report

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Price The price is determined in the industry by the intersection of market demand and supply. The firm faces a horizontal demand (or average revenue) ‘curve’ at this price. It can sell all it can produce at the market price (Pe). It would sell noth- ing at a price above Pe, however, since competitors would be selling identical products at a lower price.

Output The firm will maximise profit where marginal cost equals marginal revenue (MR = MC), at an output of Qe. Note that, since the price is not affected by the firm’s output, marginal revenue will equal price (see pages 161–2 and Figure 10.1). Thus the firm’s MR ‘curve’ and AR ‘curve’ (= demand ‘curve’) are the same horizontal straight line.

Profit If the average cost (AC) curve (which includes normal profit) dips below the average revenue (AR) ‘curve’, the firm will earn supernormal profit. Supernormal profit per unit at Qe is the vertical difference between AR and AC at Qe. Total supernormal profit is the shaded rectangle in Figure 11.1 (i.e. profit per unit times quantity sold).

What happens if the firm cannot make a profit at any level of output? This situation would occur if the AC curve were above the AR curve at all points. This is illustrated in Figure 11.2 where the market price is P1. In this case, the point where MC = MR represents the loss-minimising point (where loss is defined as anything less than normal profit). This amount of the loss is represented by the shaded rectangle.

Whether the firm is prepared to continue making a loss in the short run or whether it will close down immediately

depends on whether it can cover its variable costs (as we saw in Chapter 10). Provided price is above average variable cost (AVC), the firm will continue producing in the short run: it can pay its variable costs and go some way to paying its fixed costs. It will shut down in the short run only if the market price falls below P2 in Figure 11.2: i.e. when variable costs of production cannot be covered.

The long-run equilibrium of the firm In the long run, if typical firms are making supernormal profits, new firms will be attracted into the industry. Like- wise, if existing firms can make supernormal profits by increasing the scale of their operations, they will do so, since all factors of production are variable in the long run.

The effect of the entry of new firms and/or the expan- sion of existing firms is to increase industry supply, mean- ing that at every price level the quantity produced would be higher. This is illustrated in Figure 11.3.

The industry supply curve shifts to the right. This in turn leads to a fall in price. Supply will go on increasing, and price falling, until firms are making only normal prof- its. This will be when price has fallen to the point where the demand ‘curve’ for the firm just touches the bottom

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Loss minimising under perfect competitionFigure 11.2

P

P2

P1

O

£

O

AR1

AR2

AC1

S

D1D2

Q (millions) Q (thousands)

D2 AR2 = MR2

D1 AR1 = MR1

MC AC

AVC

Qe QQ

(a) (b)

Pause for thought

If the industry under perfect competition faces a down- ward-sloping demand curve, why does an individual firm face a horizontal demand curve?

Pause for thought

Before you read on, can you explain why perfect competition and substantial economies of scale are likely to be incompatible?

Definition

The long run under perfect competition The period of time which is long enough for new firms to enter the industry.

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of its long-run average cost curve. QL is thus the long-run equilibrium output of the firm, with PL the long-run equi- librium price.

Since the LRAC curve is tangential to all possible short- run AC curves (see section 9.5), the full long-run equilib- rium will be as shown in Figure 11.4 where:

LRAC = AC = MC = MR = AR

The incompatibility of perfect competition and substantial economies of scale Why is perfect competition so rare in the real world – if it even exists at all? One important reason for this has to do with economies of scale.

In many industries, firms may have to be quite large if they are to experience the full potential economies of scale. But perfect competition requires there to be many firms. Firms must therefore be small under perfect competition: too small in most cases for them to achieve economies of scale.

Once a firm expands sufficiently to achieve economies of scale, it will usually gain market power. It will be able to undercut the prices of smaller firms, which will thus be driven out of business. Perfect competition is destroyed. Perfect competition could only exist in any industry, there- fore, if there were no (or virtually no) economies of scale.

Does the firm benefit from operating under perfect competition? Under perfect competition the firm faces a constant battle for survival. If it becomes less efficient than other firms, it will make less than normal profits and be driven out of business. If it becomes more efficient, it will earn supernor- mal profits. But these supernormal profits will not last for long. Soon other firms, in order to survive themselves, will be forced to copy the more efficient methods of the new firm. They are able to do this because the perfect knowledge assumption implies that new methods can be copied by all producers.

KI 11 p 59

Long-run equilibrium under perfect competitionFigure 11.3

P

P1 PL

O

£

O

Se S1

(a) Industry (b) Firm

AR1 ARL

D1 DL

LRAC

Q L QQ

D

Long-run equilibrium of the firm under perfect competitionFigure 11.4

£

D AR = MR

(SR)MC

(SR)AC

LRAC

QO

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It is the same with the development of new products. If a firm is able to produce a new product that is popular with consumers, it will be able to gain a temporary advantage over its rivals. But again, any supernormal profits will last only as long as it takes other firms to respond. Soon the increase in supply of the new product will drive the price down and elim- inate these supernormal profits. Similarly, the firm must be quick to copy new products developed by its rivals. If it does not, it will soon make a loss and be driven out of the market.

Thus being in perfect competition is a constant battle for survival. Most firms in such a highly competitive environ- ment would love to be able to gain some market power: power to be able to restrict competition and to retain supernormal profits into the long run. We look at the extreme case of mar- ket power, where the firm has a monopoly, in section 11.3.

Does the consumer benefit from perfect competition? Generally it is argued that competition benefits the consumer, and that the more perfect an industry becomes the better it is for consumers. The argument centres around the question of efficiency. There are three elements to the argument.

■ Price equals marginal cost. Why is this desirable? To answer this, consider what would happen if they were not equal. If price were greater than marginal cost, this would mean that consumers were putting a higher value (P) on the production of extra units than they cost to produce (MC). Therefore more ought to be produced. If price were less than marginal cost, consumers would be putting a lower value on extra units than they cost to produce. Therefore less ought to be produced. When they

are equal, therefore, production levels are just right. But, as we shall see later, it is only under perfect competition that MC = P. This idea of producing just the right amount of the product is referred to as allocative efficiency.

■ The combination of (long-run) production being at min- imum average cost and the firm making only normal profit keeps prices at a minimum.

■ As we have seen, perfect competition is a case of ‘survival of the fittest’. Inefficient firms will be driven out of busi- ness, since they will not be able to make even normal profits. This encourages firms to be as efficient as possible and, where possible, to invest in new improved technol- ogy. This idea of production at minimum cost and of costs being driven down is known as productive efficiency.

However, perfect competition is not always best for the consumer, any more than it is for the firm. We develop the arguments in the next section and in Chapter 12.

Economic efficiency is achieved when each good is produced at the minimum cost and where consumers get maximum benefit from their income.

KEY IDEA

22

Definitions

Allocative efficiency A situation where the current combination of goods produced and sold gives the max- imum satisfaction for each consumer at their current levels of income.

Productive efficiency A situation where firms are producing the maximum output for a given amount of inputs, or producing a given output at the least cost.

What is a monopoly? This may seem a strange question because the answer seems obvious. A monopoly exists when there is only one firm in the industry.

But whether an industry can be classed as a monopoly is not always clear. It depends on how narrowly the indus- try is defined. For example, a textile company may have a monopoly on certain types of fabric, but it does not have a monopoly on fabrics in general. The consumer can buy fab- rics other than those supplied by the company. A rail com- pany may have a monopoly over rail services between two cities, but it does not have a monopoly over public trans- port between these two cities. People can travel by coach or air. They could also use private transport. Consider the blog on the Sloman News Site, which asks Is Amazon a monopolist?1

MONOPOLY11.3

1http://pearsonblog.campaignserver.co.uk/?p=14509 2http://postandparcel.info/62638/news/companies/royal-mails-challenger-tnt- post-uk-to-rebrand-as-whistl/

To some extent, the boundaries of an industry are arbi- trary. What is more important for a firm is the amount of monopoly power it has, and that depends on the close- ness of substitutes produced by rival industries. The Post Office, before 2006, had a monopoly over the delivery of letters, but it still faced competition in communications from telephone, faxes and e-mail. Now, with the ending of the monopoly over the delivery of letters, the Post Office criticises the ‘unfair’ competition it faces from other firms, such as whistl, which delivers mail, packets and parcels, but only in more profitable urban areas. An article from Post and Parcel2 considers this competition to the Royal Mail.

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Definition

Natural monopoly A situation where long-run average costs would be lower if an industry were under monopoly than if it were shared between two or more competitors.

BOX 11.2 E-COMMERCE

A modern form of perfect competition?

The relentless drive towards big business in recent decades has seen many markets become more concentrated and increas- ingly dominated by large producers. However, forces are at work that are undermining this dominance and bringing more competition to markets. One of these forces is e-commerce. In this case study, we will consider just how far e-commerce is returning ‘power to the people’.

Moving markets back towards perfect competition? Let us reconsider three of the assumptions of perfect compe- tition and the impact of e-commerce on them: a large number of firms; freedom of entry; and perfect knowledge.

A large number of firms. With the global reach of the Inter- net, the number of firms in any market has increased. Firms must now compete with others across the world, as consum- ers have access to the global marketplace. They must keep an eye on the prices and products of competitors worldwide and be aware of the continual emergence of new smaller businesses.

Freedom of entry. The Internet has had a key role to play here, reducing the costs of business start-ups. The traditional idea of rented office space, large start-up and fixed costs is no longer the only way to run a business. Small online companies have been created from home, with little more than a com- puter, and many companies are transferring their purchases to the Internet, finding that prices can be significantly cheaper. Marketing costs for small Internet-based companies can be relatively low, especially with powerful search engines, and many of these new online companies are more specialist, relying on interest ‘outsourcing’ (buying parts, equipment and other supplies through the Internet) rather than making everything themselves. They are also more likely to use deliv- ery firms rather than having their own transport fleet. Not only do all the above factors make markets more price competitive, they also bring other benefits. Costs are driven down, as firms economise on stock holding, rely more on outsourcing and develop more efficient relationships with suppliers. ‘Procurement hubs’, online exchanges and trading communities are now well established in many industries. All of these factors have made it relatively cheap for new firms to set up and begin trading over the Internet. Many of these firms are involved in ‘B2C’ (business-to-consumers) e-commerce, where they are selling directly to us as consum- ers. However, many have begun to sell to other firms, known as ‘B2B’ (business-to-business).

One particularly interesting example is eBay and the way in which it has caused a blurring between firms and consumers. Setting up a small business from home is now incredibly easy and, via eBay, consumers can become businesses with just one click. With around 130 million active users worldwide and hundreds of thousands of users running a business via eBay in the UK, buying and selling ‘junk’ has become a viable source of income. Estimates suggest that at any one time, there are over 800 million ‘listings’ on eBay. eBay itself is an example of a business that expanded with the growth of the Internet. Founded in 1995, eBay grew rapidly, reaching half a million users and revenues of $4.7 billion in the USA within three years. In 2014, eBay’s revenue was $17.9 billion, up from $8.7 billion five years earlier. In more recent years it has experienced some difficul- ties from increased competition, as there are many other sites offering similar services. However, eBay’s global reach and volume of customers, courtesy of the Internet, has enabled rapid growth to continue. Although it is just one company, the fact that it has millions of users, acting as businesses, means that it has provided a highly competitive environment. The increase in competition from the rise of e-commerce, in whatever form, has led to firms’ demand curves becom- ing more price elastic. This is especially the case for goods which are cheap to transport or for services, such as travel agents, insurance and banking. While some large firms, such as Amazon, do provide competition for the more traditional firms, the greater freedom of entry for new firms that has been created by the Internet is providing an ever-increasing degree of competition, as more and more small businesses are set up every day. This has also created a more innovative environment, where the quality and range of products is also growing daily.

Perfect knowledge. The Internet has also added to consumer knowledge. There are some obvious ways, such as facts, and figures through sites such as Wikipedia, where to eat, what to read, etc. However, it has also improved consumer knowl- edge through greater transparency. Online shopping agents such as Kelkoo and Google and online comparison sites such as GoCompare and MoneySupermarket can quickly locate a list of alternative suppliers and their prices. There is greater information on product availability, quality and consumer feedback. Virtual shopping malls, full of e-retailers, place the high street retailer under intense competitive pressure. We have seen evidence of this online competition, with the downfall of some well-known high street retailers, such as HMV, Comet, Peacocks and Borders. Although the weak

Barriers to entry For a firm to maintain its monopoly position, there must be barriers to the entry of new firms. Barriers also exist under oligopoly, but in the case of monopoly they must be high enough to block the entry of new firms. Barriers can take various forms.

Economies of scale. If the monopolist’s average costs go on falling significantly up to the output that satisfies the whole

market, the industry may not be able to support more than one producer. This case is known as natural monopoly. This is more likely if the market is small. For example, two

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3http://pearsonblog.campaignserver.co.uk/?p=2573

E-COMMERCE

A modern form of perfect competition?

trading conditions following the economic downturn after 2007 were partly to blame, it has also been the sheer volume of competition these companies face from the Internet. HMV faces steep competition from companies like Amazon, as DVDs, BluRay and CDs can be sold much more cheaply online. LoveFilm and Netflix also provide a new way of watching films. Google shopping allows consumers to compare prices on larger consumer durables such as fridges, cookers and wash- ing machines, and with the large supermarkets offering such items online and price comparisons being so easy, consum- ers are finding bargains on the Internet. These competitive pressures from online retailing certainly added to the woes of Comet and other companies. It is not just the traditional consumer that has benefited from greater knowledge. Many firms are also consumers, purchas- ing inputs from other firms. It is now commonplace for firms to use the Internet to search for cheaper sources of supply. This is even more relevant now that many firms operate in a worldwide marketplace and can source their supplies from across the globe.

1. Give three examples of products that are particularly suitable for selling over the Internet and three that are not. Explain your answer.

2. Before reading ahead, consider your own shopping and buying habits – how much shopping do you do online? What do you think are the limits to e-commerce? Compare your answers with a friend and try to determine the key factors that explain any dif- ferences and what, then, are the limits to e-commerce.

What are the limits to e-commerce? In 20 years, will we be doing all our shopping on the Inter- net? Will the only shopping malls be virtual ones? Although e-commerce is revolutionising some markets, it is unlikely that things will go anything like that far. The benefits of ‘shop shopping’ are that you get to see the good, touch it and use it. You can buy the good there and then, and take instant possession of it: you don’t have to wait. Although you can order things online and get next day delivery, it’s still not quite instant possession. Further- more, shopping is an enjoyable experience. Many people like wandering round the shops, meeting friends, seeing what takes their fancy, trying on clothes, browsing through DVDs, and so on. ‘Retail therapy’ for many is a leisure activity. Many consumers are willing to pay a ‘premium’ for these advantages.

Online shopping is limited by current technology and infra- structure. The quality of Internet access has improved signifi- cantly as broadband has become widely available, but online purchases can still be hampered by busy sites or slow connec- tions. And what if deliveries are late or fail completely? (See Box 6.4.) The busiest time for Internet shopping is in the run-up to Christmas. In 2011 Yodel, the UK’s second largest house- hold delivery company (after the Royal Mail), failed to deliver around 15 000 parcels per day as Christmas approached. 1 Similar problems occurred in 2014, when 10 days before Christmas, Yodel announced that it was no longer collect- ing parcels for delivery due to a backlog (see articles in The Guardian2 and the Mail Online3). Their delivery infrastructure simply could not cope with the increase in demand from online shopping and, clearly, over three years, it had not found a solution. Additionally, online shopping requires access to a credit or debit card, which might not be available to everyone, particu- larly younger consumers and those on low incomes. Also costs might not always be as low as expected. How efficient is it to have many small deliveries of goods? How significant are the lost cost savings from economies of scale that larger producers or retailers are likely to generate? Nevertheless, e-commerce has made many markets, both retail and B2B, more competitive. This is especially so for ser- vices and for goods whose quality is easy to identify online. Many firms are being forced to face up to having their prices determined by the market.

1. Why may the Internet work better for replacement buys than for new purchases?

2. In 2008 eBay sellers called for a boycott of the site, following changes in the fees being charged and the removal of their ability to leave feedback on buyers. Explain how eBay can both increase competition across the economy and simultaneously acquire very substantial monopoly power.

1 ‘Surge in online orders hits deliveries’, Financial Times, 23 December 2011. 2 ‘Yodel warns of parcel backlog as Christmas deliveries face delay’, The Guardian, 12 December 2014. 3 Ben Wilkinson, ‘Delivery firm Yodel’s boss forced into apology after delays mean thousands of customers may not receive parcels in time for Christmas’, Mail Online, 24 December 2014.

bus companies might find it unprofitable to serve the same routes, each running with perhaps only half-full buses, whereas one company with a monopoly of the routes could make a profit. The blog post Fair Fares?3 on the Slo- man News Site considers the bus industry. Electricity trans- mission via a national grid is another example of a natural monopoly.

Even if a market could support more than one firm, a new entrant is unlikely to be able to start up on a very large scale. Thus the monopolist which is already experiencing economies of scale can charge a price below the cost of the new entrant and drive it out of business. If, however, the new entrant is a firm already established in another indus- try, it may be able to survive this competition.

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Economies of scope. These are the benefits in terms of lower average costs of production, because a firm produces a range of products. For example, a large pharmaceutical company producing a range of drugs and toiletries can use shared research, marketing, storage and transport facilities across its range of products. These lower costs make it difficult for a new single-product entrant to the market, since the large firm will be able to undercut its price and drive it out of the market.

Product differentiation and brand loyalty. If a firm produces a clearly differentiated product, where the consumer associ- ates the product with the brand, it will be very difficult for a new firm to break into that market. Rank Xerox invented, and patented, the plain paper photocopier. After this legal monopoly (see below) ran out, people still associated pho- tocopiers with Rank Xerox. It is still not unusual to hear someone say that they are going to ‘Xerox the article’ or, for that matter, ‘Hoover their carpet’. Other examples of strong brand image include Guinness, Kelloggs Cornflakes, Coca- Cola, Nescafé and Sellotape.

Lower costs for an established firm. An established monopoly is likely to have developed specialised production and mar- keting skills. It is more likely to be aware of the most efficient production and marketing techniques and the most relia- ble and/or cheapest suppliers. It is also likely to have access to cheaper finance, as we saw with larger companies in sec- tion 3.3 (see page 40). For these reasons it is likely to be oper- ating on a lower average total cost curve. New firms would therefore find it hard to compete on price, given their higher average costs and would be likely to lose any price war.

Ownership of, or control over, key inputs or outlets. If a firm gov- erns the supply of vital inputs (say, by owning the sole sup- plier of some component part), it can deny access to these inputs to potential rivals. On a world scale, the de Beers company has a monopoly in fine diamonds because all dia- mond producers market their diamonds through de Beers.

Similarly, if a firm controls the outlets through which the product must be sold, it can prevent potential rivals from gaining access to consumers. For example, Wall’s (a division of Unilever) used to supply freezers free to shops on the condition that they stocked only Wall’s ice cream in them. On the Sloman News Site, two blog posts, Making UK energy supply more productive4 and The Big Six: for how much longer?5 show how vertical and horizontal integra- tion act as a barrier to entry in the energy market.

Pause for thought

Illustrate the situation described above using AC curves for both a new entrant and an established firm.

4http://pearsonblog.campaignserver.co.uk/?p=12358 5http://pearsonblog.campaignserver.co.uk/?p=12350

Legal protection. The firm’s monopoly position may be pro- tected by patents on essential processes, by copyright, by various forms of licensing (allowing, say, only one firm to operate in a particular area) and by tariffs (i.e. customs duties) and other trade restrictions to keep out foreign competitors. Examples of monopolies, or near monopolies, protected by patents include most new medicines devel- oped by pharmaceutical companies (e.g. anti-AIDS drugs), Microsoft’s Windows operating systems and agro-chemi- cal companies, such as Monsanto, with various genetically modified plant varieties and pesticides.

While patents do help monopolists to maintain their market power, they are also essential in encouraging new product innovation, as R&D is very expensive. Patents allow firms that engage in R&D to reap the rewards of that investment.

Mergers and takeovers. The monopolist can put in a takeover bid for any new entrant. The sheer threat of takeovers may discourage new entrants.

Retained profits and aggressive tactics. An established monop- olist is likely to have some retained profits behind it. If a new firm enters the market, the established firm could start a price war, mount a massive advertising campaign, offer attractive after-sales service and introduce new brands to compete with the new entrant. Using its retained profits, it can probably sustain losses until the new entrant leaves the market, returning its monopoly status.

Equilibrium price and output Since there is, by definition, only one firm in the industry, the firm’s demand curve is also the industry demand curve.

Compared with other market structures, demand under monopoly will be relatively inelastic at each price. The monopolist can raise its price and consumers have no alternative firm to turn to within the industry. They either pay the higher price, or go without the good altogether.

Unlike the firm under perfect competition, the monop- olist is thus a ‘price maker’. It can choose what price to charge. Nevertheless, it is still constrained by its demand curve. A rise in price will reduce the quantity demanded.

As with firms in other market structures, a monopolist will maximise profit where MR = MC. In Figure 11.5 profit is maximised by producing a quantity of Qm. The supernor- mal profit obtained is shown by the shaded area.

These profits will tend to be larger, the less elastic is the demand curve (and hence the steeper is the MR curve), and thus the bigger is the gap between MR and price (AR). The actual elasticity will depend on whether reasonably close substitutes are available in other industries.

The demand for a rail service will be much less elastic (and the potential for profit greater) if there is no bus service between the same destinations.

Since there are barriers to the entry of new firms, a monopolist’s supernormal profits will not be competed

KI 12 p 68

KI 4 p 25

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away in the long run. The only difference, therefore, between short-run and long-run equilibrium is that in the long run the firm will produce where MR = long-run MC.

Comparing monopoly with perfect competition Because it faces a different type of market environment, the monopolist will produce a quite different output and at a quite different price from a perfectly competitive industry. Let us compare the two.

The monopolist will produce a lower output at a higher price in the short run. Figure 11.6 compares the profit-maxim- ising position for an industry under monopoly with that under perfect competition. Note that we are comparing the monopoly with the whole industry under perfect com- petition. That way we can assume, for the sake of compar- ison, that they both face the same demand curve. We also assume for the moment that they both face the same cost curves.

The monopolist will produce Q1 at a price of P1. This is where MC = MR.

