Exclusive dealing in the European motor trade

    EU law bans any agreement between firms intended to prevent or distort competition.But ‘selective and exclusive dealerships’ the arrangements which govern all new car sales, are exempt under what is known as Rule 123_85. A typical European new car dealer offers models of only one make, or a few select makes. The customer cannot cross the street and buy the same car more cheaply because, by agreement, the next dealer will probably be located several miles away. The rule also applies to spare parts. Manufacturers can refuse to sell to wholesalers or can ‘advise’ their equipment producers against reaching agreements with them unless certain terms are agreed.

    SEDs are examples of what economists call vertical restraints. Vertical restraints

involve agreements between producers of complementary goods. They are distinguished from horizontal restraints which relate to agreements between producers of the same good or close substitutes. Thus if a car manufacturer places a limit on what retailers sell and how they sell the product, that is a vertical restraint. Agreements between car manufacturers themselves as regards price or market share is a horizontal restraint. Generally, vertical restraints are considered innocuous for competition. By contrast, there is a presumption that horizontal restraints are

harmful to competition.

    An SED typically specifies what retailers sell and how they sell it. Under ‘selective

dealership’, a producer uses only those retailers who agree to support its brand in specified ways – perhaps by giving information to potential customers or providing aftersales service to those who buy. ‘Exclusive dealerships’, as the name suggests, commit retailers to selling one brand. They often go hand-in-hand with ‘full-line forcing’, under which retailers stock a manufacturer’s whole range, not just one or two products.

    Other vertical restraints include ‘exclusive territories’, which limit a retailer’s sales to a particular area  and ‘franchise fees’, which are sometimes paid to manufacturers for the right to sell their wares or to put their logos above the shop door .Producers may also try to fix retail prices, either by controlling discounts or by demanding that retailers sell minimum quantities of their products.

    At first sight, these devices look like a conspiracy against consumers. But sometimes they can benefit the consumer, because contracts with vertical restraints are often the most efficient way for producers to get their products to the customer and to ensure good after-sales service.

    A manufacturing firm can sell through an independent retailer or by setting up its

own retail network. Independent retailers have stronger incentives than employees to

maximise retail profits and they may know more about local markets.

    However, retailers may set prices higher than producers would like.Suppose producers sold their goods to retailers at a uniform wholesale price. If retailers

have some monopoly power in their local markets, they can set retail prices above

wholesale prices .But manufacturers would like prices to be lower: that would expand retail sales, reduce unit costs, and boost the manufacturer’s sales and profits. One of several ways around this is to set up a SED, i.e. insist that retailers pay a franchise fee for the right to sell the product and, in return, cut wholesale prices.

Payment of a franchise fee does not affect the dealer’s profit-maximising level of sales. But a lower wholesale price does, and gives an incentive to the dealer to cut the retail price and raise sales volume.

    Complaints against vertical restraints might still be valid in that consumers’ range of choice is being restricted. However, if there are many competing producers, retailers, even with exclusive territories, do not have much market power. While they face no competition from others selling the same brand, other local retailers are selling competing brands, curbing their ability to exploit consumers.

    Hence the rationale for exempting SEDs under the competition regime. This exemption has been extended to 2004. Current economic thinking stresses the importance of market structure. The more competition between brands, the more likely that pro-competitive and efficiency effects of vertical restraints will outweigh any anticompetitive effects.

Competition policy

General principles

    Competition law is one of the most important points of interaction between business,law and economics. Firms need to understand the rationale and practice of competition legislation and rules. Competition law is also important because it

impinges so closely on the welfare of the consumer and the dynamism of the

business sector. Badly framed competition policy will bring relatively few benefits

to the consumer at a high cost to business. These costs include not only the costs

of taking or defending a competition case, but the costs arising when a firm is

uncertain about the applicability of the law to its behaviour.

    While individual countries have their own distinctive competition regimes,

four general principles underlie competition policy:

1. Highly concentrated market structures are more likely to be monopolistic than

less concentrated structures. Competition policy tends to focus on the former.

