The Costco Effect: Why Does the Wholesaler Cause Inflation?

There’s a lot of data showing that Walmart causes prices to decline when it enters a local market (see here, here and here). Why then, according to a new study, does Costco have the opposite effect, and cause competitors to raise their prices? The answer boils down to the complex ways that stores choose to compete against each other, and shows that not all big box retailers are created equal. Here’s the abstract:

Prior research shows grocery stores reduce prices to compete with Walmart Supercenters. This study finds evidence that the competitive effects of two other big box retailers – Costco and Walmart-owned Sam’s Club – are quite different. Using city-level panel grocery price data matched with a unique data set on Walmart and warehouse club locations, we find that Costco entry is associated with higher grocery prices at incumbent retailers, and that the effect is strongest in cities with small populations and high grocery store densities. This is consistent with incumbents competing with Costco along non-price dimensions such as product quality or quality of the shopping experience. We find no evidence that Sam’s Club entry affects grocery stores’ prices, consistent with Sam’s Club’s focus on small businesses instead of consumers.

The study’s authors, Charles J. Courtemanche and Art Carden have looked at big-box retailers before. Their 2010 paper, “Supersizing Supercenters? The Impact of Wal-Mart Supercenters on Body Mass Index and Obesity,” showed that each additional Walmart Supercenter per 100,000 people increases the obesity rate by 2.3 percentage points. They concluded that the proliferation of Walmart Supercenters may explain 10.5% of the rise in the obesity rate since the 1980s. (On a side note, if you haven’t already, check out this flow map depicting the growth of Walmarts and Sam’s Clubs.)

Their new study shows that a Costco store increases competitors’ grocery prices by 1.4% in the short run and 2.7% in the long run; whereas previous research shows that a new Walmart generally reduces prices by 1%  to 1.7% in the short-term, and by about four times as much in the long run. This demonstrates just how nuanced the economics of strategic behavior really are. While incumbent grocers try to match Walmart on price, they figure it’s simply not worth it to go toe-to-toe with a warehouse club like Costco. While Walmart has made its stores more physically appealing over the years, Costco’s remain drab and utilitarian: pallets of bulk items sitting on concrete floors remains the dominant aesthetic. As a result, the only competitive advantage incumbent grocers see worth pursuing is on experience and convenience, choosing, as the authors point out, to cede “price-sensitive consumers who are willing to drive longer distances for a less pleasant shopping experience in order to obtain deep discounts.” By focusing on less-price sensitive customers, incumbents are able to sneak in some price hikes without affecting sales.

The Costco effect is strongest on fruits, vegetables, meats and drinks, with the biggest price increase on lettuce.

[HT: Stephen Gandel]


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  1. Jeff says:

    This is very interesting. I’d like to see a game theoretic analysis of what’s happening.

    On a minor note, Philips misuses of the word ‘inflation’. Increases in grocery prices are not necesarily a rise in general prices. Grocery prices may go up as all other prices fall. The article should have been entitled something like “The Costco Effect: Why does the wholesaler cause regional grocery prices to rise?”

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  2. jonathan says:

    Seriously? As a former commercial landlord with grocery tenants, I can tell you the reason is not “product quality” but the difference between bulk and individual pricing. I haven’t read the study but, my word, didn’t they talk to people in the field? Costco charges more for more stuff; you buy a big bunch of bananas, a whole container of dates, a 2 pound minimum package of little cucumbers or 3 seedless at a time, an entire tray of tomatoes. This means a grocer can sell cucumbers for some pennies more because many customers want 1 cucumber, 4 tomatoes instead of 12, 3 bananas instead of 4 pounds. I thought that was obvious. It’s not exactly a secret in retailing. Costco charges you $4 for twice more of something than you need so the local grocer can charge you a little over $2 for half as much because you’ve just saved nearly $2. Sure, the per unit price is higher but you waste less.

    The difference with Walmart is they kill you – and we had Walmart as a tenant too – on price for individual items. That forces the grocer to worry about Walmart’s weekly sale prices and discount more to keep traffic up. Remember, if you get traffic, you will get a mix of sale and non-sale purchases. Walmart builds an expectation that you can walk in and find some good grocery items, from produce on over, at really low prices. (Peanut butter and canned tuna are big examples.) So people come both because they want specific specials and the surprise specials they pull out. A grocer relies more on traditional weekly sales flyers. You may see “manager’s specials” in more grocers now. That’s an attempt to build the sense of surprise that Walmart has really mastered.

