Group Project for Managerial Economics (EF3440)

Title:                        Report on Chinese Milk Industry

Authors:

                    Song Pengcheng (40001027),

                    King (50389062),

                    Oscar (50493234),

                    Solomon (50494673),

                    Kenny (50476680), and

                    Paul

Advisor:  Lawrence

Abstract:

In this report, we look into Chinese milk industry, which is promising and fast developing. After a general introduction, we identify the major three firms (Yili, Mengniu and Guangming) in the industry. Then the nature of the product and the market structure are analysed. We will see that although there are many small firms in the industry, the competition between top brands can be treated as oligopoly. We also extend our discussion to different kinds of business strategy implemented by the top three firms. Finally, we predict how Chinese milk industry will go on in the future.

Keywords:    Chinese milk industry, oligopoly, competition

Report on Chinese Milk Industry

Part One: Introduction

Chinese economy has experienced remarkable development since late 1970s and there is no evidence that such momentum will stop in the foreseeable future. Along with this trend, people earn much higher income and call for food with better quality. As a result, dairy industry began to enjoy sustained development from 1990 and the increase rate became even higher since 1998. Milk industry, as a sub-industry of dairy industry, seems very young, but it is increasing at the highest speed, mainly because people are turning their attention from milk powder to milk, which is more nutritious. Milk power dominated dairy market before 1996, but now milk industry accounts for 78% of the total market. The output of milk industry increased annually by 60% from 2001 to 2003----totally 60,810,000 tons were produced in the first half of 2002---- and it is predicted that this trend will continue at the rate of 30% for the coming years.

In this report, we will focus on Chinese milk industry, which is becoming a hot topic in China. We will identify the major firms in the industry first and this analysis constitutes Part Two. Then we turn to the nature of the product and the market structure, which is considered to be oligopoly although there are a lot of small firms. The main feature of oligopoly competition is the existence of strategic behaviours, so Part Four is dedicated to the analysis of strategies applied by firms. There is no reason for us to be too optimistic about Chinese milk industry as we will see in Part Five that Chinese milk industry is faced with several problems. Based on that, we will look into the future and make our own prediction about Chinese milk industry.

Part Two: Major firms in Chinese milk industry

There are about 1500 milk manufacturers in China but the largest ten consist 45% of the whole market since 2003. According to the latest survey, the top ten brands take up 70.6% of the market share in May, 2004.Yili, the milk manufacturer from Inner Mongolia is the winner, followed by Mengniu (also from Inner Mongolia) and Guangming(from Shanghai).The other seven largest brands are Tianyou, Sanlu, Xiajin, Longdan, Wahaha, Robust and Nestle. We have seen that Yili and Mengniu are the two largest firms dominating national milk market. In 2003, the market share of Yili was 14.37%, with total revenue 62.99 billion and net profit two million. The market share of Mengniu was 12.43%, with total revenue 40.72 billion and net profit 2.3 billion. Guangming also takes up more than 5% of the market (a chart describing market share of milk brands willl be seen in next part of this report). However, no other brand was able to cover more than 5% of the market, showing that Chinese milk industry as a whole is highly concentrated (but we will see later that it is competitive). The table below shows us the total revenue (in billions of Yuan) of Yili, Mengniu and Guangming in the last three years.

In the paragraphs above, we show the market share of major firms in the industry from the perspective of the whole country. When we limit the market boundary to be within a city, the scenario is a little bit different. The main difference is that there is usually a local brand in each city or province and it takes up a certain degree of local market share. However, as the three largest firms set up more and more branches all around China, market share of local brands is becoming smaller. It will be seen that even in the local market, the top three brands¡¯ market share is significant. We take ten major cities in east China for example. The ranking of brands in each city is shown in the table below:

As the biggest brand in China milk industry, Yili is within the top three brands in each of the ten cities. Mengniu and Guangming also shares large market proportion in east China. Below is another table showing the market share of the top three brands in five major cities.

Part Three: Nature of product and the market structure

Up until now, our analysis of the milk industry has not drawn a conclusion about whether the nature of this industry is. Now, it is a high time to take a closer look to the market structure.

