The battle for shelf space: Lewis Road Creamery vs. Fonterra

One of my favourite discussion points in the pricing strategy topic of ECON100 has little to do with pricing at all. It is actually about making the business environment difficult for your competitors, by competing with yourself. The principle is actually very simple. If you produce a wide variety of similar substitute products and stock them on supermarket shelves, then there is less space left available for competing products (meaning those made by your competitors). By competing with yourself, you actually ensure that it is more difficult for any other firm to do so, in spite of giving the consumer the impression that there is a lot of competing brands. If you doubt this happens, I suggest going to the laundry powder aisle of the supermarket, and comparing the backs of the boxes there. I can almost guarantee that most of the apparent variety of brands will actually only be produced by two (or maybe three) suppliers.

Which brings me to the current bust-up between Lewis Road Creamery and Fonterra, first reported by Liam Damm in the New Zealand Herald on 12 December (see also here and here, where the latest news is that LRC will commence legal action against Fonterra, but presumably that has more to do with packaging and less to do with shelf space). The first of those articles has the detail:

Lewis Road Creamery founder Peter Cullinane is accusing Fonterra of negotiating a "greedy" deal with supermarkets which would limit the ability of smaller dairy brands to get space in the chiller.

In an open letter to Fonterra chief executive Theo Spierings, Cullinane questions whether Fonterra is playing fair.

He said he understood that "Fonterra is looking to use its market power to introduce an exclusionary deal with supermarkets in the North Island that would all but remove non-Fonterra brands".

The deal would give Fonterra's white milk brands 95 per cent of the chiller space, he says.

This is something we should not be surprised about at all, knowing that reducing the shelf space for competing products is a viable strategy. The supermarkets gave the following responses:

Yesterday a representative for the Countdown supermarket chain said it was not involved in any deal with Fonterra.

"Countdown does not have any deal with Fonterra of this nature, and would not enter into any agreement like this," said Countdown general manager merchandise, Chris Fisher. "We treat all of our suppliers fairly and shelf space is determined based on the merit and popularity of each product," Fisher said.

A spokesperson for Foodstuffs North Island said the company had "an agreement in place with Fonterra, as we do with other suppliers including Lewis Road Creamery, to supply a range of dairy products, the terms of our supplier agreements are confidential".

I'd be more surprised if the supermarkets weren't negotiating deals with suppliers where a single supplier provides multiple competing products, especially if they involve side-payments from the suppliers. The fewer suppliers the supermarket chains have to deal with, the simpler (and therefore less costly) their logistics will be. Everybody wins. Well, everybody but the consumer who wants fair competition that leads to a variety of products and low prices.

Ultimately though, there may be a question for the Commerce Commission as to whether these agreements over-step the mark in terms of reducing competition. It will be interesting to see how this story progresses in the new year.

The most forgotten Nobel Prize winners in economics are...

A new paper (open access) in the latest issue of the journal Applied Economics Letters by Aloys Prinz (University of Munster) caught my eye. In the paper, Prinz develops a measure of the memorability of Nobel Prize winners in economics:

In this article, fame, as measured by the number of Google hits at a certain time t, is supposed to be fading with time. The importance of a Nobel Prize laureate seems to be the higher, the more she or he is remembered years after receiving the Prize.

The paper focuses on the most memorable Nobel Prize winners (in 2012) who, unsurprisingly, are Milton Friedman, Paul Krugman, and Joseph Stiglitz. However, taking Prinz's Table 1 and re-ordering it in reverse order of memorability gives us the most forgotten Nobel Prize winners, being (in order of forgottenness) Thomas Sargent, Dale Mortensen, and Christopher Pissarides:

Sargent is surprising given that, in terms of achievement (as measured in this 2013 paper by Claes and De Ceuster; ungated version here), he is tenth overall. It is sad to see the low memorability (or high forgottenness) ranking of Elinor Ostrom, the only woman ever to win the award (again, in spite of a high achievement ranking). I imagine there's been a few more searches for Schelling and Selten in recent months, which would push them up the memorability (and down the forgottenness) rankings. Finally, it would be interesting (to me at least) to know where some of the short list for next year's award would measure up.

The behavioural economics of Lotto

Lotto (and similar lotteries in other countries) presents a problem for economists' assumption of rational behaviour. A rational, risk-averse person should never choose to play Lotto - it has a negative expected value (playing Lotto hundreds of times will lose you money, on average). This point has been made many times (see here for one example from Stats Chat - a simple search on Stats Chat will find you dozens more posts relating to Lotto).

