BUS 640 Week 6 Final Assignment

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Nonprice Competition

Learning Objectives

A�er reading this chapter, you should be able to:

Iden�fy how nonprice strategic variables can be u�lized to complement pricing strategy. Describe how nonprice compe��on is a more subtle form of compe��on that rewards be�er ideas and management crea�vity, whereas price is a blunt instrument. Discuss how the Internet increases compe��on among firms and rewards firms who do nonprice compe��on well. Explain how nonprice strategic variables can be adjusted in theory to op�mal levels. Describe the prisoner’s dilemma problem facing oligopolists opera�ng under condi�ons of mutual dependence recognized.

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Aquafina prac�ces nonprice compe��on by using nonprice variables such as product design and promo�on to increase sales.

Introduction

In the preceding four chapters, we have been concerned with how the business firm engages in price compe��on, that is, how the firm should choose its price such that it expects to maximize profit (in the short run with full informa�on) or to maximize the expected present value of profit (when revenues and costs occur beyond the present period and are not known with certainty). We saw in Chapter 4 that the firm’s quan�ty demanded at any price also depends on a range of other controllable and uncontrollable variables. The other variables that are controllable by the firm are the firm’s product quality, its promo�on expenditures, and its place of sale—these are the other three Ps of the firm’s four Ps (price being the fourth)—these are the strategic variables the firm can use to influence the demand for its product or service. In Chapter 4, we saw that changes in price will cause a movement along the demand curve, whereas changes in the other three controllable variables will cause a shi� of the demand curve.

We also know from Chapter 4 that the firm’s demand depends on the concurrent ac�ons of some other firms. Specifically, the four Ps of firms that produce subs�tutes (i.e., rival firms) and the four Ps of firms that produce complementary goods will impact upon the focal firm’s demand. In addi�on, uncontrollable customer variables such as customers’ incomes, tastes, and expecta�ons will impact the focal firm’s demand curve when they change. All of these determinants of demand, other than the firm’s own price, are influences on demand that we mentally include when we say "other things being equal" in rela�on to demand curves. They are all demand shi�ers—when they change they cause the demand curve to shi� inwards or outwards at all price levels. In this chapter, we shall consider the nonprice strategic variables (i.e., the other three Ps) that the firm can use to shi� its demand curve out to the right. Thus, nonprice compe��on is the use by the firm of these nonprice variables, namely product design, promo�on, and place of sale, to gain greater sales at any given price level.

Nonprice compe��on effec�vely focuses on differen�a�ng the firm’s product, allowing the firm to increase product quality, inform and persuade customers of product differences, and offer different places of sale. In Chapter 9, we saw that the firm’s value proposi�on is judged by the customer as the ra�o of quality over price where quality is mul�dimensional and is broadly defined to include all aspects of the product that the customer finds desirable, such as how it looks, how it works, what it can do, and what it does not do (e.g., endanger or annoy). We will now argue that the other three Ps each contribute to the customer’s percep�on of product quality, such that nonprice compe��on is primarily about compe�ng on the basis of quality, when quality is broadly defined to include benefits provided by promo�onal efforts and distribu�on systems.

Star�ng with product design, we note that it includes the shape and appearance of the product that can be expected to generate psychic sa�sfac�on (to the extent that it is a�rac�ve) to the poten�al customer. Product design also contributes to the product’s durability, longevity, func�onality, and other aspects that the customer will perceive as u�lity genera�ng. For example, coffee grounds sold in an air-�ght, but easy-to-open canister will be perceived as adding addi�onal value for those who want their coffee grounds to stay fresh and yet be easily accessible. Offse�ng part of (or all of) the u�lity from these desirable design features might be some nega�ve aspects of the design that give the customer disu�lity, such as annoying or dangerous features. For example, if the easy-to-open latch tends to break your finger nails, customers will not prefer that product and will purchase a different coffee product instead.

Product promo�on typically highlights the product’s good features, informs customers of the product’s advantages (rela�ve to rival firm’s products), and effec�vely congratulates the buyers for their good judgment in buying the product. Accordingly, promo�on for a product might be expected to generate u�lity for the user, especially if it promotes a par�cular lifestyle or posi�ve emo�on or associates consump�on of the product with a celebrity endorser. Thus we see, for example, billboards and TV adver�sements for Coca-Cola where happy people are having a good �me while drinking Coke.

Place of sale, or the distribu�on system u�lized by the firm, also generates u�lity for the buyer by providing convenience both at the �me of ini�al purchase and later when the product requires scheduled maintenance or repairs. It is much more convenient, for example, to have easy access to a local automobile dealership, rather than needing to spend a lot of �me ge�ng to and from a more-distant dealership. Online availability of many goods (e.g., hardware) and services (e.g., Ne�lix) with subsequent delivery by mail or by electronic downloading has made shopping much more convenient for most people. So, while we will look at promo�on and place of sales separately from product design, it will facilitate discussion at �mes if we conceptualize more generally that

nonprice compe��on is largely concerned with the quality element of the value proposi�on.1

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Search, Experience, and Credence Goods

Some products are more suited to nonprice compe��on than they are to price compe��on, and vice versa. Search goods, which are defined as products for which the search cost of ascertaining product quality is rela�vely low, are more likely candidates for price compe��on, since the customers can more easily evaluate product quality. For example, your clothes are search goods; it takes only a few seconds to decide whether you like the quality (i.e., the cut and color of the fabric) of a shirt or jacket. Thus, when there is a price reduc�on (e.g., for Brand X shirts) the increase in the value proposi�on is easier for the consumer to judge. Importantly, search goods are also easier for rivals to imitate, since they can more easily see what it is that makes the product different.

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Thus, search goods tend to evolve towards sameness in the market as compe�ng firms modify their product offerings to more closely resemble the products of rivals that are more profitable—this is what we saw happens in monopolis�c compe��on (in Chapter 8) and as discussed when we considered product prolifera�on (in Chapter 9). As the quality of compe�ng brands tends to gravitate toward the same level, the value proposi�on will be driven almost totally by the price level. Thus, firms selling search goods and seeking higher profit will tend to engage in price compe��on to increase their profits via larger volumes at lower levels of contribu�on per unit of output. Changes in design are necessary to differen�ate their product again and thereby allow higher profit margins (at least temporarily un�l rivals also revise the design of their compe�ng products).

Experience goods, on the other hand, are products for which product quality is more difficult to judge in advance of actual consump�on. Examples of experience goods are foodstuffs, restaurant meals, vaca�on packages, and college degrees. The difficulty to judge product quality before the purchase decision can be measured by the extent of search costs necessary to ascertain and evaluate the qualita�ve aspects of the product. If these search costs would exceed the price of the product, then the cheapest alterna�ve might be for the consumer to simply buy the product and subsequently experience the quality (as we do with a new brand of cheese, for example). Alterna�vely, firms anxious to sell their experience goods are likely to offer "taste tes�ng" or other free or low-cost trials of the product that facilitate the consumer gaining informa�on about product quality, and, hopefully, informing the consumer about the value proposi�on represented by the firm’s product. These ac�ons by the firm are promo�onal strategies that serve to increase demand for the product. Note that with experience goods (that the consumer has been unable to try previously) there will be uncertainty in the consumer’s mind about the product quality, and, thus, the evalua�on of the value proposi�on will be fuzzy or indis�nct, unlike the case for search goods where both the price and quality offer can be seen dis�nctly. Thus, if the firm cuts its price it might find the demand response is quite inelas�c for experience goods (as compared to

more elas�c for search goods).2 (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/ch11introduc�on#footernote2) Thus, firms with experience goods will tend to favor nonprice compe��on over price compe��on.

Credence goods are experience goods that are likely to be different in quality the next �me the customer purchases them, such as a repeat visit to a restaurant (when the chef has changed), or to an open-air concert (when the weather is inclement). Credence goods are most suited to nonprice compe��on, other things being equal, because the prospec�ve buyer can less clearly see whether quality claims are indeed true un�l a�er purchase, and any prior purchases may give misleading informa�on about product quality the next �me around. For example, one’s enjoyment of a dinner while on vaca�on might be largely due to the a�en�ve and knowledgeable service of a par�cular waiter—returning to the same restaurant the next night may be disappoin�ng due to that waiter having the night off. Thus, the firm’s a�empts to induce purchase of a credence good by reducing the price is likely to be less effec�ve (as compared with nonprice strategies), par�cularly for promo�on but also for place of sale. Promo�on can be used to persuade the prospec�ve customer that the product is of sufficiently high quality to make it the superior value proposi�on, while place of sales can be adjusted to increase purchasing convenience (and/or reduce transac�ons costs) for the customer, which can make it the best value proposi�on for the customer.

