Prices are rising everywhere. In some places wages are also increasing, but for most prices are rising faster than wages and so in real terms, incomes are decreasing. And as real incomes fall, the amount that individuals and households spend on food will also fall.
Retailers must respond to these inflationary pressures to remain competitive and stay relevant to their customers. dunnhumby already has some great articles and insight outlining how retailers can navigate these inflationary environments – listen to this podcast for example, or see this post on our Consumer Pulse research or this post on how retailers can respond. But let’s take a deeper dive into what economics can tell us from the customer perspective and about how shoppers may respond. And in turn, how retailers should use this customer-centric insight.
But before we progress, there are some caveats to make:
- Note the “how shoppers may respond”. What we write here is informed speculation, based upon a combination of theory and economic experience/findings from previous inflationary periods. However, these are unprecedented times. We have rising food prices across multiple categories, in multiple countries that are recovering from recession, with some experiencing labour supply issues. Ongoing effects of the global pandemic and (in Europe) a significant military conflict stemming from global geo-political tensions, will mean volatility in prices could extend to the next one or two years. This means that any speculation based upon isolated micro-economic theory should be taken as a guide, not a prediction.
- It is easy for us, as technical professionals, currently employed, to write dispassionately about the effects of inflation on shoppers. For many the impact of inflation will be painful. When discussing data and economic theories we shouldn’t forget the real-life context underpinning that data. Indeed, any retailer that treats its response to inflation solely as another data-driven exercise will fail to empathise with their customers and will soon become irrelevant to those customers.
- In this short article we discuss broad themes. Any discussion of differences in shoppers’ responses is limited to how different income groups may respond. The unpleasant reality is that inflation itself may be experienced in different ways by those different income groups. In the UK, the celebrity chef and commentator Jack Monroe has suggested that not all shoppers experience the same average 10.1% UK inflation rate reported for July 2022, but that the lowest income groups will experience considerably higher effective rates of inflation as supply chain issues and costs impact low-cost and value brands more significantly. Analysis by the UK Office for National Statistics (ONS) has shown this to be true for some supermarket categories, although not necessarily all categories.
As real household incomes decrease, an economic rule, Engel’s law, tells us that the proportion of the income that is spent on food will increase. How quickly the proportion of income spent on food changes as household income decreases is quantified by another elasticity - the income elasticity of food expenditure. However, we need to exercise caution here. Engel’s law is a statement about a cross-section of households – lower income households spend a greater proportion of their income on food compared to higher income households. Engel’s law has also been observed in historical timeseries data but what happens within a specific household over the next one to two years is more difficult to determine. For example, in the UK we are seeing significant inflation in energy costs. Those energy price rises are typically above the rate of food price inflation and so will put downward pressure on the proportion of income that is spent on food. Some households will have to make real and difficult choices between heating and eating. We can be certain though that the typical absolute spend on food will decrease and shoppers will seek out value for their food spend. Let’s look at how shoppers will go about seeking out that value-for-money.
Consumers have multiple options to choose between. And where they have choices they switch between them, especially where one option is perceived to provide the same value or service but at a cheaper price. What are those options for switching? Customers can switch any of the following,
If a retailer does not understand the reasons why shoppers switch products and/or categories, then they may find themselves at the mercy of shoppers switching retailers. Micro-economics studies how consumers make those switching choices and what the key drivers are, so let’s take each of those choices in turn.
If a retailer increases the price of a supermarket product the volume of sales will go down. This is the law of demand we introduced in the previous post and is because shoppers are sensitive to price. How sensitive? How much will the sales volume go down?
If the price of only that single product is increased, then the direct price elasticity of demand of that product helps us quantify how much the sales of that product will fall. We introduced the direct price elasticity of demand also in our previous blog post.
The reduction in sales is because shoppers are switching to cheaper products in the sub-category or deciding not to buy in the sub-category at all. Here, we are talking about switching between products that essentially perform the same function, and differ largely only in price and perceived quality, for example, different brands of tins of tomatoes. The decision the shopper is making here is a straight-forward one – can I get the same for less, or can I get better for the same price?
Clearly, we expect to see less attrition from the less price-sensitive products. These will be the products with the larger market share within the sub-category. For brands, building market share without having to reduce profit margins to unsustainable levels is where brand value and brand loyalty become important – this is when CPGs will see any long-term historical investments in brand value pay off.
Stronger brands may maintain volumes or experience smaller decreases, whilst own-label value products will be the beneficiaries of mid-market brands that pass on cost increases onto the shopper. For a retailer, where a sub-category does not have a dominant CPG brand offering, a well-priced own-label product is a must (or opportunity). Where a sub-category does have a dominant brand offering an own-label product may only gain small amounts of market share and would have to be priced at a noticeable discount to make inroads.
Where prices are increased on multiple products in a sub-category at once, we obviously expect significant attrition of shoppers from the sub-category, as well as multiple inflows and outflows between products. The least attrition will occur from high basket penetration sub-categories.
To precisely quantify the product-level attrition and net changes in sales volume in these circumstances we would also need to know the various cross-price elasticities of demand, and so it is important that any model of sales demand used is capable of estimating the various cross-price elasticities as well as the direct-price elasticities.
Finally, it is clear that knowing which products and sub-categories that shoppers are price sensitive to is essential. These products and sub-categories are the Key Value Items (KVIs) that shoppers care most about. A retailer will need to be price-competitive on these KVIs to remain relevant to the shopper in these inflationary times, and to prevent the shopper ultimately switching retailers.
