A few days back some dastardly Coca-Cola employees got nabbed trying to sell corporate secrets to Pepsi. Pepsi turned the bad guys in and cooperated in the sting operation.
Did the executives at Pepsi give up the chance to make huge profits at Coke’s expense in order to “do the right thing?”
I had lunch with my friend and colleague Kevin Murphy yesterday. He made an interesting point: knowing Coke’s secret formula is probably worth almost nothing to Pepsi. Here is the logic.
Let’s say that Pepsi knew Coke’s secret formula and could publish it so that anyone could make a drink that tasted just like Coke. That would be a lot like what happens to prescription drugs when they go off patent and generic drug companies come in. The impact would be that the price of real Coke would fall a lot (probably not all the way to the price of the generic Coke knockoffs). This would clearly be terrible for Coke. It would probably also be bad for Pepsi. With Coke now much cheaper, people would switch from Pepsi to Coke. Pepsi profits would likely fall.
So if Pepsi had Coke’s secret formula, they wouldn’t want to give it away to everyone. What if they instead kept it to themselves and made their own drink that tasted exactly like Coke? If they could really convince people that their drink was identical to Coke, then the new Pepsi-made version of Coke and the Real Thing would be what economists call “perfect substitutes.” When two goods are essentially interchangeable in consumers’ minds, that tends to lead to fierce price competition and very low profits. Neither Coke nor the Pepsi knockoff of it would be very profitable as a consequence. With the price of Coke lower, consumers would switch away from the original Pepsi to either Coke or the new Pepsi-made Coke knockoff, which would be far less profitable than original Pepsi anyway.
In the end, both Coke and Pepsi would likely be worse off if Pepsi had Coke’s secret formula and acted on it.
So, maybe the executives at Pepsi were acting morally and honorably when they turned in the criminals stealing Coke’s secrets.
Or maybe they are just good economists.
From 1 to 25 of 29 Comments
I have to think it was a business decision, based on much of what you discussed in the posting.
After all, let’s be real — they’re not charities, they’re not churches, they are fierce business competitors and would do anything to maximize their bottom line, while minimizing the others’.
— mhertzHm, interesting point. Anywho, I heard on the news one time that the brand name “Coke Cola” is the 2nd most recognizable word in the world, just after “O.K”
— SonyI agree
— Tony VallencourtIf it were ever revealed that Pepsi even wanted Coke’s formula, wouldn’t that be a great boon for Coke? I mean, wouldn’t Coke go trumpeting around that Coke is so indescribably great that Pepsi has to resort to stealing to even hope to come close?
— meomaxyTo confuse this with some theft of the “formula for Coke” is a red herring of the first order.
First, the myth of the “secret forumla” is probably worth a great deal, maybe to both companies, but the actual formula for Coke isn’t worth anything. The myth of the “secret formula” is a marketing gimmick. There is no way that Pepsi doesn’t already know the exact composition of Coke. This is pretty simple flavor chemistry. Even if there were some unusual natural product involved, the quantities that are required to produce Coke on a worldwide scale are so large, and production has been going on for so long, that the “secret” is long out of the bag.
In any case, Levitt misunderstands what happened in this case. This isn’t about the formula for Coke, the drink with the mythical secret formula, it is about the forumula for a new and different product. As such, it has nothing to do with the competition between the two beverages Coke and Pepsi, but rather with the competition between the two corporations.
What the PepsiCo executives gave up was the possible advantage of an early notification of this new Coke product. This early notification is probably worth something. They could have seen what marketing gimmicks Coke was considering.
But whatever that advantage might be, it has nothing to do with the fact that “knowing Coke’s secret formula is probably worth almost nothing to Pepsi.”
— yesterayAssuming it was the original formula, and still secret, how does the equation change if Pepsi gives it to a 3rd party?