2. Competition law is applied to a wide range of markets, i.e. to public sector

commercial services and non-profit organisations, as well as to the private

sector.

3. The benefits of competition include direct benefits to the consumer. But its

indirect effects on upstream and downstream markets have also to be taken

into account. An inefficient telecoms industry, for example, affects both the

individual telephone user and also the pattern of comparative advantage,

through raising communication costs.

4. Case-by-case studies are necessary to quantify the net economic benefits and

costs of a monopoly.

5. Care needs to be taken in devising remedies which can include sanctions,

declarations, structural and behavioural actions.

Competition policy – the example of the European Union

    The EU’s competition regime provides a practical illustration of the general

principles of competition policy.

    The principles of the EU’s competition policy are contained in Articles 85 to 94

of the Treaty of Rome. Since the Treaty of Amsterdam came into effect in 1999,

these have been renumbered Articles 81 to 90. To avoid confusion, we use the

post-1999 numbering in this chapter. These articles cover both uncompetitive

behaviour between firms and state aids that affect trade between Member States.

The objective of keeping the EU market open and free from distortion is

addressed by two key articles, Articles 81 and 82 .

    Article 81 prohibits restrictive agreements relating to price, market shares or production controls, unless specifically exempted or licensed. Exemptions can be given by the Commission if the restrictive agreements can be shown to improve efficiency,allow consumers a ‘fair’ share of the resulting benefits, and preserve

some degree of competition. The exemption clause has been frequently and successfully invoked._8 For example, selective and exclusive dealerships for new car sales are permitted by virtue of this clause .

  

    Article 82 addresses the problem of abuse of dominant position. It outlaws unfair

trading practices, unjustified tie-in clauses and similar arrangements. Concepts

such as ‘dominant position’ and ‘market abuse’ have been subjected to different

interpretations. Some indication of the complexity of the issues is given in the

summary of the judgment in the Woodpulp case .

    These articles apply in principle to vertical as well as horizontal agreements

between firms. Vertical restraints are contracts between firms at different

stages of the production chain that specify more detailed commitments on the

parties than simply to exchange a given quantity of goods or services at a given

price per unit. Examples include selective and exclusive dealerships

discussed in Box 7.4, retail price maintenance, service requirements, e.g. undertakings to spend on advertising and after-sales service, and two-part pricing involving a fixed charge and a fixed price per unit. VRs essentially involve

agreements between producers of complementary goods. They are distinguished

from horizontal restraints .HRs relate to agreements between producers at the

same stage of the production chain.

    Competition law tends to take a permissive view of VRs. The reason for this is

that abuse of market power by one producer  damages the producer of the complement .Thus any limit to sales by the manufacturer to exploit monopoly power reduces sales and profits of the dealer, and vice versa in case of use of monopoly power by the dealers. Hence both parties are driven by self-interest to an efficient outcome, very much in the spirit of Adam  Smith, and no intervention by the Competition Authority is needed. In judging VRs, the EU takes a permissive view provided efficiency is in fact achieved. It adds two other criteria: equity – protection of small enterprises; and promotion of market integration – hence any measure preventing ‘parallel’ imports is unfavourably regarded. The more inter-brand competition in the market, the less the danger of a VR being in breach of competition law.

Competition policy,privatisation and regulation

    When competition prevails, firms have limited discretion over price. Profit maximization leads them to equate marginal cost to marginal revenue and, because

price is more or less ‘given’ in a competitive market, price equals marginal revenue.

Also, competition forces firms to minimise costs and to search relentlessly for new

and better ways of doing things. Competition encourages innovation. For these

reasons, maintaining a market structure that is open to competition is of the

utmost importance to an efficient economy.

    Our first task in this chapter is to assess the case for competition and to define

the characteristics of a market that encourages competition.