If the same industry were under perfect competition, however, it would produce at Q2 and P2 – a higher output and a lower price. But why? The reason for this is that for each of the firms in the industry – and it is at this level that the decisions are made – marginal revenue is the same as price. Remember that the firm under perfect competition faces a perfectly elastic demand (AR) curve, which also equals MR (see Figure 11.1). Thus producing where MC = MR also means producing where MC = P. When all firms under perfect competition do this, price and quantity in the industry will be given by P2 and Q2 in Figure 11.6.

The monopolist may also produce a lower output at a higher price in the long run. Under perfect competition, freedom of entry

eliminates supernormal profit and forces firms to produce at the bottom of their LRAC curve, keeping long-run prices down. A monopolist, however, because of barriers to entry can continue to earn supernormal profits in the long run and is not forced to operate at the bottom of the AC curve. Thus, other things being equal, long-run prices will tend to be higher, and hence output lower, under monopoly. (In sec- tion 20.2 we examine this in more detail by considering the impact of monopoly on consumer and producer surplus. You might wish to take a preliminary look at pages 343–4 now.)

Costs under monopoly. The sheer survival of a firm in the long run under perfect competition requires that it uses the most efficient known technique, and develops new tech- niques wherever possible. The monopolist, however, shel- tered by barriers to entry, can still make large profits even if it is not using the most efficient technique. It has less incen- tive, therefore, to be efficient.

On the other hand, the monopoly may be able to achieve substantial economies of scale due to larger plant, cen- tralised administration and the avoidance of unnecessary duplication (e.g. a monopoly water company would elimi- nate the need for several sets of rival water mains under each street). If this results in an MC curve substantially below that of the same industry under perfect competition, the monopoly may even produce a higher output at a lower price.

Another reason why a monopolist may operate with lower costs is that it can use part of its supernormal profits for research and development and investment. It may not

KI 21 p 175

Profit maximising under monopolyFigure 11.5

£

MR Q O

AR

AR

AC

AC

Qm

MC

Equilibrium of the industry under perfect competition and monopoly with the same MC curve

Figure 11.6

£

MR

QO

AR = D

Q1 Q2

P1 P2

MC

Pause for thought

If the shares in a monopoly (such as a water company) were very widely distributed among the population, would the shareholders necessarily want the firm to use its monopoly power to make larger profits?

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BOX 11.3 WINDOWS CLEANING

Challenging Microsoft’s monopoly power

America Online. Here Microsoft would promote America Online via Windows. In return, America Online would not promote Netscape’s browsers.

One solution, posed by Federal Judge Thomas Penfield Jack- son in 2000, was that Microsoft be split into two companies to prevent it operating as a monopoly. One would produce and market the Windows operating system; the other would pro- duce and market the applications software, such as Microsoft Office and the web browser, Internet Explorer. This was overturned on appeal in June 2001 and Microsoft agreed to provide technical information about Windows to other companies so that potential rivals could write software that would compete with Microsoft’s own software. Also Microsoft would not be allowed to retaliate against computer manufacturers that installed rival products or removed icons for Microsoft applications.

Microsoft and the European Commission findings It is not only in the US where Microsoft has faced legal action and accusations of abuse of a dominant position. In March 2004 the European Commission fined Microsoft €497 million for an Abuse of a Dominant Position in the operating system market. It found that Microsoft had harmed competition in the media player market by bundling Windows Media Player with its operating system. Further, Microsoft had refused to supply information about its secret software code to suppliers of alternative network software at reasonable rates. Such code was needed to allow non-Win- dows network software to be interoperable with (‘talk’ to) Windows network software. Without it, firms that had purchased Windows Network servers would be solely tied in to Microsoft server software. This, in turn, would discourage the develop- ment of application software products by Microsoft’s rivals. In April 2006, Microsoft launched an appeal against the judg- ment claiming that the EU’s ruling violated international law by forcing the company to share information with rivals. However, the Court of First Instance found in the Commission’s favour. Microsoft complied with the first ruling and unbundled Windows Media Player from its operating systems, much to the annoy- ance of computer suppliers who argued that their customers could easily upload alternative media players from the Web. However, until October 2007 Microsoft continued to charge high royalty rates and fees for interoperability information that would allow competitors to access secret source codes on the Windows Network System. As a result, in February 2008 the Commission penalised Microsoft a further €899 million for non-compliance with its 2004 decision and Microsoft became the first company in 50 years of EU competition policy to be fined for non-compliance with a Commission decision (see

Network effects Microsoft is a vertically integrated firm (see pages 245–8), with a dominant position in the operating system market (i.e. Windows) and in certain application software (Office and Win- dows Media Player) markets. It has built this position by creat- ing networks of users. These networks bring both benefits and costs to society. Network economies arise when consumers of a product benefit from it being used by other consumers. In the case of Micro- soft’s products, firms benefit from lower training costs because individuals who have learnt to use Microsoft products else- where can be readily absorbed into the firm. Individuals ben- efit too because they do not have to learn to use new software when they move to another organisation and the learning costs are fairly low as a new version of the software is introduced. The negative aspect of developing strong networks is that users can get ‘locked in’ to using the software and they become reluctant to switch to alternative systems. Protecting the network is vital to Microsoft’s competitive edge.

An operating system attracts software developed around that operating system, thereby discouraging new competition, since any alternative faces not only the challenge of creating a better operating system but competing against a whole array of already existing software applications. . . . These so-called ‘network effects’ give an incredible anti-competitive edge to companies like Microsoft that control so many different parts of the network.6

It is these negative network effects that have led to Microsoft being under seemingly constant investigation by competition authorities for over two decades. By controlling the Windows operating software, Microsoft attempted to force its own Internet browser, Internet Explorer, on to consumers and com- puter manufacturers and this led to Microsoft being accused of abusing its market power and seeking to crush its rivals.

Microsoft and the US court findings Interest in Microsoft’s practices began in 1991, with a Federal Trade Commission inquiry into its monopoly abuse of the PC operating system market. However, perhaps the most famous investigation began on 18 May 1998, when the US Justice Department alleged that Microsoft had committed the follow- ing anti-competitive actions:

■ In May 1995 Microsoft attempted to collude with Netscape Communications to divide the Internet browser market. Netscape Communications refused.

■ Microsoft had forced personal computer manufacturers to install Internet Explorer in order to obtain a Windows operating licence.

■ Microsoft insisted that PC manufacturers conformed to a Microsoft front screen for Windows. This included specified icons, one of which was Microsoft’s Internet Explorer.

■ It had set up reciprocal advertising arrangements with America’s largest Internet service providers, such as

Definition

Network economies The benefits to consumers of having a network of other people using the same prod- uct or service.6 N. Newman, from ‘MS Word to MS world: how Microsoft is building a global

monopoly’ (1997), www.netaction.org/msoft/world

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WINDOWS CLEANING

Challenging Microsoft’s monopoly power

Further, in an environment where technology is changing rapidly, Microsoft’s control over standards gives the user a measure of stability, knowing that any new products and applications will be compatible with existing ones. In other words, new software can be incorporated into existing sys- tems. In this respect Microsoft can be viewed as operating in society’s interest. Microsoft would argue that it has a right to protect its in-house software code from competitors and receive a fair price for it. Indeed, it is a natural response for a firm to protect its intellectual property rights. Failure to do so could lead to the firm’s demise.

Challenges to Microsoft monopoly Microsoft is facing increasing competitive pressure. The recent challenges from competition authorities (referred to above) have opened up the browser market, for example. Microsoft’s Internet Explorer is no longer the dominant browser; since the mid-2000s its market share has fallen significantly as other browsers have become widely used. In July 2003, it had an 82.7 per cent share of the global browser market; by Quarter 4, 2015, this had fallen to 10.3 per cent for all browsers – third behind Google’s Chrome (52.8 per cent) and Apple’s Safari (12.4 per cent) and only just ahead of Firefox (9.3 per cent) (although Firefox’s share had been as high as 32 per cent in 2009).10

There is also a growing challenge from new Internet firms, such as Google and Facebook. Both Google and Facebook have created enormous networks of users, who are then targeted with tailored adverts paid for by firms who want to reach these vast audiences. This is a very different business model from that of Microsoft and, as part of the desire to create large networks of users, free products are being released that will compete with those of Microsoft. For example, Google’s Google Docs and Apache’s Open Office compete with Microsoft’s Office. These are becom- ing increasingly well known and have growing market shares. Microsoft’s dominance has certainly been tested in many parts of the industry, but its market leading position for its various operating systems is still intact. NetMarketShare and Stat- Counter put Window’s market share (all versions) of the desk- top and laptop markets at just below 90 per cent, with Apple’s operating system making some gains. However, with the rise of tablet computers and smart phones, we are seeing a growing number of competitors, such as Google’s Linux open- source operating system, Android. With the rise of tablets with detachable keyboards that double as a laptop, this sector is likely to see many changes over the coming years.

You might want to follow subsequent events as the news unfolds (see section A of the Hotlinks section of Sloman Economics News site for links to newspaper sites).

1. In what respects might Microsoft’s behaviour be deemed to have been: (a) against the public interest; (b) in the public interest?

2. Being locked in to a product or technology is only a problem if such a product can be clearly shown to be inferior to an alternative. What difficulties might there be in establishing such a case?

the European Commission Press Release).7 Microsoft took the Commission to court in an attempt to overturn the fine, losing its case in 2012, though the fine was reduced to €860 million, following a ‘miscalculation’. This was not the end of Microsoft’s dealings with the European Commission. In 2009 the Commission announced an investi- gation into the bundling of Internet Explorer with Windows. The bundling was thought to be restricting competition in the mar- ket for web browsers.8 Microsoft took the Commission seriously and agreed to remove Explorer from the European versions of Windows 7. To promote competition it offered users an option of downloading one browser from a list of 12, including Mozilla Firefox, Google’s Chrome, Apple’s Safari and Opera. However, it was found that between May 2011 and July 2012, thousands of customers in Europe did not have this choice available and, as such, the European Commission imposed a €561 million fine on Microsoft (see the European Commission Press Release).9

Microsoft has been warned by the Commission about anti-competitive behaviour with its Windows 8 product and has been told that severe penalties will be imposed if it breaks the 2009 bundling agreement. Is Microsoft playing a ‘game’ with the competition authorities – maximising profits by pushing as hard as possible against the legal framework?

Microsoft and the public interest These lawsuits raise an important issue: is Microsoft acting for or against the public interest? The classic case against monopoly suppliers is that they charge higher prices and offer lower quantities to consumers than would be the case under perfect competition. In addi- tion, the supernormal profit that monopolies earn may be detrimental to society if it is used to continue to support the monopoly position, say by lobbying or bribing government officials. Further, if no competition prevails then monopoly suppliers may become more inefficient. However, the competition authorities have never penalised Microsoft simply for possessing monopoly power. It has been fined when it has abused its market power. That is, it is not the monopoly market structure that matters per se to compe- tition authorities; rather, it is the behaviour of the firm when it has monopoly power. Through its actions, Microsoft had raised barriers to entry by restricting the opportunities for potential rival firms to offer alternative products to custom- ers. Choice was thereby restricted. In its defence, Microsoft has argued that it has continually sought to reinvest its profits in new product development and offered a number of innovative solutions over the past 30 years for indi- viduals and businesses alike. (Can you think of all the versions of Windows and the ‘free updates’ there have been?)

7 European Commission, ‘Antitrust: Commission imposes €899 million penalty on Microsoft for non-compliance with March 2004 Decision’, European Commission Press Release IP/08/318, 27 February 2008.

8 See European Commission, ‘Antitrust: Commission confirms sending of a Statement of Objections to Microsoft on the tying of Internet Explorer to Windows Reference’, European Commission Press Release MEMO/09/15, 17 January 2009.

9 European Commission, ‘Commission fines Microsoft for non-compliance with browser choice commitments’, European Commission Press Release IP/13/196, 6 March 2013.

10 For figures on browser usage, see http://en.wikipedia.org/wiki/Usage_share_ of_web_browsers

1 1 . 3 M O N O P O L Y 1 8 7

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1 8 8 C H A P T E R 1 1 P R O F I T M A X I M I S A T I O N U N D E R P E R F E C T C O M P E T I T I O N A N D M O N O P O L Y

Potential competition In recent years, economists have developed the theory of contestable markets. This theory argues that what is crucial in determining price and output is not whether an industry is actually a monopoly or competitive, but whether there is the real threat of competition.

If a monopoly is protected by high barriers to entry – say that it owns all the raw materials – then it will be able to make supernormal profits with no fear of competition.

If, however, another firm could take over from it with lit- tle difficulty, it will behave much more like a competitive firm. The threat of competition has a similar effect to actual competition.

As an example, consider a catering company that is given permission by a factory to run its canteen. The cater- ing company has a monopoly over the supply of food to the workers in that factory. However, if it starts charging high prices or providing a poor service, the factory could

KI 23 p 197

POTENTIAL COMPETITION OR POTENTIAL MONOPOLY? THE THEORY OF CONTESTABLE MARKETS

11.4

have the same incentive to become efficient as the perfectly competitive firm which is fighting for survival, but it may have a much greater ability to become efficient than a small firm with limited funds.

Although a monopoly faces no competition in the goods market, it may face an alternative form of competition in financial markets. A monopoly, with potentially low costs, which is currently run inefficiently, is likely to be subject to a takeover bid from another company. This competition for corporate control may thus force the monopoly to be effi- cient in order to prevent being taken over.

Innovation and new products. The promise of supernormal prof- its, protected perhaps by patents, may encourage the develop- ment of new (monopoly) industries producing new products. It is this chance of making monopoly profits that encourages many people to take the risk of going into business.

BOX 11.4 ‘IT COULD BE YOU’

Bidding for the UK National Lottery

saw the highest annual sales total since 1994, recorded at £6.98 billion, though Camelot said it was boosted by the Olympics. Sales in the 2013/14 financial year were just behind the previous year at £6.7 billion, making it the second highest annual sales total since 1994. Initially sales were looking weak in the 2013/14 financial year, but they were turned around with a controversial decision to double Loto ticket price to £2 in autumn 2013. This created a £245 million boost to sales, as discussed in a Telegraph article.11

The institutional framework There are a number of institutions involved in providing the lottery. The Department of Culture, Media and Sport oversees the lottery as directed by the National Lottery Act and dictates its strategic direction. It appoints the National Lottery Commission (NLC), which ensures that bids for the lottery licence and the running of the lottery games maxim- ise the returns for ‘Good Causes’. There are also a number of distribution bodies that provide lottery funds to thousands of local projects. The main point of contact for lottery buyers is Camelot, which runs the lotto and scratchcard games via retail out- lets, mobile phones, digital television and the Internet.

Since its launch in November 1994, the UK National Lottery has struck at the heart of the British psyche because it offers the opportunity to win a fortune and support worthwhile ven- tures. By the start of 2015, the lottery had created over 3700 millionaires and multi-millionaires, with £53 billion paid out as prizes. However, research by VoucherCodesPro estimated that weekly National Lottery players will lose on average almost £150 over the year. The UK National Lottery also gener- ates an estimated £33 million weekly for ‘Good Causes’, bring- ing the total to £33 billion since 1994 and contributed £2.2 billion to the 2012 London Olympic and Paralympic Games. Around 70 per cent of UK adults play the lottery, spending on average about £3 per week. For the year ending 31 March 2014, for every pound spent on the lottery, approximately 52p was paid in prizes, 26p went to the National Lottery Distribu- tion Fund, which is distributed to arts (20 per cent), sports (20 per cent), health, education, environment and charitable causes (40 per cent) and heritage (20 per cent). A further 12p goes to the government in the form of Lottery Tax, 5p goes to the retailer and 5p goes to Camelot, the operator, and its Canadian parent company, Ontario Teachers’ Pension Plan. Sales of lottery tickets grew dramatically in the early years of operation but waned around the turn of the century. In 2002, a second lottery was launched and this did lead to a recovery in sales and, with the growth of EuroMillions, more people are being encouraged to participate in all lotteries. Sales grew by 12 per cent in the five years to 2012. The 2012/13 financial year

11 Nathalie Thomas, ‘National Lottery sales boosted by £2 ticket price’, The Telegraph, 20 May 2014. ▲

Definitions

Competition for corporate control The competition for the control of companies through takeovers.

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1 1 . 4 P O T E N T I A L C O M P E T I T I O N O R P O T E N T I A L M O N O P O L Y ? T H E T H E O R Y O F C O N T E S T A B L E M A R K E T S 1 8 9

The NLC is responsible for evaluating the bids and awarding the licence. There were seven bidders for the first licence but for the second licence there were only two tabled ‘bids’, one from Camelot and other from Sir Richard Branson’s The People’s Lottery (and initially the NLC rejected both before settling on the incumbent). For the third licence, the NLC tried to encourage as many bids as possible to come forward. Only one other bidder, Sugal and Dumani UK Ltd, submitted a bid. Camelot won because the NLC believed that, at a similar level of sales, they would be slightly more generous to ‘Good Causes’ and that ‘there was a higher probability that they would achieve higher sales over the length of the licence’.13

Clearly, incumbent firms like Camelot have considerable advantages over potential rivals when contracts have to be renewed and thus the number of new bidders is likely to be low. Two problems, in particular, stand out for rivals.

The ‘Winner’s Curse’ If a potential entrant outbids the incumbent in an auction to run (say) a local bus service, then it could be that winner has paid too much. After all, the incumbent has more knowl- edge about running the bus service and the likely revenues that may prevail. This situation is known as the ‘Winner’s Curse’ and a similar scenario may occur in respect of the lot- tery. Potential bidders may be put off bidding because they don’t have the same knowledge about the UK lottery market. Arguably, the lottery market might be considered a mature market and more is now known about lottery sales and the gaming market in general. However, there are strong incen- tives for risk-averse regulators to continue with accepting bids from incumbent firms because they are known to provide a certain level of sales and service.

The handover problem If Camelot were to lose the lottery licence, there would be some large risks in transferring to the new bidder. Arguably, Camelot could sell its infrastructure to the new lottery pro- vider, but there is a valuation dilemma. In terms of oppor- tunity cost, Camelot would value the infrastructure at scrap value (if it has no alternative use for it), whereas a winner with no alternative source for such infrastructure would value Camelot’s assets at close to their replacement value. This could lead to some difficult negotiations. Because of this difficulty, the NLC did require bidders for the third lottery licence to provide new infrastructure, but recog- nised that this would take time to have in place (imagine trying to replace 30 000 retail terminals as well as to make online, tel- evision and mobile games work well). Given this difficulty, it is not surprising that there was only one rival bidder to Camelot.

Camelot managed to achieve a first-mover advantage (see page 209) by winning the initial lottery licence in 1994. It is now to continue providing the UK National Lottery until 2023 and so will have been sole monopoly provider for 29 years. Removing Camelot after that date could prove to be difficult.

1. If Camelot is maximising revenue, what is the price elasticity of demand for lottery tickets?

2. To what extent is the National Lottery market a contestable market?

Camelot won the first, second and third licences for the right to run the UK National Lottery from 1994, 2002 and 2009 respectively. Camelot’s extended third-term licence will expire in 2023.

The rationale for a monopoly supplier Camelot is a monopoly supplier of the UK National Lottery, although it need not be so. The legislation currently allows for two licences, one to operate the infrastructure and another to run the games. It is possible for other companies to run games on the computer network owned by Camelot, much in the same way that Network Rail owns the railway tracks, tun- nels, etc. and allows competition between firms on particular routes on the network. Indeed, this option was briefly under- taken by Camelot in 1998, when Vernons Pools sold its ‘Easy Play’ game using the National Lottery retailer network. Its sales, though, were poor and it was scrapped in May 1999. However, the government has a strong preference for a single owner of the infrastructure and a single supplier of National Lottery games. The rationale for having a single owner of the infrastructure is fairly standard; this is a natural monopoly and it would be pointless having two lottery computer net- works, just as it would be having two separately owned rail lines from Edinburgh to London. With one firm controlling the infrastructure, economies of scale can be reaped. One of the arguments for having a single supplier of games is known, rather bizarrely, as ‘peculiar economies of scale’.12 This is a situation in which a company that offered a portfolio of innovative lottery games would be more likely to induce addi- tional players to participate in games because they can raise the size of the prize to be won. In other words, good game design can lead to more and bigger jackpots and thus more people buying lottery tickets. This reduces the average costs of supplying tickets and increases the money for ‘Good Causes’. Arguably, more than one firm may be able to supply an innovative portfolio of games if the market is large enough. However, the government is concerned about the risks involved in regulating relationships between network owners and network users (a problem that has occurred in regulating the railways – see Box 22.4). For example, there might be a lengthy legal dispute if a supplier of games is accused of unacceptable performance but it, in turn, accuses the network owner of poor service. This would then have a detrimental effect on the money raised for ‘Good Causes’. Thus the gov- ernment has always preferred a single-firm framework for running the National Lottery.

Bidding for the National Lottery monopoly Unlike auctions to run national rail franchises or a local bus route, bidding for the lottery does not involve any payment on the part of the successful bidder. The bid is purely a detailed business plan outlining all aspects of running the lottery, but its main emphasis is on providing likely revenue scenarios from games that would maximise money for ‘Good Causes’ and safeguard players. It was the uncertainty over future revenue flows that led the government in 1994 to require a paper-based bidding scheme for the first lottery licence. This view did not change when subsequent licences came up for renewal.

13 NLC press release, ‘Preferred bidder announced for the third National Lottery licence’, 7 August 2007.

12See, for example, P. Daffern, ‘Assessment of the effects of competition on the National Lottery’, Technical Paper No. 6, Department of Culture, Media and Sport, 2006.

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1 9 0 C H A P T E R 1 1 P R O F I T M A X I M I S A T I O N U N D E R P E R F E C T C O M P E T I T I O N A N D M O N O P O L Y

offer the running of the canteen to an alternative catering company. This threat may force the original catering com- pany to charge ‘reasonable’ prices and offer a good service.

Perfectly contestable markets A market is perfectly contestable when the costs of entry and exit by potential rivals are zero, and when such entry can be made very rapidly. In such cases, the moment the possibility of earning supernormal profits occurs, new firms will enter, thus driving profits down to a normal level. The sheer threat of this happening, so the theory goes, will ensure that the firm already in the market will (a) keep its prices down, so that it just makes normal profits, and (b) produce as efficiently as possible, taking advantage of any economies of scale and any new technology. If the existing firm did not do this, entry would take place and potential competition would become actual competition.

Contestable markets and natural monopolies So why in such cases are the markets not actually perfectly competitive? Why do they remain monopolies?

The most likely reason has to do with economies of scale and the size of the market. To operate at the minimum efficient scale, the firm may have to be so large relative to the market that there is only room for one such firm in the industry. If a new firm does come into the market, then one firm will not survive the competition. The market is simply not big enough for both of them.

