if there areeconomies of scale in distribution, the reduction in the number of outletsmay make the current distribution network inefficient.

C Price as a signal of quality: When consumers are not sure about thequality of a good, its price may act as a signal to them of its quality.104

If a low price signals low quality (as it is likely to, if it is not just a shortrun promotional price), then the image of the manufacturer’s productwill be adversely affected by the loss leading.105

C Lack of incentives for retailer promotion: The retailers that carry outthe loss leading clearly have incentives also to promote the product.However, other retailers, whose mark-ups are reduced by the lossleading, will be unwilling to engage in promotion of the product, andmay have incentives to give it reduced (or less advantageous) shelfspace.

These arguments seem to have been accepted. Indeed, Section 13 of the Resale PricesAct (1976) provides for a supplier to lawfully withhold supplies of goods from a retailerif he has reasonable cause to believe that the retailer has been using them as loss leaders.

The only other justification for selling a product at a loss in the short term is that it might attract new106

sellers to the product in the long term (when retail margins will again be positive). In this case,however, it is unlikely that the manufacturer would object.

This has meant that the focus of UK competition authorities has turned away fromdiscussion about whether the above arguments hold true in any particular case, andtowards the difficulty of assessing whether loss leading is actually occurring.

When the retailer’s price for a product is less than the retailer actually paid for theproduct, there seems little doubt that loss leading is occurring. It is difficult to think ofany justification for making an actual loss on a product unless it results in increased salesof products with positive price-cost mark-ups. 106

When a retailer’s price is at or above what the retailer paid for the product, however, thesituation is less clear for three reasons. First, Bliss (1988) shows that a multi-productretailer will generally not do best by setting a fixed percentage mark-up, but will preferto set higher mark-ups for products with lower elasticities of demand, and vice versa. Theproducts which are supposedly chosen for loss leading tend to have high demandelasticities. Indeed, if consumers were relatively unresponsive to price (low demandelasticity), the product would be of little use as a loss leader. Bliss’s theory thus suggeststhat these products would tend to have low mark-ups anyway, even in the absence of lossleading.

Second, the products which are supposedly chosen for loss leading tend to have strongmanufacturer brand names. This means that manufacturers of these products are instronger bargaining positions with retailers than are the manufacturers of weaker brands(or own-brand products), and thus retailers will tend to receive a lower share of total rentsfor these products (resulting in reduced retailer mark-ups).

Third, the products which are supposedly chosen for loss leading tend to be relativelyfast-selling products. This means that the costs of shelf space and inventory costs per unitsold are lower than for more slow-selling items, which again means that stores can affordto set lower mark-ups.

These arguments show that it is very hard to distinguish between loss leading and thenormal pricing of a high-elasticity, strongly-branded, fast-selling product. In addition, thecost structures and cost allocation systems of different retailers can vary substantially, sothat any simple percentage mark-up test for loss leading which is valid for one retailer isunlikely to be valid for another. Moreover, the use of a general rule of this type istantamount to RPM, which the Resale Prices Act specifically outlawed.

All of these problems arose in the case of Black and Decker (1989). The MMC examinedwhether Black and Decker (B & D), whose power tools and workbenches had been usedas loss leaders by certain large DIY retailers, was justified in refusing to supply anyretailers whose gross retail margin was under 12.5 per cent. The MMC rejected theargument that loss leading results is a lowering of brand image, on the grounds that B &D products would not be any use as promotional tools if B & D’s brand image weredamaged, and thus retailers have an incentive to maintain the brand image. The MMCwas more convinced by the possible detrimental effects of loss leading on competition,and allowed that refusal to supply was an acceptable response by manufacturers.However, the use of any general rule for loss leading (such as the 12.5 per cent rule) wasoutlawed because of the problems associated with looking at gross margins.

Although note that Rasmusen et al (1991) show how vertical restraints may be individually beneficial107

but jointly detrimental: while each individual retailer does better through accepting the verticalrestraint, all retailers collectively do worse than they would if none accepted the restraint.

7. Vertical issues

UK competition authorities have dealt with numerous cases involving vertical restraintsand relations between upstream suppliers and retailers. These covered various forms ofvertical restraint, including:

C Refusal to supply: Fine Fragrances (1993)

C Full line forcing: New Motor Cars (1992)

C Exclusivity arrangements: New Motor Cars (1992), Ice Cream (1994),and Contraceptive Sheaths (1994)

In addition, several cases have examined the importance of the countervailing marketpower of strong retailers when facing manufacturers. Examples include Kingfisher plcand Dixons Group plc (1990), and Contact Lens Solutions (1993).

In this chapter, we give a brief description of the economics of vertical restraints inretailing. We then examine implications for the assessment of vertical issues.

7.1 The economics of vertical restraints

As stated in Chapter 2, the aim of vertical restraints is to maximise the joint profits ofretailers and manufacturers in the face of divergent self-interest, or to share out these jointprofits between the two levels. Indeed, it is generally assumed that retailers andmanufacturers accept vertical restraints voluntarily (other than unilateral restraints suchas refusal to supply or refusal to stock), and thus no individual vertical restraint will beever imposed which is detrimental to either the manufacturer or retailer involved. 107

In some cases, the joint interest of manufacturers and retailers will correspond with thatof consumers. For example, where vertical restraints aim to improve levels of retailerservice, or to ensure high product quality, consumers may benefit. These are efficiencyreasons for vertical restraints. However, in other cases, vertical relationships can be anti-competitive and harmful to consumers. For example, if the aim of vertical restraints issimply to maximise joint profits by raising end-prices to monopoly levels, say, or bypreventing entry by potential competitors, consumers will lose out.

