ANALYSIS OF INDUSTRY AND COMPETITION

PAPER (GROUP N, SESSION A)

Coca-Cola, Pepsi in Super ad Battle The Washington Times 1 February 2009

Academic Year 2010/2011, 2nd Semester Prof. Sofia Franco

ABSTRACT:
The newspaper article Coca-Cola, Pepsi in Super ad Battle from The Washington Times, published on the 1st of February of 2009 is about the advertising battle between the two giant U.S. soda brands Coca-Cola and Pepsi. The two brands competing la Bertrand in prices. Since they have aggressive advertising campaigns, we will use the advertising as the differentiation parameter to set a price above the marginal cost. The two products are perceived as homogeneous by the consumers. Therefore advertising is used to create brand awareness in order to increase consumer taste (more inelastic demand) and to set prices over marginal costs, creating profits. However, competing firms will react in the same way and as a result an advertising war will arise where firms would compete sequentially and where advertising campaigns come up as strategic complements, exactly like prices. Besides the positive effects of advertising on the demand side, advertising campaigns have also an impact on the cost side by increasing the fixed costs of a firm. So the decision regarding an advertising campaign should only be taken if it seems to be profitable. But firms can use advertising not only to fight existing rivals but also to prevent the entry of new ones. They can increase the costs on advertising that an entrant firm has to incur so much that they will end up blocking the entry of new competitors.

ANA ABREU #744, DIANA HENRIQUES #793, EDUARDO CARONA #679, MARCELO FONTES #959

Index

Index
Introduction ........................................................................................................................................... 2 Companies Background ....................................................................................................................... 2 Theoretical Framework ........................................................................................................................ 3 Evidence ............................................................................................................................................... 10 Concluding Remarks .......................................................................................................................... 11 References ............................................................................................................................................ 12 Annexes ................................................................................................................................................ 13

Introduction The aim of this paper is to make a comprehensive review of the newspaper article CocaCola, Pepsi in Super ad Battle from The Washington Times, published on the 1st of February of 2009. The article describes the advertising war between the two rival soda brands, Coca-Cola and Pepsi, during the Super Bowl XLIII. The cost of this advertising campaign was predicted, by industry analysts, to be one hundred thousand dollars per second. The reason for such huge cost is that Super Bowl is the most-watched TV show in the United States and it has a wide multigenerational audience. Pepsi paid to have the exclusive rights to be the first mover, assigning Coca-Cola to the third and fourth quarters. It will be interesting to analyze who won this exciting advertising battle. The importance of the Super Bowl relies on the fact that it shows the two brands dynamics on advertising, and how it creates brand awareness and increase the barriers to entry in the market. Companies Background Coca-Cola was created in 1886 by a pharmacist named John Pemberton in the United States. Nine years later the product was already available in all states of the United States. Very earlier Coca-Cola started to spend significant amounts of money in advertising, and in 1918 their annual advertising budget reached one million dollars. Thirty two years after its foundation, Coca-Cola was already present in 53 countries. In the fifties the company started its expansion with the launch of new flavors, its annual budget on advertising continued to increase (thirty million dollars) as also its presence around the world (120 countries). In the year of 2010 Coca-Cola was present in more than 200 countries, its market share was around forty two percent, annual revenues were close to thirty one billion dollars and their annual advertising spending was approximately two billion dollars. Pepsi origins started in 1898 when Caleb Bradham, also a pharmacist, created the product in the United States. In 1905 it started as a franchise system and five years later it was present in 24 U.S.A. states. In 1923 the brand went into bankruptcy due the First World Wars sugar

rationing. On the thirties Charles G. Guth took the leadership of Pepsi and lead the company to an international expansion. In 1958 Pepsi was available in 120 countries. In 1964 the Pepsi started to diversify their products starting with Diet Coke. Only on 1966 Pepsi created its first operation in Europe and Japan. In 2010 Pepsi was present in nearly 200 countries, its market share was around thirty one percent, the annual revenue was about forty three billion dollars and their advertising spending was around one billion and one hundred thousand. Besides these two companies in the United States only one more soda brand has a relevant market share - Dr Pepper but due to its low price strategy it is perceived as a low quality brand when comparing with Coca Cola and Pepsi. In sum we are analyzing a high concentrated market in which these two brands are the biggest players which happens mainly due to the very expensive advertising war between them. Theoretical Framework Consumers perceive these two products as homogeneous, which means that there is no room for product differentiation between them. Therefore Coca-Cola and Pepsi compete in prices and advertising. They play la Bertrand choosing simultaneously their prices. However, brand awareness and consumers tastes have a very important role in this market. The two brands have similar demands, and cost structures, although there are slightly differences which count in the market (see Figure 1 in the annexes).
To clearly represent the competition within this market we performed the Bertrand Model

