Bitter Competition: The Holland Sweetner Company vs.

NutraSweet (A) Jon Bain-Chekal Introduction: The worldwide aspartame market has enjoyed patent protected financ ial prosperity since the early 1980's. In 1986 the world demand for aspartame was 5,730 tons annually with future projected world demand reaching 10,000 tons annu ally, a 75% increase over 1986 demand. The Monsanto Corporation, the current own er of the rights to manufacture aspartame, under the brand name NutraSweet (NS), reported 1986 sales of $711 million. The estimated ROA was approximately 8%.1 W ith this being such an attractive industry, companies like Holland Sweetener Com pany (HSC) needed to determine whether or not to compete in the aspartame busine ss. This paper will first analyze NS's case for accommodating or deterring entry b efore turning to a discussion as to which strategy NS will actually choose. Give n the above analysis the paper will briefly address what Holland Sweetener Compa ny's entry strategy should be. There are several industry factors that will affect how this game is played. First, the two versions of aspartame, as produced by H SC and NS, are relatively identical goods. This leaves the consumer indifferent to product attributes and only concerned with price. It is also assumed that geo graphy is not a real strategic factor since shipping costs are so low. The shipp ing costs for a pound of aspartame average 15-20 cents.2 Compared to the 1986 ma rket price of $70 per pound shipping costs only account for 0.002% of the market price, hardly a significant factor of concern even given NS's large volume. Lesso n 1 of game theory suggests, you must [first] understand the payoffs and objectiv es of the other parties you are interacting with.3 Therefore the next two section s explore NS's potential objectives regarding competitor entry strategy. Thinking Ahead Reasoning backwards: Reasons for Accommodation It may seem counter intuiti ve why a monopolist would even consider accommodating a potential entrant into t he market. Each entrant reduces market share and most commonly profits. Yet ther e are several important factors why NurtraSweet should seriously consider accomm odating the entry of HSC. This is not a one shot game. It is a complex multi-per iod game with an unknown amount of potential players. Let's assume for a minute th at NS is able to induce HSC to exit with a price war. This strategy would be app ealing as long as HSC was the only player. Since it is not, the game would not e nd. As long as the market is sufficiently attractive to entry there will be new potential entrants waiting to follow in HSC's footsteps. If this is in fact the ca se, it is better for NS to accommodate one or two small 1 2 ROA=income/assets; 142/1883=8% HBS case, Bitter Competition: The Holland Sweeten er Company Versus NutraSweet (A) 9-794-079, pg 3 3 Meaghan Busse, Lecture 9 & 10 Game Theory 1

Bitter Competition: The Holland Sweetner Company vs. NutraSweet (A) Jon Bain-Chekal entrants otherwise it will risk expending resources (i.e. forgone profits in a p rice war) to deter Holland Sweetener only to have a second company challenge NS. If there is enough potential entrants, this scenario could play out for years e ventually depleting NutraSweet's strength as well as eating up all future profits. There are several large food and chemical companies in the world that could rel atively easily decide to move into the aspartame business consequently ensuring the plausibility of the above scenario. NS may consider utilizing its customer c ontractual relationships to segment the aspartame market. Considering that 80% o f NS's business is the diet soft drink market and many of these customers are comm itted to long-term contracts, NS may be able to capture the most lucrative and s trategic customers for itself while leaving a small fringe market to HSC. Relega ting new entrants to pick up the scraps at the low end may be a safe compromise to a price war. Currently NS has 20% more capacity than world demand. Holland Sw eetener is only considering adding 500 annual tons to the market or approximatel y 7% (assuming they are able to produce at capacity). Giving up the less lucrati ve part of the market may have other benefits as well. NS may be able to use HSC as a strategic compliment because HSC, as a new entrant, will find the fringe m arket appealing given its size and situation. So HSC will enter, but once it has entered it has an incentive to deter other small potential entrants. By letting in one or two low-end players the dynamics of the game change from dominant vs. fringe, to fringe vs. fringe. In this game the price war does not affect the wh ole market, it only affects the smaller markets of tabletop and food products, a nd HSC carries the cost burden of the price war. As I mentioned in the introduct ion, I am assuming that the two versions of aspartame are identical products. In stead this argument manipulates the rules of the game via quantity, contracts, a nd size. The other way to try and differentiate a product, other than through pr oduct attributes, is with a strong brand. While NS has established a great brand , the actual value of that brand is in question. NS scores high in market resear ch tests on recognition, but does that actually equate to high loyalty? For exam ple aspartame's largest market, diet soft drinks, the consumer's decision to buy is driven more by the downstream brand names like Diet Coke and Diet Pepsi rather t han product ingredients. As the Classic Coke debacle taught us, consumers are dr iven to purchase soft drink products as a statement of personality/identity or o ut of nostalgia rather than for product attributes like taste or sweetness.4 Con sequently while NutraSweet is a well known brand it does not engender customer l oyalty when faced with a comparable product. Consequently NS's brand does not affo rd them any significant advantages, especially in a price war game. 4 HBS case, Introducing New Coke, 9-500-067 2

