How weak competition forces up food prices along the supply chain

By Millie Muroi, Economics Writer

The first most of us see of our groceries is the end product – after all the planting, growing, shipping and packaging has happened. So when we’re hit with a big bill at the checkout, it’s easy to blame supermarkets for the expensive beef, carrot or turnip that ends up on our forks.

We know Coles and Woolies have received raps on their knuckles for their behaviour recently, including alleged false discounts to lure in customers. But it’s not just customers or the competition watchdog dishing out their disdain. And it’s far from just the supermarkets that have pointed questions to answer.

Dr Andrew Leigh, former economics professor and now assistant minister for competition and treasury, has had a deep-dive into the topic. It turns out the list of possible culprits when it comes to the costly lack of competition is longer than just the supermarkets – and it’s our farmers bearing the brunt of it.

Basically, while our household budgets are getting pushed by pricier produce, farmers are getting squeezed. They’re not just facing higher prices when it comes to key ingredients such as fertiliser and machinery, but also higher costs and unfair terms once their produce is ready to be processed, shipped off and sold.

How do we know this? There are a few key signs.

Concentration is one. “Industries with plenty of competitors tend to deliver better prices, more choices and stronger productivity growth,” Leigh said in a speech this week.

The fewer players there are in a market, the less competitive it tends to be. Less competition usually means lower wages, less choice for consumers and less innovation, with dominant businesses able to charge higher prices than they might otherwise be able to, since they don’t have to worry so much about being undercut or fighting to win over customers with bargains.

Analysis by economic research institute e61 last year found all Australian industries were more concentrated than those in the US, especially in mining, finance and utilities, in which the top four firms have more than 60 per cent market share.

Generally, we see a market as “concentrated” if the biggest four firms control one-third or more of it. In 2016, Leigh and his colleague Adam Triggs found more than half of industries in the Australian economy were concentrated markets. Since then, concentration in Australia has become worse.

Farming, though, is surprisingly competitive – at least for most commodities. So why are we still seeing higher prices at the check-out?

Part of it is thanks to supply chain issues, especially during the pandemic, which meant we couldn’t get as many materials and produce from overseas, reducing supply and driving up prices. Then there’s always the temperamental weather, which can dramatically cut harvests.

But it’s a growing domestic issue which is causing headaches for farmers.

Before anything even springs out of the ground or fattens up in a paddock, farmers are dealt a tricky hand. The largest four fertiliser companies, for example, control nearly two-thirds of the market and the top four hardware suppliers control roughly half of the market, according to Leigh’s analysis of data from IBIS World.

From high-tech harvesters to tractors and seeding equipment, machinery is a big cost paid by farmers. That means when there’s a lack of options and farmers aren’t able to shop around as much, their hip-pockets – and ours – are worse off.

If you think that lack of choice is bad, Leigh says it’s even worse when farmers go to repair and service their equipment.

Farming machinery makers have a lot of power – even more than carmakers – thanks to warranties forcing farmers to go to a specific dealer for servicing, and tech restrictions holding farmers back from accessing the parts, manuals and diagnostic software they need to make repairs themselves.

Then there are seeds. From these little things, big costs can grow. One paper from the US Department of Agriculture’s Economic Research Service in 2023 found the seed sector had become more concentrated. Between 1990 and 2020, the average seed price soared 270 per cent, and 463 per cent for genetically modified types.

The huge price increase partly accounts for the fact seeds have become better – for example, GMO varieties which have made farming more productive. But as Leigh points out, “there are not many other industries where the price of a key input has grown five-fold in 30 years.”

But that’s not all. Once the cattle has been raised or the blueberries grown, farmers have little choice or bargaining power when it comes to processing, transporting and selling produce.

When it comes to slaughtering cattle, the top five Australian processors accounted for about 57 per cent of the market in 2017, meaning cattle farmers had little choice in the prices and options they accepted. For fruit and vegetable processing, the biggest four companies hold about one-third of the market.

When the produce is ready to be sent out, farmers have even less choice. Two companies – ANL and Maersk – account for 85 per cent of the shipping freight industry in Australia, and four companies control 64 per cent of the market if farmers want to send things via rail.

Farmers, especially those who produce at a smaller scale, often become the “meat in a market concentration sandwich”. 

Farmers, especially those who produce at a smaller scale, often become the “meat in a market concentration sandwich”. Credit:Louise Kennerley

As Leigh points out, the risk of spoilage further limits viable options available to farmers.

Then there’s the supermarket sector, where Coles and Woolies control about two-thirds of the market – a higher share than every OECD country except New Zealand and Norway.

