The Economics of Wal-Mart

I’ve often wondered why Wal-Mart is so singled out for attack. True, Wal-Mart is anti-union with a vengence. And Wal-Mart sources products from countries, China mostly, that do not necessarily have the best interests of workers top of mind. But say these two problems could be rectified with a sweep of the magic wand: would we still be opposed to Wal-Mart as a business model? After all, Wal-Mart just uses economies of scale to pass along low prices to consumers. That is what Ikea does and no one seems to be attacking Ikea with the same wrath aimed at Wal-Mart. Ditto for Home Depot or Staples.

A couple thought provoking pieces about Wal-Mart are worth adding to the cerebral filing cabinet. Both challenge Wal-Mart’s economics as being antithetical to the promises of a “free market” society.

First up, PEF member Tom Slee, in a new book called No One Makes You Shop at Wal-Mart, comments:

[T]hose on the political right say that we get what we choose, and that the free market shapes the world to meet our preferences. Meanwhile, many on the left say that we are fooled into making bad choices. No One Makes You Shop At Wal-Mart argues for a third possibility: that when it comes to questions like those above we mostly make good individual choices and yet these choices lead to bad outcomes. The book explores the mechanisms by which good choices can go wrong, and shows how individual choice can be used by those at the top of our societies as a way of extending their own privilege.

Drawing from the economics of game theory, No One Makes You Shop at Wal-Mart looks at issues from environmental and urban problems to discrimination and social exclusion, passing through schools and McDonald’s on the way. It claims that clear thinking about the way that individual choice works shows our society in a whole new light.

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No One Makes You Shop At Wal-Mart is an accessible introduction to game theory and its application to social and political issues. It selects several elementary games (prisoner’s dilemma, co-ordination games, games of asymmetric information, bargaining games, and games with complex utility functions) and uses each one to analyze a selection of current political and social topics, from educational choice and genetically modified foods to discrimination and the need for national content regulations in the entertainment industry.

A focus of the book is the existence of inefficient equilibria and of multiple equilibria. The prevalence of such equilibria casts doubt on much contemporary political commentary, where the notion that good choices lead to efficient outcomes is commonplace.

A second focus of the book is the ubiquitous nature of market failures in the broad sense. The nature of the competitive market equilibrium and the ubiquity of externalities provide both incentives and opportunities for corporations to “change the game” to structures with a better outcome for themselves and a worse one for many citizens.

In an excerpt on the web, Slee invokes a “typical consumer”, Jack living in Whimsly, and the impact of Wal-Mart on his consumption possibilities set:

Jack lives in Whimsley. Some time ago Jack used to do most of his shopping in the downtown area–of course, he no longer does–and he also used to walk through the downtown before crossing Whimsley Park on his way to work.

Jack shares an eccentric trait with the other inhabitants of Whimsley: he has an odd way of making choices. As he goes about his daily life, when faced with a decision he assigns numerical points to the benefits and costs of the available options, and he chooses the option that gives the most points.

Let’s follow Jack’s reasoning as he thinks about what life was like when he shopped in the downtown area.

Value. I did much of my shopping at the two downtown department stores. They provided reasonable selection and price. They were worth two satisfaction points per week.

Variety. I liked the variety of the two stores. Sometimes I went to one store, sometimes the other, depending on what I needed, how much time I had, what other errands I had, and so on. The variety of having two stores was worth an additional two points.

Atmosphere. I assigned myself another two points each week from my enjoyment of the thriving downtown as I walked through it on the way to work.

Jack was happy to the tune of six points per week: two for selection and price, two for the variety of shopping options he had available, and two for the atmosphere of the thriving downtown.

A few years ago Wal-Mart opened a new store on the outer edge of Whimsley. Wal-Mart has huge economies of scale and tremendous bargaining power with its suppliers, and thus is able to offer the lowest prices. Like any consumer, Jack likes low prices. So Jack started shopping mainly at Wal-Mart.

For a while things were pretty good. Jack was happier because of Wal-Mart’s arrival in town. Here is his reasoning.

Value. By shopping mainly at Wal-Mart I not only continue to have a reasonable selection but I also get lower prices. So I give myself three points per week for price and selection, instead of the two I used to get by shopping at the downtown stores.

Variety. What’s more, Wal-Mart has extended my range of options: I assign myself an additional satisfaction point for the extra variety that Wal-Mart introduces, because on the days I don’t feel like trekking out to Wal-Mart I can still visit one of the other stores and get what I need.

Atmosphere. There is no change to the atmosphere of the city, so I still get my two points for atmosphere.