with a spatial version (Hotelling Model). The spatial context relies on a preference line with a length of 1 mile with N consumers who are uniformly distributed along it. Coca-Cola and Pepsi are established on the extremes of the line (Exhibit 1).
DCoke = Coca-Cola Demand DPepsi = Pepsi Demand
Exhibit 1: Location of the marginal consumer

Each consumer buys one product. The parameter of differentiation is t, which is the cost that a consumer incurs to be one unit further away from his most preferred brand. The higher the t

the greater is the consumers taste for a brand. Thanks to the differentiation parameter is possible to determine the localization of the marginal consumer, the one who is indifferent of buying Coca-Cola or Pepsi
( )

. The demand for Coca-Cola is

all consumers until the location of the marginal consumer. Therefore the demand for CocaCola is the number of consumers on the line (N) times the location of the marginal consumer [ . Consequently the demand for Pepsi is the remainder of the line . Regarding costs of production

times the number of consumer

Coca-Cola and Pepsi spend Ccoke and Cpepsi per unit, respectively, and Coca-Cola is slightly less efficiency than Pepsi (see Figure 1 in the annexes). Advertising is introduced in the model as a tool that each brand can use to inform consumers of their product. Not all consumers will be exposed to advertising, thus, coke is the proportion of the total population that receives advertising of Coca-Cola, and the same with pepsi and Pepsi. Thanks to several statistic data we can affirm that coke is larger than pepsi. Then, the higher coke the greater is the brand awareness for Coca-Cola. We have two types of consumer who heard the advertising of Coca-Cola. Consumers who only receive the advertising of Coca-Cola (
( )), and since they are not aware of Pepsi, Coca-

Cola dont need to compete for them. On the other hand, there are consumers who received advertising from Coca-Cola and from Pepsi as well (
) . As these consumers

received both advertising, they will buy the more attractive deal. The attractiveness will be a result of consumers taste for one brand combined with products price. These consumers are distributed identically on the line (Exhibit 2).

Exhibit 2: Consumer who received advertising of CocaCola and Pepsi

Consumers nearer Coke (point 0) will choose Coca-Cola because have a greater consumer taste for this brand, so if they bought a Pepsi their cost of t would be higher. The same logic

for the consumers on the right, they will buy a Pepsi. Its on these consumers that Coca-Cola and Pepsi will use prices to induce them to purchase their product. The consumers choice will be based on his surplus. For instance, the lower price of Pepsi can compensate the costs (t) that a consumer on the left might incur for not buying his preferred brand. Recalling the location of the marginal consumer, although, now it is concerning to those who receive both advertisings, i.e. is the consumer who receives both advertising and is indifferent of buying a Coca-Cola or a Pepsi. Determining both brands demands, Coca-Cola demand is
( ( ) )

and

Pepsi

is

. Through these equations is clear

that both firms have the incentive to raise to increase their demand. However, it is important to understand that it will require advertising expenses. Thereby we can define advertising costs as a function of the number of consumers that a brand tries to inform ( ) . The larger the fraction () of consumers that a brand try to inform, the higher

will be the cost. Assuming that the marginal cost of raising the fraction of consumers that received advertising is ( ) , thus, the total advertising cost can be defined as

, i.e. the advertising costs increases with the square of the fraction of the

market that a firm wants to inform. Given this cost of advertising and the new demand, the new profit function of Coca-Cola is
] ( ) [ ( )

. To maximize its profits, Coca Cola will determine

its reaction function which is the best response given Pepsis price and advertising effort. Its given by the first order condition Thereby the reaction function of Coca-Cola is and the one of Pepsi is . The first part of the reaction function describes the price when all consumers in the

market are perfectly informed, however, the second one refers the additional markup that one brand has when consumers do not know about the competitor. Applying this to the Bertrand Model we get (Exhibit 4):
RFCOKE = Coca-Cola reaction on Price RFPEPSI= Pepsi reaction function on Price

