1

Utility Theory

• Utility is the satisfaction that a consumer expects to receive from the consumption of a good or service

• A consumption bundle is a particular combination of goods being considered for consumption

• A utility function is an algebraic expression that allows us to rank a consumption bundle by the total utility that it provides

Total Utility ExampleSuppose…Total Utility = (Quantity of Hamburgers * Quantity of Pizza)

12.52.0C

7.03.0B

10.02.5A

Total UtilityPizzaHamburgersBundle

25

21

25

The Marginal ParadigmMarginal utility is the change in total utility from the consumption of one more unit of a particular good

545474393302

--201

Marginal UtilityTotal UtilityQuantity of Hamburgers

10987

The Marginal Paradigm

• The Law of Diminishing Marginal Utilitystates that marginal utility will decline as more of a good or service is consumed during a specified period of time

• An indifference curve is a graph that shows all the bundles that provide a specific level of utility

• A budget constraint refers to the limitations on a consumer’s income

Engel’s Law

• Disposable income increases

• Percent of income spent for food decreases

The Consumption Decision

PizzaPizza

HamburgersHamburgers

IC 1IC 1IC 2IC 2

IC 3IC 3

2

Equilibrium

• Consumer Equilibrium describes the consumption bundle that maximizes utility and is within the budget constraint

• When relative prices change, consumers will purchase different bundles of goods– Substitution Effect: consumption changes due

to the substitution of one product for another– Income Effect: consumption changes due to

the increase or decrease in a consumer’s purchasing power

Demand

• A demand curve shows the willingness of a consumer to purchase a product at different prices in a specified market, ceteris paribus

• Change in quantity demanded refers to a movement along the demand curve as the price of the good changes

• A shift in demand refers to movement of the curve itself due to changes in…– Price of other products– Disposable income of consumers– Tastes and preferences

Demand for Fluid Milk

$1.70

$1.90

$2.10

$2.30

$2.50

$2.70

$2.90

150 200 250 300 350

Gallons per 1,000 Transactions

Pri

ce p

er G

allo

n

Supply

• A supply curve shows the willingness of a producer to provide a product at different prices in a specified market, ceteris paribus

• Change in quantity supplied refers to a movement along the supply curve as the price of the good changes

• A shift in supply refers to movement of the curve itself due to changes in…– Price of inputs– Technology– Workers’ wages

Non-Price Determinants of Supply and Demand

• Supply– Technology– Workers’ wages– Prices of inputs

• Demand– Population– Disposable income– Supply and prices of competing products– Consumer tastes and preferences

Elasticity• Own price elasticity

– Percentage change in quantity demanded with a 1% increase in price

• Cross-price elasticity– Percentage change in quantity demanded of x

with a 1% increase in the price of y• Income elasticity

– Percentage change in quantity demanded with a 1% increase in income

3

Price Elasticity of Demand

PPQQEP ∆

∆=

( ) [ ]( )( ) [ ]( )2

2÷+÷−÷+÷−

=BABA

BABAP PPPP

QQQQE

Cross-Price Elasticity of Demand

• Tells us if products are substitutes or complements

• Shows how demand is affected by the prices of other products

jj

iiij PP

QQE∆∆

=

Income Elasticity of Demand• Tells us if products are luxury items or

inferior goods• Shows how demand is affect by changes

in income

IIQQEI ∆

∆=

Total Revenue and EP

Price

Price

Inelastic(Elasticity < 1)

Elastic(Elasticity > 1)

Total Revenue Total Revenue

Total Revenue Total Revenue

Own-Price Elasticity of Demand

In General…

Functions of Marketing• Marketing Research• Buying and Selling• Credit (Finance)• Transportation and Storage• Risk Management• Standardization (and Grading)

The Food System

Food Commodities

Food Products

Farm Supply Farms First Handler

Processor Distributor Retailer

4

U.S. Food System Sales, 1996

Food Service

36%

Retail Food41%

Alcoholic Drinks

5%

Packaged Alcoholic

Beverages6%

Nonfood12%

Source: USDA, ERSSource: USDA, ERS

Macro Marketing

ProductionProduction AssemblyAssembly ProcessingProcessing WholesalingWholesaling RetailingRetailing ConsumptionConsumption

PRODUCTSPRODUCTS

PAYMENTSPAYMENTS

See Rhodes & Dauve, p. 6See Rhodes & Dauve, p. 6

Physical Marketing Functions

Form utilityProcessing

Time utilityStorage

Place utilityTransportation

Type of value addedFunction

Dr. Allen WysockiUniversity of Floridahttp://edis.ifas.ufl.edu/RM002

Farm

Grain Elevator ExportStorage/Working Inventory

Processing

Co-op

WasteSold for Human Consumption Sold for Animal

Consumption

ADM

Consumer

Gasoline Additive

Fuel Waste

Food Processing

Ethanol Production

5

Atomistic Competition

Market strategies:

Compete on:

Demand curve:

Entry/exit:

Product nature:

Number of sellers: Large

Homogeneous

Easy

Horizontal (price taker)

Cost

Timing of sales

Monopolistic Competition

Market strategies:

Compete on:

Demand curve:

Entry/exit:

Product nature:

Number of sellers: Many

Differentiated

Fairly easy

Downward sloping

Price and promotion

Pricing, branding, promotion, product design, packaging

Oligopoly

Market strategies:

Compete on:

Demand curve:

Entry/exit:

Product nature:

Number of sellers: Few

Either

Difficult

Downward sloping

A game of price and promotion

Pricing, plus the rest if product is differentiated

Processing Powerhouse

• 16,000 firms• 26,000 factories• Value-added

– Value of shipments less cost of inputs– Further processing and timely distribution

• 100 largest firms– 1970 – account for 50% of value added– 2001 – account for 75% of value added

Barriers to Market Entry

• Capital requirements• Degree of product differentiation• Patents• Secret processes• Government licensing

Concentration in Food Manufacturing

• Standard Industrial Classification (SIC)– Census Bureau method of classifying industries and

subsets of industries– Example: 20 – Food and Kindred Products’

Processing– Example: 2024 – Ice cream and ices

• Concentration Ratios– CR4 - % of total sales accounted for by the 4 largest

firms– CR8 - % of total sales accounted for by the 8 largest

firms

6

Conglomerate: Philip Morris New Product Introductions

0

5,000

10,000

15,000

20,000

25,000

1990 1992 1994 1996 1998 2000

Food Items Non-Food Items

Food Industry Stats

RestaurantsRestaurants

$440$453

878

40

12

3.4

Sales(billions)

Locations(thousands)

Employees(millions)

GroceryGrocery

Maslow’s Hierarchy of Needs

Physiological SafetyPhysiological Safety

Love and BelongingLove and Belonging

EsteemEsteem

SelfSelf--ActualizationActualization

Measuring Marketing Costs

• Marketing Bill– Measures cost of processing and

distributing– Affected by farm and retail prices,

product mix, product quantity, and quantity of marketing services

• Market Basket– Tracks prices of a fixed quantity of US

Farm originated food products

Breakdown of the Consumer Food Dollar

0

100

200

300

400

500

600

700

1955 1960 1965 1970 1975 1980 1985 1990 1995 2000

Bill

ion

Dol

lars

(Cur

rent

)

Farm ValueFarm Value

Marketing BillMarketing Bill

7

The Consumer Dollar Farm Value Share of Food Expenditures

• Has dropped over time• Differs greatly among food products

– Decreases as the degree of processing and marketing services increases

– Animal products have higher farm value shares than crop-derived products

• Long-term changes are due to changes in the cost of labor and other inputs– These costs tend to rise over time

• Asymmetry: prices may not rise or fall at the same time or by the same amount

Food Expendituresas a Percent of Disposable Personal Income

0

5

10

15

20

25

30

1930 1940 1950 1960 1970 1980 1990 2000

Perc

ent

Food at Home

Food Away From Home

Source: USDA / ERS

Food Expendituresas a Percentage of Disposable Personal

Income

0%

5%

10%

15%

20%

25%

1931 1951 1971 1981 1986 1991 1996 1999

Away fromhome

At home

3.3

20.2

3.7

17.33.6

9.9

4.4

8.7

4.3

7.5

4.2

7.4

4.2

6.6

4.2

6.2

Changes in the Per Capita Food Supply, 1970-1996

-35%-23%-22%

-15%17%21%23%26%

90%114%

143%

-50% 0% 50% 100% 150%

CoffeeEggsBeverage MilkRed Meat

Alcoholic BevFats & Oils

Fruits & VegFish

PoultrySoda

Cheese

Source: Economic Research Service

Channel Shopping Patterns

$65.521.0929%Wholesale Clubs

$17.171.5643%Dollar Stores

$17.743.0645%Convenience Stores

$20.401.2248%Drug Stores

$15.822.0265%Fast Food Restaurants

$45.411.4281%Mass Merchandisers

$72.932.0499%Supermarkets

Avg. Weekly Spending

Avg. Weekly Trips

Percent who ShopChannel

Source: Willard Bishop Consulting

8

We are all traders…

• Robinson Crusoe• Imports and exports• Competitive imports

– Imported items that are also produced domestically

• Complementary imports– Imported items that we can hardly produce at

all (bananas, tea, coffee)• When will trade occur?

Advantage in Free Trade• Adam Smith, 1776. The Wealth of Nations.