Nonprice Competition in the Different Market Forms

In Chapter 7, we introduced the four main "market structures" which were pure compe��on, monopolis�c compe��on, oligopoly, and monopoly. You will recall that in pure compe��on the products of rival firms are iden�cal and, thus, there is no benefit for any firm to compete on the basis of product quality. But, for the other three market forms there is product differen�a�on across the firms. There is a rela�vely small degree of product differen�a�on for monopolis�c compe�tors. Oligopolists typically have a greater degree of product differen�a�on, perhaps due to loca�on and branding even when their core products are otherwise quite similar. Monopolists have an extremely high degree of product differen�a�on, since they are alone in their marketplace with no direct rivals. In each of the la�er three market situa�ons, the firm has a profit incen�ve to adjust its nonprice strategic variables to increase its profitability. There is an important difference, however. In monopolis�c compe��on, the many small firms can adjust their strategic variables without expec�ng any direct reac�on from rival firms, but in oligopoly markets the firms are few and large rela�ve to the market and, as a result, they must recognize their mutual dependence. The gains from one oligopoly firm’s strategic ac�ons will have direct nega�ve impact on the sales of rival firms. We should expect these rival firms to want to react with their own adjustment of strategic variables in order to win back their lost sales. The monopolist, while facing no direct compe�tor, may nonetheless gain from using its nonprice variables to push its demand curve outwards; it might a�ract sales away from other products that are indirectly compe��ve, such as an electricity monopoly a�rac�ng sales from a gas monopoly due to one of these monopolies adver�sing that cooking with their source of energy is somehow be�er.

The More Subtle Nature of Nonprice Competition

Note that price compe��on and nonprice compe��on are very different in the �ming and severity of their impact on customers and on rival firms. Price compe��on is sudden and o�en quite severe in its impact, as customers will quickly switch towards (or away from) the focal firm based on their percep�on of the rela�ve value proposi�ons offered by compe�ng firms. Price is a rela�vely unambiguous number, assuming that transac�on costs, search costs, and other costs that make up the total price to the customer do not also change significantly when the firm changes its s�cker price. Thus, the quality-to-price ra�o calcula�on can be made quite quickly once the new price is known, based on the previous percep�on of quality. The consumer will change suppliers if a new best-available value proposi�on becomes apparent, and the impact on the focal firm and on rivals will be rela�vely sudden.

Nonprice compe��on, on the other hand, must be planned before it is implemented, and its implementa�on will typically take much longer than it takes to implement a price change. Adver�sing and promo�onal campaigns must be discussed, designed, and media �me and space must be booked before any campaign can be implemented. Changes in product quality must be proposed, considered, and tested against the preferences of poten�al customers before the produc�on facili�es are modified to produce the changed product, which must then be distributed to retailers or otherwise made available to prospec�ve purchasers. Similarly, place of sale, or the firm’s distribu�on system, cannot be changed overnight—arrangements have to be made, contracts have to be signed, facili�es have to be set up, and so on.

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Price compe��on is sudden and requires li�le advanced planning whereas nonprice compe��on takes �me to plan before it can be implemented.

Thus, while price compe��on can be decided and implemented in hours or, at most, in a few days, nonprice compe��on may take weeks or months to set up and implement. A�er that, the impact on consumers will be slower than a price change, because changes in the quality component of the value proposi�on will be harder to see and evaluate compared to changes in the price component. This is par�cularly so for experience and credence goods, of course, but even for search goods the prospec�ve customer will have to examine the quality a�ributes of the new product, interpret the nuances of the promo�onal message, or visit the new place of sale before concluding that the new value proposi�on offered is superior to rival offerings, or not.

Nonprice compe��on is therefore typically less abrupt and more gradual in its impact (on the firm’s sales) than is price compe��on. It needs to be considered and planned well in advance of its implementa�on, such that quick nonprice retalia�on in response to a rival’s nonprice ini�a�ve is usually impossible. This means that a well-planned and well-implemented nonprice strategy can gain a market advantage that endures for quite a while before rivals are able to mount their own new promo�onal campaigns, product design changes, or new distribu�on outlets. During that �me, the focal firm will enjoy increased sales at the same (or higher) price levels un�l rival firms either reduce their prices or come up with their own nonprice strategic ini�a�ves. Indeed, during the �me that rivals are trying to catch up with the focal firm’s nonprice strategic ini�a�ve, that firm can be working on its next nonprice ini�a�ve to once again shi� its demand curve outward.

In the remainder of this chapter, we will examine changes in product design, promo�on efforts, and place of sale (distribu�on systems) to see how the firm can increase its profitability by changes to these nonprice strategic variables.

1. This is not strictly true, of course. New places of sale will be more convenient for some buyers, where convenience of purchase can be viewed as a quality a�ribute, but new distribu�on points also will reduce the customer’s transac�on costs of buying the product, which we have considered as an element of the total price paid by customers. Similarly, adver�sing and promo�on might provide informa�on and persuasion that removes the customer’s need to conduct search costs, which we have also considered to be a component of the total price to the customer. Thus nonprice compe��on impacts the value proposi�on perceived by the prospec�ve customer via either or both the quality or the price percep�on. [return (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/ch11introduc�on#return1) ]

2. Recall that inelas�c means that the percentage change in quan�ty demanded will be less than the percentage change in price, so that total revenue will increase for a price increase, for example. Conversely, elas�c means that the percentage change in quan�ty demanded will be greater than the percentage change in price, so that total revenue will decrease for a price increase. [return (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/ch11introduc�on#return2) ]

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Product Promo�on: Target Marke�ng

11.1 Demand Shifting Using Nonprice Strategic Variables

As noted, the aim of nonprice compe��on is to shi� the firm’s demand curve to the right, to induce more sales at the current (or any other) price level. This is not a limitless process, however. A�er some point, addi�onal product design features, promo�onal expenditures, and distribu�on outlets will cost more to set up and operate than they will generate in terms of addi�onal sales. The manager’s problem is to increase the expenditures associated with these nonprice variables to an appropriate level such that the firm’s profit (or expected net present value) is maximized. In this sec�on, a�er a short review of the nonprice variables, we shall consider how the firm might adjust these to maximize its profit in the short run (under full informa�on) or maximize its expected net present worth (under uncertainty and longer �me horizons).

Product Quality

The mul�ple dimensions of product quality include how the product looks (e.g., its shape, appearance, or design aesthe�cs); what it does (e.g., its func�onality, or usefulness); how long it lasts (e.g., its durability, or robustness); and what it does not do (e.g., it does not endanger, annoy, or cost more money to maintain). Improving product quality means increasing the first three of these aspects of quality and reducing the la�er. In Chapter 3, we considered product a�ribute analysis, which iden�fied the main product a�ributes (or quality dimensions) that consumers will use to differen�ate between and among compe�ng products and on which they base their purchase decision. Put another way, the product a�ributes of importance to each consumer are the ones that enter the quality component of the firm’s value proposi�on that is perceived by that consumer.

Thus, the firm’s managers need to view the product through the eyes of their customers to appreciate which of these quality dimensions are more (or less) appreciated by those customers and by prospec�ve customers. Market research, which is asking customers and prospec�ve customers what they like and do not like about the product, will serve to inform management as to which of the qualita�ve features are par�cularly desirable and which might be increased, reduced, added, or deleted (Kim & Mauborgne, 1999).

Packaging and People

As first men�oned in Chapter 3, some marketers talk about the six Ps of marke�ng, adding packaging and people to the tradi�onal four Ps. Packaging refers to the way in which a product or service is presented to the poten�al customer. For example, a�rac�veness and the security of the packaging can be viewed as aspects of product quality. The pictures on the boxes in which new TVs are delivered raise the customer’s an�cipa�on of the viewing experience and the strength and rigidity of the box and interior packaging ensures that the TV will work immediately when it is turned on. The term people relates to the human element, or the quality of personal service associated with the purchase and delivery of the product. Note that by "product" we mean "product or service" and that both physical products and intangible services can be delivered with be�er (or worse) personal service by the provider. This personal service is o�en inextricably combined with the product, of course, and even when it is a minor component of perceived product quality (such as for impulse purchases of commodity items) it is rarely irrelevant. Thus, what we have said above about adjus�ng quality dimensions to the op�mal levels also relates to packaging and personal service—these should be augmented to the extent that the marginal cost of addi�onal packaging and service is just equal to the marginal revenue deriving from that addi�onal packaging and service. For example, a restaurant manager considering whether to hire an addi�onal waiter (for say, $100 per day) must consider whether the improved service provided will generate at least $100 addi�onal contribu�on to overheads and profit from addi�onal food and beverages ordered either immediately or via repeat purchases of sa�sfied customers.

Promotion

Promo�on includes a variety of ac�vi�es that are designed to induce the prospec�ve customer to purchase the firm’s product or service. Adver�sing is perhaps the most commonly used promo�onal tool, but also Internet websites, Google adver�sing and key-word purchase, point-of- sale displays and give-aways, and support of spor�ng events are also common promo�onal vehicles.

Many firms have an adver�sing budget, o�en calibrated to be a par�cular propor�on of sales revenue, to be spent on adver�sing or other promo�onal ac�vi�es. For example, Coca-Cola is reported to spend about 30% of its revenue (or wholesale price per can) on adver�sing in order to

maintain its market share in the face of adver�sing by rival firms.3

(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec11.1#footernote3) Managers will be concerned whether or not the current level of promo�onal expenditure is the profit-maximizing level. They should expect that increased adver�sing expenditures will lead to increased sales of their products, assuming, of course, competent adver�sing campaigns that do not "turn off" customers. But they should also expect diminishing returns to adver�sing expenditures, such that there is an op�mal level of adver�sing expenditures for their par�cular product and market situa�on. Assuming that Coca-Cola has gravitated over �me to an op�mal level of adver�sing expenditure, any reduc�on in their adver�sing is likely to be accompanied by a reduc�on in both sales and profits.