P*COKE= P*PEPSI=

3 3

4 6 3 4 6 3

Exhibit 4: Bertrand Competition on Price

Hence, in equilibrium the price (Figure 2 in annexes) of Coca-Cola is higher due to its higher costs and to its greater consumers taste. Despite Coca-Cola lower efficiency, it is the greater brand awareness that allows it to practice a higher price. Both reaction functions are upward slopping, which means that their prices are strategic complements. Therefore if one brand increases its prices the other will follow the increase as well, ceteris paribus. Concluding, prices are similar and it isnt the most effective tool to win competitive advantage, because even having a lower price Pepsi dont has the whole market due Coca-Cola consumers taste. Advertising could be viewed as an integral element of competitions among firms that sells different brands of the same good1. Recalling the previous spatial model and taking the same logic of the reaction functions but now for the fraction of consumers () that a brand should try to inform given what the competitor is doing. Therefore we performed the first order condition of the profit function in order to : Cola and Pepsi are and
( ) ( [( ) ) [(

The reaction functions for Coca) ], ] respectively. For

other words, the marginal benefit of reaching additional consumer through advertising increase will be to the marginal cost of such advertising given a firms price level and the action of its competitor. Graphically we get, again, upward slopping functions which mean
1

Pepall, L., Richards, D. & Norman, G. (2008). Industrial Organization: Contemporary Theory and Empirical Applications. Wiley-Blackwell

that Coca-Cola and Pepsi are strategic complements in advertising as well, and compete sequentially in it. When one increases the expenses in advertising the other will increase its expenses too, ceteris paribus (Exhibit 5).
RFCOKE = Coca-Cola reaction on Advertising RFPEPSI= Pepsi reaction function on Advertising

Exhibit 5: Competition in Advertising

There must be a reason for such high investments in advertising that both brands engage constantly in it. In order to understand such practice we need to measure the effects of advertising. Assuming that inverse demand curve of Coca-Cola is the one of Pepsi is , and

. Advertisement has two main effects for a firm. A

firm uses advertising to shift its demand curve to the right, and to make it more inelastic, however as we will discuss further advertising increase firms fix cost. The effects on the demand are a consequence of increasing the brand awareness, which increases demand, and makes consumer willing to pay a higher price. Hence, the competitor of the brand that advertised will have exactly the opposite effects on its demand. The demand curve will shift to the left, which result in a lower demand, and it will become more elastic, for each variation in price the quantity demanded will have a higher variation. For instance, if Coca-Cola performed advertising the effect will be the follow on its demand and on Pepsis demand (Exhibit 6 and 7):
D = Demand before Advertising
0

D = Demand before Advertising

0

D = Demand after Advertising

1

D = Demand after Advertising

1

MR = Marginal revenue before

0

MR = Marginal revenue before

0

Advertising MR = Marginal revenue after

1

Advertising MR = Marginal revenue after

1

Advertising MC = Marginal Cost

Advertising MC = Marginal Cost

Exhibit 6: Advertising effects on the Demand.

Exhibit 7: Advertising effectson the competitors demand

The conclusion that we get on these graphics are contradictory from the one that we reach previously. Since the two brands are strategic complements in prices, if Coca-Cola increase its prices Pepsi should increase too. Although we see the opposite and this is a result of Advertising. We referred above that if one increase its price, the other increase its price as well if everything remains constant (ceteris paribus), which is not the case in here. Advertising changes the brand awareness which will change the demand and the amount that consumer will be willing to pay for a Coca-Cola. Therefore the reaction functions of both brands will vary. The result will be the follow (Exhibit 8):
RF0COKE = Coca-Cola reaction function before Advertising RF1COKE = Coca-Cola reaction function after Advertising RF0PEPSI= Pepsi reaction function before Advertising RF0PEPSI= Pepsi reaction function after Advertising P0*= Price before Advertising P1*= Price after Advertising