Concentration at all these points means farmers are at greater risk of facing power imbalances, which show up in things such as unfair contracts, where terms are obviously lopsided. Bigger players in these concentrated industries can generally muscle in with terms which are worse for farmers, such as restricting them from raising issues or selling things at unfairly cheap prices.

All of this not only puts pressure on farmers, but can reduce their ability and incentive to invest in improving their product and the way they do things.

As Leigh puts it, farmers, especially those who produce at a smaller scale, often become the “meat in a market concentration sandwich”.

There’s no easy fix in all this, but preventing too many mergers, where companies combine and gobble each other up to become even bigger, is key to promoting competition.

Of course, bigger companies are not always worse. Their scale can allow them to do things more cheaply. But too little competition can lead to pumped-up prices which flow all the way through from more expensive seeds and fertiliser to the prices charged by supermarkets.

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Are the supermarket twins too keen to raise their prices?

The cost-of-living crisis has left many convinced the two big supermarket chains – known to some as Colesworth – have been “price gouging” – raising their prices without justification. “Gouging” is a rude, pejorative phrase that would never cross an economist’s lips (nor mine), but economic theory does say that, when an industry is dominated by just a few huge companies, this will give them the power to manipulate prices to their own advantage.

But anecdotes and even economic theory are one thing, hard evidence is another. And knowing what to do about it is a third. So it’s good that last Friday, Treasurer Jim Chalmers launched a full inquiry into supermarket prices by the Australian Competition and Consumer Commission. Chalmers said this was “about making our supermarkets as competitive as they can be so Australians get the best prices possible”.

The inquiry, which will take a year, will include an examination of online shopping, the effects of loyalty programs and how advances in technology are affecting competition.

The competition watchdog’s chair, Gina Cass-Gottlieb, said the commission will use its compulsory information-gathering powers to collect financial details from the supermarket giants.

The government has also commissioned a former Labor minister and economist, Dr Craig Emerson, to review the effectiveness of the “food and grocery code of conduct”, introduced in 2015 to stop the big supermarkets from using their buying power to extract unreasonably low prices from their suppliers, particularly farmers.

The code is voluntary and has no way of punishing bad behaviour, so hasn’t worked well. It’s drawn few complaints from suppliers, probably because they’re afraid of retaliation by Colesworth. Only if it’s made compulsory and given teeth is it likely to improve the farmers’ lot.

Our groceries market is one of the most concentrated in the developed world. Woolworths has 37 per cent of the market and Coles has 28 per cent, leaving Aldi with 10 per cent and Metcash (wholesaler to IGA stores) with 7 per cent. So our two giants’ combined share of 65 per cent compares with Britain’s top two’s share of 43 per cent. In the United States, the four largest chains make up just 34 per cent of the market.

While we wait for the competition watchdog’s report, what do we know about the chains’ behaviour?

The report of an unofficial inquiry into price gouging and unfair pricing practices, commissioned by the ACTU from a former competition commission chair, Professor Allan Fels, will be published on Wednesday.

But we know from a letter Fels sent to Chalmers last month what it will say about supermarkets. Fels said the inquiry had been inundated with concerns from experts and regular Australians alike on the prices set by the chains.

Fels found that neither Coles nor Woolworths suffered declines in profit during the pandemic because their services had been deemed essential. Since then, however, both have increased their profit margins, thanks to weak competition and their ability to delay passing on any cost reductions.

Fels noted that high prices, including co-ordinated price increases between the two, aren’t actually prohibited by competition law, except where there is unlawful communication or agreement between the firms. (Which, of course, doesn’t prohibit tacit collusion.)

Duopolies have a mutual incentive not to decrease prices where possible, Fels said, particularly on those goods whose prices are closely watched by customers.

“There has not been a price war between the major supermarkets in some years,” he said. This contrasts with the British experience, where Tesco and Sainsbury’s entered an aggressive price war with Aldi.

Here, the entrance of Aldi has been helped by outlawing the ability of the big two to do deals with shopping centre owners preventing rival supermarkets from setting up. Fels said he shared the watchdog’s concern about the big two’s ability to limit competition by engaging in “land banking” – hoarding supermarket sites, so rival companies can’t get a foothold.

Fels worries also about the giants playing “rockets and feathers”. When their costs rise, their prices go up like a rocket, but when their costs fall, their prices drift slowly down like a feather.

Fels found that, as prices have increased, consumers had noticed again and again that once-normal prices were being advertised back to shoppers as “special”.

