The economics of the agri-food value chain

Course review

Let me paraphrase what Tukey once said: I truly believe that getting in contact with different fields and expertise is one of the perks of being a data scientist. Pictorially:

The best thing about being a statistician data scientist, Mr Tukey once told a colleague, is that you get to play in everyone’s backyard.

So, even if you can legitimately play in everyone’s backyard - which oftentimes means cleaning it as a first step, it also means that you will be speaking to people with different backgrounds ad expertise.

Metaphors aside, a shared language and foundational notions can do magic, especially at the very beginning of a project. This is the reason why decided to take this course, offered by the Munchen University TUM through Coursera. I was particularly interested in the mechanics and economics of the value chain.

For the detailed content, there is a syllabus available: let me just say that the course topics are extremely broad and probably each week could be a course on its own.

How is that different from other value chains? Or what do consumers expect from food products - and are thus willing to pay for? How does an economist describe consumer choices as a function of product attributes? Even more broadly: what’s the difference between an invention and an innovation? If you want answers to these questions this course is definitely worth taking.

You can see that every single of the above questions (and more…) is definitely relevant to the agri-food value chain and, contemporarily, very deep. The course delivers good content and clear enough lectures through multiple teachers. After taking it you will not get extensive content, but a good set of basic facts, mental frameworks and references to orientate yourself in learning more about the agrifood value chain, which is what I was asking for.

If I had three magic wishes from a lamp to improve the course, I would have asked to:

  • add exercises: verification through quizzes is not always enough to feel confident.
  • Spend less time on very specialized stuff (e.g. data analysis or standards - which are to be mentioned but relevant only for professionals in the field: they have to know much more than that),
  • extend the theoretical sections about market asymmetry, consumer choice and coordination.

But those are probably biased observations derived from my expectations about the course.

All in all, I have yet again to recognize that coursera delivers good quality content and makes (continuos) education accessible to everybody - it’s fun to see reviews from other parts of the world!.

We live in difficult and awesome times.

P.S. the section Interesting readings below collect noteworthy papers cited during the course to know more and maybe of general interest. From the subsequent section onward my (unrevised), notes begin: do not take them at face value

Interesting readings

Collected by me and throughout the course:

Carlo Russo suggests the following:

  • EU Agricultural outlook 2015-2015. European commission (available at https://ec.europa.eu/agriculture/sites/agriculture/files/markets-and-prices/medium-term-outlook/2015/fullrep_en.pdf )
  • Ellickson (2015): The evolution of the supermarket industry: form A&P to Walmart
  • Gwin, C. F., & Gwin, C. R. (2003). Product attributes model: A tool for evaluating brand positioning. Journal of Marketing Theory and practice, 11(2), 30-42.
  • Chiappori, P. A., & Lewbel, A. (2015). Gary Becker’s a theory of the allocation of time. The Economic Journal, 125(583), 410-442.
  • Heckman, J. J. (2015). Introduction to a Theory of the Allocation of Time by Gary Becker. The Economic Journal, 125(583), 403-409.
  • Gardner, B. L. (1975). The farm-retail price spread in a competitive food industry. American Journal of Agricultural Economics, 57(3), 399-409.
  • Sexton, R. J., & Zhang, M. (2001). An assessment of the impact of food industry market power on US consumers. Agribusiness, 17(1), 59-79.
  • Lancaster, K. (1990). The economics of product variety: A survey. Marketing science, 9(3), 189-206.
  • Tirole (2008). Industrial Organization. Pages 296-298 only
  • Office of Fair Trading (2014). Competing on quality –Lit review. Pages 21-26 only
  • Peterson, H. C., Wysocki, A., & Harsh, S. B. (2001). Strategic choice along the vertical coordination continuum. The International Food and Agribusiness Management Review, 4(2), 149-166.
  • Bogetoft, P., & Olesen, H. B. (2002). Ten rules of thumb in contract design: lessons from Danish agriculture. European Review of Agricultural Economics, 29(2), 185-204.
  • Stiglitz, J. E. (1974). Incentives and risk sharing in sharecropping. The Review of Economic Studies, 41(2), 219-255.
  • Bloom, P. N., Gundlach, G. T., & Cannon, J. P. (2000). Slotting allowances and fees: Schools of thought and the views of practicing managers. Journal of Marketing, 64(2), 92-108.
  • European Parliament (2016). Structural change in EU farming. Part III only

Week 3

Trust and signaling

Premiums for high-quality products as returns to reputation (Shapiro, C. 1983)

a.k.a. How much would you spend for the salesman/firm reputation?