The following subsections examine three main explanations for vertical restraints, whichapply whatever the form of the vertical restraint: Efficiency motives; anti-competitivemotives; and economic rent sharing.

7.1.1 Efficiency motives

Vertical restraints may be useful for overcoming divergent incentives:

C between manufacturers and retailers;

C between retailers;

For example, suppose that the manufacturer is selling at a price higher than marginal cost (making a108

profit A on each unit), and thus wants to sell as many units as possible. Retailers can increase thenumber of units sold by carrying out store promotions, or by giving the product superior shelf spaceor location within the store. In the absence of vertical restraints, the retailer will receive only the retailmargin r on each extra unit sold, whereas the total joint profit on each is (r + A). The retailer will thuscarry out too little sales promotion for joint profit maximisation.

A further, and rather different, rationale for manufacturers’ use of vertical restraints is based on thefact that retailers may locate further apart than is optimal from a manufacturer's point of view, in orderto reduce price competition between them (an idea which is drawn from Hotelling, 1929). Verticalrestraints such as RRP can then be used to soften price competition between retailers and so encouragethem to locate closer together. This rationale for vertical restraints is given in Mathewson and Winter(1986).

C between manufacturers;

7.1.1.1Divergent incentives between manufacturers and retailers

Co-operation between manufacturer and retailer can be crucial for providing customerswith the right products and the right levels and types of retailing activity, at the right sortsof prices. More generally, co-ordination between the two levels can be vital formaximising their joint profits. However, as was discussed above, the individual self-interest of manufacturer and retailer can sometimes conflict with this joint interest.Vertical restraints can help solve this.

A simple example of this is the issue of ‘double marginalisation’. When the manufactureris selling at a price higher than marginal cost, it wants to sell as many units as possible.Under perfect competition in retailing, prices will be competed down to their competitivelevel, and output will be maximised, benefiting the manufacturer. However, whenretailers have some market power, they may be able to set price above the competitivelevel, which reduces sales and so reduces the profits of the manufacturer. Because theretailers do not take this reduction in profit into account, prices in this situation will behigher than is in the joint interest of manufacturer and retailers. Vertical restraints suchas quantity forcing, quantity discounts and recommended retail price can alleviate thisproblem, raising joint profits for retailers and manufacturers and also improving consumerwelfare.

This case is one where manufacturer and retailer have diverging incentives concerningpricing. The same story applies when they have diverging incentives on other aspectssuch as product quality and retailer service. For example, as long as manufacturer and108

retailer both stand to gain from any increase in the quality or promotion of themanufacturer’s product, then neither will individually have incentives to do the jointlyprofit maximising amount of quality improvement or promotion.

General vertical restraints can help to solve such problems indirectly. For example,vertical restraints can reduce direct price competition, and so encourage competition onquality and promotion instead. However, when retailers and manufacturers are largeenough to make monitoring compliance worthwhile, this problem is more often solvedthrough more direct vertical constraints: from minimum promotion requirements anddeals whereby the costs of advertising will be split between manufacturer and retaileraccording to the benefits each expect to receive from it, to direct intervention by theretailer in the upstream production process or by the manufacturer in the retailing process.

7.1.1.2Divergent incentives between retailers

Promotional services provided by retailers on the behalf of manufacturers cannot be

separately charged for and are therefore vulnerable to free-riding. Suppose that therewere to exist car dealers which do not provide test drives and which can therefore affordto charge lower prices. In principle, consumers could then test drive a car at a car dealerwhich provides test drives, and then go and purchase the car from a cheaper car dealerwhich does not. In practice, this would not be a sustainable situation, because the cardealer which provides test drives would go out of business. Thus, in this simple example,if car dealers which do not provide test drives are allowed to exist, the eventual outcomewill be that no car dealers provide test drives, and total car sales will be reduced (reducingthe joint profits of manufacturer and retailers, and also damaging consumer welfare).

Refusal to supply can solve this problem directly: the manufacturer can simply refuse tosupply its product to any retailer which does not provide the appropriate retailingactivities. Full line forcing can be a useful way of ensuring that retailers do not free-ridein terms of product range. Resale price maintenance can alleviate the problem byreducing the ability of retailers which do not provide the appropriate level of retailingactivity to steal customers from those who do (this argument has been used in the case ofbooks). Territorial exclusivity, meanwhile, can reduce the problem by reducing the easewith which consumers can switch between retailers.

Divergent incentives between manufacturers

Again, it is important to remember that many vertical issues are in fact symmetric betweenretailers and manufacturers. Suppose that there are various brands of a product, and thatadvertising any particular brand has positive spill-over effects on the other brands. In thissituation, free-riding between manufacturers will result in too little advertising, which isdamaging for both retailers and manufacturers. Exclusive dealing can alleviate thisproblem indirectly, but again direct intervention is more likely to be used as a solution.

7.1.2 Anti-competitive motives (and effects)

Not all vertical restraints are motivated by efficiency improvements, and even those thatare may have anti-competitive effects.