He quoted one submission to his inquiry asserting that, until August 2022, Coles and Woolies sold a 200-gram jar of Timms coffee for $8. Then Coles increased the shelf price to $12.70 before, a couple of weeks later, reducing the price to $10.70 with a tag saying “was $12.70 per bottle, now ‘down, down!’.”

Another submission asserted that Devondale cheese had gone from $5 to $10 in recent months, but had then been on “special” for $10.

Cass-Gottlieb has said the commission was “carefully looking” at claims that some discounts amounted to deceptive conduct. She also said it was concerned by “was, now pricing”, which might be outlawed.

If all the pain of the cost-of-living crisis at last prompts this government to get tough with the game-playing supermarkets, it will be some consolation.

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Who’s doing best in the rent-seeking business

Economists joke that, whereas they are taught that any barriers to new firms entering a market are bad, allowing profits to be too high, MBA students are taught that "barriers to entry" are good, and shown ways to raise them.

Economists have no quarrel with businesses making profits. The shareholder-owners who provide the financial capital needed to sustain those firms are entitled to a return on their investment, one that reflects not only the (opportunity) cost of their capital, but also the riskiness of the particular business they're in.

Economists call such a return on equity "normal profit". But sometimes the various barriers to new firms entering a market limit competition, allowing the incumbents to make profits in excess of those needed to induce them to stay in the industry.

These are called "super-normal" profits (super as in "above"). Now get this: the other name for super-normal profits is "rents" – economic rents, to be precise.

We're used to thinking of rent-seekers as businesses or industries that ask governments for special treatment. But it's common for rents to be sought in situations that have nothing to do with government favours.

One of the most informative pieces of economic research undertaken last year was conducted by Jim Minifie, of the Grattan Institute, who made detailed estimates of the economic rents being earned in particular industries – something no government agency would be game to do.

He focused on the two-thirds of the economy made up by the "non-tradable private sector", excluding export and import-competing industries and the public sector.

He found that the annual return on equity in the most competitive part of this sector averaged 10 per cent. That compares with returns exceeding 30 per cent in internet publishing, which includes online classified advertising of homes, jobs and cars.

Then came internet service providers on 25 per cent and wired telecom on a fraction less. Supermarkets were on about 23 per cent, sports betting on 22 per cent, liquor retailing on 19 per cent, and wireless telecom and (get this) private health insurance on about 18 per cent.

Delivery services and fuel retailing are on 15 per cent, with banking not far behind on 14 per cent, level pegging with electricity distribution and airport operations.

But the rate of an industry's super-normal profit or economic rent isn't the same as its absolute amount. Most industries with very high rates of profit are quite small.

Measured in dollar terms, the most rents are in banking, followed by supermarkets, electricity distribution (just the local poles and wires), wired and wireless telecom.

Minifie estimates that rents account for 20 per cent of the non-tradable private sector's total annual after-tax profits of $200 billion. This is equivalent to more than 2 per cent of gross domestic product.

Another way to judge the significance of super-normal profits is to express them as "mark-ups" – as proportions of total sales.

The average mark-up across the whole non-traded private sector is 2 per cent. So, if rents were eliminated, but costs didn't change, average prices would fall by 2 per cent.

Within that average, however, the mark-up in internet publishing is 26 per cent. Then come airport operations on 20 per cent, wired telecom on 19 per cent and electricity distribution on 12 per cent.

Further down the league table, electricity transmission – the high-voltage power lines, not the local poles and wires – has an estimated mark-up of 7 per cent.

But get this: the banks' mark-up is just 4 per cent and the supermarkets' is a bit over 3 per cent.

How come, when super-profits account for more than half the supermarkets' total profit? Because supermarkets are a high-volume, low-margin business (as are banks).

Minifie notes that Coles and Woolworths are so big they achieve huge economies of scale. And, as dairy farmers well know, they achieve further cost savings by using their market power to force down the prices they pay their suppliers.

Trick is, they pass much of these cost savings on to their customers, but keep enough of them to remain highly profitable.

Coles and Woolies have substantially higher profit margins than their smaller rival IGA, even though their average prices are lower than IGA's prices. So the big two's costs must be a lot lower than IGA's.

The list of industries with the highest super-profits reminds us how badly governments have stuffed-up the national electricity market, how much better they could be doing in controlling the prices of monopoly businesses such as Telstra, airports and port terminals, and in charging for liquor and gambling licences, not forgetting the indulgent treatment of private health funds.