A market characterized by:

  • asymmetric information: firms know more about the quality of their products wrt customers
  • moral hazard: firms can reduce the quality of their products without the consumers noticing. Consumers can still learn the quality of the products after purchase (“experience” products)
  • competitiveness: all agents are price-takers 1 and there is free entry into the industry

Firms can build a reputation based on trust when:

  • products are purchased/consumed repeatedly over time
  • buyers have the possibility of punishing bad behaviors

How can reputation be built? By selling high quality at low prices initially. In the Shapiro model, the opportunistic behavior is given by the short-run incentive to companies to reduce product quality and sell at high prices (before consumers realizing).

It is worthwhile for a company to remain honest if: $$p(q’)>=c(q’)+r[c(q’)-c(q_0)]$$

where $q’$ indcates the initial status, $p$ is the relevant price and $q_0$ is the degraded quality status (that can be initially sold for $p(q’)$). The quantity in square brackets is called credibility constraint, i.e. the price premium that incentivizes the company to remain honest.

Another interesting result is that, at equlibrium, entering the market is to be done at zero profit (aka “new zero profit condition”).

The resultin equality is called price-quality schedule: $$p(q) = c(q) + r[c(q)-c(q_0)]$$

which shows that in the market with asymmetric information, it is possible to provide incentives for firms to produce and maintain quality by using trademarks (brands?) that allow consumer to confer the reputation premiumn. I.e. all levels of quality greater than the minimum one, require a reputation premium (due to the asymmetry of information).

Takeaways:

  • Reputation is an imperfect mechanism to assure quality because quality can be provided only at a premium above marginal costs.
  • In the reputation model by Shapiro, the equilibrium price-quality schedule suggests that the equilibrium price is higher than production costs for all quality levels excerpt for the minimum one. This means that a price premium is required to produce qualities above the minimum level. The equilibrium price of the minimum quality level is equal to the production costs.

Pricing

Pricing strategies overview

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How is pricing determined?

  • price floor: cost of the product
  • price ceiling: customer value and perception
  • other considerations: competitors pricing, (macro)economic situations2, marketing objectives

In general, there are 3 main categories, identified as:

  1. Customer (value-based) pricing - consumer centered
  2. Competition-based pricing
  3. Cost-based pricing (driven by markup considerations)

There are also 3 alternative categorizations:

  • price discrimination: charge different price to different customers by measure their willingness to pay (either in terms of reservation price, quantity consumed or market segments)
  • loss leader price: aggressive price strategy that can be used on a subset of the items. E.g. draw the consumer into the supermarket, then make it up on other goods
  • product mix: combine different, related items (e.g. printer+cartridge) for captive pricing stategy, bundle pricing (menu in fast foods)

Psycohological pricing - know your biases

e.g. “Effects of $9 Price Endings on Retail Sales: Evidence from field experiments - Quantitative Marketing and Economics, March 2003”

  • Consider that price can act as signal for quality (especially for experience good) when consumer knowledge is limited
  • Price differences can drive choices: two alternative products -with different prices- may act as anchor and trigger to action. This is called reference price strategy

Spending can cause real pain to people (Knutson, 2007 - Neurological predictors for purchase). Scott (2008 Tightwads and Spendthrifts - Journa of Consumer Research), divided people into 3 groups:

  1. “tightwads” - 24% in his experiments
  2. “unconflicted” - 61%
  3. “spendthrift” 15%

If buying is painful - bundling can avoid creating a single purchase rather than individual pain points! Value reframing is another popular technique: 1500/year or 125€/month?

See references section.

