New Zealand's supermarket duopoly and coordinated behaviour

The National Business Review reported yesterday (probably gated):

Consumer and food manufacturer representatives say accommodating behaviour between the two dominant supermarket groups is a “major risk”,  that it is “highly likely”,  and that growth in private label products should be thoroughly investigated.

Foodstuffs and Woolworths, meanwhile, have played down any concerns in the hundreds of pages of submissions made on the Commerce Commission’s proposed scoped of its study into the country’s retail grocery market, saying it is “intensely competitive”...

A key feature of the preliminary issues paper was the proposed investigation of whether the country’s grocery sector is vulnerable to “accommodating” or “coordinated” behaviour, which it cites as a potential outcome in oligopolies.

The commission said such conduct does not necessarily require an explicit agreement or express coordination.

“Coordinated behaviour involves firms recognising that they can reach a more profitable outcome if they act to limit their rivalry when taking each other’s actions into account (such as by following a rival’s price increases),” the paper said.

The two Foodstuffs cooperatives have more than 400 retail stores nationwide predominantly under the New World, Pak’n’Save and Four Square banners, serving more than three million customers a week...

A market with two firms is a duopoly (and when there are more than two firms, but not many, the market is an oligopoly). The thing about duopoly markets (and oligopoly markets) is that the firms can more easily act to coordinate their behaviour, in terms of pricing or 'market splitting', to lower competition. Lower competition means higher profits for the firms.

To see how this works, consider the game laid out in the table below. There are two players (firms) - Foodstuffs and Woolworths. Each player has two strategies - price high, or price low. If both firms price low, then there is a price war and both are worse off. If both firms price high, then both are better off. The outcomes and payoffs are illustrated in the table (the payoff numbers represent profits, but are just made up to illustrate this example).

To find the Nash equilibrium in this game, we use the 'best response method'. To do this, we track: for each player, for each strategy, what is the best response of the other player. Where both players are selecting a best response, they are doing the best they can, given the choice of the other player (this is the definition of Nash equilibrium). In this game, the best responses are:

1. If Woolworths chooses to price low, Foodstuffs' best response is to price low (since 50 is a better payoff than 25) [we track the best responses with ticks, and not-best-responses with crosses; Note: I'm also tracking which payoffs I am comparing with numbers corresponding to the numbers in this list];
2. If Woolworths chooses to price high, Foodstuffs' best response is to price low (since 180 is a better payoff than 80);
3. If Foodstuffs chooses to price low, Woolworths' best response is to price low (since 50 is a better payoff than 25); and
4. If Foodstuffs chooses to price high, Woolworths' best response is to price low (since 180 is a better payoff than 80).

Note that Woolworths' best response is always to choose to price low. This is their dominant strategy. Likewise, Foodstuffs' best response is always to choose to price low, which makes it their dominant strategy as well. The single Nash equilibrium occurs where both players are playing a best response (where there are two ticks), which is where both firms choose to price low.

Notice that both firms would be unambiguously better off if they chose to price high. However, both will choose to price low, which makes them both worse off. This is a prisoners' dilemma game (it's a dilemma because, when both players act in their own best interests, both are made worse off).

So, it makes sense for the firms to try and find some way to avoid the bad (low price) outcome, and come to an 'arrangement' that ensures they get the better (high price) outcome. The NBR article gives suggestions of how this might be playing out:

Consumer NZ’s submission said it believed accommodating behaviour was a “major risk” in the market, particularly regarding price.

It detailed investigations it had made comparing prices between Woolworths’ private label brands sold at Countdown here and Woolworths in Australia, and found that New Zealand consumers paid 30% more for the same basket of 20 items...

Note that this type of behaviour doesn't actually require the two firms to collude. They can coordinate their actions even if they aren't directly communicating with each other. However, the structure and payoffs of the game haven't changed, so there will always be an incentive to 'cheat' on this sort of arrangement, and throw in a low price occasionally. Interesting, even that behaviour seems that it may be baked into the 'arrangement':

Consumer NZ’s supermarket price surveys, meanwhile, found that stores appeared to have ‘turns’ offering specials on the same products – for example, a particularly brand of cheese might be on special at one supermarket one week and then be on special at another the following.

Notice that in the game above, players colluding to set a high price would get a payoff of 80 each. However, if the game was played over and over again, and the two firms alternated who would have the low price, each firm would get 180 in the low price week, and 25 in the high price week, for a total of 205 (compared with 160 for sticking with high prices all of the time).

And this brings us to the idea of a repeated game. In a repeated game, the outcome may differ from the equilibrium of the non-repeated game, because the players can learn to work together to obtain the best outcome. And this could be what is happening. If Woolworths and Foodstuffs work together to alternate their low prices, both firms benefit. Both firms have a short-term incentive to 'cheat' (by setting a low price when the other firm does), but if they were to do so the arrangement could break down and both firms would end up back at the low price Nash equilibrium.

This is one of the aspects that the Commerce Commission is investigating as part of its market study into the grocery sector. Unsurprisingly, the supermarket firms are denying that any of this is going on. Maybe it isn't, or maybe it is and they just think that everyone is naive enough to believe them.