Food Price Inflation — and the Power of Supermarket Oligopolies.

If you buy food — and most of us do — you cannot help but notice the significant rise in prices. We know inflation is running high, but food price inflation is higher still at an extraordinary 18%. Both CPI and food inflation are way in excess of the Target 2% inflation that the Bank of England is supposed to target.

This is all the more startling because, as the chart shows, we had become very accustomed to low inflation and sometimes falling food prices through the past 10 years. This provided a small but welcome boost to our real incomes. Small because as a nation gets richer, food accounts for a smaller proportion of the average person’s spending — so falling prices make only a little dent to their real incomes because we simply do not purchase that much food in comparison to all the other things we spend money on.

But those days appear to be over.

Most commentators will agree that the cause of food price inflation is 3 fold: the cost of feed for livestock, the cost of fuel, and the cost of fertilizer. Given the global shocks of the last few years, the prices of all 3 items have increased significantly. And as costs of production increase, farmers and food producers increase the price of the food that they then sell on to retailers.

Our simple supply curve models this relationship:

This diagram might represent the supply of tomatoes. The supply line S1 shows the quantity of tomatoes that a farmer is willing to supply at any given price. That quantity is determined by the farmers’ costs of production and the expected profit they can make at any given price. So at P1, the farmer will supply Q1 tomatoes because, given the costs of producing Q1, they expect to make a profit at price P1.

But if costs of feed, fertilizer and fuel increase, we can expect that the farmer will supply fewer tomatoes. The cost of producing quantity Q1 has increased. So at any given price, the farmer is incentivized to supply fewer tomatoes as they cannot make the same profit as before. Or another way to view this is that to maintain profit, they will only be willing to supply quantity Q1 at a higher price. Both of these can be shown as a leftward shift of the supply line to S2.

And we can see the result is that the equilibrium price of tomatoes and many other food stuffs, increases to P2.

As food producers sell to supermarkets it is clear that supermarkets also then face higher costs of production as their purchases are now more expensive. Again, they would argue that as their costs have increased, they must pass on these higher costs in the form of higher prices, to the final consumer — us.

As the table below shows we are paying more for everything from milk to chocolate.

But is this inevitable? We think not: just because costs rise, it is not inevitable that the price to the final consumer should rise.

Samuel Tombs, chief UK economist at consultancy Pantheon Macroeconomics, highlighted in a research note recently that “supermarkets appear to have widened their margins”. Data from the ONS and British Retail Consortium show food prices are rising faster than ever recorded.

The supermarket grocery sector is dominated by a few large firms. Such an industry is said to have an Oligopolistic market structure, where a few firms (say three, four or five) account for the bulk of market share. Supermarket retail definitely has that characteristic — as the following table shows.

The largest four retailers control 64% of the market.

Why does this matter?

It is impossible to predict with certainty how an oligopolistic industry will behave — since there are a few large producers, each of which reacts to the conduct of others, we are never quite sure what they will do — or how they will react. They might decide to cooperate and work together; or they may compete and seek to expand at the expense of a rival. Because of this unpredictability there is no one model of oligopoly behavior. There, in fact, several models. One of the most influential has been the kinked Demand Curve model developed by Paul Sweezy in the 1930s.

This model assumes that, once an equilibrium price for a product is established, other oligopoly firms will react to the price changes of any one firm. In particular, it assumes that each firm believes that if it initiates a price cut other firms will match it, but if it raises its price, no other firm will follow suit. The demand curve facing such a firm is then as shown below:

Here the current price is P1 and the firm is producing q1. If the firm increases its price competitors will not follow suit and demand will fall considerably — hence the firm’s demand curve is ELASTIC above price P1. By contrast, a price cut below P1 is matched by the other firms and hence demand will increase by little — the demand curve is therefore INELASTIC at prices below P1. A kink in the demand curve thus exists.

To return to our question: is it inevitable that supply-cost increases will feed through to increased supermarket prices, this kinked-demand curve model of Oligopoly suggests two reasons why cost increases may not feed directly through to higher prices:

  1. As we have seen, a firm will gain little by changing its price — if it raises price demand will fall a lot as other firms will undercut it. The firm will therefore probably keep price at the market equilibrium.
  2. The discontinuous MR curve means that at the profit maximizing output q1 if costs -MC- changes by small amounts the firm will still be at its MC=MR position. This can explain why firms do not always change their output or prices in response to changing costs.

In this case firms will be more likely to compete through forms of non-price competition, such as advertising, branding and loyalty cards.

This kinked-demand curve model of Oligopoly would seem to have fitted the supermarket sector for many years. The large supermarkets reacted competitively to each other. Each shop was reluctant to raise its prices for key products, fearing that it might lose market share to its rivals. And the emergence of new competitor firms like Lidl and Aldi further enforced the need to keep prices stable.

So what has changed? It may be that the pronounced and general increase in food-supply costs that have rendered the kinked-demand model (for a time at least) obsolete. Remember the kinked-model focuses on one firm deciding whether to increase prices alone. Thinking its price increase would not be matched by the others made it unwilling to raise its prices and take a large hit on market share. But if all supermarkets experience an increase in costs at the same time, all will be strongly tempted to raise their prices, and if all raise their prices at roughly the same time there will be no kinked-demand effect. Prices can rise and demand will be inelastic — which is likely given that food is a necessity with a low Price Elasticity of Demand.

Hence if we are to ask: why has food-price inflation been so high?, a first answer might be: a series of supply-side shocks have raised the price of farm-food, and this has caused a general rise in the input-prices of the major retailers, and the general nature of this cost increase has meant that they have had a shared interest in raising their prices, and by doing so together they have avoided the competitive pricing that previously kept food prices constant as predicted by the kinked-demand curve model.

Is this the end of the matter? We would suggest no. If the kinked-demand model no longer applies to supermarkets, what model does? There is good reason to consider the possibility of collusion — and the supermarkets have been found to engage in price fixing in the past. Together they can raise their prices further still. Acting collectively, they increase their market power to that of a monopoly. As the diagram below shows, a monopoly has the power to charge price Pm whereas firms in a competitive market — where consumers can switch between producers — can charge no more than Pc.

The question is then, if we had significantly greater competition in UK food retail, would food price inflation be lower?

Recently policy makers have accused companies of “greedflation” — when companies with market power use public events and disruption (such as high inflation and strikes, for example) to justify an increase in price. In the USA there has been talk of increased scrutiny of pricing behaviour and of targeted price controls.

As the data below shows — while rates of energy price inflation are declining, the rates of food price inflation continue to accelerate

It may be that if prices continue to rise then consumers will, with time, find alternative sources for their weekly shop making our demand for supermarkets more elastic and reducing their power to raise prices.

By KS & Dr I St John

Causes of inflation