Soon after Wal-Mart arrived, then, Jack was getting eight points per week: three from Wal-Mart’s selection and everyday low prices, three from the expanded variety he has available, and, as before, two from walking through the lively downtown to work. Jack was happier than before Wal-Mart built its store.

* * *

Of course, Jack was not the only person in Whimsley to be making choices, and that is where his problems started. Like him, many other people started to shop at Wal-Mart. The smaller department stores downtown started to have troubles, and gradually they went out of business.

Wal-Mart became the only department store in Whimsley. Jack had to shop at Wal-Mart all the time, like it or not. As a result, Jack’s points for variety moved down to just a single point. Jack wanted more variety, but instead he got less. With the closing of the downtown department stores, Jack was down to six points per week again. He was as happy as before Wal-Mart came, but no happier. That’s not too bad. At least Jack was no worse off than he was before.

But Jack’s problems did not stop there. Once the downtown department stores closed, the slower customer traffic in the area meant that other stores closed too. Now downtown is not so interesting anymore: a number of shops are boarded up, others have been replaced by dollar stores, and the buildings are shoddy. Jack does not enjoy walking past the rundown area on the way to work. It gives him no pleasure. No points.

Now Jack has only four points per week. He is less happy than he was before Wal-Mart came.

In the beginning Jack made a choice that he believed would make him happier, but now he finds that he is less happy.

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Jack is, of course, an archetypal consumer and citizen, and his tale embodies the frustrating predicaments that many of us face. We have the right to make individual choices, and we make them sensibly, like Jack did, and yet that is not enough to lead to a happy outcome. In fact, we shall see that a system of private enterprise and free markets is particularly likely to produce such poor results on a regular basis.

There is no catch to the tale of Jack and Wal-Mart. There is no hidden information or trick that can lead to a happy answer. Instead, Jack’s predicament is just one example of what happens when the individual choices made by different people have a larger impact. Jack’s particular choice influenced, in a small way, the outcome for other shoppers, and their choices in turn influenced Jack’s happiness.

The moral of the story is simply that individual choice carries no guarantee of a happy ending. Choices are rarely made in isolation. They become quickly and intricately tangled, and their outcome is often not what we intended or hoped for. Stories like this one about Jack and Wal-Mart lie at the heart of many problems with our modern free-market corporate economy.

A different tack on the economics of Wal-Mart is on the supply side of the operation, and comes from a recent Harper’s article making the anti-trust case against Wal-Mart, by Barry Lynn:

From Adam Smith onward, almost all the great preachers of laissez-faire were tempered by a strain of deep realism. Most accepted that a national economy ultimately served a nation that had to survive in an often brutal world. So, too, did most accept that all economies are characterized by struggles for power and precedence among men and institutions run by men; in other words, that all economies are fundamentally political in nature. And so most accepted the need to use the power of the state—most dramatically in the form of antitrust law—to prevent any one man or firm from consolidating so much power as to throw off basic balances. The invisible hand of the marketplace, and all that derives from it, had to be protected by the visible hand of government.

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Popular notions of oligopoly and monopoly tend to focus on the danger that firms, having gained control over a marketplace, will then be able to dictate an unfairly high price, extracting a sort of tax from society as a whole. But what should concern us today even more is a mirror image of monopoly called “monopsony.” Monopsony arises when a firm captures the ability to dictate price to its suppliers, because the suppliers have no real choice other than to deal with that buyer. Not all oligopolists rely on the exercise of monopsony, but a large and growing contingent of today’s largest firms are built to do just that. The ultimate danger of monopsony is that it deprives the firms that actually manufacture products from obtaining an adequate return on their investment. In other words, the ultimate danger of monopsony is that, over time, it tends to destroy the machines and skills on which we all rely.

Examples of monopsony can be difficult to pin down, but we are in luck in that today we have one of the best illustrations of monopsony pricing power in economic history: Wal-Mart. There is little need to recount at any length the retailer’s power over America’s marketplace. For our purposes, a few facts will suffice—that one in every five retail sales in America is recorded at Wal-Mart’s cash registers; that the firm’s revenue nearly equals that of the next six retailers combined; that for many goods, Wal-Mart accounts for upward of 30 percent of U.S. sales, and plans to more than double its sales within the next five years.

