Evolution of Food and Agricultural Market
Structure and the Rise of Product Differentiation
Ian Sheldon (Ohio State University)
Conference on “All Food is Not Created Equal: Policy for Agricultural
Product Differentiation”, Berkeley, California, November 14-16, 2004
Introduction

Early analysis of industrial organization of food
industry based on the Bain (1951) SCP paradigm

Levels of concentration (structure), determine
pricing behavior (conduct), which in turn affects
profits (performance)

Key assumption that structure is determined by
exogenously given barriers to entry
 Economies of scale
 Product differentiation measured by advertising
outlays relative to sales
Introduction

Connor et al. (1985) concluded in their study
of US food manufacturing:

Highest rates of advertising intensity in
concentrated industries

Entry barriers high due to cumulative effects of
advertising

SCP paradigm questioned in IO literature:

NEIO focus on estimating conduct

Focus on simultaneous determination of
structure and performance
Evolution of Market Structure

Literature has returned to old question of what
determines market structure? (Sutton, 1991)

Basic idea is to focus on cases where product
differentiation is determined endogenously as
of part industry equilibrium

Industries split into those with either exogenous
or endogenous sunk costs

Allows useful classification of food industries as
regards product differentiation
Exogenous Sunk Costs and Market Structure

Product is homogeneous, and firms incur
sunk cost σ of acquiring plant of minimum
efficient scale, then compete in price

Market structure (C) function of:




Market size S relative to σ
Intensity of price competition
Markets contestable if σ = 0
With horizontal product differentiation, sunk
cost of producing specific variety, and price
competition mitigated
Exogenous Sunk Costs and Market Structure

Possibility of multiple equilibria if firms can
produce several different varieties

Market structure depends on whether different
firms enter each sub-market, same group of firms
enter all sub-markets, or firms occupy several
niche markets

Function of: demand effects (market expansion
vs. competition), costs (economies of scope), and
possibility of first-mover advantage (product
proliferation)
Exogenous Sunk Costs and Market Structure
Lower bound to C
C
C
Mergers/exit
X
S
Homogeneous Goods
S
Differentiated Goods
Endogenous Sunk Costs and Market Structure

With vertical product differentiation, each product
has single attribute u – its brand image, all
consumers having same tastes

Firms incur sunk cost σ, but now choose u, at an
additional sunk cost A(u), before competing in
price

If consumer willingness to pay increases with
advertising, A(u) can be thought of as an
advertising response function
Endogenous Sunk Costs and Market Structure

Link between increased market size S and
structure C is broken

Competitive escalation of A(u), raises
equilibrium level of sunk costs {σ + A(u)} as S
increases, offsetting tendency toward
fragmentation – advertising is an endogenous
barrier to entry

If saturation level of advertising, Aα,
fragmentation still occurs as S increases –
advertising is as an exogenous barrier to entry
Endogenous Sunk Costs and Market Structure
C
(a) Increased product differentiation
dampens price competition for
small levels of S
(a)
(b) Product differentiation makes
advertising more effective, C
increases with S
(b)
(c) If Aα, fragmentation as S increases
(c)
S
Vertical Product Differentiation
Asymmetric Advertising

Advertising levels may differ across firms:

Consumer tastes vary (different levels of u),
creating dual market structure, e.g., retail
markets and non-retail markets

Income effects such that high (low) income
consumers purchase high (low) quality u

Sequential entry, first entrant can “monopolize”
by setting u so high that other firms only find it
profitable to enter with lower A(u)
Strategic Groups in Food Manufacturing
Producer goods markets
Advertised brands
Flour (48)*, sugar (85), soybean
milling (80), wet-corn milling (72)
Frozen food (31)*, soft drinks (47)(99)**
RTE cereals (83)(85), chocolate (80),
soup (85)(92), coffee (53)(73), beer (90)(82)
Homogeneous products
Exogenous sunk costs?
Foodservice market
Typically small food manufacturers
Brands not important – except soft
drinks, alcoholic drinks and candy
Advertising, product development,
issue of shelf-space
Endogenous sunk costs?
Private-label, generic, and unbranded
products sold via retail stores
Emphasis on price, advertising and
labeling by retailers
Price, quality and service critical
Part of dual market structure?
Part of dual market structure?
Source: Porter (1976), Connor et al. (1985). * 1997, 4-firm concentration (US Census of
Production, 2001); ** 1999, share of advertising by top-3 firms (USDA/ERS, 2001)
Example 1

