Product Diversity

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 ERSBerkeley, 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 categories—large in most

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

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: Welch’s • early 1990s: new products—introduced in the last 5 years—accounted 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 couldn’t 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 Kellogg’s cereals to private labels at half the price, Kellogg’s • 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

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

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 • rival’s 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

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

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