Tesco makes more cuts than a slasher film

It's easy to roll your eyes when you hear a supermarket firm is cutting its prices. The claims of "smoke and mirrors" carry a warning, and as one analyst mentioned, "The devil is in the detail." (Source)

So why is Tesco's plan of £500m of price cuts being considered as a good strategic move then? First, for those who haven't heard of Tesco (there aren't any stores here in Saudi), or any of its subsidiary firms such as Fresh & Easy, it's the second-largest retailer in the world by profits, and it's a firm known for taking strategic risks. It is perhaps slightly misleading to call this new strategy as simply a series of price cuts; it's more of a pricing revamp across their stores, with the aim of reducing the complexity of their pricing system to make necessities more affordable. But why is this necessary?

Supermarket "savings"

Tesco's plan seems to be partly in response to the growing outcry that supermarket offers and deals, such as buy-one-get-one-free, are encouraging consumers to buy more than they need, which increases wastage and voids the savings they made in the first place.

This problem is particularly apparent for fresh goods. For instance, one day I might buy 12 yoghurt pots at 50p each if there's an offer that says, "Buy 10 yoghurt pots and get 2 free." At first, I think I've made a saving; I've spent £5 instead of what 12 pots would usually cost (£6), so I've "saved" £1. However, it's only a saving if I would have had the incentive to buy 12 pots had the offer not been there. It's very unlikely that I would eat this many pots within the expiry date, so any pots that I don't eat are wastage, and I've lost out. But even if I did eat all that yoghurt in that particular week, I would still have lost out because of the opportunity costs of my usual buying habits - I never buy yoghurt!  (Although an utilitarianist might ask if I enjoyed eating all that yoghurt before coming to such a rash conclusion...)

Anyway, that was slightly off the beaten track, but I hope that that example shows whether all these supermarket offers do actually save consumers money, as well as the complexity of calculating these savings out. Considering the amount of deals that consumers are bombarded by in these stores, in some ways these offers can be seen as too manipulative by supermarket firms (I say too because it's extremely naïve to think that firms should stop manipulating consumers altogether - they need to make money!).

The Big Price Drop

Now half-price.

Tesco's plan is to reduce their offers and instead simply cut prices, in the hope that it will reduce families' wastage and halve the rate of food inflation (source). The prices of necessities such as milk, bread, cheddar, vegetables, etc. of Tesco's own-label goods will be reduced from between 15 to 20%. Surely this will help those suffering from the recession to buy the goods they need, and shop in places less saturated with offers for goods that they don't need?

Well yes, it will. (Did you think I was being sarcastic?) To simplify, one analyst described Tesco's move like this:

"Price cutting is usually a smoke and mirrors affair. But I think this will cut through the fog of promotions and concentrate on very low pricing. Most consumers don't want four for the price of three, because they don't want four packets of whatever. They just want it cheaply. This should put Tesco on the front foot." (Source)

Nevertheless, there are two downsides to this. First is the Clubcard scheme - customers will no longer receive double Clubcard points, but instead one point for every pound spent. Cynics/rivals are claiming that this is where Tesco will save £350m, but so what if they are?

Loyalty cards and reward schemes have devalued over the past few years with so many companies offering some form of their own; while I imagine many price-savvy consumers save money with them, it doesn't instil the same brand loyalty like it used to. I, a person who rarely goes shopping and doesn't buy the food for the house, have 13 loyalty cards in my wallet. Of course, some Tesco shoppers will be annoyed by this at first, but people dependent on the Clubcard may end up saving more anyway with the price cuts. And like the buy-one-get-one-free offers, Clubcard isn't disappearing, it's simply being reduced.

The second problem is far more serious. What happens when a major oligopolistic firm lowers its prices?

"1, 2, 3, 4, I declare a price war"

Here's some theory for you: the UK supermarket industry is an oligopoly - there are a few large firms that dominate the industry. Interdependence between the firms exists as they are large enough to influence the market, and so each firm needs to take notice of their competitor's actions.

Oligopolies tend to compete through non-price competition. Advertising, brand names, sales promotions - these are the kinds of competition that exist between oligopolistic firms. Prices changes far less in oligopolies as firms are usually unwilling to engage in this type of competition. If a firm raises its price above the current market price, other firms will not follow. Their demand will fall as consumers flock to the other firms, causing the firm to lose trade, sales and most likely profit.

If a firm lowers its price below the current market price, this can also spell trouble - but for the entire industry. Since other firms are afraid that their demand will fall as consumers go to buy from the firm with the lower prices, they too will lower their prices. But they won't just equal out their prices, these firms will undercut the original firm to stay ahead of the game.

This can repeat itself numerous times as the industry heads into a downwards spiral until one firm simply cannot keep up with losses it is making at such a low price, causing it to go bankrupt. Firms like Tesco, on the other hand, are so massive that they are able to absorb sustained losses in a price war from elsewhere (if you want to know how well they are doing globally, have a look at their impressive expansion in Thailand at the moment).

What makes the supermarket industry particularly interesting at the mention of a price war are companies' price guarantee schemes. It seems that Ocado will suffer the worst from Tesco's price cuts, with its promised price-match on Tesco for most brands. Sainsbury's also might be in trouble with its recent testing of a price-match scheme in Northern Ireland.

So is it all doom and gloom for UK's supermarkets? The Guardian's article about supermarket shares plunging might suggest so. My opinion: this price war threat does seem more substantial than previous times when Tesco has announced to drop prices, but my real worry is whether Tesco's suppliers are going to be affected by all this. It's difficult to debate how much each supermarket firm is going to be affected at this point in time; obviously firms will be reluctant to reveal if they are struggling or not, so only time will tell how this will all pan out. For now, we might be better off asking this question:

What could this all mean for the UK's economy?

Any way you look at it, consumers are going to benefit in the short-run. With reduced prices on basic foodstuffs, consumers, especially those who have been suffering from the recession, will effectively increase disposable income. This could all lead to an increase in expenditure in the economy.

But on what? Time will play a big factor in this, because if the prices stay low (or become even lower as a result of a price war) for a sustained amount of time, then people will not only have more money but greater confidence to buy luxury items, which would have previously been used for essential goods.

However, if these luxury items are all exports, such as a new Sony TV, or a Honda car, then the economy is not better off at all. Tesco looks like it's striving to cut back the price of necessities, not luxuries. Given that many necessities are fresh products, of which a large proportion are British fresh products, British farmers and food suppliers could actually be worse off with the price cuts. So in effect, Tesco could be harming the economy if their supply chains are squeezed in this potential price war.

Conclusion: the devil is most definitely in the detail

There are a lot of "ifs" throughout this post, predominantly because I have no first-hand evidence on prices of actual goods being cut. As for this price war that's been featured in the newspapers recently, it's only really supermarket shares that have indicated what's about to come. If you want my advice to see whether The Big Price Drop has affected the supermarket industry, see what savings you make over the next few months with your normal buying habits. And keep an eye on the development of this price war, especially with slightly smaller firms like Ocado which are more at risk.