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UNIVERSITY OF CRETE ECONOMICS DEPARTMENT B.E.NE.TeC LABORATORY

FOODIMA. Modeling Food Industry: Product & Process Innovation, Technology Adoption & Mergers. UNIVERSITY OF CRETE ECONOMICS DEPARTMENT B.E.NE.TeC LABORATORY. Emmanuel Petrakis, Chrysovalantou Milliou & Igor Sloev Business Economics and New Technologies Laboratory,

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UNIVERSITY OF CRETE ECONOMICS DEPARTMENT B.E.NE.TeC LABORATORY

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  1. FOODIMA Modeling Food Industry: Product & Process Innovation, Technology Adoption & Mergers UNIVERSITY OF CRETE ECONOMICS DEPARTMENT B.E.NE.TeC LABORATORY Emmanuel Petrakis, Chrysovalantou Milliou & Igor Sloev Business Economics and New Technologies Laboratory, Department of Economics, University of Crete, Department of Economics, Athens University of Economics and Business & Department of Economics, Universidad Carlos III de Madrid

  2. Ι. Introduction (1) Food Industry is characterized mainly by: • A large number of Farmers → perfectly competitive structure in the primary sector • A limited number of Food Processing Firms/ Manufacturers → oligopolistic structure in food processing with food processors producing (horizontally and/or vertically) differentiated goods • A relatively small number of Supermarkets/Retailers, each selling most of the food products → oligopolistic structure in retailing • Intensive Product Creation, Differentiation and Innovation Activities at the Food Processing layer → Target: enhancement of product variety and product quality, increase product differentiation • Frequent Mergers/Acquisitions both in the Retailing and the Manufacturing layer of the tree-tier industry

  3. Ι. Introduction Motivation of the research project • To capture (some of) the characteristics of the Food Industry we build a series of industrial organization models that properly address the following issues: • The food processors strategic incentives to invest in innovative activities and in new technology adoption in order to increase product variety, augment differentiation of the goods produced and enhance product qualities, as well as their market and welfare implications of their strategies • The food processors and/or the retailers’ incentives to merge and/or to acquire rivals, as well as the market and welfare implications of such mergers

  4. F1 F2 F3 Fn M2 M1 Mn R1 R2 RnS FinalConsumers Figure 1: Industry Structure

  5. Ι. Introduction Purpose of the current research • The main purpose of this research is to develop a tractable • model of a tree-tier industry which allows the investigation of: • The product and process innovation activities of food processing firms and the effects of such activities on prices, product variety, consumer surplus, firms’ profits and welfare. • The role of the economies of scope in product creation processes. • The food processors and supermarkets incentive to merge and the effects of mergers on prices, product variety, consumer surplus, firms’ profits and welfare.

  6. ΙI. The Model (1) Farmers: • A large number of price-taking farmers produce and sell agricultural products to the food processors at a price equal to their marginal (and unitary) cost, which is normalized to zero. Manufactures: • L food processing firms/manufacturers, ℓ=1,2,…,L. • Each manufacturer ℓ decides how many differentiated food products to produce, nℓ. The total number of goods produced is N= n1+…+ nL. • Manufacturers compete in prices: each manufacturer ℓ sets the prices for all the good he produces, {tℓ1, tℓ2, …,tℓ nℓ}. The vector of all manufacturers’ prices is (t1,…,tN)=(t11,…, tℓ nℓ,…,tN1,…, tN nN). • The vector of quantities sold in the market by retailers is: (Q1,…,QN) =(Q11,…, Q1 nℓ,…, QL1,…,QL nL), where the first n1 elements refer to manufacturer 1’s goods, the next n2 elements refer to the manufacturer 2’s goods etc.).

  7. ΙI. The Model (2) Retailers: • R supermarkets/retailers, r=1,2,…,R, each (potentially) selling all manufacturers’ goods. • Each retailer r chooses the quantity of each good that he buys from each manufacturer and resells it to the final consumers, (qr1,…qrN), r=1,…,R • The total quantity of good i sold in the market by all retailers is • Qi = q1i+…+ qRi, i=1,…,N

  8. ΙI. The Model (3) Manufactures’ cost structure: • The marginal cost of transformation of any agricultural product to any food product is normalized to zero. • Each manufacturer faces a cost of creation of a spectrum of goods, c(nℓ): c(1)>0, c’(nℓ)>0. • Thus the cost function of manufacturer ℓ is TCℓ(nℓ)=c(nℓ) Retailers’ cost structure: • There are no reselling costs. Thus the retailing marginal cost for each food product is equal to the food processor’s wholesale price, tℓ,kℓ, ℓ=1,2,…,L; kℓ=1,…,nℓ,or in another notation (t1,…,tN).