In terms of competition between retailers, where manufacturers have a choice, and wherethere are no efficiency gains to be made, manufacturers will tend to prefer morecompetition at the retail level rather than less. The reason is straightforward: for givenmanufacturer price, the manufacturer wants to sell as many products as possible, whichis done when retail margins are as low as possible. This point has been used to argue thatmanufacturers would never want to ease collusion or even limit competition betweenretailers, except for efficiency reasons.

In a traditional situation, where large manufacturers with high market power face smallretailers with little market power, this argument may hold true. However, if retailers arelarge and have significant market power, as is now the case in many UK retail markets,there may be other, anti-competitive, reasons why manufacturers seek to promotecollusion at the retail level.

Suppose that there are a number of manufacturers who are competing for the custom ofretailers. If one manufacturer is willing to facilitate collusion between retailers, throughthe use of RRP for example, then retailers will be more willing to stock thatmanufacturer’s product. Thus, competition between manufacturers for retail outlets mayend up being in terms of the degree to which they are willing to restrict competitionbetween retailers.

For examples of the Chicago school view, see Bork (1978) or Posner (1976, 1979).109

As well as anti-competitively restricting competition between retailers, vertical restraintsmay be used by a retailer to improve its competitive advantage vis-à-vis its rivals. Forexample, a retailer who requires exclusive supply (or encourages manufacturers to refuseto supply its competitors) can gain a competitive advantage in terms of product selection,and a manufacturer will be willing to fulfil this requirement if the retailer has sufficientlyhigh market power. At the extreme, this use of vertical restraints may even prevent theentry of new competitors into the retail market by preventing access to the necessaryproducts.

Economists of the ‘Chicago school’ dispute this entry prevention point. They argue109

that vertical restraints and integration should not be a concern of antitrust policy becausethey are always motivated by considerations of efficiency, and any antitrust problemssimply result from a lack of horizontal competition. For example, with respect to refusalto supply, the Chicago argument was that it is always more profitable for an incumbentmonopolist manufacturer to provide access to key inputs to a more efficient rival atmonopoly prices than to attempt to foreclose a potentially competitive market by refusingto supply. Hence refusal to supply would occur only if it were in the interests ofproductive efficiency.

However, more sophisticated recent economic analyses have shown that, except in somespecial cases, foreclosure and exclusion through vertical restraints are both possible andrational. For example, analysis by Bolton and Whinston (1991, 1993) and Hart andTirole (1990) provides formal and quite general conditions under which refusal to supplycan be a rational and credible policy. Nevertheless, these papers still suggest thatforeclosure effects are more likely to occur where one of the markets (manufacturer orretailer) is highly concentrated.

7.1.3 Rent sharing motives

Various vertical devices can be used to adjust the shares of economic rents received bymanufacturers and retailers, including franchise fees, quantity discounting, or moregeneral forms of discounting. The relative sharing of economic rents between retailersand manufacturers will depend on their relative bargaining power, which will in turndepend on their relative sizes, their relative contributions to value-added, and the intensityof competition at each level.

Although rent sharing per se is not anti-competitive, it can have important anti-competitive consequences, especially when different retailers receive significantlydifferent discounts. There are two reasons for this:

C differential discounting may be used to prevent discounts frommanufacturers being passed onto consumers; and

C it may be used to prevent entry/induce exit at the retail level.

The first of these will depend on the form of competition that exists between retailers. If,for example, retail prices are constrained downwards by the unit costs of the highest costretailer, then all retailers with lower unit costs than this marginal retailer will make profits.The total profits of the retail sector will thus be equal to the shaded area in the figurebelow. The more unequal the differential discounting between retailers, the higher theprofits that accrue to this sector.

Retailers in order of decreasing discounts

(increasing unit costs)

unit costs

price

Retail profits

This roughly describes the pharmacy retail market.110

A more extreme example is that where the retail market is characterised by one largeretailer (which receives large discounts) and a competitive fringe (which receivesnone). In this case, higher discounts to the large retailer are unlikely to get passed onto110

consumers, but instead will be taken as economic rents.

Secondly, differential discounting may induce exit from the retail market. Consider theretail market just described with one large retailer and a competitive fringe. If the largeretailer were instead to pass on some of its increased discount to consumers, it may wellforce the competitive fringe out of the market, since they are unable to compete with thesenew low prices. This may or may not be detrimental to consumer welfare: the benefitsof lower prices would have to be weighed up against the reduction in consumer choice.However, if exit from the market is easier than entry into it, there is a serious risk that,after driving out the competitive fringe, the large retailer will be able to raise prices again.

However, differential discounting will not always have such deleterious consequences.If price competition between retailers is sufficiently strong, then increased discounts will– at least to some extent – be passed onto consumers. Indeed, price competition providespart of the motivation for retailers trying to achieve higher discounts: the retailer whichachieves the highest discounts will have a competitive advantage in terms of pricecompetition.

Thus, when retailers use their countervailing market power to negotiate for higherdiscounts from manufacturers and then compete these increased discounts away in pricecompetition, they carry out a beneficial function from the point of view of consumers, interms of reducing end-prices. This beneficial function of retailers was noted in the MMCand OFT reports on discounts to retailers (1981,1985) which argued that as long as thereis sufficient competition at the retail level then increased discounts to retailers are a goodthing.

