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. 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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  2. 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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  3. 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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  4. 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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  5. 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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