23 August 2017

British supermarkets and the genius of capitalism

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The news that Lidl has just surpassed Waitrose to become the seventh largest supermarket chain in the UK by sales provides an excellent opportunity to explain why this odd mixture of capitalism and markets makes us all so damn rich.

The reason, of course, is that the competition induced by the greed for the pilf and gelt that can be made selling stuff to us leads to us, the consumers, benefitting most. Lidl is just the latest instalment of this welcome and ongoing story.

The British supermarket trade has historically been adorned with what are, for the industry globally, some juicy margins. As the various woes of Morrisons, Tesco and Sainsbury’s demonstrate, those margins have been difficult to maintain in recent years. The reason for the struggle has been the irruption of Aldi and Lidl into that marketplace.

Here, it is crucial to understand that retail is a technology and technologies can and do change. The traditional British supermarket might carry 15,000 SKUs (stock keeping units), meaning that we not only do we get a choice between smoked ham and honey roast ham, but also organic and non-organic, and quite possibly several brands of each.

Managing such wide stock ranges costs money. Aldi and Lidl employ a different technology, carrying just a few thousand SKUs. There will be ham, there may well be smoked and honey roast, but there will only be one brand of each. Usually own brand too. (A wrong but useful sketch of branded products is that they’re expensive to pay for the advertising to persuade you they’re worth being expensive; own brands avoid this entirely.)

There is nothing right or wrong with either technology, they’re just different means to the same end: extracting money from our pocketbooks. How well that extraction works depends on whether suppliers offer what we think increases our utility the most.

Do though note what the aim is here. To extract that cash from us in order to increase the fortunes of those who own the extraction method. We are not reliant upon the benevolence of the grocer, any more than we are upon that of the butcher or the brewer.

This is where the market comes in. We do not know whether we consumers prefer the small shops, the supermarkets, the pile it high and sell it cheap, the range of products available, own brands or nationally advertised and so on.

This isn’t something that can be worked out by surveys as the New Coke people found out. As every organiser of a petition against planning permission for a supermarket finds out, many sign up to save the High Street and then immediately shop at the new megastore. We can only suck it and see.

That’s when the competition kicks in, with suppliers each employing some mixture of the available technologies. We consumers are free to choose which we prefer – that maximises our utility by our lights which is the only reasonable definition of utility itself. And, nota bene, it collapses the margins across all retailers as the more traditional suppliers have been bitterly complaining these recent years.

That capitalism part is that the suppliers are all trying to get their hands on our money. Who gets enriched might change a little but not the basic idea. The top supermarkets are all attempting the same tune. Whether it’s Tesco (largely owned by our pensions), Sainsbury’s (some billionaires plus our pensions), Asda (American billionaires plus US pensions), Morrisons (pensions), Aldi (German billionaires), Co-Op (customer-owned cooperative) Lidl (another German billionaire) or Waitrose (worker-owned cooperative), the question is the same: how do we get the most money out of those wallets at least cost to us producers?

Capitalism ain’t that pretty up close. Its saving grace, however, is that competition drives firms on to both greater efficiency and also a moderation of those margins. The net effect of this can be seen in American supermarket monolith Walmart. Jason Furman, recently Obama’s Chair of the Council of Economic Advisers had this to say about the chain:

There is little dispute that Walmart’s price reductions have benefited the 120 million American workers employed outside of the retail sector. Plausible estimates of the magnitude of the savings from Walmart are enormous – a total of $263 billion in 2004, or $2,329 per household.

That’s an old number but still, it gives us something to work with. Sam Walton’s heirs are worth about $100 billion as a result of the existence of Walmart. Us consumers benefit from the existence of Walmart by that $263 billion a year.

That benefit is not just felt by Walmart customers. Just by existing, the chain forces everyone else to lower their prices and margins. And the balance between the private and public benefit of Walmart is tilted even further towards the latter than it first appears. The $100 billion is a capital sum, a one off, while the $263 billion is an annual gain. Over a few decades to match the period the stock market values that capital sum perhaps some $8 trillion or so benefit to us consumers.

All of which nicely accords with this paper from William Nordhaus. In it, he demonstrates that the entrepreneurs who bring a new technology to market end up with about 3 per cent or so of the total value created. Nearly all of the rest of it flows through to us as the consumer surplus, neatly equalling those results from the detailed study of the effect of Walmart.

The lesson being that the capitalists – or, if you prefer, the producers – really are out to extract absolutely as much as they can from us. It is the market which restricts their ability to do so, leading to it being us consumers who get ever richer as technology marches on.

All of which leaves us with that unresolvable puzzle. The British Left doesn’t like the capitalism and the greed bit. Fair enough. But they then spend their time railing against the market and competition part, the very solution to the perceived ill. Why?

Tim Worstall is senior fellow at the Adam Smith Institute