Entry deterrence in the RTE breakfast cereal industry -By Richard Schmalensee (1978) Presented By: Rashi Saxena MBA (Infrastructure)
Arguments about Industry conduct Avoid price competition Entry deterrence & Profit protection New brand introduction
RTE Cereal Market in U.S.• Highly concentrated post-war• Kellogg, General Mills, General Foods, and Quaker Oats: 85% of sales• Top six firms: 95% of sales• 1940-early 1970s: no new producers of RTE cereal attained significant market shares• Early 1970s: – Overall demand growth slackens – New firms entered; national marketing of so-called natural cereals
Timeline1950-mid 1960s: Rapid and steady growth in RTE cereal sales Early 1970s: Entry of new large firms in RTE cereal market Apr 1972: U.S. FTC charges 4 U.S. RTE cereal manufactures of “Brand Proliferation, Product Differentiation, Trademark Promotion…resulting in high barriers to entry into the RTE cereal market Apr 1976-Jan 1978: Trial period Feb 1976: Quaker Oats dismissed from the case
Some ‘facts’ taken as given…• Entry Eligibility• Brand-specific production knowhow• Clear product differentiation• Advertising sales ratio>10% (Glossary)• Absolute capital costs~ $80-150 M (Glossary)
Assumptions C(q): Cost of producing• Increasing Returns at brand level and marketing a brand – C(q) = F + v.q F, v: Positive constants – Introductory advertising cost is independent of its subsequent sales – Intensity of advertising one brand vs. another• Localized Rivalry – “Variations in consumer taste give rise to product differentiation” – Brand patronizing also depends on distance proximity – ‘Localized Oligopoly’ – Hence, marketing plans stress more on the actions of only a few rivals
…continued• Relative Immobility – Economic space vs. Geographic space: If brands differ only in their locations, then changes in location are not costless – Re-positioning costs: Cost of moving an old brand to an arbitrary location vs. cost of introducing a new brand
Static Theory of Entry Deterrence• N brands Brand N Brand 1• Distance between 2 Buyer consecutive brands: 1/N Brand… Brand 2• Price charged: p• Buyers patronize the Buyer Unit Buyer ‘closest’ brand (≤N/2) circumference• q(p,N) = a(p).b(N) Brand 6 Brand 3• Total sales of product do not fall as no. of brands Brand 5 Buyer Brand 4 increase• ∏ (p,N) = A(p).b(N)-F A(p)= (p-v).a(p);• ∏(p,Ń)=0 All brands p>v are profitable if N<Ń
Another assumption…• Established sellers collude to deter entry at minimum cost to themselves• Methods used to create barriers to entry: – Increase no. of brands instead of using limit- pricing policy – Increase promotional outlays in the face of threatened entry
Problems with Limit Pricing• Entrants are more crowded after entry than are established firms before entry• Forgoing short-run profits to impose greater costs on potential entrants in collective interest of established brands• If entry still occurs, it is relatively immobile• Now, profits can be generally raised by increasing prices• Limit pricing ceases to be an effective deterrent
Effect of Advertising d(F) is an increasing F: Expenditure by all• q(p,N,F) = a(p).b(N).d(F) function brands on advertising• Advertising expands sales in direct proportion to its market area• Higher maintenance spending by established brands would raise the level of introductory spending an entrant must do to get noticed
When to crowd the Economic space?• After • Before – Threat to surround an – Entry deterring threat is entrant with new brands that “brands will not be – Mutually damaging moved if entry occurs” warfare – Since repositioning – Poor credibility brands is not costless, – Higher credibility
Application to RTE Cereals Industry• The assumptions of perfect collusion and static market must be appropriately relaxed• So, consider the 3 following questions: – Could such a pattern of deterrence have arisen in the absence of such coordination? – How could the entry of new firms have been deterred, even though established firms found it profitable to launch new brands? – Is the explanation advanced here for lack of entry during 1950-60s consistent with the appearance of new firms in this market in the early 1970s?
Question 1• Price competition was suppressed and possibly ‘cooperative’• Rivalry was channeled into advertising (probably non-cooperative) and new product introductions (surely non-cooperative) – Private label brands were discouraged – Information exchanges through Nielson until 1972
Question 2Two Reasons:1. Differential expectations: At any point in the segment’s growth, the expected value of a new brands is less to potential entrants than to established sellers. Ceteris paribus, existing firms that have a modus vivendi with the major rivals find new brand introduction profitable.
2. Minimum efficient firm size: A potential entrant would need 3% of market share to produce efficiently, while an existing firm can do with 1% The research task of potential entrants is distinctly harder than those of established sellers
Question 3• After a rise in consumer interest in “health foods”, the natural cereals’ market share had increased steadily: – 1972: all collective market share of all natural cereals was 0.5% – 1973: 4% – 1974: 10%• The shifts in consumer taste were poorly anticipated by most of the established firms. Hence, a substantially new market was up for grabs!