7.2 Assessing vertical restraints

We showed in Chapter 2 that the form of vertical restraints has changed over time.Vertical restraints of the traditional form are rather blunt instruments, in that they achievetheir primary aims only indirectly. The reason for using these indirect methods lies inmonitoring costs. Historically, retailers tended to be small and local, while manufacturerswere relatively large. This meant that, although manufacturers were in a position toimpose general vertical restraints such as RRP and exclusive territories, the costs ofmonitoring compliance with specific contract conditions were too high to be worthincurring.

As retailers have grown larger, two changes have been seen in the form of verticalrestraints. First, monitoring costs have become less important relative to total turnover,which has resulted in manufacturers and retailers increasingly solving divergences ofincentives between them more directly, through the use of specific agreements andcontracts, and direct intervention, rather than through the more traditional verticalrestraints. Indeed, the line between vertical intervention and vertical integration has beenbecoming more and more blurred: if a retailer makes most of the manufacturers’investment and production decisions for him, then the retailer is effectively acting as themanufacturer, and there is no obvious difference between this and full vertical integrationin terms of implications for competition policy.

Second, it has become more common that retailers want to have some control over whatmanufacturers are doing, rather than vice versa, than was traditionally the case. Indeed,even where these traditional vertical restraints are used, they may not be being used forthe traditional reasons. For example, refusal to supply is known as a method which canbe instigated by manufacturers for overcoming free-rider problems among retailers.However, there have been recent allegations of retailers instigating refusal to supply, byforcing manufacturers to refuse to supply certain other retailers in order to reduce theeffectiveness of these other retailers as competitors.

In terms of competition policy in retailing, it is thus very important to examine all theways in which retailers and manufacturers intervene in each other’s behaviour, and notjust to examine the more traditional vertical restraints, such as RRP and refusal to supply.It is also very important to discover:

which side instigated the restraint;

C whether the other side accepted it willingly;

C whether any other retailers or manufacturers object;

C what the aims of the restraint seem to be;

C what the effects of the restraint are; and

C how much each side stands to gain from it.

In fact, this alleged equivalence of different kinds of vertical restraints holds only under very special111

circumstances. If, for example, uncertainty is introduced, then the insurance effects of differentvertical restrictions have to be considered, and the risk preferences of manufacturers and retailersmatter. However, the general point that the form of vertical restraints is unimportant holds true fromthe point of view of competition policy.

The first three of these questions may be possible to answer through interviews.

In terms of aims and effects, we have also distinguished three possible motives for verticalrestraints: efficiency, anti-competitive, and economic rent sharing.

a)Efficiency: When the incentives of retailers and manufacturers diverge(perhaps because they each receive only a share of economic rents, or perhapsbecause they have different information), vertical restraints can align theirincentives. This will generally benefit both sides, and it will also often benefitconsumers. These are efficiency motives for vertical restraints.

b)Anti-competitive: Chapter 2 discussed various ways in which verticalrestraints can be used purely anti-competitively, either to limit competition or todeter entry.

c)Rent sharing: Franchise fees, quantity discounting, and general differentialdiscounting are all methods of sharing economic rents between manufacturersand retailers. Own-brand products can also be an effective means of extractingmanufacturers’ economic rents.

This categorisation gives rises to a four step methodology for dealing with vertical issues.Step 1 examines whether the manufacturing and retail markets are competitive. If bothare, then vertical restraints will not generally require intervention by competition. Step2 examines whether the vertical restraint can be explained by efficiency gains oreconomic rent sharing. if not, they are likely to be anti-competitive. Step 3 looks atwhether the restraint has any effects on horizontal competition. If not, there unlikely tobe an anti-competitive effect. Finally Step 4 attempts to weigh up any positive efficiencyor rent sharing effects against any negative effects on competition.

This four step methodology is described in more detail in Appendix 1. The final step isgenerally only carried out by the MMC. The OFT will pass cases on to the MMC onlyif they fail Steps 1 to 3.

Note that the suggested methodology says nothing about the form of vertical restraints,but rather focuses on their aims and effects. The idea that the form vertical restraints takeis relatively unimportant was made famous by Mathewson and Winter (1986), whoshowed that various pairs of vertical restraints could be perfect substitutes.111

7.3 Implications for recent cases

Vertical restraints

The MMC has generally been relatively lax on vertical restraints, giving a lot of weightto the positive efficiency effects.

In Fine Fragrances (1993), the MMC accepted the argument that in order to maintain thehigh brand image of their products, perfume suppliers were justified in refusal to supplyto Superdrug and Tesco, on the grounds that these retailers would have no positive impacton brand image themselves and would simply free-ride on the contributions to brand

image made by current retailers. There was also however a clear anti-competitive effectthat had to be weighed against this, and the OFT was correct to refer the case to theMMC.

In New Motor Cars (1992), there were a variety of vertical restraints imposed on cardealers by manufacturers. In this case the MMC again had to weigh up the positiveefficiency effects of the restraints and the negative anti-competitive effects. In fact, it ispossible to argue that the MMC did not take a hard enough line in this case:

C Car dealers objected that they were forced to take a supplier’s wholerange, when only parts of the range sold well. The MMC concluded thatthe forcing of the supplier’s complete product range was acceptable, asan important and necessary part of the supplier’s sales system.

C The use of exclusive territories was examined. Again the MMC thepractice to continue, on the grounds that it was necessary to allow cardealers a sufficient margin to maintain their high standards.

