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The increasing importance of services in industrialized economies is reflected in the relative importance of service in product offerings at the retail level. Yet, typical economic studies account only for physical product attributes in models of product differentiation even when conducted with retail data. In U.S. food retailing, the issue is very important as raw farm products account for only 19% of every dollar the consumer pays for food, most of the remaining going to services that do not transform the product but that add consumer utility and cost. In this paper, we examine this issue using the case of breakfast cereals in Boston in the context of upscale retail services provided by supermarkets. Focusing on ready-to-eat cereals (RTECs) allows us to look more closely at the role of services in product market equilibrium. First, supermarket retail services go beyond the obvious single product exchange function as consumers value services and suppliers incur a cost in providing them. Given that retail services affect the primitives of the market, i.e., demand and costs, they also affect retail prices. Third, regardless of inter-supermarket variation in costs and prices, the issue of who’s got the power in the RTEC vertical market channel has been a hotly debated issue. The usual suspect has been the RTEC manufacturing industry, although previous studies have not modeled the retailing stage of the marketing channel to determine their relative contribution to channel price-cost margins and the role of retail services. The conventional wisdom is that the RTEC manufacturing industry mutes price competition and engages in non-price competition (Schmalensee, 1978; Scherer, 1982). This paper contributes to the literature in two important ways. First, it extends the Berry, Levinsohn and Pakes (BLP, 1995) model of market equilibrium to ready-to-eat cereals (RTECs) in Boston by including consumer taste for supermarket retail services. Second, it tests and compares alternative pricing games between manufactures and supermarkets in order to assess their relative market power.


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