Loss leading with salient thinkers

• Author: Martin Obradovits,Roman Inderst
• Date: 01 March 2020
• Published date: 01 March 2020
• DOI: http://doi.org/10.1111/1756-2171.12312

RAND Journal of Economics

Vol.51, No. 1, Spring 2020

pp. 260–278

Loss leading with salient thinkers

Roman Inderst∗

and

Martin Obradovits∗∗

In various countries, competition laws restrict retailers’freedom to sell their products below cost.

A common rationale, sharedby policymakers, consumer interest groups and brand manufacturers

alike, is that such “loss leading” of products would ultimately lead to a race-to-the-bottom in

product quality. Building on Varian’s (1980) model of sales, we provide a foundation for this

critique, though only when consumers are salient thinkers, putting too much weight on certain

product attributes. But we also show how a prohibition of loss leading can backfire, as it may

make it even less attractive forretailers to stock high-quality products, decreasing both aggregate

welfare and consumer surplus.

1. Introduction

In 2002, Germany’s highest court passed a landmark decision against Wal-Mart’s attempt

to gain market share through heavy discounts and in particular below-cost selling. Apart from

Wal-Mart’sexit from the German market in 2006, this sparked a subsequent change of the national

competition law: it now bans loss leading explicitly in the food retailing industry. A proclaimed

main objective of this regulation was to prevent a race-to-the-bottom in product quality and a

crowding-out of high-quality products, promoting consumer well-being and food safety.1Next

to Germany, prohibitions of loss leading exist in various other, notably European, countries.2

Overall, policymakers seem to be particularly worried when loss leading affects staple goods of

∗Johann WolfgangGoethe University Frankfurt; inderst@finance.uni-frankfurt.de.

∗∗University of Innsbruck; martin.obradovits@uibk.ac.at.

Wethank seminar par ticipants at ETH Zurich (May2015, Zurich), the Barcelona GSE Summer Forum 2015 (June 2015,

Barcelona), the Competition and Bargaining in Vertical Chains Workshop 2015 (June 2015, D¨

usseldorf), EARIE 2015

(August 2015, Munich), the Bergen Competition Policy Conference 2016 (April 2016, Bergen), and IIOC 2017 (April

2017, Boston) for helpful discussions. We are especially indebted to three anonymous reviewers and David Myatt as

editor, whose comments havehelped to g reatlyimprove the article.

1See, for example, page 9 of the legislative proposal 16/5847 from June 27, 2007 bythe then Ger man government

where, concerning the below-cost selling prohibition, it is stated that (own translation from German): “In the long run,

the competition between retailers, which is characterized bylow-price strategies, also poses a threat to the quality of food.

With the general ban on the sale of food below cost, the FederalGovernment therefore wants to send out a signal for a

high standard of food safety and counteract low-price strategies.”

2These include Belgium, France and Ireland. Although US federal law does not forbid below-cost selling or loss

leading per se, several states have enacted below-costselling laws. California goes even further and rules in its Business

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INDERST AND OBRADOVITS / 261

the national cuisine, such as dairy products in the United Kingdom or olives and wine in southern

European countries,3reflecting concerns for quality, consumer health, and safety.

From an economic point of view, the alleged positive effects of an imposition of price floors

may seem dubious, and such prohibitions have frequently been criticized by economists. In this

article, we show, however, that a ban of below-cost selling can indeed prevent retailers from

stocking products of inefficiently low quality, though only when consumers are salient thinkers

who put too much attention on certain product attributes. Then, heavy discounting of loss leaders

makes the provision of high-quality products unattractive, as consumers focus too much on low

prices rather than on high quality. We expose the precise mechanism in detail below.

In our model, retailers compete for consumers by selecting which product to stock and which

price to set in a prominent product category. Retailers may choose between either a high-quality

(branded) variant or a low-quality (possiblyprivate-label) alternative. We are primarily interested

in the case where the provision of the high-quality product is more efficient. Consumers are

one-stop shoppers who make their shopping decision based solely on the (observable) offers in

the prominent product category. Competition on the (potentially loss-leading) prominent items

occurs through promotional discounts, as in Varian (1980). Varian’s model seems to capture

well the concerned retail markets, with frequent and largely unpredictable price promotions.4

Moreover, even when populated with salient thinkers, it allows for surprisingly tractable results.

Wefollow the seminal analysis in Bordalo, Gennaioli, and Shleifer (2013) in stipulating that

salient-thinking consumers put too much weight on the attribute of a product, that is, price or

quality, along which the product differs more, in relative terms, compared to the market average

of the respective attribute. When consumers are salient thinkers in this sense, we establish

that increased competition and the thereby decreasing prices in the prominent category induce a

gradual replacement of high-quality products, as then even small absolute price differences appear

relatively large in the eyes of consumers, putting low-cost, low-quality firms at an advantage.

In terms of positive implications, our model provides new insights into the rapid growth

of private labels5as a consequence of increased retail competition and the spread of one-stop

shopping. We also derive precise conditions on when the high-quality outcome is restored by a

prohibition of below-cost pricing and when such a prohibition instead accelerates a race-to-the-

bottom in product quality. Which outcome prevails depends on whether the regulation constrains

retailers’ pricing more for high- or low-cost products. The perception that such a prohibition

would unambiguously promote high quality is thus wrong. And evenif it does, we show that there

is potentially a trade-off between higher social efficiencyand lower consumer rent in case such a

ban dampens retail competition too much.6

Although economists have typically been skepticalabout prohibitions of loss leading, recent

contributions have somewhat changed this picture. Chen and Rey (2012) show how with asym-

metric retailers and a lack of competition, loss leading may be used as an exploitative device

to screen consumers according to their shopping cost. They establish that a ban of loss leading

and Professions Code Section 17044 that “[i]t is unlawful for any person engaged in business within this State to sell or

use any article or product as a ‘loss leader’ [ .. . ].”

3For instance, in Spain, the government repeatedly undertook efforts to curb discounts on olive oil (e.g., “Deal

Could Stop Use of Olive Oil as Loss Leader,” Olive Oil Times,March 4, 2013). These efforts are helped by Spain’s legal

prohibition of loss leading, of which recently the German discounter Lidl fell foul when selling wine at a discount (“Lidl

Rapped for Selling Wines at a Loss,” The Drinks Business, October 16, 2014).

4Promotions (sales) are a defining feature of modern retailing competition and account for a large share of the

observed price variation in retailing. Recent empirical studies documenting the ubiquity of retail promotions include

Volpe(2013), Nakamura and Steinsson (2008), Berck et al. (2008), and Hosken and Reiffen (2004).

5The market share of private labels in European food retailing has risen significantly, with now more than 40% in

some countries, such as the United Kingdom. Frequently, but not exclusively, private labels are positioned at the lower

end of the quality and price range. See European Commission (2011) for an overview across Europe.

6Allain and Chambolle (2005) and Rey and Verg´

e (2010) show howalso intrabrand, next to interbrand competition,

can thereby be dampened, as below-costpricing regulations may allow manufacturers to impose price floors.

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The RAND Corporation 2020.