Final Report Summary - RETAIL (Retailer Market Power and Competition Policy) Executive Summary The research project started in June 2010 and ends in May 2012, and has been conducted by the researcher, Dr. Zhijun Chen, and the scientific supervisor, Professor Patrick Rey. In these two years, we have focused on two topics following the research outlines. The first topic, “retailer market power and loss leading”, is concerned about the abuse of market power by large retailers, through the loss leading pricing strategy, which harms small rivals as well as consumers. The research outcome is formalized in the research paper, “Loss Leading as an Exploitative Practice”, which has been accepted for publication in the American Economic Review, the flagship journal in Economics. The second topic, “cross-subsidization in competitive markets”, studies the pricing strategy of cross-subsidization by multi-product firms in competitive markets such as grocery retailing, and its research outcome is formalized in the working paper, “Competitive Cross-Subsidization”. We will submit this paper in later this year to some top economic journal such as the Review of Economic Studies. In overall, we think the project has been implemented quite well and the research outcomes are excellent. The host institute provides high quality infrastructure and excellent research environment, and the researcher works hard with the supervisor to make the excellent achievements. The researcher’s capacity has been largely enhanced through this two-year joint research project and thus the project brings a profound impact on the researcher’s academic career. Summary of the Project Context and Main Results Large retailers, supplying a broad variety of products, often engage in cross-subsidization, i.e. pricing some products below costs while subsidizing the loss by the profits from other products. Such cross subsidy strategy is well-known as loss leading in grocery retailing. For instance, in its recent report of the investigation on grocery markets, the UK Competition Commission (2008) notes that most large retailers in the UK engage in loss leading, and it finds that the sales of loss leader products represent up to 6% of a retailer's total sales. Cross-subsidization involves below-cost pricing and is thus subject to antitrust scrutiny. However, antitrust enforcement against cross subsidization in retail markets causes hot debates. In the UK, for example, in its first sector inquiry the Competition Commission, noting that "nearly all the main parties sold a small number of products at prices below the cost of purchase", expressed the concern that loss leading "may have a predatory impact on small and specialist retailers" and limit the growth of particular retailers such as hard discounters; yet in its second inquiry it dismissed the concern and argued instead that loss leading "may represent effective competition between retailers and may benefit consumers by reducing the average price for a basket of products". In Germany, the highest court upheld in 2002 a decision of the Federal Cartel Office enjoining WalMart to stop selling basic food items (such as milk and sugar) below its purchase cost, confirming that a firm "with superior market power in relation to small and medium-sized competitors" should not price below cost. By contrast, OECD (2007) argues that rules against loss leading are likely to protect inefficient competitors and harm consumers. A similar discrepancy appears in below-cost resale statutes.Cross-subsidization has been often treated as predatory pricing in antitrust cases, in the absence of specific regulations. However, the persistence of below-cost sales over time does not fit well with a scenario in which the predator would recoup the losses incurred during the predation phase by raising the prices afterwards, once rivals have been pushed out of the market. In the economic literature, cross-subsidization such as loss leading has been viewed as an advertising strategy adopted to attract consumers who are imperfectly informed of prices; however, this may be less relevant for routine grocery shopping, where consumers seem to be reasonably aware of prices.This begs the several related questions: what is the rationale for cross-subsidization in retail markets if it is not predatory? What's the impact on consumer surplus and social welfare if below-cost selling is banned by competition laws? This research project aims at filling the gap between theory and practice. We develop a new framework for the analysis of pricing behavior for multi-product firms. Our key modeling feature is to account for the heterogeneity in consumers' shopping costs incurred for sourcing a supplier: some consumers face higher shopping costs, e.g. because of tighter time constraints for visiting a store or adopting a new technology, and thus have a strong preference for one-stop shopping, whereas others have lower shopping costs and can therefore benefit from multi-stop shopping. Equipped with this new modeling approach, we analyze the cross-subsidization by large retailers in two scenarios: asymmetric competition and symmetric competition. In the scenario of asymmetric competition, large retailers compete with smaller stores that carry a narrower range. We show that large retailers can exercise market power by pricing below cost some of the products also offered by the smaller rivals, in order to discriminate multi-stop shoppers from one-stop shoppers. Loss leading thus appears as an exploitative device rather than as an exclusionary instrument, although it hurts the smaller rivals as well; banning below-cost pricing increases consumer surplus, rivals' profits, and social welfare. Our insights extend to industries where established firms compete with entrants offering fewer products. They also apply to complementary products such as platforms and applications. We then consider the scenario of symmetric competition between two multi-product firms (such as large retailers) and analyze competitive cross-subsidization by multiproduct firms, stemming from the heterogeneity of consumer shopping patterns. In a setting where each firm has a comparative advantage on some of the products, although all firms are equally effective in serving one-stop shoppers, cross subsidization arises in equilibrium, and allows firms to better screen consumers according to their shopping patterns. Firms earn positive profits from multi-stop shoppers, while fierce price competition dissipates any profit from one-stop shoppers. In this context, banning below-cost pricing leads to higher prices for one-stop shoppers and may reduce consumer surplus as well as total social welfare. Therefore, adopting cross-subsidization by large retailers in asymmetric competition could harm small competitors and consumers, and banning such practices would improve social welfare. However, cross-subsidization in competitive markets with symmetric competition is unlikely to impede competition, and thus banning below-cost pricing in competitive markets may cause perverse effects. This suggests that assessing practices involving below-cost sales should take into account the market structure at play. Such practices could impede competition when the engaging firms are in dominant positions and possess significant market power, whereas these practices are unlikely to be harmful when engaging firms are competing against each other. The impact and Dissemination The research project delivers important contributions to the economic literature. The first paper has been accepted for publication in the American Economic Review, which is the flagship journal of economics with broad audience of economists. The second paper will be submitted soon to one of the top 5 economic journals like the Review of Economic Studies, which has high impact factor in economic literature. Meanwhile, the two research papers have been widely circulated and also presented in 10 conferences and invited seminars in some top universities including Harvard University. Our research outcomes also provide a solid theoretical foundation for the competition authorities in assessing the practices involving below-cost sales by large retailers. In particular, we show that cross-subsidizing strategy such as loss leading can be used by dominant retailers as an exploitative device, which harms competitors and consumers, and banning such practices would improve social welfare. These theoretical findings could be transmitted into policy implications, to bring important impacts on competition policy for below-cost sales, in the EU and international levels.