In oligopoly markets, the firm will be concerned about the level of its adver�sing expenditures rela�ve to the adver�sing expenditures of rival firms. If rivals increase their adver�sing the focal firm should expect some erosion of its own market share as rivals’ demand curves shi� outwards and its own demand

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Internet promo�on like Google adver�sing is designed to induce the prospec�ve customer to purchase a firm’s product or service.

curve shi�s inwards. A large frac�on of the oligopolist’s adver�sing budget may be required simply to maintain its market share. Thus oligopolists keep a sharp eye on the adver�sing campaigns of rivals and will feel compelled to increase their own adver�sing (or adjust another strategic variable) to counter increased adver�sing by rivals. In most oligopoly markets, the firms will gravitate towards a level of adver�sing that seems to provide the op�mal contribu�on to overheads and profit, and then watch their rivals to see that they maintain the status quo.

A complica�ng issue for the evalua�on of adver�sing expenditures is that adver�sing campaigns are likely to differ qualita�vely and in their impact on consumers—some adver�sing concepts will be more successful than others, and some campaigns will be interrupted by adverse weather or major events that distract consumers and reduce the effec�veness of the adver�sing campaigns. For example, during the Olympic Games, or the presiden�al elec�on campaign, adver�sing by the firm might be overlooked by customers more interested in the spor�ng or poli�cal events. Similarly, new health informa�on, such as new data rela�ng obesity to the sugar and fat content of fast food, may render adver�sing less effec�ve in increasing the firm’s demand. Where adver�sing can be increased by more of the same promo�onal message (e.g., more billboards in new loca�ons u�lizing the same promo�onal message, or the same adver�sement placed in more newspapers) the firm’s managers can gain a more reliable es�ma�on of the marginal impact of increased adver�sing on the demand for their products.

Internet Promo�on

Quickly replacing billboards, print media, radio and television adver�sements, and even point- of-sale promo�onal materials as the media of choice for many firms is Internet promo�on, informa�ve and persuasive material posted on the firm’s (and other) websites, cross-pos�ng with other firm’s websites, purchase of Google "ad-words" and paid adver�sements that pop- up when people search for specific informa�on on the Internet. Social media sites, such as Facebook, allow the firm to have ongoing communica�on with customers and poten�al customers, and also allow the firm’s products, service quality, and corporate social responsibility to be rated by millions of customers and, thus, provide informa�on to poten�al customers about the value proposi�on offered by the firm.

Increasingly, people search for informa�on just-in-�me on the Internet, that is, just before they plan to use the informa�on, rather than keep printed adver�sements and other materials on hand for reference just-in-case they will need this informa�on at a later �me. It stands to reason that the immediate availability of product price and quality informa�on via Internet websites tends to reduce the impact of other forms of just-in-case promo�on. Whereas print media, radio, and television provide seller-supplied (and poten�ally biased) informa�on about the product, the Internet allows the prospec�ve customer to quickly find (and compare) offers from various sellers and usually also to find reviews and ra�ngs of the firm’s product in comparison with rival products. These reviews and compara�ve ra�ngs are par�cularly effec�ve for the promo�on of experience and credence goods, assuming the firm’s product is rated highly, of course. Thus, the Internet has not only impacted the efficacy of other forms of promo�onal media but has also served to increase the quality of many firms’ products since any adverse comparisons or deficiencies are quickly noted and publicized by consumers and other interested third par�es. Indeed many companies explicitly ask (on their websites) for ra�ngs and reviews of their products to provide them with the informa�on they need to improve product and service quality.

Place of Sale

The place of sale refers more broadly to the firm’s distribu�on system, which includes the way in which the product is made available for viewing or considera�on by prospec�ve customers, and the means by which it is delivered to the customer at or a�er the point of sale. Thus, the firm might set up physical shops where the product can be viewed, purchased, or consumed by customers who travel to the shop and purchase the product there. Heavy or bulky items may need to be delivered subsequently to the customer’s place of residence or business, or the purchaser may take delivery at the point of purchase, consume it there (consider the case of services, food, and beverages, for example), or transport it themselves to the desired loca�on.

As men�oned elsewhere, the place of sale creates more or less inconvenience, search, and transac�on costs for the prospec�ve buyer. This will enter the prospec�ve customer’s evalua�on of the value proposi�on offered by the firm, either as a transac�on or search costs on the (price) denominator, or as a product a�ribute on the (quality) numerator of the value proposi�on. By having mul�ple places of sale, the firm reduces transac�ons and search costs and increases the convenience for at least some customers and, as a result, may become the best value proposi�on for some of those customers, thus selling more units of output.

In Chapter 9, we considered franchising as a means of gaining addi�onal market share and greater firm-level profit even under condi�ons of monopolis�c compe��on where the individual franchise might make only normal profits. By opening addi�onal franchises, the firm is effec�vely making its place of sale more convenient while reducing the search and transac�on costs for more people and, thus, gaining customers that previously did not perceive that firm to be offering the best value proposi�on.

Internet Sales

As implied earlier, the physical store is declining as the major place of sale for many goods and services, being progressively replaced by the Internet websites of firms where prospec�ve customers can view images of the product, gain informa�on about product a�ributes and comparisons with rival products, and then purchase and pay online, with delivery subsequently to the customer’s desired loca�on within hours, in some cases, and, generally, within a few days. Prospec�ve customers, increasingly "�me-poor" and faced by an increasing array of rival products (including imports or products that

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would be imported directly to the consumer a�er purchase), find that their transac�on costs are reduced significantly by Internet purchases. Thus, buying online offers a be�er value proposi�on even when buying the same item from the same seller at that firm’s physical store. In addi�on to the savings of transac�on costs, the customer may find that Internet prices are lower than in-store prices for two main reasons. First, the costs of displaying and selling the items in-store are likely to be higher than selling via the Internet and shipping from a warehouse. Second, the customer who is in the store has already invested �me (and possibly also parking costs) and would need to repeat this investment in other stores to find compara�ve price and quality informa�on. That person is likely to make the economically ra�onal decision to buy in store at what is likely to be a higher price than may be available in other stores or on the Internet rather than incur addi�onal search costs to find out if that is in fact true.

3. Firms need to keep their brand name product quality asser�ons in the minds of consumers, not only to prevent direct rivals (e.g., Pepsi and RC-Cola in Coca-Cola’s case) but to avoid being replaced by indirect rivals (other beverages) and to avoid being forgo�en amongst the "noise" of many other firms adver�sing their unrelated products. [return (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec11.1#return3) ]

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U�lity companies such as electricity and gas suppliers, are o�en regulated in the public interest, since no compe�ng firms exist to s�mulate increased efficiency in produc�on and more compe��ve pricing.

11.2 The Optimal Level of Nonprice Competition

It is useful to consider the adjustment of a nonprice strategic variable in two stages. First, for simplicity of exposi�on, we shall consider adjus�ng the nonprice variable while holding price constant, which is appropriate for some market situa�ons. Later we shall adjust price and the nonprice variable simultaneously to find the profit-maximizing combina�on of price and nonprice strategies, which is appropriate for other market situa�ons. We saw in Chapter 7 that firms opera�ng in oligopoly markets with mutual dependence recognized o�en face price rigidity—they will be reluctant to raise their price for fear of the elas�c demand response that would happen if their rivals did not also raise their prices, which would cause their market share and profitability to decline substan�ally. They might also be reluctant to reduce their price for fear of an inelas�c demand response, which would happen if all rivals also reduce their price to protect their market share, such that while their market share would stay the same, each firm’s profit margin on each unit sold would be substan�ally less. In such kinked- demand-curve markets the oligopoly firm effec�vely faces a price that it prefers to keep fixed

at the current level.4 (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec11.2#footernote4)

We might also expect price to be held constant in monopoly markets where the firm’s price is regulated by a government authority and is, thus, set at a par�cular level that is maintained for a considerable period between regular (perhaps annual) reviews of the price level by the regulatory authority. As indicated earlier, public u�li�es, such as the post office, electric company, and gas suppliers, are o�en regulated in the public interest since there are no compe�ng firms to induce the firm to be more efficient in produc�on and more compe��ve with their prices. Without compe��on, monopolies tend to allow their cost structures to inflate such that prices would periodically increase, so public regula�on of prices is u�lized to prevent upward creep in their prices due to managers’ unwillingness to pursue produc�on efficiencies.

So, in the following sec�on, we shall first consider the most simple case where the firm leaves price at its current level and adjusts one of the other strategic variables to the profit-maximizing level. Although this could be any one of the three nonprice strategic variables, in the following we will discuss the process in terms of product quality, and later generalize our findings to refer to all other nonprice strategic variables. If the firm were to increase its product quality by constant increments to expenditure (e.g., $1,000) we should expect the demand curve to shi� outward but we should also expect to observe diminishing returns to market demand for the product quality. That is, for a series of increases to product quality (with each increase cos�ng $1,000), we should expect the outward shi� of the demand curve to be progressively less, as shown in Figure 11.1.

