Product DiversityJeffrey M. Perloff

University of California, BerkeleyGiannini Foundation

ALL FOOD IS NOT CREATED EQUAL:Policy for Agricultural Product Differentiation

Farm Foundation, Giannini Foundation, USDA ERSBerkeley, California, November 15, 2004

Questions

Too little differentiation?

Specific questions

What effect does a new, differentiated product have on

• firm profit and industry profit

• consumer well-being?

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

Outline

• degree of differentiation of food and beverage products

• why do firms differentiate?

• oligopoly differentiation theories and evidence

• information theories

Increased Differentiation?

Differentiation varies across categories—large in most

Items Brands Firms

Canned

ham86 41 30

Ice cream 7,294 626 342

Firms report increased innovation

• new contents (new flavor, carbonate,...)

• new size or package

• new category or type of product (organic food, functional food,…)

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

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

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

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

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

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)

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

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

Why Differentiate?

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)

Respond & innovate

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

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

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

Private Label

Private label history

discount products introduced:

• generics: late 1970s

• high-quality private labels: late 1980s-early 1990s

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

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

Pricing

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

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

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)

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)

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

Question

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

Answer

Contrary to executives’ claims, firms:

• do not increasingly differentiate their products

• do not increase sales

• promotional activities fall

• name-brand firms’ prices rise

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

Market Power

Product differentiation works

$/Quart Source

Crystal Geyser $0.77 springs in CA and TN

Evian $1.46 spring in French Alps

Dasani $1.58 purified tap water

DWL

Why differentiate

Unit cost

Demand

Competition

Oligopoly

Price, $

Quantity

Profit

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)

Quantity effects on firm

• firm gains from sales to new customers

• but it may cannibalize sales of its older products

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

Thus,

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

Oligopoly Differentiation: Theories & Evidence

Oligopoly theories

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

Variety-quantity tradeoff

Number of brands

Quantity of each

Total output

1 95 95

2 45 90

3 28⅓ 85

Optimal

A

B

Variety, number of products

Quantity of each product

variety-quantity tradeoff (PPF)

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

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

Aeroflot Airlines: You Have Made the Right Choice.

—Ad campaign for the only airline in the then Soviet Union

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)

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)

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)

Comparing the models

• Why do representative consumer and spatial models give different results?

• to answer: Deneckere and Rothschild’s (1986) model nests• Perloff-Salop representative consumer

model

• Salop spatial model

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

Empirical Evidence

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

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

Small empirical literature on welfare• Hausman (1996) and Nevo (2000):

cereal• concentrate on the implications for

measuring the consumer price index

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

Experiments

• Dole’s 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 Dole’s products

Price effects from eliminating pineapple juice products

Price effect (%) on

Dole's 46 oz can -4.1 0.3 0.8

All Dole products - 0.8 0.9

All pineapple products

- - 1.0

Eliminated pineapple products

Dole's 6-pack of 6 oz cans

Other pineapple products

Non-pineapple products

Experiment

• eliminate Dole’s 46 oz pineapple juice can • how quantity shares shift:

• 5.8% goes to Dole’s 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 Dole’s large can

Eliminate Dole 46 oz ($thousands/month)

Eliminate Dole 46 oz Change

Consumer Surplus -495

Profit -301

Welfare -796

Eliminate all Dole pineapple ($thousands/month)

Eliminate all Dole Change

Consumer Surplus -1,183

Profit 417

Welfare -766

Eliminate all pineapple juice ($thousands/month)

Eliminate all pineapple juice Change

Consumer Surplus -1,677

Profit 720

Welfare -957

Welfare effects of eliminating a large firm ($ thousands/month)

ΔProfit ΔCS ΔW |ΔW|/R

Nestle Canned Fruit Juice 2.05 -14.69 -12.65 1.20

Campbell Soup 0.76 -2.29 -1.54 0.39

Procter & Gamble 0.11 -4.32 -4.21 1.41

Dole 0.69 -1.47 -0.78 0.34

Nestle Canned Juice Drinks -0.12 -0.69 -0.81 0.42

Citrus World 0.37 -1.13 -0.77 0.46

Texas Citrus Exchange 1.05 -1.51 -0.47 0.38

Empacadora de Frutas -0.11 -0.52 -0.63 0.65

Compensating variation of eliminating a firm plotted against its revenue

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 products—but 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

Information

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

Promotion

• societal critics: advertisers con consumers into thinking they want a good

• most economists: difficult to judge welfare effects of promotions given tastes change

Dixit-Norman (1978)

• a small increase in advertising raises welfare only if the firm finds it profitable (thus can’t be too little advertising)

• reducing advertising from the profit-maximizing level raises welfare—there’s too much advertising

• Fisher-McGowan and Shapiro take issue with Dixit-Norman’s analysis

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

Akerlof’s (1970) lemon model

anagram for General Motors: or great lemons• when buyers cannot judge a product’s quality

before purchasing it, low-quality products—lemons—may drive high-quality products out of the market

• Akerlof’s lemon problem can be overcome by• branding• government standards and certification

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)

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