Retailer pricing behavior

There are two major retailer pricing strategies in literature (not bipolar, think there is a continuum in between - Fassnacht 2013, EDLP versus Hi-LO pricing strategies in retailing):

  1. hi-low pricing
  2. everyday low-pricing

In practice, weekly price adjustements are often observed basd on decisions as wholesale promo/price changes, competitor price, consumer demand, consumer factors. Li and Sexton, 2013 documented the following leading pricing patters

  • markup pricing: fixed or proportional markup - high correlation between production cost and farm price3
  • fixed pricing: regardless of fluctuation of farm price (edlp being a special case)
  • periodic sale: temporary price discount
  • high-low: frequent price fluctuations - high price volatility

How does this situation affect farmers prices? This is stuff for research.

Consumer’s purchasing process (buyer’s decision problem)

Consumer behavior ultimately drives company success. How do consumers respond to various marketing techniques? Let’s view the consumer as a Black box in a stimulus response model, supposing a Buyer’ decision is a seuqntial problem:

  1. recognize the problem (marketer can stimulate problem recognition, e.g. place advertisement near lunchtime)
  2. search for information (marketer: SEO, targeted advertising…)
  3. evaluate alternatives, restricting the options for further configurations (which attributes matter?)
  4. choose THE product: heuristics may be used (“price equals quality”, “brand x is good”, “country of origin is tied to quality”)
  5. post-purchase evaluation (did marketing campaign create fair expectations?)

Consumer characteristics

Lot of factors (cannot be affected by the marketer):

  • Cultural: cultural/subcultural/social classes
  • Social: family/role/opinion leaders/networks opinions
  • Personal situation: age/occupation/lifestyle (Activities Interests Opinions)
  • Psychological: motivation
  • Perception (Exposure, Attention, Interpretation)
  • Rewarding experiences (e.g. wine tours)

Segmentation, positioning and brand personality

How to serve different customers? There’s no unique or best way, some common ones are:

  • Geographic segmentation (e.g. many companies are running campaign locally)
  • Demographic (age, life-cycle)
  • Behavioral segmentation (e.g. a small portion of users may produce the majority of the sales)
  • Psycographic segmentation

Product positioning is often reported using perceptual maps

Brand personality: A set of human characteristics associated with a brand

Week 4

Geographical Indications (GI): concept relevance and protection

Geographical Indication are a form of property rights, recognized on the TRIPS (Trade Related Aspects of Intellectual Property Rights) agreement at WTO in 1994.

TRIPS sets a minimum standard for intellectual property protection.

TRIPS art 22. GI are indications which identify a good as originating in the territory of a Memeber, or a ragio or locality in that territory, where a given quality, reputation or other carachteristic of the good is essentially attributable to its geographical origin.

Standard example: link between soil quality and Champagne, air quality and Prosciutto di Parma. Several GIs in the EU (1151/2012, 1234/2007, 110/2008, 1601/91). Two types of GI:

  • PDO: higher, the qualities of the product are essentially or exclusively to to a particular geographic environment, and production processing and preparation take place in a defined geographical area
  • PGI, protected geographical indication: possesses a specific quality/reputation attributable to the geographical origin. The production and/or processing and/or preparation of which take place in a defined geographical area.

The EU has placed GI at the core of its quality policy, as a tool to alleviate the asymmetry of information. As of today, about 900 products at 2000 wines of spirits have this indication. Clearly importance of GI varies among members states. On average 5.7% of EU foods and drinks have GI (but it’s 14% in FR and 4% in DE).

Tipically, the largest market for GI is the domestic one (60% domestic, 20% intra-eu).

  • only groups of producers can apply for a GI
  • justifying the GI-quality link, area of production and product specification
  • applications are screened ex-ante, only high quality products become GIs
  • third-party inspection on GI-labeled products are guaranteed to counteract moral hazard (opportunistic behavior)
  • all producers within the GI are are entitled to use the GI if they comply with the specification - that’s a collective right
  • groups are responsible for the application process, are in charge of the promotions and for monitoring the GI name, but have no control over the supply.
  • member states must be proactive in defending the GI (“ex officio protection”)

GIs and market efficiency

How geographical indications may improve market efficiency? Paper by Menapace et al, based on the model of firm reputation by Shapiro.

Reputation is (initally) the quality expected by consumers -> quality expectations are based on past quality, thus reputation evolves over time. Firms can cheat before being discovered. Hence: firms can cheat, consumer tends to punish cheating produces and firms have to incur in short run losses to build reputation

Market implications:

  • Quality can be provided at a premium above marginal cost
  • Menapace argues that GIs complement trademarks by helping firm reputation. In this situation, the premium needed to support quality decreasese.