Exhibit 8: Advertising effects on Reaction Functions

The reaction function of Coca-Cola shift to the right in result of a greater preference that advertisement created in consumer for this brand. The opposite happens with Pepsi, as the consumers have a lower taste for it the reaction function will shift to down. Through this the price of Coca-Cola will increase and the Pepsis will decrease. This is a static scenario in which one brand advertises and the other doesnt react. In reality they are constantly reacting to the other player advertising in order to cross out the effect of the competitor. This creates a sequential competition in advertising by Coca-Cola and Pepsi. Recalling the effects of advertising, it increases fix cost, which result on a shift of the average total cost upwards. Hence, these two brands whenever engage in advertising need to be sure that the positive effects (on the demand) are at least enough to compensate the increase in fixed costs in order to raise their profits. To understand the strength of each advertising effect is better to analyze it graphically (Exhibit 9). It is possible to analyze that the increase in price and in the quantity demanded more than compensate the increase in fixed costs. So, in this case, advertising is a profitable tool.

D = Demand before Advertising

0

D = Demand after Advertising

1

MR = Marginal revenue before Advertising

0

MR = Marginal revenue after Advertising

1

MC = Marginal Cost FC = Fix costs before Advertising

0

FC = Fix cost after Advertising

1

Exhibit 9: Trade-off between Advertising effects

Although its huge potential to increase brand awareness, advertising can also be used to deter new entrants. In profitable markets it is expected that over time new firms would attempt to enter in order to capture some of these profits. However, sometimes is not easy to enter in an industry due to the existence of barriers to entry. A barrier to entry is an obstacle to enter into the industry. The barriers can be natural (e.g. the control of a particular resource), legal (e.g. patents) or strategic. The strategic ones are designed to block potential entrants from entering into the market. They seek to protect the market power of existing firms and therefore maintain the associated profits in the long run. In order to prevent competitors to enter the incumbent(s) can either increase the costs a firm has to incur (e.g. advertising) or set a limit price. Advertising can, them, be used to increase the costs of a firm and prevent its entry in the market if the residual demand is not enough to compensate those costs and it is shown in the graph (Exhibit 10):

Exhibit 10: The role of advertising as an entry barrier

As it is shown in the graph without the advertising expenditure the entrant would be able to have positive profits (purple area). However with the increase in the average total costs caused by the expense on advertising the firm is only able to break even and decides not to enter the market. This is more likely to occur when a new firm is trying to enter into a market where the existing firms are already in it for a long period of time. In order to create a similar reputation the entrant has to spend much more than the incumbents: it is less costly to maintain one consumer than attract a new one.

Evidence In order to verify the conclusions of our theoretical model we performed several researches to gather material evidence. First and concerning to prices we check the retailers in the U.S.A market. Both Target2 and Wal-Mart3 dont have a fix price for these brands in their website, therefore we could not conclude if the Coca-Cola price is really higher in this market. To gather such information we went to the nearest market that we have, the Portuguese market 4. And there we found the information that we were looking for. The data of prices in the Portuguese market support our theoretical conclusions, in which Coca-Cola has a higher price due to its higher costs and greater consumers taste (Pcoke=0.59 > Ppepsi=0.48; Figure 3 in annexes) . The two brands dont engage much in differentiation, however, it is possible to observe a third brand in the U.S. market, which is Dr. Pepper 5 , and it tries to compete through differentiation within the soda market. Regarding advertising and to understand the relationship between the two brands in this feature, we checked the annual reports to collect the expenses in advertising in the last 6 years (Exhibit 11).
Billions of U.S.$
$4,00 $3,00 $2,00 $1,00 $2004 2005 2006 2007 2008 2009 2010 Coca-Cola Pepsi

Exhibit 11: Advertising expenditures (per year)

Sources: 2010, 2009 and 2006 Coca-Cola Company Annual Report on form 10-K; 2010, 2009, and 2006 Annual Report PepsiCo.

