Staples Case Study

1. How would you classify the office superstore industry? Who are the competitors? What are the characteristics of this industry that lead to this conclusion? Today’s office superstore industry in the United States provides a convenient one-stop shopping experience for small businesses and individuals with home offices. Operating as the retail- chains selling consumables, office superstore industry is classified as an OLIGOPOLY with three main competitors dominated the market. They are Office Depot, Staples, and Office Max. All of them offer a variety of office supplies, as well as computers, office furniture and other business related items.

Competitors in the industry:

1. Staples
2. Office Deport
3. Office Max

Office Depot, found in 1986, is the largest office superstore chain in the United States. Office Depot is first in total number of stores, first in average sales per store, first in average weekly store sales, first in total delivery sales and first in net earnings. Most importantly, Office Depot is the lowest price competitor among office superstore chains.

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Staples, also found in 1986 in Framingham, Massachusett, is the second-largest office superstore chain in the United States which has annual revenue (2013) is over $24 billion, 90,000 employee worldwide, over 1,500 stores in US and over 2,200 locations (worldwide); and OfficeMax, founded in 1988 in Cleveland, Ohio, the third major player in the office superstore industry which has over 900 locations in the US and annual revenue (2011) of $7.1 billion. The intense competitive rivalry between Staples and Office Depot turned to be quite beneficial for consumers. Both competitors had to reduce prices, introduce innovative approaches to marketing, distribution and store layout and expand into new areas of the country, bringing increasing numbers of consumers the convenience of one-stop shopping at low prices.

Office Depot has been the most aggressive and lowest-price competitor, in turn forcing Staples and OfficeMax to compete more aggressively. Staples' office supply prices are the lowest in the cities where all three of the national office superstores (Staples, Office Depot and OfficeMax) compete. Prices are higher in markets where the only other competitor is OfficeMax and higher in those areas of the country where Staples faces no other superstore rival. Similarly, Office Depot charges significantly higher prices where it faces little or no superstore competition. Business superstore industry is characterized as a Stackelberg oligopoly because: 1. There are few firms serving many consumers (3 large firms dominate the market). 2. The firms produce either differentiated or homogeneous products. 3. Office Deport (the leader) chooses an output before all other firms choose their outputs. 4. Staples and OfficeMax (the followers) take as given the output of the leader and choose outputs that maximize profits given the leader’s output. 5. Barriers to entry exist.

2. What barriers to entry help maintain the industry structure? Capital costs
As mentioned above, this can act as a barrier to exit as well as a barrier to entry. Quite simply, if you are struggling to get the funds together to start the business, then this is a 'barrier' to you entering the market. Even if you do have the capital, the worry that you will be stuck in an unprofitable situation with a lot of unrecoverable capital invested in the business may stop you entering the market in the first place. These 'unrecoverable' costs are often referred to as sunk costs. In most markets, if things go pear-shaped you can sell much of the equipment on to other firms in the industry. But costs like advertising are unrecoverable. Obviously, the larger the industry you intend to enter, the bigger the capital (and sunk) costs and the bigger the barrier to entry (and exit).

Limit pricing

Existing firms may be operating a predatory pricing policy. As the title suggests, this is a policy designed to kill off competitors by reducing the price below cost price temporarily. The idea is that once the competitor is killed off, the firm can raise the price back up to the old level and steal all their customers. Limit pricing is similar to predatory pricing, except the firm in question is trying to 'limit' the entry of new firms by setting the price low enough to prevent new firms entering, but high enough to still make some sort of profit. Actions like this by incumbent firms obviously act as a barrier to entry for potential new firms.

Economies of scale

If existing firms are large, they are probably benefiting from economies of scale. This means that their average costs are lower by virtue of their size. Bulk buying economies is a good example. Potential firms are likely to start on a smaller scale and so will find themselves at an immediate cost disadvantage.

Patents

A patent is something that a firm may apply for if it has just invented a genuinely original product. If the patent is granted by the government, it gives the firm legal protection to produce the product without competition for a given time period (usually a number of years). After all, what is the point of spending time and money inventing something if everyone can copy you straight away? Patents create incentives for individuals to be innovative. Obviously this creates a barrier for firms wishing to join this new market. There are other legal barriers imposed by the government. The Post Office, for example, is the only body that is allowed to offer postal services costing less than £1. Notice that there are loads of firms offering delivery services for larger packages (like DHL and FedEx), but nobody else offers 26p stamps for small letters.