    As for service and ambience, that’s mostly for pushing prepared foods. Costco drives a lot of that too; they have bigger packages of the processed crap Americans devour so you have more grocers offering much more higher margin prepared foods – which are usually highly processed. You see this in a range from grab n go stations to Whole Foods that have nearly entire restaurants of steam tables and the like set up – selling the imagery of high quality food without the actual quality.

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    • William says:

      Jonathan, you missed the point. We all know that individual items will sell for more than a bulk package(this is usually the case anyways). This article isn’t saying that grocery stores charge 1-1.7% more than costco. It’s saying they charge 1-1.7% more than they charged themselves before costco came in! I.E. if a single banana is $1 at the grocery store, but costsco has 5 for $4, the grocer will instead raise their price to $1.01 or $1.02 in the short term, and eventually as high as $1.06 or so in the long term. This article has nothing to do with grocery store prices as compared to costco prices. It’s grocery store prices compared to what they were before costco came in.

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      • jonathan says:

        Hidden due to low comment rating. Click here to see.

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  3. ohhai says:

    This is not inflation. It’s a price increase. Inflation is a monetary phenomenon

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    • commonsenseless says:

      Thank you! it annoys me whenever “economists” use the term to mean something else completely different!

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  4. Enter your name says:

    Jonathan, although your explanation explains why bulk-oriented Costcos drive prices up, it does not explain why the equally bulk-oriented Sam Clubs drive prices down.

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    • Carl Natale says:

      Aren’t Sam’s Clubs paired with Walmarts? The ones I have seen are close to each other. Seems that would negate any upward price movement.

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  5. John B says:

    “This is consistent with incumbents competing with Costco along non-price dimensions as product quality or quality of the shopping experience.” Costco product quality exceeds any big box store and that of most smaller competitors.

    If that statement was true, then the pricing effect of Walmart would be the opposite, since the quality and enjoyment of shopping in a Walmart is well below its competitors.

    I believe a true study would show that prices go up because Costco forces its competitors to improve their offerings and provide higher quality–and more expensive products.

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    • M says:

      I like your insights.

      Your last comment, about Costco pushing prices up because it forces competitors to provide higher quality and thus more expensive items, is consistent with what one comment above says about Costco offering more prepared foods and thus forcing other grocery stores to do likewise. Also, it’s consistent with the author’s belief that perhaps other grocery stores focus more on convenience, quality, or selection since they can’t compete solely on price with the bulk pricing of Costco.

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  6. Mike B says:

    Is there a way to correlate flow maps? I would like to see which infectious disease Wal*Mart best matches up to.

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    • Sincerely Confused says:

      I am legitimately confused; why is Wal-Mart (WMT) evil? I stress legitimately because I understand that many people HATE Wal-Mart and I honestly, sincerely, do not know why.

      I like WMT because:
      1) prices are low
      2) I can buy a belt, lunch, get a key made, and pick up a prescription at the same location
      3) there is always one close

      I understand that they pay low wages, but the employees that I have seen look like they don’t deserve minimum wage. They’re usually stupid and apathetic, not all, but a large portion (again, that I see). Of course, WMT is getting what they pay for, but isn’t that their right? It’s not like these employees would be building rockets or curing cancer if WMT wasn’t around to keep them employed. Don’t we need someone to employ the low-skilled?

      I’ve heard that they put local “mom-and-pop” (M&P) stores out of business, but so what? Is it bad to have fewer M&P stores? If WMT can deliver the same TV cheaper, wouldn’t society benefit from this competitive advantage?

      If there is a legitimate, researched stance that WMT is a negative to society, I’d be open to listen.

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      • Joshua Northey says:

        Not to mention the fact that centralized goods distribution is more efficient and a better use of resources. That is why I love places like IKEA and the like. Better to have one super efficient location then 20 inefficient tiny ones keeping the costs really high. The main people Walmart hurt were small business owners and that is one of the reasons the opposition to it gets national play.

        People dislocated by new economic efficiencies always complain vociferously about the things dislocated them, and if the people being dislocated have money those complaints can get some traction.