C Car dealers objected that they that they were restricted from holdingdealerships from competing suppliers. The MMC decided thatrestrictions on dealers holding competing dealerships at the same sitewere essential to ensure that the supplier’s marque were sold effectively

In fact, one of the few recommendations that the MMC made in this case was ratherpeculiar. It recommended that competing dealerships at separate locations should beallowed, on the grounds that this would allow dealers to become bigger and thus to exertmore negotiating power against the manufacturers. However, given that this would – ifanything – reduce competition at the retail level, it is not at all clear that any benefits ofthis increased negotiating power would be passed onto consumers.

In Ice Cream (1994), the two main suppliers of impulse ice cream (Birds Eye Walls Ltdand Nestlé td) provided freezers to retailers free, on the condition that no other brand ofice cream was stocked in these freezers. The MMC decided that this practice did not actas a major barrier to entry, on the grounds that retailers could always terminate theagreement and acquire their own freezer (in which case they would also receive their icecream more cheaply), or they could add a second freezer where space permitted (this wasthought to be possible in around 80% of outlets).

In fact, application of Step 2 might have helped in the case of Ice Cream (1994). TheMMC decided in this case that the anti-competitive effects of freezer exclusivity were notstrong enough to require intervention. However, they did not show any significantefficiency benefits which might have justified this vertical restraint.

The MMC was more critical of vertical restraints in Contraceptive Sheaths (1994). TheLondon Rubber Company had arrangements with at least three major chemists to stockonly Durex condoms. Two of these said that they had decided to stop stocking Matesanyway, due to low sales, and the third said that it would soon have done so, so thatbehaviour was actually unchanged. However, Mates claimed to find the delistingspuzzling and said that it had been far harder to sell Mates to these stores than seemednormal. The MMC decided that these agreements increased barriers to entry and requiredLRC to cease them.

Countervailing market power

The issue of the countervailing market power of grocery retailers was discussed directly

by the MMC in Discounts to Retailers (1981) and by the OFT in Competition andRetailing (1985). Both studies concluded that the practice of granting discriminatorydiscounts was part and parcel of developments which had been beneficial to competitionand to the consumer, and that the general effect of the practice on the public interest overthe recent past had not been harmful:

“Despite some further increase in concentration ingrocery retailing since the MMC’s report, competitionin this sector is evidently still very strong, and ingeneral lower buying prices have been passed on to thebenefit of consumers.” (OFT, 1985)

It was emphasised however that this conclusion would remain valid only as long as therecontinued to be effective competition among both suppliers and retailers.

This is not the case in all retailer markets, however. The issue of the bargaining powerof big retailers arose in Kingfisher plc and Dixons Group plc (1990). A merger betweenthese two groups would have formed a huge electrical goods retail group with a great dealof bargaining power, and an ability to get very high discounts from suppliers. Kingfishersuggested that this would not have anti-competitive effects, but that instead supplierswould be forced to grant to all retailers any improved terms. The MMC felt, though, thatsuppliers would instead seek to restore their own margins by selling to smaller retailersat higher prices or on less advantageous terms than would otherwise rule.

Similarly, in Contact Lens Solutions, the big discounts given by suppliers to the largerretailers were not being passed onto consumers. Rather they just constituted a transfer ofeconomic rents from suppliers to retailers.

Appendix 1 LE recommended checklists

As discussed in the main body of the report, we recommend a five stage approach tocompetition enquiries in retailing.

1. identification of competition issues

2. preliminary analysis of retailing:

C the characteristics of consumersC the dimensions of competition between retailers

1. market definition

2. barriers to entry

3. competition assessment:

C market structureC pricing issuesC vertical issues

This Appendix provides checklists of questions for stages 2 to 5 that it is useful to askunder each of these stages (other than market definition and market structure).

Preliminary analysis of retailing

The characteristics of consumers

One of the characteristics of retail markets is that end-consumers tend to be relatively:

C small (in the sense that the size of a given purchase forms a small partboth of a consumer’s total expenditure and of the retailer’s total sales);

C immobile (in the sense that they are often not able or willing to travellong distances in order to purchase the appropriate product); and

C uninformed (the costs of becoming fully informed about each of theproducts and prices available in the market are too high for manyconsumers profitably to undertake).

In order to discover which of these characteristics are important in a given case, it isuseful to ask the following questions:

C How frequently do different consumers groups purchase the product, anddo they tend to purchase it from the same retailer?

C How big is an individual purchase (relative to the average wage, and interms of the average turnover of the retailer)?

C Do consumers generally make the purchase independently of otherpurchases, or are they likely to include it in a shopping trip. If the latter,how large is the average shopping trip?

Note that many of these questions will recur later in this chapter, since they may tell us about barriers112

to entry and other aspects of market behaviour, as well as dimensions of competition.

C Where do consumers tend to shop for the product in question (close tohome/work, in town centres, in out-of-town retail sites, through mail-order, at home over the telephone), and why?

C How well informed are consumers about the product:

i. in terms of what prices are available where in the market;

ii. in terms of the range of products available in the market;

iii. in terms of which retailers sell which products; and

iv. in terms of the quality and characteristics of products?

C If consumers are informed about the product and market:

i. how do they get this information;

ii. how hard is it to collect;

iii. is it provided freely; and

iv. are published reports available (such as Which? reports) or isreputation crucial?

Dimensions of competition between retailers

In Chapter 2, we separated out four dimensions of competition in retailing.

