Price Wars Cited As Grower Folds

Sarah Elks, The Australian, 13 April 2011

Andrew Kuszczakowski

 

 

      i.        Briefly, why have you chosen this particular article to demonstrate your learning of economic analysis skills?

I have chosen to analyse the article titled ‘Price wars cited as grower folds’. The core issue highlighted in this article is collapse of a relatively large family business, Barbera Farms that produces tomatoes, capsicums and zucchinis.

There are a number of stakeholders that can be identified here, including:

·         Employees of Barbera farms –facing the loss of their jobs.

·         Suncorp – financiers of Barbera Farms who have called in a loan.

·         Ernest & Young – receivers who have taken control of the organisation.

·         Ausveg – an industry body representing the interests of Australian vegetable growers (Ausveg, 2011).

·         Coles & Woolworths – retailers and key customers of Barbera Farms.

·         Australian Public – consumers.

Adam Smith’s observation of the ‘invisible hand’ that guides households and firms in market interaction is said to lead to desirable market outcomes (Gans, King, Stonecash, & Mankiw, 2009). Considering this core economic concept, I chose this article as it provides an opportunity to investigate the operation of this ‘invisible hand’ in the context of this market. I also chose this article as it is relatively brief and I considered that I would be able to go into a low level analysis which would aid my learning in this topic.

 

 

    ii.        Describe in your own words the key economic concepts that are relevant to the article.

There are two main economic concepts that I identified in this article. Firstly, the key issue I will consider is the impact on the supply if Barbera Farms is closed down and the resources are used for other purposes. Economic concepts can be applied to explain the impact of this on the overall market price equilibrium. This analysis must consider the elasticity of the supply price and demand price of tomatoes, capsicums and zucchinis.

Secondly, it has been suggested that the activities of the retailers Coles and Woolworths have contributed to the hardship faced by Barbera Farms. The two retailers recently entered into a price war when Coles dropped the price of milk to $1 a litre (Gans, King, Stonecash, & Mankiw, 2009). It appears that Coles is prepared to suffer short-term losses in order win market share from its competitors. Analysis of the economic concepts and oligopolies may help to explain the behaviour of Coles and Woolworths in this recent price war.

 

 

   iii.        Explain the author’s argument using those economic concepts.

There are a number of positive and normative statements made in this article that I will discuss and evaluate. In order to evaluate these statements, I will concentrate only on the market for tomatoes in Australia and assume that this can be extended to the markets for capsicums and zucchinis.

The first step is to draw a supply and demand curve for the tomato market. I assume an inelastic price of supply for tomatoes in the short-run, as producers are unable to immediately adjust supplies in response to cost or price changes (Gans, King, Stonecash, & Mankiw, 2009). I also assume an inelastic price of demand for tomatoes as this is an inexpensive necessity, having limited scope for substitution (Gans, King, Stonecash, & Mankiw, 2009). This assumption suggests that the quantity of tomatoes demanded would not decrease substantially as a result of a significant increase in price. Based on these assumptions, the supply and demand curves for this market are shown in Figure 1.

 

Figure 1

 

The chairman of Ausveg, John Brent, suggests that increased cost of production (i.e. fertiliser, fuel and electricity) is hurting growers (Elks, 2011). A Coles spokesman makes the point that there have been increases in the tomato prices due to natural disasters in Queensland and increases in prices have been passed on to consumers (Elks, 2011). These are all positive statements as they attempt to describe the world as it is and the validity of these claims can be evaluated (Gans, King, Stonecash, & Mankiw, 2009). Increased cost of production and reduced number of sellers (due to natural disasters) suggests a shift in the supply curve to the left because at every price, the amount that producers are able to sell is reduced (Gans, King, Stonecash, & Mankiw, 2009). This is shown in Figure 2 by the shift in the supply curve from ‘S1’ to ‘S2’.