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      • Kevin says:

        If you watch the documentary, Wal-Mart: The High Cost of Low Price (2005), it paints a very negative image of Wal-Mart.

        The points that were brought up and were the most disturbing were the lack of environmental protection policies, poor workers rights (US and Internationally) and the racism and sexism employees faced.

        The film also focused on the driving out of small business, and the anti-union practices of Wal-Mart. I agree competition should be welcomed, to a degree. Wal-Mart should force others to compete, but I also think Wal-Mart should not become a towns only option for business. And with a big company like Wal-Mart it becomes hard for those “mom-and-pop” stores to compete.

        I know you wanted a researched stance but the film is something worth checking out and using to help formulate an opinion.

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      • S says:

        I like Wal-Mart, but that documentary and other critics do have good points. I think these critics have made Wal-Mart more responsive to environmental and community concerns.

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      • Joshua Northey says:

        Because if there is one thing the retailers Walmart is pushing out of business were it was pro-union, anti-discrimination, anti-sweatshop, and environmentally conscious?

        Every loves to say “buy local” but then the local store buys 90% of its inventory from China, which is worse then Walmart.

        There are things not to like about the transit heavy nature of big box development, but other then that I don’t see many downsides. If you are worried about the environment or discrimination I would much rather have a big behemoth dealing with the issues then 50,000 small businesses many of which are run horribly.

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      • Enter your name says:

        They also engage in some startlingly unethical business practices. For example, go read about Vlasic’s experience with them: Walmart basically said, “According to your legally mandated public statement of financial performance, last year you earned X in profits. Therefore, this year you will sell us your product at a price that equals your cost minus the entire amount of the previous year’s profits. We figure that this gives us the lowest possible price and will keep you from actually going bankrupt… for 12 months… and will make sure that you can’t afford to let anyone else have a price that is even close to ours. Your other choice is to lose half your business, default on your contracts with your suppliers, fire most of your employees now, and probably go out of business next year. Make your choice.”

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      • Sincerely Confused says:

        RE: Enter your name

        I looked up the Vlasic case, but I’m not seeing what you have claimed. Vlasic was already selling its product for a low price for several years, and asked to raise the price. Wal-Mart said it wanted to keep it the same. Nothing like you have claimed.

        It appears that Vlasic was overleveraged from a spin-off from Campbell Soup. I read about the price negotiations in the book “The Wal-Mart Effect” by Charles Fishman. Below is an excerpt:

        Pat Hunn, Vlasic’s head of marketing, said…

        [“They did not put a gun to our head and say, ‘it’s $2.97 or you’re out of here,” says Hunn. “They said, ‘We want the $2.97 gallon of pickles. If you don’t do it, we’ll see if someone else might.’ I knew our competitors were saying to Wal-Mart, ‘We’ll do the $2.97 gallons if you give us your other business.’
        “we’re all big boys, “ Hunn says, “We all make decisions.”]

        Seems like an executive at Vlasic believes Wal-Mart was just doing business. It also appears that Vlasic had too much debt and too much reliance on one buyer. I don’t really see anything nefarious or unethical about this.

        There are several other academic papers available through Google Scholar that say the same thing.

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  7. M R says:

    I also believe it has more to do with the size of the package. Local grocers know that some of us don’t want to buy a 5 lb package of whatever, so we won’t mind paying more per oz to buy a smaller package. Our reasons are we either don’t want to store that huge amount or don’t want to get tired of eating the same thing for months.

    Costco only carries one huge size of something. Walmart usually carries several sizes and the largest isn’t always cheapest per oz. So local grocers are more inclined to compete with Walmart.

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  8. AaronS says:

    I’m betting cash-flow has a lot to do with this. The incumbent grocers know that many shoppers are not going to be able to put down $20 for a 20 boxes of cereal at Costco…when they can shop at the incumbent grocer and buy a single box of cereal for $1.25.

    People need the extra money they would spend buy in bulk…to buy the rest of the groceries they need.

    Of course, if a group of neighbors got together, splitting up the bulk purchases, they could save a lot of money, no doubt.

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    • AaronS says:

      A needed clarification:

      The grocery stores, seeing an opportunity caused by Costco’s bulk offerings, can now RAISE their own prices, so long as buying from them is still an advantage over buying from Costco.