  9. ΙI. The Model (4) Utility function of the representative consumer: (1) where: • A: reflects the size of the market. • ß: 0<ß<1 represents the degree of product substitutability/ product differentiation . • V: represents the income spent on the rest of the goods. Hence, the system of the demand function is: (2)

  10. ΙI. The Model (5) Therefore, the manufacturer ℓ’sprofit function is: (3) where:Ωℓis the set of goods produced by the manufacturer ℓ. and the retailer r’sprofit function is: (4)

  11. ΙII. Timing of the Game • Stage1: Farmers sell their agricultural products to the food processors at the competitive market prices. • Stage 2: Manufacturers decide simultaneously and independently how many goods each to produceand also set the prices of their goods. • Stage 3: Retailers buy all food processors’ products and resell them to final consumers, setting simultaneously their food product quantities (qr1,…qrN), r=1,…,R. Solving by Backwards Induction We consider a three-stage game:

  12. IV. Analysis (1) EquilibriumAnalysis when the number of manufacturers (L) and retailers(R) are given exogenously. In theSymmetric SPNE(symmetry in prices and in the number of produced goods) the optimal price and number of goods produced by each manufacturer are (implicitly) determined by the system of equations: (5)

  13. IV. Analysis (2) In addition, in theSymmetric SPNE: Manufacturer’s optimal output of each single good: (6) • Manufacturer’s equilibrium profits: (7) Retailer’s prices: (8) Retailer’s profits: (9)

  14. IV. Results Proposition1:The manufacturer’s profits are decreasing in L and increasing in R. The Benchmark case: We consider the case where each manufacturer produces one good only. Then its cost function is given by TCℓ=c(1). Let tsdenote the equilibrium price in this case for a given number of manufacturers Ns(which is equal to the number of goods too). Let L be such that Ln* = Ns. Proposition2: The equilibrium prices of the single good manufacturers are always lower than the prices of the multi-product manufacturers, ts< t*. Let c(n) = g na, where a ≥ 0. Then a < (>) 1 reflects economies (diseconomies) of scope.

  15. V. Numerical Simulations Numerical simulation when L and R are given exogenously Table 1. β=0.6, A=10, g=0.1, a=0.7, L=2 Pr.U : manuf.’s profit, Ln*: total number of goods, TQ : total quantity produced, Pr.D : retailer’s profit, CS: consumers’ surplus, TW : total welfare

  16. V. Numerical Simulations Numerical simulation when L and R are given exogenously. Table 2. β=0.6, A=10, g=0.1, L=2, R=4 Pr.U : manuf.’s profit, Ln*: total number of goods, TQ : total quantity produced, Pr.D : retailer’s profit, CS : consumers’ surplus, TW : total welfare

  17. V. Numerical Simulations Numerical simulations when L and R are given exogenously. Table 3. A=10, g=0.1, a=0.7, L=2, R=4 Pr.U : manuf.’s profit, Ln*: total number of goods, TQ : total quantity produced, Pr.D : retailer’s profit, CS : consumers’ surplus, TW : total welfare

  18. V. Numerical Simulations Numerical simulations when L and R are given exogenously. Table 4. β=0.5, A=10, g=0.1, a=0.9, R=2 Pr.U : manuf.’s profit, Ln*: total number of goods, TQ : total quantity produced, Pr.D :retailer’s profit, CS : consumers’ surplus, TW : total welfare

  19. V. Numerical Simulations Numerical simulations when L and R are given exogenously. Table 5. A=10, β=0.6, a=0.7, L=2, R=4 Pr.U : manuf.’s profit, Ln*: total number of goods, TQ :total quantity produced, Pr.D :retailer’s profit, CS : consumers’ surplus, TW :total welfare

  20. VI. Numerical Simulation Findings • As the number of manufacturers (L) increase we observe an increase in: The total number of goods produced (L n*) The total quantity (L n*Q) The retailers’ profits The social welfare • While the product variety produced by each manufacturer (n*) decreases • As the economies of scope become stronger (lower a) we observe an increase in The total number of goods produced (L n*) The product variety produced by each manufacturer (n* ) The total quantity (L n*Q) The retailers’ profits The consumers’ surplus and social welfare • While the manufacturers’ profits decrease