If, however, there are no entry or exit costs, new firms will be perfectly willing to enter even though there is only room for one firm, provided they believe that they are more efficient than the existing firm. The existing firm, knowing this, will be forced to produce as efficiently as possible and with only normal profit.

The importance of costless exit Setting up in a new business usually involves large expendi- tures on plant and machinery. Once this money has been spent, it becomes part of the fixed costs. If these fixed costs are no higher than those of the existing firm, then the new firm could win the battle. But, of course, there is always the risk that it might lose.

But does losing the battle really matter? Can the firm not simply move to another market?

It does matter if there are substantial costs of exit. This will be the case if the capital equipment cannot be trans- ferred to other uses. In this case these fixed costs are known as sunk costs. The losing firm will exit the industry, but is left with capital equipment that it cannot use and this may deter the firm from entering in the first place. The market is not perfectly contestable, and the established firm can make supernormal profit.

If, however, the capital equipment can be transferred, the exit costs are zero (or at least very low), and new firms will be

more willing to risk entering the market. For example, a rival coach company may open up a service on a route previously operated by only one company, and where there is still only room for one operator. If the new firm loses the resulting bat- tle, it can still use the coaches it has purchased. It simply uses them for a different route or sells them for a fair price on the second-hand market. The cost of the coaches is not a sunk cost.

Costless exit, therefore, encourages firms to enter an industry, knowing that, if unsuccessful, they can always transfer their capital elsewhere.

The lower the exit costs, the more contestable the mar- ket. This implies that firms already established in other similar markets may provide more effective competition against monopolists, since they can simply transfer capital from one market to another. For example, studies of air- lines in the USA show that entry to a particular route may be much easier for an established airline, which can simply transfer planes from one route to another.

Assessment of the theory Simple monopoly theory merely focuses on the exist- ing structure of the industry and makes no allowance for potential competition. The theory of contestable markets, however, goes much further and examines the size of entry barriers and exit costs. The bigger these are, the less con- testable the market and therefore the greater the monop- oly power of the existing firm. Various attempts have been made to measure monopoly power in this way.

One criticism of the theory, however, is that it does not take sufficient account of the possible reactions of the estab- lished firm. Entry and exist may be costless (i.e. a perfectly contestable market), but the established firm may let it be known that any firm that dares to enter will face all-out war, thus deterring new entrants! In the meantime, the established firm may charge high prices and make supernormal profits.

If a monopoly operates in a perfectly contestable market, it might bring the ‘best of both worlds’ for the consumer. Not only will it be able to achieve low costs through econ- omies of scale, but also the potential competition will keep profits and hence prices down.

KI 18 p 141

Pause for thought

Think of two examples of highly contestable monopolies (or oligopolies). How well is the consumer’s interest served?

Definitions

Perfectly contestable market A market where there is free and costless entry and exit.

Sunk costs Costs that cannot be recouped (e.g. by trans- ferring assets to other uses).

SUMMARY

1a There are four alternative market structures under which firms operate. In ascending order of firms’ market power, they are: perfect competition, monopolistic competition, oligopoly and monopoly.

1b The market structure under which a firm operates will affect its conduct and its performance.

2a The assumptions of perfect competition are: a very large number of firms, complete freedom of entry, a ▲

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R E V I E W Q U E S T I O N S 1 9 1

REVIEW QUESTIONS

1 Why do economists treat normal profit as a cost of pro- duction? What determines (a) the level and (b) the rate of normal profit for a particular firm?

2 Why is perfect competition so rare? 3 Why does the market for fresh vegetables approximate

to perfect competition, whereas that for frozen or tinned ones does not?

4 Illustrate on a diagram similar to Figure 11.3 what would happen in the long run if price were initially below P

L .

5 We discussed e-commerce in Box 11.2, but are there any other examples of the impact of technological develop- ment on the competitiveness of markets or on meeting specific assumptions of perfect competition?

6 As an illustration of the difficulty in identifying monopo- lies, try to decide which of the following are monopolies: a train-operating company; your local evening newspa- per; British Gas; the village post office; the Royal Mail; Interflora; the London Underground; ice creams in the cinema; Guinness; food on trains; TippEx; the board game ‘Monopoly’.

7 Try this brain teaser. A monopoly would be expected to face an inelastic demand. After all, there are no direct substitutes. And yet if it produces where MR = MC, MR must be positive, demand must therefore be elastic. Therefore the monopolist must face an elastic demand! Can you solve this conundrum?

8 For what reasons would you expect a monopoly to charge (a) a higher price and (b) a lower price than if the indus- try were operating under perfect competition?

9 ‘The outcomes of perfect competition are always good, whereas monopolies are always bad.’ Discuss this statement.

10 In which of the following industries are exit costs likely to be low: (a) steel production; (b) market gardening; (c) nuclear power generation; (d) specialist financial advisory services; (e) production of fashion dolls; (f) production of a new drug; (g) contract catering; (h) mobile discos; (i) car ferry operators? Are these exit costs dependent on how narrowly the industry is defined?

11 Think of three examples of monopolies (local or national) and consider how contestable their markets are.

MyEconLab This book can be supported by MyEconLab, which contains a range of additional resources, including an online homework and tutorial system designed to test and build your understanding. You need both an access card and a course ID to access MyEconLab: 1. Is your lecturer using MyEconLab? Ask your lecturer for your course ID. 2. Has an access card been included with the book at a reduced cost? Check the inside back cover of the book. 3. If you have a course ID but no access card, go to: http://www.myeconlab.com/ to buy access to this interactive study

programme.

homogeneous product and perfect knowledge of the good and its market by both producers and consumers.

2b In the short run of perfect competition, there is not time for new firms to enter the market, and thus supernormal profits can persist. In the long run, however, any super- normal profits will be competed away by the entry of new firms.

2c The short-run equilibrium for the firm under perfect competition will be where the price, as determined by demand and supply in the market, is equal to marginal cost. At this output the firm will be maximising profit.

2d The long-run equilibrium in a perfectly competitive mar- ket will be where the market price is just equal to firms’ long-run average cost.

2e There are no substantial economies of scale to be gained in a perfectly competitive industry. If there were, the industry would cease to be perfectly competitive as the large, low- cost firms drove the small, high-cost ones out of business.

3a A monopoly is where there is only one firm in an industry. In practice, it is difficult to determine where a monopoly exists because it depends on how narrowly an industry is defined.

3b Barriers to the entry of new firms will normally be neces- sary to protect a monopoly from competition. Such barri- ers include economies of scale (making the firm a natural monopoly or at least giving it a cost advantage over new

(small) competitors), control over supplies of inputs or over outlets, patents or copyright, and tactics to eliminate competition (such as takeovers or aggressive advertising).

3c Profits for the monopolist (as for other firms) will be maximised where MC = MR.

3d If demand and cost curves are the same in a monopoly and a perfectly competitive industry, the monopoly will produce a lower output and at a higher price than the perfectly competitive industry.

3e On the other hand, any economies of scale will in part be passed on to consumers in lower prices, and the monop- olist’s high profits may be used for research and devel- opment and investment, which in turn may lead to better products at possibly lower prices.

4a Potential competition may be as important as actual com- petition in determining a firm’s price and output strategy.

4b The greater the threat of this competition, the lower are the entry and exit costs to and from the industry. If the entry and exit costs are zero, the market is said to be per- fectly contestable. Under such circumstances, an existing monopolist will be forced to keep its profits down to the normal level if it is to resist entry of new firms. The lower the exit costs, the lower are the sunk costs of the firm.

4c The theory of contestable markets provides a more real- istic analysis of firms’ behaviour than theories based simply on the existing number of firms in the industry.

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Profit maximisation under imperfect competition

Business issues covered in this chapter

■ How will firms behave under monopolistic competition (i.e. where there are many firms competing, but where they produce differentiated products)?

■ Why will firms under monopolistic competition make only normal profits in the long run? ■ How are firms likely to behave when there are just a few of them competing (‘oligopolies’)? ■ What determines whether oligopolies will engage in all-out competition or instead collude with each other? ■ What strategic ‘games’ are oligopolists likely to play in their attempt to out-do their rivals? ■ Why might such games lead to an outcome where all the players are worse off than if they had colluded? ■ Does oligopoly serve the consumer’s interests?

Very few markets in practice can be classified as perfectly competitive or as a pure monopoly. The vast majority of firms do compete with other firms, often quite aggressively, and yet they are not price takers: they do have some degree of market power. Most markets, therefore, lie between the two extremes of monopoly and perfect competi- tion, in the realm of ‘imperfect competition’. There are two types of imperfect competition: namely, monopolistic competition and oligopoly (see section 11.1).

MONOPOLISTIC COMPETITION 12.1

Monopolistic competition is towards the competitive end of the spectrum (as we saw in section 11.1). It can best be understood as a situation where there are a lot of firms competing, but where each firm does nevertheless have some degree of market power (hence the term ‘monopolis- tic’ competition): each firm has some discretion as to what price to charge for its products because they are differenti- ated from those of other firms.

Assumptions of monopolistic competition ■ There is quite a large number of firms . As a result, each firm has

only a small share of the market and, therefore, its actions are unlikely to affect its rivals to any great extent. This means that when a firm makes its decisions, it will not have to worry about how its rivals will react. It assumes that what its rivals choose to do will not be influenced by what it does.

12

C h

a p

te r

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This is known as the assumption of independence. As we shall see later, this is not the case under oligopoly.

■ There is freedom of entry of new firms into the industry. If any firm wants to set up in business in this market, it is free to do so.

In these two respects, therefore, monopolistic competi- tion is like perfect competition.

■ Unlike perfect competition, however, each firm produces a product or provides a service that is in some way differ- ent from its rivals. As a result, it can raise its price without losing all its customers. Thus its demand curve is down- ward sloping, albeit relatively elastic given the large num- ber of competitors to which customers can turn. This is known as the assumption of product differentiation.

Petrol stations, restaurants, hairdressers and builders are all examples of monopolistic competition – as is the case of busking, which is discussed on the Freakonomics blog.1

When considering monopolistic competition it is impor- tant to take account of the distance consumers are willing to travel to buy a product. In other words, the geographical size of the market matters. For example, McDonald’s is a major global and national fast-food restaurant. However, in any one location it experiences intense competition in the ‘informal eating-out’ market from Indian, Chinese, Italian and other res- taurants (see Box 12.1). So in any one local area, there is com- petition between firms each offering differentiated products.

Equilibrium of the firm under monopolistic competition: (a) short run; (b) long runFigure 12.1

£

Ps

ACs

Qs MR

(a)

AR D

O

MC AC

£

PL

QL MRL (b)

ARL DL

O

LRMC LRAC

Quantity Quantity

1http://freakonomics.com/2012/05/21/the-economics-of-busking/

Definitions

Independence (of firms in a market) When the deci- sions of one firm in a market will not have any significant effect on the demand curves of its rivals.

Product differentiation When one firm’s product is suf- ficiently different from its rivals’, it can raise the price of the product without customers all switching to the rivals’ prod- ucts. This gives a firm a downward-sloping demand curve.

Equilibrium of the firm Short run As with other market structures, profits are maximised at the output where MC = MR. The diagram will be the same as for the monopolist, except that the AR and MR curves will be more elastic. This is illustrated in Figure 12.1(a). As with perfect competition, it is possible for the monopolis- tically competitive firm to make supernormal profit in the short run. This is shown as the shaded area.

Just how much profit the firm will make in the short run depends on the strength of demand: the position and elasticity of the demand curve. The further to the right the demand curve is relative to the average cost curve, and the less elastic the demand curve is, the greater will be the firm’s short-run profit. Thus a firm facing little competition and whose product is considerably differentiated from its rivals may be able to earn significant short-run profits.

KI 4 p 25

KI 12 p 68

Pause for thought

Which of these two items is a petrol station more likely to sell at a discount: (a) engine oil; (b) sweets? Why?

Long run If typical firms are earning supernormal profit, new firms will enter the industry in the long run. As new firms enter, they will take some of the customers away from established firms. The demand for the established firms’ products will therefore fall. Their demand (AR) curve will shift to the left, and will continue doing so as long as supernormal profits remain and thus new firms continue entering.

Long-run equilibrium will be reached when only normal profits remain: when there is no further incentive for new firms to enter. This is illustrated in Figure 12.1(b). The firm’s demand curve settles at DL, where it is tangential to (i.e. just touches) the firm’s LRAC curve. Output will be QL: where ARL = LRAC. (At any other output, LRAC is greater than AR and thus less than normal profit would be made.)

KI 10 p 52

KI 11 p 59

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It is important to note that there is a difference between the transition from the short run to the long run under perfect competition and monopolistic competition, even though the long-run equilibrium of normal profits for the firm is the same in both market structures.

■ Under perfect competition, when new firms enter (or leave) the market, it is the industry supply curve that shifts, which changes the market price and leaves just normal profits.

■ Under monopolistic competition, however, the entry of new firms is reflected by shifting an established firm’s demand curve inwards and this eliminates the supernor- mal profits.

As all firms under monopolistic competition are produc- ing a slightly differentiated product, each firm is different

and hence we cannot create an industry demand or supply curve. Instead, we have to focus on the effect on a given firm when new firms enter the market. This can be seen as a limitation of the model, as we discuss next.

Limitations of the model There are various problems in applying the model of monopolistic competition to the real world:

■ Information may be imperfect. Firms will not enter an industry if they are unaware of the supernormal profits currently being made, or if they underestimate the demand for the particular product they are considering selling.

■ Firms are likely to differ from each other, not only in the product they produce or the service they offer, but also

BOX 12.1 EATING OUT IN BRITAIN

A monopolistically competitive sector

The ‘eating-out’ sector (i.e. takeaways, cafés, restaurants and pubs) is a highly competitive market in the UK, with sales, in 2012, of some £77 billion, according to the Office for National Statistics.2 The sector has grown less strongly in recent years than in the late 1990s and early 2000s. The financial crisis and subsequent recession had an impact on sales in this sec- tor and, according to a PwC discussion document,3 from 2007 to 2011, the average growth in sales revenue was just 2.1 per cent – not enough to keep up with inflation (which averaged 3.1 per cent over the period). However, according to the Cof- fer Peach Business Tracker,4 January 2015 recorded the 22nd consecutive month of positive like-for-like growth in sales based on its sample. The sector exhibits many of the characteristics of a monopo- listically competitive market.

■ Large number of local buyers. According to a Mintel survey in 2011, around 94 per cent of UK adults had eaten out within the previous three months; and in 2014, Ernst and Young found that 31 per cent of UK consumers would eat out at least once a week, up from 17 per cent in 2011.5 According to PwC, there ‘has been a structural shift over the last c. 20 years’ and ‘eating out has become embedded in UK consumer behaviour’.6

■ Large number of firms. Research from Horizons indicates that there are 23 514 restaurants and 49 953 pubs in the UK.7 This means that in many areas there are a significant number of competing places to eat and hence consumer choice. In the cases of both restaurants and pubs, there are more independent companies than those belonging to a group – again providing significant choice.

■ Competitive prices. Margins are very tight because firms have to price very competitively to catch local custom. Only around 60 per cent of these businesses survive longer than three years.

■ Differentiated products. To attract customers, suppliers must each differentiate their product in various ways, such as food type, ambience, comfort, service, quality,

advertising and opening hours. Firms have to cater for the dynamic nature of consumer preferences and respond to the behaviour of competitors. They must constantly adapt or go under.

Casual dining One area that has out-performed traditional restaurants and pubs has been casual dining, which includes street food, cof- fee shops and fast-food outlets. Worth £4 billion of the total eating-out sector, this area grew by 11.6 per cent in the five years to March 2014.8 This translates to 47 million more visits to these places in 2014 than in 2009. It has also proved much more resilient to the economic downturn. The growth has been driven by both demand- and supply-side factors. The report by PwC cited above found that casual din- ing places provide greater affordability for consumers. This in turn has been driving a change in tastes, with people seeing eating out as a habit and not just a special treat; they would often stop to refuel rather than have a three-course meal. But this means that, while more people are eating out, the aver- age spend on each visit tends to be falling. Another part of the casual dining sector is the sandwich and lunchtime food outlets. These too have undergone significant growth. As lunch is seen by many as a refuelling exercise rather than a leisure activity, the convenience, fast service and value for money provided by many of these new casual dining places is a key factor behind this sector’s growth.

2Input-Output Supply and Use Tables, ONS, 2014. 3UK Casual Dining Market: Discussion Document, PwC, December 2013. 4Coffer Peach Business Tracker, CGA Peach, February 2015. 5Restaurant and Casual Dining Insight Report, Ernst and Young, September 2014. 6UK Casual Dining Market, PwC 7Insight Report, Ernst and Young, p. 5. 8Ibid., based on data from NPD group.

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in their size and in their cost structure. What is more, entry may not be completely unrestricted. For exam- ple, two petrol stations could not set up in exactly the same place – on a busy crossroads, say – because of local authority planning controls. Thus although the typical or ‘representative’ firm may only earn normal profit in the long run, other firms may be able to earn long-run supernormal profit. They may have some cost advan- tage or produce a product that is impossible to duplicate perfectly.

■ Existing firms may make supernormal profits, but if a new firm entered, this might reduce everyone’s profits below the normal level. Thus a new firm will not enter and supernormal profits will persist into the long run. An example would be a small town with two chemist shops. They may both make more than enough profit

to persuade them to stay in business. But if a third set up (say midway between the other two), there would not be enough total sales to allow them all to earn even normal profit. This is a problem of indivis- ibilities. Given the overheads of a chemist shop, it is not possible to set up one small enough to take away just enough customers to leave the other two with normal profits.

■ One of the biggest problems with the simple model out- lined above is that it concentrates on price and output decisions. In practice, the profit-maximising firm under monopolistic competition will also need to decide the exact variety of product to produce, and how much to spend on advertising it. This will lead the firm to take part in non-price competition (which we examined in Chapter 8).

EATING OUT IN BRITAIN

Indeed, Mintel found that only 3 per cent of those purchasing weekday lunches found the time to sit down in a restaurant, café or bar. But many customers still place importance on value-added and are willing to pay a premium to have sand- wiches made in front of them, perceiving this as providing them with greater choice and a fresher final product.

Chain restaurants Another factor behind the growth in eating out has been the expansion of many chain restaurants, such as Pizza Express, Nandos, Carluccio’s and Wagamama. While they differ from each other, and thus offer consumers greater choice and constant innovation, they offer a common menu within each chain and sometimes loyalty programmes for repeat diners. This product differentiation with clear product characteristics is a key characteristic of monopolistically competitive markets, where prices can vary but the market is still highly competitive.

The Internet As with many other areas, the Internet has had a big influence on the eating-out sector. The use of social media has created a new way for restaurants and casual dining places to adver- tise. This has meant that sole traders, starting out with a van selling street food, can now compete with the bigger chains. By marketing through social media, they can reach any cus- tomer with a smartphone or anyone who accesses sites such as Twitter and Facebook. This has therefore reduced barriers to entry, creating an even more competitive market, with growing consumer choice. Consumers post reviews of dining experiences or will post a comment about a great meal they just ate. In addition, more and more people take photos of what they eat, posting them online and encouraging others to try out a new place. Accord- ing to the Ernst and Young report cited above, research pub- lished on eMarketer in April 2014 showed that photos of food or meals received the most engagement on Facebook. As the saying goes: ‘A picture is worth a thousand words’.

Another development in the take-out industry has been the emergence of companies such as Hungry House. Co-founded in 2003 and launched in 2006, it allows households to enter their postcode online and then search through sometimes hundreds of restaurants and local take-aways to pick out exactly what they want. These orders are then delivered to your door. This is another innovation where an online plat- form is bringing eating outlets into direct competition with each other and making it easier for consumers to eat out. With different types of food going in and out of fashion, this allows consumers to have access to almost any type of food they could want and perhaps provides some of the smaller companies with another opportunity to break into this highly competitive market.

It seems inevitable that the eating-out sector will continue to grow over the next decade and it will be interesting to see the innovations and trends that occur. Simon Stenning, strategy director at Allegra Foodservice, said:

The growth will be hard fought for in an increasingly competitive trading environment and gains will be patchy across the market. The onus on operators will remain innovating on product, refining menu price architectures and adding greater value across the consumer experience to build stronger customer loyalty.9

1. What are the main barriers to entry in the eating-out sector?

2. What can be said about the price elasticity and cross-price elasticity of demand for meals at pubs/restaurants/hotels/ casual dining places?

3. What are the main reasons for the growth in the popularity of eating out and the switch towards casual dining?

9 Owen McKeon, ‘Street Food set to boost UK’s eating out sector’, Evolve, www.evolvehospitality.co.uk/evolve-hospitality-news-detail/street-food-set-to- boost-uk-s-eating-out-sector/159

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Comparing monopolistic competition with perfect competition and monopoly Comparison with perfect competition It is often argued that monopolistic competition leads to a less efficient allocation of resources than perfect competition.

Figure 12.2 compares the long-run equilibrium positions for two firms. One firm is under perfect competition and thus faces a horizontal demand curve. It will produce an output of Q1 at a price of P1. The other is under monopolistic competition and thus faces a downward-sloping demand curve. It will produce the lower output of Q2 at the higher price of P2. A crucial assumption here is that a firm would have the same long-run average cost (LRAC) curve in both cases. Given this assumption, we can make the following two predictions about monopolistic competition:

■ Less will be sold and at a higher price. ■ Firms will not be producing at the least-cost point.

By producing more, firms would move to a lower point on their LRAC curve. Thus firms under monopolistic com- petition are said to have excess capacity. In Figure 12.2 this excess capacity is shown as Q1 - Q2. In other words, monopolistic competition is typified by quite a large number of firms (e.g. petrol stations), all operating at less

KI 12 p 68

Long-run equilibrium of the firm under perfect and monopolistic competition

Figure 12.2

£

P2 P1

Q2 Q1

LRAC

O

DL under monopolistic competition

DL under perfect competition

Q

Pause for thought

Which would you rather have: five restaurants to choose from, each with very different menus and each having spare tables so that you could always guarantee getting one; or just two restaurants to choose from, charging a bit less but with less choice and making it necessary to book well in advance?

than optimum output, and thus being forced to charge a price above that which they could charge if they had a bigger turnover.

Definition

Excess capacity (under monopolistic competition) In the long run, firms under monopolistic competition will produce at an output below that which minimises average cost per unit.

