Rafi Mohammed

Why are There So Many Different Types of Cereals?

Posted on October 25th, 2007 (1 Comments)

I have been thinking about Richard Schmalensee’s “Entry Deterrence into the Ready to Eat Cereal Industry” paper (Bell Journal of Economics, 1978) lately. It’s a fascinating paper which many consider to be “seminal” in the economics literature. Let me discuss some of Schmalensee’s key points and I’d love to hear your thoughts on his central idea.

In the 1970’s, the top 4 U.S. cereal manufacturers had an 85% market share (the top 6 enjoyed a 95% market share) and were making high profits. Much like it is today, there were a wide variety of products in the cereal lane of supermarkets. Between 1950 – 1972, the six leading manufacturers launched 80 new cereals beyond the test market stage. Schmalensee thought it was odd, as do I, that so many new brands were introduced during this period. What’s interesting is that these new brands were introduced by incumbents, not by new cereal companies.

Schmanlensee hypothesized that major cereal makers blanketed the market with new products to deter entry by new cereal makers. He feels they tried to fill possible niches before new companies entered. Why do that…you may be wondering? To prevent price competition. Here’s the rationale: I like Raisin Bran. To me, Corn Flakes are an imperfect substitute. If prices were equal, I’d always buy Raisin Bran. That said, if Corn Flakes were priced 33% lower, I’d buy Corn Flakes. In other words, discounted new cereals that fill a niche – imperfect substitutes - can be bad for an incumbent cereal maker’s profits. Schmalensee’s theorizes that incumbents saturated the market to prevent new companies from entering and as a result, minimized possible price competition.

Schmalensee felt this behavior was a form of tacit collusion between cereal makers (they were minimizing competition by filling up niches and keeping prices high) and advocated that the U.S. government take antitrust actions to open up the cereal market for competition.

It’s an interesting question. Let’s be cynical and assume cereal makers took up space to prevent new entrants from competing, hence keeping prices high (just to be clear, I’m not advocating this). Instead, should their position have been: “I know new entrants may enter this niche and as a result, my prices will go down. That’s fine, let them in?” On the flip side, it doesn’t seem fair to consumers that incumbents’ fill niches to keep prices artificially high.

What’s do you think about this most interesting and controversial pricing policy issue?

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Readers' Comments on This Blog Entry

From donna on October 26th, 2007
Interesting issue...I think the main issue is access to the distribution channels/shelf space. If putting out so many sub-brands saturates the customer access point (retail space) and there is no incentive for the retailers to stock new co's brands at lower cost cereals...new co's are prevented customer access and can not create demand for their new products...although you could argue that there are local specialty retailers but their focus is typically high end, foo-foo cereal. But I don't think this is a collusion issue...it's a huge barrier to entry and is similar in MANY markets where the top players control the market, new products & innovation.