So, if a rational person would never play Lotto, there must be some other explanation for that behaviour. So, I was happy to read this article in The Conversation by Ryan Anderson and David Mitchell (both James Cook University), which used some behavioural economics (among other reasons) to explain why people play Lotto. One reason related to availability bias:

The availability bias/heuristic relates to the idea that people judge the likelihood of something based roughly on how readily examples of it come to mind.

For example, you can probably think of news stories about when a shark has bitten a swimmer. One reason is this kind of a story is sensational, and will likely be highly reported. How often have you seen the headline: “No sharks at the beach today”?

Because you can easily bring to mind examples of shark attacks, you might be tempted to conclude shark attacks are far more common than they actually are. In fact, the chances of being attacked by a shark are somewhere in the neighbourhood of one in 12 million.

You hear and read stories about lottery winners all the time. Jackpot winners always make the news, but the battlers who have been playing for 20 years without winning are relegated to obscurity.

Based on this, it’s at least reasonable to think “jackpotting” can’t be that rare. The net effect is that winning seems possible.

Another related to the sunk cost fallacy:

In economics, a sunk cost is any previous expense that can’t be recovered – like a previous business expenditure on software, education, or advertising. Because this cost has already occurred and can’t be recovered, it should no longer be factored into future decisions. But this is seldom the case.

The sunk-cost fallacy occurs when you make a decision based on the time and resources you have already committed. Research suggests adults are more likely to fall victim to the sunk-cost fallacy than either children or lower-order animals.

In lotto, people will often persevere with what they sometimes know is economically irrational – like buying more lotto tickets – simply because they have already invested so much.

People are susceptible to the sunk cost fallacy because of loss aversion and mental accounting. Loss aversion simply means that we value losses more than we value equivalent gains - we prefer to avoid losses more than we seek to capture gains. This would seem to suggest we should avoid the losses that are inherent in Lotto. However, mental accounting (as the name implies) suggests that we keep 'mental accounts', such as an account for Lotto, and we like to keep those accounts in positive balances. Once we've played Lotto once, we will continue to play because if we stopped when we are behind, then we have to accept the loss from that mental account. As long as we keep playing, there is the chance that we win and the mental account turns positive. Note that this is also an explanation for much gambling behaviour, but also why we stay in jobs we hate, relationships we don't enjoy, investments that are not paying off, and so on. We don't want to acknowledge the loss.

Another behavioural economics explanation that Anderson and Mitchell referenced was our misunderstanding of small probabilities:

Gambling studies professor Robert Williams suggests that although humans have evolved some appreciation for numbers, we don’t really understand big numbers.

We deal with amounts like six, 24 and 120 all the time, but throughout history it’s never really been important to measure out 18 million of something, or count 50 million of something else.

Odds of one in 200 million don’t seem that different to odds of, say, one in 3 million. In both cases success is really unlikely.

Give someone a choice between odds of one in three and one in 200, however, and the difference is really obvious. It’s certainly not that people can’t grasp really big numbers, but that they don’t have much meaning until we stop and think about them.

It's actually worse than Anderson and Mitchell infer. Not only do people not understand probabilities, we have a tendency to overestimate the likelihood of very unlikely events. This is one of the cornerstones of prospect theory, the theory developed by Nobel Prize-winner Daniel Kahneman, along with Amos Tversky. So, if we overestimate small probabilities, we overestimate our chances of winning Lotto, and this makes us more likely to play (compared with if we understood the real probability of winning).

Finally, Anderson and Mitchell also made a point that I have made before, that people facing hard times have less to lose and are more willing to take a punt on Lotto. This isn't behavioural economics at work though - it is people becoming less risk averse. Either way, Lotto is more proof (if any were needed) that our behavioural biases are actively working against us making rational decisions, and the assumption of rationality is dead.

The supply-and-demand puzzle that is the Boxing Day sale

In basic supply-and-demand models, if there is an increase in demand the equilibrium price rises (ceteris paribus; which means 'all else being equal'). However, Boxing Day is the biggest shopping day of the year - so we know demand is high. Why are prices so low then? Surely they should be higher?

Helpfully, the New York Times had a good article last month about the price of turkeys in the lead-up to Thanksgiving in the U.S., which illustrates a similar point:

According to government data, frozen whole-turkey prices drop significantly every November; over the last decade, retail prices have fallen an average of 9 percent between October and November.

That trend seems to defy Econ 101. Think back to those simple supply-and-demand curves from introductory micro, and you’ll probably remember that when the demand curve shifts outward, prices should rise. That’s why Major League Baseball tickets get most expensive during the World Series — games that (theoretically, anyway) many more people want to see. Similarly, airline tickets spike around Christmas...