S o h o w d o e s t h i s a f f e c t t h e c o n s u m e r ? A l t h o u g h the firm under monopolistic competition may charge a higher price than under perfect competition, the dif- ference may be very small. Although the firm’s demand curve is downward sloping, it is still likely to be highly elastic due to the large number of substitutes. Further- more, the consumer may benefit from monopolistic com- petition by having a greater variety of products to choose from. Each firm may satisfy some particular requirement of particular consumers.

Comparison with monopoly The arguments are very similar here to those when compar- ing perfect competition and monopoly.

On the one hand, freedom of entry for new firms and hence the lack of long-run supernormal profits under monopolistic competition are likely to help keep prices down for the consumer and encourage cost saving. On the other hand, monopolies are likely to achieve greater econ- omies of scale and have more funds for investment and research and development.

OLIGOPOLY12.2

Oligopoly occurs when just a few firms between them share a large proportion of the industry. Some of the best-known companies are oligopolists, including Ford, Coca-Cola, BP and Nintendo. On the Sloman News Site, you will find many blogs written about different oligopolies and it is both useful and interesting to compare the outcomes. Some examples of powerful oligopolies include toothbrush manufacturers, supermarkets and energy.

There are, however, significant differences in the struc- ture of industries under oligopoly, and similarly significant differences in the behaviour of firms. The firms may pro- duce a virtually identical product (e.g. metals, chemicals, sugar, petrol). Most oligopolists, however, produce differ- entiated products (e.g. cars, soap powder, soft drinks, elec- trical appliances). Much of the competition between such oligopolists is in terms of the marketing of their particular

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brand. Marketing practices may differ considerably from one industry to another.

The two key features of oligopoly Despite the differences between oligopolies, there are two crucial features that are common to oligopolies, one of which distinguishes oligopoly from other market structures.

Barriers to entry Unlike firms under monopolistic competition, there are various barriers to the entry of new firms. These are simi- lar to those under monopoly (see pages 182–4). The size of the barriers, however, will vary from industry to industry. In some cases entry is relatively easy, whereas in others it is virtually impossible, perhaps due to patent protection or prohibitive research and development costs.

Interdependence of the firms Because there are only a few firms under oligopoly, each firm will take account of the behaviour of the others when making its own decisions. This means that they are mutu- ally dependent: they are interdependent. Each firm is affected by its rivals’ actions. If a firm changes the price or specification of its product, for example, or the amount of its advertising, the sales of its rivals will be affected.

The rivals may then respond by changing their price, specification or advertising. No firm can therefore afford to ignore the actions and reactions of other firms in the indus- try and must always consider its rival’s behaviour before making any decisions. It is this feature that differentiates oligopolies from the other market structures. It is illustrated in the blog post Pizza price wars.

KI 1 p 10

People often think and behave strategically. How you think others will respond to your actions is likely to influence your own behaviour. Firms, for example, when considering a price or product change will often take into account the likely reactions of their rivals.

KEY IDEA

23

Definitions

Interdependence (under oligopoly) This is one of the two key features of oligopoly. Each firm is affected by its rivals’ decisions and its decisions will affect its rivals. Firms recognise this interdependence and take it into account when making decisions.

Collusive oligopoly When oligopolists agree, formally or informally, to limit competition between themselves. They may set output quotas, fix prices, limit product promotion or development, or agree not to ‘poach’ each other’s markets.

Non-collusive oligopoly When oligopolists have no agreement between themselves – formal, informal or tacit.

It is impossible, therefore, to predict the effect on a firm’s sales of, say, a change in its price without first mak- ing some assumption about the reactions of other firms. Different assumptions will yield different predictions. For this reason there is no single, generally accepted theory of oligopoly and no common response to a given market situ- ation in terms of prices, output and profits. Firms may react differently and unpredictably.

Competition and collusion Oligopolists are pulled in two different directions:

■ The interdependence of firms may make them wish to collude with each other. If they can club together and act as if they were a monopoly, they could jointly maximise industry profits.

■ On the other hand, they will be tempted to compete with their rivals to gain a bigger share of industry profits for themselves.

These two policies are incompatible. The more fiercely firms compete to gain a bigger share of industry profits, the smaller these industry profits will become! For example, price competition drives down the average industry price, while competition through advertising raises industry costs. Either way, industry profits fall.

Sometimes firms will collude. Sometimes they will not. The following sections examine first collusive oligopoly, where we consider both formal agreements and tacit collusion, and then non-collusive oligopoly.

Collusive oligopoly When firms under oligopoly engage in collusion, they may agree on prices, market share, advertising expendi- ture, etc. Such collusion reduces the uncertainty they face. It reduces the fear of engaging in competitive price cut- ting or retaliatory advertising, both of which could reduce total industry profits and probably each individual firm’s profit.

KI 21 p 175

Profit-maximising cartelFigure 12.3

£

P1

QQ1O Industry MR

Industry D AR

Industry MC

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Cartels A formal collusive agreement is called a cartel. The cartel will maximise profits by acting like a monopolist, with the members behaving as if they were a single firm. This is illus- trated in Figure 12.3.

The total market demand curve is shown with the cor- responding market MR curve. The cartel’s MC curve is the horizontal sum of the MC curves of its members (since we are adding the output of each of the cartel members at each level of marginal cost). Profits are maximised at Q1 where MC = MR. The cartel must therefore set a price of P1 (at which Q1 will be demanded).

Having agreed on the cartel price, the members may then compete against each other using non-price compe- tition, to gain as big a share of resulting sales (Q1) as they can.

Alternatively, the cartel members may somehow agree to divide the market between them. Each member would be given a quota. These quotas could be the same for every firm, or they might be allocated according to the current market share of the firm. Whatever the method of allo- cation, the sum of all the quotas must add up to Q1. If the quotas exceeded Q1, either there would be output unsold if price remained fixed at P1, or the price would fall to clear the market.

In many countries cartels are illegal, being seen by the government as a means of driving up prices and profits and thereby as being against the public interest. (Govern- ment policy towards cartels is examined in Chapter 21.)

The most famous example of a cartel is OPEC, which was set up in 1960 by the five major oil-exporting coun- tries. You may want to investigate the behaviour of OPEC and how it has influenced oil prices. There are numerous blogs on the Sloman News Site that consider this most famous of cartels: see, for example, the blog titled The price of oil in 2015 and beyond. See also Case study E.10 in MyEconLab.

KI 4 p 25

Pause for thought

1. Which countries are members of the OPEC cartel and what are its objectives?

2. How has OPEC’s behaviour affected oil prices and have the problems of a typical cartel been experienced by OPEC?

Pause for thought

If this ‘fair’ solution were adopted, what effect would it have on the industry MC curve in Figure 12.3?

Definitions

Cartel A formal collusive agreement.

Quota (set by a cartel) The output that a given member of a cartel is allowed to produce (production quota) or sell (sales quota).

Tacit collusion When oligopolists follow unwritten ‘rules’ of collusive behaviour, such as price leadership. They will take care not to engage in price cutting, exces- sive advertising or other forms of competition.

Dominant firm price leadership When firms (the follow- ers) choose the same price as that set by a dominant firm in the industry (the leader).

Barometric firm price leadership Where the price leader is the one whose prices are believed to reflect market con- ditions in the most satisfactory way.

Where open collusion is illegal, firms may simply break the law, or find ways to get round it. Alternatively, firms may stay within the law, but still tacitly collude by watching each oth- er’s prices and keeping theirs similar. Firms may tacitly ‘agree’ to avoid price wars or aggressive advertising campaigns.

A price leader aiming to maximise profits for a given market share

Figure 12.4

£

PL

QQ L Q TO

MC

MRleader

AR Dleader

AR Dmarket

a tl

Tacit collusion One form of tacit collusion is where firms keep to the price that is set by an established leader. The leader may be the largest firm: the firm which dominates the industry. This is known as dominant firm price leadership. Alternatively, the price leader may simply be the one that has proved to be the most reliable to follow: the one that is the best barome- ter of market conditions. This is known as barometric firm price leadership. Let us examine each of these two types of price leadership in turn.

Dominant firm price leadership. This is a ‘sequential game’, where one firm (the leader) moves first and then the fol- lowers, having observed the leader’s choice of price, move second. We will discuss sequential games in more detail in section 12.3. Here we are interested in determining how

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the leader sets the price. This depends on the assumptions it makes about its rivals’ reactions to its price changes. If it assumes that rivals will simply follow it by making exactly the same percentage price changes up or down, then a simple model can be constructed. This is illustrated in Figure 12.4. The leader assumes that it will maintain a con- stant market share (say 50 per cent).

The leader will maximise profits where its marginal rev- enue is equal to its marginal cost. It knows its current posi- tion on its demand curve (say, point a). It then estimates how responsive its demand will be to industry-wide price changes and thus constructs its demand and MR curves on that basis. It then chooses to produce QL at a price of PL: at point l on its demand curve (where MC = MR). Other firms then follow that price. Total market demand will be QT, with followers supplying that portion of the market not supplied by the leader: namely, QT - QL.

There is one problem with this model. That is the assumption that the followers will want to maintain a con- stant market share. It is possible that, if the leader raises its price, the followers may want to supply more, given that the new price (= MR for a price-taking follower) may well be above their marginal cost. On the other hand, the followers may decide merely to maintain their market share for fear of invoking retaliation from the leader, in the form of price cuts or an aggressive advertising campaign.

Barometric firm price leadership. A similar exercise can be conducted by a barometric firm. Although the firm is not dominating the industry, its price will be followed by the others. It merely tries to estimate its demand and MR curves – assuming, again, a constant market share – and then pro- duces where MR = MC and sets price accordingly.

In practice, which firm is taken as the barometer may change frequently. Whether we are talking about oil com- panies, car producers or banks, any firm may take the initi- ative in raising prices. If the other firms are merely waiting for someone to take the lead – say, because costs have risen – they will all quickly follow suit. For example, if one of the bigger building societies or banks raises its mortgage rates by 1 per cent, this is likely to stimulate the others to follow suit.

Other forms of tacit collusion. An alternative to having an established leader is for there to be an established set of sim- ple ‘rules of thumb’ that everyone follows.

One such example is average cost pricing. Here pro- ducers, instead of equating MC and MR, simply add a cer- tain percentage for profit on top of average costs. Thus, if average costs rise by 10 per cent, prices will automatically be raised by 10 per cent. This is a particularly useful rule of thumb in times of inflation, when all firms will be experi- encing similar cost increases.

Another rule of thumb is to have certain price bench- marks. Thus clothes may sell for £9.99, £24.99 or £39.99 (but not, say, £12.31 or £36.42). If costs rise, then firms simply raise their price to the next benchmark, knowing that other

Pause for thought

If a firm has a typical-shaped average cost curve and sets prices 10 per cent above average cost, what will its supply curve look like?

Definitions

Average cost pricing Where a firm sets its price by adding a certain percentage for (average) profit on top of average cost.

Price benchmark This is a price which is typically used. Firms, when raising prices, will usually raise them from one benchmark to another.

firms will do the same. (Average cost pricing and other pric- ing strategies are considered in more detail in Chapter 17.)

Rules of thumb can also be applied to advertising (e.g. you do not criticise other firms’ products, only praise your own); or to the design of the product (e.g. lighting manufacturers tacitly agreeing not to bring out an everlasting light bulb).

Factors favouring collusion Collusion between firms, whether formal or tacit, is more likely when firms can clearly identify with each other or some leader and when they trust each other not to break agreements. It will be easier for firms to collude if the fol- lowing conditions apply:

■ There are only very few firms, all well known to each other. ■ They are open with each other about costs and produc-

tion methods. ■ They have similar production methods and average

costs, and are thus likely to want to change prices at the same time and by the same percentage.

■ They produce similar products and can thus more easily reach agreements on price.

■ There is a dominant firm. ■ There are significant barriers to entry and thus there is

little fear of disruption by new firms. ■ The market is stable. If industry demand or production

costs fluctuate wildly, it will be difficult to make agree- ments, partly due to difficulties in predicting market con- ditions and partly because agreements may frequently have to be amended. There is a particular problem in a declining market where firms may be tempted to under- cut each other’s price in order to maintain their sales.

■ There are no government measures to curb collusion.

Non-collusive oligopoly: the breakdown of collusion In some oligopolies, there may be only a few (if any) factors favouring collusion. In such cases, the likelihood of price competition is greater.

KI 1 p 10

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Even if there is collusion, there will always be the temp- tation for individual oligopolists to ‘cheat’, by cutting prices or by selling more than their allotted quota. The danger, of course, is that this would invite retaliation from the other members of the cartel, with a resulting price war. Price would then fall and the cartel could well break up in disarray.

When considering whether to break a collusive agree- ment, even if only a tacit one, a firm will ask: (1) ‘How much can we get away with without inviting retaliation?’ and (2) ‘If a price war does result, will we be the winners? Will we suc- ceed in driving some or all of our rivals out of business and yet survive ourselves, and thereby gain greater market power?’

The position of rival firms, therefore, is rather like that of generals of opposing armies or the players in a game. It is a question of choosing the appropriate strategy: the strategy that will best succeed in outwitting your opponents. The strategy that a firm adopts will, of course, be concerned not just with price, but also with advertising and product development.

Non-collusive oligopoly: assumptions about rivals’ behaviour Even though oligopolists might not collude, they will still need to take account of rivals’ likely behaviour when decid- ing their own strategy. Firms will make assumptions about how they believe their rivals will behave and are likely to base these assumptions on past behaviour. There are three well- known models, each based on a different set of assumptions.

Assumption that rivals produce a given quantity: the Cournot model One assumption is that rivals will produce a particular quan- tity. This is most likely when the market is stable and the rivals have been producing a relatively constant quantity for some time. The task, then, for the individual oligopolist is to decide its own price and quantity given the presumed output of its competitors.

The earliest model based on this assumption was devel- oped by the French economist Augustin Cournot in 1838. The Cournot model (which is developed in Web Appendix 4.2) takes the simple case of just two firms (a duopoly) pro- ducing an identical product: for example, two electricity generating companies supplying the whole country.

This is illustrated in Figure 12.5, which shows the prof- it-maximising price and output for firm A. The total market demand curve is shown as DM. Assume that firm A believes that its rival, firm B, will produce QB1 units. Thus firm A perceives its own demand curve (DA1) to be QB1 units less than total market demand. In other words, the horizontal gap between DM and DA1 is QB1 units. Given its perceived demand curve of DA1, its marginal revenue curve will be MRA1 and the profit-maximising output will be QA1, where MRA1 = MCA. The profit-maximising price will be PA1.

If firm A believed that firm B would produce more than QB1, its perceived demand and MR curves would be further to the left and the profit-maximising quantity and price would both be lower.

The Cournot model of duopoly: Firm A’s profit-maximising position

Figure 12.5

PA1

QuantityQA1O

MRA1 DA1 DM

MCA

Firm A’s profit- maximising output and price are QA1 and PA1.

Firm A believes that firm B will produce QB1.

QB1

At the same time as firm A makes an assumption about firm B’s output, firm B will also be making an assumption about how much it thinks firm A will produce. This is there- fore a ‘simultaneous game’, as both firms are making their decisions at the same time, as we will discuss in section 12.3.

Profits in the Cournot model. Industry profits will be less than under a monopoly or a cartel. The reason is that price will be lower than the monopoly price. This can be seen from Figure 12.5. If this were a monopoly, then to find the prof- it-maximising output, we would need to construct an MR curve corresponding to the market demand curve (DM). This would intersect with the MC curve at a higher output than QA1 and a higher price (given by DM). Nevertheless, profits in the Cournot model will be higher than under perfect com- petition, since price is still above marginal cost.

Assumption that rivals set a particular price: the Bertrand model An alternative assumption is that rival firms set a particu- lar price and stick to it. This scenario is more realistic when firms do not want to upset customers by frequent price changes or want to produce catalogues which specify prices. The task, then, for a given oligopolist is to choose its own price and quantity in the light of the prices set by rivals.

The most famous model based on this assumption was developed by another French economist, Joseph Bertrand, in 1883. Bertrand again took the simple case of a duopoly, but its conclusions apply equally to oligopolies with three or more firms.

Definitions

Cournot model A model of duopoly where each firm makes its price and output decisions on the assumption that its rival will produce a particular quantity.

Duopoly An oligopoly where there are just two firms in the market.

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The outcome is one of price cutting until all supernormal profits are competed away. The reason is simple. If firm A assumes that its rival, firm B, will hold price constant, then firm A should undercut this price by a small amount and, as a result, gain a large share of the market. At this point, firm B will be forced to respond by cutting its price. What we end up with is a price war until price is forced down to the level of average cost, with only normal profits remaining.

As with the Cournot model above, this is also a simul- taneous move game, except here the variable of interest is price. The supermarket industry is a good example of a mar- ket where price wars are a constant feature: see, for example, the blog on the Sloman News Site titled Supermarket price wars and the effect on suppliers.

Nash equilibrium. The equilibrium outcome in either the Cournot or Bertrand models is not in the joint interests of the firms. In each case, total profits are less than under a monopoly or cartel. But, in the absence of collusion, the outcome is the result of each firm doing the best it can given its assumptions about what its rivals are doing. The resulting equilibrium is known as a Nash equilibrium, after John Nash, a US mathematician (and subject of the film A Beautiful Mind) who introduced the concept in 1951. We will return to this concept in section 12.3.

In practice, when competition is intense, as in the Ber- trand model, the firms may seek to collude long before prof- its have been reduced to a normal level. Alternatively, firms may put in a takeover bid for their rival(s).

The kinked demand-curve assumption In 1939 a theory of non-collusive oligopoly was developed simultaneously on both sides of the Atlantic: in the USA by Paul Sweezy and in Britain by R. L. Hall and C. J. Hitch. This kinked demand theory has since become perhaps the most famous of all theories of oligopoly. Economists noted that

Definitions

Nash equilibrium The position resulting from everyone making their optimal decision based on their assump- tions about their rivals’ decisions.

Takeover bid Where one firm attempts to purchase another by offering to buy the shares of that company from its shareholders.

Kinked demand theory The theory that oligopolists face a demand curve that is kinked at the current price: demand being significantly more elastic above the cur- rent price than below. The effect of this is to create a situ- ation of price stability.

even when oligopolists did not collude over price, the price charged across the industry often remained relatively stable. The kinked demand curve model was developed to explain this observation and it rests on two asymmetrical assumptions:

■ If a firm cuts its price, its rivals will feel forced to follow suit and cut theirs, to prevent losing customers to the first firm.

■ If a firm raises its price, its rivals will not follow suit since, by keeping their prices the same, they will thereby gain customers from the first firm.

On t hese assumpt ions, each oligopolist will face a demand curve that is kinked at the current price and out- put (see Figure 12.6(a)). A rise in price will lead to a large fall in sales as customers switch to the now relatively low- er-priced rivals. The firm will thus be reluctant to raise its price. Demand is relatively elastic above the kink. On the other hand, a fall in price will bring only a modest increase in sales, since rivals lower their prices too and therefore cus- tomers do not switch. The firm will thus also be reluctant to lower its price. Demand is relatively inelastic below the kink. Thus oligopolists will be reluctant to change prices at all.

(a) Kinked demand for a firm under oligopoly; (b) stable price under conditions of a kinked demand curveFigure 12.6

P1

£

QQ1O

(a) (b)

D

Assumption 1 If the firm raises its price, rivals will not. Assumption 2

If the firm reduces its price, rivals will

feel forced to lower theirs too.

P1

£

QQ1O

D AR

MR

MC2 MC1

a b

If MC is anywhere between MC1 and MC2,

profit is maximised at Q1.

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BOX 12.2 OLIGOPOLIES: THE GOOD, THE BAD AND THE UGLY

Market power in oligopolistic industries

Oligopolies are complex markets and the behaviour of firms within them can be very different. We see some highly competi- tive oligopolies and others where collusive agreements emerge. One thing they often have in common is being of interest to the relevant country’s competition authorities. Many will be under seemingly constant scrutiny or investigation over anti-compet- itive practices. We examine competition policy in section 21.1. In this box, we consider two classic oligopolies: the supermarket industry and the energy market. You will also find many other examples of oligopolies discussed on the Sloman News Site.

Supermarkets In the UK supermarket industry, the largest four supermarket chains have a combined market share of over 70 per cent, as shown in the chart. Although this combined share has fallen in the past few years, it still represents market dominance by a few firms – a key characteristic of oligopoly. Oligopolies are often the subject of inquiries by the Compe- tition authorities, as the market power held by the dominant firms can be abused. In the case of the supermarket industry, it has faced two major inquiries: first in 2000, concerning their relationship with suppliers, and then in May 2006, when they were referred to the Competition Commission (CC) by the Office of Fair Trading (OFT). (The OFT and CC have since been replaced by the Competition and Markets Authority.) In 2007, the Competition Commission said that it was ‘con- cerned with whether Tesco, or any other supermarket, can get into such a strong position, either nationally or locally, that no other retailer can compete effectively’.10 The government’s Office of Fair Trading had identified four major areas where the supermarkets might gain from the use (or abuse) of mar- ket power: (i) barriers to entry to new competitors; (ii) the relationship between the large supermarket chains and their suppliers; (iii) the lack of effective price competition; and (iv) reducing competition in the convenience store sector.

1. What do you think are the main barriers to entry in the supermarket industry?

The Competition authorities have had particular concerns about the big four supermarkets attempting to restrict competition and hence consumer choice at the local and national level. Key barriers to entry, such as buying up tracts of land where rival retailers could set up, or using large economies of scale to make it impossible for new firms to compete on price, have enabled the big supermarkets to maintain market dominance. To this end, the Commission proposed a ‘competition test’ in planning decisions and action to prevent land agreements, both of which would lessen the market power of supermarkets in local areas. However, despite the high market share enjoyed by the big four, some price competition does exist and the TV adverts since the recession in 2008 have highlighted this, with each supermarket indicating that they have thousands of baskets of goods cheaper than their rivals! But is there really true price competition? The supermarket chains have adopted a system of ‘shadow pric- ing’, whereby they observe each other’s prices and ensure that they remain at similar levels – often similarly high levels rather

KI 21 p 175

Tesco 28.0%

Sainsbury’s 16.7%

Asda (Walmart)

16.2%

Morrisons 11.0%

The Co-operative 6.2%

Aldi 5.6%

Waitrose 5.1%

Lidl 4.4%

Iceland 2.0%

Other 4.8%

10 Peter Freeman, Chairman of the Competition Commission and Inquiry Chairman, ‘Grocery enquiry goes local’, News Release, Competition Commission, 22 January 2007.

