Economics Q&A: How might rising food prices affect food retailers and manufacturers in the UK?

Food retailers are service sector businesses selling food products to consumers. The leading retailers in the UK are Tesco, Sainsbury’s, Asda (Walmart) and the Co-Op/Somerfield. Although the food retail industry in the UK is dominated by a handful of national chains, there are many others including thousands of small-scale retailers. And discount retailers that have done well in recent years including Aldi and Lidl.

Food manufacturers process foodstuffs into new products and they rely on buying raw materials from wholesalers. Good examples to use might be Nestle, Heinz and Sara Lee.

The larger retailers manufacture some of their own-label foods although they may choose to out-source this to another manufacturer. And likewise, some food manufacturers have their own chain of retail stores or outlets - for example Gregg’s the Baker or Domino’s Pizza.

For both retailers and manufacturers, the rising global price of foodstuffs such as soya, edible oils and sugar will increase their costs. For food processing businesses, this is an increase in their variable costs and, other factors remaining the same, will cause an inward shift in their supply curve. Show this using a supply and demand diagram to aid your analysis.

For example bakers and pasta and biscuit producers will see a rise in their costs when the UK and international price of wheat rises. In the first week of January 2011, the cost of UK wheat hit a record high in the London market at £203.30 per tonne. The standard analysis here is that food processors will probably pass on some or all of these higher costs to wholesalers who in turn will charge more to retailers.

This depends in part on the significance of foodstuffs in the overall operating costs of the business. And whether all foodstuffs are rising in price or just some of them? There are many ingredients that go into making chocolate or coffee cakes - sugar, coffee, chocolate and milk for example. For Gregg’s, the cost of ingredients accounts for 25 per cent of overall costs - but wages, store rental and VAT are more important.

For large-scale high volume food manufacturers, improvements in efficiency over the years may mean that foodstuffs have become a smaller percentage of total cost. Business might be able to find off-setting cost improvements elsewhere in their manufacturing processes. or they might seek to source their ingredients from other countries where prices might be lower.

Food retailers also have difficult decisions to make. How much of a rise in their wholesale costs can be passed on to final consumers in store? We can safely assume that the demand for food overall is relatively price and income inelastic - there are many staple products that must go into the weekly shopping basket. And when brand loyalty is strong there is scope for retailers to pass on higher prices.

But competition at retail level is frequently fierce and with higher prices, consumers will be more intent on shopping around for the best discounts.

Many UK food retailers have opted to focus on promoting value brands - Waitrose for example has done terrifically well with it’s Essential Range. In part this is a response to a shift in consumer preferences towards the discount retailers and increased demand for cheaper substitutes.

And some analysts claim that aggressive price wars between supermarkets on staple products creates sufficient confusion among consumers for shops to lift prices on other food and non-food products to support total profits.

Small scale independent food retailers are most at danger from higher food prices as their profit margins are often thin and the have little scope for finding fresh sources of revenue when shoppers are cutting back.

There is evidence that dual manufacturing and retailing food businesses are finding it easier to manage costs during a time of super-high food prices. But both retailers and manufacturers have to find ways of absorbing higher costs. A further danger to both is that rising food prices will cause UK CPI inflation to remain high and could bring about an earlier than expected rise in monetary policy interest rates – further depleting household incomes, spending power and confidence - three things that all businesses rely on for their profits.