Menapace shows cost-quality curves under the assumption that two technologically different production methods exists: a standard method and a “GI” one. The GI cert makes clear to consumers that the product has been produced with a technology that makes reducing costs unattractive. Moreover, a firm that uses a trademark in addition to the GI cert can entirely capture the premium associated with the GI.

To summarize:

  • A lower price is sufficient to mantain quality for GI certified producers (as it is more unconvenient to decrease quality)
  • a mimum quality standard brings additional efficiency gains
  • Standard technology has a cost advantage in the production of low quality whereas GIs have a cost advantage in the production of high quality goods

Keep in mind:

  • The maximum quality a firm could build a reputation by using a GI-certification is the GI-specific minimum quality.
  • A firm that uses a trademark in addition to the GI certification can entirely capture the premium associated with a product’s additional quality

Definitions and types of innovation

Held by Francesco Bimbo.

J. Schumpeter greatly influenced the theory of innovation in the early 90s. Schumpeter called “creative destruction” the process where new productive factor or new technological methods replace older ones.

OECD: an innovation is the implementation of a new or significantly improved product (good or service), process or marketing technique.

Invention designates a novel scientific idea used to create new product, whereas, innovation a change that adds value to the product or service. It’s when something new is introduced into the market that fulfills the needs of the customer by delivering better products and service.

Innovation can take different form, e.g. process innovation (production technique, softwares etc can reduce cost or increase quality) product innovation (introduction of product or service which is new, e.g. “superfoods”) and marketing (open new markets, e.g. Pepsi QR codes during super bowl 2015) or organizational innovation

Example of organizational innovation, Syngenta case study. Before 2010, Syngenta had a “product leader” strategy, basically 2 non-interactive divisions.

Syngenta: Changing a Global Company. International Food and Agribusiness Management Review. 2015

One can classify innovation by its level of novelty:

  1. Radical (significant breakthrogh, change market structure). Example “insect-based” foods
  2. Incremental - minor modifications to existing products. Example “functional foods”.

Models and diffusion of innovation

Early model, first generation: science push innovation (1950-1960), market captures the fruit of developments. The evolution of consumers preferences required firms to innovation: consumers started to buy only products they liked. A new model arises: demand/market pull model.

In the 1970s, economic downturn created the condition for a more complex set of interactions, in this environment the interactive model is defined as a mix of the first two ones. Interactive model is still used nowadays, even if new ones have been developed, e.g. “open innovation model”, impliying that the organization can suceed in the market by utilizing external knowledge and internal capabilities (to fit the market needs).

Example of open innovation model - P&G “Pringles prints”

Historically P&G relied on internal source of knowledge and well-established netowrk.

Sarkar, Costa (2008) - Dynamics of open innovation in the food industry

Pringles print had questions trivia etc printed on their surface. The product was an immediate hit. At the beginning it was deemed just unfeasible (thousands of crisps to be printed per minute, food safety requirements…)!

First idea: build an “inkjet” device - that would have required a lot of effort. P&G CEO created a summary defining challenges and problems encountered while developing the product. Such report was firstly sent to the institutional network which led to a bakery in Bologna that already developed a working printing machinery. The product was developed in less than 1yr.

Diffusion of innovation

The following are archetypical firm owners, organized by their attitude towards innovation (Rogers, 1962):

  • Innovators want to be the first in the market and therefore they spend time, energy, and creativity on developing new ideas and products which are then launched in the market.
  • Early adopters become innovation testbenches, they are looking out for strategic innovation - they may “reinvent” what innovators originally created to make it more palatable for the market. More economically successful than the majority of firms.
  • Firms into early majority group are owned by individuals that are pragmatist, comfortable with moderately progressive idea. But won’t act without a solid proof of benefits. Indeed, firm owners belonging to the early majority share decide to start the business only if generate solid proof of profit - cost sensitive and risk adverse.
  • Late majority: follow the mainstream to avoid being kicked out of the market
  • Laggards - almost never innovate

Drivers and barriers of innovation

Innovation is mainly driven by consumer interest in products with enhanced sensory properties (healty features, easy to handle, ethical…). Innovations in the agri-food sector are mainly product innovations rather than process ones, as well as are often incremental, rarely radical.

