Why food prices rise like a rocket, fall like a feather

After a freeze in Arizona's lettuce growing region, why does the price of lettuce across the United States go up like a rocket, then fall like a feather after the crop recovers? Why do the size and shape of food packages change so often? Why do wholesale food prices fluctuate wildly, while retail prices don't change much?

The average shopper, considering these questions while wandering the colorful, staged aisles of an oversized supermarket, might suspect that grocery retailers are using their marketing prowess and size to take advantage of consumers. Shoppers also might wonder if grocers are acting like monopolies or colluding with other retailers — creating what is known in economics as a condition of "market failure."

Timothy Richards, agribusiness professor at the W. P. Carey School's Morrison School of Agribusiness, views the ways grocery stores function quite differently. He believes that most of the time, the retail food business is an efficient market with both consumers and retailers exhibiting rational behavior. "It's easy for the public and for economists to conclude that the market is failing," Richards says. "But once you get under the hood and take a close look at what is happening, nine times out of 10 you find that the market really isn't failing, and, in fact, is working pretty well."

A subject people care about

Richards is a microeconomist who studies the behavior of individual consumers and firms, primarily in the business of food. A self-described data junkie, Richards has spent much of the past 15 years analyzing food industry data to uncover why individuals and companies behave the way they do.

Unlike the many quantitatively oriented economists who labor in obscurity, Richards finds that people often are quite interested in his work. An analysis he did recently on the possible effects of the California drought on fruit and vegetable prices was picked up by dozens of news outlets, including The New York Times, The Los Angeles Times, Reuters and the BBC.

"It's a topic that is relevant and important to people," he says. "Everybody buys food. Everybody eats food." In the past dozen years or so, behavioral economics has been on the rise. This emerging field challenges the basic principles of classical economics that people tend to behave rationally and that markets are efficient.

Behavioral economists look for cognitive, emotional and social reasons for economic decisions. From this starting point, it's not hard to come up with explanations for how the market for food functions. For most people, food is emotionally loaded, and it's easy to see shoppers casting aside rationality as they push their carts down the aisles.

But Richards questions the applicability of behavioral economics to the market for food. "Behavioral economics is a convenient excuse for a lot of things, but it's really, really hard to say that people are irrational," he says.

Why prices are stable

Richards has studied a broad range of models, from behavioral economics to neo-classical, and has tested them with data on food prices and purchasing. His research points to a phenomenon that explains why food shoppers and retailers do what they do: hysteresis.

The concept, which comes from physics, refers to the perpetuation of a phenomenon after its initial impetus has disappeared. In physics, an object set in motion tends to stay in motion. "In economics, hysteresis means that people stick to a certain mode of behavior even though the initial incentive that gave rise to that behavior is gone," Richards says. "It can apply to any economic decision-maker." Uncertainty encourages hysteresis, according to Richards.

He cites the example of a grower who plants grapes to make Cabernet Sauvignon when demand for the wine is strong. But by the time the vines produce grapes, demand for Cabernet has softened, and wine drinkers want Zinfandel. However, the grower does not rip out the Cabernet vines and replace them with Zinfandel because some day Cabernet prices may rise again.

"If we were to drop down from Mars and look at what is happening, we'd say, that doesn't make sense — all of these acres of Cabernet Sauvignon vines, and yet the price is low," Richards says. "But the grower knows that the price for grapes is variable, and one day Cabernet could become profitable again. Hysteresis is why we see lots of Cabernet Sauvignon out there even though the price has gone through the floor."

Hysteresis arises in the market for food because there are option values inherent in the decisions of the participants, according to Richards. Consumers must weigh the costs and benefits of becoming informed about prices. Retailers have to consider the potential negative consequences that could come from shifting prices.

"Options in the grocery market are similar to those in the world of finance," he says. "It's a right but not an obligation to buy something. And if you've got a right but not an obligation, then the costs and benefits of becoming informed about prices becomes relevant."

Comparing apples to apples

Hysteresis explains the "rockets and feathers" phenomenon of prices going up quickly and falling slowly, according to Richards. Consumers monitor the price of a product as it goes up, but when the price starts to fall, they don't follow it that closely.

All they care about is that the price is falling, and the benefits of becoming more informed about prices don't outweigh the costs they would incur in time, energy and attention. "Retailers and marketers know that when prices vary a little bit around what people think the price should be, nothing really happens," Richards says. "There are lots of psychological theories that say it's because people are inherently irrational. My thesis is that people are incredibly rational and they understand there are costs and benefits to becoming informed about prices."

A product that Richards has studied extensively over the years is apples. Wholesale prices for manufactured goods like cereal or pasta sauce are proprietary information, but in the state of Washington, growers publicly report the wholesale price of apples.

Richards thus has been able to track and compare wholesale and retail apple prices. He is fond of displaying graphs with wholesale and retail prices represented by lines of different colors. The wholesale line jumps up and down constantly, while the retail line has long plateaus punctuated by sharp up and down shifts.

For retailers, changing prices to conform to shifting supply and demand can be a risky move, according to Richards. "It doesn't make sense to change retail prices every time the wholesale price changes, especially if there is volatility in the market. If retailers change the price, and then conditions change, are they going to have to change it again tomorrow?

When you change prices, you can confuse and alienate your customers." According to Richards, this is often the reason manufacturers change the shapes and sizes of packaging. Once short and stocky, cereal boxes sometimes become tall and thin. Jars of jelly come with dimples on the bottom. "Consumers are a lot less aware of sizes than they are shelf prices," Richards says.

The long tail of food shopping

Many in retail and those who study it expected the rise of online shopping to exert enormous downward pressure on prices. Consumers would be able to compare prices with a few mouse clicks. Richards has studied the effects of Internet shopping generally, he also has looked closely at the emerging business of online grocery markets.

What he has found is that online commerce does not necessarily mean lower prices. "What we see online is that prices can actually be higher," Richards says. "People often go online to shop not for prices but for what we call specific product attributes, or highly differentiated, niche products."

In the case of food, consumers will use the Internet to find things that their local supermarket probably doesn't have, such as a cereal that is organic, free of genetically modified ingredients, and also low in sugar, fat and calories. "You would think that once everything went online there would not be any money in grocery shopping because prices would be driven down to cost. But it's exactly the opposite. There are lots of opportunities for value," Richards says. These findings conform to the notion of the "long tail," popularized by WIRED magazine editor Chris Anderson, author of a book of that name.

The Internet lowers the cost of production and distribution, which means that goods and services can be narrowly targeted and sold in smaller quantities over a longer period of time. "The long tail of retailing means that there are going to be more people seeking niche products and fewer people who go to the store and just buy the Cheerios," Richards says.

Although the idea of the long tail has been applied to many areas of retail for many years, it is only just now coming to the market for food, according to Richards. The rise of online grocery shopping should accelerate the process, he says. "In the United Kingdom, about 6 percent of all grocery dollars are spent online. In the United States, it's about half of one percent.

Admittedly there are differences in behavior in the US and the UK, but we are going to go toward their number. Online is going to be the wave of the future." The idea that the market for food is distorted by monopoly power or collusion ignores the intense competition in the grocery business, according to Richards.

Margins in the retail food industry in the United States are razor thin, with profits on a dollar in sales averaging a mere penny and a half, he says. "The Phoenix metro area happens to be one of the most competitive markets in the country. We have Wal-Mart and Target. We have WinCo Foods, Bashas’, Albertsons and Safeway. We've got everybody, and coming down the pike is AmazonFresh. The food industry is super, super competitive."

First published in W. P. Carey Magazine, Spring 2015

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