Figure 11.1: Diminishing returns to quality

Figure 11.1 demonstrates diminishing returns to product quality—the demand curve shi�s outwards by progressively less for each constant increment to expenditures on product quality. Because total revenue (TR) is equal to price �mes quan�ty (i.e., PQ) and since price (P) is constant, it is evident that TR must be increasing at a decreasing rate because the quan�ty (Q) is increasing at a decreasing rate (as adver�sing is augmented by constant increments). This means that the marginal revenue associated with quality augmenta�on must be falling. But, in addi�on, we should also expect to find the marginal cost of quality augmenta�on is increasing, due to diminishing returns to expenditures on product quality. That is, constant increments (e.g., $1,000 increases) to expenditures on quality will increase the level of quality by diminishing amounts. This means that the marginal cost of quality augmenta�on (i.e., the cost per unit of addi�onal quality) will be increasing.

In Figure 11.2, we show the profit-maximizing level of quality augmenta�on—it will occur when the (rising) marginal cost of quality augmenta�on just equals the (falling) marginal revenue due to quality augmenta�on. The marginal cost and marginal revenues associated with quality augmenta�on are shown in Figure 11.2 as the slopes of the total curves, respec�vely. The curve TCqa (for total cost of quality augmenta�on) rises at an increasing rate as quality is

increased, while the curve TRqa (for total revenue from quality augmenta�on) rises at a decreasing rate as quality is increased. These are the total cost and

total revenue associated with changing quality above the ini�al level (and do not include the produc�on cost of the basic product). The slopes of these curves represent the marginal cost and the marginal revenue associated with augmen�ng adver�sing. These slopes are equal at the quality level shown as K*, which is the profit-maximizing level of quality, since the marginal cost of increasing quality is just equal to the marginal revenue due to the increase in quality, all other things being held constant.

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This result is the (by-now-familiar) marginal-equality condi�on of economics—for profit maximiza�on any strategic variable should be adjusted to the point that the marginal revenue obtained from that adjustment is just equal to the marginal cost associated with that adjustment. In this case it is profit- maximizing to raise quality to the level where the marginal cost of quality augmenta�on is just equal to the marginal revenue due to quality augmenta�on. At quality levels below K* the marginal revenue exceeds the marginal cost so it increases profit to augment quality up to this level. At quality levels above K* the marginal cost exceeds the marginal revenue from quality augmenta�on so profit would fall if quality was augmented to these levels. Thus, the profit- maximizing level of quality is K* where the last dollar spent on quality augmenta�on is just covered by a dollar contributed by the addi�onal sales of the product in the market.

Figure 11.2: The quality augmenta�on decision

It is important to note that the marginal cost of quality augmenta�on as shown in Figure 11.2 will be composed of two separate cost categories that are likely to shi� upwards as the level of quality increases. The first is an increase in fixed costs. Addi�onal machines and specialized equipment might be required to allow the firm to produce higher quality products, so we might imagine the total fixed cost (TFC) curve shi�ing upwards con�nually (or jumping up at points where be�er equipment is needed to improve quality further). Secondly, the total variable cost (TVC) curve is likely to shi� upwards as quality is con�nually increased, because more labor �me and higher quality raw materials or components are required to increase quality progressively. Thus the MCqa curve in Figure 11.2 is the change in both TFC and TVC that is required to raise quality by an addi�onal unit (of quality). You can see that the

analy�cal process underlying Figure 11.2 is a no�onal planning exercise conducted to find the op�mal level of quality. Once that level has been found (in theory) or es�mated (in prac�ce) the firm can select the appropriate combina�on of machines and equipment that can provide the desired level of quality and, thus, have a par�cular level of TFC. Similarly, it will u�lize the appropriate level of labor per unit of output and quality of raw materials and components such that the desired level of quality is a�ained. The firm would have a par�cular TVC curve that it would move along as quan�ty of produc�on changes while quality is constant at the chosen level.

We know that product quality is mul�dimensional, so we must note that the above conceptual analysis applies to only one par�cular dimension of product quality. For example, the dimension under considera�on could be package size. Suppose a new firm that is planning to produce fresh orange juice can only afford one bo�ling set-up and wants to choose the best size of a plas�c container for its orange juice. It will consider packaging its juice in, for example, 1- quart, 2-quart, 3-quart, or 4-quart bo�les, or indeed any frac�onal volume along the spectrum from 1 quart to 4 quarts. The above analysis would allow the op�mal container size to be determined. In prac�ce, of course, the firm needs to consider the market reality that orange juice is normally presented to consumers in standard packaging sizes (e.g., 1- and 2-quart containers), so it may wish to choose whichever package size is superior in terms of profit genera�on. Alterna�vely, it may decide to offer a dis�nctly different container size (e.g., 1.35 quarts) and in its promo�on claim that this size provides "extra value" for the customer if it believes that this is the profit-maximizing combina�on of nonprice strategies.

In theory, the firm would repeat this analysis for each dimension of product quality that is recognized by its customers. For example, the sweetness of the orange juice can be adjusted by the choice of orange variety as a raw material or by the addi�on of sugar or other sweetener. Similarly, the color could be adjusted by the addi�on of minute quan��es of food dye, or the frac�on of solid content (pulp) in the juice can be adjusted by calibra�ng the juicing process of raw oranges. Each one of these quality dimensions for orange juice must be considered and set by the firm at the op�mal level, with a view to maximizing its short-term profit or net present value of profit.

In prac�ce, the firm’s managers would adjust each dimension to the levels indicated by their market research. Conjoint analysis is a market research technique that allows customers to conjointly value (i.e., consider together, rela�ve to each other) the quality dimensions of any product and thus, managers can determine how much each quality a�ribute should be augmented or diminished (Green & Srinivasan, 1978). Just as the reserva�on price of customers varies, each respondent to a marke�ng survey will poten�ally value the quality dimensions (which we called product a�ributes in Chapter 3) of the product somewhat differently. These customer valua�ons will reflect how much extra the customers would, on average, pay for an addi�onal unit of each quality dimension. The manager will consider the average customer valua�on and compare this with the cost of augmen�ng quality and, subsequently, choose the level of quality for each par�cular product a�ribute. For example, Kia Motor company introduced a six-speed transmission and a smaller turbo-diesel engine to its range of automobiles to allow enhanced accelera�on and increased fuel economy, a�er concluding that its customers wanted be�er accelera�on and be�er economy.

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From taste to color, each quality dimension of orange juice must be considered and set by the firm at what it thinks is the op�mal level to maximize profit.

Simultaneous Adjustment of Price and Quality

For the monopolis�c compe�tors (and for the monopolist whose price is not regulated), the fact that they can set prices without fear of rival reac�ons means that the increase in demand due to quality augmenta�on also means that they can raise their price to find the profit-maximizing price and quality level simultaneously. To show this graphically we need to develop several new concepts and then bring them together in one (admi�edly more complex) diagram. But you will be ready for this level of complexity because each of the concepts is rela�vely simple and the analysis u�lizes knowledge that you have learned in the preceding chapters.

We start with the locus of op�mal prices (LOP) which is a line joining the op�mal (i.e., profit-maximizing) price level at each different quality level. In Figure 11.3 we show two demand curves (and related MR curves) that reflect two different levels of quality—D1 and MR1 reflect one quality scenario while D2 and MR2 reflect a higher level of quality

scenario. We also show two marginal cost of produc�on curves, MC1 and MC2, which relate to two different levels

of quality that might be chosen. The op�mal price in the first quality scenario is P1, and the op�mal price in the

second quality scenario is P2. (Note that the op�mal output level is found where MR = MC in each scenario, and

these prices are found by projec�ng up to the relevant demand curve from those output levels in each scenario.) The line joining those two op�mal price levels, shown as LOP, is the locus of these profit-maximizing price and output combina�ons (and many other op�mal price and quan�ty combina�ons). We need this locus showing all possible op�mal price and quan�ty combina�ons so that we can superimpose it on the cost side of the quality augmenta�on issue, which we now address.

Figure 11.3: The locus of op�mal prices

The locus of average quality costs (LAQC) is a line joining the average quality cost at each profit-maximizing price level. The average quality cost (AQC) is the total costs of quality at a par�cular level of quality, divided by the number of units of output subsequently produced and sold. Total cost of quality can be regarded as a fixed cost once the product design (and thus the level of quality) is chosen and the firm’s plant is set up for that quality level. Subsequently, when output is produced, the total costs of quality is a constant, and thus, the average quality cost curve will be a rectangular hyperbola, as shown in Figure 11.4, for each of the two quality scenarios. In each scenario AQC values will be very high ini�ally but will fall progressively as the total cost of quality is divided by a progressively increasing level of output. As you can see in Figure 11.4, in the first quality scenario the op�mal output level was Q1 (from Figure 11.3) and the average level or quality costs per unit at that output level is A1. For the second quality scenario, the average quality cost is A2 at

output level Q2. The line drawn through these AQC and Q coordinates will be a locus of average quality costs, shown as LAQC, which represents the AQC

value at each of the op�mal output levels associated with each quality scenario.

