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
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
Canned
ham
Ice cream
Items
Brands
Firms
86
41
30
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 1980searly 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
Dasani
$1.58
spring in
French Alps
purified tap
water
Why differentiate
Price, $
Oligopoly
Profit
DWL
Competition
Unit cost
Demand
Quantity
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
Variety, number of products
variety-quantity tradeoff (PPF)
A
Optimal
B
Quantity of each product
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
Eliminated
pineapple
products
Dole's 6pack of 6
oz cans
Other
pineapple
products
Nonpineapple
products
Dole's 46 oz can
-4.1
0.3
0.8
All Dole products
-
0.8
0.9
All pineapple
products
-
-
1.0
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
Consumer Surplus
Change
-1,183
Profit
417
Welfare
-766
Eliminate all pineapple juice
($thousands/month)
Eliminate all pineapple juice
Consumer Surplus
Profit
Welfare
Change
-1,677
720
-957
Welfare effects of eliminating a large
firm ($ 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 profitmaximizing 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