Bitter Competition: The Holland Sweetner Company vs. NutraSweet (A) Jon Bain-Chekal NutraSweet is quickly nearing the end of its product life cycle. There are two s ignificant product weaknesses the company must contend with: NS has a relatively short shelf life in soft drinks and it is unstable when exposed to high tempera tures. These weaknesses leave aspartame susceptible to product substitutes like Hoechst's Acesulfame-K, which is heat stable and shelf stable or Pfizer's new Alitam e which is heat stable and 2,000 times sweeter than sugar5. Hoechst's Acesulfame-K is currently sold in Europe. Pfizer applied for FDA approval in 1986 meaning th at Alitame could be approved for use as early as 1995. Both of these product's pot ential entry into the US market shortens NS's window to regain profits after a pri ce war. Not entering into a price war and instead directing profits toward incre ased R&D would better serve NS. There is also great uncertainty as to the indust ry cost structure. HSC claims that its patented natural catalyst process would b e less costly and more flexible than NutraSweet's6. NutraSweet is claiming that it has been able to cut its manufacturing costs by 70% over the previous decade. A s long as HSC's pronouncement is sufficiently credible, NS would want to adopt an accommodating strategy until the cost uncertainties could be resolved. Finally, the often-overlooked non-market strategy issues must be factored into NS decisio n process. The threat of antitrust laws is an important reason for NutraSweet to consider an accommodating strategy. NS does not want to find itself in a protra cted and costly legal battle. Allowing HSC to enter may provide sufficient evide nce to prevent NS from violating anti-trust law. Even though Holland is consider ing entering the European and Canadian markets US trust law applies outside of t he US if the companies are seen as harming US consumers.7 NS would consider this only to preempt a potential entrant from gaining bargaining power via the court system. Is the future too soon? Reasons to deter Theoretically a firm wants to deter entry if it believes that the NPV of future cash flows will exceed the pre sent cost of deterring entry. As mentioned above though entering into a price wa r to deter entry is not necessarily a profit maximizing decision, yet there are other important considerations that affect the revenue stream. If NS expects a s eries of entrants vying for the aspartame market, it may want to incur the cost of a price war with HSC to develop a reputation as a fierce competitor. This rep utation will hopefully forestall the consideration of other entrants thereby all owing Monsanto to recoup lost profits after HSC exits. 5 6 HBS Case, Bitter Competition: The Holland Sweetener Company Versus NutraSweet (A ) 9-794-079 HBS Case, Bitter Competition: The Holland Sweetener Company Versus N utraSweet (A) 9-794-079 7 Meaghan Busse, Lecture 6 Antitrust 3

Bitter Competition: The Holland Sweetner Company vs. NutraSweet (A) Jon Bain-Chekal If HSC is allowed to enter the European and Canadian market, NS runs the risk th at HSC will grow and move up the learning curve. This could inadvertently increa se HSC's ability to threaten NS in 1992 in the US market after the expiration of t he patent. NS may prefer to have HSC sitting on the sidelines for several years, missing out on any production or marketing learning opportunities in order to r etain NS's knowledge advantage when their prime market opens up in 1992. HSC will increase buyer power. The largest aspartame customer, the diet soft drink market which accounts for 80% of all sales, would be able to split its contracts betwe en the two manufacturers encouraging them to provide more favorable terms. In th e previous section I argued that the players costs structures are uncertain, yet NS does have an advantage over HSC in size and experience. NS will have better economies of scale, thereby being able to shift more fixed costs across all sale s. The fact that they have been in business for several years and have a culture focused on process improvements means NS is further down the learning curve in the production of aspartame. These two factors do not remove the uncertainty of the cost structures, but they do give NS the upper hand. Depending on the compan y's tolerance for risk this may or may not be enough to convince them to enter int o a price war. Finally the historical entry and exit trends of the market are wo rth considering. Relative to other industries the chemical and food processing i ndustries have little entry.8 This trend reduces the threat of other potential p layers entering the game and raises the effectiveness of a price war. NutraSweet's move Given the above analysis of NurtraSweets potential options and interests H SC can be relatively confident that NS will accommodate their entry. The key com pelling factors driving NS decision are: a) a homogenous product, b) with a shor t life-cycle due to pending entry of new superior products, therefore insufficie nt time to recoup profits lost in a price war, c) an uncertain cost structure co mparison, d) a brand with high recognition, but low loyalty, e) the looming thre at of antitrust laws, f) the first mover advantage. Here is how the game will mo st likely play out. Figure 1 depicts a game tree in which NurtraSweet's strategic choices are to charge monopoly pricing or to use a price limiting strategy to tr y and prevent HSC from even entering the market (for the purpose of this paper I am going adopt Besanko's argument that price limiting as a strategy is flawed bec ause it is not subgame perfect and therefore I will prune that option and 8 Besanko, Economics of Strategy, second edition, John Wiley & Sons, NY 2000, pg 3 28. 4

