What’s happened in the board rooms of Australia’s oligopolies? After Virgin and Qantas recently crashed each others profits by fighting a capacity war, the supermarkets appear set to follow. In so doing, both are breaking some golden rules of duopoly business practice and potentially crashing their shareholder’s returns into the earth. The rest of us may benefit for a time, however!
This post has been triggered by the news today that Metcash is set to cut its dividend to chase the recently announced uber-aggressive expansions of Coles and Woolies:
Metcash will reduce its dividend payout to fund almost $700 million of capital investment over the next five years as it embarks on a transformation plan aimed at securing the future of the grocery wholesaler and independent retailers in the face of increased competition from Coles and Woolworths.
Releasing long-awaited details of the plan on Friday, chief executive Ian Morrice said the strategy would underpin long-term sustainable growth for Metcash and its customers by growing sales and improving efficiency.
Mr Morrice says Metcash can no longer rely on cost-cutting to boost margins and profits and plans to reignite sales growth in the food and grocery channel through six growth levers.
…Metcash plans to convert more independent retailers to its liquor, hardware and automotive banners; extend its retail footprint; reinvigorate retail execution and enhance category growth opportunities.
The good news for Metcash shareholders is that most of the money is going towards quality and efficiency upgrades that make sense. Only $125 million will be new stores, which is modest compared to the recently announced expansion at Woolies and especially Coles.
In game theory there are two main models for duopolistic behaviour. The first is the Bertrand model in which duopolists can compete on prices but if the two players know what each other know they may not. There is no benefit in either changing his strategy because the other immediately counters and if the only product differentiation is price then that leads inevitably to losses as the two simply outbid one another below marginal cost. This implies a Nash equilibrium in which it is not in either party’s interests to compete. Australia’s major banks are a classic example.
The second model is more interesting in the supermarket’s case. Cournot competition, named after nineteenth century French Antoine Augustin Cournot, posits that in a market in which there is no product differentiation – ie supermarkets – then the firms may compete on capacity and the market sets the price. This is considered rational behaviour.
The two models are not as distinct as they sound and can flow over and between one another but the Cournot model is generally thought to be better in that it increases capacity and lowers prices. Both models, however, are considered to be compromises on “perfect competition”.
Having said all of that, it may, in fact, be the aggressive expansion plans of Aldi that is driving the “space race” as some analysts call it. So the equilibium is already busted and the major duopolists are moving to get it back! In that case, they may be doing what the airlines have done, and have been seized by a bout of “competitive irrationality”.
Either way, it’s good for consumers even if not so good for shareholders. For the economy the investment is very well-timed as some offset to the capex cliff but one does wonder about the long-term effects on productivity of operational over-capacity.