    Our second task is to analyse competition policy. Competition policy refers to

the rules governing the conduct of firms in a market. Without well-developed

and effective competition rules, the market system will not function properly. Yet

a competition regime has to balance the need for active competition on the

domestic market with the equally pressing need to allow firms to attain a

minimum efficient scale and be able to match international competition. On

occasion, it may make sense to tolerate, even encourage, high concentration

ratios in the domestic market. The extension of competition policy to deal with

state aids to industry, and particularly support for state-owned enterprises, is also

examined. We illustrate these issues with examples from the competition policy

of the EU.

    Third, the move to privatisation is analysed. Starting in the 1980s in the UK and

New Zealand, privatisation programmes have been implemented throughout the

world economy. ‘New consensus’ thinking goes far to explaining the rapid spread

of these privatisation programmes. They have been motivated by the desire to

introduce competition where it was absent as well as assisting governments to

improve their financial situation.

    The degree of popular enthusiasm for competition has waxed and waned.

Proponents of competitive market structures are now in the ascendant. In order

to understand why, we must understand the origin of this pro-competitive viewpoint.

It is not necessarily pro-business, though it has coincided with a strongly

pro-business trend in other areas of economic policy. Most businesses feel under

 threat from competition. They are more likely to believe that their problems

derive from excess competition rather than an insufficiency of competition. They

argue for space and time to adjust to the pace of technological advance and to

build up competitive advantage. Getting the balance right between sectoral

strength and optimal competitive pressure is vitally important for economic

performance.

The case for competition

    Competition policy is based on a belief in the economic benefits of competition.

The starting assumption is that market forces are the most effective means of

ensuring efficiency in the allocation of resources, of adapting to change and,

ultimately, of maximising consumer welfare. A much-quoted passage from the

European Commission’s first report on competition policy reflects this basic philosophy:

  

    Competition is the best stimulant of economic activity since it guarantees the widest possible freedom of action to all. An active competition policy ... makes it easier for the demand and supply structures continually to adjust to technological development.Through the interplay of decentralised decision-making machinery, competition enables enterprises continually to improve their efficiency, which is the sine qua non for a steady improvement in living standards and employment prospects within the countries of the Community. From this point of view, competition policy is an essential means for satisfying to a great extent the individual and collective needs of our society.

    Competition has several major advantages over monopoly .First,it provides static benefits through elimination of deadweight losses illustrated in Figure 6.2. This figure shows how competition can lead to more output at a lower price – and it accords with the practical experience of falling prices and higher sales volumes that followed the introduction of competition to formerly monopolized industries ranging from air transport to telecoms. Estimates of the importance of this static effect vary widely, but some have reached as high as 1 per cent of GDP._2 Second, competition brings dynamic benefits:

- It makes organisations internally more efficient by sharpening incentives to

avoid slackness.

-It allows the more efficient organisations to prosper at the expense of the

inefficient .

- It improves dynamic efficiency by stimulating innovation.

The above arguments emphasise efficiency. Equity is another important consideration in competition policy. Governments enforce competition policy in order

to protect weaker companies against the abuse by monopolies of their dominant

market position. Support for the free market presupposes ‘fair’ trading rules and a

level playing field. Defining ‘fairness’ is not, of course, always easy. Moreover,

the dictates of fairness, efficiency and competition sometimes pull in different

directions. Efficiency may require a more concentrated industrial structure than a

government concerned with equity might want to tolerate. Somehow, consistent

rules must be formulated which encourage competition and allow business a

reasonable degree of certainty, but have enough flexibility to deal with cases

where market power may be necessary on technical grounds.

How the system operates – control production, dominate the trade, influence demand

    The Central Selling Organisation ,based in Switzerland and London, is the

collective name of companies controlled by De Beers and its associates. It buys

rough diamonds from the mines, valuing them and selling them to sightholders.

CSO sales peaked at $6.7 billion in 1997. By keeping rough prices at the highest

sustainable level, the cartel aims to achieve long-run profit maximisation over

the demand cycle rather than short-run market clearing at spot prices. The key

characteristics of the cartel are:

1. The system of producer quotas. Most significant producers have a long-term and

exclusive contract to supply a certain proportion of De Beers’ annual diamond

sales.

