Grocery Duopoly, Entry Barriers, and Regulatory Remedies
New Zealand's grocery market has two main supermarket chains with a combined share of about 80% of retail grocery sales. The Commerce Commission's 2022 market study found return on capital employed of 12-13% for the two majors, above the cost of capital, and identified barriers to entry including land banking, restrictive covenants on sites, and wholesale supply arrangements. A new entrant has announced a 60-store rollout but faces planning consent delays; its projected gross margin is 6 percentage points below the incumbents'. Wholesale access is concentrated: the two majors supply about 70% of the groceries sold by the remaining independent retailers at prices set by the majors. The government is considering (a) a mandatory wholesale access regime with a regulated margin, (b) a divestment order requiring sale of some stores, and (c) a code of conduct governing supplier relations.
1. Using an oligopoly model, explain how entry barriers and wholesale pricing could sustain the incumbents' returns above the cost of capital, and identify the welfare losses involved.
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Model. A duopoly with high barriers to entry can sustain prices above marginal cost. In Cournot competition with two firms, equilibrium price exceeds marginal cost, and the gap depends on the elasticity of demand and the number of firms. With 80% share, the two incumbents face a residual demand curve that is relatively inelastic; their markups can be sustained because entry is blocked.
Barriers. Land banking and restrictive covenants limit sites; wholesale arrangements mean independents depend on the majors, giving the majors a cost advantage and the ability to set wholesale prices. A new entrant's gross margin 6 points lower reflects scale and supply-chain disadvantages.
Welfare losses.
- Allocative: price above marginal cost reduces quantity; deadweight loss.
- Productive: X-inefficiency if competition is weak; but scale economies may offset.
- Dynamic: incumbents may have less incentive to innovate, though they may invest in logistics.
- Transfer: consumers pay more; shareholders gain.
Evidence. Return on capital employed of 12-13% above the cost of capital is consistent with market power, though it could reflect efficiency or risk. The Commission's findings on covenants and wholesale access support the market power interpretation.
Nuance. The counterfactual matters: with high fixed costs, some concentration may be efficient; the question is whether the observed returns exceed a competitive benchmark after adjusting for risk.
2. Evaluate the three policy options against efficiency, dynamic efficiency (investment and innovation), and administrative cost criteria.
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Wholesale access regime. Lowers barriers to entry for independents and a new entrant. If the regulated margin is set at a competitive benchmark, it can reduce the incumbents' ability to foreclose. Risks: regulated margins may distort investment in distribution; the regulator faces an information problem; and incumbents may degrade service quality. Administrative cost is moderate.
Divestment. Structural separation reduces concentration directly. It can lower prices and improve entry. But divestment is costly, may sacrifice scale economies, and the new entities may still have local market power. It is a one-off, high-intervention remedy; credible only if the competition problem is severe.
Code of conduct. Addresses supplier relations (unfair terms, retroactive changes) but does not directly tackle retail market power or entry barriers. Low cost, but limited effect on prices. It may be a complement, not a substitute.
Evaluation. On efficiency, wholesale access is best targeted at the entry barrier; divestment is stronger but riskier; the code is weakest on allocative efficiency. On dynamic efficiency, wholesale access preserves investment incentives if the margin is well designed; divestment may reduce coordination economies. On administrative cost, the code is cheapest, the access regime moderate, and divestment high. A package of access plus a code is likely optimal.
3. Assess whether the counterfactual of a successful third entrant would deliver the same outcomes as regulation. What assumptions must hold?
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Assumptions for equivalence.
- The entrant must achieve sufficient scale; 60 stores may be below minimum efficient scale in grocery distribution.
- It must secure supply at competitive wholesale prices; if it depends on the majors, it may be foreclosed.
- Planning consent delays must be resolved; otherwise entry is delayed and the competitive threat is weakened.
- Consumer switching must be sufficient; if loyalty is high, the entrant may remain small.
- The entrant's cost disadvantage (6 points lower gross margin) must be overcome through efficiency, not just lower prices.
Conclusion. A successful third entrant could deliver similar or better outcomes than regulation, because it introduces competitive rivalry rather than regulated access. But the counterfactual is uncertain; the entrant may fail, merge, or occupy a niche. Regulation is warranted if entry barriers are structural (land, covenants) and entry is unlikely within a reasonable horizon. The Commission's findings suggest the barriers are not purely transitory, so reliance on entry alone is risky. A credible threat of entry can discipline incumbents, but only if the threat is backed by resolved planning and wholesale access.