Product Diversity

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

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Questions
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Too little differentiation?
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Specific questions

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

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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

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Outline

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

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Increased Differentiation?
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Differentiation varies across categorieslarge in
most
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Firms report increased innovation

• new contents (new flavor, carbonate,...)
• new size or package
• new category or type of product (organic food,
  functional food,)

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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

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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

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Popular canned products

• Type
• juice
• juice drink
• nectar
• drink
• juice cocktail
• Count
• 1
• 6
• 12
• 24
• 4

• Flavor
• vegetable
• fruit punch
• tomato
• pineapple
• apple
• grape
• citrus

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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 years old
• spends ¼ of its resources on new
  products/business ideas

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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

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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)

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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

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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

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Why Differentiate?
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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)

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Respond innovate
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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

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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

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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

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Private Label
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Private label history

• discount products introduced
• generics late 1970s
• high-quality private labels late 1980s-early
  1990s

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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

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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

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Pricing

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

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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

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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)

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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)

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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

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Question

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

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Answer

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

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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

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Market Power
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Product differentiation works
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Why differentiate
Price,
Oligopoly
DWL
Profit
Competition
Unit cost
Demand
Quantity
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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)

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Quantity effects on firm

• firm gains from sales to new customers
• but it may cannibalize sales of its older products

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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

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Thus,

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

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Oligopoly Differentiation Theories Evidence
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Oligopoly theories
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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

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

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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

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Aeroflot Airlines You Have Made the Right Choice.

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

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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)

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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)

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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)

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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

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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

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Empirical Evidence
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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

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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

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Small empirical literature on welfare

• Hausman (1996) and Nevo (2000) cereal
• concentrate on the implications for measuring the
  consumer price index

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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

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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

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Price effects from eliminating pineapple juice
products
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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

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Eliminate Dole 46 oz (thousands/month)
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Eliminate all Dole pineapple (thousands/month)
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Eliminate all pineapple juice (thousands/month)
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Welfare effects of eliminating a large firm (
thousands/month)
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Compensating variation of eliminating a firm
plotted against its revenue
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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

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Information
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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

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Promotion

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

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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

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Grossman-Shapiro (1984)

• market equilibrium has too many firms (excessive
  diversity)
• each firm advertises 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

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Akerlofs (1970) lemon model

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

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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)

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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