Advertising and marketing

Established large firms tend to spend a fortune on advertising. Apart from the fact that they are trying to get you to buy the product in the short term, the long-term aim is to create brand loyalty. How many of you, when buying Coca-Cola from a newsagent, ask for a 'Coke' even if the only brand they sell is Pepsi? Does your mum do the vacuum cleaning or the hoovering? In both cases, the brand name is so entrenched that most people use the brand name as the generic name for the product. In the case of 'Hoover', the brand name has even turned into a verb! Having a strong brand image is very powerful for the firm in question and creates a huge barrier to entry for a potential new firm. The strength of vertically integrated firms

Vertical integration is a form of merger. It is where one firm merges (or takes over) another in the same industry but at a different level of production. For example, a firm that manufactures cars could merge with a firm that produces car parts, or with a steel plant. This is known as backward vertical integration. If the car manufacturing firm merged with a group of car showrooms, this would be Forward vertical integration. In the first case, the firm would now have control over some of the raw materials. In the second, it would have control over some of the retail outlets for cars. In both cases, the firm has become more powerful, making it harder for new firms to compete. The knowledge of this extra power would put off new firms from entering the car industry.

Experience economies

Although it is difficult to put figures on this, established firms are likely to have a cost advantage over new firms because they have more experience of the industry in question. An established restaurant will know when it will be busy and when it will be quiet. They are less likely to order too many materials or employ too many waiters on a given night. These are the sorts of things that can only be learnt with experience. 3. If the merger were to be allowed, how would you characterize the merged firm’s own price elasticity in a geographic market that contained only that firm? How would this change over time? The final structure variable we discuss in this chapter is the potential for entry into an industry. In some industries, it is relatively easy for new firms to enter the market; in others, it is more difficult. The optimal decisions by firms in an industry will depend on the ease with which new firms can enter the market. Numerous factors can create a barrier to entry, making it difficult for other firms to enter an industry.

One potential barrier to entry is the explicit cost of entering an industry, such as capital requirements. Another is patents, which give owners of patents the exclusive right to sell their products for a specified period of time. Economies of scale also can create a barrier to entry. In some markets, only one or two firms exist because of economies of scale. If additional firms attempted to enter, they would be unable to generate the volume necessary to enjoy the reduced average costs associated with economies of scale. As we will learn in subsequent chapters, barriers to entry have important implications for the long-run profits a firm will earn in a market. Therefore, if the merger were allowed, the merged firm’s price in a geographic market that contained only that firm would be inelastic. If price increase, customers will still buy office supplies from it for their demand because they have no any other substitute sources to be replaced. 4. What is the relevant market for this case?

Should retailers that sell, but do not specialize in office products, be considered as part of the market? What evidence supports this conclusion? What are the geographic considerations? Product markets are defined by "the reasonable interchangeability of use or the cross elasticity of demand" between the product itself and possible substitutes for it. The relevant product market "must be drawn narrowly to exclude any other product to which, within reasonable variations in price, only a limited number of buyers will turn . . . ." In other words, if prices go up, will so many consumers switch to substitutes that the price increase becomes unprofitable? If not, those possible substitutes are properly excluded from the relevant market. A relevant product market is a market where "sellers, if unified by a hypothetical cartel or merger, could raise prices significantly above the competitive level."

The 1992 Horizontal Merger Guidelines provide an analytical framework for finding the relevant product market by taking the smallest possible grouping of competing products or distributors, here office superstores, and asking whether a "hypothetical monopolist over that [product or] group of products would profitably impose at least a 'small but significant and non-transitory' [price] increase. United States Department of Justice and Federal Trade Commission, 1992 Horizontal Merger Guidelines, (hereinafter "Merger Guidelines") use five percent as the usual approximation of a "small but significant and non-transitory" price increase. Commentators have noted that, for retail markets characterized by high volume of sales but low profit margin per dollar of sales, a hypothetical price increase lower than 5% is appropriate.

Harris & Jorde, Market Definition in the Merger Guidelines: Implications for enough customers will continue to buy from the monopolist to offset any sales lost to other sellers. So long as the additional profit from the price increase exceeds the profits lost from those consumers who turned to substitutes, the price increase would be profitable overall and the particular grouping of products is deemed to be a separate market for antitrust purposes. In this case, the exercise need not be hypothetical. The defendants' own current pricing practices show that an office superstore monopolist has the ability profitably to raise prices above competitive levels. When Staples, Office Depot and OfficeMax all compete in the city, prices are lowest. In two firm markets where Staples faces only its arch rival Office Depot, it charges slightly higher prices. But where Office Depot is not in the market and just Staples and OfficeMax are present, Staples raises its prices.

