Supermarkets are not natural monopolies, and should NOT be regulated as public utilities

In The Conversation last week, Robert Hamlin (University of Otago) wrote:

The Commerce Commission’s report into New Zealand’s supermarket sector has been criticised for not going far enough to reduce food prices, but the answer to the current duopoly might lie in treating the sector as a public utility instead of a private industry...

This fairer supermarket sector could be achieved if the industry power players were governed as regulated public utilities, much like power and water. But such an approach would need to be legislated and has to combine simplicity with easy and effective enforcement.

To do this, the government should implement some key regulatory principles.

New regulations would need to ensure supermarkets do not engage in wholesale or manufacturing activity. The key to supermarket power is their control of the retail point of sale. If supermarkets are to be regulated as public utilities, then it is essential they are restricted solely to this activity.

The problem with Hamlin's argument is that he equates supermarkets with other utilities like power and water. However, supermarkets and public utilities like power and water differ in two fundamental ways. First, power and water are natural monopolies. They have large up-front costs, and then the marginal costs of production and distribution are fairly low. Natural monopolies are a tricky problem for governments, because as I noted in this earlier post, if the government regulates them such that total welfare is maximised, the natural monopolies make a loss and reduce investment and service quality, and may even shut down entirely. The second-best solution here is to regulate the natural monopoly, but not to such an extent that it makes economic losses. That is essentially what Hamlin is arguing for, when he writes:

As public utilities, individual supermarket sites should only be allowed to charge a single fixed and publicly stated margin on the goods they sell. This is a novel requirement, but it is core to the process of regulating a supermarket as a utility.

Supermarkets act as a middleman between consumers and producers. The mutual ignorance of what is happening on the other side of the retail barrier allows the supermarkets to manipulate consumers and suppliers at will. It is the key process that converts supermarket power to profit.

The requirement that supermarkets must apply a single, publicly posted margin to all the products in their store sets this capacity to zero, and promptly makes the retailer a fully transparent channel for suppliers and consumers.

This 'publicly-posted margin' is essentially what economists refer to as 'cost-plus' regulation. As Eric Crampton noted earlier this week, that solution is totally impractical, because of the second difference between public utilities and supermarkets: supermarkets sell many products. Public utilities typically sell one product, e.g. water, or electricity. That makes it relatively straightforward to impose a 'cost-plus' pricing regulation, since there is only one product to calculate this cost-plus margin for. working out the costs is not straightforward because of the mixed of fixed and variable costs, depreciation and other things. But that process is even more difficult when a firm sells many products. As Crampton wrote:

 A big part of the fight at ComCom was around calculating rates of return. How capital costs get treated matters. How land costs under the supermarkets are counted matters. There are piles of complex lease agreements around those that need to be worked through, and would themselves be endogenous to whatever stupid rule you set to regulate rates of return. 

It isn't straightforward. 

And then this guy wants to run it product-by-product as some kind of mark-up regulation with a fixed mark-up on each good? How's that going to work? Different goods have different turnover. A foot of shelf-space that turns over three times a day pays for itself differently than a foot of shelf-space that turns over once every three days. 

The policing of this kind of thing would be impossible. If you force a single markup on all products based on the price at which the retailer bought it, you force slow-moving goods off the shelves. If you allow some measure of the cost of shelf-space to enter in, you're going to be chasing your tail forever in policing it. It's just so impossibly stupid.

However, it's not just heterogeneity of products that make this proposal unworkable. It's the heterogeneity of supermarkets as well. Public utilities are easy to regulate, because there is few of them (they are natural monopolies, after all). But supermarkets are actually quite diverse. There is about a hundred-fold difference in turnover between a corner dairy and a large urban supermarket. Even within the supermarket category (i.e. excluding dairies), I wouldn't be surprised if there was a fifty-fold difference in turnover between supermarkets in small urban areas like Te Kauwhata and large cities like Hamilton. Should the government impose the same cost-plus regulation on all supermarkets, regardless of size? This could easily make small supermarkets unviable, leaving consumers with less choice and ultimately worse off.

Then, there are the incentive effects. When firms have to worry about their profits and margins, then they have an incentive to keep costs low as it keeps their profits high. However, if a firm has a cost-plus regulation in place, then they can earn the regulated margin regardless of their costs. There is less incentive for keeping costs low. This proposal could easily have the unintended consequence of higher prices for consumers in the long run, more waste and less efficiency in the supermarket sector.

Finally, the supermarket firms are not just retailers, but wholesalers. By itself, this proposal on retail prices would need to be carefully designed. Otherwise, the supermarkets will simply route around it by separating out their wholesale operations into a different business, which sets the wholesale prices, upon which the retail prices (cost-plus wholesale) will be based. Then the supermarket profits will simply back up one step as wholesale, rather than retail, profits. [*] This might be one way that the supermarkets will respond to the Commerce Commission's recommendation that the supermarkets be required to offer wholesale supply to other grocery retailers (see here) anyway.

All in all, regulating supermarkets as public utilities is thoroughly impractical, and possibly counter-productive. The Commerce Commission has made its recommendations. In general, they seem a sensible way of opening the retail grocery market (if not the wholesale market) to more competition. We should see whether those changes work before we open the door to crazy ideas.

*****

[*] This would work for Countdown, which owns all the retail stores, but possibly not so well for Foodstuffs, where the stores are owner-operated. However, I'm sure Foodstuffs could find some way to make a flavour of this work.