11 The Supply of Groceries in the UK Market Investigation, Competition Commission, 30 April 2008.

than similarly low levels! This has limited the extent of true price competition, and the resulting high prices have seen profits grow. Nevertheless, in 2008 the Competition Commission reported that it found little evidence of tacit collusion between the supermarkets.11

Furthermore, intense price competition has tended to be only over basic items, such as the own-brand ‘value’ products. To get to the basic items, you normally have to pass the more luxurious ones, which are much more highly priced and often marketed to make them stand out! Supermarkets rely on shoppers making impulse buys of the more expensive lines, which have much higher profit margins. However, with the rapid growth of Aldi and Lidl, these discount retailers are placing more and more demands on the big four to bring their prices down or at least identify their target market. With their current structures and costs, Asda, Sainsbury’s, Morrisons and Tesco cannot compete with Aldi and Lidl on price and they are not selling the ‘up-market’ foods of Marks and Spencer and Waitrose. As these retailers have increased their market share, it is the big four who have lost out, despite still retaining a significant advantage.

2. Have supermarkets reduced competition in the convenience store sector? In what ways might convenience stores be able to compete with the big supermarkets?

Although the large supermarkets have huge selling power in the industry, another cause for concern is the buying power that they have. Suppliers have complained about the ‘heavy-handed tactics’ employed by the large supermarkets, which can drive costs down by forcing suppliers to offer discounts. One might suggest that this isn’t a bad thing if it means lower prices for the final consumer, but these cost savings do not appear to have been passed on from sup- plier to shopper. So, while this has enabled the supermarkets to increase their profits, it has had a detrimental effect on suppliers, whose profit margins have been cut to the bone. The CC also found that this may have had an inhibiting effect on innovation. Accountancy firm Moore Stephens has blamed the supermarket price war for the rise in insolvencies in the food production sector. Duncan Swift from this firm said:

UK supermarket food market share (12 weeks to 6/12/2015)

Source: Based on data from Kantar Worldpanel

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OLIGOPOLIES: THE GOOD, THE BAD AND THE UGLY

Market power in oligopolistic industries

The supermarkets are going through the bloodiest price war in nearly two decades and are using food producers as the cannon fodder … Supermarkets have engaged in questionable buying practices for years, but it’s getting worse and clearly wreaking havoc on the UK food production sector.12

In order to regulate this relationship, a new Groceries Supply Code of Practice was proposed, to be enforced by an inde- pendent ombudsman. Attempts to create a voluntary code of practice failed and so a consultation on the creation of such an ombudsman began in 2010, with Christine Tacon being appointed in 2013.13

In this classic oligopoly, we can see interdependence between the firms and the price wars that have emerged. In some cases, this does act in the consumer’s interest, but it has repercus- sions for the suppliers. There are high barriers to entry and this does restrict competition and so we are likely to see continued monitoring of this sector by the Competition Authorities.

3. Explain why manufacturers of food products continue to supply supermarkets, despite concerns that they are not always treated fairly.

Who has the energy to switch? Another well-known oligopoly is the energy sector, domi- nated by six big firms (the ‘Big Six’), which sell to over 90 per cent of UK households. You can find many articles about the energy sector on the Sloman News Site, considering the bar- riers to entry; the referral to the CMA and the savings that are possible from switching suppliers.

Barriers to entry As with most oligopolies, a key problem in the energy sector is the existence of barriers to entry. In this industry, there is both vertical and horizontal integration within firms (see Chapter 15), such that the big six energy suppliers are involved in both generation of power and the local distribu- tion of it (vertical integration) and offer ‘dual-fuel’ deals, where customers can receive a discount from buying electric- ity and gas from the same supplier (horizontal integration). The vertical integration, in particular, has made it difficult for smaller suppliers to enter the market, as they have had to buy wholesale from one of the big six. Thus a key focus of the indus- try regulator, Ofgem (the Office of Gas and Electricity markets: see section 21.1), has been how to reduce the barriers to entry to make the market more competitive. Through an increased number of suppliers, competition should increase and this should keep prices down, thereby benefiting households.

4. Does vertical integration matter if consumers still have a choice of supplier and if generators are still competing with each other?

In June 2014, following months of political pressure, Ofgem referred the industry to the Competition and Markets Authority (CMA) to see if there was a possible breach of a dominant mar- ket position. Ofgem asked the CMA to investigate accusations of profiteering by the big six and discuss mechanisms to reduce structural barriers to entry that undermine competition, including the potential breaking up of these dominant firms. The Chief Executive of Ofgem, Dermot Nolan, said:

A CMA investigation should ensure there are no barriers to stop effective competition bearing down on prices and delivering the benefits of these changes to consumers.14

12 ‘Supermarket price war heaps pressure on food producers as insolvencies jump 28%’, Moore Stevens blog, 24 November 2014.

13 ‘Christine Tacon named as supermarket ombudsman’, BBC News, 21 January 2013. 14 ‘Ofgem refers the energy market for a full competition investigation’, Press

Release, Ofgem, 26 June 2014. 15 Energy Market Investigation: Updated Issues Statement, Competition and

Markets Authority, 18 February 2015.

Consumer inertia As well as the traditional barriers to entry discussed above, new competitors face another obstacle, which also acts to reduce competition between existing firms. In some sense it is a form of brand loyalty, where customers are reluctant to switch to an alternative supplier, making it difficult for new entrants to attract customers. However, in the case of energy firms, a big criticism levelled at the Big Six was that it was ‘impossible’ to switch. By 2011, there were more than 300 different tariffs available to domestic consumers and, although choice is often seen as a benefit of competition, there appears to have been too much choice, leading to very confused consumers. This then created inertia, whereby households simply stayed with their existing supplier, even if they were not the cheapest. The suppliers were thus accused of exploiting these ‘loyalty’ customers. An updated Issues Statement, by the CMA said:

Comparing all available domestic tariffs – including those offered by the independent suppliers – we calculate that, over the period Quarter 1 2012 to Quarter 2 2014, over 95% of the dual fuel customers of the Six Large Energy Firms could have saved by switching tariff and/or supplier and that the average saving available to these customers was between £158 and £234 a year (depending on the supplier).15

By making it difficult for customers to switch between tariffs and between companies, competition is limited and this can make it very difficult for new firms to enter the market and gain a sufficient number of customers to make a profitable business. In 2013, Ofgem introduced a full set of pricing rules in the retail sector. Energy companies had to publish simple ‘per-unit’ prices, allowing customers to compare tariffs at a glance. The aim of this was to encourage consumers to switch to the cheapest tariff and hence create a more competitive market, where companies are forced to offer the best deals to retain their customers. Furthermore, from March 2014, the Big Six and the largest independent generators have had to trade fairly with inde- pendent suppliers or face penalties. In particular, they have to publish prices up to two years in advance to ensure more effective competition.

In both the wholesale and retail sector, Ofgem, and more recently the Competition and Markets Authority, have taken continuous steps to break down the barriers to entry in the industry in an attempt to make the market genuinely compet- itive. Critics suggest that the current reforms have still not gone far enough, with the combined market share of the Big Six remaining well above 90 per cent in both sectors.

5. The Big Six have been required to open up their finances to greater scrutiny and publish prices up to two years in advance. How will this help to boost competition?

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This pr ice stability can be shown formally by draw- ing in t he fir m’s marginal revenue cur ve, as in Figure 12.6(b).

To see how this is done, imagine dividing the diagram into two parts either side of Q1. At quantities less than Q1 (the left-hand part of the diagram), the MR curve will cor- respond to the shallow part of the AR curve. At quantities greater than Q1 (the right-hand part), the MR curve will cor- respond to the steep part of the AR curve. To see how this part of the MR curve is constructed, imagine extending the steep part of the AR curve back to the vertical axis. This and the corresponding MR curve are shown by the dotted lines in Figure 12.6(b).

As you can see, there will be a gap between points a and b. In other words, there is a vertical section of the MR curve between these two points.

Profits are maximised where MC = MR. Thus, if the MC curve lies anywhere between MC1 and MC2 (i.e. between points a and b), the profit-maximising price and output will be P1 and Q1. Thus prices will remain stable even with a con- siderable change in costs.

Oligopoly and the consumer If oligopolists act collusively and jointly maximise industry profits, they will in effect be acting as a monopoly. In such cases, prices may be very high. This is clearly not in the best interests of consumers.

Furthermore, in two respects, oligopoly may be more disadvantageous than monopoly:

■ Depending on the size of the individual oligopolists, there may be less scope for economies of scale to lower costs and mitigate the effects of market power.

■ Oligopolists are likely to engage in much more extensive advertising than a monopolist. This will raise costs. Consumers could thus end up paying higher prices, though it may lead to product development and better information about the product’s characteristics.

These problems will be less severe, however, if oligopo- lists do not collude, if there is some degree of price compe- tition and if barriers to entry are weak. For example, in the Bertrand model, prices end up being set at the perfectly competitive level.

Moreover, the power of oligopolists in certain markets may to some extent be offset if they sell their product to other powerful firms. Thus oligopolistic producers of baked beans or soap powder sell a large proportion of their output to giant supermarket chains, which can use their market power to keep down the price at which they purchase these products. This phenomenon is known as countervailing power.

In some respects, oligopoly may be more beneficial to the consumer than other market structures:

Definition

Countervailing power When the power of a monopo- listic/oligopolistic seller is offset by powerful buyers who can prevent the price from being pushed up.

Pause for thought

Assume that two brewers announce that they are about to merge. What information would you need to help you decide whether the merger would be in the consumer’s interests?

■ Oligopolists, like monopolists, can use part of their super- normal profit for research and development. Unlike monopolists, however, oligopolists will have a considerable incentive to do so. If the product design is improved, this may allow the firm to capture a larger share of the market, and it may be some time before rivals can respond with a similarly improved product. If, in addition, costs are reduced by technological improvement, the resulting higher profits will improve the firm’s capacity to withstand a price war.

■ Non-price competition through product differentiation may result in greater choice for the consumer. Take the case of tablets or mobile phones. Non-price competition has led to a huge range of different products of many different specifications, each meeting the specific requirements of different consumers.

It is difficult to draw any general conclusions about the outcomes in this market structure, since oligopolies differ so much in their behaviour and performance. Although an oligopoly is closer to the non-competitive end of the spec- trum, it can still be a highly competitive market structure.

Oligopoly and contestable markets The theory of contestable markets has been applied to oli- gopoly as well as to monopoly, and similar conclusions are drawn.

The lower the entry and exit costs for new firms, the more difficult it will be for oligopolists to collude and make supernormal profits. If oligopolists do form a cartel (whether legal or illegal), it will be difficult to maintain it if there is a threat of competition from new entrants. What a cartel has to do in such a situation is to erect entry barriers, thereby making the ‘contest’ more difficult. For example, the cartel could form a common research laboratory, denied to outsiders. It might attempt to control the distribution of the finished product by buying up wholesale or retail out- lets. Or it might simply let it be known to potential entrants that they will face all-out price, advertising and product competition from all the members if they should dare to set up in competition.

The industry is thus likely to behave competitively if entry and exit costs are low, with all the benefits and

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costs to the consumer of such competition – even if the new firms do not actually enter. However, if entry and/ or exit costs are high, the degree of competition will sim- ply depend on the relations between existing members of the industry.

Pause for thought

Which of the following markets do you think are contestable: (a) credit cards; (b) brewing; (c) petrol retailing; (d) insurance services; (e) compact discs?

GAME THEORY12.3

The interdependence between oligopolists requires firms to think strategically and game theory was developed by econ- omists to examine the best strategy that a firm can adopt, given the assumptions it makes about its rivals’ behaviour.

This section will provide some useful insights into firms’ behaviour, but it is also worth bearing in mind that game theory can be applied to a huge range of areas. In the BBC News article, ‘What exactly is “game theory”?’,16 we can see the application of game theory by Greek Finance Minister Yanis Varoufakis in 2015 in his approach to negotiations over Greek debt.

Single-move games As we have seen, the firm’s choice of strategy under non- collusive oligopoly depends, in part, on how it thinks its rivals will react to its decisions on prices, new products, advertising, etc. The simplest type of ‘game’ is a single-move or single-period game. This involves just one ‘move’ by each firm in the game. For example, two or more firms are bidding for a contract which will be awarded to the lowest bidder. When the bids are all made, the contract will be awarded to the lowest bidder; the ‘game’ is over.

Simple dominant strategy games Many single-period games have predictable outcomes, no matter what assumptions each firm makes about its

KI 23 p 197

rivals’ behaviour. Such games are known as dominant strategy games. The simplest case is where there are just two firms with identical costs, products and demand. They are both considering which of two alternative prices to charge. Table 12.1 shows typical profits they could each make.

Let us assume that at present both firms (X and Y) are charging a price of £2 and that they are each making a profit of £10 million, giving a total industry profit of £20 million. This is shown in the top left-hand cell (A).

Now assume they are both (independently) consider- ing reducing their price to £1.80. In making this decision, they will need to take into account what their rival might do, and how this will affect them. Let us consider X’s posi- tion. In our simple example there are just two things that its rival, firm Y, might do. Either Y could cut its price to £1.80, or it could leave its price at £2. What should X do?

To answer this question we need to take each of firm Y’s two possible actions and look at firm X’s best response to each. If we assume that firm Y chooses a price of £2, firm X could decide to keep its price at £2 giving it £10m in profit. This is shown by cell A. Alternatively, firm X could cut its price to £1.80 and earn £12m in profit, in cell B. Firm X’s best response is therefore to cut price to £1.80, preferring a profit of £12m to one of £10m.

What about if we now assume that firm Y charges £1.80 – how should firm X best respond? If firm X charged £2, we would end up in cell C and firm X would earn only £5m in profit. On the other hand, firm X could also cut its price to £1.80, moving us to cell D and it would earn £8m profit. By comparing these two profit outcomes, we can see that firm X’s best response to firm Y lowering its price to £1.80 is to cut its own price to £1.80 as well, preferring a profit of £8m to a profit of £5m.

16Chris Stokel-Walker, ‘What exactly is “game theory”?’, BBC News Magazine, 18 February 2015.

Definitions

Game theory (or the theory of games) The study of alternative strategies that oligopolists may choose to adopt, depending on their assumptions about their rivals’ behaviour.

Dominant strategy game Where different assumptions about rivals’ behaviour lead to the adoption of the same strategy.

Profits for firms X and Y at different prices

Table 12.1

£2 £1.80

£2

£1.80

X’s price

Y’s price

A B

C D

£10 m each

£8 m each £12 m for Y £5 m for X

£5 m for Y £12 m for X

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Note that firm Y will argue along similar lines, cutting price to £1.80 as well, no matter what it assumes that firm X will do.

This game is a dominant strategy game, since the firm’s best response is always to play the same (dominant) strat- egy (namely, cutting price to £1.80) irrespective of what it thinks the other firm will do. Both firms do what is best for them, given their assumptions about their rivals’ behav- iour. The result is that we end up in cell D, with each firm earning a profit of £8 million.

As we saw in the previous section, this equilibrium out- come, when there is no collusion between players, is known as a Nash equilibrium. This occurs when all players do what’s best for themselves, given the assumptions they make about their rivals’ behaviour.

Nash equilibrium. The position resulting from every- one making their optimal decision based on their assumptions about their rivals’ decisions. Without collusion, there is no incentive for any firm to move from this position.

KEY IDEA

24

However, it is important to note that the profits earned by each firm in the Nash equilibrium (cell D) are lower than they would have been had the firms colluded and charged the higher price (cell A). Each firm would have earned £10 million.

But even with collusion, both firms would be tempted to cheat, or renege, on the agreement and cut prices. This is known as the prisoners’ dilemma (see Box 12.3). You can watch the scene on YouTube17 from the film A Beauti- ful Mind, where John Nash begins to formulate the famous ‘Nash Equilibrium’ concept.

More complex games More complex ‘games’ can be devised with more than two firms, many alternative prices, differentiated products and various forms of non-price competition (e.g. adver- tising). We may also see ‘games’, where the best response for each firm depends on the assumptions made, meaning there is no dominant strategy. Consider the payoff matrix in Table 12.2.

17www.youtube.com/watch?v=2d_dtTZQyUM

Profits for firms X and Y at different prices

Table 12.2

£25 £19

£20

£15

X’s price

Y’s price

A B

C D

£6m for Y £6m for X

£4m for Y £4m for X

£4m for Y £3m for X

£2m for Y £5m for X

If firm X assumes that firm Y will charge £20, then firm X will either earn £6m in profit if it charges £25 or £5m in profit if it charges £19. Firm X’s best response would be to charge £25 (cell A). However, if it assumes that firm Y will charge £15, then firm X’s best response will now be to charge £19, preferring £4m in profit (cell D) to £3m in profit (cell C). We no longer have a dominant strategy. Firm X’s best response depends on its assumption about Y’s price.

Pause for thought

What is firm Y’s best response to each of firm X’s possible choices in the game shown in Table 12.2? Does it have a domi- nant strategy in this game?

In many situations, firms will have a number of different options open to them and a number of possible reactions by rivals. Such games can become highly complex.

The better the firm’s information about (a) its rivals’ costs and demand, (b) the likely reactions of rivals to its actions and (c) the effects of these reactions on its own profit, the bet- ter the firm’s ‘move in the game’ is likely to be. It is similar to a card game: the more you know about your opponents’ cards and how your opponents are likely to react to your moves, and the better you can calculate the effects of their moves on you, the better your moves in the game are likely to be.

Multiple-move games In many situations, firms will react to what their rivals do; their rivals, in turn, will react to what they do. In other words, the game moves back and forth from one ‘player’ to the other like a game of chess or cards. Firms will still have to think strategically (as you do in chess), considering the likely responses of their rivals to their own actions. These multiple-move games are known as repeated games.

Definitions

Prisoners’ dilemma Where two or more firms (or peo- ple), by attempting independently to choose the best strategy, based upon what other(s) are likely to do, end up in a worse position than if they had co-operated from the start.

Tit-for-tat Where a firm will cut prices, or make some other aggressive move, only if the rival does so first. If the rival knows this, it will be less likely to make an initial aggressive move.

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1 2 . 3 G A M E T H E O R Y 2 0 7

One of the simplest strategies in a repeated game is tit-for-tat. This is where a firm will cut prices, or make some other aggressive move, only if the rival does so first. To illustrate this in a multiple-move situation let us look again at the example we considered in Table 12.1, but this time we will extend it beyond one time period.

Assume that firm X is adopting the tit-for-tat strategy. If firm Y cuts its price from £2.00 to £1.80, then firm X will respond in round 2 by also cutting its price. The two firms will end up in cell D – worse off than if neither had cut their price. If, however, firm Y had left its price at £2.00 then firm X would respond by leaving its price unchanged

too. Both firms would remain in cell A with a higher profit than cell D.

As long as firm Y knows that firm X will respond in this way, it has an incentive not to cut its price. Thus it is in X’s interests to make sure that Y clearly ‘understands’ how X will react to any price cut. To do this X can make a threat.

The importance of threats and promises In many situations, an oligopolist will make a threat or promise that it will act in a certain way. As long as the threat or promise is credible (i.e. its competitors believe it), the firm can gain and it will influence its rivals’ behaviour.

BOX 12.3 THE PRISONERS’ DILEMMA

each of these prisoners, the more certain they are that their compatriot will maintain their innocence, the greater the incentive for them to confess and reduce their sentence! Of course the police know this and will do their best to pre- vent any collusion. They will keep Nigel and Amanda in sep- arate cells and try to persuade each of them that the other is bound to confess. Thus the choice of strategy depends on:

■ Nigel’s and Amanda’s risk attitudes: i.e. are they ‘risk lovers’ or ‘risk averse’?

■ Nigel’s and Amanda’s estimates of how likely the other is to own up.

1. Why is this a dominant strategy game?

2. How would Nigel’s choice of strategy be affected if he had instead been involved in a joint crime with Adam, Ashok, Diana and Rikki, and they had all been caught?

Let us now look at two real-world examples of the prisoners’ dilemma.

Standing at concerts When people go to some public event, such as a concert or a match, they often stand in order to get a better view. But once people start standing, everyone is likely to do so: after all, if they stayed sitting, they would not see at all. In this Nash equilibrium, most people are worse off, since, except for tall people, their view is likely to be worse and they lose the comfort of sitting down.

Too much advertising Why do firms spend so much on advertising? If they are aggressive, they do so to get ahead of their rivals. If they are cautious, they do so in case their rivals increase their advertising. Although in both cases it may be in the individual firm’s best interests to increase advertising, the resulting Nash equilibrium is likely to be one of excessive advertising: the total spent on advertising (by all firms) is not recouped in additional sales.

3. Give one or two other examples (economic or non- economic) of the prisoners’ dilemma.

Game theory is relevant not just to economics. A famous non-economic example is the prisoners’ dilemma. Nigel and Amanda have been arrested for a joint crime of seri- ous fraud. They are both guilty. Each is interviewed separately and given the following alternatives:

■ First, if they say nothing, the court has enough evidence to sentence both to a year’s imprisonment.

■ Second, if either Nigel or Amanda alone confesses, he or she is likely to get only a three-month sentence but the partner could get up to ten years.

■ Third, if both confess, they are likely to get three years each. These outcomes are illustrated in the diagram. What should Nigel and Amanda do? Let us consider Nigel’s dilemma. Should he confess in order to get the short sentence (the maximax strategy)? This is better than the year he would get for not confessing. There is, however, an even better reason for confessing. Suppose Nigel doesn’t confess but, unknown to him, Amanda does confess. Then Nigel ends up with the long sentence (cell B). Better than this is to confess and to get no more than three years (cell D). Nigel’s best response is always to confess. Amanda is in the same dilemma and so the result is simple. When both prisoners act in their own self-interest by confess- ing, they both end up with relatively long prison terms (cell D). Only when they collude will they end up with relatively short ones, the best combined solution (cell A). However, for

UK supermarket food market share (end March 2015)

Not confess Confess

Not confess

Confess

Amanda’s alternatives

Nigel’s alternatives

A B

C D

Each gets 1 year

Each gets 3 years

Nigel gets 3 months

Amanda gets 10 years

Nigel gets 10 years

Amanda gets 3 months

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2 0 8 C H A P T E R 1 2 P R O F I T M A X I M I S A T I O N U N D E R I M P E R F E C T C O M P E T I T I O N

A decision treeFigure 12.7

A

B1

Boeing decides

Airbus decides

Airbus decides

50 0

se at

er

500 sea

ter

400 seater

400 seater

Boeing –£10 m Airbus –£10 m

Boeing –£10 m Airbus –£10 m

Boeing +£30 m Airbus +£50 m

Boeing +£50 m Airbus +£30 m

(1)

(2)

(3)

(4)

B2

500 sea

ter

400 seater

Take the simple situation where a large oil company, such as Esso, states that it will match the price charged by any competitor within a given radius. Assume that com- petitors believe this ‘price promise’ but also that Esso will not try to undercut their price. In the simple situation where there is only one other filling station in the area, what price should it charge? Clearly it should charge the price which would maximise its profits, assuming that Esso will charge the same price. In the absence of other filling stations in the area, this is likely to be a relatively high price.

