The Role of Retail Services in Food Market Equilibrium

The increasing importance of services in industrialized economies is reflected in the relative importanceof service in product offerings at the retail level. Yet, typical economic studies accountonly for physical product attributes in models of product differentiation even when conductedwith retail data. In U.S. food retailing, the issue is very important as raw farm products accountfor only 19% of every dollar the consumer pays for food, most of the remaining going to servicesthat do not transform the product but that add consumer utility and cost. In this paper, weexamine this issue using the case of breakfast cereals in Boston in the context of upscale retailservices provided by supermarkets.Focusing on ready-to-eat cereals (RTECs) allows us to look more closely at the role of servicesin product market equilibrium. First, supermarket retail services go beyond the obvious singleproduct exchange function as consumers value services and suppliers incur a cost in providingthem. Given that retail services affect the primitives of the market, i.e., demand and costs, theyalso affect retail prices. Third, regardless of inter-supermarket variation in costs and prices, theissue of who’s got the power in the RTEC vertical market channel has been a hotly debated issue.The usual suspect has been the RTEC manufacturing industry, although previous studieshave not modeled the retailing stage of the marketing channel to determine their relative contributionto channel price-cost margins and the role of retail services. The conventional wisdom isthat the RTEC manufacturing industry mutes price competition and engages in non-price competition(Schmalensee, 1978; Scherer, 1982).This paper contributes to the literature in two important ways. First, it extends the Berry, Levinsohnand Pakes (BLP, 1995) model of market equilibrium to ready-to-eat cereals (RTECs) inBoston by including consumer taste for supermarket retail services. Second, it tests and comparesalternative pricing games between manufactures and supermarkets in order to assess theirrelative market power.