Figure 11.4: The locus of average quality costs

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On the basis of the LOP and LAQC curves we can now demonstrate the simultaneous determina�on of the profit-maximizing quality (K), output (Q) and price (P) levels. Note that each of the locus curves in Figures 11.3 and 11.4 represents an average, and there must be a marginal curve associated with each of these average curves. These marginal curves would show the rate at which the total in each case was changing—that is, the locus of marginal quality costs (LMQC) will show the rate at which total quality costs are changing as quality changes (see Figure 11.2), and the locus of op�mal marginal revenue (LOMR) will show the rate at which the total revenue is changing as quality changes (see Figure 11.2). Whereas Figure 11.2 was in two dimensions (i.e., quality vs. cost/revenue) holding output level constant, we now need to find the op�mal output level while allowing both quality and the cost/revenue dimensions to vary. Rather than show a three-dimensional diagram, in Figure 11.5 we show the marginal and average locus curves for both prices and quality costs mapped against the third variable of interest, the output level. At the output level where the marginal curves intersect (i.e., LOMR = LMQC), we sketch in the demand curve (D*) and the AQC curve (AQC*), both of which must cross the LOP and LAQC curves, respec�vely, at that output level. These show the profit-maximizing price and quality levels that the firm should set to maximize its profit. The profit-maximizing price will be P*, the profit- maximizing level of average quality costs will be AQC*, and the profit-maximizing level of output will be Q*. The total expenditure on quality augmenta�on will be the AQC* �mes the output level Q*.

Figure 11.5: Simultaneous choice of price and quality levels

Thus we have demonstrated that the op�mal levels of price and quality can be determined simultaneously to solve the manager’s problem of finding the op�mal value proposi�on for the firm. The above model serves to demonstrate the principle that price and any one of the nonprice strategic variables can be adjusted simultaneously to increase profitability. Indeed, in theory, price and all of the other strategic variables (and all of their composite dimensions) can be adjusted simultaneously to best posi�on the firm’s product in its market, but to prove that here would require mathema�cs of a fairly high order and is best le� alone! In prac�ce, of course, managers will not have the informa�on necessary to draw in all these curves and see where they intersect, and so will need to u�lize an itera�ve procedure to approach this op�mal price and quality combina�on by trial and error and the exercise of judgement based on their knowledge of consumer behavior in their markets.

Estimating the Optimal Level of Nonprice Strategic Variables

The foregoing sec�ons have established the theory of op�mal nonprice compe��on and have demonstrated the principles involved in adjus�ng several strategic variables simultaneously to find the profit-maximizing combina�on of those strategic variables. In prac�ce, the firm will find that the informa�on search costs required to u�lize these theore�cal models would be prohibi�ve. Nonetheless, an understanding of the theory of nonprice compe��on will allow the manager to use parts of the theory (for which informa�on is available) to es�mate the profit-maximizing level of par�cular nonprice strategic variables.

For example, a firm that consistently adver�ses could, at rela�vely small cost, collect �me-series data on monthly quan�ty demanded (in thousands) and adver�sing expenditures per month (in thousands of dollars), and could calculate a line of best fit between these two sets of data observa�ons. Suppose a firm has done this and u�lizing correla�on analysis (see Chapter 4) has found the line of best fit to be Qd = a + bA where A represents adver�sing

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expenditures in thousands of dollars. The coefficient to adver�sing in this line of best fit, that is, b, is the marginal impact on quan�ty demanded for a

$1,000 change in adver�sing expenditure. It is a simple ma�er to then calculate the marginal revenue due to a $1,000 change in adver�sing5

(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec11.2#footernote5) and compare it with the marginal cost (i.e., $1,000) of a unit of expenditure on adver�sing. The sta�s�c b will be some frac�on or mul�ple of a unit of output. Let us suppose it is 0.25, meaning that an addi�onal $1,000 spent on adver�sing increases sales by one quarter of 1,000 units (i.e., 250 units) of the product. Now, if the contribu�on to overheads and profit of the product is say, $5, those 250 units generate $1,250 in contribu�on, which exceeds the $1,000 marginal increment in adver�sing expenditures. Thus, adver�sing could be increased to maximize profit, assuming that all other influences on quan�ty demanded remain the same. Perhaps several more increments of $1,000 could be spent,

un�l the marginal revenue due to adver�sing falls to equality with the ($1,000) cost of the marginal unit of adver�sing.6

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Using mul�ple regression analysis, the manager can control for other variables that are likely to have changed to be�er isolate the impact of adver�sing on quan�ty demanded, as we saw in Chapter 4. Also, mul�ple regression analysis allows us to es�mate nonlinear rela�onships between quan�ty demanded and the nonprice variables. We have argued above that there will almost certainly be diminishing returns to these nonprice variables. As an example, suppose the demand func�on for a firm has been es�mated as:

Q = 10,000 + 25.2 A – 0.8 A2 (11-1)

Where Q is quan�ty demanded in units and A represents adver�sing expenditures in thousands of dollars. The op�mal level of adver�sing will be the level at which the last $1,000 spent on adver�sing contributes just $1,000 towards overheads and profit. Thus the maximizing condi�on is dπ/dA = 1 where π (the lowercase Greek le�er pi) represents the contribu�on to overheads and profit. To find dπ/dA we must first find out how quan�ty demanded varies with adver�sing (i.e., dQ/dA) and then how profit varies with quan�ty demanded (i.e., dπ/dQ, which is the contribu�on margin). Thus dπ/dA expands to:

dπ/dA = dQ/dA · dπ/dQ (11-2)

From equa�on 11-1, we can find dQ/dA by taking the first deriva�ve of the es�mated demand func�on with respect to adver�sing expenditures, which is:

dQ/dA = 25.2 – 1.6A (11-3)

Since the profit-maximizing condi�on is to set dπ/dA = 1, and because dπ/dQ is the contribu�on margin (CM), we can restate equa�on 11-2 as:

dQ/dA = 1/CM (11-4)

Thus, the profit-maximizing rule is to set the marginal impact of adver�sing on quan�ty demanded equal to the reciprocal of the contribu�on margin. From the es�mated demand func�on (11-1), we found the marginal impact of adver�sing on quan�ty demanded as shown in equa�on 11-3. Now assuming that the contribu�on margin is $6 per unit, we can solve for A by se�ng equa�on 11-3 equal to 1/6 as follows:

25.2 – 1.6A = 1/6

Mul�plying both sides by 6 we find:

151.2 – 9.6A = 1

Taking 151.2 from both sides we have:

– 9.6A = – 150.2

Finally, by dividing both sides by –9.6, we find that A = 15.646. Thus, when the contribu�on margin is $6 per unit of output, the es�mated op�mal level of adver�sing is $15,646.

In the above example, we implicitly assumed that the contribu�on margin was constant at $6, regardless of the output levels, and that the shi�ing outward of the demand curve due to adver�sing would allow all addi�onal units of output to be sold at the same price level. This is a simple case that, nonetheless, might be applicable (or sufficiently close to reality) in many business situa�ons. But, where there are diminishing returns in produc�on (i.e., rising MC as output increases), the contribu�on margin will fall as output levels increase so this must be incorporated into our calcula�ons. Recalling that the contribu�on margin is equal to price (P) minus average variable costs (AVC), and that a rising MC causes the AVC value to rise, we would have an expression for contribu�on margin of the form CM = P – AVC – (δAVC/δQ), where the la�er term indicates the extent to which AVC is expected to rise as output increases. But you will recall from Chapter 5 that as the output rate is increased, AVC falls at first; bo�oms out where MC cuts the minimum value of AVC; then rises again as the MC con�nues to rise. Thus, if the firm is opera�ng at an output level anywhere near the minimal point of its AVC curve, the AVC curve will be rela�vely flat on each side of that minimal point, and so the assump�on of a constant contribu�on margin may be a sufficient approxima�on for calcula�ng the op�mal level of adver�sing.

Where managers do not have inexpensive access to sufficient data on the rela�onship between prior adver�sing (or other nonprice variable) and the quan�ty demanded, they might experiment by implemen�ng a slight increase or decrease in adver�sing expenditures (or other variables) to observe by how

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A price war occurs when the prices of all firms are adjusted downward repe��vely un�l no firm is making any or much profit. To avoid a price war, firms can create price leadership and price fixing agreements.

much sales volume changes as a result of the change in that nonprice strategic variable and thus, gain an apprecia�on of whether they should increase or decrease that strategic variable further in pursuit of the maximiza�on of their firm’s net present worth.

Nonprice Competition With Mutual Dependence Recognized

In oligopoly markets, the firm should realize that its adjustment of strategic variables will have no�ceable impact on the sales of rival firms and consequently that these other firms are likely to react by adjus�ng their own strategic variables and thus impac�ng the focal firm’s sales, triggering another round of adjustments, and so on. When the strategic variable being adjusted is price, this sequence of ac�on and reac�on could result in a price war, whereby the prices of all firms are adjusted downward repe��vely un�l no firm is making any or much profit. Clearly, profit- maximizing firms will want to avoid this outcome, resul�ng in the emergence of price leadership and price fixing agreements, as men�oned in Chapter 8.

We have noted that, unlike price compe��on, it typically requires a significant lead �me to implement a change in a nonprice strategic variable. As a result, if an oligopolist is caught napping by a rival’s new promo�onal campaign, product improvement, or new retail outlet, there will be a significant lag before it can retaliate effec�vely, during which �me it may have lost a significant part of its market share that may be very hard to regain. The existence of this lag, therefore, mo�vates firms to maintain an ongoing involvement in promo�onal ac�vity—if the firm is always planning its next promo�onal campaign, it will not be caught napping to the extent that it would be if it had to start from scratch a�er a rival launches a new promo�onal campaign.