The most intuitive and popular explanation for a high-demand price dip is that retailers are selling “loss leaders.” Stores advertise very low prices — sometimes even lower than they paid their wholesalers — for big-ticket, attention-grabbing products in order to get people in the door, in the hope that they buy lots of other stuff. You might get your turkey for a song, but then you also buy potatoes, cranberries and pies at the same supermarket — all at regular (or higher) markups. Likewise, Target offers a big discount on select TVs on Friday, which will ideally entice shoppers to come in and buy clothes, gifts and other Christmas knickknacks on that frenzy-fueled trip.

That is the supply-side explanation of what’s going on. But plenty of economists disagree, and argue that it’s actually demand-side forces — changing consumer preferences — that drive these price drops...

Consumers might get more price-sensitive during periods of peak demand and do more comparison-shopping, so stores have to drop their prices if they want to capture sales. Perhaps, during the holidays, the composition of consumers changes; maybe only rich people or people who really love turkey buy it in July, but just about everybody — including lower-income, price sensitive shoppers — buys it in November. Or maybe everyone becomes more price-sensitive in November because they’re cooking for a lot of other people, not just their nuclear families.

Count me among the economists with a preference for demand-side explanations, especially for Boxing Day sales. The discounts are so widespread that loss-leading seems extraordinarily unlikely as an explanation. To me, the most likely explanation for the low prices on Boxing Day is that consumers have more price elastic demand then. To see why that leads to lower prices, consider the diagram below (which is the profit-maximising diagram for a firm with market power - note that this is a constant-cost firm to make the diagram a bit easier). The black demand curve (D0) is associated with the black marginal revenue curve (MR0). With this demand curve the firm profit-maximises where marginal revenue (MR0) meets marginal cost (MC), at a quantity of Q*. The profit-maximising price (the price that leads to exactly Q* being demanded) is P0. Compare that with the red demand curve (D1), which is associated with the red marginal revenue curve (MR1). The red demand curve is more price elastic (flatter). With this demand curve the firm profit-maximises where marginal revenue (MR1) meets marginal cost (MC), which is still at a quantity of Q*. The profit-maximising price (the price that leads to exactly Q* being demanded) is P1. Note that when demand is more elastic (for a product with the same cost), the profit maximising price will be lower (the mark-up over marginal cost is also lower).

Why would demand be more elastic on Boxing Day? Consider the factors associated with higher (more elastic) price elasticity of demand. Are there more, or closer, substitute goods available? Arguable. Do consumers have longer time horizons? Perhaps (especially if you compare with shopping the day before Christmas). Is there a higher significance of price in the total cost to the consumer? Doesn't seem to fit. That leaves as a possibility that there is a higher proportion of income spent on the good. [*] If consumers spent a large proportion of their income on gifts and food for Christmas, that leaves a much smaller budget constraint for shopping on Boxing Day, which should lead to more elastic demand. That is, consumers with less money left over for shopping on Boxing Day will be more price sensitive, and retailers respond by lowering their prices to attract those price-sensitive shoppers. [**]

Finally, the NYT article had an interesting comparison between frozen turkeys on Thanksgiving (high demand and low price) and roses on Valentine's Day (high demand and high price), which is worth sharing:

There are a few possible reasons why market forces are different for roses and frozen turkeys on their respective holidays. For one, the loss-leader strategy really only works if you’re a multiproduct retailer, says Chevalier. Florists sell only flowers; they’re not willing to take a loss on the one thing they sell in the hope that you’ll buy a bunch of other stuff, since you’re not likely to buy anything else.

More important, roses — like airline seats or World Series tickets — are what economists refer to as “supply inelastic.” It’s costly to ramp up rose production in time for peak demand, since the roses must all be picked (and for the most part, flown in from Colombia and Ecuador) in the single week preceding Valentine’s Day.

Which is also why you see the biggest discounts on Boxing Day are on items that the retailer can easily hold back for the day, like electronics. Which I admit I took full advantage of!

*****

[*] Alert readers and economics students will notice that I have ignored two other factors that are associated with more elastic demand: (1) narrower definition of the market; and (2) normal goods (compared with inferior goods). Both of these factors compare different goods, so don't make sense when comparing elasticity for the same good on Boxing Day and not-on-Boxing-Day.

[**] Another alternative is that the composition of shoppers is different on Boxing Day from other days, with more low-income (and hence, price-sensitive) shoppers shopping on that day. Unless I see some evidence of this, I'm going to discount it as an explanation.