This article eventually became required reading in the microeconomics component in FNCE 103, the required course for Joseph Wharton Scholars, taught by Dr. William Whitney at Wharton.

Abstract

Lysine, an important livestock feed additive, is produced only by a handful of firms throughout the world.  They are part of an industry that involves high sunk costs in technology investment and factory construction.  This business model, coupled with the homogeneity of lysine, has created an environment that promotes collusion among the largest producers: Archer Daniels Midland, Ajinomoto, Kyowa, and Sewon. 

Description of Lysine Industry

“Shaping the future of what’s to come” 
-Archer Daniels Midland

Lysine is an amino acid and a building block of protein essential for muscle growth in both humans and animals.    In agribusiness, it is mainly used as an animal feed additive to increase the lean muscle mass of hogs, poultry, and fish.  There is no substitute for lysine in the industry.

In 1956, a Japanese cancer researcher accidentally discovered the bacterial fermentation process by which lysine was artificially made.  The technology was first used to produce pharmaceuticals by Japanese producers Ajinomoto and Kyowa, but by the 1960s they began producing feed-grade lysine for the more lucrative livestock industry.  By the 1980s, these two Japanese firms produced over 70% of the world’s supply of lysine.

The American agribusiness giant Archer Daniels Midland (ADM) entered the market for producing lysine in 1989 by making the decision to start construction of its own lysine plant in Decatur, Illinois.  Completed in 1991 and later expanded throughout the early 1990s, ADM’s plant cost in excess of 150 millions dollars.  ADM’s move into the industry also marked the last significant entrant into the market until the 1996 antitrust investigation by the U.S. Department of Justice[1].

There are four major firms in the lysine industry today: ADM, Ajinomoto, Kyowa, and Sewon, a South Korean producer.  The U.S. is the main consumer of lysine.  In 1994, ADM held a 40% market share in the U.S., Ajinomoto 24% to 28%, Kyowa 20% to 22%, and Sewon Group 5% to 10%.  The Herfindahl-Hirschman index[2] during the mid-Nineties moved between 2600 and 3000.  The U.S. Department of Justice considers a market highly concentrated if its HHI was above 1800.  Another measure of market concentration, the CR4, also reflects this high degree of concentration in the market.  CR4[3] during this time was about 60% to 70% in the U.S.  The deficit was made up for by imports, but those imports came mostly from the foreign factories of the East Asian producers.

The market for lysine had become highly concentrated in the period of a few decades.  Given the prevailing market conditions, it is highly unlikely to see a significant fifth entrant into the industry at the present time.  The contestability of the market has been eliminated by the incumbent firms.

Forms of Competition Amongst Firms

“The competitor is our friend, and the customer is our enemy.”
- James Randall, former President of ADM

ADM’s entry into the U.S. lysine market in 1991 set off a vicious price war with incumbent firms, particularly Ajinomoto and Kyowa.  The U.S. price of lysine dropped from $1.32 per pound in 1990 to a low of $0.64 in 1992.  At this selling price, ADM and its competitors stood to lose millions of dollars should the price war continue.  Alternatives to price competition were carefully examined.

Given the homogenous nature of the product (there is no difference between the lysine produced by different firms), forms of non-price competition such as product differentiation through advertising was not an available option to the firms.  As ADM has demonstrated earlier, increased production in lysine only drove down the price to disastrously low levels, so increasing output share was an equally unviable option.

The industry’s largest producers finally settled on a scheme to fix prices and fix market share.  The firms did not compete, but rather collaborated in a “live and let live” style.  Firms agreed to follow a negotiated policy of not aggressively expanding their market share beyond 50% in any given geographical region.  Because certain companies were better established in certain regions than others, they held larger market shares in the area.  In 1994, ADM accounted for 42% of U.S. and Canadian lysine sales while Ajinomoto and Kyowa shared about 25% each of that market.  In Latin America, Kyowa controlled just under 50% of all sales.  In Europe, Ajinomoto dominated with 45% of sales.  The Asian market was more fragmented with Ajinomoto in the lead at 34%, followed by Sewon at 24%, ADM at 27%, and Kyowa at 19%.  A monthly volume reporting system of the different regions prevented excessive price cutting on the part of the colluding firms, and the threat of costly compensation to other members of the cartel in the event of a price cut served to reduce the incentive to cheat.  Given this arrangement with the firms carefully monitoring their shares of the market, the downward spiral into a destructive price war was prevented.  This arrangement allowed post-1992 prices to rise above the $1.00 level.

Forms of Entry Deterrence

“Year round production at low margins”
- Archer Daniels Midland, principal business goal

The lysine produced by the oligopolies in the market is an essentially homogenous product.  This does not mean that entry into the business has been made any easier for prospective contestants.  Underutilization of production capacity, high technical barriers, high sunk costs of plant building, and the secretive nature of lysine sales prevent new entries into the market.

The arrival of ADM into the lysine market at the end of 1991 tripled the industrial capacity of lysine in North America.  During this time, incumbents in the business, Ajinomoto and Kyowa, also scaled up the production capacity of their plants.  ADM’s new factory and the plant expansion of the incumbent Japanese firms reduced capacity utilization to around 63 to 68 percent during the mid-Nineties.  From the prospective of a new entrant, the underutilization of plant capacity discourages further entry.  Incumbent firms, like Ajinomoto, have the ability to raise production and take away any market share new entrants could gain.  New entry when there is still unused capacity in the industry would also lead to overproduction of lysine and prices that would possibly yield below-normal profits.  While incumbents may be able to withstand these conditions temporarily, new entrants would be quickly driven out.