Food expenditure elasticities of various broad food groups are typically close to 1, with small cross-elasticities, meaning that spend on a particular food group/category simply scales near linearly with the total food budget. So, shoppers typically don’t change the mix of their basket that much in response to a small change in overall food budget, and we would expect to see them simply reduce spend across the board.
For larger reductions in budget, shoppers will make more radical adaptations to their shopping. Econometric theory says those adaptations will take place over long timescales – over short timescales customers are less price sensitive because they haven’t yet worked out what adaptations to make, and so most likely will reduce volume or switch to cheaper retailers in response to a large budget reduction. However, what defines the ‘short-run’ timescale? The natural timescale is the purchase/consumption cycle. Given for most grocery goods consumption cycles are short (under one month), we would expect that customers that have experienced larger income reductions will have already begun to adapt their category and product purchase patterns.
What form might those changes to category purchase patterns take? When customers switch between products it is because those products are substitutes – they fulfil the same need or perform the same function. Switching between categories can occur when two categories are seen as fulfilling a similar function at a higher level. What would those higher levels be? Calories and volume. So, we will see switch to cheaper and less-perishable categories, for example, a switch out of fresh to frozen, or a switch from more expensive protein sources to cheaper protein sources, e.g., from beef to chicken.
That we will see shoppers leave discretionary categories is a no-brainer. These are more likely to be low-basket penetration categories. Higher-priced discretionary categories will certainly see outflows. However, lower priced discretionary categories could see inflows if shoppers view them as a radical substitute for a higher-level need, e.g., providing an uncommon source of protein. These larger shifts will emerge over longer timescales and within the more heavily income impacted shopper segments.
Shoppers have a choice of retailers. They can in principle substitute one mid-market grocery retailer for another mid-market grocery retailer, or one value retailer for another value retailer. In practice, there are barriers to switching retailers. Shoppers will often gravitate to the closest physical store within their price-bracket because there are costs associated with doing multiple trips – time costs and transport costs. Consequently, shoppers traditionally don’t multi-stop shop. Previously this has meant that the retailer that wins a shopper’s custom for one or two of their KVIs will typically win the shopper’s entire basket. The winner-takes-all nature of this competition means that retailers have traditionally been willing to sacrifice significant profit margin to ensure they win. A pre-Covid econometric study of the UK market suggests that the big UK supermarkets were willing to sacrifice up to 50% of their potential margin.
How will this change in the post-Covid inflationary environment? One of the obvious impacts is increased price sensitivity due to the reduced household income. There are multiple facets to this, one of which is that shoppers will be willing to spend more time searching out low prices.
Economic theory says that whilst the potential benefit (finding a cheaper price) of continuing to search for lower prices outweighs the cost (of the shopper’s time), then the shopper will continue to search. With falling real incomes, the effective value of a shopper’s time has been reduced, and so they are willing to search for longer than before to find the same price savings.
As shoppers spend more time in price comparison, they will become aware of, and hence sensitive to, the prices of a wider range of products, thereby increasing the range of KVIs that retailers will need to be competitive on. A secondary consequence of extending the number of KVIs into the tail of the retailer’s assortment is that retailers may begin to see the differentiation between customers, segmented by which of the lower basket penetration KVIs matter to those customers. When we consider just a small number of the most important KVIs these are likely to all have high basket penetration and so are important to all customers. When we consider a longer list of KVIs, we are likely to be looking at products that can be important to just a subset, albeit a large subset, of customers. Retailers will need to serve this increased KVI differentiation whilst keeping the costs to do so down. This will only be possible for retailers that know and understand their customer base better by having a customer-first approach.
With shoppers increasingly seeking out value, their willingness to multi-stop shop should increase, and online has an important role to play here. The Covid pandemic has resulted in increased online grocery shopping in some geographies and so at first sight the fact that information gathering is notionally easier for online shopping means we would expect multi-stop online shopping to increase in these inflationary times. The reality will be more complex. Delivery costs are a non-negligible percentage of an online grocery shop, acting as a disincentive to shoppers spreading their online shopping across multiple retailers. Potentially, there are also other, cognitive, disincentives to multi-stop shopping.
Omni-retailers such as Amazon offer alternatives to multi-stop online shopping whilst keeping delivery costs down for the shopper. With an increasing number of shoppers becoming comfortable with online grocery shopping this may cause the middle ground of retailers to become squeezed, with shoppers being attracted to the very big online players and the very small niche providers. Specialisation and particularly collaboration will then become a key mechanism by which those mid-size retailers can remain competitive.
In times like this, when customers are facing a range of inflationary pressures, with huge variation across country and income, retailers and CPGs must respond to these inflationary pressures to remain competitive and stay relevant to their customers. While much of this piece has focused on the uncertainty ahead, and likely routes that the industry could take, one thing remains certain: it has never been more crucial for retailers and brands to keep the customer at the heart of every decision.
 Estimated UK annual inflation rate (CPI) for year up to July 2022, at time of writing – 25 August 2022. The CPI value was retrieved from www.ons.gov.uk/economy/inflationandpriceindices/timeseries/d7g7/mm23
 See https://twitter.com/ONS/status/1531191505649541120 for the social media press release and this ONS website for details of the analysis.
 Thomassen et al., American Economic Review 107:2308-2351, 2017
 Stigler, J. Political Economy 69:213-225, 1961, Marmorstein et al., J. Consumer Research 19:52-61, 1992
 See this recent dunnhumby post on how retailers should use data to drive their collaboration strategy - https://www.dunnhumby.com/resources/blog/supplier-collaboration/en/do-you-have-the-right-data-to-drive-your-collaboration-strategy/
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