2. The cartel has created a strong antidote to any individual producer’s incentive to

cheat. De Beers backs up the carrot of higher prices with a powerful stick – its

ability to release from its stocks a supply of any type of diamond. Every

diamond mine has its own characteristic output. If De Beers chooses to release

more stones of this characteristic from its stockpile, the stockpile-supported

price can drop dramatically.

3. De Beers acts as a swing producer. In a buoyant market, De Beers benefits from

both higher prices and stock appreciation as goods are sold from the bufferstock.

But in a depressed market, it absorbs excess supply and reduces its own

production. It can play this role credibly since its mines are among the cheapest

sources of fine diamonds in the world and because of the company’s financial

strength. De Beers holds stocks worth US$4 billion .

4. The cartel pays careful attention to demand management. It spends over $150

million a year on advertising. Rather than ride out cyclical fluctuations

the company wants to drive incremental demand through targeted marketing

campaigns.

Threats to the system

    Any interference with the market system runs the danger of encouraging unintended countervailing and competing reactions. An official price ceiling gives an

incentive to sell diamonds outside the system while minimum prices

encourage over-supply. The diamond cartel is not exempt from these tendencies

and its operations are under periodic threat.

1. Advertising can influence demand, but its effects can easily be overwhelmed by

business cycles and by the ebb and flow of fashion. If De Beers expects a glut of

a certain type of diamond, it will stop putting it in boxes, but months can pass

before the effect of the move is felt in the market for polished stones.

2. De Beers’ sway over customers for rough diamonds is not matched by its influence on customers for polished diamonds – jewellers and their suppliers. This

makes it difficult for De Beers to control prices to the end-buyer.

3. New entrants add uncertainty to the diamond market. The new Ekati diamond

mine in Canada accounts for 6 per cent of world supply. Political instability in

Africa and Russia can also create problems by magnifying the incentive to

cheat and favouring short-term over long-term perspectives of national interest.

This explains why De Beers has embarked on a marketing campaign to

create a De Beers brand rather than to promote diamonds in general.

4. De Beers’ main concern is the confidence of its members. If they sense that the

cartel lacks the strength needed to fulfil its role as swing producer, cartel

members will be tempted to sell their diamonds before others do the same. The

main cement to this cartel, as to others, is the conviction that centralised

selling and buffer-stock management are in its collective interest.

The diamond cartel

‘A diamond is forever’ boasts the glamorous advertisement of De Beers. But diamonds are valued mainly because they are considered a sound investment, relatively immune from the vagaries of economic ups and downs. Diamonds are cheap to produce and would be lower in price but for the global cartel operated by De Beers.The cartel has protected its market monopoly by flattening out short-term fluctuations in supply, and to some extent demand, with the aid of a huge buffer-stock.

    The diamond cartel was set up by Sir Ernest Oppenheimer, a South African

mining magnate, in 1934. The cartel is the vehicle through which over 80 per

cent of world rough sales are marketed and administered.

    Unlike other commodity cartels, the diamond cartel both controls supply and influences demand, combining the roles of major distributor, marketing agency and buffer-stock manager. It has developed an expertise in matching supply to demand and the financial strength to hold diamonds temporarily off the market.

Structure of the diamond market

    Diamond mines are relatively few in number, are easily identified and cannot be

increased at will. The major producers are South Africa, Botswana, Namibia, the

former Soviet Union and Australia. Owing to the wide variation in diamond

quality, a country’s volume of output is not an accurate indicator of the value of

its production. For example, Australia is the world’s largest producer of diamonds

in volume terms but, because of the low average price of its output, it ranks much

lower in terms of value.