1. price

2. geographical location

3. product selection (the gatekeeper function)

4. level and quality of retailer service (including advertising andpromotion)

In order to assess which of these four dimensions are important in any particular enquiry,and the level at which competition takes place (for example, is competition in pricecarried out at a national level, with national pricing policies, or at a local level), it is usefulto ask some of the questions presented below:112

a) Price levels and costs

C How wide a range of margins and final retail prices for apparentlysimilar products can be observed?

C Do manufacturers set RRPs, and are these generally followed?

C Do any particular kinds of retailers tend to sell apparently similarproducts at lower (or higher) prices than others?

Although in some industries you get national price lists but local discounting, so that prices are not113

effectively set nation-wide.

C Are consumers price responsive?

C What factors tend to influence retailing costs?

C Are mark-ups the same (in percentage terms) for all products soldby the retailer(s)?

C Is there a stable relationship between retail prices andmanufacturer/wholesale prices?

C Are retailers integrated upstream into either distribution ormanufacture, and is this mainly for efficiency reasons?

C Are prices set nationally or locally? (the existence of national pricelists or mark-up structures would be evidence of the former, as113

would national advertising which included price information)

C Is there any evidence of price wars, and are these local or national?

C Is there evidence of prices remaining sticky, in the face of costchanges?

C Is there evidence of price leadership by larger retailers (either interms of raising price to above the competitive level, or in terms ofcompeting price down to below levels that would otherwise bechosen by smaller retailers)?

C Is there any evidence of retailers selling a product at a price whichis lower than (i) the cost of that product to other retailers, or (ii) thecost of that product to itself?

C What sort of discounting occurs in the market? Is it simple pricecutting or are price cuts hidden in other offers (such as ‘three for theprice of two’ offers, for example)?

b) Geographical location

C Do retailers of similar goods tend to cluster, or spread out ingeographical space?

C How high are property costs as a proportion of total retailing costs?

C What are the differentials between rents (or imputed rents) indifferent retail sites?

C Is there any evidence of retailers buying up sites well in advance ofusing them?

C Are retail chains concentrated in particular regions of the country orspread across the country?

C Do consumers tend to walk to purchase the product, so that location

close to offices/homes is very important?

C Do they tend to drive, so that parking space is very important, oftenresulting in location out-of-town?

c) Product selection (the gatekeeper function of retailers)

C In national chains, is product range chosen locally or nationally?

C Do retailers tend to focus on selling similar products (e.g. hi-fishops and clothes shops), or do they tend to sell many differenttypes of products (e.g. supermarkets)?

C Do retailers tend to sell products which differ horizontally (e.g.clothes shops) or vertically (e.g. hi-fis)?

C Has there been a trend in the market toward greater product range?

C Do retailers tend to cluster, or spread out in product space?

C Are there specialists which focus on one particular section of theproduct range (niche operators)? If so, how successful are they?

C Are there any vertical restraints restricting in any way the productrange stocked (such as full-line forcing or refusal to supply)?

C Do retailers engage in bundling or tying of products (for example‘three for the price of two’ offers and ‘free with ...’ offers)?

d) Retailer service, including advertising and promotion

C How important are staff costs relative to product costs?

C Are point of sales services important to consumers?

C How important to consumers are quality assurances/reputation?

C Can the products in the market be bought via mail-order? If so,what proportion of total sales are via mail-order?

C Are there any kinds of quality certification or compensationschemes?

C How strong are the brand names of the products, how strong are thebrand names of the retailers, and which tends to be more important?(consumer brand awareness surveys may be useful here)

C Do retailers supply own-brand versions of brand-name products?

C If own-brand versions are offered, what share of the total market dothey account for and do they compete at all levels of quality or justthe lower quality end of the market?

C How large a share of total retail costs consists ofadvertising/promotion?

C Are retail advertising campaigns national or local?

C Do they contain price information or product range information?

Barriers to entry

The following lists of questions can be helpful for assessing barriers to entry.

Legal and regulatory restrictions

C are there any legal and regulatory restrictions to entry into the retailmarket, in terms of quality and safety regulations, restrictions onretailer type, restrictions on retailer numbers, or restrictions onadvertising?

Access to retail sites

C How high are property costs as a proportion of total costs?

C What are the differentials between rents (or imputed rents) indifferent retail sites?

C Are there major obstacles to obtaining planning permission for newsites. Is planning permission transferable?

C Is there any evidence of retailers buying up sites well in advance ofusing them?

C How important is geographical location for consumers’ choicesbetween retailers?

C How important a barrier to entry do retailers consider access toretail sites to be?

C How strongly are consumers’ choices between retailers affected bygeographical location/availability of parking facilities?

Economies of scale and scope

In order to examine the importance of sunk costs as a barrier to entry, two sets ofquestions can be asked. The first set examines the cost structure of the incumbent(s).

C How large are the various economies of scale and scope in retailing(i) at a store level, and (ii) at a national level?

C How high are retailers’ current sales, and how large is the totalpotential market (i) at a store level, and (ii) at a national level?

C What is proportion of investment in these economies is sunk (i) ata store level, and (ii) at a national level? (For example, how costlywould it be to scale down retail operations, or even exit themarket?)

C How sunk are these costs (short-term or long-term)? (For example,

if there is a vibrant market in out-of-town retail sites, the costs ofincreased floor space may be easy to recoup. On the other hand, itmay be less easy to sell off a highly retailer-specific distributionnetwork).