— Jim KataI’ll admit I know nothing about flavor science, but if Yesteray’s claim is true that the secret to Coke’s formula is actually out there, I’d think that a non-Pepsi competitor would have great incentive to start selling a perfect substitute. I’m not sure how it would come to be that Pepsi would know the formula and other companies wouldn’t. It’s not like Pepsi’s the only one with access to soda-analyzing technologies.
With regard to Levitt’s question about whether Pepsi would want to start producing a Coke knockoff, my understanding is that Pepsi and Coke are currently engaged in monopolistic competition whereas by producing perfect subsitutes they’d become engaged in pure competition. Monopolistic competition tends to be more profitable for all competitors, which is why branding is such a big deal.
It’s interesting that in this case Pepsi seems to be acting morally by not engaging in espionage, but is also acting immorally by preserving a state of competition that is not economically optimal.
— Dr. Funk2 items:
A. Suppose you are Pepsi execs and someone approaches you with a secret formula.
What do you consider?
worth to yourself.
worth to your company.
risk of discovery
penalty for discovery
In this case it seems like the perpetrators may have been flaky and thus highly likely to be discovered. i.e. high risk
B. One possible use Pepsi might make of a Truly Secret formula.
Use the secret formula as a starting point for internal research and _possibly_ discover a similar formula that is actually “better”.
— JRipI worked at for PepsiCo for a while (ending about 20 years ago) and I can assure you that the Pepsi-Cola Company is certain that they can make a cola (or other soft drink) that is as good or better than anyone else’s without any help from a secret formulas. Hell, they have their own secret formulas! I’m also sure that they value market differention for the reasons that Leavitt gives, though they would see it in marketing terms rather than economic terms.
Successful introduction of new product in the soft drink business is very difficult, and successful introduction of a me-too product by a major player is pretty much unknown.
— pvanderwaartWhat puzzles me is why are the cola wars over? There are so many things that could be improved with cola. Why not a bitter, less sweet, cola? An adult beverage? A pre-mixed rum and cola? There could be a micro-cola industry. Somehow the beer industry was fragmented effectively by innovation that fed a thirst for beer with more character and differentiation than Bud, Pabst, and Michalob. Why not the coal industry?
Stiennon
— stiennonI agree that Pepsi acted in its own self-interest. But instead of fearing a price war, I believe Pepsi chose to cooperate with Coke in order to signal that both companies should play fair. Pepsi signaled that the two cola warriors should follow the Golden Rule and help each other eliminate unfair opportunities, rather than just following the letter of the law. Meanwhile, the company sends a strong, public signal to potential spies on either side that they will be dealt with harshly.
See here for more: http://www.thechallengedividend.com/the_challenge_dividend/2006/07/cola_wars_genev.html
— BobGThis game assumes Pepsi will only have 1 cola product. Why wouldn’t they introduce a new product since they do it all the time (flavored pepsi, the diet variations, the caffenated variations). Then, I’d think the coke/pepsicoke war would go all out as perfect substitutes, yet leaves the classic Pepsi fans to pay full price for the specific taste.
— mlibbeyThere’s no one “secret formula” for Coke; it varies around the world. My understanding is that it is approximately as hard for a trained chemist to figure out the composition of Coke as it is for a trained software developer to reverse engineer software: tedious, but not hard.
The things Coke’s competitors can’t copy are the brand and, more importantly, the distribution channels (retail placement, soda machines, fast food fountain service, etc). I don’t think the secrecy of the formula plays much into the cola industry these days.
— tqbfI work for a company that supplies services to several divisions of Pepsico. Pepsi is relentlessly competitive and is a very demanding customer. But they play by rules, and this was outside the rules.
In a company as big as PepsiCo, if there are not rules there is chaos. This is a symbol — not just to Coke, but to Pepsi’s OWN employees — that Pepsi expects rules to be followed.