Bitter Competition: The Holland Sweetner Company vs. NutraSweet (A) Jon Bain-Chekal continue with the example).9 Knowing that the current monopoly pricing is $70 pe r pound, it is within reason to assume for the purposes of this example that the Stackelberg price will be $60 and the Cournot duopoly price will be $50 per pou nd. Because the European and Canadian markets are at a monopoly quantity, I am a ssuming that actual demand is 10% higher (i.e. it will increase from 550 tons pe r year to 605 tons per year). Table 1 summarizes useful sales and pricing inform ation for this situation. Using the fold-back method we start from the end of th e tree and work backwards. In this case HSC will clearly choose to enter because it will make $20 million vs. making $0 by not entering. If HSC enters NutraSwee t will price accommodate because $60 million is optimal over $33 million estimat ed in the price war. For this case I reasoned that the price accommodation would take the form of a Stackelberg game where the dominant firm derives quantity ba sed on the residual demand curve. The subgame perfect Nash equilibrium is depict ed by the bolded lines. While the actual payoffs may vary, it is a plausible sce nario which will help predict NutraSweet's strategy and subsequent moves. NutraSwe et should accommodate entry because of growing demand and the looming threat of technologically superior substitutes for aspartame. Given these facts, entry is too attractive to potential entrants. Even if there is only one entrant to this market, NS should not waste resources trying to deter it, given the introduction of new and superior products. HSC puppy dog ploy: Knowing what NurtraSweet will do, HSC should use NS's large size to its advantage. HSC should focus on signalin g to NS that it is not a large threat to profitability. At least not as large a threat to profitability as a price war would be. In the above example HSC would earn $20 million in sales or only 3% of NS's worldwide sales. It will then depend on the true cost structures of the firms and the relevant minimum efficient scal es (MES). If HSC's improved production process has a MES at or near 500 tons per y ear HSC can stay small. If in fact the MES is closer to NS's 2000 tons, HSC will h ave to grow or it will go out of business. So let the games begin! 9 Besanko, Economics of Strategy, second edition, John Wiley & Sons, NY 2000, pg 3 41. 5

Bitter Competition: The Holland Sweetner Company vs. NutraSweet (A) Jon Bain-Chekal Figure 1 Game Tree Form for HSC Entry INCUMBENT: NutraSweet Pmonopoly Plimit ENTRANT: HSC IN INCUMBENT: NutraSweet OUT NS: 85 million HSC: 0 Pwar Paccomodate Please note that the conceptual theory of this argument was adapted from Besanko et.al, Economics of Strategy, second edition, John Wiley & Sons, NY, 2000. NS: 33million NS: 60 million HSC: Profit Under Different20 million HSC: Competitive Conditions Table 1 Price and 33million Market Structure NS % of Price NS Annual Market Profit (millions) Monopoly 100% $70 $85 Cournot Duopolyprice 50% $50 $33 war scenario Stackelbergdom inant 75% $60 $60 fringe accommodating scenerio It is assumed that the current sales in Europe and Canada do not reflect market demand due to the current market structure being a monopoly which lowers the qua ntity below the socially optimal demanded. Therefore a conservative estimate of a 10% increase in total sales in Europe and Canada is assumed (i.e. demand will increase from 550 to 605 annual tons of aspartame). HSC Annual Profit (millions) $0 $33 $20 6