The threat that a rival might launch a major nonprice strategy and gain market share at the expense of the focal firm may cause the mutual-dependence-recognized oligopolist to increase its adver�sing, quality, or distribu�on outlets as a defensive move, just in case a rival firm does the same thing. In effect the oligopolist is involved in a strategic game in which the rival’s next move is an�cipated, so the firm will be induced to make an aggressive nonprice adjustment in order to render less potent the rival’s move if indeed it occurs.

4. As we saw in Chapter 6, the short-run profit-maximizing firm will want to change its price if its MC curve intersects a concrete sec�on of the disjointed MR curve that accompanies the kinked demand curve, and will tolerate the market share loss because its objec�ve is to maximize profits in the short run, and thus the subsequent-period benefits of market share (such as repeat sales) are not included in the firm’s objec�ve func�on. When oligopolists consider the longer run impacts of their pricing decisions they are likely to hold price constant to maintain market share for future period benefits, assuming they are not prac�cing price leadership or followship, of course. [return (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec11.2#return4) ]

5. The marginal revenue will be the increase in quan�ty demanded mul�plied by the contribu�on per unit, assuming that price and AVC remain constant at the higher output level. [return (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec11.2#return5) ]

6. Although the line of best fit is a linear expression, we expect that there will be diminishing returns to adver�sing expenditures, so the marginal impact on quan�ty demanded of $1,000 of adver�sing is not likely to remain at the value b = 0.25. Thus the firm must monitor the impact of addi�onal adver�sing on its quan�ty demanded, and stop increasing adver�sing when the incremental revenues just equal the incremental costs. [return (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec11.2#return5) ]

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11.3 Game Theory in Mutual-Dependence-Recognized Oligopoly

A game is a situa�on in which two or more players choose strategies to compete for a reward or payoff of some kind. In mutual-dependence-recognized (MDR) oligopoly the game is producing and selling a similar product, the strategy is (let’s say) adver�sing expenditures, and the payoff is market share and the profit associated with that market share. A game that contests market share is a zero-sum game, meaning that the gains of some players equal the losses of the other players. In Table 11.1 we show the payoff matrix for a two-person, zero-sum game in which the players are Firm A and Firm B. We assume that they are each considering two alterna�ve strategies—strategy 1 is to maintain their adver�sing at $4 million per year, and strategy 2 is to increase their adver�sing expenditure to $6 million per year. The four quadrants of Table 11.1 show the four possible combina�ons of the two firms’ strategies. The numbers in the top-le�-hand quadrant show the payoffs to the two firms if both maintain adver�sing at $4 million each—by conven�on we show A’s payoffs first, followed by B’s payoffs, in each quadrant. When both firms spend $4 million on adver�sing the expected profits are shown to be $10 million for each firm.

Table 11.1: Payoff matrix for two-person game Firm B’s Adver�sing Budget

$4m $6m

Firm A’s Adver�sing Budget $4m $10m, $10m $5m, $12m

$6m $12m, $5m $8m, $8m

Suppose now that Firm A were to increase its adver�sing expenditure to $6 million while Firm B maintains its adver�sing at $4 million. The payoffs for this scenario are shown in the lower-le�-hand quadrant: Firm A’s profits increase to $12 million while Firm B’s profits decline to $5 million. This result occurs because the addi�onal adver�sing of Firm A causes some customers to be persuaded that Firm A offers the be�er value proposi�on and as a consequence they switch their purchases from Firm B to Firm A. Oppositely, suppose that it was Firm B that increased adver�sing to $6 million while Firm A maintained adver�sing at $4 million (the payoffs for this scenario are shown in the top-right-hand quadrant, and are $5 million to Firm A and $12 million to Firm B). Finally, suppose that both firms increase adver�sing to $6 million, the payoffs (shown in the lower-right-hand quadrant) are $8 million to each firm. This result occurs because the increased adver�sing of each firm essen�ally offsets the impact of the other firm’s increased adver�sing, but while the increased adver�sing does a�ract new buyers to both firms, the shi� of their demand curves does not increase total revenue by enough to cover the addi�onal $2 million in adver�sing expense that each firm incurs. This is the worst possible outcome, since profits have fallen compared to the ini�al situa�on where $4 million adver�sing returned a profit of $10 million.

Given that the managers of these firms are likely to be risk-averse to some degree or another, and that there will be a significant lag before the firm can retaliate if the other firm were to increase its adver�sing, the focal firm will worry that if the other firm moves first to increase its adver�sing to $6 million then the focal firm’s profits will fall from $10 million to $5 million. The other firm will have exactly the same fear, so both firms are likely to increase their adver�sing expenditures to $6 million, and if they do they will end up in the lower-right-hand quadrant with profits down from the $10 million level to $8 million but this will be be�er than the worst outcome, which is to remain at $4 million adver�sing and see profits fall to $5 million.

The Prisoner ’s Dilemma Problem and the Maximin Strategy

In the previous example, the firms are subject to what has been called the prisoner’s dilemma. A prisoner’s dilemma is a situa�on in which two par�es who act independently to make gains for themselves actually create a worse outcome for both par�es. This is called the prisoner’s dilemma a�er the supposed situa�on in which two bank robbers are caught with a bag of money, which they tell the police they found lying in an alley. The police have no more than circumstan�al evidence that these two men actually did rob the bank, but they are in possession of stolen goods, which would earn them a one-year prison sentence. The police put the men in separate rooms and interrogate them individually. They tell each robber that if he confesses and implicates the other, he will walk free under a "state witness" deal, while the other will get eight years in jail. But if the other one confesses, the "state witness" deal is off the table and they will both get five years in jail. So the payoff matrix for the bank robbers looks like the one in Table 11.2.

Given the inability of the two prisoners to communicate with each other (and because "there is no honor among thieves"), each will be mo�vated to avoid the worst possible outcome, which is eight years in jail if he denies the robbery while the other robber confesses and implicates him. If each prisoner confesses, they each end up with five years in jail, which is far worse than the one year they would get if they both deny the robbery and are convicted of being in possession of stolen goods.

Table 11.2: The prisoner’s dilemma payoff matrix (jail sentences in years) Op�ons for Prisoner B

Deny Confess

Op�ons for Prisoner A Deny 1 year; 1 year 8 years; 0 years

Confess 0 years; 8 years 5 years; 5 years

In each of the situa�ons men�oned above, the players in the game are mo�vated to avoid the worst outcome. Each strategy has two outcomes that differ in value depending on what the other player does at the same �me—one of these outcomes is worse than the other. For example, if Prisoner A denies

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involvement in the robbery, the payoff will be either 1 year if Prisoner B also denies or 8 years if prisoner B confesses and implicates. On the other hand, if Prisoner A confesses, the payoff will be 0 years if Prisoner B denies or 5 years if Prisoner B also confesses. The worst outcome for each strategy is 1 year for denial and 0 years for confessing. The best of these worst outcomes is 0 years and so the best strategy for a person who dislikes jail is to confess. Choosing the op�on that has the best of the worst outcomes is called the maximin strategy, which signifies the maximum of the minimum outcomes.

Now let’s refer to the case of the mutual-dependence-recognized oligopolies choosing the level of their adver�sing budgets. If Firm A keeps adver�sing at $4 million, the profit payoff to Firm A is $10 million if Firm B also keeps adver�sing at $4 million, but profit falls to $5 million if Firm B raises its adver�sing to the $6 million level. Alterna�vely, if Firm A increases adver�sing to $6 million, the payoffs are $12 million if Firm B maintains adver�sing at $4 million, but only $8 million if Firm B also increases its adver�sing to $6 million. The worst of these payoffs is $5 million and $8 million, respec�vely. The best of these worst outcomes, $8 million, is likely to occur because the managers of both firms are risk-averse and prefer larger profits to smaller profits and will be mo�vated to follow the maximin strategy of increasing adver�sing to the higher level.

The prisoner’s dilemma problem applies to the oligopolists’ prices, adver�sing, product quality choices, and distribu�on system choices. Thus, they are at constant risk of reducing their profits by cu�ng prices or launching nonprice strategies that actually reduce their profits because their rivals were mo�vated to do the same thing at the same �me. These examples illustrate the incen�ve for oligopolists to make agreements to maintain prices and nonprice variables at current levels. Such agreements are known as price fixing, in the case of agreements to hold prices at current levels (or to raise them simultaneously), or collusive agreements when two or more firms agree to maintain at current levels or increase or reduce other strategic variables simultaneously or at about the same �me. As you will probably be aware, collusive agreements are illegal and are policed by the An�trust Division of the U.S. Department of Jus�ce. Firms can be fined millions of dollars for engaging in collusive behavior and the managers of such firms will also receive huge fines and jail terms as well. Clearly, when invited or tempted to collude with the managers of a rival firm—walk away and don’t even think about it! Even talking to managers of rival firms might be construed as circumstan�al evidence of collusive behavior, so choose your friends and acquaintances carefully. Be�er to be subject to the prisoner’s dilemma problem out in the business world than to be subject to the problems of a prisoner on the inside!