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Who's ripping it off? Competition theory and reality

Puzzling over the rich economies' poor productivity improvement and weak wage growth (but healthy profits), American economists are pointing the finger at reduced competition between firms. But can this explain Australia's similar story?

Jim Minifie, of the Grattan Institute, set out to answer this in his report, Competition in Australia.

Economists regard strong competition between businesses as essential to ensuring market economies function well, to the benefit of consumers and workers.

Competition is what economic theory says stops us being ripped off by the capitalists. Firms that overcharge for their products lose business to firms that undercut them.

So competition pushes prices down towards costs (which economists – but not accountants – define as including the "cost of capital", or "normal profit", the minimum rate of profit needed to induce firms to stay in the market).

Competition helps ensure that economic resources - land, labour and (physical) capital – move to the uses most valued by consumers.

Competition also encourages firms to come up with new or better products – or less costly ways of producing a product – in the hope of higher profits. But those that succeed in this soon find their competitors copying their ideas, and bidding down the price to get a bigger slice of the action.

The innovations improve the economy's productivity (output per unit of input), but competition soon takes away the higher profits, delivering them into the hands of consumers, who often get better products for lower prices.

That's the theory. Question is, to what extent does it hold in practice? And does it hold less in recent years than it used to?

The simple theory assumes any market has a large number of sellers, each too small to be able to influence the market price. In practice, however, many of our markets are dominated by two, three or four big firms.

Why? Mainly because of the presence of economies of scale. It's very common that the more you produce of something – up to a point – the less each unit costs.

So, it makes great sense to have a small number of big firms doing much of the production – provided competition ensures most of the cost saving is passed on to customers in lower prices. Which, as a general rule, it has been over the decades.

Trouble is, big firms do have some degree of control over prices. And it's common for the few big firms in an industry to come to an unspoken agreement to compete using advertising or product differentiation, but not price.

Firms can increase their pricing power by taking over their competitors to get a bigger share of the market. It's the role of "competition policy" – run in our case by the Australian Competition and Consumer Commission – to prevent overt collusion between firms, and takeovers intended to increase market power. But how well is that working?

"Natural monopolies" – where it simply wouldn't make economic sense for more than one firm to serve a particular market, such as rival sets of power lines running down a street, or two service stations in a small town - are another common departure from the theoretical model.

So, what did Minifie find in his study of competition in practice? He found evidence it had lessened in the United States, but not here.

He found plenty of markets where a few firms did most of the business. But "the market shares of large firms in concentrated sectors are not much higher in Australia than in other countries [of comparable size], and they have not grown much lately," he says.

Nor have their revenues (sales) grown faster than gross domestic product. The profitability of firms – profits relative to funds invested - hasn't risen much since 2000.

Minifie identifies eight industries characterised by natural monopoly (in descending order of size): electricity transmission and distribution, wired telecom, rail freight, airports, toll roads, water transport terminals, ports and pipelines.

Then there are nine industries where large economies of scale mean they're dominated by a few firms: supermarkets, wireless telecom, domestic airlines, then (of roughly equal size) internet service providers, pathology services, newspapers, petrol retailing, liquor retailing and diagnostic imaging.

Next are eight industries subject to heavy regulation by government: banks, residential aged care, general insurance, life insurance, taxis, pharmacies, health insurance and casinos.

(Often, these industries are heavily regulated for sound public policy reasons, but the regulation often acts as a barrier to new firms entering the market, thus allowing them to be dominated by a few firms.)

But note this: by Minifie's calculations, natural monopolies account for only about 3 per cent of "gross value added" (a variant of GDP), while high scale-economies industries account for 5 per cent and heavily regulated industries for 7 per cent.

So that means the parts of the economy where "barriers to entry" limit competitive pressure make up about 15 per cent of the economy. Then there are 29 industries with low barriers to entry making up the rest of the "non-tradables" private sector, and about half the whole economy.

That leaves the tradables sector (export and import-competing industries) accounting for 14 per cent of the economy and the public sector making up the last 20 per cent.

Even so, Minifie confirms that, in industries dominated by a few firms, many firms make "super-normal" profits – those in excess of what's needed to keep them in the industry.

By his estimates, up to half the total profits in the supermarket industry are super-normal. In banking it's about 17 per cent.

Other companies and sectors with substantial super profits include Telstra, some big-city airports, liquor retailers, internet service providers, sports betting agencies and private health insurers.

Comparing this last list with the lists of natural monopolies and heavily regulated industries suggests governments could be doing a much better job of ensuring the regulators haven't been captured by the companies being regulated.

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