Dual market structure: frozen food industry

Low set-up costs, advertising-sensitive retail
sector, and non-retail segment where price is
key

Retail sector dominated by small number of
firms with well-known brands, e.g., Stouffer
(Nestlé), Birds Eye (General Foods), Ore-Ida
(Heinz)
Example 2

First-mover advantage: canned soup industry

Campbell established market for condensed
canned soup based on heavy advertising and
price – 80% market share

Heinz tried to enter branded market, but was
unable to erode Campbell’s share – focused
instead on retailer private label sales

In contrast, Heinz dominates UK canned soup
market, Campbell’s supplying private labels
Example 3

Competitive escalation of advertising: soft
drinks

Coca-Cola and Pepsi take 75% of cola market

Coke dominant initially, until Pepsi began to
compete in 1960s and subsequent decades with
successful advertising campaigns, e.g., “the
Pepsi Challenge”

Coke introduced “New Coke” in 1985, followed
by “Coke Classic” after new brand’s failure
Example 4

Endogenous advertising and/or brand
proliferation: RTE breakfast cereals

Process of endogenous advertising outlays
imposed lower bound on market structure
(Sutton, 1991)

Kellogg had first-mover advantage, pre-empting
entry via brand proliferation (Schmalensee, 1978)

Scherer (1982) argues leading firms pulled
ahead early through aggressive nationwide
advertising campaigns
Example 5

Interaction of scale economies and escalating
advertising: beer industry

Elzinga (1982) emphasized change in minimum
efficient scale, Greer (1970) role of escalating
advertising

Sutton (1991) argues influences not independent

Increase in sunk costs of new plant caused
existing structure to no longer be an equilibrium,
and for a given S, advertising became more
effective
Brewing Market Structure
C
σ1
σ2
σ2
X
Initial market structure
Y
Structure with new plant, but
ineffective adverting
Y’
Structure with new plant and
more effective advertising
Y’
Y
σ1
X
S’
S
Does Vertical Structure Matter?

How do food retailers affect evolution of market
structure and product differentiation?

If there are vertical externalities in the food
marketing chain, we would expect there to be
vertical restraints

Type of vertical restraint depends on who has
bargaining power

This will affect price competition upstream, and
hence role of endogenous sunk costs
Vertical Restraints

Vertical restraints include resale price
maintenance (RPM), exclusive dealing, exclusive
territories and slotting allowances

Prior to early-1990s, US anti-trust cases typically
involved RPM and exclusive territories contracts
relating to branded products such as beer and
soft drinks (McCorriston and Sheldon, 1997)

Since late-1980s, slotting allowances a common
vertical restraint (Shaffer, 1991; Sullivan, 1997)
Slotting Allowances

Scarce retail shelf-space and high rates of
product failure common explanation for slotting
allowances (Sullivan, 1997; Richards, 2004)

Other analysis treats payment of slotting
allowances as signals by manufacturers of the
likely success of their new product (Chu, 1992)

Whatever the story, retailers can impact the
ability of manufacturers to escalate advertising
for new brands by controlling shelf-space
Retailer Bargaining Power

Some debate as to whether slotting allowances
reflect retailer bargaining power (Shaffer, 1991;
Rao and Mahi, 2001)

Rise of private labels in US does suggest though
that balance of power may be shifting to retailers
(Harris et al., 2000; McCorriston, 2002)

Combination of slotting allowances and private
labels indicates that there will likely be further
movement to a dual market structure in food
manufacturing
Summary

Recent theory indicates a key connection
between evolution of market structure and
notion of endogenous sunk costs

Allows food manufacturing to be divided into
producer goods and advertised brands

As balance of power shifts to food retailers,
likely to affect equilibrium expenditures on
product differentiation in equilibrium

Dual market structure will become the norm