    The industry’s major producer is the De Beers corporation, which has direct

and indirect interests in mines throughout the world, as well as in South Africa. tradeable substitutes. At the micro-level, the diamond market is not a single

market, but embraces many sub-markets with different prices and distinctive

supply and demand characteristics. Price differentials exist for different product

grades in most commodity markets. The lack of homogeneity in diamonds is such

that there is no single price which acts as a reliable benchmark for the market as

a whole. The market is highly segmented and prices range from $1 to tens of

thousands of dollars. This has important implications for their marketing by the

cartel.

    Good stones are relatively scarce – around 10 per cent of the market by volume

accounts for 50 per cent of the market by value.

    Industrial diamonds refer to stones that are too small or flawed and too opaque

and imperfect to be saleable as polished stones. Historically, industrial diamonds

have formed about 80 per cent by volume and 20 per cent by value of all diamonds

found. This segment of the market is also served by synthetic diamonds.

Natural industrial diamonds nowadays probably account for less than half of all

diamonds sold by volume and for less than 5 per cent by value. De Beers and

General Electric dominate the world market for industrial diamonds.

    De Beers sorts diamonds into boxes and sells them to sightholders who represent

the main cutters. These cutters and polishers of diamonds are spread around

three main centres: Antwerp, Tel Aviv and Bombay. They sell the polished stones

to polished diamond buyers who in turn supply the retail trade. China is a recent

newcomer in this part of the business and could also be an important new source

of demand.

Market power with few firms – the case of oligopoly

    The case of monopoly, in which just one seller dominates the entire market, is

useful for illustrative purposes. However, in reality single-seller monopolies are

the exception. More common is the case of markets dominated by a few large

firms. Economists call this oligopoly. Oligopoly and monopoly are close cousins

from an economic viewpoint. For example, a firm needs to supply only one

quarter of the total market in order to be characterised by the UK’s Office of Fair

Trading as possessing a ‘monopoly position’.

    Oligopolies come in many guises. There are different ways in which market

power can be exercised when interdependence between the small number of

firms prevails in the market. Firms might try to form a cartel, whereby price,

market share and investment decisions are made collectively, with the objective

of maximising profits. At the international level, the best-known cartels include

OPEC and the De Beers diamond ‘monopoly’. Within the EU, cartels have been found in a diverse range of industries: cases involving dyestuffs, quinine, vitamins and cement have come to attention in recent years.

    Suppose there are two producers, firm 1 and firm 2. They form a cartel in order

to avoid competing away their profits. Total profits are maximised when MR # MC for the industry as a whole. This is the level of profits the profit-maximising cartel will seek to earn. To determine the marginal cost curve for the industry, each firm’s MC curve is laterally summated by finding out how much output can be produced in each firm at each MC level. The MR curve is derived from the industry demand curve, estimated by the techniques described  in Chapter 4. The profit-maximising output for the two-firm cartel in Figure 6.5 is OQ and price OP. Total industry profits are represented by the area PRSF.

    The cartel then has the task of determining production quotas for each firm.

This is not an easy task. One possibility would be to order each firm to sell at OP and to allocate a quota of OQ_1 to firm 1 and OQ_2 to firm 2. Because of firm 1’s lower cost structure, however, it earns more profits than firm 2. Some haggling might take place as to the share-out. Each participant has a selfish interest in the other participant being reasonably satisfied with the outcome, but the unbalanced nature of the distribution in Figure 6.5 may lead to tension. If this imbalance is not corrected, firm 2 will be tempted to ‘cheat’, i.e. to sell a few extra units at OP, in order to obtain a larger share of the cartel’s profits. This will be a profitable exercise for firm 2 if undetected, since MC is well below OP at its assigned production level OQ_2. Of course, if everyone cheats, the cartel’s effectiveness is undermined. Hence a mechanism for detecting and limiting cheating is an essential requirement for a cartel. Many cartels have self-destructed because of their inability to implement such a mechanism.