Where Staples faces no office superstore competition, prices are higher than in three-firm markets. If Staples became a superstore monopolist, it would find it profitable to raise prices by much more than 5%. In this case, the relevant markets include 42 metropolitan areas where both Staples and Office Depot operate office superstores and the numerous metropolitan areas throughout the country where -- but for this merger -- Staples and Office Depot had planned to be competitors in the near future. The relevant product market for this case does not include the other outlets or supermarkets that sell some office supplies beside other products, or those retailers should not be considered as part of the market.

The study demonstrates that in the geographic areas where all three superstore compete, the demand cross elasticity between office superstores and other retail sources of office supplies is low. Even in the face of significantly higher prices, not enough customers consider these other sources to be adequate substitutes for office superstores to force prices down to the competitive levels. The office superstores advertise primarily on a local basis, and advertised prices vary dramatically from city to city. The business realities, therefore, demonstrate that metropolitan areas are relevant geographic markets for the purposes of assessing the merger's likely impact on competition. The fact that office superstores actually price higher in metropolitan areas where they face no office superstore competition demonstrates that they can charge supra-competitive prices without causing customers to travel elsewhere for office supplies. They advertise primarily on a local basis, and advertised prices vary dramatically from city to city. The business realities, therefore, demonstrate that metropolitan areas are relevant geographic markets for the purposes of assessing the merger's likely impact on competition.

The geographic markets impacted by the proposed transaction include many of the most populous cities in the United States, across eighteen states and the District of Columbia. In 15 markets, the proposed merger will result in an office superstore monopoly. In another 27 metropolitan areas, the number of superstore competitors will be reduced from three to two. Finally, the merger eliminates future competition in many additional metropolitan areas, including four where Office Depot and Staples planned or had planned to compete with one another in the next few months. 5. How is the Herfindahl-Hirschman Index (HHI) affected by the merger? Why does the case list a range, instead of an exact number? Are the HHI levels in the case indicative of high industry concentration? Mergers that significantly increase market concentration are presumptively unlawful because the fewer the competitors and the bigger the respective market shares, the greater the likelihood that a single firm, or a group of firms, could raise prices above competitive levels.

Market concentration may be measured by determining the market shares of industry leaders or by calculating the Herfindahl-Hirshman Index ("HHI"). The combined shares of Staples and Office Depot in the office superstore market would be 100% in 15 metropolitan areas. In 27 other metropolitan areas, the post-merger market shares range from 45% to 94%, with HHIs ranging from 5,003 to 9,049. These percentages are far in excess of the levels raising a presumption of illegality. Even were a market defined to include the other retailers of office supplies who both Staples and Office Depot contend compete at least to some degree with office superstores, the combined market share of the defendants raises competitive concern. Concentration is high and would increase significantly because of the merger. In the 42 geographic areas where Staples and Office Depot today compete, the post-merger HHI's average over 3,000, ranging from approximately 1,800 to over 5,000.

Increases in HHI's are, on average, over 800 points; ranging from 162 to over 2,000. This case lists a range of HHI instead of an exact number because the competition is evaluated in many metropolitan areas where the market shares of Staples and Office Depot vary. In many areas, there are only stores of Staples, Office Depot and Office Max or even two of them and the merger will turn many local markets into duopoly or monopoly. As per US Federal Trade Commission (FTC) and Antitrust Division of the US. Department of Justice, industries with HHI in excess of 1,800 are “highly concentrated”. The HHI levels in the case are therefore indicative of VERY HIGH industry concentration. 6. What arguments have Staples and Office Depot made in defense of the proposed merger?

To defend against the objection of the FTC on the proposed merger, Staples and Office Depot have argued that: (1) Entry either by a new superstore chain or by repositioning of an existing retailer will be enough to avert anticompetitive effects from the acquisition. (2) The functional equivalent of entry would be repositioning by an existing retailer to attract office superstore customers. The likely "repositioners" are retailers such as Target, Wal-Mart, and Kmart, and computer superstores catering to small businesses, such as Best Buy. (3) The proposed acquisition would generate significant cost savings and therefore keep prices competitive. They claim that if they are allowed to merge, they may well be able to reduce their costs by using the "best purchasing practices" of each company and by pressuring suppliers to give them bigger discounts.

Reference:
1. Baye M. & Scholten P. Proposed Merger Between Staples and Office Depot Leads to Concerns of Higher Prices 2. Michael R. Baye, “Managerial Economics and Business Strategy”, 7th ed., McGraw Hill Irvin (2010), New York, NY 3. Wikipedia – Office Deport - http://en.wikipedia.org/wiki/Office_Depot 4. Wikipedia – Staples Inc. - http://en.wikipedia.org/wiki/Staples_Inc. 5. Wikipedia – Chain store - http://en.wikipedia.org/wiki/Chain_store 6.