      For example, now that you, the customer, must either buy, say, 20 boxes of cereal from Costco or an buy them individually from the incumbent grocer, the incumbent grocer, seeing that people will opt for the individual boxes (for the most part), raise the prices slightly to take advantage of Costco’s high price to entry.

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    • Frank says:

      Note that you don’t need to buy a tray of tomatoes at Costco (you can get a small bag) nor buy 20 boxes of cereal at a time (instead you buy one jumbo box of cereal about the size of two boxes of normal cereal).

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      • Ulysses says:

        Costco does have regular sized products (like cans of tomatoes, in boxes of 8) and bigger-but-still-manageable sized items like 2 lbs of crumbled feta cheese or packs of lunch meat. It simply requires considerably more of your currently available money to shop there and get all the different things you’d like to get. This is where Costco fails with, say, college students in apartments, who live very much week to week without the ability to spend more than, say, 50 bucks during a trip to the store (because that would hog too much of their money leaving them unable to pay a utility, or to spend on recreation that weekend, etc).

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      • ThatMattGuy says:

        Except at the beginning of the semester, when that super-sweet check comes. Wish I had thought of that. Imagine how much cheaper 3 months of ramen is when you buy it in bulk? Of course, this isn’t a viable option for frozen things, since most 18 year-olds don’t have deep freezers, but all that ramen sounds SWEET.

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  9. Konrad says:

    Different business models require a different mindset when shopping at each.

    Costco carries a 60-pk of granola bars for something like eight bucks, which is great if you have a three-year-old constantly in need of a snack. (While they don’t keep forever, they’ll definitely last for the two months that we’ll have the package.) A common refrain is that Costco members can make back their annual memberships on diapers alone. Diapers don’t go bad. Hersheys chocolate syrup won’t go bad (or at least won’t for a couple of years).

    On the other hand, if you don’t have a large freezer, the savings on produce, ice cream, and that kind of thing aren’t likely worth it in the long run, and a WalMart is going to be the better option. They’re still my go-to for yogurt, for example. No one other than Duggars buy eggs in quantities of 72.

    Costco’s strategy seems to be to whack the prices down on about 75% of the merchandise, keep identical prices on 15%, and jack up the remaining 10% as soon as you’re conditioned into the bulk model. For example, we were all set to buy 900 baby wipes for $19.99, but I then remembered that WalMart now carries 80 for $0.98. Work this margin out.

    Maybe Sam’s club just has a different, more WalMart-like stategy, in other words. I don’t know.

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  10. BadgerDave says:

    This is hardly inflation. Inflation is either a rise in the supply of money, or a rise in the general price level.

    I agree, it is an interesting effect, FREAKY even.

    But to call it inflation is wrong and irresponsible. When words are used improperly, the cease to have any meaning at all.

    Please try to keep this in mind in the future.

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  11. Doug Stephens says:

    There’s something else to consider here that is likely happening.

    If Costco’s presence in a market results in even a modest decline in the sales of competitors (which is entirely likely), many may actually respond by raising their prices to bridge the shortfall in profit caused by the initial decline in sales. So, the counterintuitive raising of prices you mention, may in fact be a survival response to lost sales.

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  12. Ron Santos says:

    But what’s the impact on communities with a Costco in their town where the workers there have average wages of over $20 an hour to pump into the local economy verses employees at other stores who pay their employees an average of $12 an hour? Especially since the $12 an hour wage is low income and therefore is eligible for government assistance like fuel assistance, affordable housing, reduce utility rates and so on.

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  13. Karissa says:

    I work in the grocery industry at a ‘mom and pop’ grocery store where we always have low prices. Recently I have been noticing that when Costco raises their price on milk, we HAVE to raise our price. And we had some frozen pies advertised at a cheaper price than Costco and we were forced to pull those pies from the sales floor. So I have been trying to search the web for an answer to my question: Why does Costco set the legal low price limit? So far, I have found nothing on the subject. But I had to raise the price of milk in my department, even though I could have kept it the same price as always and still made a profit, because Costco had raised their price. Very frustrating..

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  14. Diane says:

    You are so full of it Costco is the best, I have been shopping there for 8 years and what is more they treat their employees well. Isn’t that really what you’re afraid of?

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