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Product Diversity Jeffrey M. Perloff University of California, Berkeley Giannini Foundation ALL FOOD IS NOT CREATED EQUAL: Policy for Agricultural Product.

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Presentation on theme: "Product Diversity Jeffrey M. Perloff University of California, Berkeley Giannini Foundation ALL FOOD IS NOT CREATED EQUAL: Policy for Agricultural Product."— Presentation transcript:

1 Product Diversity Jeffrey M. Perloff University of California, Berkeley Giannini Foundation ALL FOOD IS NOT CREATED EQUAL: Policy for Agricultural Product Differentiation Farm Foundation, Giannini Foundation, USDA ERS Berkeley, California, November 15, 2004

2 Questions

3 Too little differentiation?

4 Specific questions What effect does a new, differentiated product have on firm profit and industry profit consumer well-being?

5 Why investigate? food industries have large number of differentiated products rapid entry and exit of items, brands, firms theory ambiguity: may be too little or too much differentiation, hence need empirical studies industry proposal: government help firms differentiate, creating market power

6 Outline degree of differentiation of food and beverage products why do firms differentiate? oligopoly differentiation theories and evidence information theories

7 Increased Differentiation?

8 Differentiation varies across categorieslarge in most ItemsBrandsFirms Canned ham 864130 Ice cream7,294626342

9 Firms report increased innovation new contents (new flavor, carbonate,...) new size or package new category or type of product (organic food, functional food,…)

10 New contents Snapple's 2000 U.S. fruit drinks: Diet Orange Carrot Fruit Drink Raspberry Peach Fruit Drink Proctor & Gamble's new German Punica fruit juice drinks are canned carbonated drink (Punica Fruitshot): aimed at teenagers

11 New size of package Welch's (National Grape Cooperative Assoc. Inc.) introduced new sizes leads to relocation before: in one section of supermarkets now: in many supermarket aisles, vending machines, convenience stores, and membership wholesale clubs

12 Popular canned products Flavor: vegetable fruit punch tomato pineapple apple grape citrus Type : juice juice drink nectar drink juice cocktail Count : 1 6 12 24 4

13 Example: General Mills Our fiscal 2000 plans call for higher levels of new product innovation across our U.S. businesses.Stephen Sanger, chairman and CEO averages 27% of its volume from products < 5 years old spends ¼ of its resources on new products/business ideas

14 Example: Welchs early 1990s: new productsintroduced in the last 5 yearsaccounted for only 1/10 of overall sales 1999: 1/3 of sales from new products

15 Growth rates because births of new products deaths of old ones number of branded items and firms is constant or decreasing in most categories more likely to be growing where total quantity growing, but not tight relationship (ready-to-drink tea: counterexample)

16 Items per firm or per quantity increase over time in few categories: name-brand items per firm falling at a statistically significant rate in 13 categories and growing in only 8 items per quantity is falling at a statistically significant rate in 9 categories and growing in 6

17 Sources of new products product differentiation by existing firms entry of new firms with new products private labels products sold by retailers (grocery stores) usually manufactured by existing firms

18 Why Differentiate?

19 Reasons to differentiate respond to changes and opportunities tastes change new products of rivals market niche: some consumers were not served private labels increase market power: if a firm convinces consumers that its product is different and superior to other firms it charges more without losing substantial sales (e.g., Coke vs. Pepsi)

20 Respond & innovate

21 Respond to taste changes Innovation is the lifeblood of profitable growth. Leading brands possess great long term value only if they can evolve over time to respond to the tastes and needs of new generations. Quaker Oats' CEO Robert S. Morrison

22 Flagpole strategy Let's run it up the flagpole and see who salutes it products frequently added and then dropped if unsuccessful. firms constantly innovate due to changing consumer tastes. low-fat and low carb products Campbell Soup microwaveable single serve bowls tempered by slotting allowances

23 Market niche I couldnt believe no one had addressed the mule market. Sharon Doherty, president of Vellus Products, on discovering a market niche for mule shampoo and conditioners

24 Private Label

25 Private label history discount products introduced: generics: late 1970s high-quality private labels: late 1980s- early 1990s

26 Private label growth generics and private labels volume share: 15.3% in 1988 19.7% in 1993 20.2% in 1996 21% in 1997 25% in 2002 1997-2003: private labels went from being in 69% to 75% of the categories tracked by ACNielsen; entered 88 new categories