Now assume that there are several filling stations in the area. What should the company do now? Its best choice is probably to charge the same price as Esso and hope that no other company charges a lower price and forces Esso to cut its price. Assuming that Esso’s threat is credible, other companies are likely to reason in a similar way. Prices will therefore be kept high, because of the credible threat made by Esso.

to decisions taken by other firms. Here we are considering a ‘sequential game’ where the ‘order of play’ is important.

Take the case of a new generation of large passenger aircraft which can fly further without refuelling. Assume that there is a market for a 500-seater version of this type of aircraft and a 400-seater version, but that the individual markets for each aircraft are not big enough for the two manufacturers, Boeing and Airbus, to share them profitably. Let us also assume that the 400-seater market would give an annual profit of £50 million to a single manufacturer and the 500-seater would give an annual profit of £30 million, but that if both manufacturers produced the same version, they would each make an annual loss of £10 million.

Assume that Boeing announces that it is building the 400-seater plane. What should Airbus do? The choice is illustrated in Figure 12.7. This diagram is called a decision tree and shows the sequence of events. The small square at the left of the diagram is Boeing’s decision point (point A). If it had decided to build the 500-seater plane, we would move up the top branch. Airbus would now have to make a deci- sion (point B1). If it too built the 500-seater plane, we would move to outcome 1: a loss of £10 million for both manufac- turers. Clearly, with Boeing building a 500-seater plane, Air- bus would choose the 400-seater plane: we would move to

Pause for thought

Assume that there are two major oil companies operating fill- ing stations in an area. The first promises to match the other’s prices. The other promises to sell at 1p per litre cheaper than the first. Describe the likely sequence of events in this ‘game’ and the likely eventual outcome. Could the promise of the sec- ond company be seen as credible?

The importance of timing Most decisions by oligopolists are made by one firm at a time rather than simultaneously by all firms. Sometimes a firm will take the initiative. At other times it will respond

Definitions

Credible threat (or promise) One that is believable to rivals because it is in the threatener’s interests to carry it out.

Decision tree (or game tree) A diagram showing the sequence of possible decisions by competitor firms and the outcome of each combination of decisions.

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1 2 . 3 G A M E T H E O R Y 2 0 9

outcome 2, with Boeing making a profit of £30 million and Airbus a profit £50 million. Airbus would be very pleased!

Boeing’s best strategy at point A, however, would be to build the 400-seater plane. We would then move to Air- bus’s decision point B2. In this case, it is in Airbus’s interests to build the 500-seater plane. Its profit would be only £30 million (outcome 3), but this is better than a £10 million loss if it too built the 400-seater plane (outcome 4). With Boeing deciding first, the Nash equilibrium will thus be outcome 3.

There is clearly a first-mover advantage here. Once Boeing has decided to build the more profitable version of

KI 24 p 206

Definition

First-mover advantage When a firm gains from being the first one to take action.

BOX 12.4 THE HUNGER GAMES

To sleep or not to sleep?

many nights when you can go without sleep and the more nights you do this, the more likely it becomes that you will be susceptible to an attack.

Many stabs in the dark Looking at the matrix that you have constructed and perhaps making some assumptions about the relative value of sleep versus progress, the likely outcome seems to be ‘Don’t sleep’ for everyone. After all, being sleep deprived is better than being dead. This would suggest that all members of the coa- lition should avoid sleep, knowing that if they do fall asleep, they are very vulnerable to an attack from another member of the coalition. So, why do the members of the coalition get any sleep? The Hunger Games goes on for many nights, so it is not just a one-shot game, but a repeated game. Perhaps if the Games had to be over in one night, we would see a clear incentive not to sleep. But, in the Hunger Games, no player knows when their last night will be. The members of the coalition will have to make the sleep decision night after night, knowing that every night they don’t sleep they may make progress, but will become more vulnerable to other attacks. Furthermore, as there are multiple members of the coali- tion, each member will become less trustworthy if others are killed during the night. So, perhaps the best response in this infinitely repeated game is to co-operate from the start and thus trust everyone within the Coalition – everyone gets some sleep. However, if one night a member is killed, then the next night we would probably see each player once again best responding by remaining awake. Perhaps here would be a typ- ical ‘tit-for-tat’ strategy, until a winner emerges. This is just one more example of the application of game the- ory to areas beyond traditional economics.

Search for the game show Golden Balls online or go onto YouTube and watch a clip of the very last part of the game ‘£66,885 Split or Steal?’19 Try constructing a matrix for this game and working out what the Nash equilibrium is.

Suzanne Collins published the first book of the trilogy, The Hunger Games in 2008 and since then it has been made into four films (with the final book, Mockingjay being split into two parts). The Hunger Games is the story of Katniss Everdeen, living in an unknown future time where the country has been divided into Districts, ranging from the wealthy Capitol that rules the other 12 Districts. Each year, one girl and one boy from every District are chosen randomly and they must com- pete to the death against each other in the Hunger Games, which is set in a dangerous and very public arena. Katniss Everdeen volunteers in place of her younger sister and enters the arena with Peeta, the male ‘Tribute’ and so the use of strategic thinking and game theory begins.18

The Hunger Games lasts until all but one ‘Tribute’ is left alive (although there is a slight deviation in the 74th Hunger Games). However, survival is not just about avoiding being killed by one of the other ‘Tributes’ as the Games could last for weeks. Survival is also about having enough sleep to sustain yourself. The problem is, when you are asleep there is the chance of a stealth attack by another competitor, but if you don’t sleep, you become more susceptible to any future attack, due to sleep deprivation.

Try constructing a matrix and determine the Nash equilibrium in this game.

One thing you might have considered in answering the ques- tion above is even if you don’t sleep and everyone else does, will it necessarily mean that you can find and kill another Tribute? One thing that happens in the Games is that a coa- lition is formed between a group of Tributes – they agree to work together, but still know that they are competing against each other and hence at some point, each of them would have to try to kill their rivals. They are camping together and so within that group, they know where everyone is.

Does the Nash equilibrium in the game change if we are now thinking about the decision of one member of the coalition, given the possible responses of the other members of the coalition?

The value that each member places on sleep and getting closer to the finishing line is obviously a key factor in deter- mining how any member should behave. Also, with sleep being a natural response to being tired, there are only so

18Samuel Arbesman, ‘Probability and game theory in The Hunger Games’, Wired, 10 April 2012.

19www.youtube.com/watch?v=yM38mRHY150

the plane, Airbus is forced to build the less profitable one. Naturally, Airbus would like to build the more profita- ble one and be the first mover. Which company succeeds in going first depends on how advanced they are in their research and development and in their production capacity.

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More complex decision trees. The aircraft example is the sim- plest version of a decision tree, with just two companies and each one making only one key decision. In many business situations, much more complex trees could be construct- ed. The ‘game’ would be more like one of chess, with many moves and several options on each move. If there were more than two companies, the decision tree would be more com- plex still.

Pause for thought

Give an example of decisions that two firms could make in sequence, each one affecting the other’s next decision.

The usefulness of game theory The advantage of the game-theory approach is that the firm does not need to know which response its rivals will make. It does, however, need to be able to measure the effect of each possible response. This will be virtually impossible to do when there are many firms competing and many differ-

ent responses that could be made. The approach is only use- ful, therefore, in relatively simple cases, and even here the estimates of profit from each outcome may amount to no more than a rough guess.

It is thus difficult for an economist to predict with any accuracy what price, output and level of advertising the firm will choose. This problem is compounded by the dif- ficulty of predicting the type of strategy – safe, high risk, compromise – that the firm will adopt.

In some cases, firms may compete hard for a time (in price or non-price terms) and then realise that maybe no one is winning. Firms may then jointly raise prices and reduce advertising. Later, after a period of tacit collusion, competition may break out again. This may be sparked off by the entry of a new firm, by the development of a new product design, by a change in market demand, or simply by one or more firms no longer being able to resist the temptation to ‘cheat’. In short, the behaviour of par- ticular oligopolists may change quite radically over time.

If you are interested in reading more about game theory, then the website ‘Game Theory .net’ provides some useful resources.

SUMMARY

1a Monopolistic competition occurs where there is free entry to the industry and quite a large number of firms operat- ing independently of each other, but where each firm has some market power as a result of producing differenti- ated products or services.

1b In the short run, firms can make supernormal profits. In the long run, however, freedom of entry will drive prof- its down to the normal level. The long-run equilibrium of the firm is where the (downward-sloping) demand curve is tangential to the long-run average cost curve.

1c The long-run equilibrium is one of excess capacity. Given that the demand curve is downward sloping, its tangency point with the LRAC curve will not be at the bottom of the LRAC curve. Increased production would thus be possible at lower average cost.

1d In practice, supernormal profits may persist into the long run: firms have imperfect information; entry may not be completely unrestricted; there may be a problem of indivisibilities; firms may use non-price competition to maintain an advantage over their rivals.

1e Monopolistically competitive firms, because of excess capacity, may have higher costs, and thus higher prices, than perfectly competitive firms, but consumers gain from a greater diversity of products.

1f Monopolistically competitive firms may have less econo- mies of scale than monopolies and conduct less research and development, but the competition may keep prices lower than under monopoly. Whether there will be more or less choice for consumers is debatable.

2a An oligopoly is where there are just a few firms in the industry with barriers to the entry of new firms. Firms recognise their mutual dependence and each firm must consider the reactions of rivals to any changes it makes.

2b Oligopolists may aim to maximise their joint profits. This will tend to make them collude to keep prices high. On

the other hand, they will want the biggest share of industry profits for themselves. This will tend to make them compete.

2c They are more likely to collude: if there are few of them; if they are open with each other; if they have similar products and cost structures; if there is a dominant firm; if there are significant entry barriers; if the market is stable; and if there is no government legislation to prevent collusion.

2d A formal collusive agreement is called a ‘cartel’. A cartel aims to act as a monopoly. It can set the price and leave the members to compete for market share, or it can assign quotas. There is always a temptation for cartel members to ‘cheat’ by undercutting the cartel price if they think they can get away with it and not trigger a price war.

2e Tacit collusion can take the form of price leadership. This is where firms follow the price set by either a domi- nant firm in the industry or one seen as a reliable ‘barom- eter’ of market conditions. Alternatively, tacit collusion can simply involve following various rules of thumb such as average cost pricing and benchmark pricing.

2f Even when firms do not collude they will still have to take into account their rivals’ behaviour. In the Cournot model, firms assume that their rivals’ output is given and then choose the profit-maximising price and output in the light of this assumption. The resulting price and profit are lower than under monopoly, but still higher than under perfect competition. In the Bertrand model, firms assume that their rivals’ price is given. This will result in prices being competed down until only normal profits remain.

2g In the kinked-demand curve model, firms are likely to keep their prices stable unless there is a large shift in costs or demand.

2h Non-collusive oligopolists will have to work out a price strategy. This will depend on their attitudes towards risk and on the assumptions they make about the behaviour of their rivals. ▲

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R E V I E W Q U E S T I O N S 2 1 1

2i Whether consumers benefit from oligopoly depends on: the particular oligopoly and how competitive it is; whether there is any countervailing power; whether the firms engage in extensive advertising and of what type; whether product differentiation results in a wide range of choice for the consumer; how much of the profits are ploughed back into research and development; and how contestable the market is. Since these conditions vary substantially from oligopoly to oligopoly, it is impossible to state just how well or how badly oligopoly in general serves the consumer’s interest.

3a Game theory is a way of modelling behaviour in strategic situations where the outcome for an individual or firm depends on the choices made by others. Thus game theory examines various strategies that firms can adopt when the outcome of each is not certain.

3b The simplest type of ‘game’ is a single-move or single- period game. Many single-period games have predictable

outcomes, no matter what assumptions each firm makes about its rivals’ behaviour. Such games are known as dominant strategy games.

3c Non-collusive oligopolists will have to work out a price strat- egy. By making the best decisions based on assumptions about their rivals’ behaviour we can arrive at a Nash equilib- rium. However, a ‘Nash’ equilibrium may not always be the most efficient strategy for the firms collectively. It is possi- ble that both could do better by co-operating or colluding.

3d In multiple-move games, play is passed from one ‘player’ to the other sequentially. Firms will respond not only to what firms do, but also to what they say they will do. To this end, a firm’s threats or promises must be credible if they are to influence rivals’ decisions.

3e A firm may gain a strategic advantage over its rivals by being the first one to take action (e.g. launch a new product). A decision tree can be constructed to show the possible sequence of moves in a multiple-move game.

REVIEW QUESTIONS

1 Think of 10 different products or services and estimate roughly how many firms there are in the market. You will need to decide whether ‘the market’ is a local one, a national one or an international one. In what ways do the firms compete in each of the cases you have identified?

2 Imagine there are two types of potential customer for jam sold by a small food shop. One is the person who has just run out and wants some now. The other is the person who looks in the cupboard, sees that the pot of jam is less than half full and thinks, ‘I will soon need some more’. How will the price elasticity of demand differ between these two customers?

3 Why may a food shop charge higher prices than supermar- kets for ‘essential items’ and yet very similar prices for delicatessen items?

4 How will the position and shape of a firm’s short-run demand curve depend on the prices that rivals charge?

5 Assuming that a firm under monopolistic competition can make supernormal profits in the short run, will there be any difference in the long-run and short-run elasticity of demand? Explain.

6 Firms under monopolistic competition generally have spare capacity. Does this imply that if, say, half of the petrol stations were closed down, the consumer would benefit? Explain.

7 Is the supermarket sector an oligopoly or monopolisti- cally competitive? Explain.

8 Will competition between oligopolists always reduce total industry profits?

9 In which of the following industries is collusion likely to occur: bricks, beer, margarine, cement, crisps, washing powder, blank audio or video cassettes, carpets?

10 Draw a diagram like Figure 12.4. Illustrate what would happen if there were a rise in market demand.

11 Devise a box diagram like that in Table 12.1, only this time assume that there are three firms, each considering the two strategies of keeping price the same or reducing it by a set amount. Is the game still a ‘dominant strategy game’?

12 Having watched the clip from the film A Beautiful Mind, can you work out why the situation that Russell Crowe describes as being a ‘Nash equilibrium’ is actually not a Nash equilibrium? Specifically, in the example used, would all of the males be best responding if they behave as John Nash suggests they should?

13 What are the limitations of game theory in predicting oli- gopoly behaviour?

14 Which of the following are examples of effective counter- vailing power? a) A power station buying coal from a large local coal

mine. b) A large factory hiring a photocopier from Rank Xerox. c) Marks and Spencer buying clothes from a garment

manufacturer. d) A small village store (but the only one for miles

around) buying food from a wholesaler. Is it the size of the purchasing firm that is important in

determining its power to keep down the prices charged by its suppliers?

MyEconLab This book can be supported by MyEconLab, which contains a range of additional resources, including an online homework and tutorial system designed to test and build your understanding. You need both an access card and a course ID to access MyEconLab: 1. Is your lecturer using MyEconLab? Ask your lecturer for your course ID. 2. Has an access card been included with the book at a reduced cost? Check the inside back cover of the book. 3. If you have a course ID but no access card, go to: http://www.myeconlab.com/ to buy access to this interactive study

programme.

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2 1 2 C H A P T E R 1 2 P R O F I T M A X I M I S A T I O N U N D E R I M P E R F E C T C O M P E T I T I O N

ADDITIONAL PART E CASE STUDIES IN THE ECONOMICS FOR BUSINESS MyEconLab (www.pearsoned.co.uk/Sloman)

E.1 Is perfect best? An examination of the meaning of the word ‘perfect’ in perfect competition.

E.2 B2B electronic marketplaces. This case study examines the growth of firms trading with each other over the Internet (business to business or ‘B2B’) and considers the effects on competition.

E.3 Measuring monopoly power. An examination of how the degree of monopoly power possessed by a firm can be measured.

E.4 X-inefficiency. A type of inefficiency suffered by many large firms, resulting in a wasteful use of resources.

E.5 Competition in the pipeline. An examination of attempts to introduce competition into the gas industry in the UK.

E.6 Airline deregulation in the USA and Europe. Whether the deregulation of various routes has led to more competition and lower prices.

E.7 The motor vehicle repair and servicing industry. A case study of monopolistic competition.

E.8 Bakeries: oligopoly or monopolistic competition. A case study on the bread industry, showing that small-scale local bakeries can exist alongside giant national bakeries.

E.9 Oligopoly in the brewing industry. A case study showing how the UK brewing industry is becoming more concentrated.

E.10 OPEC. A case study examining OPEC’s influence over oil prices from the early 1970s to the current day.

E.11 Cut throat competition. An examination of the barriers to entry to the UK razor market.

WEBSITES RELEVANT TO PART E

Numbers and sections refer to websites listed in the Web appendix and hotlinked from this text’s website at www.pearsoned .co.uk/sloman

■ For news articles relevant to Part E, see the Economics News Articles link from MyEconLab or the Sloman Economics News site.

■ For general news on companies and markets, see websites in section A, and particularly A1, 2, 3, 4, 5, 8, 9, 18, 23, 24, 25, 26, 35, 36. See also A38–44 for links to newspapers worldwide.

■ For student resources relevant to Part E, see sites C1–7, 9, 10, 14, 19, 25.

■ For models and simulations relevant to Part E, see sites D3, 5, 7, 8, 10, 13, 14, 16–20

■ For sites that look at competition and market power, see B2; E4, 10, 20; G7, 8. See also links in B1; I7, 11, 14 and 17.

■ For a sites on game theory, see D4; C20; I17 and 4 (in the EconDirectory section).

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F Part

Supply: alternative strategies

The Financial Times, 2 August 2015

Industrial giants caught in LED headlights Philips, Osram and GE face decline of traditional light bulb units as new technology takes off

By Chris Bryant

© The Financial Times Limited 2015. All Rights Reserved.

Lighting is starting to become part of the “inter- net of things” – where different devices are all connected on telecoms networks – but for incum- bent manufacturers this rapid technological shift is causing huge upheaval.

Industrial giants Philips, Siemens and General Electric for decades enjoyed an oligopoly in the hitherto slow-moving lighting market, which James Stettler, an analyst at Barclays, compares with a “licence to print money”, partly because people have to regularly replace their bulbs.

Now LEDs are fast displacing traditional light sources such as incandescent, halogen and fluo- rescent bulbs, catalysed partly by double-digit an- nual price declines in components.

Government regulations also have supported the growth of LEDs because of their energy efficiency. They produce light using semiconductors — whereas traditional light bulbs rely on filaments — and therefore consume less electricity.

LEDs also last much longer than old-style bulbs and are far more sophisticated. For example, the new 68-storey International Youth Culture Centre in Nanjing, China, has 700,000 LED lights capable of illuminating the building façade in different colours at night.

Frost & Sullivan estimates the global LED light- ing market grew 35 per cent to $32.3bn last year, and it is forecast to more than double to $70bn by 2019. LED as a proportion of the total lighting market is set to near 50 per cent by the end of 2015 and reach 84 per cent by 2020.

The incumbents saw the tech revolution coming and are now among the biggest players, but the rapid growth in LEDs has attracted new low-cost competitors, particularly from Asia.

The incumbents are responding to these chal- lenges in different ways, but broadly speaking they are restructuring legacy, high-volume light- ing units and regearing their business models towards “smart” and “connected lighting”.

“In 10 years there might not be a single light bulb left. If your core competence isn’t needed any more, then you need to adapt — the challenge is to move from being a general lighting company to a solution provider,” says Ms Nocchi. ...

Although sales of traditional light bulbs are in structural decline, the market remains profitable because there is so little competition. The incum- bents therefore talk about a “long” or “golden tail”.

“From an investor perspective, this is a cash cow and a solid one, despite the top line decline,” says Frans van Houten, Philips chief executive.

The FT Reports . . .

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Many small companies, especially those facing fierce competition, may be forced to pursue profit as their overriding goal, merely to survive. With large companies, how- ever, where mere survival is not the overriding concern, the pursuit of short-run profit is likely to be only one of many business objectives.

The modern business enterprise is often a complex organisation, with many different departments and divisions. What is more, the ownership and control of the firm are often in totally different hands: i.e. shareholders and managers. With many competing interests there are often several objectives being pursued simultaneously.

In Part F we will consider what these alternative objectives might be and the strategies that businesses might adopt in their pursuit. Having the correct strategy is crucial for business survival. For example, a strategy for lighting manufacturers that worked well for many years may no longer be appropriate as new types of lighting, such as LEDs, replace older types (see the Financial Times article on the left).

We start, in Chapter 13, by introducing you to the world of business strategy. We show how crucial the degree of competition is in shaping not only business success but also the strategic approaches open to business.

In Chapter 14 we will outline various alternative theories of the firm – alternative, that is, to the traditional theory of short-run profit maximisation. Then, in Chapter 15, we will focus on one particular strategy: that of growth. Should a firm seek to grow by simply expanding the scale of its operations, or should it merge with other firms or enter into alliances with them? Chapter 16 looks at the small-firm sec- tor, and compares the objectives and behaviour of small firms with those of their bigger rivals.

Finally, in Chapter 17, we will look at alternative pricing strategies and how they vary with market structure and the different aims that firms might pursue.

The competitive forces reveal the drivers of industry competition. A company strategist who understands that competition extends well beyond existing rivals will detect wider competitive threats and be better equipped to address them. At the same time, thinking comprehensively about an industry’s structure can uncover opportunities: differences in customers, suppliers, substitutes, potential entrants, and rivals that can become the basis for distinct strategies yielding superior performance. In a world of more open competition and relentless change, it is more important than ever to think structurally about competition.