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Summary

In this chapter we have examined nonprice compe��on, meaning the use of the firm’s strategic variables other than price, namely product quality, promo�on, and place of sale. Each of these nonprice strategic variables is a demand shi�er causing the firm’s demand curve to shi� outwards to the right, if augmented, or inwards to the le� if diminished. Nonprice compe��on essen�ally focuses on product differen�a�on and thus has no applica�on to pure compe��on where products are iden�cal. Nonprice compe��on is an important adjunct to price compe��on in monopolis�c compe��on, oligopolies, and even monopolies, since the monopolist can a�ract demand away from indirect compe�tors. The manager’s problem is to adjust the nonprice variables such that the firm’s product is seen as the superior value proposi�on by its target customer, where value is equal to quality over price, and quality is broadly defined to include aspects of all three nonprice strategic variables. Using the value proposi�on approach allows us to note that some nonprice compe��on raises the value proposi�on by reducing the total price that the customer has to pay. For example, informa�ve adver�sing reduces the customer’s search costs, and opening addi�onal sales outlets reduces the customer’s transac�ons costs.

We saw that there will be diminishing returns to the augmenta�on of any one nonprice variable and, thus, the op�mal level of that variable needs to be found. The usual profit-maximizing condi�on, that the marginal cost associated with the last unit sold should be no greater than the marginal revenue received from the sale of that last unit, is again u�lized, but we noted that the marginal cost now includes not only produc�on costs but also the incremental cost of product quality augmenta�on, promo�on, and distribu�on. The marginal revenue from the last unit sold comes not from a movement down a demand curve but from a shi� outward of the firm’s demand curve.

Thus, as nonprice variables are changed, both the demand curves and the cost curves will shi� outwards and upwards, respec�vely. We u�lized a new analy�cal technique, involving locus curves, to show the path traced by the profit-maximizing price (i.e., average revenue) in each quality scenario and similarly, we used a locus curve to trace the average selling costs associated with each profit-maximizing output level. Introducing curves that are marginal to each of these average locus curves allowed us to find the output level where the marginal equality condi�on was sa�sfied, and this in turn iden�fied the op�mal level of the price and nonprice strategic variables, determined simultaneously.

In the real world, informa�on search costs would typically make it economically inefficient to implement the theore�cal solu�on. But, understanding the process involved will assist the managers in u�lizing whatever informa�on they can obtain at reasonable costs. We noted that if records are kept of monthly sales levels and adver�sing levels, then correla�on analysis can be conducted to ascertain the apparent marginal impact of adver�sing on sales. By u�lizing dummy variables to indicate the periods before and a�er a product improvement is introduced, or a new distribu�on channel is opened, regression analysis can be u�lized to es�mate the impact of the change in product quality or the distribu�on system.

Finally, we focused on the mutual-dependence-recognized problem of the oligopolist, who must expect rivals to react to both its price and nonprice compe��on ini�a�ves. Indeed, since nonprice compe��on needs to be premeditated due to the inevitable lags between deciding to take ac�on and implemen�ng ac�on, oligopolists try to "steal a march" on their rivals by preemp�vely introducing nonprice ini�a�ves using the maximin decision criterion. As a result, they fall foul of the prisoner’s dilemma problem that occurs when par�es have conflic�ng interests and are not able to effec�vely communicate with each other to ensure that no one is taking self-serving ac�on that will damage the other par�es.

Ques�ons for Review and Discussion

Click on each ques�on to reveal the answer.

1. It is some�mes said nonprice compe��on is hard to do well, whereas any fool can cut prices. Discuss this in the context of an oligopoly. (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/boo

Non-price compe��on requires more �me for planning and implementa�on, more crea�ve thinking to come up with good ideas for effec�ve promo�onal campaigns, more resources that need to be invested prior to execu�on of the plan, and more scope for something to go wrong – anything might happen in the period between the decision to engage in non-price compe��on and the implementa�on of that strategy. In oligopolies, rival firms might launch a campaign that preempts or nullifies yours, or events may happen that cause your strategy to be inappropriate. Yet the "prisoner's dilemma" effec�vely forces oligopolists to engage con�nually in non-price compe��on and to con�nually "raise the ante" in case a rival does the same thing.

2. Why should we expect diminishing returns to apply to the effec�veness of adver�sing and promo�onal ac�vi�es? Outline several reasons. (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/boo

We expect diminishing returns to adver�sing because while adver�sements may be perceived as interes�ng and/or entertaining at first, repeated exposure will later be seen as repe��ve and boring. Even if the message is varied, or different media are u�lized, the marginal impact of adver�sing must be expected to fall. The human brain is interested in new and exci�ng things, and ignores repeated informa�on without sugges�ng a reac�on to it, except perhaps to induce us to stop buying that product.

3. Suppose that it would be possible to improve the quality of a product further and further un�l it was perfect. Why would the profit-maximizing firm not want to do that? (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/boo

Diminishing returns to product quality must be expected, such that the marginal cost of equal quality improvements (e.g., 1% improvements) must escalate steeply. The last increment to quality before it reaches perfec�on might cost an infinite amount of money, and unless the near-perfect product could be sold for an infinite amount, the profit-maximizing firm would not a�empt to make the perfect product.

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4. What is the rule for finding the profit-maximizing level of adver�sing expenditures in the short run, given that price and average variable cost levels would remain constant? (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/boo

The profit-maximizing rule is to increase the total expenditure on adver�sing up to the point where the marginal revenue due to adver�sing is just equal to the marginal cost of adver�sing. For example, the last dollar spent on adver�sing should return at least an addi�onal dollar of contribu�on to make it worthwhile. Given diminishing returns to adver�sing this ensures that adver�sing has been increased to the point that profits are maximized.

5. How is that profit-maximizing rule modified if (a) average variable costs rise as quan�ty demanded increases, and (b) if the price declines as addi�onal units of the product are placed into the market? (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/boo

If average variable costs rise, and price is constant, the contribu�on margin will fall as more and more product is sold. The change in contribu�on must be expressed as an equa�on and set equal to the marginal cost of adver�sing to find the profit-maximizing level of adver�sing. If the price will decline as more is demanded (perhaps due to rivals' reducing prices in retalia�on) this must also be factored into the expression for the contribu�on.

6. Outline the logic behind the process for the simultaneous determina�on of the profit-maximizing price and quality levels. (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/boo

The logic is that two variables, both price and adver�sing, can be adjusted to maximize profit, and they can be adjusted together or separately. Since each is subject to diminishing marginal returns there is an op�mal combina�on that takes them both just far enough to maximize profits, but not too far such that the last increment reduces profits.

7. Why is price elas�city of demand likely to be rela�vely high for search goods, as compared to experience goods? (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/boo

Price elas�city depends on the closeness of subs�tutes and the price of the product rela�ve to the buyer's income. Search goods are easy to evaluate for their quality and thus easy to determine if they are close subs�tutes or not. Firms tend to evolve their products to imitate the best-selling rival products, so search goods tend toward sameness (i.e., closeness of subs�tu�on) and are thus likely to have higher price elas�ci�es, other things being equal.

8. In what ways has the Internet acted to increase compe��on among rival firms and raise the value proposi�on that the firm can offer to a customer? (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/boo

The Internet has made informa�on more readily available at near-zero search costs, and thus allows consumers to quickly find price and quality informa�on, including the reviews of previous users. Similarly, firms can easily find out what their rivals are doing in terms of quality augmenta�on and price changes and can react by improving their quality in the dimensions (a�ributes) that seem to be in high demand. Firms can also offer online specials to present a be�er value proposi�on for consumers.

9. Does the Internet have an impact on the adver�sing elas�city of demand, rela�ve to pre-Internet �mes? Please explain. (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/boo

The Internet almost certainly has increased the adver�sing elas�city of demand—i.e., the percentage change in quan�ty demand due to a given percentage change in adver�sing—because new adver�sing informa�on is quickly available to consumers via search engines like Google if they are looking for it specifically. If they have previously searched for the focal product or product category, and even if they are searching for something else, Google will offer adver�sements on the focal product or product category, assuming that you might s�ll be interested in that category.

10. Why do oligopolists face a prisoner’s dilemma problem when it comes to deciding on the level of their adver�sing budgets? (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/boo

Oligopolists face a prisoner's dilemma for the same reason the two prisoners do – they are not allowed to communicate with each other. Communica�on between or among oligopoly firms might be taken as circumstan�al evidence of collusion or price fixing if joint price increases or joint modera�on of adver�sing expenditures were subsequently observed. Being unable to reassure each other that they will hold adver�sing at current levels, they are each mo�vated to insure against a worse profit outcome by over-spending on adver�sing.

Decision Problems

1. The Thompson Tex�le Company has asked you for advice as to the op�mality of its adver�sing policy with respect to its Product X. The following data is supplied. Assume that price would remain unchanged if adver�sing expenditure is varied, and that the marginal cost of produc�on is constant at that level.

Sales (units) per month Adver�sing budget for Product X per month Adver�sing elas�city Price per unit Marginal cost of produc�on

282,500 $56,000 2.5 $2 $1

a. Is Thompson’s adver�sing budget profit-maximizing at the current level? b. If not, can you say how much more or less it should spend on adver�sing? c. Outline the qualifica�ons you would want to a�ach to your advice.

