On supermarket petrol vouchers

Yesterday I received a phone call asking why New Zealand supermarkets offer petrol vouchers with purchases, and whether consumers are really paying for it all anyway!

(Update:  I’ve been informed that they were actually discussing this on Close Up yesterday, and they were trying to say that for some reason people pay “more” – because people who don’t use the vouchers are cross-subsidising people who do use the vouchers.  This sort of issue fits into point 2 below – and I’m not convinced that we are seeing a welfare loss due to this, in fact I think even this view would lead to better outcomes for consumers … ignoring point 3 below which strongly shows why this is likely to be the case.)

I decided the best way to answer the question was to try and understand the reasons why supermarkets and petrol companies would set up an agreement where these vouchers are offered and there is some (unknown) transfer between supermarkets and petrol companies.

Now remember, for the supermarket and petrol companies to come to an arrangement, it must be in both of their interests.  They must decide that offering a voucher to consumers who shop at the supermarket increases the sum of total profit in both markets – if that occurs, then they can negotiate over any “surplus” gained when they set up the contract.

At first brush we might say that it must somehow make consumers worse off, because profits are higher then they were without the supermarket and petrol company coming to that arrangement.  But if we think a little deeper, we are going to find out this is not the case 😉

Off the top of my head I can pick out three reasons why this agreement exists:

  1. Assume a monopoly supermarket and petrol station to start with.  The first reason may be weird behaviour by consumers.  For some reason, the fact the voucher is offered gets them to spend more at supermarkets and petrol stations overall.  This is the least compelling explanation in my opinion – but it is the only one that could create the result of consumers genuinely being worse off.
  2. Price discrimination:  Stick with our monopolies.  Lets remember that some people drive, and some don’t.  People who don’t drive tend to live in big cities, and are often environmentally conscious – both factors correlated with higher incomes, and more inelastic demand for supermarket goods.  This tell us that, by offering petrol vouchers our monopoly supermarket can then increase prices – thereby imposing a form of implicit price discrimination.  And of course, price discrimination shouldn’t be seen as a bad thing!
  3. A prisoner’s dilemma:  Now our assumption of a monopoly has been ridiculous – we actually have a duopoly in the supermarket industry in New Zealand, and even greater competition in the fuel industry.  This gives us another way to justify the use of vouchers – competition.  Take our two supermarkets – if neither supermarket agreed set up a deal with a petrol station, they would both sit there making tidy profits.  However, if one of them offers vouchers, a lot of customers would go to that supermarket – making the supermarket offering the vouchers heaps better off, and the other one much worse off.  If both offer vouchers, then consumers once again don’t really care where they go – so the supermarket does better than in the case when their competitor offers vouchers and they don’t, but worse than in the case when no-one offers vouchers (due to the cost of the voucher).  In this case, it is in the supermarket’s interest to enter the scheme – as they make a higher profit by offering vouchers no matter what the choice of the other supermarket is.  But the existence of the scheme makes consumers undeniably better off!

Overall, this suggests to me that the existence of the petrol vouchers is adding to consumers welfare – and we should encourage any sort of scheme that increases competition in the marketplace 🙂

  • Boy this is a good and fun problem. The kind of thing that could be a chapter in Armchair Economist. Many thanks. I’ll have to think on it more. 

    • Industrial economics problems are definitely the most interesting economic problems you can get – even if they may not have the gravity of macroeconomics in some peoples minds.

  • Seamus Hogan

    There is clearly some truth to explanation 3, but it raises another question: Why are supermarkets competing on petrol vouchers rather than price? The transactions costs to consumers of the former is far lower. The answer is probably based in behavioural economics: petrol-price reductions are more salient to consumers than a few cents off each item in the shopping basket. But I reckon the fun answer would involve the interaction between monopolisticly competitive supermarkets and monopolisticly competitive petrol companies. And, I regret that either way, the conclusion would be that vouchers are welfare reducing.

    • Very true, if the two firms just competed on price there would be no scope for schemes that rely on such inefficient income transfers – and the only real explanation would be price discrimination (or a behavioural explanation, which I am steering away from).