From the chart, we notice that the three major companies-Yili, Mengniu and Guangming- have taken up about 32% of the whole market. Recall the definition of Oligopoly, which refers to a market structure in which there are only a few firms, each of which is large relative to in the total industry. For these three out of 1500 milk manufacturers represent over a quarter of the whole China milk industry, we strongly believe that the China milk market is now experiencing a type of Oligopoly Competition.

To decide which kind of oligopoly model----Sweezy, Stackelberg or Cournot---- fits the China situation most, we may first look into the price in milk market. We¡¯ve seen price wars leading the price to be close to marginal cost. Secondly, we would like to regard that those three companies produce homogeneous products in nature, although due to the loyalty to the brand name and the advertisement effect people may classify those products differentiate. The two conditions given above show that Bertrand model fits Chinese milk industry most.

We also suggest that the consumer enjoys perfect information. At least, we wouldn¡¯t think that the information cost is high for the consumers. It is because what the consumers need to do to get the information is just to take a look in the supermarket

Another issue is market segment and location. According to the history of the 2 biggest dairy manufacturers, ¡°Mengniu¡± and ¡°Yili¡±, they both started their business in Inner Mongolia, a northern state of China. At the beginning of the business, they were selling their products mostly in northwest, northeast and north of China due to the high transportation cost of transporting their stock to the southern part of China. Milk market in south China is dominated by Guangming. However, after a few years of making huge profit, both of the manufacturers started to set up plants in different part of China. This lower the transportation cost of transporting their stock to the south. And so the market segment was broken.

Part Four: Competition between the top firms

Although there are several firms dominating the market, Chinese milk industry is highly competitive. Nowadays, price wars leaded by top brands in milk industry are very popular. As result, small milk manufacturers which can not make use of economies of scale to lower costs are faced with bankruptcy and more and more of them are taken over by large firms. For the same reason, we consider the large amount of small firms to be of little influence on milk industry. As to top brands----Yili, Mengniu and Guangming, we have shown that they are involved in oligopoly competition and to some extent we can say they are competing towards Bertrand equilibrium.

In this report, we assume that firms in milk industry are rational. That is to say firms always seek to maximize their profits. In a highly competitive market like this, this assumption seems to be untrue because firms are sacrificing their short run profits by lowering price. However, when we take long run profit into account, it is evident that lowering price or other strategies that seems harmful to short run profit are simply means to gain higher market share and to maximize long run profit. We can also see that, after phases of price war, milk price has decreased to a point very close to marginal cost. Under such condition, market share and thus long run profit seem to be the mail goal of Yili, Mengniu and Guangming.

Besides price wars, there are other strategies for top brands to get higher market share and maximize long run profit. Lower price is a sharp weapon to defend rivals. Advertising can build a good brand image for firms and attract more consumers. Firms differentiate their products by developing new products with additional healthy ingredients or different flavour. What¡¯s more, Advertising can build a good brand image for firms and attract more consumers firms differentiate their products by developing milk with additional healthy ingredients or simply by offering more alternatives of volume. To summarize, there are mainly three strategies----price, quality and advertising----applied by top brands to enhance their business.

We should never forget that factory location is an important factor for milk industry. Milk gets sour quickly, especially fresh milk. Big brands like Yili can only get into milk market in Shanghai by establishing a branch there. That¡¯s also the reason why, before top brands set up branches nationally, small local milk manufacturers could earn some profits but now more and more of them bankrupt or are taken over by large firms. So, to get higher market share, setting up branches is imperative for top brands. We will illustrate these strategies mentioned above in more detail.

Price competition

Price war is the main form of price competition. However, we do not intend to supply concrete data about how prices have changed by time. Instead, we will state the main features of price war in milk industry. First, besides directly lowering price(For example, in this summer market price for 250ml milk decreased from more that 1.8 Yuan to 1-1.1 Yuan) , buy one and get one free or gifts are used to attract consumers. What¡¯s more, during price war, newly developed products are of low prices on the stage of their debut. It is even said that milk is cheaper than distilled water. Thirdly, price does not always decrease, but fluctuates. When demand is high, price tends to increase. When demand is low, price war appears.

