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 categorieslarge in
most
Items Brands Firms
Canned ham 86 41 30
Ice cream 7,294 626 342
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
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

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 lt 5
  years old
• spends ¼ of its resources on new
  products/business ideas

14
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

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 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

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 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

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
/Quart Source
Crystal Geyser 0.77 springs in CA and TN
Evian 1.46 spring in French Alps
Dasani 1.58 purified tap water
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
• rivals 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
Number of brands Quantity of each Total output
1 95 95
2 45 90
3 28? 85
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

51
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)

52
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)

53
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)

54
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

55
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

56
Empirical Evidence
57
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

58
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

59
Small empirical literature on welfare

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

60
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

61
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

62
Price effects from eliminating pineapple juice
products
63
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

64
Eliminate Dole 46 oz (thousands/month)

Eliminate Dole 46 oz Change
Consumer Surplus -495
Profit -301
Welfare -796
65
Eliminate all Dole pineapple (thousands/month)
Eliminate all Dole Change
Consumer Surplus -1,183
Profit 417
Welfare -766
66
Eliminate all pineapple juice (thousands/month)
Eliminate all pineapple juice Change
Consumer Surplus -1,677
Profit 720
Welfare -957
67
Welfare effects of eliminating a large firm (
thousands/month)
?Profit ?Profit ?CS ?CS ?W ?W ?W/R ?W/R
Nestle Canned Fruit Juice Nestle Canned Fruit Juice 2.05 2.05 -14.69 -14.69 -12.65 -12.65 1.20
Campbell Soup Campbell Soup 0.76 0.76 -2.29 -2.29 -1.54 -1.54 0.39
Procter Gamble Procter Gamble 0.11 0.11 -4.32 -4.32 -4.21 -4.21 1.41
Dole Dole 0.69 0.69 -1.47 -1.47 -0.78 -0.78 0.34
Nestle Canned Juice Drinks Nestle Canned Juice Drinks -0.12 -0.12 -0.69 -0.69 -0.81 -0.81 0.42
Citrus World Citrus World 0.37 0.37 -1.13 -1.13 -0.77 -0.77 0.46
Texas Citrus Exchange Texas Citrus Exchange 1.05 1.05 -1.51 -1.51 -0.47 -0.47 0.38
Empacadora de Frutas Empacadora de Frutas -0.11 -0.11 -0.52 -0.52 -0.63 -0.63 0.65
68
Compensating variation of eliminating a firm
plotted against its revenue
69
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

70
Information
71
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

72
Promotion

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

73
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

74
Grossman-Shapiro (1984)

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

75
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

76
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)

77
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