      I was attempting to say that welfare would be higher than it is in the case without vouchers – where you seem to be suggesting that welfare is lower than it would be if the firms competed (if I am interpreting correctly).  I agree 110%, and don’t think the agruments are inconsistent – furthermore, if we had the welfare optimum it is true that the voucher scheme would be unncessary, I also agree there.

      If I wanted to strech my argument I could say: why we can’t appeal to an incomplete form of tacit collusion between the firms here – they tacitally collude on price, but then can compete on the type of schemes they put in place.  Or I could simply assume that the offer of a voucher scheme from petrol companies is a mechanism that can be used to breakdown tacit collusion by changing incentives for the supermarket – and its existence then implicitly increases competition.

    • “But I reckon the fun answer would involve the interaction between monopolisticly competitive supermarkets and monopolisticly competitive petrol companies.”

      FYI, I do agree that this would be the fun answer 🙂

  • Steve

    I would think it is both 2 and 3.  In addition, consumers may be more price sensitive to fuel prices, so are more likely to switch supermarkets if it offers a better fuel discount, than they would be to switch supermarkets based on the price discounts of groceries.  This reinforces explanation 3.

    Explanation 2 might explain the initiation of these price discounts, but the continuing program is probably more explanation 3. 

  • peakhealth

    I have trouble accepting the argument that once the market is saturated with vouchers, that they add to (all) consumers welfare. Perhaps directly to some consumers, but certainly not all. This is because of the false assumption that rich people, who “tend to live in big cities” and are more “environmentally conscious” are less likely to drive than poor people.

    The data, however, shows clearly and consistently that vehicle ownership is strongly and positively related to income (Figure 4, Litman T., The Future Isn’t What It Used To Be) When you add up the poor people who can’t afford to drive, the young (half of 16-19 y/o don’t even have a full license), old and disabled who can’t drive, and those who choose not to drive, it’s hard to see how vouchers are not a wealth transfer from those that are poor, disabled, can’t or choose not to drive.

    Further, your discussion did not take into account the cost externalities of petrol subsidies if they turn out to lead to more driving which includes more crashes, injuries, congestion, poorer health, vehicle expenditures and local and global pollution, among other established costs.

    • I’ll just pop in the comments I emailed 🙂

      Indeed, the issue involves looking at a range of factors in more detail than I did in a cheeky little blog post. However, we have to be careful with how we split all these sorts of issues when trying to figure out our counterfactual – my goal was solely to make the point that such scheme could also increase competition in the face of existing tacit price collusion. Also, I didn’t intend to give the impression it added to ALL consumers welfare – just that consumer surplus overall was higher. Those are very different concepts of course.

      With price discrimination for example, we need to ask who’s demand will be more responsive to the implied wedge between prices that comes from the fuel voucher. The supermarket and fuel station are entering into this scheme because it offers them a way to increase profits, and so in terms of this argument we need the people receiving the voucher to be more responsive to price changes – that way ex-post the supermarket and fuel stations will set higher prices. If the voucher is actually working the other way, I find this argument less compelling – and would in turn put more weight on it being some form of “commitment” towards competition.

      Furthermore, the “externalities” are irrelevant for thinking about this specific example. All costs and benefits pertaining to the market are captured in the market in this case – any direct externality from fuel consumption shouldn’t be counted as a cost of the market response, but instead as a direct cost of fuel consumption. This isn’t to say the costs aren’t relevant – it is just to say that they are only relevant insofar as there is a separate market failure that should be dealt with, presumably with a tax on fuel. A tax that in NZ is estimated to be about right.

      Just to clarify my point on the externalities (as I was likely very unclear), we know that the voucher lowers the price for some, and that its existence increases the price for others – we don’t know whether the effective price is lower or higher. In fact, in the absence of the “prisoner’s dilemma” the effective price is likely to be higher given that market demand is inelastic and the firm is increasing profitability by price discriminating. In this case, relative to the Pareto-optimal allocation we would need a smaller fuel tax in the face of these vouchers rather than a larger one.