High technical barriers also represent a deterrent to entry.  The process of industrial lysine production is closely guarded by the major producers.  Knowledge of the bacterial fermentation process alone is not enough to enter the industry.  Factory-scale production brings in a host of new considerations that laboratory-scale production can ignore.  Something as simple as temperature and environmental controls may require significant trial-and-error testing before they are perfected.  Since this technology is not freely available, these research and development barriers represent a sunk cost to prospective entrants.  While the technology for mass producing lysine may have similarities to other chemical industrial processes, new entrants would still not be able to fully skirt these costs of research and planning of the industrial production process. 

Even if the requisite technologies have been researched, building the factory for production carries a hefty price tag.  ADM’s lysine plant that started production in 1992 cost over 150 million dollars.  The marginal cost of producing a pound of lysine for ADM hovers around $0.50.  This characterizes the lysine industry as one with heavy sunk costs and low marginal costs.  Potential entrants would be deterred by the large initial invest in capital which they might never get back.  Uncertain of whether or not they can become successful in the lysine business, entrants would consider the roughly 150 million dollars that would go into a new plant as a reason not to enter since cheaper forms of production have not yet been discovered.

Lastly, the secretive nature of lysine sales contributes to the deterrence of new entrants.  Lysine is not traded on any public exchange.  The only time when prices are available to the public is when it is traded internationally.  Transactions often come about under private treaty negotiations, where incumbent firms can exercise their market power through price discrimination.  Because price reporting is spotty at best, new entrants would not be able to judge whether or not they have the ability to enter the market based on lysine prices, nor will they have the established connections like incumbents to conduct business.  This lack of information adds to the uncertainty of success held by entrants as they decide whether of not to enter.  Taken together, these four deterrents to entry present a formidable obstacle for new players in the lysine game.

Theoretical Forms and Models Describing the Industry

Bertrand Price Competition in the Lysine Market

Above is the Bertrand price competition model for the lysine industry, and perhaps the model that best explains the market structure of the industry and the reasons its firms have a tendency to support collusion.  R_ADM and R_ind are the reaction curves for ADM and the other firms of the industry respectively.  Price_ADM and Price_ind are the prices that ADM and the other firms will charge for lysine per pound respectively.

Since lysine is a homogenous product regardless of who produces it, there is little ability for the firms in the industry to compete based on product differentiation.  An alternative would be to compete on price.  The Bertrand model shows what would happen if the firms did.  Arrows on the graph illustrate that competition on price will quickly drive the market price of lysine to marginal cost, which is represented by the intersection between the reaction curves.  This was exactly what happened in 1992 when ADM increased its production in its Decatur plant and drove prices down to $0.60 a pound.  Because the lysine industry is a high sunk cost industry, a company like ADM, producing at marginal cost may never regain its initial investment (i.e. factory, machines, research) at prices near marginal cost.  Therefore, it would be undesirable for the firms in the industry to produce at that price.  Since the option of product differentiation is very limited in this industry, it becomes clearer why price-fixing and collusion became more attractive alternatives for firms like ADM, Ajinomoto, Kyowa, and Sewon. 

Diagram of the Characteristics of a Lysine Producing Firm

This graph shows the strategies of an individual firm such as ADM or Ajinomoto in the lysine industry.  MC is marginal cost.  ATC is average total cost.  MR is marginal revenue.  D is demand.  Three industry-wide traits stand out from this graph.

First, the high sunk costs associated with this industry means that if the producers produced at point A, where marginal cost meets demand, they would not be able to make a profit because the ATC curve rests above that intersection.  In this example, ADM would not be able to regain the cost associated with factory building and research. 

Second, the low capacity utilization rate for the industry which hovers around 65%, may imply that the firms are operating at a point where there marginal cost is declining or remaining constant.  Because there is so much extra capacity, producing an extra pound of lysine would not require the use of resources devoted to other work.  Given the scale of these factories, producing more might even reduce marginal costs. 

Third, the two grey areas that are shaded represent the profits that the firms make.  The darker rectangle, representing profits if production is held at Q*, results from selling lysine at the lowest price the firm is willing to offer – where marginal revenue equals marginal cost.  That is to be expected.  The lighter triangle above is the result of price discrimination exercised by the firms.  Since many transactions of lysine are determined by private contracts, price discrimination on the part of the oligopoly can result.  Buyers have no way of comparing the price they pay, because lysine is not publicly traded.  Therefore, firms have a negotiating advantage which they can use to set prices depending on the willingness of the buyer to purchase.  This produces the profit represented by the lighter grey triangle.

Conclusion

The market structure that existed within the lysine industry was dominated by a handful of large firms under an environment that encouraged practices such as price fixing.  Homogeneity of the product in this industry dominated by oligopolies restricts the availability of non-price competition.  High barriers to entry due to underutilization of production, technical sunk costs, factory costs, and secrecy of the trade in lysine all contributed to deterrence of new entrants.  Given the prevalence of these factors, the few firms in the industry, in order to prevent a debilitating price war as the one in 1992, chose to collude instead of compete. 

These firms’ collusive behavior translates to hidden social costs.  Consumers of meat products indirectly pay higher prices due to the increased costs of lysine as a feed additive.  Until the previously mentioned structural characteristics that promote collusion can be removed from the lysine industry, there is little indication that there will be a change in the status quo.