Attributes add value to a product as long as they do not modify taste, since consumers tends to be conservative on this matter.

Innovation clearly has actor specifics, e.g. farmers introduce production specific innovation (as drone for fertilizers), while transformers are more focused on the supply chain. Example of Val Venosta cooperative - reorganizing storage to sell apples to big retailers.

Each sector has its own priorities (Arthur Little, 2013), e.g:

  • Cereal sector: lower glycemic index, minimize waste
  • Dairy: better process and manufacturing, plant design, food safety
  • Fruit and vegetables: develop smart package to increase product shelf life
  • Ready meals: reduce salt, sugar saturated facts
  • Soft drinks: new tech of production

Who’s innovating? Private investments in R&D is about 2.8B in 2014, which is comparatively lower wrt oriental companies. EU agri food sector is mainly made of medium small firms.

Most relevant barriers to R&D in EU:

  1. Access to founding - to public funding. Companies have difficulties finding the right source of funding, which is provided by a wide range of organization with low coordination. It’s a very costly process!
  2. Lack of skill - especially technological, industry ability to attract engineers is low.
  3. Lack of internal priority - often focused on very short term product developemnt. Short term focus delivers only incremental benefit, in small size.

Week 5

Corporate social responsibility (CSR)

Early definition of CSR (Davis, 1973) which went beyond the neoclassical theory:

the firm’s consideration of, and response to, issues beyond the narrow economic, technical, and legal requirements of the firm (to) accomplish social benefits along with the traditional economic gains which the firm seeks”.

So there are clearly issues that go beyond the economic gain. See also Davis (1973), Frederick (1986). The most complete definition of CSR includes social and environmental responsibility, which a firm can achieve through the use of ethical values, the compliance with legal requirements, and the respect for people, communities, and the environment.

The Corporate Social Performance model

Formulated by Carroll, 1979.

“The corporate social performance model” is the first and well-defined framework to analyze firms’ social responsible behavior and it was proposed by Carroll in 1979. This model points out the existence of three related elements of corporate social responsibility that have to be assessed at the firm level: principle, process, and outcome. Such elements have to be considered simultaneously in analyzing or assessing CSR firms’ behavior.

Principles:

  • Legitimacy: expectations that sociaty puts on firms. In the long run, those who do not use power in a manner which society considers responsible, will tend to lose it. Modern theory emphasizes that planet resources are finite and thus ethical condirations are important. This principle applies to all businesses, not to a specific firm.
  • Public repsonsibility: business are responsible for outcomes related to their primary and secondary areas of involvement with society (e.g. prevent car accidents, reduce emissions). This principle applies at the firm level
  • Managerial discretion: managers are moral actors, within every domain of CSR, they are oblied to exercise discretion towards socially responsible outcomes.
  • Corporate Social responsiveness: the capacity of a corporation to respond to social pressures. E.g. environmental assessment, stakeholder management, issues management.

CSR in the agri-food sector

There are a number of arguments describing why CSR is particularly relevant in the agri food sector: high production impact, food as a basic himan need and complex sector structure which leads to possibly conflicting interests.

CSR in the agro food sector is defined according to the ISO 26000. Socially responsible firms take decision through transparent and ethical behaviors. Means: sustainable development, health and welfare of society, expectactions of stakeholders.

ISO 26000, CSR in the agro-food sector is defined as: “….the responsibility of an organization for the impacts of its decisions and activities on society and the environment, through transparent and ethical behaviour that contributes to sustainable development, including health and welfare of society, takes into account expectations of stakeholders, is in compliance with applicable law and consistent with international norms of behaviour and is integrated throughout and practiced in an organization’s relationships”

Less tha 500 companies control 70% of the food production! Some big producers were found to produce unethically or even illegally (Unilever 2011 vs Rainforest alliance, Nestle in Ivory Coast).

Premium price can reward firms for mitigating social problems! Consumers seem to value more food coming from firms adopting CSR principles, also loyalty and consumer trust are enhanced. Consumers also often organize themselves to boycott unethical consumers/products (e.g. Starbucks 2007 - accused of using milk containing bovine growth hormones).