Quality (product differentiation)

Nowadays, as people concern about the healthy ingredients more than just the taste of food when consuming, there is a growing trend in buying healthy food products. To satisfy this trend and also to make their products different from others, both three companies keep developing different types of liquid milk to attract more consumers. For instance, Guangming has High Calcium Fresh Milk, Fat-Free Milk, Low-Fat & Hi-Calcium Milk, and Flavoured Milk. Mengniu also have these types of milk and recently they have produced a new product called green beam milk. However, Yili seems to be weak in this field of competition and they only focus on producing pure milk.

Besides milk, both three companies produce several types of milk product in order to enlarge the market. For example, powder and ice cream. Guangming has devoted lots efforts to innovation. Besides powder and ice cream, it also has yogurt, butter and cheese. Since we are discussing liquid milk in this report, we do not intend to explain this point further.

Advertisement

Advertising is a way to win consumer loyalty and attract potential buyers, so all the top three brands spend a lot of money in putting advertisements on CCTV---- the most popular TV station in China----and local TV stations. They were all increasing advertisement expenditures in the last three years. To be concrete, from January to October in 2003£¬Mengniu spent 3.74 billion in advertising£¬which took up 9% of its total revenue. Yili spent 4.27billion, which is 8.7% of its revenue. Guangming spent 2.17 billion which is 5.5% of its total revenue.

Since all three companies have their own comparative advantages, their promotion strategies are not the same. Guangming has a long history and high market share in major cities like Shanghai. Its advertisement strategy is to maintain the sales and the slogan is fresh and healthy.

The advantage of Yili is that before embarking on liquid milk production, they had already built up a good brand image from ice cream. Also they have direct milk supply from Inner Mongolia. So their advertisement slogan is natural, not pollutant and no man-made chemicals.

Mengniu has the shortest history compared to Guangming and Yili. To catch up with its older brothers, it is destined to make its advertisements more innovative. For example, in the period of SARS, Mengniu was the first company to donate money to the government. This helped it to build up a good image to customers. Moreover, the most famous advertisement by Mengniu is that it made perfect use of the launch of the Shenzhou V spacecraft and the astronaut Yang Liwei to promote their product----immediately after Shenzhou V came back to earth, when it is of great significance and excitement to Chinese, Mengniu introduced its new advertisement and said that its milk was the exclusive milk used by Chinese astronauts. This has made high increase in the sales of Mengniu liquid milk.

Location and branches

We have stressed the importance of setting up branches to capture higher market share. Mengniu and Yili are more popular in Northern China while Guangming is more popular in Southern China. To compete with Guangming, both Mengniu and Yili have set up branches in south part. The picture below shows the distribution of Mengniu¡¯s branches. By establishing branches, lots of transportation costs are saved and fresh milk with the brand of Mengniu is available to people all over China

    More specifically, in order to compete with Guangming (the market leader 57% market share) in Shanghai, Mengniu and Yili have set up braches there to lower serve Shanghai people i.e. capture more market share in Shanghai.

Part Five: Look into the future

Based on our analysis, we can now make perditions on how Chinese milk industry will be like in the future. Let¡¯s first look into the consumer side. Consumers get benefits directly from the competition in milk industry and we see no evidence that such competition will cease. So, in the future, consumers can still benefit a lot from the low price of milk and also they can choose from more various milk products. Secondly, price is becoming closer and closer to the marginal cost, leading small firms to bankruptcy or being merged by large firms. We predict that there will be fewer firms in the future but existing firms will have larger scale. Actually, many large brands including the top three are accumulating capital from stock market or foreign investment to be of larger scale. Thirdly, we do not talk about the competition to get better raw milk source. As demand goes up, more and more raw milk is needed to produce more milk. In order not to fall into capacity constraint, top firms are always looking for and buying cow farms. Since cow firms are also scarce resources, we can say that the competition between firms in the input side will also be fierce in the future.