The Determinants of Retail Tyre Price Dispersion in the Uk*
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THE DETERMINANTS OF RETAIL TYRE PRICE DISPERSION IN THE UK* JUAN DELGADO (UNIVERSIDAD CARLOS III DE MADRID) AND MICHAEL WATERSON (UNIVERSITY OF WARWICK) Abstract We investigate price dispersion in a retail market (tyres) characterised by outlets each selling a range of products. Consumers face substantial price dispersion across outlets even for very tightly defined products. Our modelling incorporates search behaviour and some market power at the retail level. Empirically, we employ both matched pair and regression approaches. Significant components of price dispersion are accounted for by our finding that retail chains as a group are more expensive for tyres than standalone outlets. One specific result is that chains owned by manufacturers sell other manufacturers’ tyres over 17% more expensively than do independent stores. Keywords: price dispersion, vertical restraints, search behaviour JEL nos: L13, L81, D83 This version: May 1999 *We would like to thank the Consumers' Association for providing the tyre price data samples. We also thank seminar audiences at Carlos III, Copenhagen, Edinburgh, Fundación Empresa Pública, IHS Vienna, XII Jornadas de Economía Industrial, LSE, Queen Mary Westfield, Warwick and York. In particular we thank Steve Dowrick, Chris Gilbert, Morten Hviid, Francine Lafontaine, Dennis Leech, Pedro Marín, Peter Mollgard, Andrew Oswald, Consuelo Pazó, Margaret Slade, Dylan Supina and John Sutton for comments at various stages, Jeremy Smith for his patience and tyre industry representatives at retail and manufacturer level for general discussions and specific help. Juan Delgado would like to thank The British Council and the “Fundación Cultural Caja de Ahorros del Mediterráneo” for financial support at the initial stages of this research. The usual disclaimer applies. Corresponding Author: Professor Michael Waterson Department of Economics University of Warwick Coventry CV4 7AL Phone: 01203 523427 Fax 01203 523032 email: [email protected] 2 1. Introduction This paper investigates the determinants of price dispersion in a retail market in which the product may be closely defined and is widely available. Pricing dispersion within a market for tightly defined products may exist for two reasons. First, because suppliers can sort on observable types or because consumers self-select amongst packages offered them. This dispersion can persist in the presence of extensive consumer search. Airline travel between city pairs provides a classic example which has been the subject of several studies (e.g. Borenstein and Rose, 1994). Second, it exists because consumers engage in only limited search. Thus, even in the absence of different customer types observable by suppliers, price dispersion can persist. Salop and Stiglitz (1977) were amongst the first to demonstrate this theoretically. Our focus is on this second type of market, which has received much less attention. We look for specific patterns in the pricing structure beyond the basic dispersion identified in search theoretic analyses and resulting from consumer behaviour. Within this context, we believe ours is the first paper to carry out such an empirical examination on retail markets. Several studies (e.g. Pratt, Wise and Zeckhauser, 1979) have found considerable price dispersion, but they have not gone on to investigate its character by reference to firm behaviour1. We treat consumer behaviour as given and examine firm behaviour. In our empirical analysis, we investigate a specific product (retail tyres). We have several reasons for the choice of product: the good may be very tightly defined (a particular brand and class), consumers have considerable choice amongst stores but do little search, all stores sell a range of types, and the retail structure provides a rich variety of arrangements. This allows for examination of differing firm behaviours across local markets. Modelling suggests a pattern in which the lowest prices are set by small independent stores. Chains will charge more on average, with those chains which are vertically integrated with tyre manufacturers setting higher prices for other manufacturers’ tyres than their own, all else equal. Thus the central argument, which receives substantial empirical support from two quite different approaches, is that it is necessary to consider the vertical linkages in the tyre industry in order to understand the pattern of retail tyre prices across outlets2. 1 We should also note the important papers by Shepard (1991), on petrol stations, which examines price dispersions of the first type identified above, and by Roberts and Supina (1997) on firm effects on dispersion for essentially homogenous basic manufactures. 