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Transcript of Evolution of Food and Agricultural Market Structure and the Rise of Product Differentiation Ian...
Evolution of Food and Agricultural Market Evolution of Food and Agricultural Market Structure and the Rise of Product DifferentiationStructure and the Rise of Product Differentiation
Ian Sheldon (Ohio State University)
Conference on “All Food is Not Created Equal: Policy for Agricultural Product Differentiation”, Berkeley, California, November 14-16, 2004
IntroductionIntroduction
Early analysis of industrial organization of food industry based on the Bain (1951) SCP paradigm
Levels of concentration (structure), determine pricing behavior (conduct), which in turn affects profits (performance)
Key assumption that structure is determined by exogenously given barriers to entry
Economies of scale
Product differentiation measured by advertising outlays relative to sales
IntroductionIntroduction
Connor et al. (1985) concluded in their study of US food manufacturing:
Highest rates of advertising intensity in concentrated industries
Entry barriers high due to cumulative effects of advertising
SCP paradigm questioned in IO literature:
NEIO focus on estimating conduct
Focus on simultaneous determination of structure and performance
Evolution of Market StructureEvolution of Market Structure
Literature has returned to old question of what determines market structure? (Sutton, 1991)
Basic idea is to focus on cases where product differentiation is determined endogenously as of part industry equilibrium
Industries split into those with either exogenous or endogenous sunk costs
Allows useful classification of food industries as regards product differentiation
Exogenous Sunk Costs and Market Structure Exogenous Sunk Costs and Market Structure
Product is homogeneous, and firms incursunk cost σ of acquiring plant of minimum efficient scale, then compete in price
Market structure (C) function of:
Market size S relative to σ
Intensity of price competition
Markets contestable if σ = 0
With horizontal product differentiation, sunk cost of producing specific variety, and price competition mitigated
Exogenous Sunk Costs and Market Structure Exogenous Sunk Costs and Market Structure
Possibility of multiple equilibria if firms can produce several different varieties
Market structure depends on whether different firms enter each sub-market, same group of
firms enter all sub-markets, or firms occupy several niche markets
Function of: demand effects (market expansion vs. competition), costs (economies of scope),
and possibility of first-mover advantage (product proliferation)
Exogenous Sunk Costs andExogenous Sunk Costs and Market StructureMarket Structure
S
C
X
Homogeneous Goods
S
C
Differentiated Goods
Mergers/exit
Lower bound to C
Endogenous Sunk Costs and Market StructureEndogenous Sunk Costs and Market Structure
With vertical product differentiation, each product has single attribute u – its brand image, all
consumers having same tastes
Firms incur sunk cost σ, but now choose u, at an additional sunk cost A(u), before competing in price
If consumer willingness to pay increases with advertising, A(u) can be thought of as an
advertising response function
Endogenous Sunk Costs and Market StructureEndogenous Sunk Costs and Market Structure
Link between increased market size S and structure C is broken
Competitive escalation of A(u), raises equilibrium level of sunk costs {σ + A(u)} as S increases, offsetting tendency toward fragmentation – advertising is an endogenous barrier to entry
If saturation level of advertising, Aα, fragmentation still occurs as S increases – advertising is as an exogenous barrier to entry
S
C
Vertical Product Differentiation
Endogenous Sunk Costs and Market StructureEndogenous Sunk Costs and Market Structure
(a)
(b)
(c)
(a) Increased product differentiation dampens price competition for small levels of S
(b) Product differentiation makesadvertising more effective, C increases with S
(c) If Aα, fragmentation as S increases
Asymmetric AdvertisingAsymmetric Advertising
Advertising levels may differ across firms:
Consumer tastes vary (different levels of u), creating dual market structure, e.g., retail markets and non-retail markets
Income effects such that high (low) income consumers purchase high (low) quality u
Sequential entry, first entrant can “monopolize” by setting u so high that other firms only find it profitable to enter with lower A(u)
Strategic Groups in Food ManufacturingStrategic Groups in Food Manufacturing
Producer goods markets
Flour (48)*, sugar (85), soybeanmilling (80), wet-corn milling (72)
Homogeneous products
Exogenous sunk costs?
Foodservice market
Typically small food manufacturers
Brands not important – except soft drinks, alcoholic drinks and candy
Price, quality and service critical
Part of dual market structure?