CSR case study: Coca-Cola

Coca-Cola company protected its production in Vietnam by running a community-based water project. Notice CocaCola uses 2.43 liters of water to produce 1lt of beverage! At that time in Vietname roughly 2/5 did not have access to good quality drinking water (FAO), also toilet sanifications was poor. Hence, the intense use of potable water was definitely at question.

Coca-Cola decided to start a water replenishment program. Management also operated a water program called Reduction Reduce and Replenish. For a successful project, companies should interact with NGOs.

Coordination

Specific form of coordination: contract design. Issues in coordination: the incentive problem.

What is coordination? Ethimology: “togheter”+“organization”+“action”. The joint effort of independent people must be organized (efficient). Drivers of coordination: complexity of food products, scaler of production and size of food markets, advances in the science of organization.

Most basic form of coordination: two firms involved in a transaction. Is that transaction efficient? We measure it according to the efficiency of the resulting allocation - could have we done better (without harming someone). Efficiency is not fair (at least is not required!).

A neo-institutional perspective, is given through the efficiency principle:

If people are free to bargain effectively and can enforce their decisions, then the outcomes of the economic activity tend to be efficient.

Free-bargainers would never accept a transaction if the outcome makes him worse off. The tend reflects the fact that other factors may make the transaction still unefficient (e.g. asymmetrical information).

What about distribution? Who wins/lose in transactions? Do the initial allocation of resources affect the end allocation? Coarse theorem:

If parties bargain with selfish objectives, if parts reach an agreement, then the outcome will be efficient, independent on the initial allocation of resources and bargaining power. The distribution of bargaining power only affect the resulting amount of compensations.

An important condition is the “no wealth effect” - no bargainer must be in a state of need (external force). In that case, the transaction can be unefficient.

Example: the spot market. In the sport market allocation is achieved only exchanging info about price and quantity. This is informationally efficient, but is the resulting allocation efficient? Within the theory of perfect markets, it would be. I.e. there is no “make vs buy” question, buying a product from a specialized firm is always more efficient.

However there are transaction costs to be considered (Institutional Economics). Transaction costs are key concepts in coordination studies.

Transaction costs are all costs that firms pay for participating in a market. E.g. Search and Information cost, Bargaining Costs (during transactions), Enforcing costs (usually after transactions - make sure the counterpart delivers)

If transaction costs are low, spot market is preferrable, otherwise hierarchy (“make”) is preferrable.

Coordination continuum

A variety of hybrid models - between Spot Market (buy) and Hierarchy (make) exists. For instance: long-term contracts, strategic alliances, production contracts.

From now on, we define Coordination as organizing transactions among firms with separate ownership with the exchange of extra information (in addition to price and quantities).

When is coordination preferrable to spot market? A rule of thumb: if coordination allows for higher profits (i.e. if there is a coordination surplus, i.e. if acting together leads to value added). Requirements (aka Design Attributes - they can be viewed as transaction costs):

  • A priori knowledge in at least one of the parts (there is at least one firm that has enough information about the optimal outcome)
  • Failure is costly (market coordination is a trial and error procedure)

Consider a priori knowledge: the firm in charge of the coordination, must know what consumer wants. Also, failing in innovation is costly! In general, production of quality food may be preferrable in coordination. This perspective explain why coordination is so important in today agrifood value chain.

There are many forms of coordination: a problem is choosing which is the preferrable one.

Contracts and the incentive problem

Contracts (legally-binding voluntary agreement between parties) are a specific form of coordination. Let’s see what they are - from an economic perspective. Each party commits to an action. Default conditions define cases in which obligations are not fulfilled.

How can one write a contract so that the other party behaves exactly as you expect? Perfect contracts are actually difficult to achieve and unpractical. We are in practice dealing with incomplete contracts and opportunism. Hence the question arises: “do I maximize my objective by breaching the contract”? If the answer is no, then the contract is self-enforcing.

Self-enforcing contracts are a special case of Nash Equilibrium.

Contract design should maximize the coordination surplus (and set its distribution). The principal-agent model is a useful model. The Principal is in charge of organizing activities, while the agent carries out the activity. The Principal writes down the contract (and the agent subscribes it).

The Principal’s problem: he wants to maximize own profit, and wants to maximize (coordination surplus x appropriation share). The agent must obtain a fair amount of utility (Individual Rationality Constraint) and the contract must be self-enforcing (Incentive Compatibility Constraint).