– Countries export the things they are able to produce more efficiently than anyone else

– Absolute advantage• David Ricardo, 1817. Principle of Political

Economy and Taxation.– A country might have absolute disadvantage in

everything– Mutually advantageous trade is still possible– Produce and export the good where absolute

disadvantage is less– Comparative advantage

The Law of Comparative Advantage

8or2France

10or5US

Relative price of food(Pf / Pc)

ClothingFood

Output from 1 unit of resource

2

4

Price is a Signal

• Fluctuating prices reflect the interdependence of several factors– Production– Transportation– Storage– Processing– Merchandising– Consumption

Seasonal Price Patterns

• The yearly change in prices that generally follow the same behavior year to year

• Can be affected by the storability of the commodity

• More perishable products are more costly to store and can only be stored to a certain degree

• Commodities that are more expensive to store will have a more distinct seasonal price pattern

9

Cobweb Model

• Shows how prices could be in continual disequilibrium

• Its logically possible to have fluctuating prices with the supply and demand curves in the same place

• Three possibilities– Continual disequilibrium– The converging case– The diverging case

Measuring Price Spreads

• Price Spreads for individual items– Difference between consumer’s price

and farm value of the ingredients– Affected by types of marketing and

processing services demanded by consumers

Farm-to-Retail Price Spread

• Farm-Retail spread = Pretail - Pfarm

• Must cover the operating costs of marketing firms plus profit

• Another measure of the marketing bill• Could also compare farm prices to a

market basket• Are retail prices the result of “cost plus”?• Are farm prices the result of derived

demand?

Transportation• Provides place and time utility• Truck

– Most of the shorter hauls– Accessible, convenient, quick– Perishables – milk, eggs, meat, fruits and vegetables

• Railroads– 30,000 railcars loaded with

grain each week on average• Barges

Storage• Adds time utility by good available when

they are desired• Matches production patterns with

consumption patterns

Quantity in Storage

Time

WI

Costs of Storage• Fixed Costs

– Bins and warehouses– Interest and depreciation– Repairs– Insurance and Taxes

• Variable Costs– Shrinkage– Quality deterioration– Loading and unloading– Quality maintenance

10

Grading

• Quality: the sum of commodity attributes that influences its acceptability to many buyers (and therefore price)

• Grading: dividing of a commodity into different quality classes

• Grades are useless unless they conform to differences in demand– Are people willing to pay more for a given quality

attribute?• Enables efficient trading – a short-cut to market

equilibrium

Problems with Grading

• Are grades objective measures of quality?• What happens if quality deteriorates after

grading?• Do grade standards change from stage to

stage of the marketing system?• Do grades reflect consumer preferences?• Are grades useful or meaningful to

consumers?

Examples of US Grades

Beef

Eggs

Proc Veg

Fresh Potatoes

Cheese

4th

Grade3rd

Grade2nd

GradeTop GradeProduct

Grade AA Grade A Grade B Grade C

Extra No 1 No 1 Commercial No 2

Grade A Grade B Grade C Grade D

Grade AA Grade A Grade B

USDA Prime

USDA Choice

USDA Select

USDA Standard

Grading vs. Branding

• Brands– Differentiate food products from one another– Increase non-price competition– Encourage product R&D and innovation

• Grades– Place foods into homogeneous classes– Increase price competition– Discourage product R&D and innovation

The Battle of the Brands

• Manufacturers’ brands (also called “national brands”)

• Store brands (also called “private labels”)• A struggle for channel leadership?• Do retailers want to replace the

manufacturers’ brands?

Combining Store and National Brands

• Increases category sales and profitability• Provides a means of price reference• Creates a usefulness measure (assurance

or value)• Provides greater shelf presence to attract

the shopper’s attention• Provides more opportunities for promotion

11

Private Label Penetrationin U.S. Supermarkets

0%

5%

10%

15%

20%

25%

1988 1990 1992 1994 1996 1998 2000

Unit ShareDollar Share

Source: Private Label

Commodity (Generic) Promotion

• Goal: increase demand (a positive shift)• Promotes the consumption of the general

commodity through a cooperative effort of producers

• Increased consumption of one commodity may offset another

• Reinforces the perception of product homogeneity

The Free Rider Problem

• Who pays for promotional efforts? Some generous individual?

• Benefits of commodity promotion accrue for all producers regardless of who pays

• Solution: make everyone pay– Promotional checkoff– A portion of all sales kept for promotion

The Marketing Mix

• Product– Incorporates a set of characteristics that are meant to

provide value to the consumer• Place

– Channels used to bring the product to the consumer –specialty or intensive distribution?

• Price– The most easily changed portion of the marketing mix

• Promotion– Includes advertising, personal selling, and sales

promotion

New Product Introductions

0

5,000

10,000

15,000

20,000

25,000

1989 1992 1995 1998Food Nonfood

• The annual average in the 1970s was about 1,000

• How many is “too many”?

