Fixed costs determine structure of the supermarket industry

Durham, N.C. – September 17, 2008 – In many retail industries, the most successful firms are the ones that offer the widest selection. For example, Home Depot and Staples offer a wide array of products at competitive prices. Maintaining this variety requires substantial firm-level investments. An article published in the RAND Journal of Economics analyzes an Endogenous Fixed Cost (EFC) model of retail competition in regards to the supermarket industry, showing how escalating investments in variety-enhancing distribution systems results in a few high-quality firms that can greatly influence price and other market factors.

Paul B. Ellickson of Duke University adapted the EFC model to retail chains, utilizing data for the supermarket industry from the Trade Dimension's Retail Tenant Database. Ellickson constructed a model of supermarket competition where escalating investment in firm-level distribution systems is driven by the incentive to produce a greater variety of products in every store.

Employing a store-level census and 51 distinct geographic markets, results demonstrate that the supermarket industry is a natural oligopoly in which a small number of firms (between four and six) capture the majority of sales, regardless of market size.

"This study provides evidence that endogenous fixed costs play a central role in determining the equilibrium structure of the supermarket industry," Ellickson concludes. "Instead of encouraging entry, increases in market size yield a concentrated industry with better products, perhaps explaining the high premiums people will pay to live in larger cities."

Source: Wiley-Blackwell