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Vertical Differentiation in the UK Grocery Market Essay

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Updated: May 20th, 2020

Introduction

Consumer goods come in various brands and forms. ‘Product differentiation’ is when different brands of a given product exist in a market. Product differentiation is a source of market power for firms operating in a particular industry, as it facilitates the competitive pricing of perfect substitutes. In vertical differentiation, product quality ordering and attributes drive consumer demand. Under vertical differentiation models, companies determine the qualities and prices of their products (Burdett & Judd 1993).

In the UK supermarket sector, firms offer products with different qualities to consumers. Therefore, consumers prefer to shop at a particular store because it offers high-quality products. This phenomenon can be explained using a vertical differentiation model. According to Lewis (2008), “in vertical differentiation, consumers rank products/brands based on their quality” (p. 656). This paper applies the vertical differentiation model on the prices of consumer products (groceries) sold by the ‘Big Four’ supermarkets in the UK, which comprise of Tesco, ASDA, Sainsbury’s, and Morrisons. Moreover, product specifications the firms use to enhance the quality and increase market share will be analyzed.

Real-World Market Analysis

The Tesco Price Check compares prices of the major stores in this industry. Based on the data generated by this price comparison tool, the consumers’ purchase trends during a shopping trip can be determined. The Competition Commission (2000) writes that about 75% of consumers do not care much about the prices of individual products as they do with the total basket price. In this regard, the vertical differentiation model in this paper will focus on the price of the total basket rather than that of individual products. The retailers must store the products contained in the shopping basket. The price differences among the basket products indicate vertical product differentiation.

The shopping basket constructed includes food products, which are priced differently by the stores. The Competition Commission (2000) establishes that “64% of shoppers spend less than $50 on their weekly shopping at supermarkets” (p. 6). Based on this finding, the basket size can be taken to be $50. However, this would result in several possible combinations of products in the shopping basket. The mySupermaket.co.uk website compares the prices of 24 products commonly purchased by shoppers. These products are popular items and supermarket brands like minced meat, rice, and dairy products, among others. Supermarkets employ different pricing strategies to increase the sales of these products. An overview of five items included in the basket is given in the table below.

Item Standard Price Minimum Price Maximum price
Thick sliced white loaf 800g 0.73 (0.01) 0.72 0.75
Bananas loose 0.78 (0.03) 0.77 0.85
Golden delicious apples class 1 loose 1.38 (0.10) 1.00 1.49
Mixed peppers 3 pack 1.32 (0.13) 1.00 1.38
Cucumber portion 0.34 (0.02) 0.25 0.37

Source: (Competition Commission 2000).

It is evident that the prices of the selected products vary across stores. The model assumes that the stores use a similar utility strategy, and thus, price data from each supermarket can be used to determine consumer choices. However, determining the number of competitors in the market will be useful in calculating utility distribution. All the supermarkets in the UK have a market share of more than 0.5%, which can be used to represent the number of players (competitors) in the market (Competition Commission 2000).

The products sold in the stores include supermarket brands and branded items. Nevertheless, most of the products are the same (in terms of quality) across the stores. Additionally, store brands are rarely the focus of most consumers. Thus, in a vertical differentiation model, the quality differences observed between stores will be indicated by disparities in the store brands’ characteristics. As a result, the prices of store brands with superior quality characteristics are high compared to those of similar products. The model assumes that all supermarkets sell items at the same wholesale prices for the products included in the basket. However, discounts affect the net prices of similar products. According to the Competition Commission (2000), retailers pay different wholesale prices due to the discounts and other payments offered.

The vertical differentiation model indicates that retailers select the prices of store brands from a distribution. This means that each retailer has a unique ‘price’ distribution that it uses to determine the prices of its products. The level of diversity in a given industry would determine whether the price distributions of different firms would overlap (Anderson & Renault 1999). If firm heterogeneity is lacking, the distributions converge, and prices keep on changing. On the other hand, if there is heterogeneity, distributions remain distinct, and prices do not fluctuate (Baye & Morgan 2001). Price rankings for common products (basket) fluctuate over time. As shown in the figure below, Sainsbury’s price rankings for the basket items are the highest (fourth-placed). The other supermarkets, like ASDA and Tesco, show variability in terms of price rankings. Morrisons is placed third in terms of prices. On the other hand, utility rankings show great variability among the supermarkets.

Table 2: Price and Utility Variability.

Quartile Prices (%) Utilities (%)
Tesco Sainsbury’s ASDA Tesco Sainsbury’s ASDA
Q1 16.7 0.0 75.0 16.7 25.0 50.0
Q2 58.3 0.0 16.7 58.3 16.7 16.7
Q3 25.0 0.0 8.3 25.0 25.0 0.0
Q4 0.0 100.0 0.0 0.0 33.3 41.7

Although the rankings are relatively the same for ‘big four’ supermarkets, prices and utilities show great variability each week. The variability in prices and utilities is shown in the table above. The variability indicates that the four retailers have different price distributions, and thus, the pricing of branded items varies among them.