Advertised brands
Frozen food (31)*, soft drinks (47)(99)**RTE cereals (83)(85), chocolate (80), soup (85)(92), coffee (53)(73), beer (90)(82)
Advertising, product development,issue of shelf-space
Endogenous sunk costs?
Private-label, generic, and unbranded products sold via retail stores
Emphasis on price, advertising andlabeling by retailers
Part of dual market structure?
Source: Porter (1976), Connor et al. (1985). * 1997, 4-firm concentration (US Census of Production, 2001); ** 1999, share of advertising by top-3 firms (USDA/ERS, 2001)
Example 1Example 1
Dual market structure: frozen food industry
Low set-up costs, advertising-sensitive retail sector, and non-retail segment where price is key
Retail sector dominated by small number of firms with well-known brands, e.g., Stouffer (Nestlé), Birds Eye (General Foods), Ore-Ida (Heinz)
Example 2Example 2
First-mover advantage: canned soup industry
Campbell established market for condensed canned soup based on heavy advertising and price – 80% market share
Heinz tried to enter branded market, but was unable to erode Campbell’s share – focused instead on retailer private label sales
In contrast, Heinz dominates UK canned soup market, Campbell’s supplying private labels
Example 3Example 3
Competitive escalation of advertising: soft drinks
Coca-Cola and Pepsi take 75% of cola market
Coke dominant initially, until Pepsi began to compete in 1960s and subsequent decades with successful advertising campaigns, e.g., “the Pepsi Challenge”
Coke introduced “New Coke” in 1985, followed by “Coke Classic” after new brand’s failure
Example 4Example 4
Endogenous advertising and/or brand proliferation: RTE breakfast cereals
Process of endogenous advertising outlays imposed lower bound on market structure (Sutton, 1991)
Kellogg had first-mover advantage, pre-empting entry via brand proliferation (Schmalensee, 1978)
Scherer (1982) argues leading firms pulled ahead early through aggressive nationwide advertising campaigns
Example 5Example 5
Interaction of scale economies and escalating advertising: beer industry
Elzinga (1982) emphasized change in minimum efficient scale, Greer (1970) role of escalating advertising
Sutton (1991) argues influences not independent
Increase in sunk costs of new plant caused existing structure to no longer be an equilibrium, and for a given S, advertising became more effective
S
C
Brewing Market StructureBrewing Market Structure
σ1
σ1
X Initial market structure
Y Structure with new plant, butineffective adverting
Y’ Structure with new plant andmore effective advertising
σ2
σ2
X
S’
Y
Y’
Does Vertical Structure Matter?Does Vertical Structure Matter?
How do food retailers affect evolution of market structure and product differentiation?
If there are vertical externalities in the food marketing chain, we would expect there to be vertical restraints
Type of vertical restraint depends on who has bargaining power
This will affect price competition upstream, and hence role of endogenous sunk costs
Vertical RestraintsVertical Restraints
Vertical restraints include resale price maintenance (RPM), exclusive dealing, exclusive territories and slotting allowances
Prior to early-1990s, US anti-trust cases typically involved RPM and exclusive territories contracts relating to branded products such as beer and soft drinks (McCorriston and Sheldon, 1997)
Since late-1980s, slotting allowances a common vertical restraint (Shaffer, 1991; Sullivan, 1997)
Slotting AllowancesSlotting Allowances
Scarce retail shelf-space and high rates of product failure common explanation for slotting allowances (Sullivan, 1997; Richards, 2004)
Other analysis treats payment of slotting allowances as signals by manufacturers of the likely success of their new product (Chu, 1992)
Whatever the story, retailers can impact the ability of manufacturers to escalate
advertising for new brands by controlling shelf-space
Retailer Bargaining PowerRetailer Bargaining Power
Some debate as to whether slotting allowances reflect retailer bargaining power (Shaffer, 1991; Rao and Mahi, 2001)
Rise of private labels in US does suggest though that balance of power may be shifting to retailers (Harris et al., 2000; McCorriston, 2002)
Combination of slotting allowances and private labels indicates that there will likely be further movement to a dual market structure in food manufacturing
SummarySummary
Recent theory indicates a key connection between evolution of market structure and notion of endogenous sunk costs
Allows food manufacturing to be divided into producer goods and advertised brands
As balance of power shifts to food retailers, likely to affect equilibrium expenditures on
product differentiation in equilibrium
Dual market structure will become the norm