 

Figure 2

 

The economic law of supply and demand suggest that the shift of the supply curve to the left will result in an increase in price (Gans, King, Stonecash, & Mankiw, 2009). This can be seen in Figure 2, as the price has increased from ‘P1’ to ‘P2’ and quantity supplied decreased from ‘Q1’ to ‘Q2’. This supports the statement from the Coles spokesman that consumers have seen increases in the prices of tomatoes.

Investigating the competition between Coles and Woolworths in the Australian supermarket (grocery) market, it appears that the supermarkets compete in an oligopoly. The characteristics that support this are:

·         the fact that the two account for 80% of supermarket sales in Australia (Ethical Consumer Group, 2010);

·         there are significant economies of scale for large national supermarkets; and

·         barriers to market entry are high.

These factors serve to maintain the status quo. Coles’ pricing strategy suggests that it does not operate in a cooperative oligopoly, but rather take their rivals’ strategy into account, as represented by the ‘Prisoner’s Dilemma’ (Gans, King, Stonecash, & Mankiw, 2009).

Coles’ current discounting campaign suggests that it has objectives that are competitor-oriented (i.e. increase market share in comparison to competitors). Armstrong & Green’s (2007) study suggests that the pursuit of profit should be the objective of businesses, rather than competition-based objectives which may actually harm profitability.

 

 

   iv.        Assume you disagree with the author. Construct a counter-argument to the author‘s argument using economic concepts.

The Coles spokesman suggests that the aggressive discounting campaign undertaken by Coles has not been contributed to the demise of Barbera Farms (Elks, 2011). Whilst I do not disagree with this statement, I will argue that a sustained discounting campaign will impact suppliers.

In constructing the supply and demand curves for the milk market in Australia, I assume that the supply and demand curves for milk are inelastic in the short term, similar to the market for tomatoes.

Figure 3 shows the market supply and demand before the discounting campaign, with the equilibrium price of ‘P1’ and supply to market of ‘Q1’. At this equilibrium level, I assume that for individual suppliers, the price equals the minimum of average total costs ‘ATC’, as shown in Figure 4.

The impact of the discounting campaign can be seen in Figure 5, where the price has been driven down from ‘P1’ to ‘P2’ and at this level, suppliers will supply a quantity equivalent to ‘Qs’. However, the demand from consumers at the price of ‘P2’ is equivalent to the quantity of ‘Qd’. Therefore there is a market shortage equivalent to ‘Qd’ less ‘Qs’. I assume that these price reductions will (eventually) be borne by suppliers and not the retailers. Therefore, suppliers will bear a loss since this price is below the average total cost (see Figure 6). Under these conditions, suppliers will exit the market as they realise that they are able to make use of their scarce resources in more economically beneficial ways. A reduction in the number of suppliers will cause a shift in the supply curve to the left. In reference to Figure 7, the supply curve for milk will move from ‘S1’ to ‘S2’, resulting in greater supply shortages (equivalent to ‘Qd’ less ‘Qs’). Shortage of supply will result in suppliers being able to demand a higher price for milk, increasing the price from ‘P2’ to ‘P3’ (see Figure 7). Interestingly, the price is now above the initial long-run price ‘P1’. At the price level of ‘P3’, suppliers will generate profits (see Figure 8) since the price ‘P3’ is above the average total cost ‘ATC’. The generation of profits will encourage new suppliers to enter the market in the long-run. The impact of this is shown in Figure 9, as the supply curve shifts to the right from ‘S2’ to ‘S3’. This shift will push the price down from ‘P3’ to ‘P1’, where producers will earn zero profit (see Figure 10). The long-run result is the return of the market to the initial equilibrium price, which demonstrates Adam Smith’s ‘invisible hand’ of the market at work (Gans, King, Stonecash, & Mankiw, 2009).

Based on the end state of this analysis, it would appear that a discounting campaign will have little impact, since the market returns to its equilibrium state in the long-run (with all things being equal). However, we must review the consequences of this chain of events that were drive by the reduction in price by Coles.

