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Evolution of Food and Agricultural Market Structure and the Rise of Product Differentiation

Evolution of Food and Agricultural Market Structure 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. Introduction.

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Evolution of Food and Agricultural Market Structure and the Rise of Product Differentiation

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  1. Evolution of Food and Agricultural Market Structure 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

  2. Introduction 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

  3. Introduction 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

  4. Evolution 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 endogenoussunk costs Allows useful classification of food industries as regards product differentiation

  5. Exogenous Sunk Costs and Market Structure Product is homogeneous, and firms incur sunk cost σof 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

  6. 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)

  7. Exogenous Sunk Costs andMarket Structure Lower bound to C C C Mergers/exit X  S S Homogeneous Goods Differentiated Goods

  8. Endogenous 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

  9. Endogenous Sunk Costs and Market Structure Link between increased market size S andstructure 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

  10. Endogenous Sunk Costs and Market Structure • Increased product differentiation • dampens price competition for small levels of S • Product differentiation makes • advertising more effective, C increases with S • (c) If Aα,fragmentation as S increases C (a) (b) (c) S Vertical Product Differentiation

  11. Asymmetric 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)

  12. Strategic Groups in Food Manufacturing Producer goods markets Flour (48)*, sugar (85), soybean milling (80), wet-corn milling (72) Homogeneous products Exogenous sunk costs? 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? 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? Private-label, generic, and unbranded products sold via retail stores Emphasis on price, advertising and labeling 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)

  13. Example 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)

  14. Example 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

  15. Example 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

  16. Example 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

  17. Example 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

  18. Brewing Market Structure C σ1 σ2 X Initial market structure Y Structure with new plant, but ineffective adverting Y’ Structure with new plant and more effective advertising σ2 Y’ Y σ1 X S’ S

  19. 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

  20. Vertical 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)

  21. Slotting 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

  22. Retailer 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

  23. Summary  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

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