Critical Evaluation of the Model

Although vertical differentiation aptly explains the price differences observed in the grocery sector, it may not be clear how well it does it. One way of determining how well it explains the price disparities is by comparing the search cost estimates from homogeneous stores with those of vertically differentiated supermarkets. When there is no heterogeneity, the estimated costs are higher than when firms are vertically differentiated (Armstrong, Vickers, & Zhou 2009). According to Armstrong (2008), about 62% of price variations observed across retailers arise from store brand differences. In this view, the searching costs are much lower in inhomogeneous search models than in vertical differentiated models. Thus, under the homogeneous search model, the ‘search gains’ should be higher than in the vertical differentiation model.

It is important to note that the vertical differentiation model better explains both the observed prices and the observed patterns compared to the homogeneous model because it includes price and utility distributions. On the other hand, the homogeneous search model cannot explain the ‘utility’ patterns and price rankings for the four retailers examined (Hortacsu & Syverson 2004). Even when each firm is examined separately, the ‘vertical differentiation’ approach estimates search cost distributions more accurately than the homogeneous model. However, if utility levels are substituted with price distributions, different search costs are obtained for each supermarket. This shows that the quality differences among the stores should be corrected first before estimating the price dispersions. It helps reinforce the homogeneity assumption relating to utility distributions across different stores. Correction for quality disparities can be achieved through the analysis of the pricing strategies.

Although the model explains the price differences in the grocery sector, it cannot effectively explain extreme fluctuations in prices (high and low). In particular, in a case where firms are homogeneous, in terms of prices, the model cannot explain the high or low prices observed. Moreover, this model cannot explain the deviations from the product prices, which are constantly fluctuating. Thus, the pricing pattern observed in the supermarket sector may not reflect the changes in quality or consumer demand.

Future Product Specifications

Competition in the supermarket sector is very high. The ‘big four’ stores employ product differentiation to gain a competitive advantage over their rivals. Among the competitive strategies employed are diversified product offerings (cotton products) and online marketing. With regard to the grocery market, Sainsbury’s and Tesco have diversified into the organic food products sector. In recent years, organic food has grown in popularity as people consider it healthier than processed food. According to Hong and Shum (2006), organic food consumers are people with more than average incomes, women, educated, and older individuals. Since organic consumers’ demographics are different from those of regular consumers, their search costs must differ as well.

Organic food producers are required to adhere to more stringent safety and quality standards than their non-organic counterparts do. Currently, only Sainsbury’s and Tesco sell organic items in the UK (Pesendorfer 2002). Competition between these two firms is likely to make them seek for international certifications and food labels for their product brands.

Conclusion

Product differentiation allows firms to expand their market share by increasing their market offerings. Vertical product differentiation models explain the ordering of similar products based on quality. Consumers often prefer quality products, which makes firms differentiate their products towards quality to gain more profits. Four supermarket stores dominate the UK grocery market. Vertical differentiation models explain the differences in prices of similar products sold by these stores.

References

Anderson, S & Renault, R 1999, ‘Pricing, Product Diversity, and Search Costs: A Bertrand-Chamberlin-Diamond Model’, RAND Journal of Economics, vol. 30, No. 1, pp. 719-725. Web.

Armstrong, M 2008, ‘Interactions between Competition and Consumer Policy’, Competition Policy International, Vol. 4, no. 3, pp. 97-107. Web.

Armstrong, M, Vickers, J & Zhou, J 2009, ‘Prominence and Consumer Search’, RAND Journal of Economics, Vol. 40, no. 9, pp. 209-223. Web.

Baye, M & Morgan, J 2001, ‘Information Gatekeepers on the Internet and the Competitiveness of Homogeneous Product Markets’, American Economic Review, Vol. 91, no. 1, pp. 454-474. Web.

Burdett, K & Judd, K 1993, ‘Equilibrium Price Dispersion’, Econometrica, Vol. 51, no. 2, pp. 955-969. Web.

Competition Commission [CC] 2000, Supermarkets: A Report on the Supply of Groceries from Multiple Stores in the United Kingdom, The Stationery Office, London. Web.

Hong, H & Shum, M 2006, ‘Using Price Distributions to Estimate Search Costs’, RAND Journal of Economics, Vol. 37, no. 4, pp. 257-275. Web.

Hortacsu, A & Syverson, C 2004, ‘Product Differentiation, Search Costs, and Competition in the Mutual Fund Industry: a Case Study of S&P 500 Index Funds’, Quarterly Journal of Economics, Vol. 119, no. 6, pp. 403-416. Web.

Lewis, M 2008, ‘Price Dispersion and Competition with Differentiated Sellers’, Journal of Industrial Economics, Vol. 56, no. 3, pp. 654-678. Web.

Pesendorfer, M 2002, ‘Retail Sales: A Study of Pricing Behavior in Supermarkets’, Journal of Business, Vol. 75, no. 1, pp. 33-46. Web.

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