2. The McWilliams Beverage Company (MBC) manufactures and markets its own brand of bo�led water. MBC’s present adver�sing and sales levels (month 9) are $4,000 and 99,500 bo�les sold. The contribu�on margin is constant at $0.22 per bo�le. MBC sells most of its product through vending machines in stores, bus sta�ons, train sta�ons, and other public places. Because vending machines accept only nickels, dimes, and quarters, plus dollar bills, and must give change in coins, the cost of changing the price from the current level ($1.50) is almost prohibi�ve, so MBC engages mostly in nonprice compe��on,

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arguing that its water is more pure than other brands, on billboards, le�er-box leaflets, and posters at the place of sale. MBC has no�ced that quan�ty demanded responds to varia�ons in the level of adver�sing and promo�onal expenditures. The firm has kept the following records over the past 8 months.

Month Sales (bo�les) per month Adver�sing spent ($) per month

1 96,000 $3,400

2 103,000 $4,350

3 93,000 $3,750

4 111,000 $5,900

5 90,000 $2,600

6 76,000 $1,850

7 104,000 $5,200

8 120,000 $7,300

a. Plot the sales data against the adver�sing expenditures and sketch in what appears to be the line of best fit to the data. b. Advise MBC as to the es�mated op�mal level of its adver�sing expenditures per month. Explain and defend your recommenda�on.

3. Flintrock Fixtures is a small firm that produces a variety of polished granite and marble kitchen and bathroom counter tops. The market for these items in the region is not highly compe��ve, since rival firms tend to focus on different segments of the market for new and renovated bathrooms and kitchens. Over the past few years, Charles Flint, one of the senior partners, has been experimen�ng with the levels of expenditures on adver�sing to determine the impact of this strategic variable on quan�ty demanded. Regressing monthly sales revenue against adver�sing expenditures, he has obtained the following

regression equa�on: TR = 110,482.5 + 2,318.6A – 103.2A2, where TR is monthly sales revenue, and A is adver�sing expenditures in thousands of dollars. This

equa�on was derived from adver�sing data ranging from $1,000 to $8,500 per month and has R2 = 0.99, significant at the 1% level.

The present level of adver�sing is $6,000 per month, and Mr. Flint, who is more concerned with longer term profit and wants to maximize sales revenue in the short run, says he wants to increase adver�sing to $7,500 per month. Rocky Spinelli, the other senior partner, is more concerned with maximizing profit in the short run. He argues that given their pricing policy of marking up AVC by 100%, monthly profits would be increased by reducing adver�sing below the current level by at least $2,000 per month.

a. Assuming this data is reliable, what level of adver�sing would maximize sales revenue in the short run? Please explain. b. What level of adver�sing would maximize profit in the short run? Please explain. c. Make an argument to support Mr. Flint’s posi�on that a lower price in the current period will lead to greater profits over the longer term.

4. Vincenzo Pizzeria operates the only pizza parlor in a small western town, although there are several other fast-food outlets that are in compe��on with Vincenzo. The owner-manager, Vincenzo Fiorelli, feels that selling more pizzas is simply a ma�er of convincing people to eat out more o�en. Consequently, he holds price constant and adver�ses in the local newspaper and on the local television sta�on. His pizzas come in three sizes with a variety of toppings, from plain cheese and tomato all the way up to the top-of-the-line deluxe pizza.

Vincenzo’s son Paolo has recently completed his business degree and has joined the family business as marke�ng manager. Paolo is interested in maximizing profits since his father has said Paolo can have half of any addi�onal profit generated as a bonus. Paolo decides to conduct an analysis of the cost and demand condi�ons facing the firm. First, he examines the cost structure. Given the three sizes of pizza and the various combina�ons of toppings they are effec�vely offering a very broad product line. Paolo’s first task is to convert all the different pizzas into the terms of a common denominator, which he calls the medium pizza equivalent (MPE). Thus, a medium deluxe pizza is equal to 1 MPE, a small deluxe is equal to 0.75 MPE, and a large deluxe pizza is equal to 1.5 MPEs, with lesser weights in each size for lesser toppings (e.g., a plain tomato and cheese in the small size is 0.5 MPE). Paolo finds that the average variable cost of an MPE is $2.65 and that this is constant across a wide range of output levels. The first major decision Paolo makes is to standardize prices on all pizzas by marking up the AVC by 50%.

Paolo then conducts marke�ng research by interviewing a random sample of 500 customers and poten�al customers, and derives the following regression equa�on:

Q = 28,105.1 – 5,842.2P + 1,061.6A – 22.5A2

Where Q is the number of MPEs demanded per month, P is the price of an MPE in dollars, and A is the adver�sing expenditures per month. At present, prices are determined by a 50% markup on AVC and adver�sing expenditure is running at $8,000 per month.

a. Using graphical analysis, find the op�mal price and monthly adver�sing levels. b. Confirm your graphical es�mates algebraically. c. How much will Paolo’s monthly bonus be? d. State all assump�ons and qualifica�ons that underlie your answers.

5. The Silk Purse Cosme�cs Company operates in close compe��on with several other major suppliers of cosme�cs and toiletries. In this market, consumers do not seem to be very price conscious—if they believe a product can help them, they tend to buy the product, as long as it seems like a reasonable value proposi�on. Consequently, Silk Purse and its rivals tend to compete on the basis of claimed quality features, such as elimina�ng wrinkles and preven�ng hair

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from going gray. Silk Purse’s adver�sing budget is currently $25 million per annum, and it es�mates that its rivals collec�vely spend $100 million annually. Silk Purse’s net profit for this year is expected to be $2.8 million. The vice-president of finance is worried that this profit level will be insufficient to support con�nua�on of Silk Purse’s research and development program, not to men�on that dividends, taxes and management bonuses must also be paid from these profits. She suggests that a reduc�on of adver�sing to around $20 million would cause the profit situa�on to improve. The vice-president of marke�ng disagrees; he thinks that a reduc�on in adver�sing to $20 million will cause sales to drop by $10 million and profit to fall to $300,000. He advocates that Silk Purse should increase adver�sing to $30 million, which would increase sales by $8.5 million and generate profits of $4 million. The president, Mr. Hogg, feels that rivals are likely to react to protect their market shares.

a. Construct a payoff matrix and explain the vice-president of finance’s argument to Mr. Hogg. b. Explain the vice-president of marke�ng’s argument to Mr. Hogg. c. What informa�on do you suggest Silk Purse gather before making any decision to change its level of adver�sing?

Key Terms

Click on each key term to see the defini�on.

average quality cost (AQC) (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

The total costs of quality at a par�cular level of quality, divided by the number of units of output subsequently produced and sold.

collusive agreements (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

Illegal agreements, whereby two or more firms agree to set or maintain prices or other strategic variables at par�cular levels, or to change the value of strategic variables simultaneously or at about the same �me.

credence good (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

An experience good for which the quality is both unobservable before purchase, and where the quality is likely to vary from the previous �mes that customers have purchased that product, such that the consumer must give credence (believability) to the quality claims of the seller.

Internet promo�on (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

A form of company adver�sing that includes informa�ve and persuasive material being posted on websites, as well as purchasing Google "ad-words" and paid adver�sements that pop-up when people search for specific informa�on on the Internet.

just-in-case (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

A philosophy of maintaining inventory or another resource at a rela�vely high level in case it is suddenly demanded by consumers or needed by the firm, to avoid losing business due to not being able to supply products to consumers.

just-in-�me (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

An approach to stocking components or finished goods inventories where a firm maintains a rela�vely small supply of these, but is able to supply products quickly when a buyer wants to purchase a given item.

locus of average quality costs (LAQC) (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

A hypothe�cal line joining combina�ons of the average quality cost and the output level, at each profit-maximizing output level, for different quality scenarios.

locus of marginal quality costs (LMQC) (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

A line joining the combina�ons of marginal cost of quality augmenta�on and the output level, at each profit-maximizing output level, for different quality scenarios.

locus of op�mal marginal revenue (LOMR) (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

A line joining the combina�ons of the marginal revenue associated with quality augmenta�on and the output level, at each profit-maximizing output level, for different quality scenarios.

locus of op�mal prices (LOP) (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

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A line joining the profit-maximizing price and output coordinates for different quality scenarios.

marginal-equality condi�on (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

The requirement that the marginal revenue obtained from the adjustment of a strategic variable is just equal to the marginal cost associated with that adjustment.

market research (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

A process where the firm inves�gates the propensity of poten�al consumers to actually purchase the firm’s product, which may include interviews, focus groups, and surveys to es�mate the likelihood that consumers will purchase the product.

price fixing (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

The illegal process of se�ng the price of a service or good in collusion with other firms, and thereby se�ng a higher price than might otherwise occur if the firms behaved compe��vely.

price war (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

A situa�on of aggressive price compe��on where compe�ng firms keep lowering their prices to undercut the prices set by other firms in the market.

prisoner’s dilemma (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

The situa�on where the strategy that maximizes the payoff to an individual or firm actually makes that individual or firm worse off because of the simultaneous choice of the same strategy by other player(s) in the contest, or game.

zero-sum game (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

A rivalrous situa�on where the loser’s damages are of the same absolute magnitude as the winner’s gains, such as the change in market share when two firms compete with each other.