“Our competitors are our friends. Our customers are our enemies.” – James Randall, former president of Archers Daniel Midland
We tend to think that higher input costs will automatically be passed onto the end consumer in the form of higher prices. Higher commodity prices, and escalating shipping and wage costs over the past 18 months have consumers, businesses and investors concerned about what that might mean for inflation in the year ahead.
But it may not be that simple. You see the extent to which companies wish to pass on costs to their consumers depends on the degree to which they have market power, and how they wish to use that power. To see how we need to turn to the economic phenomenon that is game theory.
In an infinite series of games of ‘The Prisoners Dilemma’ the optimal strategy is one of Tit for Tat. If the other side cooperates, you also cooperate; if they cheat then you punish them by also cheating.
Many industries see similar games being played out every day. Individual firms observe the actions of their competitors over the period of several years or even decades in the case of the oldest and most established industries. The greater the number of interactions they have the greater the incentive to cooperate.
Individual firms may cooperate by maintaining or raising prices, or responding to a competitor slashing prices by engaging in a price war. In industries with low concentration (i.e. lots of small firms) this degree of cooperation is much more difficult to achieve. One firm can’t possibly keep track of the actions of multiple competitors even if it tried to speak to all of them regularly. This degree of cooperation is much more easily achieved in heavily concentrated industries in which there are few players. This type of market structure is known as an oligopoly.
Of course speaking to your competitors and attempting to coordinate quantity and / or price would likely be considered illegal in most national jurisdictions. But you don’t even need firms to actually talk to each other to cooperate. Tacit collusion as its know is defined as a collusion between competitors, which do not explicitly exchange information and achieving an agreement about coordination of conduct. Tacit collusion on the other hand is legal, and perfectly rational.
There are two ways that oligopolies practice tacit collusion: price leadership and price signalling. Price leadership is where a ‘leader’ adjusts prices, and its small competitors follow the leader in lockstep. This is more likely to occur in markets where there is an undisputed leader, typically the largest firm in the sector.
Price signalling meanwhile involves the CEO issues a public statement about the market which suggests where prices should be, often justifying the change on some fundamental ground that anyone outside the industry would have trouble countering. The CEO can then listen to the ‘public’ response from its competitors, investors, regulators and perhaps even its customers. In the book Confessions of the Pricing Man by Hermann Simon, the author advises that, “As long as companies keep their communications relevant to everyone in the marketplace, including customers and investors, and do not go overboard, they are usually on the safe side.”
Over the past few months, big companies in heavily concentrated, oligopolistic markets have been out ‘price signalling’ to the market. Watching the public statements from these companies on expected price hikes can be an important indicator to follow of likely future inflation.
Here’s Tyson Foods.
..and here’s appliance manufacturer Whirlpool.
Here’s an example from TSMC, the Taiwanese semiconductor manufacturer that dominates the global chip sector.
Where to find this type of industry? According to Edward Chancellor, author of the book Capital Returns: Investing Through the Capital Cycle, “A basic industry with few players, rational management, barriers to entry, a lack of exit barriers, and noncomplex rules of engagement is the perfect setting for companies to engage in cooperative behaviour.”
Despite the appearance of perfect competition (lots of small individual firms competing against one another), the problem is particularly acute in agricultural markets. According to Jonathan Tepper and Denise Hearn, authors of The Myth of Capitalism, “Only four corporations provide 57% of all poultry, 65% produce all pork, and 79% control all beef in the United States. Today, over 96% of chickens are raised under production contracts with large companies that set out exactly how they’re raised, how they’re fed, the size of facilities and so on.”
It’s true across other aspects of the agricultural market too. For example, ADM, Bunge, Cargill and Louis Dreyfus control up to 90% of the global grain trade. Known as the CR4, the concentration ratio of the top 4 companies in a sector is a standard measure for oligopolies.
Remember though that looks can be deceiving. As Tepper et al. highlight in The Myth of Capitalism, many industries, operate on the basis of an hour-glass structure. Lots of individual firms at the top, lots of customers at the bottom, yet heavily concentrated in the middle – and it is in the middle where all the margin is typically made.
The relationship between costs and consumer price inflation may if anything be more transparent than it has been in the past, and as we’ve seen, not necessarily related to the change in underlying input costs. The increased concentration of many industries gives us a window in to the pricing decisions that will ultimately affect us all, whether we like it or not.
Related article: Which asset is the best hedge against inflation?
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