    In some instances, rather than form a cartel, oligopolists may decide to allow a

dominant firm to assume a leadership role. If the leader raises price, the others

follow, and vice versa in the event of a fall in price. The price leader then decides

on the price that maximises its profits, on the assumption that all other producers

will sell as much as they find profitable at the price chosen by the leader. The

net result is a higher price and more profits for all in the industry. It is not as

advantageous for the producers as a cartel, but it is less transparent and, therefore,

less likely to encounter legal problems. Too blatant price leadership behaviour

can, of course, attract attention. In the US, the Department of Justice has taken

exception to ‘conscious parallelism’ of price decisions, even in the absence of

overt collusion – and hence can object to the leader advertising price changes._15

A well-publicised example of price leadership is the case of ICI and British Salt.

The two firms accounted for a 45 per cent and 50 per cent share, respectively, of

the UK market. In its 1986 Report on the UK Salt Market, the Monopolies and

Mergers Commission criticised British Salt for having chosen to ‘follow’ the price

increase of ICI. The Commission recommended that the price of salt should be

controlled through the use of an index, based on the costs of the more efficient

producer, British Salt.

How to sustain monopoly power

    Monopoly power can be achieved in a number of ways:

- Economies of scale, if sustained over a sufficiently large range of output, give big

firms a cost advantage over smaller competitors. Eventually, this could result in

just one firm serving the market (single-firm monopoly). More usual is the

situation where a few firms dominate the industry.

- Government policies such as provision of a patent, nationalisation or regulation,

create monopoly situations. For example, until recent times, private buses were

prevented from competing with the state-owned bus monopoly in many

European cities.

- Ownership of know-how can confer market power even in the absence of specific

legislation and economies of scale. This know-how could embody organisational,

marketing or financial procedures, as well as technological leadership.

- Ownership of natural resources – such as oil, diamonds, uranium, etc., where the

number of producers is limited by physical constraints.

    Monopoly profits act as a beacon to potential entrants to the industry. If they

succeed in gaining entry to the industry, monopoly profits will be competed

away. Strategic management textbooks advise firms on how to protect and insulate

themselves from potential entrants. Hence a paradox of the market system:

profit maximisation drives firms to seek to acquire monopoly power; at the same time

this self-same drive for profits attracts new entrants and makes monopoly power hard to sustain.

    The way in which market power can be sustained, once it has been acquired,

needs careful attention. Many firms fail to sustain market power. In Britain, GKN,

Courtaulds and British Leyland, and in Germany, AEG and Mannesman, are examples of once great companies which survive in much diminished shape or have

fallen by the wayside. Sustaining market power involves three primary elements:

- Architecture. The network of relational contracts written by or around the firm.

Companies such as IBM and Marks & Spencer exemplify strong architecture in

that they have established a structure, a style, a set of routines, which motivate

employees and suppliers. These routines resulted in exceptional corporate results

over many years and through many changes in the economic environment.

- Reputation. Relevant in markets where quality is important, but verifiable only

through long-term experience. Examples include car hire, accountancy services

and international hotel chains. In these markets, reputations are costly and difficult

to create but, once established, can generate substantial market power.

Reputation is bolstered by advertising and development of brand names.

- Innovation. Development of product differentiation and patents, as already

noted, are a source of market power, but many types of innovation are not protected

by patent. The key issue is how to protect a specific innovation in a

world where innovations – from software to personal stereos to cream liqueurs

 - are difficult and expensive to protect through legal measures. The most powerful

means of protection usually is to combine innovation with architecture

and reputation, much as, say, Microsoft combines its constant innovation with

sedulously created marketing and distribution.

    Architecture, reputation and innovation together give a firm what Professor John

Kay has termed distinctive capability, which in the long term sustains its monopoly

power.

  Market power can also be preserved by strategic entry-deterrent measures such as

1. setting price deliberately below the profit-maximising level in order to reduce

the attractiveness of the industry to outsiders, 2. concealing profit

figures for monopolised parts of its business – a common practice in the case of

subsidiary operations of large companies, 3.below-cost selling, predatory pricing

and dumping, and 4. deliberate over-investment in capacity and extension of

product range.

