The Waterbed Effect Doesn’t Hold Water
Afamiliar concern in antitrust-adjacent debates goes like this: when a company such as Walmart grows large enough, it can strong-arm suppliers into steep discounts. Suppliers, in turn, recoup those lost margins by charging smaller grocery stores more. Those smaller stores raise prices. The big chain’s gains come at everyone else’s expense—prices fall on one end because they rise on the other. That’s the “waterbed effect.”
It’s a—maybe not compelling—but a story. A 2023 New York Times op-ed argued that this mechanism drives high grocery prices, noting that “as suppliers cut special deals for Walmart and other large chains, they make up for the lost revenue by charging smaller retailers even more, something economists refer to as the water bed effect.” The Organisation for Economic Co-operation and Development (OECD) has raised concerns about it for years. The United Kingdom’s Competition Commission has investigated it.
Regulators that have actually examined the waterbed effect tend to be skeptical. In its 2008 groceries investigation, the UK Competition Commission considered the theory and declined to rely on it, finding the evidence insufficient. Two years earlier, the UK Office of Fair Trading concluded that “there are theoretical questions that would need to be resolved before concluding that the price differentials observed are evidence of a waterbed effect.” As Eric Fruits put it on this blog, the waterbed was a notion without a model—and without a model, it was headed the same way as the real-world waterbed.
Then it got a model.
In 2011, Roman Inderst and Tommaso Valletti published a paper in the Journal of Industrial Economics that gave the waterbed a formal theoretical foundation. Their model features a supplier selling to a large buyer and smaller rivals. The large buyer’s scale gives it bargaining leverage, so the supplier compensates by charging the smaller rivals more. In the model, that is exactly what happens: the large buyer pays less, and the smaller rivals pay more. That result is straightforward.
The paper goes further. It claims the waterbed harms consumers—not just smaller firms, but shoppers at the checkout, who face higher prices on average. That is the result that matters for antitrust, which turns on consumer harm. It is also how the authors close their abstract.
I have a new working paper that shows consumer harm is impossible in their model.