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Food Prices: An Overview of Current Evidence

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5. Price Transmission

It seems that increases in food prices have been brought about by a combination of demand and supply factors rather than a single event or trend. If the assumption that the temporary factors which acted on the supply side have contributed most to the increases in food prices observed in the UK was in essence cost-push inflation, driven by rising costs of energy and agricultural commodity inputs.

However, it is unclear how costs are being passed on along the supply chain. Depending on the market structure, all of the cost increases could be passed on to the consumer or some of these increases could be absorbed somewhere in the supply chain. Alternatively, market power could also allow firms in some sectors to raise prices on food over and above the rise in the cost of their production - some evidence on how the share of retail price is split between different supply chain components and how this has changed over the years is presented in Section 5.2.

5.1 Price transmission and asymmetry of adjustment

It is widely accepted that prices are sticky, i.e. they do not respond to market changes immediately and the speed of adjustment can vary. The extend to which they stick is dependent on a number of factors, such as competition, labour market structure, customer behaviour patterns and whether they are operating in foreign markets. In Euro area countries, consumer food prices appear to have come down quicker following the recent decline in agricultural price levels whilst in the New Member States consumer prices have reacted more slowly 21 indicating differences in those factors across the EU.

Price stickiness also depends on whether market changes are the result of cost or demand shocks. A survey conducted by the Bank of England in 1995 asked around 670 companies about their pricing behaviour in response to either temporary cost and demand shocks or their short-term response to permanent shocks 2122.

According to the survey, an increase in demand is significantly less likely to prompt a price response than a fall in demand, i.e. prices are upwardly rigid in response to demand shocks. Around 67% of firms surveyed reported that they would reduce price in response to a fall in demand. However, if the demand was to increase, only 47% of firms reported that they would raise prices. 23

Conversely, an increase in costs is much more likely to prompt firms to change prices than a fall in costs - prices are rigid downwards in response to cost shocks. The difference comes across as significant, with 88% of firms reporting that they would raise prices in response to increased costs and 54% claiming they would reduce prices in response to a fall in costs. 24

This is reasonably consistent with the movements in prices that have been observed over the past year. As costs of food production increased with rises in commodity prices, retail prices quickly rose in response. Now that commodity prices have fallen dramatically, the retail price response has not been as pronounced. Food prices are still on the increase, although the rate of their inflation is now lower.

The extent of asymmetry can differ from one supply chain to another. For meat, this asymmetry was observed in the market for pork meat - at the retail-wholesale stage retailers were found to be responding twice as quickly to price rises compared to price falls. For beef, the speed of price adjustment of wholesalers was found to be twice as rapid to producer price rises as compared with falls, whilst no price asymmetry was observed on retail-wholesaler level. 25

Currently the world is facing economic downturn and the fall in consumer and business confidence have had major impacts on the demand. The responsiveness of prices to the demand shocks is seen in the changes of oil prices. Descending from their peak of around $140 per barrel in July 2008, in December of the same year, the oil price was only just above $40. As economic conditions worsen in the UK, prices on all goods, including food, should be expected to fall as firms lower them in response to contractions in demand. This however, has not yet been seen in food prices in the UK.

In addition, the Bank of England survey concluded that the more competitive are the firms product markets, the greater is the propensity to change prices in response to a demand shock. However, market structure does not seem to affect the responsiveness of prices to changes in costs.

A study into the meat supply chain 26 found three factors caused delays in cost transmission. First, there could be a technical delay. This is the time it takes for the product to get from the producer to the retailer. The full price transmission effect will only take place once the product has passed through the whole process. For meat this includes slaughtering, the period of maturation, packing, distribution and shelf life. For lamb and pork for example, this can take 1-2 weeks and 2-3 weeks in the case for beef (up to 6 weeks for fully matured hindquarter). Second, there could be institutional barriers to timely transmission of price changes. These refer to contractual terms which fix the price for a period of time at different stages of the marketing chain. In the case of meat, wholesaler-retailer contracts can be of up to 4 weeks in duration. Third, there could be a delay in retailer response. Retailers may not react immediately to the changes in price if these are perceived to be temporary. This usually happens because retailers try to avoid the additional costs associated with changing prices (menu costs). They also like to provide the consumer with a relatively stable price to prevent them from switching to other retailers in search of a better offer. A combination of these factors could make retailers more reluctant to respond to a change in wholesale price immediately.

Thus the length of the supply chain, the length of contracts and the cost of changing prices play a role in determining how quickly firms will respond to cost shocks. These are likely to vary from one supply chain to another, which could be part of the reason why great variations in price changes are seen across different food products (see Figure 15)

Both retailers and wholesalers may also engage in price levelling behaviour which flattens out variability in producer prices. Such behaviour indicates that the wholesaler or retailer may be concerned with the average margin over time rather than the margin at any one point in time. 27

5.2 Share of the retail price along the food supply chain

Looking at the retail price earned by grocery retailers, intermediaries and primary producers in four primary products, the Competition Commission found that the share of the UK retail price of milk, red meat (beef and lamb) and fresh fruit (apples, pears and strawberries) captured by the primary producers has fallen over the period of 1997 to 2006, although significant variations existed during that period. An exception to this is pig meat, where there has been an increase in the proportion of the retail price captured by primary producers. For all products analysed, the share of the retail price captured by processors over this period has typically been stable. The share of retail price for grocery retailers has increased across all products, except for pig meat, where it declined, and beef, where it remained stable. However, the Competition Commission did not consider this evidence to indicate the degree of market power, as these are affected by many other factors. 28