    To sum up, what matters in terms of exercising market power is the firm’s

ability to earn above-average profits while keeping potential new entrants out of

the industry. If entry is not too costly and cannot be deterred, even a 100 per cent

market share may leave the incumbent firm with little market power. A high firm

concentration ratio will signal market power only if it is accompanied by a low

degree of contestability.

Multi-product and multi-plant monopolists

    Occasionally, some parts of a monopolist’s product range are sold under highly

competitive conditions, while other items are sold under monopoly conditions.

In that event, the MR # MC rule continues to apply, with allowance being made

for the different demand conditions in each market.

    Take, for example, the pricing policy of a large supermarket. Part of its sales

consist of products whose price is well known, such as milk, bread and hamburgers.

These are called known-value items .Also on the supermarket’s shelves

are many goods whose price is not familiar to the average customer .

Once inside the store, the customer is likely to purchase both types of good. In a

one-stop shop, KVIs and non-KVIs are complements. The supermarket can be

viewed as being able to exercise a certain degree of monopoly power

over its customers, once they are inside the store. In such circumstances,

it can be shown that the supermarket’s profit-maximising strategy might lead it

to charge below-cost prices for the KVIs in order to attract customers and recoup

these losses through sales of non-KVIs at monopoly prices

    A loss-leader price strategy can, therefore, be compatible with profit maximisation.

In this instance, the important point is to ensure that the MR of KVIs is

properly defined so as to include the revenue obtained from additional sales of

non-KVIs to customers attracted to the supermarket as a result of the loss leaders.

    A multi-plant monopolist, by contrast, faces a single MR, but a different MC

schedule in each plant. The profit-maximising rule ordains that the cost of

producing the last unit in each plant should be the same for all plants and equal

to the common MR: where n is the number of plants. Suppose this rule were breached. MR was £10;MC_1 was £8 and MC_2 was £12 in plants 1 and 2. By transferring production from plant 2 to plant 1, profits could be increased. Such allocation will continue until the  MCs are equalised. This rule can have important practical application when allocating quotas between different participants in a cartel the MCs are equalised. This rule can have important practical application when allocating quotas between different participants in a cartel

When competition induces pricing below cost

    Loss-leading is a pricing strategy which is widely used in multi-product retailing. It

involves the sale of a subset of ‘traffic building’ items at below-cost prices. This appears to contradict the rule of profit maximisation. Another interpretation is that it is an outcome of anti-competitive behaviour, i.e. large firms price below cost in order to

drive the weak out of business. However, closer analysis shows that it is perfectly consistent both with profit maximisation and with competition in the market. The critical issue in selecting the optimal price of a retail product is the correct definition of marginal revenue. In multi-product retailing the marginal revenue of any one product must incorporate the spillover effects arising from the pricing of other products in the store. These effects include the mark-up earned on goods purchased by customers attracted to the store by loss leaders.

    Loss-leading is an inherent feature of supermarket retailing. The distinguishing

feature of the retail market is the vast range of product categories and different brands offered to the consumer. The average American supermarket of 40,000 square feet typically carries between 20,000 and 30,000 different products.

Consumers will only have prior knowledge of prices in a subset of known-value items that are characterised by frequently purchased standardised staple products such as bread and milk. The prices of all other products,non-KVIs, will be unknown to the customer prior to entering the store.

    Consumers are rational and enter stores that are deemed to offer lower retail prices. Given the costs and disutility associated with acquiring price information, customers’ entry decision will be based upon their perceiveed value for money from shopping in a particular store, as indicated by KVI prices. Retailers will therefore compete for market share on the basis of KVI prices. The information costs that are associated with finding out the relative price of non-KVIs in different stores generate switching costs for consumers.Once consumers have entered the store, therefore, switching costs result in spatial market power that allows the retailer to extract price_–_cost mark-ups on non-KVIs.

    Thus retailers sell certain ‘traffic building’ KVI items below cost in an endeavour to

attract consumers into the store, and to charge higher prices on other goods.