Case study: the optimal contract choice depends on specific circumstances (e.g. information)

Week 6

Modern retail

The emergence of supermarkets: origin in the early 1930s. Three key drivers, societal changes (+education, +income per capita, +women employment -> increase in opportunity cost of time), new technologies, development in management sciences.

  • societal: Higher education and more income result in more complex attributes/demand (e.g. food-> health link). There is also a demand for time-saving services.
  • Technologies: think of food preservation, transportations, ICT and data management.
  • Management: finance (capital procurement, cash management), logistics, market analysis, organization and contracts

in the retailing business quality is bringing to the producers what they want at the lowest possible price.

Offers is segmented also in terms of shops (supermarket, ecommerce, city stores in large cities). Modern retailing is still an evolving business model.

Consumer value in modern retail

Bulding blocks: Time (1 stop shop, convenience), Low prices (promotions, Q/P), Variety (assortment, product selection), Quality (willing consumers what they are willing to pay for).

The proportion of these 4 changes among different supermarket chains.

Normal trade supply chains have three main characteristics: low degree of coordination (spot market), specialized supply chains (by product), value is built on margin (markup approach).

In modern retail supermarket - procurmenets and processing is aggregated by the supermarket logistic platform. There is a high degree of vertical integration (requiring large capital), industry is highly consolidated (resulting in high bargaining power), de-specialization (many products follow the same path). Value is build on margin, time and variety. Efficient supermarkets cash the good price 30-60-90 days before paying the suppliers - they use it to reinvest in financial activities.

Expectations is the driver of consumer value (especially for 1 stop shops where you buy a basket of goods). Consumer Bounded Rationality gives the supermarket some degree of freedom - shops carry loads of products and consumer cannot elaborate it at once!

Supermarkets are used to divide products in 2 groups: Drivers (see advertising: consumers go there to buy that kind of item) and Complements. A strategic pricing of complements ensures the profit of the supermarket - and the consumer does not realize. The set of this techniques is called category management. Each supermarket acts as a constrained monopolist: competition ends at the parking lot.

Coordination in modern retail

The chain is strongly interdependent: even if the process is highly efficient, a failure in one part of the chain affects all subsequent steps (think of frozen food transportation, it’s fragile).

Supermarkets build shareholder value based on time, so low inventories and category management are essential, errors are costly and failure in coordiantion in particular.

So, how does one prevent problem? Maximum effort is put in cooperation.

Example: consider a supplier. A lot of requirements are required on him (must be reliable, on time, problem solver, pro active, helpful efficient etc.). In the procurement process, the HQ acts as a buying desk: they design a framework contract (Tier 1), which is a Long Term contract (1-2 yrs, it is never extended). The main elements of the framework contract is listing, promotions (joint-participations), quality standard, trade spending (acess to specific services, information system) are defined.

Once Tier 1 contract is defined, the supplier is qualified as a provider, i.e. “listed”. The order is then fullfilled at the local branch by using Tier 2 contracts - derogations may apply and often they are in favor of the retailer. Tier 3 contracts at the store level may be applied for particular foods (e.g. “super fresh”).

Why is this structure of contracts is enforced? In normal conditions, when supermarkets are low on inventory (and sales are good) there is potential for opportunism, hence the supermarket would have low bargaining power under pressure. With the contact structure, the supplier actually has 2 alternative: Fulfill or Breach agreements. The procurement contract is designed for maximum future retaliation onto the supplier! This is called delisting retaliation - which means that the supplier would lose all the shops from that supplier. Fines and liabilities rules are just add-ons contracts as it’s harder to enforce them.

De-listing is a credible and seriour threat for many suppliers. The mere possibility of de-listing is often sufficient to ensure max effort and cooperation, supermarkets do not even have to mention it as the contract does not automatically renew.

The shelf allocation problem

The join choice of product and supplier is called shelf allocation. Several models possible:

  • Integrated model: The supermarkets select both products and suppliers
  • Mixed model: supermarket chooses product, a middleman choose suppliers
  • Outsourcing: middleman chooses suppliers and products (e.g. supermarket sells the space)

Optimal assortment: high margins, sells fast.