The graph display that expenses in advertising of both brands follow the same trend, which means that when one increase their expenses the other will follow it. This support our conclusion that they are strategic complements in advertising. Still concerning to this subject, we checked the key festive seasons in the U.S.A. and we conclude that Coca-Cola and Pepsi

Target website, Grocery, viewed 10 December 2011, < http://www.target.com/c/grocery/-/N-5xt1a/Ntk-All/Ntt-Coca+Cola/Ntxmatchallany> 3 Wal-Mart website, Grocery, viewed 10 December 2011, < http://www.walmart.com/ip/Coca-Cola-Cola-1.25-l/17670814> 4 Continente Colombo, viewed 8 December 2011. 5 Dr. Pepper website, Products, viewed 10 December 2011 < http://www.drpepper.com/products/>

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compete obviously sequentially in advertising. For instance if Coca-Cola won the Halloween, Pepsi will come to a mega advertising to the thanks given and so on (Figure 4 in annexes). Regarding the evidence about the article, Pepsi paid to have the exclusive rights to announce its commercial in the first part of the Super Bowl XLIII, thus, Pepsi advertised in the first and second slots of the game, leaving Coca-Cola to the third and the last one. Thereby, despite the fact that the show where both brands advertised was at the same timeline, they advertised sequentially. A priori Pepsi will have as advantages the guarantee that everyone is watching the game, and the audience is not tired of advertising. As disadvantages Pepsi has the risk of being forgotten, and the game could be less interesting at beginning. Coca-Cola as the second mover can have the advantage of be the last memory in consumers head, and if the game became exciting more people will watch. As disadvantages has that some audience could quit watching the game, and its harder to fulfill the audience. In a nutshell, in this game the advantages or disadvantages will clearly depend on the course that the game will take. Concluding Remarks After a deeply study in the soda market we could conclude that we Coca-Cola and Pepsi have homogenous products, however, sometimes engage in horizontal differentiation (Figure 5 in
annexes).

Regarding price, both brands compete simultaneously in a competition la Bertrand,

and they are strategic complements. Furthermore, both brands are also strategic complements in advertising, although, they compete sequentially. Advertising is used to enhance brand awareness of each firm in order to make it more profitable and to increase expected fix costs that enforce the entry barriers in the soda market. For last and concerning the article, the truth is that was a fierce game, and therefore the audience increased in the second part. On top of that Coca-Cola won a Grammy for its commercial. Therefore Coca-Cola won the Super Bowl XLIII advertising war and had a larger increase in revenues during the year 2009 (Figure 6 in
annexes).

It is also interesting to share that Pepsi didnt advertise on Super Bowl XLIV, which

were more impact than any commercial of this Super Bowl.

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References 1. Bloomberg L.P. Bloomberg database. Nova School of Business and Economics, viewed 10 December 2011. 2. Continente, Colombo Shopping Center, viewed 8 December 2011. 3. Morton, Fiona M. Scott. Barriers to entry, brand advertising, and generic entry in the US pharmaceutical industry. International Journal of Industrial Organization, 18 (2000) 1085-1104. 4. Pepall, L., Richards, D. & Norman, G. (2008). Industrial Organization: Contemporary Theory and Empirical Applications. Wiley-Blackwell 5. Pepsi, Legacy Book, viewed 9 December 2011 <

http://www.pepsi.com/PepsiLegacy_Book.pdf>. 6. PepsiCo. The United States Securities and Exchange Commission. The Pepsi Company, 2006 Annual Report, Viewed 10 December 2011 <

http://thomson.mobular.net/thomson/7/2222/2446/>. 2009 Annual Report, Viewed 10 December 2011 < http://pepsico.com/annual09/>. 7. Steinberg, Brian. Pepsi block Coke from first half of Super Bowl. Crains New York Business Magazine, December 2008. Viewed 10 December 2011, < http://www.crainsnewyork.com/article/20081212/FREE/812129984>. 8. The Coca-Cola Company, Heritage Timeline, viewed 9 December 2011 < http://heritage.coca-cola.com/>. 9. The Coca-Cola Enterprises, Inc. The United States Securities and Exchange Commission. 2006 Annual Report, The Coca-Cola Company, viewed 10 December 2011. 2009 Annual Report, The Coca-Cola Company, viewed 10 December 2011 < http://www.cce2009annualreport.com/>.

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Annexes

Figure 1: Coca Cola and Pepsi demand, cost and profit functions.

Figure 2: Coca Cola and Pepsi Equilibrium prices

Figure 3: Coca Cola and Pepsi prices.

Figure 4: Coca Cola and Pepsi competing sequentially in advertising.

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Figure 5: Coca Cola and Pepsi horizontal differentiation.

Figure 6: Coca Cola and Pepsi revenues after Super Bowl.

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