Michael E. Porter, ‘The five competitive forces that shape competition’, Harvard Business Review, January 2008, p. 93

Key terms

Porter’s five forces Strategic management Value chain Core competence Profit satisficing Managerial utility Behavioural theories of

the firm Organisational slack Internal expansion External expansion Transaction costs Takeover constraint Horizontal and vertical

integration Vertical restraints Diversification Merger Enterprise Strategic alliance Networks Logistics SME Cost-based pricing Price discrimination Transfer pricing Peak-load pricing Inter-temporal pricing Product life cycle

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An introduction to business strategy

Business issues covered in this chapter

■ What are the objectives of strategic management? ■ What are the key competitive forces affecting a business? ■ What choices of strategy towards competitors are open to a business? ■ What internal strategic choices are open to a business and how can it make best use of its core competencies when decid-

ing on its internal organisation? ■ How does a business’s strategy relate to its vision and mission? What is the role of various stakeholders in shaping

strategy? ■ Should a business ‘go global’?

Ben & Jerry’s is founded on and dedicated to a sustainable corporate concept of linked prosperity. Our mission consists of 3 interrelated parts:

Social Mission: To operate the Company in a way that actively recognizes the central role that business plays in society by initiating innovative ways to improve the quality of life locally, nationally and internationally.

Product Mission: To make, distribute and sell the finest quality all natural ice cream and euphoric concoctions with a continued commitment to incorporating wholesome, natural ingredients and promoting business practices that respect the Earth and the Environment.

Economic Mission: To operate the Company on a sustainable financial basis of profitable growth, increasing value for our stakeholders and expanding opportunities for development and career growth for our employees.

Underlying the mission of Ben & Jerry’s is the determination to seek new and creative ways of addressing all three parts, while holding a deep respect for individuals inside and outside the company and for the communities of which they are a part.

Source: © Ben & Jerry’s Homemade Holdings Inc.

Being a successful business means what? According to its mission statement, for Ben & Jerry’s it means produc- ing a high-quality product, returning a profi t, presiding over business growth and enhancing shareholder value. The company also claims that a successful business rests upon a ‘deep respect for individuals’ and that it wants to initiate ways of improving the quality of life. What strategy or strategies will Ben & Jerry’s need to adopt in order to achieve these goals?

13

C h

a p

te r

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1 3 . 1 W H A T I S S T R A T E G Y ? 2 1 7

Ben & Jerry’s was formed in 1978 by Ben Cohen and Jerry Greenfield. In 2000, it was taken over by Unilever, the Anglo-Dutch multinational, but it still maintains its identity and its mission. Since its early years as a two- person operation, Ben & Jerry’s has expanded to have operations in 26 countries. However, as the mission state- ment suggests, the founders of Ben & Jerry’s were in search of more than profits from their business activities. With a clear philosophy of social responsibility, the business strategy has been one in which the search for profit has been regulated by a wider set of social and environmental goals.

WHAT IS STRATEGY?13.1

Defining strategy Business strategy describes the way in which an organisa- tion addresses its fundamental challenges over the medium to long term. Usually, the term ‘strategy’ is applied to the decision-making processes of the senior management team, but it can be applied at all levels of the organisation.

The term can also be applied to a number of everyday situations. Thus, an individual may have a strategy to keep fit that involves a healthy diet and going to the gym. A student may have a career strategy that involves passing examinations.

Businesses use strategy in an attempt to be more compet- itive than their rivals. Sometimes these strategies are suc- cessful: businesses outperform their competitors. Similarly, individuals’ strategy may be successful: people keep their weight under control; students pass exams.

Sometimes, however, strategies fail. Businesses under- perform; individuals put on weight; students fail their exams. If this is the case, then a re-evaluation of existing goals and strategies has to take place with new strategies being developed to meet long-term objectives. For a busi- ness that has failed to perform, this is an opportunity to regain its competitive position.

Clearly the type of business ‘strategy’ that is appropriate depends upon the context in which the strategy is being developed. In an attempt to capture the diversity of the term, Henry Mintzberg1 suggests that we need to look at the ‘five Ps’ of business strategy. A strategy can be:

■ a plan; ■ a ploy; ■ a pattern of behaviour; ■ a position with respect to others; ■ a perspective.

A plan. This represents the most common use of the term strategy. It involves, as Mintzberg states, a ‘consciously intended course of action to deal with a situation’. Plans most commonly operate over a given period of time, in which the business outlines where it would like to be at a given point in the future. This might be in terms of its market

KI 23 p 197

share or its level of profitability, or some other combination of criteria upon which business progress or success might be evaluated. As such, plans tend to focus on long-term issues facing the business rather than operational details.

A ploy. In contrast to the long-term nature of the plan, strat- egy as a ploy is generally short term in its application. It often focuses on a specific manoeuvre by business in order to outwit or counteract the behaviour of rivals. Aggressive pricing policy and the use of special offers by supermarkets is a frequently adopted ploy to gain, or more commonly protect, market share. Such a strategy may have limited objectives and be liable to frequent changes.

A pattern of behaviour. Rather than a consciously planned framework of action, business strategy may in fact emerge naturally from a consistent response to events: e.g. intro- ducing a new product variety each year. Such consistent action involves a pattern of behaviour, which takes on a strategic form. Such strategies tend to evolve as circum- stances change. There is no clear long-term objective; unlike plan and ploy, here strategy just happens.

A position with respect to others. Here strategy is determined by the position of the business in its market. For example, a firm may attempt to gain or defend market share. Thus a car company such as BMW may set out to defend its position as a manufacturer of high-quality motorcars by focusing on design and performance in its product development and advertising campaigns. Conversely, Aldi and Lidl might focus on defending and developing their claim to have some of the lowest prices in grocery retailing.

A perspective. In this respect strategy is based upon establish- ing a common way of perceiving the world, primarily within the organisation itself. It may be that this perspective of the world is based on the views of a forceful leader or a strong senior management team, though it can also involve a con- sensus between stakeholders in the organisation. Businesses with strong ethical and environmental objectives, such as Ben & Jerry’s, would see a shared perspective as an impor- tant part of their business strategy. Employees are encour- aged to take on board the company’s philosophy. This, it is hoped, will not only contribute to the business’s success through motivation and commitment, but also encourage employees to feel good about what they do.

1 Henry Mintzberg, ‘The strategy concept I: five Ps for strategy’, California Management Review, vol. 30, no. 1, 1987, pp. 11–24.

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Mintzberg notes in his analysis of the term ‘strategy’ that businesses might adopt any number of approaches to stra- tegic behaviour. Pursuing strategy as a plan, for example, does not preclude using strategy as a ploy or as a position in respect to others. Businesses may interpret strategy in a number of ways simultaneously. What these different understandings of strategy do is to enable us to analyse dif- ferent aspects of business behaviour and organisation.

Strategic management For most of the time, most managers have as their primary function the managing of the routine day-to-day activi- ties of the business, such as dealing with personnel issues, checking budgets and looking for ways to enhance effi- ciency. In other words, they are involved in the detailed operational activities of the business.

Some managers, however, especially those high up in the business organisation, such as the managing director, will

be busy in a different way, thinking about big, potentially complex issues, which affect the whole company. For exam- ple, they might be analysing the behaviour of competitors, or evaluating the company’s share price or considering ways to expand the business. In other words, these managers are involved in the strategic long-term activities of the business.

Both types of management are equally important in the management process, as each contributes in its own way to the business’s overall success. However, what is clear is that strategic and operational management are quite distinct managerial functions.

S t r a t e g i c m a n a g e m e n t c o m p r i s e s t h r e e m a i n components.

■ Strategic analysis is concerned with examining those factors which underpin an organisation’s mission (or purpose) and its long-term vision. These factors are key in determin- ing a business’s performance and include internal factors, such as the development of business skills and knowledge,

BOX 13.1 BUSINESS STRATEGY THE SAMSUNG WAY

Staying ahead of the game

Samsung is a major South Korean conglomerate involved in a number of industries, including the machinery and heavy engineering, chemical, financial services and consumer electronic sectors. In its various divisions it has over 489 000 employees globally and is a major international investor and exporter. This box outlines some of the strategic initiatives that have been taken in recent times by one of its most successful divi- sions, Samsung Electronics, which has become the world’s largest mobile phone producer. The unit sales of its devices overtook those of long time market leader Nokia in the first quarter of 2012. By 2014, it had a 20.9 per cent share of the global mobile phone market, in contrast to its leading rival Apple, which had 10.2 per cent. It was also the world’s biggest producer of LCD TVs in 2014 and the second biggest producer of tablet computers, with global market shares of 21.8 per cent and 14.5 per cent respectively. Samsung Electronics is also one of the world’s largest producers of memory semiconductors and employs 280 000 people in more than 80 countries. The division’s success over the past few years is quite an achievement, given the massive financial problems it faced following the Asian financial crisis in the late 1990s. Since that time it has managed not only to shake off its debts and post significant improvements in profits, but also to reposi- tion itself in the upmarket segment of the consumer electron- ics industry.

The key features of Samsung’s strategy How has Samsung achieved this? What have been the keys to its success? First, it has a strong management team led by Mr Kwon Oh-Hyun, vice-chairman and CEO of Samsung Electronics. Together they have a clear vision of the future of the sector. Second, there has been a dramatic streamlining of the business and the decision-making structure following poor financial

performance in the mid-1990s and an association with low-end brands in televisions and air-conditioning units. The manage- ment team took aggressive measures to improve the division’s finances by cutting jobs, closing unprofitable factories, reduc- ing inventory levels and selling corporate assets. They then ‘delayered’ the company, ensuring that managers had to go through fewer layers of bureaucracy, thereby speeding up the approval of new products, budgets and marketing plans. Third, Samsung Electronics has been investing heavily in research and development (R&D) to increase its product portfolio and reduce the lead time from product conception to product launch. In 2014 the division invested $13.4 billion in R&D – a 28 per cent increase on the previous year. This made it the second biggest R&D spending company in the world behind Volkswagen. Between 2010 and 2014 it increased its employment of R&D staff by 27 per cent and employed 63 628 people across its 34 R&D units. It has also engaged in a number of strategic alliances with major players such as Sony, IBM and Hewlett-Packard to share R&D costs. One way of measuring the output of successful R&D activity is by looking at the number of patents a business has been awarded. In the USA, Samsung was ranked second behind International Business Machines (IBM), having successfully registered 4952 patents in 2014. It has been in second place behind IBM in every year from 2006 to 2013. In the EU Sam- sung was ranked in first place in 2014 having filed 2541 cases with the European Patent Office. Samsung has a vision of achieving $400 billion in revenue and becoming one of the world’s top five brands by 2020. To achieve this end, Mr Kwon Oh-Hyun and his team recognised that most of its flagship products will be obsolete in 10 years’ time. This is why innovation is central to Samsung’s 2020 vision. The company intends to build on its existing capabili- ties in three areas: new technology, innovative products and creative solutions.

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1 3 . 1 W H A T I S S T R A T E G Y ? 2 1 9

and external factors, such as the competitive environment, resource availability and changes in technology.

■ Strategic choice, by contrast, is primarily concerned with the formulation and evaluation of alternative courses of action that might be adopted in order to achieve the business’s strategic objectives. What strategic choices are available? How suitable are such strategies, given their risks and constraints such as time, cost and the busi- ness’s values?

■ Strategic implementation is concerned with how strategic choices might be put into effect. In other words, it consid- ers how a strategy might be translated into action. Who is responsible for its implementation? How will it be man- aged? How is its success or otherwise to be monitored?

In the following sections of this chapter we are going to con- sider these three dimensions of strategic management and the issues they raise for the conduct of business. Before we

do so, it is worth considering what strategic management means for different business types. How might businesses differ in respect to their analysis, choice and implementa- tion of strategy?

Big business/small business. The strategic requirements of a small local computer assembler and Microsoft are clearly going to be massively different. A small business, operating in a niche market, providing a limited range of products or services, would certainly not require the complex strategic assessment of a large business operating in many markets and providing a whole range of products. Not only would

KI 6 p 37

BUSINESS STRATEGY THE SAMSUNG WAY

Staying ahead of the game

Fourth, Samsung is concerned about volumes from which it can achieve economies of scale. To this end it invests heavily in modern factories that can cope with large production runs. To help achieve these economies, Samsung also supplies com- ponents to its competitors as well as making them for its own product range. For example, it sells flash memory chips for Apple’s iPod, Nokia phones and digital cameras. Further, pro- duction systems are flexible enough to allow customisation for individual buyers, ensuring that selling prices are above the industry average. Alongside longer production runs, Samsung is concerned with ensuring that production costs are minimised by making its own business units compete with external rivals. For example, Samsung buys colour filters from Sumitomo Chemical Com- pany of Japan and from its own factories. Finally, Samsung has been developing its global brand name in consumer electronics and marketing, particularly sports marketing. For example, it sponsored Chelsea football club from 2006 to 2015 and was one of the eleven official part- ners of the London 2012 Olympics. The company recently announced that it has extended its sponsorship deal with the International Olympics Committee until 2020. It also has a $100 million sponsorship deal in the USA with the National Basketball Association (NBA). As a result of these changes, Samsung Electronics rose from 42nd in BusinessWeek/Interbrand’s list of the top 100 global brands in 2001 to 7th in 2014.

Recent developments The dramatic growth of Samsung Electronics has been largely achieved since the turn of the twenty-first century. In 2010 the company altered its top management team to include a slightly younger team. It also restructured some of its divi- sions, producing a better fit with changes in the market and product offerings. This was intended to support Samsung in maintaining its growth into the foreseeable future.

However, Samsung Electronics had a difficult year in 2014. It made an annual net profit of $21.3 billion, which may give the impression that its performance was excellent. This was however a 27 per cent fall on the previous year. It struggled, in particular, in the mobile phone market where sales of its products fell by 21 per cent. The major reason for this decline was increasing competition from other handset makers. For example, it faced strong competition in the high end premium segment of the mar- ket from Apple. Its successful launch of the larger screen iPhone6 and iPhone6 plus in September 2014 removed one of the key competitive advantages that Galaxy phones had over its key rival. It has also faced more intense competition from producers of lower price Android devices in emerging markets. For example Huawei, Lenovo and Xiami have recently become significant rivals in the Chinese market. Xiami was the leader in the 4th quarter of 2014, with a market share of 13.7 per cent, while both Lenovo and Huawei were ahead of Sam- sung which was down in 5th place. Although it remained the market leader in India, it also faced increasingly strong competition from local companies such as Micromax, Lava and Karbonn. In March 2015, Samsung launched the new Galaxy 6 Edge handset. Many of the changes were focused on trying to improve the design and appearance of the phone with a new curved screen, metal frame and glass back. It will be inter- esting to see if Samsung will remain focused on its battle with Apple in the premium segment of the market or whether it will start to cut prices aggressively in response to its new low-cost rivals.

1. What dangers do you see with Samsung’s recent business strategy?

2. Given Mintzberg’s five Ps, which would you say fit(s) Samsung’s approach to strategy most closely and why?

Definition

Strategic management The management of the strate- gic long-term activities of the business, which includes strategic analysis, strategic choice and strategic imple- mentation.

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the strategy for a small business usually be simpler, it would probably be easier to formulate, given that the managers of small businesses are often the owners and generally the principal creators of the businesses strategy.

Manufacturing business/service provider business. Although in many respects the strategic commitments of both a manu- facturer and a service-sector business might be similar, in some crucial respects the focus of strategy will differ. Manu- facturers will tend to focus a large part of their strategic effort on product issues (technology, design, inputs, etc.), whereas service providers will tend to focus on strategic issues related to the customer, especially in the area of retailing.

Domestic business/multinational business. The crucial differ- ence in strategic thinking between a domestic business and a multinational business concerns the geographic spread of the multinational corporation. The multinational will need to focus its strategy not only in global terms but possibly also within the context of each international market within which it operates. Depending upon the diversity of these markets, this may require a quite distinct strategic approach

within each. Similarly, a business serving a national market will have more complex strategic issues to consider than one serving a local market.

Private-sector business/public-sector business. Quite clearly the strategic considerations of the National Health Service will in many respects be quite different from, say, Ford, but how different will they be from those of BUPA, the private-sector medical care provider? Increasingly, public-sector organi- sations, like their private-sector counterparts, are having to adopt a more business-orientated approach to service pro- vision. Stakeholders may be different and profit may not be the principal motivation of business activity, but efficiency, targets and accountability are increasingly becoming public-sector as well as private-sector organisational goals.

For-profit organisations/not-for-profit organisations. Not- for-profit businesses such as charities are essentially based upon a mission underpinned by principles of value. In shaping their strategic goals, such values will be para- mount in determining the direction and focus of strategic behaviour.

STRATEGIC ANALYSIS13.2

In order for an organisation to make strategic decisions, it must first analyse what the organisation is about (its mission) and how it envisages where it wants to be (its vision). In other words, the mission and vision will affect the strategic choices made. Take the case of Ben & Jerry’s. Its proclaimed ethical stance limits potential strategic avenues.

Strategic choices also depend on an analysis of (a) the external business environment and (b) the organisation’s internal capabilities.

■ How much competition does the firm face and what forms does it take?

■ What other external factors, such as laws and regula- tions, technological changes and changes in consumer tastes, are likely to affect the firm’s decisions?

■ Similarly, what internal factors drive an organisation’s performance?

In the case of Ben & Jerry’s, the nature of its supply chain is likely to affect not only the quality of the product but also the ability of the company to develop and grow.

Vision and mission At the beginning of this chapter, we referred to the mis- sion statement of Ben & Jerry’s, in which the company clearly expresses a purpose for its business: a purpose that goes far beyond simply making a profit. Such wider social,

KI 1 p 10

environmental and ethical considerations are increasingly shaping business thinking, as expectations regarding cor- porate responsibility grow.

It is now widely expected that a business must look beyond ‘the bottom line’ (i.e. profitability) and take account of the interests of a wide group of stakeholders, such as employees, customers, creditors and the local com- munity, and not just the owners of the business. It would be a risky business strategy indeed that pursued profit without taking into account the social, environmental and ethical implications that this might entail (see section 20.5). As such, the formulation of strategy must take into account the purpose of the organisation and the values and objectives that such a purpose involves. Organisa- tional purpose is most often found in a business’s mission statement, which is in turn shaped by a number of distinct influences (see Figure 13.1).

Corporate governance. Corporate governance refers to the way in which a business is run and the structure of decision making. It also includes the monitoring and supervision, and in some cases regulation, of executive decisions. The way a business is run depends on the purposes of the busi- ness and in whose interests it is run.

Stakeholders. Stakeholders differ in power and influence, but ultimately they might all shape the purpose of the organi- sation in certain respects. Given the wide number of stake- holders, many conflicts of interest can arise.

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1 3 . 2 S T R A T E G I C A N A L Y S I S 2 2 1

Factors influencing organisational purpose

Figure 13.1

Organisational purpose

Stakeholder views

Cultural context

Business ethics

Corporate governance

Business ethics. A business’s ethical position might, as in the case of Ben & Jerry’s, be driven by the values of its founders. Alternatively, ethics might be determined and shaped by wider cultural values and standards that determine what is and what is not acceptable behaviour. As previously remarked, business today would find it very difficult to pursue a strategy that failed to exhibit a degree of social responsibility.

High-profile cases can have a significant impact on a firm’s reputation and standing in both the business community and society in general. For example, Oxfam produce a ‘Behind the Brands Scorecard’ which ranks the ten biggest food companies based on seven ethical standards. They call on people to use social media to put pressure on these companies to introduce more ethical policies. Since the campaign started in 2013, Oxfam claims that a number of these businesses have improved their practices.

An example of a company responding to criticism is Apple. It has received damning reports from a number of sources about the working conditions at factories managed by its suppliers. In response to this, it now produces an annual Supplier Responsibility Progress Report. Many firms recognise that ethically sound behaviour is good for busi- ness and the bottom line.

Cultural context. How does the cultural context of the organ- isation influence its objectives? Not only will national cul- ture be significant here, but also the subculture of managers. Wider questions are also raised given the growth in multi- national business activity, and the cross-cultural nature of such organisations. Recognising differing cultural contexts

might be crucial in shaping business success within such increasingly global markets.

The business environment We considered the various dimensions of the business envi- ronment and how they shape and influence business activ- ity (Chapter 1). We divided the business environment into four distinct sets of factors: political, economic, social and technological. Such factors comprise what we call a PEST analysis. In this section we will take our analysis of the busi- ness environment forward and consider more closely those factors that are likely to influence the competitive advan- tage of the organisation.

KI 1 p 10

Pause for thought

Give some examples of cultural differences between countries or regions which might influence business strategy.

The Five Forces Model of competition Developed by Professor Michael Porter of Harvard Business School in 1980, the Five Forces Model sets out to identify those factors which are likely to affect an organisation’s competitiveness (see Figure 13.2). This then helps a firm choose an appropriate strategy to enhance its competitive opportunities and to protect itself from competitive threats. The five forces that Porter identifies are:

■ the bargaining power of suppliers; ■ the bargaining power of buyers; ■ the threat of potential new entrants; ■ the threat of substitutes; ■ the extent of competitive rivalry.

The bargaining power of suppliers. Most business organi- sations depend upon suppliers to some extent, whether to provide raw materials or simply stationery. Indeed, many businesses have extensive supply or ‘value chain’ networks (as we shall discuss later in this section). Such suppliers can have a significant and powerful effect on a business when:

■ there are relatively few suppliers in the market, reducing the ability of the firm to switch from one supply source to another;

■ there are no alternatives to the supplies they offer; ■ the prices of suppliers form a large part of the firm’s total

costs; ■ a supplier’s customers are small and fragmented, and as

such have little power over the supplying business.

Car dealers often find that car manufacturers can exert con- siderable pressure over them in terms of pricing, display and after-sales service.

KI 21 p 175

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The bargaining power of buyers. The bargaining power of companies that purchase a firm’s products will be greater when:

■ these purchasing companies are large and there are rela- tively few of them;

■ there are many other firms competing for their custom, and hence a firm that produces an undifferentiated product is likely to be more prone to ‘buyer power’ than one that produces a unique or differentiated product;

■ the costs for the purchasing companies of switching to other suppliers are low;

■ purchasing companies are able to backward integrate and effectively displace the supplying firm.

The UK grocery-retailing sector up until recently was dom- inated by a small number of large supermarket chains such as Tesco, Sainsbury and Asda Wal-Mart. These exert mas- sive levels of buyer power over farmers and food process- ing companies. Not only do such supermarkets dominate the market, but also they can normally find many alter- native supply sources, both domestic and international, at relatively low switching costs. Also, all the supermar- kets sell own-brand labels, either produced themselves or through agreement with existing manufacturers, and these are often sold at prices considerably below those of equivalent branded products (see Box 8.1 on page 125).

The threat of potential new entrants. The ability of new entrants to enter the marketplace depends largely upon the existence and effectiveness of various barriers to entry.