A similar theme shows up in this quote from Polly Kawalek, former president of Quaker Foods (part of Pepsico) at http://www.bkadvice.com/catalog.cfm?dest=itempg&itemid=2102&linkon=subsection&linkid=4&secid=37
— zbicyclist“One of the first things Kawalek became aware of after the acquisition by Pepsico is the intensity of the competition between Pepsi and Coca-Cola. “That’s why Pepsi puts an awful lot of time and energy into making very clear where the boundaries are. I grew up at Quaker,” she says. “Quaker made it easy to know where the boundaries were. Pepsico, in its much bigger, hyper-competitive world, also makes that very clear. Every employee and vendor signs Pepsico’s code of conduct, so everyone understands the rules,” Kawalek explains. The guidelines specify that vendors may never pay employees’ expenses at a conference, meal or other event. Holiday gifts from vendors are limited to a value of $50.
“We have a very clear set of guidelines that says, ‘If it wouldn’t look good on the front page of the Chicago Tribune, don’t do it. If you’re not sure, ask somebody. Most people’s judgment is pretty good.”
Coke is more than its “taste”. It’s not the stuff in the bottle. It ’s a brand and a distribution system. So is Pepsi.
The knockoffs are so close that the idea of the brand “Coke” or “Pepsi” and the distribution is much more valuable than the product. Big K Cola’s product would be a premium brand if marketed/distributed by Coke/Pepsi.
— smilistiennon,
In Australia we have pre-mixed rum and cola beverages made by Bundaberg (to name one).
You’re not missing out on anything.
— Blandyit’s not about morality and honor. it’s about legality and lawsuits!
I work in Intellectual Property. What Coca-Cola owns with the formula of Coke is a trade secret, and it’s protected under federal statute. As long as Coca-Cola takes reasonable steps to protect its trade secret, it is protected from malfeasance like this (including Pepsi’s use of the trade secret, known as trade secret misappropriation). The downside: if someone else comes up with your trade secret, you’re SOL. (Compare this to a patent, which provides an exclusive license for 20 years, but requires full public disclosure of hte invention in the form of a patent).
Just like patent litigation, trade secret litigation is insanely expensive, and the damages (like in patent infringement) can be upped if misappropriation is found to be wilfull (buying a well-known competitor’s trade secret is unlikely to be ruled otherwise). So, there’s another incentive at work here–legal, and financial.
— nicktto clarify, trade secrets are also protected by state statutes, as well (see, e.g., the Illinois Trade Secrets Act:
— nickthttp://www.ilga.gov/legislation/ilcs/ilcs3.asp?ActID=2239&ChapAct=765%26nbsp%3BILCS%26nbsp%3B1065%2F&ChapterID=62&ChapterName=PROPERTY&ActName=Illinois+Trade+Secrets+Act%2E
Coca-Cola is the most valuable brand in the world. It has been for some time now. Its not that people like drinking Coke; people like drinking whatever happens to be in a Coke can (or bottle, which is another valuable Coca-Cola asset). Its all about branding.
Coca-Cola uses different formulas all over the U.S. let alone the world. Pepsi knows this. More importantly, Pepsi has there own flavor the many people enjoy. People dont drink more Coke because it tastes better (although, it does). People drink more Coke because it comes in a Coke can, which happens to be another thing pepsi knows all about, but cant (and wont) duplicate.
Its not about lawsuits or legality. As an aspiring billionaire corporate tyrant, I’d like to think that executives can actually be decent human beings. Pepsi would much rather beat Coke in the marketplace. Its marketing. Branding as well as distrobution. Coca-Cola has the largest truck fleet in the world (followed by the U.S. Postal Service).
If consumers were really willing to by another Cola because its cheaper, they would buy a lot more of the generic colas out there. Most soda drinkers are brand loyal, if not brand advocates. If Coke is too expensive, they go without rather than searching for an alternative.
— edwardmkingThis may be a bit of a digression, but this made me think of OpenCola, which was a promotional tool for open source software and a company by the same name.
Here is an example of the recipe being widely known, but yet there still being a market for the product.
If, as was imagined earlier, the recipe were widely known I think there would still be a pretty significant market for the “official” version. Making something like a cola is a non-trivial exercise (or so I would assume). That, in itself, would be of value.