27 Private label shares private label and generic volume shares vary widely across categories 1% for pickles and relish 65% for frozen fruit generics 0.5% or less

28 Pricing Private-label prices are lower than those of name-brand goods in all categories (except frozen poultry)

29 Why supermarkets switched to private labels private label products offer higher gross margins: 35% vs. 25% on other products private labels create loyalty to supermarket chain

30 Name-brand executives: We innovate faster in response to new private labels Introductions up 22% from 1990 to 1991. In 1991, firms introduced 16,143 products 12,398 food products 3,745 non-food products (diapers, shampoo)

31 Name-brand executives claim Name brands engaged in brand building by Increasingly differentiating their products, Conducting sales Expanding nonprice promotional activities Cutting price (Marlboro, Pampers, Kraft cheese)

32 Example When consumers started switching from Kelloggs cereals to private labels at half the price, Kelloggs further diversified its products increased advertising issued more coupons to make its prices more competitive with generic brands

33 Question How do most name-brand firms actually respond to increased competition from private-label firms?

34 Answer Contrary to executives claims, firms: do not increasingly differentiate their products do not increase sales promotional activities fall name-brand firms prices rise

35 Leading brand harmed increased private-label share relatively harms leading name-brand firm, leads to slightly more equal name-brand item and firm shares overall more harm to biggest firm not to third, fourth, fifth or smaller as predicted

36 Market Power

37 Product differentiation works $/QuartSource Crystal Geyser$0.77springs in CA and TN Evian$1.46spring in French Alps Dasani$1.58purified tap water

38 DWL Why differentiate Unit cost Demand Competition Oligopoly Price, $ Quantity Profit

39 Price effects from new product price may go up or down differentiating products allows firm to raise its price (less elastic demand) but more products tend to lower prices (greater competition)

40 Quantity effects on firm firm gains from sales to new customers but it may cannibalize sales of its older products

41 Effects of new products on rivals price may go up or down (more likely to fall) differentiation may allow all firms to raise prices but an increase in competing products tends to lower prices loses sales to new product rivals promotional activities may increase demand for the category or steal customers

42 Thus, before the introduction, the profit effect of new, differentiated product is ambiguous for both the introducing firm and its rivals

43 Oligopoly Differentiation: Theories & Evidence

44 Oligopoly theories

45 Variety vs. quantity tradeoff between additional products and quantity of each product fixed cost of producing new products takes resources and reduces quantity suppose society has 100 units of inputs unit cost of production = 1 fixed cost of a new product = 5

46 Variety-quantity tradeoff Number of brands Quantity of each Total output 195 24590 32885

47 Optimal A B Variety, number of products Quantity of each product variety-quantity tradeoff (PPF)

48 Tradeoff for extra products or firms if all products are identical cost: a new item/brand/firm requires incurring a fixed cost benefit: lower price from greater competition

49 All products are identical can show that there are too many identical firms (in monopolistic competition) by having fewer products, we avoid unnecessary fixed costs lower price effect is inadequate to fully offset fixed costs if government can regulate price, optimal # of firms is 1

50 Aeroflot Airlines: You Have Made the Right Choice. Ad campaign for the only airline in the then Soviet Union

51 Differentiated products tradeoff cost: a new item/brand/firm requires incurring a fixed cost benefit: lower price from greater competition value of extra variety (diversity)

52 Representative consumer models I alone am here the representative of the people. Napoleon Bonaparte all products compete with each other Spence 1976, Dixit-Stiglitz 1977 too little or too much differentiation (either point A or B is possible)

53 Spatial models products compete only with neighbors in product space Hotelling (1929) line model Salop (1979) circle model (A circle is the longest distance to the same point. Tom Stoppard) too much differentiation (e.g., point A)

54 Comparing the models Why do representative consumer and spatial models give different results? to answer: Deneckere and Rothschilds (1986) model nests Perloff-Salop representative consumer model Salop spatial model

55 Deneckere and Rothschild find that adding a brand benefits fewer consumers in spatial than in representative consumer model consequently too many brands in a spatial model: competition is localized too many or too few in a representative consumer model

56 Empirical Evidence

57 Evidence on profits little direct evidence on profit, but substantial evidence on market power (ability to set price above unit cost) few studies on the effect on other firms

58 Entry effects on price Hausman (1996): price effects on similar products from entry of a new cereal Kadiyali, Vilcassim, and Chintagunta (1999): When 1 of 2 national yogurt manufacturers introduces a new variant, it gains price-setting power; firms' combined sales increase most existing studies ignore effect of diversity per se