KI 1 p 10

Porter’s Five Forces ModelFigure 13.2

Source: Reprinted with the permission of the Free Press of Simon & Schuster, Inc., from Competitive Strategy: Techniques for Analyzing Industries and Competi- tors by Michael E. Porter. Copyright © 1980, 1988 by The Free Press. All Rights Reserved

BuyersSuppliers

Substitute products

Potential entrants

Industry competitors

Rivalry among existing firms

Threat of new entrants

Bargaining power of suppliers

Bargaining power of buyers

Threat of substitutes

These barriers to entry were described fully in section 11.3 (pages 182–4), but are listed here as a reminder:

■ economies of scale and scope; ■ product differentiation; ■ capital requirements; ■ lower costs of established firm; ■ ownership of/control over key factors of production; ■ ownership of/control over wholesale or retail outlets; ■ legal protection; ■ aggressive tactics and retaliation.

Barriers to entry tend to be very industry, product and market specific. Nevertheless, two useful generalisations can be made. First, companies with products that have a strong brand identity will often attempt to use this form of product differentiation to restrict competition; second, manufacturers will tend to rely on economies of scale and low costs as a basis for restricting competitive pressure.

The threat of substitutes. The availability of substitutes can be a major threat to a business and its profitability. Issues that businesses need to consider in relation to the availability of substitute products are:

■ the ability of and cost to customers of switching to the substitute;

■ the threat of competitors bringing out a more advanced or up-to-date product;

■ the impact that substitute products are likely to have on pricing policy.

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The makers of games consoles such as Sony, Nintendo and Microsoft have had to face the arrival of substitutes into the market (as discussed in Box 14.1, page 234). People can now play games such as Minecraft and Candy Crush on their Smartphones and tablets instead of using a PlayStation 4 or Xbox One. The Steam download service owned by Valve also means that games such as Call of Duty can be down- loaded and played on a personal computer as a substitute to using a console.

The relatively good sales of static games consoles in 2014/15 suggest that they have been able to withstand the competition so far, whereas the sale of handheld consoles has fallen considerably. It is highly likely that another new substitute will enter the market. For example, the company Valve is working in partnership with more gaming-focused PC manufacturers to produce custom-built computers which can be plugged into a TV in the same way as a games console. Firms operating in the games console market will need to reconsider their strategies as the market continues to change.

The extent of competitive rivalry. The previous two chapters focused on market structure and were primarily concerned with how businesses respond to differing levels of competi- tion. Clearly the degree of competition a firm faces is a cru- cial element in shaping its strategic analysis. Competitive rivalry will be enhanced when there is the potential for new firms to enter the market, when there is a real threat from substitute products and when buyers and suppliers have some element of influence over the firm’s performance. In addition to this, competitive rivalry is likely to be enhanced in the following circumstances:

■ Competitors are of equal size. ■ Markets are growing slowly. This makes it difficult to

acquire additional sales without taking market share from rivals.

■ There are high fixed costs, which require the firm to gain a large market share in order to break even.

■ Productive capacity in an industry increases in large increments, often resulting in over-production in the short term. This adds to competitive pressure by putting downward pressure on prices.

■ Product differentiation is difficult to achieve; hence product switching by consumers is a real threat.

■ There are high exit costs. When a business invests in non-transferable fixed assets, such as highly specialist capital equipment, it may be reluctant to leave a market. It may thus compete fiercely to maintain its market posi- tion. On the other hand, as we have seen in the section on contestable markets (page 190), high exit costs may deter firms from entering a market in the first place and thus make the market less contestable.

■ There exists the possibility for merger and acquisition. This competition for corporate control may have consid- erable influence on the firm’s strategy.

Pause for thought

Given that the stronger the competitive forces, the lower the profit potential for firms, describe what five force characteris- tics an attractive and unattractive industry might have.

Limitations of the Five Forces Model One of the great values of the Five Forces Model is that it creates a structured framework for a business to analyse the strategic issues that it faces. However, it does have a number of weaknesses.

First, the Five Forces Model presents a largely static view of the business environment, whereas in reality it is likely to be constantly changing.

Second, the model starts from the premise that the busi- ness environment is a competitive threat to the business organisation, which, if the business is to be successful, needs to be manipulated in particular ways. Often, how- ever, success might be achievable not via competition but rather through co-operation and collaboration. For exam- ple, a business might set up close links with one of its major buyers; or businesses in an industry might establish links either to build barriers or to share costs via some form of collaborative research and development. In such instances, the business environment of the Five Forces Model might be viewed as a collaborative opportunity rather than a competitive threat. (The section on strategic alliances in Chapter 15 (section 15.6) will offer a fuller evaluation of collaborative business agreements.)

Finally, critics of the model argue that it fails to take suf- ficient account of the microenvironment of the organisa- tion and its human resources. For example, factors such as country culture and management skills might have a deci- sive impact on a firm’s choice of strategy and its successful implementation.

Value chain analysis and sustainable competitive advantage As with the Five Forces Model, value chain analysis was developed by Michael Porter, and as such the two con- cepts are closely related. A value chain shows how value is added to a product as it moves through each stage of production: from the raw material stage to its purchase by the final consumer. Value chain analysis is concerned with evaluating how each of the various operations within and around an organisation, such as handling

Definition

Value chain The stages or activities that help to create product value.

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inputs, manufacturing the product and marketing it, contributes to the competitive position of the business. Ultimately it is these value-creating activities which shape a firm’s strategic capabilities. A firm’s value chain can be split into two separate sets of activities: primary and support (see Figure 13.3).

Primary activities Primary activities are those directly concerned with the pro- duction, distribution and sales of the firm’s product. Such primary activities can be grouped into five categories:

■ Inbound logistics. Here we are concerned with the han- dling of inputs, storage and distribution of such inputs throughout the business.

■ Operations. These activities involve the conversion of inputs into the final product or service. Opera- tions might include manufacturing, packaging and assembly.

■ Outbound logistics. These are concerned with transferring the final product to the consumer. Such activities would include warehousing and transport.

KI 19 p 142

The value chainFigure 13.3

Inbound logistics

Operations

Outbound logistics

Marketing and sales

After-sales service

Fi rm

in fr

as tr

uc tu

re

Technological

developm ent

H um

an re

so ur

ce m

an ag

em en

t

Procurem ent

Definition

Logistics The process of managing the supply of inputs to a firm and the outputs from a firm to its customers.

■ Marketing and sales. This section of the value chain is concerned with bringing the product to the consumer’s attention and would involve product advertising and promotion.

■ Service. This can include activities such as installation and repair, as well as customer requirements such as training.

A business might attempt to add value to its activities by improving its performance in one or more of the above cat- egories. For example, it might attempt to lower production costs or be more efficient in outbound logistics.

Support activities Such primary activities are underpinned by support activ- ities. These are activities that do not add value directly to any particular stage within the value chain. They do, how- ever, provide support to such a chain and ensure that its various stages are undertaken effectively. Support activities include:

■ Procurement. This involves the acquisition of inputs by the firm.

■ Technological development. This includes activities within the business that support new product and process developments, such as the use of research departments.

■ Human resource management. Activities in this category include things such as recruitment, training, and the negotiation and determination of wage rates.

■ Firm infrastructure. This category includes activities such as financial planning and control systems, quality con- trol and information management.

As well as creating value directly themselves, most firms buy in certain value chain activities, such as employing another firm to do its advertising, or using an external delivery firm to distribute its products. The outsourcing of these activities might prove to be far more beneficial to a business than providing the activities itself. You can employ the best advertisers or the most efficient and reli- able distributors.

Thus the value system extends beyond the individual organisation and encompasses the value chains of all those individual businesses that the organisation might deal with. The implication is that the value chain and the value system may be highly complex, and the competitive posi- tion of a business may extend well beyond the immediate value chain of the organisation. This will have significant implications for the formulation and choice of business strategy.

Having now discussed the background to strategic anal- ysis, we can shift our focus to consider strategic choice and implementation. What strategies are potentially open to businesses and how do they choose the right ones and set about implementing them?

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Theories of strategic choice fall into two main categories: market based and resources based.

Market-based theories argue that strategic choices are ulti- mately determined by the competitive environment that the business faces. As such, understanding this competitive environment and identifying appropriate ways to deal with it will determine whether you are successful or not.

Resource-based theory also looks at the firm’s competitive position, but focuses on its internal situation. It considers how strategic decision making is affected by the ownership, control and use of an organisation’s resources. It is seen that such resources ultimately deliver profits and it is through a manipulation of such resources that a business can main- tain and enhance its competitive position.

Clearly market- and resource-based explanations of stra- tegic choice overlap and interact, and in practice most busi- nesses will attempt to evaluate both their resource base and the threats posed by competitors. However, the two types of explanation do address the issue of strategic choice from quite distinct starting points and this, as we shall see, affects the strategic solutions they offer.

Environment or market-based strategy As with many other areas in this field, our analysis of mar- ket-based theory starts with the observations of Michael Porter. As an extension of his Five Forces Model of compe- tition, Porter argued that there are three fundamental (or ‘generic’) strategies that a business might adopt:

■ cost leadership; ■ differentiation; ■ focus.

In order to identify which of these was the most appropri- ate strategy, a business would need to establish two things: (a) the basis of its competitive advantage – whether it lies in lower costs or differentiation; (b) the nature of the target market – is it broad or a distinct market niche?

Cost leadership As the title implies, a business that is a low-cost leader is able to manufacture and deliver its product more cheaply than its rivals, thereby gaining competitive advantage. The stra- tegic emphasis here is on driving out inefficiency at every stage of the value chain. ‘No-frills’ budget airlines, such as easyJet and Ryanair, are classic examples of companies that pursue a cost-leadership strategy.

A strategy based upon cost leadership may require a fundamentally different use of resources or organisational structure if the firm is to stay ahead of its rivals. Wal-Mart’s

KI 1 p 10

KI 6 p 37

KI 7 p 38

STRATEGIC CHOICE13.3

hub and spoke distribution system would be an example in point. Here the company distributes its products to shops from regional depots in order to minimise transport costs.

In addition, firms which base their operations on low costs in order to achieve low prices (although that may not necessarily be the aim of low costs) are unlikely to have a high level of brand loyalty. In other words, if customer choice is going to be driven largely by price, demand is likely to be relatively price elastic. Other virtues of the prod- uct that might tie in buyers, such as quality or after-sales service, are largely absent from such firms’ strategic goals.

Differentiation A differentiation strategy aims to emphasise and promote the uniqueness of the firm’s product. As such, high rather than low prices are often attached to such products. Prod- uct characteristics such as quality, design and reliability are the basis of the firm’s competitive advantage. Hence a strat- egy that adds to such differences and creates value for the customer needs to be identified.

Such a strategy might result in higher costs, especially in the short term, as the firm pursues constant product devel- opment through innovation, design and research. How- ever, with the ability to charge premium prices, revenues may increase more than costs: in other words, the firm may achieve higher profits. Mobile phone handset producers such as Apple and Samsung provide a good example. Even though they are in fierce competition with each other, both firms focus their strategy on trying to differentiate their products from their rival’s. This differentiation is in terms of features and performance, not price. Screen size, camera quality (megapixels), speakers, screen resolution, availa- bility of apps, operating systems, battery life and overall design are all characteristics used in the competitive battle.

Differentiation strategies are not, however, risk free. Pricing differentiated products can be problematic. At what point does the price premium for the product deter poten- tial buyers, such that the differentiated nature of the prod- uct is insufficient to outweigh such price considerations? The fact that tastes and fashion change could also have a sig- nificant impact upon the sales of a differentiated product.

Laura Ashley clothing was a case in point. In an attempt to differentiate itself from other high street clothing rivals, Laura Ashley promoted a strategy producing rather exclu- sive good-quality clothing for women, which was very feminine and rooted in a country lifestyle. During the early 1980s Laura Ashley’s profits grew as its differentiated product attracted a large following. But the fickle nature of fashion had turned by the early 1990s and Laura Ashley’s fashion products were seen as dated and stuffy.

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But while its differentiated product and brand image had become somewhat of a liability in the clothing market, the company has successfully diversified into the home decorations and furniture market. Here the existing brand image was used to create an affluent customer base.

Focus strategy Rather than considering a whole market as a potential for sales, a focus strategy involves identifying market niches and designing and promoting products for such niches. Such a strategy may or may not be applicable to other niches. As such, a business might pursue any number of dif- ferent strategies simultaneously for different market niches. In such cases, a business that does not hold a competitive advantage in a market in general may be able to identify distinct market segments in which it might exploit some advantage it might have over its rivals, whether in terms of costs, or product difference. Ben & Jerry’s ice cream would be a case in point. The mass low-cost ice-cream market is served by a number of large multinational food manu- facturers and processors, but the existence of niche high- q u a l i t y i c e - c r e a m m a r k e t s o f f e r s o p p o r t u n i t i e s f o r companies like Ben & Jerry’s and Häagen-Dazs. By focusing on such consumers they are able to sell and market their product at premium prices.

Niche markets, however profitable, are by their nature small and as such are limited in their growth potential. Hence firms that focus upon niche market opportunities are likely to have limited growth prospects. There is also the possibility that niches shift or disappear over time. This would require businesses to be flexible in setting out their strategic position.

Sometimes a focus strategy may be combined with a cost-leadership strategy to develop a niche market into a mass market. Amazon.com, the online bookseller, was until relatively recently a business that had a clear cost focus strategy. With low overheads it was able to sell books at knockdown prices to online customers (its niche mar- ket segment) and over time, thanks to lower costs, lower prices and the spread of the Internet, this has become a mass market.

Resource-based strategy Resource-based strategy, as already mentioned, focuses on exploiting a firm’s internal organisation and production processes in order to develop its competitive advantage. It is the firm’s distinctiveness that sets it apart from its compet- itors. If a business does not have a distinctive feature then it needs to set about creating one.

Core competencies Core competencies are those skills, knowledge and tech- nologies that underpin the organisation’s competitive advantage. These competencies are likely to differ from one business to another, reflecting the uniqueness of each individual organisation, and ultimately determining its

Definition

Core competence The key skills of a business that under- pin its competitive advantage.

Pause for thought

Referring back to Box 13.1, what core competencies does Samsung have? Remember, you must justify a core competence in terms of all four listed criteria.

Core competencies. The key skills of a business that underpin its competitive advantage. A core compe- tence is valuable, rare, costly to imitate and non- substitutable. Firms will normally gain from exploiting their core competencies.

KEY IDEA

25

potential for success. Given these differences, how does a firm select an appropriate strategy?

When a firm has unique competencies, its strategy should seek to sustain and exploit these, whether in the design of the product or in its methods of production. In many cases, however, firms do not have any competencies that give them a distinctive competitive advantage, even though they may still be profitable. In such instances, s t r a t e g y o f t e n f o c u s e s u p o n e i t h e r d e v e l o p i n g s u c h resources or more effectively using the resources the firm already has.

What defines a core competence? A core competence must satisfy the following four capabil- ities to serve as a source of competitive advantage for the business. It must be:

■ valuable: a competence that helps the firm deal with threats or contributes to business opportunities;

■ rare: a competence or resource that is not possessed by competitors;

■ costly to imitate: a competence or resource that other firms find difficult to develop and copy;

■ non-substitutable: a competence or resource for which there is no alternative.

Clearly then, whether we adopt a market-based view of strategic choice or a resource-based view will have signifi- cant implications for how a firm can develop and exploit competitive advantage.

Before we consider issues of how to implement strategy, there is one dimension of the business environment that we need to consider and that is the impact of globalisation on the world economy in general and business activity in particular. Few businesses have been left untouched by the phenomenon. So how has globalisation affected strategic analysis and strategic choice?

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BOX 13.2 HYBRID STRATEGY

Are the big four UK supermarkets stuck in the middle?

For example, a large Tesco store will typically stock over 40 000 different product lines. This generates relatively high administration costs and hence higher prices. In contrast, companies such as Lidl and Aldi that focus on a strategy of cost leadership stock far fewer product lines – normally around 1600. This generates much lower administration costs and so enables the companies to charge lower prices. The recent success of the cost leadership strategy of Lidl and Aldi has seen their combined market share increase from 5.2 per cent in 2009 to 9.4 per cent in 2014. The hybrid strategies followed by the ‘big four’ supermarkets (Tesco, Asda, Morrisons, Sainsbury) that were once so successful have resulted in their combined market share falling from 75.6 per cent in 2009 to 71.6 per cent in 2014. A number of observers have commented that the big four are struggling because they are ‘stuck in the middle’ between the discounters at the bottom end of the market, and companies like Waitrose and Marks & Spencer in the higher-quality segment of the market. Another problem for the ‘big four’ is that an increasing num- ber of people are changing the way they buy their groceries. For a number of years the norm for many customers was to travel to a large out-of-town supermarket and do a weekly shop. Instead many shoppers are now buying online many of the basic goods they consume regularly, using their mobile phones or tablets. They then make more regular visits to local convenience stores to ‘top up’ on purchases of fresh goods. In April 2015, Tesco announced a record annual pre-tax loss of £6.4 billion for the year to the end of February. Around £4.7 billion of these losses were caused by a big fall in the property value of its UK stores – a direct consequence of far fewer people shopping at out-of-town supermarkets. Losses were also announced by Sainsbury’s and Morrisons.

1. Choose three supermarket chains and identify the strategy or strategies they adopt. To what extent have they changed over the past few years?

2. Do you feel the classification of business strategy options into cost leadership, differentiation and focus is adequate to describe the strategic approaches that businesses might adopt?

Michael Porter,2 in his analysis of alternative business strat- egies, suggested that it could be disastrous for a business to be ‘stuck in the middle’, having no clear strategic direction. Attempting both to differentiate its product and to offer lower prices would be a serious strategic error. According to Porter, consumers would be confused, as the business would have no clear market identity to which they could relate. His advice was to pick one strategy and stick with it exclusively. But is a single generic strategy always the best choice? Is a mixed strategy always inappropriate? Consumers often demand a range of product characteristics that cover not only issues such as quality and reliability, but also price and convenience. As such, businesses are often forced to adopt a strategic position that attempts to capture both difference and low prices simultaneously. Hybrid theories that focus on a combination of strategies are greatly influenced by the market in which the business is operating. Grocery retailing in the UK offers a clear example of hybrid strategy. The various supermarket chains not only look to differentiate themselves from their rivals in terms of the look and feel of their stores, customer service, and loyalty schemes such as Sainsbury’s Nectar card and Tesco’s Clubcard, but also compete fiercely over price. Then there is the range of their products. At the ‘bottom’ end of the range, with their own-branded ‘basic’ products, the supermarkets compete primarily in terms of price (e.g. the Tesco ‘Value’ and Morrisons ‘M Savers’ ranges). But with more upmarket products, they compete in terms of the variety of lines stocked and their quality (e.g. Asda’s ‘Extra Special’ and Sainsbury’s ‘Taste the Difference’ ranges). A mixed strategy that appears to work well in a market at one point in time might not be so effective if conditions change. This appears to be the case in the grocery market. The impact of the recession and the continued squeeze on consumer incomes during the economic recovery appears to have made many customers more price sensitive. One downside with following a hybrid strategy is that it means the business has to offer a large number of different products.

2 M. E. Porter, Competitive Advantage: Creating and Sustaining Superior Performance (Free Press, 1985).

BUSINESS STRATEGY IN A GLOBAL ECONOMY13.4

In many respects a firm’s global strategy is simply an exten- sion of its strategy within its own domestic market. However, opening up to global markets can present many new busi- ness opportunities: access to new markets, new customers, new supply sources, new ideas and skills. In addition to such opportunities, the global marketplace can also present com- petitive threats, as new market entrants from abroad arrive with lower costs, innovative products and marketing, or some other core competency which the domestic firm finds diffi- cult to match. In this section we explore the strategic implica- tions for business in facing up to the global economic system.

Why go global? The following are reasons why a business may wish to expand beyond its domestic market.

Market size International markets can potentially offer a business massive new opportunities for growth and expansion. Such markets would be particularly attractive to a business where domes- tic growth opportunities are limited as a result of either the maturity of the market or shifting consumer taste. Businesses that conduct extensive research and development (R&D) would also be attracted to larger markets as potential returns can be used to offset the firm’s R&D investment costs and risk.

Increased profitability Expanding beyond the domestic economy offers a number of opportunities for increasing profits.

Location economies. The internationalisation of a firm’s value chain would enable it to place each value-creating

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activity in the most appropriate or effective geographic location. So if production costs are lower in one country, it could locate production there. If another country has the specialist skills to offer superior product design and research facilities, then these functions could be located there. Nike, the US training shoe and sportswear manufacturer, under- takes most of its manufacturing at production sites in South East Asia. However, product innovation and research, along with marketing and promotion, are largely undertaken in the USA.

As businesses relocate many dimensions of their value chain, the structure and organisation of the business takes on a web-like appearance, with its various operations being spread throughout the world.

Pause for thought

Identify some of the potential strengths and weaknesses of businesses having their value chains located in a variety of different countries.

Scope for significant cost reductions. It is widely observed that over the life cycle of a product a firm’s average costs fall. This is partly the result of economies of scale as the firm gets bigger and plants can specialise in particular functions. Clearly, these cost reductions can be greater by expanding globally.

Cost reductions over time are also the result of what is known as ‘learning by doing’. This is where skills and productivity improve with experience. Such learning effects apply not only to workers in production, sales, distribution, etc., but also to managers, who learn to develop more efficient forms of organisation. When a firm expands globally, there may be more scope for learn- ing by doing. For example, if a firm employs low-cost labour in developing countries, initially the lower cost per worker will to some extent be offset by lower produc- tivity. As learning by doing takes place, and productivity increases, so initial small cost advantages may become much more substantial.

Using core competencies. A firm may be able to exploit its core competencies in competing effectively in global markets. The firm might look to expanding first in those countries where it has a clear competitive advantage over already established companies. Wal-Mart’s logistic expertise is one example of a business that might exploit such an advan- tage, in particular overseas markets.

Learning from experience in diverse markets. Successful busi- nesses will learn from their global operations, copying or amending production techniques, organisation, marketing, etc. from one country to another as appropriate. In other words, they can draw lessons from experiences in one coun- try for use in another.

KI 25 p 226

Spreading risk (diversification) Clearly one of the main reasons a business might have for going global is to spread risk, avoiding being overly reliant on any specific market or geographic region. As such, fall- ing profitability in one region of the global economy might be effectively offset by improved or more favourable eco- nomic conditions elsewhere.