Double Marginalization and Vertical Integration: Why Specialty Producers Bypass Supermarkets

An important insight from industrial organization is that, regardless of recent economic conditions, the outcome of any market is determined not only by how much demand or supply there is but also by the structure in which firms are organised across the value chain. The concept of double marginalization, which is taught in traditional microeconomic courses, sheds light on a notable phenomenon of the modern market. Increasingly, more food producers—including specialty meat and fish, caviar, and high-quality infant formula—are opting to bypass supermarkets and sell directly to their consumers.

Even though supermarkets appear to provide clear advantages in terms of size, logistics, and access to large numbers of consumers, in many instances producers in specialty product markets make a conscious decision to go around them. This occurs due to the economics associated with vertical restraints, bargaining power, and the costs associated with the addition of markup prices.

Supermarket Power and Margin Compression

Supermarkets are the gatekeepers of access to store shelves, and in order for specialty manufacturers to gain access to the store shelves, they may have to pay slotting fees, in addition to meeting the following requirements set forth by the retailer:

• Pay upfront slotting fees for shelf space
• Mandatory promotional discounting
• Adhere to strict wholesale price requirements
• Risk of being copied by the retailer with private label products if successful in the marketplace

Slotting fees in the U.S. can range from $5,000–$50,000 or more per SKU, dependent on category and region. For producers focused on niche products with little to no production capacity, the costs associated with slotting fees can far exceed expected profits before the sale of any units.

Retailers own the consumer relationship; thus, they also wield significant buyer power, causing the wholesale price of goods to be forced downward, while still keeping the retailer's margin intact. This dual influence results in a compression of producer margins and discourages creativity in smaller category development.

Double Marginalization in Practice

Double marginalization occurs when manufacturers and retailers both apply a markup to their products over and above the marginal costs of production and distribution, respectively. In basic terms:

• The manufacturer sets a wholesale price greater than the marginal cost.
• The retailer then marks up the price above the wholesale price.

This effect is to raise the final price, reduce the quantity sold, and diminish total surplus consumed.

In cases where the products are basic commodities, competition is strong and prices are highly elastic, so double marginalization has limited negative effects (margins are very low). But for many consumer products that are highly branded and not as price-elastic, the effects of double marginalization can lead to economically significant welfare losses.

One area of interest would be premium infant nutrition, where parents seeking out the best organic baby formula typically have a high willingness to pay for good-quality products, as well as a strong preference for products from reputable manufacturers. Since both the manufacturer and the supermarket apply a markup to the price, the ultimate price that parents must pay for the product may exceed the price that would be optimal for both the manufacturer and retailer to sell at, leading to decreased quantities that are sold and to the exclusion of some parents.

Why Direct-to-Consumer Changes the Equation

By selling directly to customers, producers have achieved a level of vertical integration not possible before, effectively bypassing all of the costs associated with selling to retailers. Although logistics and marketing may have increased, it is not uncommon to see that total margin has declined while producer surplus has increased.

One commonality among DTC specialty food entrepreneurs is that they typically experience:

• Gross margins of 60 to 75 percent, compared to only 30 to 40 percent with a wholesale business model;
• Greater control over the price they set for their products, as well as a reduction or elimination of forced discounting; and
• Direct access to their customers' data, allowing them to manage retention and offer subscriptions.

From an industrial organization viewpoint, DTC addresses the double marginalization issue by bringing all pricing decisions into one organization, instead of having separate pricing policies for each step in the distribution chain.

Scarcity, Exclusivity, and Vertical Restraints

Producers can use bypassing supermarkets as a means of obtaining greater efficiency by strategically using vertical restraints to create or shape a market for their products. Limited product drops, waitlists, and exclusive access to drops create the perception of scarcity, which involves psychological perceptions created by consumers as defined by demand theory.

Examples of the strategy include:

• Small batch smoked meat manufacturers who release monthly product drops that sell out within hours.
• Premium caviar manufacturers who tier access to their products based upon prior purchases.
• Imported brands of baby formula who limit the availability of their products to signal the level of quality.

While supermarkets are designed to eliminate the effects of scarcity and maximise the turnover of inventory on the shelf, they are not as well suited for selling products that require an element of exclusivity as part of their value proposition.

Multiple Factors Driving This Change

Lowering logistics costs has contributed to the feasibility of a nationwide cold-chain shipping environment.
The shift of search costs to the internet has created a direct connection between consumers and specialty products.
The growth in data ownership will continue to increase the long-term value of direct-to-consumer channels.

These factors together are creating a shift away from the intermediary role of the supermarket.

Ramifications for Market Structure

The market structure impact of skipping supermarkets is unclear for all of these reasons. Vertical integration can have some very positive effects:

• It can lower final prices.
• It can increase the amount of surplus collected by producers.
• It can help with the production of new and innovative types of products.

Companies that do not support vertical integration can have the following negative consequences:

• They cause market fragmentation.
• They create an environment for less price transparency.
• Their operations often favour customers with high income and digital access.

Conclusion

The increasing number of specialty foods available directly from manufacturers is a natural result of vertical integration and double marginalization rather than an accident of marketing. Because supermarket intermediation causes double marginalization by taking away value from producers through multiple layers of profit and by decreasing the bargaining power of producers, it is rational for producers to combine operations with their distributors in order to obtain more profit or to be able to access their end customers more efficiently. From an economic perspective, this example demonstrates that traditional industrial organization principles continue to govern and define today's commerce, even in an area as mundane as what we eat.