UK Price Wars: Microeconomic Analysis of Supermarkets and Mobile Phones

Introduction

Recently in the UK, there have been price wars in both the supermarket and mobile phone industries. These price wars are a natural part of competition in a market economy, and the behaviour of firms in these sectors can be understood using microeconomic principles. This paper examines both the supermarket and mobile phone price wars using microeconomic models in order to demonstrate how these basic economic principles apply in the real world.

Competition in Supermarkets and Mobile Phones

While there are many types of competition in microeconomic models, most industries in market economies operate under the condition of monopolistic competition. This is a condition in which firms have many competitors, and each competitor seeks to differentiate itself in some way from the others (Economics Online, 2014). In the supermarket industry, companies require fairly broad target markets in order to generate the revenue they need to survive. Waitrose, for example, tends toward higher-end products and pricing, whereas Iceland is strictly low-end on both. Marks & Spencer focuses on own-brand items, and Tesco aims for the mainstream of the supermarket industry.

For most consumers, convenience and price are the two most important variables. Changing store locations is not easy — it is a sticky variable — but changing prices can be done with little effort. The major British supermarket chains have therefore been engaging in price wars in order to win consumer loyalty. Discount food chains appear to be winning: sales figures show that Aldi and Lidl in particular are gaining sales at the expense of Tesco, and this price war has encouraged Sainsbury's and Asda to join in as well (Rayner, 2014).

Similar competition is occurring in mobile phones. Now that smartphones in particular are reaching a saturation point, there is little new market share to gain. As a result, firms are fighting intensely over existing market share. It is difficult to differentiate mobile phone service in meaningful ways; however, firms in the industry carry high fixed costs. Every new customer therefore contributes to covering those fixed costs while adding very little in the way of variable cost. By lowering prices, mobile companies are able to win customers from competitors. Three sparked the price war in early 2013 in a bid to increase its market share by offering better value for money than its rivals (The Telegraph, 2013).

Microeconomic Analysis of Price Wars

The first basic microeconomic concept at play here is the law of supply and demand. Under equilibrium conditions, supply and demand are equal at a given price. Under the basic scenario, when supply exceeds demand, a firm will exit the industry so that supply and demand return to equilibrium. The problem in both of these industries is that exit costs are high. Typically, if a firm can earn enough revenue to cover its fixed costs, it will remain in business even if it consistently fails to earn a profit. Firms in these industries face significant exit costs in terms of debt obligations, disposal of assets, and unwinding their operations. Thus, even where there is oversupply in the marketplace, firms in both industries choose to remain in the market.

This dynamic drives prices down. Firms need to earn enough revenue to cover fixed costs and, ideally, turn a profit. With both food and mobile telephony, there is a certain amount of customer loyalty from which profit-taking can be achieved. In mobile, a customer pays every month and, once signed up with a provider, may be reluctant to switch for fear of losing their number. With grocery stores, discounts on staple items attract customers through the door, at which point higher-margin items can compensate for the lower prices on staples.

The supermarket wars offer a particularly instructive case study. Supermarkets have strong bargaining power over suppliers, so they drive down prices on staple goods. The problem is that when prices fall, some suppliers are no longer profitable. In conditions of market equilibrium nobody earns excess profit, so when prices decline, some supply must leave the market simply to restore equilibrium. In the UK, milk producers have been exiting the business in response to lower prices, to the point where there are fewer than half the number of producers there were in 2005 (Gilbert, 2014). It is a natural consequence that as price drops, suppliers exit the market while demand increases. A new equilibrium point must therefore be established, and in this case the dairy industry appears to be forced to consolidate. For dairy farmers, there are also opportunity costs to consider: farmers have always preferred to use their land for whichever agricultural pursuit yields the best return, and exiting the dairy business may reflect exactly that calculation.

Conclusion

Both macroeconomic and microeconomic principles can be found in our daily lives. Microeconomics provides insight into concepts like supply, demand, and pricing. It frames transactions in terms of utility and opportunity cost, allowing a transaction to be understood as a set of trade-offs. Price wars in UK supermarkets and rising demand for mobile phones in the developing world become straightforward to explain once these microeconomic tools are applied. Macroeconomics, meanwhile, reflects broader economic performance — entire economies in aggregate — and understanding its principles illuminates phenomena such as unemployment, inflation, and exchange rates, all of which are directly relevant to everyday life.

References

Bhargava, H. & Gangwar, M. (2013). Mobile telephony pricing in emerging markets. Indian School of Business. Retrieved November 6, 2014.

Economics Online. (2014). Monopolistic competition. Economics Online. Retrieved November 6, 2014.

Gilbert, M. (2014). Milk sours in UK supermarket wars. Bloomberg. Retrieved November 6, 2014.

Investopedia. (2014). Opportunity cost. Investopedia. Retrieved November 6, 2014.

Rayner, J. (2014). Why a supermarket price war is bad news for Britain's ability to feed itself. The Guardian. Retrieved November 6, 2014.

The Telegraph. (2013). Three's free 4G upgrade to spark mobile price war. The Telegraph. Retrieved November 6, 2014.