As policymakers grapple with an increasingly challenging economic landscape characterized by galloping inflation, a new mechanism, which I call “adaptive gross margin,” can play a key role as an innovative method for quickly and efficiently stabilizing retail prices.
This innovative mechanism can enable the Government of Montenegro to react quickly to the worrying trends of galloping inflation, which we have been witnessing lately. Using the adaptive gross margin as a strategic lever of economic policy, the Government of Montenegro can effectively protect citizens from unacceptable price increases, alleviate inflationary pressures and preserve economic stability, without harming the possibility of purchasing products or the fair profitability of the trade sector.
Montenegro as an oligopoly economy
Montenegro is a typical example of an oligopolistic economy, especially when it comes to retail trade in food products.
An oligopoly is a situation where a small number of companies exert significant control over a particular market and they can control prices by colluding with each other, dictating non-competitive prices in the market. These companies can raise prices without fear of losing the market, which has been especially evident since February 2022, when, due to the Russian Federation's aggression against Ukraine, a huge number of Russian and Ukrainian citizens came to Montenegro.
Since February 2022, companies operating in the food trade sector have significantly increased retail prices and justified this by increasing purchase prices. In addition, initiatives to cap retail prices have rightly been rejected in advance due to the potential risk of disruption in the supply chain, which, according to retailers, could lead to shortages of items.
Increasing purchase prices leads to extra profits
During periods when purchase prices are on the rise, retailers often maintain or even increase their fixed gross margins, which represent the difference between the purchase price and the selling price (excluding VAT). This practice leads to a significant increase in profits for companies, but at the same time negatively affects the standard of living of citizens.
Example: let's say that two years ago the purchase value of a product was one euro. Let's add to that euro a fixed trade gross margin of 25% and we get a retail price of 1,25 euros. The merchant's gross profit in this case is 25 cents.
Today, the same product costs two euros to purchase. We add the same trade fixed gross margin of 25% and arrive at a retail price of 2,50 euros. The merchant's gross profit in this case is 50 cents or twice as much as in the case when the purchase price was one euro.
From this simple example, it can be concluded that the traders did not improve the product or create additional value for it, but their profit increased solely due to increased purchase prices, with an unchanged fixed gross margin.
This is precisely what underlies the high profits of trade chains, especially in periods of inflation and rising import prices.
Bearing in mind the fact that Montenegro does not have the possibility or capacity to manage inflation through the usual mechanisms of monetary policy, the adaptive gross margin appears as a new and effective economic mechanism for quickly and efficiently lowering high prices on the market.
Adaptive gross margin
The concept of adaptive gross margin represents a mechanism for controlling retail prices with the aim of quickly lowering prices and preserving the living standards of citizens, but without a negative impact on the possibility of purchasing products and the fair profitability of trading companies.
The first step in the implementation of the adaptive gross margin is to determine the seasonally adjusted reference base month (for example, January 2022), which will serve as the basis for calculating the price difference.
The mechanism works as follows: in situations where there is an increase in purchase prices compared to the base month, the gross margin is fixed in the monetary amount of the price difference from the base month, i.e. retail chains are obliged to adjust their gross margins so that they reflect the price difference expressed in euros compared to the base month and not in percentages as is the case now.
In the above example, if the purchase price of the product increases from one to two euros, the retailer with an adaptive gross margin of 12,5% would make a profit of 25 cents. This is the same profit as at a fixed gross margin of 25% with an original purchase price of one euro.
In the event that the purchase price falls below the price in the base month, the adaptive gross margin would be adjusted to the percentage gross margin for that item from the base month.
The application of adaptive gross margin must be comprehensive and include importers, distributors and retailers, in order to effectively regulate the entire supply chain. Domestic producers would be excluded from the mechanism, given the imported character of inflation. In addition, the mechanism can be applied to individual products, groups of products or even the entire sales range in stores.
Considering that this mechanism has not been implemented until now, its application must be phased, which means that it must start with a smaller number of items, in order to eliminate any shortcomings and continue with the implementation.
By using this economic tool, there is no risk that it will lead to problems with the procurement of certain products due to unprofitability for traders.
It is important to define a minimum adaptive gross margin that would also take into account potential changes in indirect costs such as energy, taxes, interest and wages, compared to the base month. This is important in order not to jeopardize the profitability for traders.
Due to the large number of mechanisms that exist in economic flows and which cannot be tracked in a simple way (book approvals, unrealistic increase in the purchase price, "closing" and "set-off" of debts abroad and through third companies, transfer prices, compensations, cessions and assignments ), the basic assumption for the complete success of the mechanism is the agreement of trade chains and all retail establishments.
The adaptive gross margin mechanism would be temporary and remain in place until global economic conditions stabilize - specifically, until global inflation falls to 2% per year and US Treasury yields are similarly low. This is expected to happen in the coming years.
Additionally, this mechanism can have a quick and positive multiplier effect on the service sector, such as cafes and restaurants, as inputs for their products will be lower.
Finally, the adaptive gross margin does not contain elements of state aid that could limit its application.
SWOT analysis
Strengths:
1. Effectiveness in the fight against inflation: enables a quick reaction to galloping inflation and protection of citizens from drastic price increases.
2. Preservation of standard of living: helps protect citizens' purchasing power.
3. Maintaining a fair level of profit: enables the preservation of profitability for trading companies.
4. Flexibility: it can be adapted to various economic conditions and various types of products.
5. A pragmatic solution for oligopolistic economies: the concept is particularly useful in economies such as Montenegro, which has limited competition in the retail sector.
6. Positive multiplier effects: price reductions can have positive multiplier effects on sectors such as hospitality and tourism.
Weaknesses:
1. Management complexity: introducing and monitoring the adaptive gross margin requires a sophisticated price monitoring system for which the state must design an operational team.
2. Sector resistance: importers, distributors and traders may oppose this form of regulation.
3. Legal challenges: pthe need to update legal frameworks and possible harmonization with European laws and rules.
4. Unexplored mechanism: this mechanism has not been implemented in practice so far, which can make its application difficult.
Opportunities:
1. Innovation in economic policy: pleaves the basis for additional innovative price control mechanisms.
2. Increased social harmony in society: lowering prices can lead to lower social tensions and increased trust in the Government.
3. Supply Chain Assurance: lower risk of supply chain disruption compared to other price control methods.
Threats:
1. Non-compliance by traders: if merchants do not follow the rules, the efficiency of the entire system can be compromised.
2. Temporary mechanism: as the mechanism is temporary, there may be challenges in winding it down once economic conditions stabilize.
3. Weaker collection of original budget revenues: implementation will lead to lower collection of VAT, profit tax and other related taxes, which may affect budget planning.
4. Political risks: the introduction of such a mechanism can lead to political tensions and conflicts with interest groups.
Conclusion
Adaptive gross margin represents an innovative economic policy tool that has the potential to effectively deal with the challenges of galloping inflation. However, its success will largely depend on proper implementation, cooperation with the trade sector and constant monitoring to ensure the expected outcome - lower prices for citizens with fair profitability for traders.
With the application of the adaptive gross margin mechanism, Montenegro can in a relatively short period of time (a month after its introduction) achieve a reduction in the prices of food products to a sustainable level, in order to preserve the living standards of citizens while protecting the fair profit of traders, and minimal budget expenditures.
The author is the CEO of Fidelity consulting
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