  21. VI. Numerical Simulation Findings • As the degree of product substitutability β increases we observe a decrease in: • The product variety produced by each manufacturer (n*) • The total number of the goods produced (Ln*) • The total quantity (Ln*Q) • The retailers’ and manufacturers’ profits • The social welfare • As the number of the retailers R increases we observe an increase in: • The product variety produced by each manufacturer (n*) • The total number of the produced goods (Ln*) • The total quantity (Ln*Q) • The manufacturers’ profits • The consumers surplus. While the retailers’ profits decrease

  22. VI. Analysis under Free Entry (1) EquilibriumAnalysis under free-entry condition. In this case we assume thatthere is free entry in the food processing layer, i.e. the number of manufacturers L*is such that the manufacturers profits are equal to zero. Proposition 3:The degree of scope economy can take prices 0 < â < ã such that • If the degree of economies of scope is high enough (0<a≤ ã), then there is only one manufacturer in the market. • If the degree of economies of scope is low enough (a≥â), or there are diseconomies of scope, then each manufacturer produces a single good.

  23. VI. Analysis under Free Entry (2) EquilibriumAnalysis under free-entry condition. For any intermediate degree of economies of scope, â ≤a ≤ ã, the equilibrium values of L*, n*, t*are determined by the system of equations: (10) (11)

  24. VI. Free Entry Results (1) Lemma 1:The number of varieties produced by each manufacturer n* is increasing in A, R, a and is decreasing in g • Asymptotic Results • Suppose that the parameters [a, β, g, A, R] are such, that n*is big enough. Then the equilibrium values of total output, retailers’ profits, consumers surplus, number of manufacturers and social welfare are approximately:

  25. VI. Free Entry results (2) • The Benchmark case under free entry condition: • We consider the case where each manufacturer produces a single good only. In addition, let tsdenote the equilibrium price in this case and let Nsbe the number of manufacturerswhich are determined by the free entry condition (Ns is also equal to the number of goods in this case). • Proposition 4 : The total number of goods, the total output and the retailers’ profits are higher in the case of multi-product manufacturers than the respective ones in the case of single product manufacturers. On the contrary, the multi-product manufacturers’ prices are lower thanthose in the case of single product manufacturers.

  26. VII. Numerical Simulations Numerical simulations under free entry conditions. Table 6. β=0.6, A=10, g=0.1, a=0.7 Ns, TWs: number of firms (goods), total welfare in the case of single-product manufacturers

  27. VII. Numerical Simulations Numerical simulation under free entry conditions. Table 7. ß=0.6, A=10, g=0.1, R=4 Pr.U: manuf.’s profit, Ln*: total number of goods, TQ: total quantity produced, Pr.D: retailer’s profit, CS: consumers’ surplus, TW: total welfare

  28. VII. Numerical Simulations Numerical simulation under free entry conditions. Table 8: A=10, g=0.1, a=0.7, R=4 Pr.U: manuf.’s profit, Ln* :total number of goods, TQ: total quantity produced, Pr.D: retailer’s profit, CS: consumers’ surplus, TW: total welfare

  29. VII. Numerical Simulations Numerical simulation under free entry conditions. Table 9: β=0.6, A=10, R=4, a=0.7 Pr.U : manuf.’s profit, Ln* : total number of goods, TQ : total quantity produced, Pr.D : retailer’s profit, CS : consumers’ surplus, TW : total welfare

  30. VIII. Numerical Simulation Results • The product variety produced by each manufacturer, n*, the total number of goods, Ln*, the total output, Ln*Q, the retailers’ profits, the consumers’ surplus and the social welfare are decreasing in a, while the number of manufacturers is increasing in a. • As the degree of product substitutability β increases, the product variety produced by each manufacturer, n*, the total number of goods, Ln*, the total output, Ln*Q, the retailers’ and manufacturers’ profits, and the consumers’ surplus and the social welfare decrease. • An increase in the number of retailers, R, leads to an increase in the product variety produced by each manufacturer, n*, the total number of goods, Ln*, the total output, Ln*Q, the manufacturer’s profits, the consumers’ surplus and the total welfare, while it leads to a decrease in the retailers’ profits.