2 It is no part of our purpose to test the contention that there is a degree of monopoly power enjoyed by the manufacturers of popular branded tyres in respect of replacement purchases. Our data are not particularly well designed to examine this issue, but in any case it is generally accepted in the industry 3 In examining the nature of competition in tyre retailing, we first wish to investigate whether, for a given tyre brand and type, prices are the same across outlets in the same market. What is somewhat surprising is the degree of price variation for a homogeneous product, despite the urban nature of the samples and the consequent proximity of the retailers. To illustrate, consider the following snapshot from our data. A consumer living in Gloucester (a city of around 100,000 people) wishing to buy a specific leading brand, size and rating of tyre, namely a Michelin Classic 175/70R13 T could, amongst other stores, visit at least five outlets in or around the same street where it is on sale at prices between £40 and nearly £62! The important new point we establish in this paper is that the price variation is decidedly non-random. Specifically, to preview results, we find that manufacturer-owned outlets sell rivals' tyre brands over 17% more expensively than do standalone stores, whilst also being expensive for their own tyres. This finding is systematically true across the sample. Some independent tyre chains pitch their prices up to 25% above standalone store prices, and large chains are more expensive in general. Thus our own investigations suggest that to a significant extent we can explain such price dispersion by means of industry structural features. We choose to develop initial hypotheses using the lens of search theory, which allows price divergences even in a market which is competitive in the sense that firms break even. We then add to the model the possibility that an element of market power at an upstream level, transmitted to the downstream, bears responsibility along with downstream market power for price differences. Candidate models are developed in Section 3 below, following a brief section describing the market. Our data are built round two sets of observations of prices collected by agents of the UK Consumers' Association in February 1994 and February 1996. We have copies of the original data sheets, which turn out to provide a remarkably useful sample. From their sample, we select only observations from outlets in narrowly specified urban markets. Unusually, we then adopt two quite different approaches. One is very exclusive, involving only comparisons between matched observations. The other is a more standard econometric approach. Remarkably and reassuringly, both yield very similar conclusions. In Section 4 we describe the data more fully, then in Section 5 that tyre manufacturers supply product to car assemblers at relatively low prices safe in the knowledge that a considerable proportion of consumers wanting replacement tyres buy the brand which matches their original equipment. This is of course consistent with normal profits overall for tyre manufacturers, or supernormal profits. 4 we describe the estimations using these two approaches. Section 6 contains a few concluding remarks. 2. The Market for Retail Car Tyres in the UK3 We consider here only the replacement or "aftermarket", the market for tyres other than original equipment (and only that part of it relating to private motorists).4 Replacement tyres are certainly the most important spare part market for cars in the UK, by value worth over £800m in 1995, making it over 20% of the total replacement car parts market (Euromonitor 1996). It is the only significant such market in which manufacturer brands play a part. The value share of the top five manufacturers is approximately 79% (Euromonitor 1996). For many customers (possibly up to 60%, MMC, 1990) matching brand with original equipment is important. Thus there is not perfect substitutability between brands, and some may command a price premium over others, particularly if they are widely specified as original equipment,5 ie there is clearly some manufacturer market power. In industry parlance, tyres are said to be a "distress" purchase. According to industry sources almost all consumers buy tyres only when prompted by failure of the tyre by incident or at the annual roadworthiness test, or as a result of their inspection that a tyre is worn out. In this case, economists' models of consumers either buying one unit of a good, or not, make good sense. Of course, tyres are necessary in order to travel by car but, at current prices, only a small fraction of the value of the typical car. Hence by Marshall's rules we would expect the consumer’s derived demand to be very inelastic (Layard and Walters, 1978, ch. 9).6 There are many outlets from which one can purchase tyres, but in the UK over 90% of purchases (MMC, 1990) are from a specialist tyre dealer who supplies and fits for a fixed price (normally providing the same service for exhausts but only a very limited range of other goods). The 3 Useful descriptions of the industry are available in Monopolies and Mergers Commission (MMC 1990 and 1992), also Euromonitor (1996). 4 Many new cars are purchased for fleet use in the UK. However, because these are retained only for relatively short periods, and despite high relative mileage, around 2/3 of tyre purchases (MMC, 1990) are by private buyers.