Which one of these contracts design is most profitable? It depends on the information. If supermarket has good knowledge about suppliers and consumers, the integrated model is probably the best. Review the theory of design attributes. The firm with the most accurate information is the one deciding allocation.

Trade spending

Means payments from suppliers to the supermarkets. Trade spending fees are lump sum independent of quantity, designed as compensation for services (listing fees, contribution to new store openings, mandatory ICT services or training, negotiation fees). They are estimated, on avg to be 11% of suppliers revenues (in Italy). Why imposing these fees instead of managing the price directly?

There’s and efficiency perspective to this:

  • the specialized supplier may have more information than the retailer
  • in order for the supermarket to expose the product, they need to pull out something else (incrementality)
  • with trade spending, supplier must increase its volume to break even (bc of fixed cost)
  • the supermarket can set a trade spending fee TS such that any supplier with an average cost higher than a threshold value X*TS achieves negative profit - the inefficient suppliers have no interest in searching for contracts
  • also, when trade spending is in place, delisting is more effective

Summarizing: supermarkets prefers trade spending over decrease in price for multiple reasons (hence they can appear high - if compared with the services offered): reduce the risk of product innovation, elicit high production volume, helps in selecting most efficient suppliers. In other words, they solve asymmetries in production innovation, elicit production, make threat mechanism more effective and helps selecting efficient suppliers (i.e. those able or willing to producing high volumes).

Industrial standards

The government developed new legislation and regulations to ensure high levels of quality and sustainability in the food supply chain FSC. Private sector, specially the supplier, has also assumed responsibility for high standards of quality standards to enforce an higher level of vertical coordination.

A transactional cost is a cost incurred in making an economic exchange. Categories: search and information, bargaining or negotiation, policing and enforcement.

Quality and vertical coordination

What happens when there is closer vertical coord? [Young and Hobbs, 2002]: Rise in contracting, greater product differentiation, importance of supply chain relationship.

Further implications: Some producers may experience difficulties entering in market, market becoms less transparent, quality and verification becomes more complex on both sides of the transaction. A third party can provide an independent assessment of the quality attribute of the products (to reduce informational cost). ISO 8402 defines quality as the totality of features and characteristics of a product that bear on its ability to satisfy stated or implemented needs.

Quality attributes of a product or process can be tied to different parts of the supply chain (from the selection of seeds, to the transporation condition). The market outcome for quality is determined by the supply of characteristics, the demand of attributes and the information that consumers have about these attributes.

What’s a standard?

An agreed way of doing something - reaching a level of quality or attainement. Standards are agreed upon criteria. Standards may be either mandatory or voluntary. Voluntary standards are used for differentiation, should be monitored by 3rd parties and can be organized according to (i) leading organization (are they unilateral? Multi-stakeholder) (ii) motivations for the standard (risk management, food safety) (iii) scope (emphasis, geography, product) (iv) enforcement (which kind of monitoring? By 1st, 2nd or 3rd party?).

Meta standards

Standards can be aggregated in meta standards or meta system. Food quality management systems (metasystems) are strategies that affect quality attributes, their aim is to reduce product waste, comply with requirements, responding to customer demands etc.

In contrast to product specs, which are very detailed to industry or firms, standards have wider rules. Several characteristics success (certification audit, documentation practices). Metasystem defined a process to be undertaken by a company to guarantee quality on an ongoing basis, requiring an holistic approach.

Example of metasystems from late 1980s to today:

  • product quality ISO 9000
  • environmental management systems 14001
  • worker empowerment (Total Quality management)
  • customer feedback
  • supply chain management and inventory control
  • food safety

Some metasystems may shift the cost curve downward, others upward. Metasystems are adopted because of internal benefits, competitive advantage, possible gains in system efficiency.

Examples

  1. Good practice: a method or technique that has consistently shown results superior to those achieved by other means
    • good agricultura practices (GAP), for instance FAO, USDA. Non prescriptive rules, providing technical references for stakeholders. Topics covered are soil, animal production, water, crop protection, human welfare…

  1. more on price-taking firms at core ↩︎

  2. after 2008 crisis there has been a paradigm shift: companies started repositioning and creating subsidiaries “value” brands ↩︎

  3. sensitive to external shocks ↩︎

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