The effects of monopsony also can be difficult to pin down. But again we have easy illustrations ready to hand, in the surprising recent tribulations of two iconic American firms—Coca-Cola and Kraft. Coca-Cola is the quintessential seller of a product based on a “secret formula.” Recently, though, Wal-Mart decided that it did not approve of the artificial sweetener Coca-Cola planned to use in a new line of diet colas. In a response that would have been unthinkable just a few years ago, Coca-Cola yielded to the will of an outside firm and designed a second product to meet Wal-Mart’s decree. Kraft, meanwhile, is a producer that only four years ago was celebrated by Forbes for “leading the charge” in a “brutal industry.” Yet since 2004, Kraft has announced plans to shut thirty-nine plants, to let go 13,500 workers, and to eliminate a quarter of its products. Most reports blame soaring prices of energy and raw materials, but in a truly free market Kraft could have pushed at least some of these higher costs on to the consumer. This, however, is no longer possible. Even as costs rise, Wal-Mart and other discounters continue to demand that Kraft lower its prices further. Kraft has found itself with no other choice than to swallow the costs, and hence to tear itself to pieces.

The idea that Wal-Mart’s power actually subverts the functioning of the free market will seem shocking to some. After all, the firm rose to dominance in the same way that many thousands of other companies before it did—through smart innovation, a unique culture, and a focus on serving the customer. Even a decade ago, Americans could fairly conclude that, in most respects, Wal-Mart’s rise had been good for the nation. But the issue before us is not how Wal-Mart grew to scale but how Wal-Mart uses its power today and will use it tomorrow. The problem is that Wal-Mart, like other monopsonists, does not participate in the market so much as use its power to micromanage the market, carefully coordinating the actions of thousands of firms from a position above the market.

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In essence, Wal-Mart has grown so powerful that it can turn even its largest suppliers, and entire oligopolized industries, into extensions of itself. The effects of this practice are most obvious in Wal-Mart’s horizontal competition against other retailers. Retail experts sometimes talk of a “waterbed effect,” which takes place when a supplier insists on collecting from weaker retailers at least some of the rent a more powerful firm refuses to pay. One recent study of how such power plays out within an entire system shows that a small retailer can expect to pay upward of 10 percent more than a powerful firm for the same basket of items. The effect also explains what takes place economically between communities served by Wal-Mart and those served by less powerful firms—the more power Wal-Mart accrues, the more it is able to shift costs from, say, suburb to city. And so every day the competitive landscape tilts just that much more in Wal-Mart’s favor. And so, every year, the landscape is littered with that many more dead or half-dead retailers—including such once-big names as Winn Dixie, Albertsons, K-Mart, Toys R Us, and Sears.

This advantage is simply what can be quantified in price. Many of the benefits Wal-Mart extracts from its suppliers lie in a realm far beyond the market economy. If Wal-Mart’s aim were simply to dictate the price it will pay for a product, then leave up to its suppliers all decisions as to how to get to that price, it would cause far less economic damage than it does now. But that is not Wal-Mart’s way. Instead, the firm is also one of the world’s most intrusive, jealous, fastidious micromanagers, and its aim is nothing less than to remake entirely how its suppliers do business, not least so that it can shift many of its own costs of doing business onto them. In addition to dictating what price its suppliers must accept, Wal-Mart also dictates how they package their products, how they ship those products, and how they gather and process information on the movement of those products.
…There are many ways to counterbalance the power of Wal-Mart and the other new goliaths. In the case of Wal-Mart, we could encourage yet more mergers among its suppliers and its competitors. Or we could make it easier for its workers to unionize. Or we could micromanage the firm through our state and municipal governments (e.g., requiring it, as Maryland recently did, to devote 8 percent of its payroll to health insurance). Yet every one of these approaches runs the risk of only further warping our economy and perhaps even reinforcing Wal-Mart’s power by creating new allies for it. After all, super-consolidated suppliers already share many of Wal-Mart’s political interests; labor unions now committed to Wal-Mart’s destruction could overnight become equally as committed to the further extension of Wal-Mart’s power; and new bureaucracies will generally tend to sympathize with the firms they regulate. We can also, of course, choose to do nothing, and surrender to the immense retailer all the decisions that in the past were made within the marketplace itself or by democratically elected legislators. In other words, we can cede to Wal-Mart the role it so relentlessly seeks for itself—to be dictator over the central functions of the U.S. consumer economy.

If, however, we choose the path of the free market, and of individual freedom within the market; if we choose to ensure the health and flexibility of our economy and our industrial systems and our society; if we choose to protect our republican way of government, which depends on the separation of powers within our economy just as in our political system—then we have only one choice. We must restore antitrust law to its central role in protecting the economic rights, properties, and liberties of the American citizen, and first of all use that power to break Wal-Mart into pieces. We can devise no magic formula or scientific plan for doing so—all antitrust decisions are inherently subjective in nature. But when we do so, we should be confident that we act squarely in the American tradition, as illuminated by the cases against Standard Oil and the A&P.