— twopoint718In Mark Pendergrast’s “For God, Country and Coca-Cola”, Pendergrast actually includes a version of the Coke recipe from sometime in the early 20th century, found in the Coca-Cola Corporation’s archives. When he went to a Coke exec to get confirmation and permission to include it in the book, the exec proposed a thought experiment, wherein Pendergrast would get the most contemporary version of the Coke recipe. The exec than asks what a cola-baron wannabe would do with the recipe? He can’t call his product “Coke”, he might be able to say that it’s the same recipe, but unless he is able to produce and sell product in the same quantities as a Coke or Pepsi, he can’t get his costs low enough to make any money.
As others have already mentioned (and Pendergrast makes abundantly clear in his book), people aren’t buying Coke because it’s a better cola. They certainly aren’t buying Coke glasses, signs, clothing, and other non-soft drink paraphernalia because they keep choosing Coke in blind taste tests. Coke is synonymous with America (USA if you want to be picky, but the picky ones don’t usually like Coke) and a certain way of life, or at least symbolic with a desire for a certain way of life.
It’s also worth noting the recent Wikipedia entry on “Inca Cola”, and the business disaster Pepsi suffered in Peru with the Pepsi Challenge. The suggestion there is that even though most people picked Pepsi over Coke in blind taste tests (a result that seems universal, and unchallenged by Coke), Coke drinkers didn’t like being proven “wrong”.
All of these would seem to contradict Dr. Levitt’s suggestion that Coke and Pepsi are fundamentally fungible. Generic colas *are* fungible, but for most people, Coke and Pepsi are miles apart, despite the efforts of flavor consultants.
And anyway, “Coke” doesn’t even taste like Coke anymore. High fructose corn syrup is much sweeter cane sugar, and also gives a smoother “mouth feel”. If someone in the US wants to get a taste of the “real thing”, circa pre-”Classic Coke”, they can either head down to Mexico (where they’ll also get a more vanilla-flavored Coke), or pick up some Passover Coke from a Jewish grocer. Corn (even in syrup form) is a leavening and is considered not kosher for Passover, so Passover Coke is make with real sugar.
— meteorplumStuff is all poison. Who cares?
Okay.. That might be a bit strong, and I drink it so I hope not.
I just wanted to say that the incentive structure is intact. That is, as long as people keep drinking fizzy caramel stuff they’ll(meaning whomever is making money by selling it) keep marketting it.
Just like to see some more real freakonomics. Or perhaps a Freakonomics II, or is the sequel always a disappointment?
Can’t help but think of even numberred Startrek’s.
— blog_ErFor ease of reading, I’m going to quote tqbf first:
The things Coke’s competitors can’t copy are the brand and, more importantly, the distribution channels (retail placement, soda machines, fast food fountain service, etc). I don’t think the secrecy of the formula plays much into the cola industry these days.
I agree that the “secret formula” is unimportant, though I wouldn’t downplay the brand as much as you do. Coke and Pepsi both spends huge amounts of money on advertising each year, but it only comes to pennies per can sold. If a new entrant were to come in, even if they had Coke’s secret formula, there’s no way they could get their name out there because the amount of advertising they’d need to do to compete would be too expensive for their basically non-existent sales. It’s effectively a barrier to entry, much greater than any secret formula (which apparently isn’t that necessary since Pepsi’s obvously doing fine).
All the above is stolen from my Competitive Strategy professor by the way.
— shmooMr. Levitt
Has this story become to cold for me to comment on?
I worked for one of the companies mentioned here and delt with their “secret” formulation daily.
Some of the above comments came pretty close to the truth of it all. Just thought you might like hearing it from someone that was on the inside.
— JerryI would like to patent my new invention, a new top can opener,
it has a completely new approach of can opening, and much convenient than
the existing now.
whom shall I refer to patent it?
Merrick S.
— samtopqwest@yahoo.com