  31. IX. The Case of Upstream Process Innovation Activities • The Process Innovation Activities case: • In this scenario, we consider the case where manufacturers have the option to invest in process innovation activities. Thus, in the first stage of the game manufacturers decide both on the number of the goods that they produce and their prices, as well as decide the level of process innovation activity that they will undertake. • Assumptions: • The number of the manufacturers (L) is given exogenously. • The investment in process innovation activities lead to a reduction of the manufacturers’ production costs. In fact, the manufacturer's cost function is given now by: TC(n,x)=(g-x)na-kx2 where: x represents the level of investment in innovation activities and kx2 is the cost of these activities.

  32. X. Numerical Simulations Numerical simulations: The case of U process innovation activities. Table 10: R=2, A=10, g=0.1, a=0.9, β=0.5, k=500 Pr.U : manuf.’s profit, Ln*: total number of goods, TQ : total quantity produced, Pr.D : retailer’s profit, CS :consumers’ surplus, TW : total welfare

  33. X. Numerical Simulations Numerical simulations The case of U process innovation activities Table 11: R=4, A=10, g=0.1,β=0.6, L=2, k=500 Pr.U : manuf.’s profit, Ln* :total number of goods, TQ: total quantity produced, Pr.D: retailer’s profit, CS: consumers’ surplus, TW: total welfare

  34. X. Numerical Simulations Numerical simulations: The case of U process innovation activities Table 12: R=2, A=10, g=0.1, a=0.7, L=2,k=500 Pr.U: manuf.’s profit, Ln*: total number of goods, TQ: total quantity produced, Pr.D: retailer’s profit, CS: consumers’ surplus, TW: total welfare

  35. XI. Comparison Results Comparing the case of Innovation Activities with that with no investment in process innovation, in case that the number of manufacturers (L) is exogenously given, we observe that: • In the case where manufacturers invest in process innovation activities, we observe an increase in: The product variety that each manufacturer produces (n*) The total number of produced goods (Ln* ) The Retailers’ profits (slightly) The Consumers’ Surplus The Total Welfare • On the contrary, when manufacturers invest in process innovation activities, we observe a decrease in their profits.

  36. XII. Conclusions • In the presentresearch we investigate the product and process innovation activities of the food processing firms, as well as the merger incentives of the food processing firms and their retailers. In particular, the role of the economies of scope at the product creation process is analyzed. Finally, the effects of innovation and mergers on the price levels, the product variety, the number of firms at both the retailing and food processing layer, as well as their welfare effects are analyzed. Our main findings suggest that: • When the number of manufacturers ( L) and the number of the retailers (R) is given exogenously, then the equilibrium product variety n*and the total number of goods (Ln* ), are increasing in the market size (A), while there are decreasing in the degree of product substitutability (ß) and the diseconomies of scope (a). • An increase in the number of manufacturers leads to an increase in the total number of goods. However, the product variety produced by each firm decreases. • The higher is the number of retailers the higher are both the product variety, n*, and total number of goods, Ln*.

  37. XII. Conclusions • Under free entry, the equilibrium number of manufacturers and the product variety produced by each manufacturer crucially depends on the degree of the economies of scope (a): • If a is “very small” then there is only one manufacturer who produces all goods. • If a is “very high” then each manufacturer produces only a single product • For intermediate values of a, the number of manufacturers is increasing in the degree of the diseconomies of scope (a),whilethe product variety produced by each manufacturer and the total number of the produced goods are decreasing in a. • The product variety produced by each manufacturer is increasing in the number of the retailers (R ). In addition the number of the manufacturers (slightly) increases in the number of the retailers (R ).

  38. XII. Conclusions • When the manufacturers invest in process innovation activities we observe an increase in: the product variety that each manufacturer produces (n*), the total number of produced goods (Ln* ), the retailers’ profits, the Consumers’ Surplus and the Total Welfare. • In contrast, when the manufacturers invest in process innovation activities, they are locked in a Prisoners’ Dilemma. Thus, we observe lower manufacturers’ profits.

  39. THANK YOU UNIVERSITY OF CRETE ECONOMICS DEPARTMENT B.E.NE.TeC LABORATORY • Emmanuel Petrakis • Business Economics & New Technologies (B.E.NE.TeC) Laboratory • Economics Dept, University of Crete • E-mail: petrakis@econ.soc.uoc.gr

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