• Only about 1/3 of new products actually make it to supermarket shelves

22,572

17,977

Slotting Allowances

• Lump-sum payments made to retailers by manufacturers in order to stock a new product

• Guaranteed trial period, typically 6 months

• May be required for space renewal on a poorly performing product

• Widely used only in the grocery industry• Ethical? Legal?

12

Average Slotting Fees by Category

$0

$5,000

$10,000

$15,000

1994 1999 2004*

GroceryHBC/GMProduceDeli

*Forecast

Product Life Cycle

Sale

sSa

les

StartStart GrowthGrowth MaturityMaturity DeclineDecline

Life Cycle Characteristics

DecliningStable Number

Growing NumberFewCompetitors

LaggardsMajorityEarly Adopters

Innova-torsCustomers

DecliningHighRisingNegativeProfits

LowLowAverageHighCosts per Customer

DecliningPeakRapidly RisingLowSales

DeclineMaturityGrowthIntroSTAGE

Marketing Variables change with Life Cycle

Meet competition (especially in oligopoly)Price dealing and price cutting

Skimming or penetrationPRICE

Build selective demandInform / persuade persuade / remind

Build primary demandPROMOTION

Moving toward more intensive distribution

Build channelsMaybe selective distribution

PLACE

Some drop out

“All the same” battle of brands

Variety,Build brand familiarity

One or fewPRODUCT

Pure Competition?

Monopolistic Competition,Oligopoly

Monopoly,Monopolistic Competition

COMPETITIVE SITUATION

DeclineMaturityGrowthIntroSTAGE

Break Even Point AnalysisTR

TC

FC

$$

QQ

VC

Pricing at Retail

• Two basic strategies– High-low variable pricing

• Prices and margins for small fraction of all products are varied in any given week

• Price cuts for these cases are significant– Everyday low prices (EDLP)

• Advertises a set of products with low prices• Prices may not be as low, but don’t fluctuate

• Loss leader pricing• Psychological pricing

13

Weekly Store Circular

•• 100100--150 items150 items

•• Items priced at low Items priced at low or possibly negative or possibly negative marginsmargins

•• Goal:Goal: increase traffic increase traffic by diverting by diverting customers from customers from competing storescompeting stores

Psychological Pricing

• Pricing methods meant to influence consumer buying habits based on consumer perceptions– Odd-cent pricing– Multiple-unit pricing– Prestige pricing

• For the most part, the effectiveness of these methods has not been proven

Philosophies of Marketing

• Mass marketing– One size fits all (hopefully)

• Product-variety marketing– Consumer needs and wants are always

changing– Provide more variety in quality, size and

styles• Target marketing

– Many products targeted at different subsets of the market

Steps in Target Marketing

1. Market segmentation– Divide the market into distinct groups of

buyers– Groups have different needs,

characteristics, or behaviors2. Market targeting

– Decide which market segment is most attractive (profitable)

3. Market positioning– Formulate a competitive position, and the

marketing mix

Demographic Segmentation

• Used a lot in marketing

• Matches well with the identification of consumer needs

• Easily measurable• Must be careful not to

stereotype your targeted market

• Geography• Age• Gender• Household size• Income• Occupation• Education• Ethnicity• Religion• Life-cycle stage

Psychographic Segmentation

• Similar to demographic segmentation• Segment the market according to social

class, lifestyle, personality• People within a demographic segment

could have very different psychographic profiles

14

Behavioral Segmentation

• Segment the market based on consumer knowledge about, attitude, use, or response to a product

• Buying occasions• Benefits sought in the product• Usage rate

– Light, medium, and heavy users• Loyalty

– Brand, store, or company

Definition of a Cooperative

“A user-owned and controlled business from which benefits are derived and distributed

equitably on the basis of use.”

Remember:

• The users are the customers

• This is a private business that competes in a free enterprise market economy

Why Cooperatives?

• To pool financial resources• To have access to more business

activities• Because certain goods or services might

not otherwise be provided• To combat market power

– Purchase inputs and services at lower costs– Receive better market prices and/or access

Universally Accepted Cooperative Principles

• Services at Cost– Does not mean nonprofit

• Ownership by Users– In proportion to use

• Control by Users– Not based on equity

Agricultural Co-ops by State

0

50

100

150

200

250

300

MN ND TX WI IL CA IA KS SD NE

Service Farm Supply Marketing

238

Centralized Cooperative

Member Member Member

Centralized Cooperative

Voting control, ownership, flow of patronage refunds

Physical flow of products purchased or marketed

15

Federated Cooperative

Member Member Member

Federated Cooperative

Member Member Member

LocalLocalCoCo--opop

LocalLocalCoCo--opop

LocalLocalCoCo--opop

Voting control, ownership, flow of patronage refunds

Physical flow of products purchased or marketed