Coca-Cola and Pepsi are both very profitable soft drinks. Inputs for these products include corn syrup, bottles/cans, and soft drink syrup. Coca-Cola and Pepsi produce the syrup themselves and purchase the other inputs. They then enter into exclusive

Question

contracts with independent bottlers to produce their products. Use the five forces framework and your knowledge of the soft drink industry to explain how Coca-Cola and Pepsi are able to retain most of the profits in this industry.

Answer 1

While consumers perceive an intensely competitive relationship between Coke and Pepsi, these major players in the soft drink industry have structured their businesses to retain most of the profits in the industry by concentrating operations in its least competitive segments. Coke and Pepsi have segmented the soft drink industry into two industries—production of soft drink syrup and manufacturing/distribution of the soft drinks at the retail level. Moreover, they have chosen to operate primarily in the production of soft drink syrup, while leaving the independent bottlers with the more competitive segment of the industry.
Coca-Cola and Pepsi compete primarily on brand image rather than on price. They sell their syrup to independent bottlers who have exclusive contracts to distribute soft drinks and other company products within a specific geographic area. (While other syrup producers exist, they are typically regional and have very small shares of the market.) Given the large number of competing forms of containers for soft drinks (glass bottles, plastic bottles, aluminum cans, etc.), it is difficult for bottlers to earn any more than a normal return on their investment. Consequently, Coke and Pepsi can write exclusive contracts with bottlers prohibiting them from simultaneously bottling for a competitor. It is also difficult for independent bottlers to switch from Coke to Pepsi products, since there is likely to be an existing Pepsi bottler in the same geographic area. Consequently, independent bottlers have little bargaining power and Coke and Pepsi are able to charge them relatively high prices for syrup.
The threat of new entrants at the syrup level is restricted by limited access to adequate distribution channels and by the valuable brand names that have been created by both Coke and Pepsi. While soda syrup is relatively inexpensive and easy to make, a new syrup producer would have difficulty finding a distributor that could get its products to retail stores and placed in desirable shelf space. The high levels of advertising by Coke and Pepsi have created highly valued, universally recognized brands, which would be difficult for a potential competitor to replicate.
The main ingredients of syrup are sugar and flavoring, and the markets for these inputs are generally competitive. As a result, Coke and Pepsi exert considerable influence over their suppliers. For example, in the 1980s when corn syrup became a less-expensive sweetener than cane sugar, Coke and Pepsi switched to corn syrup. Thus, Coke and Pepsi are able to retain profits rather than pay them out to their suppliers.
The production and distribution of soft drinks at the retail level is likely to be less profitable than is syrup production for several reasons. First, despite tremendous amounts of advertising designed to create differentiated products, many people view sodas as being relatively similar and switching costs for consumers are very low, which makes it difficult to price one soft drink significantly higher than another. Second, there are a great number of substitutes for soft drinks, such as water, milk, juice, athletic drinks, etc., which consumers could switch to if the price of soda were to increase. Third, because of low switching costs, consumers can be price sensitive and also exercise relative bargaining power over independent bottlers. Finally, as discussed before, the structure of the relationship between Coke and Pepsi and the independent bottlers gives Coke and Pepsi greater bargaining power over the bottlers, further limiting the ability of independent bottlers to keep a larger share of their profits.