59 Small empirical literature on welfare Hausman (1996) and Nevo (2000): cereal concentrate on the implications for measuring the consumer price index

60 Does diversity matter? we can estimate the value consumers place on diversity Perloff-Ward find that consumers of canned juices place a small (but statistically significant) value on diversity for its own sake possibility: diversity may be more valued for goods where consumers switch more frequently

61 Experiments Doles pineapple juice is the second-best selling canned juice (after V8) Dole sells a 46 oz (big) can and a six-pack of 6 oz (small) cans thought experiments: eliminate one or more of Doles products

62 Price effects from eliminating pineapple juice products Price effect (%) on Dole's 46 oz can- All Dole products - 0.80.9 All pineapple products - - 1.0 Eliminated pineapple products Dole's 6- pack of 6 oz cans Other pineapple products Non- pineapple products

63 Experiment eliminate Doles 46 oz pineapple juice can how quantity shares shift: 5.8% goes to Doles small cans 3.4% to other brands of pineapple juices 90.7% to other products thus, consumers do not view small cans of Dole pineapple juice or other pineapple juices as close substitutes for Doles large can

64 Eliminate Dole 46 oz ($thousands/month) Eliminate Dole 46 ozChange Consumer Surplus-495 Profit-301 Welfare-796

65 Eliminate all Dole pineapple ($thousands/month) Eliminate all DoleChange Consumer Surplus-1,183 Profit417 Welfare-766

66 Eliminate all pineapple juice ($thousands/month) Eliminate all pineapple juiceChange Consumer Surplus-1,677 Profit720 Welfare-957

67 Welfare effects of eliminating a large firm ( $ thousands/month) ΔProfit ΔCS ΔW|ΔW|/R Nestle Canned Fruit Juice2.05-14.69-12.651.20 Campbell Soup0.76-2.29-1.540.39 Procter & Gamble0.11-4.32-4.211.41 Dole0.69-1.47-0.780.34 Nestle Canned Juice Drinks-0.12-0.69-0.810.42 Citrus World0.37-1.13-0.770.46 Texas Citrus Exchange1.05-1.51-0.470.38 Empacadora de Frutas-0.11-0.52-0.630.65

68 Compensating variation of eliminating a firm plotted against its revenue

69 Summary consumers place a relatively low value on variety (diversity) branded canned juice companies exercise substantial market power exit leads to only moderately price changes in other productsbut total profit may rise entry or exit of a firm in this market has large welfare effects: larger than but of the same order of magnitude as revenue

70 Information

71 Branding and differentiating may be means of promoting providing information consumers pay more (10-60%) for Dole pineapples Chiquita bananas many attempts to brand have been unsuccessful, however

72 Promotion societal critics: advertisers con consumers into thinking they want a good most economists: difficult to judge welfare effects of promotions given tastes change

73 Dixit-Norman (1978) a small increase in advertising raises welfare only if the firm finds it profitable (thus cant be too little advertising) reducing advertising from the profit- maximizing level raises welfaretheres too much advertising Fisher-McGowan and Shapiro take issue with Dixit-Normans analysis

74 Grossman-Shapiro (1984) market equilibrium has too many firms (excessive diversity) each firm advertises < than optimal level per firm however, given large number of firms, there is too much total advertising: beneficial effect of improved matching of consumers and products is outweighed by the wasteful effect of merely shuffling consumers between firms thus, private return to advertising exceeds the social return: there is excessive advertising

75 Akerlofs (1970) lemon model anagram for General Motors: or great lemons when buyers cannot judge a products quality before purchasing it, low-quality products lemonsmay drive high-quality products out of the market Akerlofs lemon problem can be overcome by branding government standards and certification

76 Europe vs. U.S. 2003: EU lists 41 wines, cheeses, and other products that it wants to protect by global trade pact: geographical indicators are a quality guarantee U.S. and Canada oppose proposal (Canadian producer registered Parma ham, so Italian Parma ham cannot be sold in Canada)

77 Conclusion new, differentiated brands are frequently introduced but old brands die at about the same rate not a response to private labels firms differentiate to keep up w/ changing tastes fill newly discovered niches gain market power informational reasons Oligopoly differentiation theories and evidence likely too much differentiation/products little empirical evidence of value of diversity or too few products Information theories could justify standards and certification

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