The second set attempts to gauge more directly what would happen post-entry

C What is the nature and what are the instruments of marketcompetition (see the preliminary analysis)?

C How has the market reacted to entry in the past (in terms of pricewars, accommodation, and collusion)?

C How has the market reacted to exit in the past (in terms of priceincreases, output reductions, and the re-establishment of stable orcollusive pricing strategies)?

Advertising and promotion

In order to assess how important advertising and promotion are as barriers to entry in aparticular retail market, we can ask the following questions.

C How important are advertising and promotion by incumbents (interms of total costs, for example)?

C How strong are the incumbent retailers’ brand names, in terms ofconsumer awareness? (Information on this may be available throughconsumer surveys)

C How much initial advertising and promotion was carried out byprevious entrants to the market?

C How important are information asymmetries between consumersand retailers (that is, how strongly are seller reputation andreliability valued by consumers)?

C Is reputation capital (retailer brand image) transferable betweenretail markets (allowing entry from one retail market into another)?Has there been a history of this type of entry?

Goodwill and loyalty

In order to assess the importance of switching costs as a barrier to entry, it is thus worthasking the following questions.

C Do consumers tend to shop around, or do they tend to stick to thesame retailer(s)? And if the latter, why?

C Do consumers have good information about all the retailers in therelevant market, or would they have to search?

C Do retailers try artificially to create ‘customer loyalty’ throughpoints schemes of some sort? And if so, are the reward schemeslinear, or do they offer disproportionate rewards for larger numbersof points collected?

Customer loyalty/goodwill will again be a greater barrier to entry from some directionsthan from others. For example, goodwill may difficult to build up from scratch, but maybe easily transferable from one retail market into another.

Product proliferation and retailer differentiation

The following questions may be useful in assessing these issues.

C Are retailers in the market highly differentiated?

C How costly would it be for an incumbent retailer to remove itself,or one of its products, from the market entirely?

C How costly would it be for an incumbent retailer to change themarket positioning of itself or one of its products?

C Has there been a history of such repositioning and how successfulhas it been?

Competition assessment

Pricing issues

1. Price collusion

In order to assess whether or not there is implicit collusion in a retail market, werecommend a three step procedure.

Step 1 involves re-examining the height of any entry barriers into the market. Generally,while the existence of entry barriers does not imply collusion, collusion can only be aseffective as entry barriers are high.

Step 2 involves determining whether there are any practices that may facilitate collusionamong retailers. In order to detect practices which facilitate collusion in a particular retailmarket, the following kind of questions might be useful.

C Are there few enough retailers for co-ordination to be feasible?

C Are there one or two clear market leaders? Are their prices clearlyvisible to competitors?

C Do retailers follow RRPs?

C Is price competition important (collusion on prices is more difficultif retailers compete through the other strategic dimensions such asquality of services and product portfolio)?

C Are prices displayed prominently? (this would ease detection ofcheating)

C Are retailer percentage mark-ups fixed across different products? (itmay be easier for retailers to collude on a single percentage mark-upthan to co-ordinate on a whole series of different prices for different

One reason for sticky pricing under collusion is that it takes time for retailers to co-ordinate on a new114

price. A second reason is that, in the absence of full information, a retailer may not know whether agiven change in costs is common to all retailers in the market or specific to it. To the extent that theretailer thinks that the change is specific to it, then it will not want to change its price in case thechange is though to be an act of cheating by other retailers (leading to a price war). Thus collusiveprices may not move until retailers have ascertained that there has been a change in common costs.

For an interesting analysis of the Salt duopoly case, see Rees (1993a).115

The use of Granger causality tests can help to alleviate this problem. 116

Green and Porter (1984) show why, in the presence of a degree of asymmetric information between117

colluding firms about demand and supply conditions, we would expect to see co-operation over pricesmay then be punctuated by occasional price wars, or breakdowns in co-operation.

See Rees (1993b) for a summary of some of the possible punishment strategies and their credibility.118

products)

C Do any retailers promise to ‘never knowingly be undersold’? (thismay stop any competitor from engaging in price competition, forfear of an immediate reaction that would cancel out any advantagethat the price cut might have yielded).

Evidence of such practices is obviously not sufficient to infer price collusion. Indeed, inmany cases (such as the ‘never knowingly undersold’ offer), they may be an instrumentof price competition. However, the absence of any such practices might lead one todeduce that collusion is unlikely (without needing to progress to Step 3).

Step 3 involves looking at market price data and asking the following questions:

a) Is there any plausible explanation for the observed price behaviour, otherthan the existence of price collusion?

b) If we were observing collusion, would retailers have sufficient incentivesnot to cheat on the collusive price (that is, are there credible punishmentstrategies that would make it optimal for them not to cheat in the shortrun)?

