Vertical Integration in Soft Drinks

Julian Gropp

The Coca-Cola Company, PepsiCo, Inc., and the Dr Pepper Snapple Group sell concentrates to bottling firms, which subsequently bottle the raw product and distribute it. Thus, concentrate can be described as an intermediary product, while the bottle filled with a carbonated soft drink can be seen as the final good. Coca-Cola and PepsiCo are therefore upstream manufacturing firms, which sell their products to downstream bottling and distributing firms. In early 2010 PepsiCo underlined with a much-noticed acquisition of its two biggest bottlers, The Pepsi Bottling Group and PepsiAmericas, a change in strategy. According to PepsiCo, these vertical integrations allowed a higher flexibility in pricing and products. One month later Coca-Cola announced that it will buy Coca-Cola Enterprises, which is the company’s biggest bottler.

Double marginalization?

From an oligopoly model perspective, vertical integration solves the problem of double marginalization since a downstream firm cannot maximize profits anymore by equating marginal costs and marginal revenue. Hence, the model suggests that prices will be lower in a vertically integrated market compared to a vertically unintegrated market. Although indeed a price reduction by about 3-5 percent can be observed, empirical evidence, nevertheless, shows that double marginalization is not the main reason for vertical integration. The main rationale is, in fact, the elimination of inefficiencies. In sum, the statistical data emphasize the claim that vertical integration leads to a price reduction for retail products. However, the price reduction is not mainly a consequence of eliminating bottlers’ market power but rather of increasing efficiencies and reducing marginal costs.

Tacit collusion?

Recent papers concluded that vertical integration results in tacit collusion and should therefore lead to higher prices and lower output. That is to say, within an oligopoly model there is an outlets effect and a punishment effect of vertical integrating with a downstream firm. The punishment effect increases the incentive to cheat for an upstream firm, while the outlets effect decreases the incentive to deviate from a colluded price. In the long-term the outlets effect dominates the punishment effect and thus vertical integration has anti-competitive consequences. Nevertheless, for various reasons the theoretical model seems not be applicable to the carbonated soft drink industry. The constant threat of new entry, transparent pricing-schemes, and competition with substitute beverages deter Coca-Cola, PepsiCo, Dr Pepper from engaging in collusion.

Conclusion

Therefore, we have to come to the conclusion that vertical integrations in the carbonated soft drink industry increases consumer surplus and decreases deadweight loss by reducing retail prices. Although the industry faces a very high concentration ratio with the oligopoly of Coca-Cola, PepsiCo, and Dr Pepper Snapples, tacit collusion does not seem to pose a threat to consumers.

6 thoughts on “Vertical Integration in Soft Drinks

  1. It is interesting to think that vertical integrations can increase consumer surplus, particularly given the fact that this could potentially increase market power of the producer. Soft drink companies appear to be very good at achieving both economies of scale and economies of scope (in the drink markets) without becoming monopolies and harming consumers by using their market power to raise prices. Do you think the lack of tacit collusion is a result of the fact that soft drinks are a discretionary good, which can be switched with water, coffee, beer, etc?

  2. It has always been interesting to me that Pepsi and Coke are able to produce almost the exact same products. Coke:Pepsi, Sprite:Sierra Mist, Mello-Yello:Mountain Dew. The list goes on and on. With coke deciding to vertically integrate right after pepsi it seems that both companies work hard to limit product differentiation.

  3. First, I don’t really think that product differentiation is eliminated through vertical integration. Upstream manufacturing firms can still come up with new ideas for drinks and then the downstream firms will have to bottle the new product. In fact, in my opinion product differentiation will always play an important role in the carbonated soft drink industry since costs of entry are very low. If Coke and Pepsi don’t meet consumer demand, another company will enter the market.
    Second, with respect to market power I argue in my paper that alternative drinks such as bottled water, juice etc. actually do constrain Coke and Pepsi. Moreover, the soft drink industry is a market that heavily relies on increases in quantity. In general, it seems as if this special industry is not susceptible to tacit collusion.

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