Coles and Woolworths combined account for 80% of supermarket sales in Australia (Ethical Consumer Group, 2010). Therefore, given their market coverage, I suggest that a sustained discounting campaign by Coles and Woolworths would drive suppliers out of those markets in the long-run, as shown by this analysis. I also suggest that the smaller suppliers would be the first to exit the market as they may have reduced ability to ride out the adjustment of the market back to an equilibrium point.

 

 


Initial condition before discounting campaign.

Figure 3

Figure 4

 


 

Short-run response to price reduction of milk, assuming price reductions are eventually borne by producers.

Figure 5

Figure 6

 


 

Long-run response to reduced number of suppliers.

Figure 7

Figure 8


 

Long-run response to shortage of supply of milk.

Figure 9

Figure 10


 


 

    v.        Which argument is better, and why?

A response to this question depends on the point of view of the person providing the judgement. It is true that discounting milk to $1 litre was not the cause of Barbera Farms collapse into receivership however the implication of such a pricing strategy will alarm Australia dairy farmers and other supermarket suppliers alike.

From the suppliers’ point of view, I have shown that one impact of a sustained price war on milk would involve suppliers being driven out of the market. However, from the view point of Coles, the pricing strategy appears to be part of a competitor-based objective to win market share from Woolworths at all costs, with the hope of longer term gains.

My analysis is based on economic concepts from Gans, King, Stonecash, & Mankiw (2009) that show that a sustained discounting campaign will impact producers. Evidence from Armstrong & Green’s (2007) study suggests that firms making decisions in the pursuit of greatest profit may yield better results than those focus on achieving competitor-based objectives.

Other suppliers to these supermarkets would be concerned that this price war could spread to other goods and may result in hardship for suppliers. The analysis presented here shows that this would eventually lead to an increase in prices for consumers before prices return to equilibrium. If Coles’ intends on a sustaining its discounting strategy then it appears difficult for Coles to argue that this strategy will not push suppliers to exit the market (assuming that price pressures are passed onto suppliers).


 

 

   vi.        Briefly discuss the broader social and economic implications of the main issue discussed in the article.

There are a number of social and economic implications that standout in this article. Firstly, there is a possibility that if there is no buyer of Barbera Farms then over 500 people face losing their jobs which would have an obvious social impact in the Bundaberg and Bowen regions. In this scenario, Australia consumers face higher prices for tomatoes, capsicums and zucchinis which will have an economic impact on Australia consumers.

From the analysis performed, if Coles sustains its current pricing strategy, it will have an economic impact on the milk market. One such impact will be pressure on dairy farmers to exit the market. Few suppliers will lead to a shortage that would cause prices to increase, before prices eventually return to an equilibrium price. This price volatility will therefore impact consumers.

In terms of the broader picture, forcing Australian dairy farmers out of the market may result in the forming of a monopoly or oligopoly in the dairy industry. This may be the case if we assume that smaller producers will be the first to exit the market as a result of price cuts. In that case, Australian consumers will be impacted if the market for milk moves away further from resembling a perfectly competitive market.

 

 

 

References

Armstrong, J. S., & Green, K. C. (2007). Competitor-oriented Objectives: The Myth of Market Share. International Journal of Business , 12 (1), 117-136.

Ausveg. (2011). About Us. Retrieved May 1, 2011, from Ausveg: http://ausveg.com.au/about-us/overview.htm

Elks, S. (2011, April 13). Price wars cited as grower folds. The Australian.

Ethical Consumer Group. (2010). Ethical Consumer Guide. Retrieved May 1, 2011, from Supermarkets in Australia - Issues: http://www.ethical.org.au/issues/?issue=16

Gans, J., King, S., Stonecash, R., & Mankiw, N. G. (2009). Principles of Economics (4th ed.). Australia: Cengage Learning.