In terms of answering question (a), a traditional method of detecting collusion was to testfor price parallelism and high profits. Price parallelism may be equally a result ofcompetition, but profitability should be low. The timing of price changes relative to costchanges may also be important: under competition prices should change immediately,whereas under collusion they may be sticky. Evidence of price leadership is stronger,114

and was used by the MMC enquiry into White Salt. But it is often difficult to find115

conclusive evidence on this, unless the parties are honest about it, partly because it canbe hard to show statistically that one retailer’s price choice causes the price choices ofothers in any way, and partly because the identity of the price leader often changes over116

time. Evidence of different pricing regimes may be stronger: this would be more difficultto explain other than a result of price collusion combined with periodic breakdowns inprice collusion. 117

Answering question (b) is more complicated, and is likely to require information on costsas well as on prices. The key question is whether there exist possible threats ofpunishment in the face of cheating that would be credible. Recent economic theory hasfocused on the issue of ‘renegotiation proofness’: if cheating happens, will retailers havean incentive ex post to carry out the punishment or would they prefer to renegotiate theimplicit contract? This suggests that collusion will only be successful in a particularmarket under fairly stringent conditions on market and retailer-specific parameters.118

The lack of such a rationale for predatory pricing was one of the principal criticisms levelled at the119

OFT’s investigation into local bus services by Utton (1990).

Step 3 is difficult to apply. This means that it is often difficult to make a strong argumentfor the existence of price collusion, especially when there is no available documentaryevidence. Moreover, even if retailers do seem to be colluding, it is not clear how suchcollusion can be remedied, especially since fines are not possible in the UK.

2. Predatory pricing

In order to test for predatory pricing it is important to ask the following two questions:

1. Does the behaviour of the alleged predator deviate from its short runprofit maximising behaviour in any way?

2. Would predatory pricing in fact be a rational strategy? 119

For this, the following questions may be useful steps:

C What sort of retailers are being driven out of the market (in terms of howbig they are, what market segments they compete in, whether they arevertically integrated)?

C What are relative cost structures of incumbents and exiters.

C How high are the sunk costs of exit?

C How high are the sunk costs of entry (both for current exiters and forother kinds of entrants)?

C Are the exiters constrained by capital requirements?

C What are the expectations of exiters (and other potential future entrants)about the level of incumbents’ costs and the likelihood of aggressivebehaviour by the incumbent in the future?

3. Price discrimination

In order to judge whether price discrimination (of whatever form) is on balance beneficialor detrimental to welfare, the following questions may be useful:

C Are there potential competitors into the lower price market segment?

C Is the cost structure of the incumbent such that it recoups most of itsfixed costs in the uncompeted markets, so that, in a market where it facescompetitors, it only needs to cover the incremental costs of serving thatmarket?

C Do consumers benefit – in terms of time and effort – from any bundlingof products?

C If the incumbent were to be forced to charge an identical price in eachmarket, what would the profit-maximising price be, and would this resultin the closure of either market? (this would require relativelysophisticated analysis of the retailer’s cost structure and demand

Evidence about loss of image can be gained from consumer surveys, and evidence on why retailers120

switched to other suppliers can be gained by interviewing some such retailers. This step might have helped in the case of Ice Cream (1994). The MMC decided in this case that the121

anticompetitive effects of freezer exclusivity were not strong enough to require intervention. However,they did not show any significant efficiency benefits which might have justified this vertical restraint.

conditions)

4. Loss leading

We agree with the MMC decision that general tests of loss leading (of the 12.5% mark-uptype) should be outlawed. However, the MMC did not make clear how one might test forloss leading in any specific case. We suggest that the best way of doing this is firstly toexamine whether the particular retailer is setting the price of a particular product with apurpose other than making a profit on the sale of that product, and secondly to determinewhether we actually observe any of the supposed harmful effects of loss leading formanufacturers:

C Switching of supplier;

C Price as a signal of quality; and

C Lack of incentives for retailer promotion.120

Only if this can be shown, should refusal to supply ever be allowed.

It also important that the manufacturer only threaten the instigator(s) of the loss leadingwith refusal to supply. If the manufacturer refuses to supply retailers which are merelyfollowing the price leadership of others (in order to maintain sales), then it will not curethe loss leading and will harm exactly those retailers which are anyway put most at riskby the loss leading. For this reason, we suggest a further condition that must be satisfiedbefore refusal to supply is allowed: the retailer must be promoting the low price in someway and must have the lowest (or joint lowest) price of any retailer.

Vertical issues

We suggest a four step methodology for dealing with vertical issues:

Step 1: Anti-competitive effects are more likely to be present where one of the markets(manufacturer or retailer) is highly concentrated, and unlikely to be present whereboth markets are competitive. Thus, if both the manufacturing and retail marketsare competitive, vertical restraints will not generally require intervention bycompetition authorities (no need to progress to Step 2).

Step 2: If there is no explanation for a vertical restraint in terms of significant efficiencygains or rent sharing, then it is almost certainly anti-competitive (if effective), andneeds addressing (no need to progress to Step 3).121

Step 3: As Kay (1990) and Waterson (1993) point out, vertical restraints are rarelydetrimental to welfare unless they have adverse effects on horizontal competition.Thus, where a vertical restraint has no effects on horizontal competition, then wecan presume that its motivation is efficiency that it is beneficial (no need to

Note that it is important to look for adverse effects on all dimensions of horizontal competition, and122

not just price competition.

progress to Step 4).122

Step 4: Steps 1 to 3 enable us to separate out some vertical restraints as being eitherdefinitely bad or definitely not bad for consumers. However, many other verticalrestraints will remain: vertical restraints which do have adverse effects onhorizontal competition (in any dimension), but which also have significantefficiency gains or rent sharing benefits. In such situations, vertical restraintsmust be examined on a case by case basis, the aim being to weigh up the positiveefficiency or rent sharing effects against the negative effects on competition.

Note that the above four step methodology does not focus at all on the form of verticalrestraints, but rather on their aims and effects.

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