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