Law of Supply and Demand | Entry Barriers
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The Economic Environment and Anatomy of Business
Law of Supply and Demand
The first economic phenomenon that we are going to look at is the law of supply and demand. In its raw form it states that if the demand for certain product is higher than its availability (supply) then the price for that product goes up and if the vice versa is present then it decreases (Baye, 2010).
A current example of this is the lightning fast selling of Google’s latest flagship smartphone - Nexus 6. Upon its release in the Google Play Online store, the first shipment was sold out within minutes. After that, when the second shipment arrived, the same situation repeated. This is a clear indicator that the demand of Nexus 6 was way higher than the actual supply.
The reasons for such a high demand can be attributed to several factors. Firstly, Google’s Nexus 6 came with the new Android operating system version 5.0 (Code name Lollipop), being the only phone on the market that supports it. Secondly, the price of Nexus 6 was (and currently is) relatively lower than its competitor‘s – it is cheaper than Apple’s IPhone 6, 6Plus and Sony’s Xperia Z3 (Luke Johnson, 7 November, 2014), and approximately same priced as Samsung’s Galaxy S5. This gives an extra layer of appeal to buyers and combined with its high quality, the reason behind the extremely high demand of the Google’s smart phone is justified.
The graph below illustrates an example of the current supply and demand of Google’s Nexus 6:
We mark the current price level of Nexus 6 with P1, the current quantity that Google can supply with Qs and the current quantity that is demanded with Qd. P* and Q* are our equilibrium price and equilibrium quantity respectively.
Setting a lower price for the smartphone compared to the competitor’s and offering the exclusivity of the new Android operating system, has made the demand for the product extremely high. On one hand, this is good indicator, however, in this case Google could not provide an adequate amount of supply to the market. Those two factors led the company to an excess of demand. Assuming, the basic principles of the law of supply and demand are functioning, the rivalry between customers, who want to buy the modern smartphone, will push the price up to the equilibrium point. That point represents the place, where the demand from customers and the supply from Google, meet and form an equilibrium (supplied quantity is equal to the demanded one or our equilibrium price and quantity, conforms).
Naturally, another scenario may occur – the demand for Nexus 6 might eventually drop as a result of oversaturation of the market with smartphones from the same class, adoption of the Android 5.0 OS by rival firms (it is predicted that this will happen by the end of 2014 (James Rogerson, Matthew Hanson, October 2014) due to the fact that the Android OS is open-source) or a drop in prices of competitor’s phone offers. In case this happens, the equilibrium point will be achieved at a significantly lower price compared to the first scenario.
To summarize, in the base of every modern economy stands the law of supply and demand and it dictates its basic behavior. Companies such as Google and its Nexus 6 smartphone, visualize the stated law perfectly with its clear excess of demand.
Headline: Latest OS share data shows Windows still dominating in PCs
The second economic mechanism that we are going to focus on is that of entry briers. Entry barriers or barriers of entry by definition are blockades set on a specific market that make it difficult for new firms to enter. The reason of their formation can be due to government laws and regulations (this creates governmental monopolies), to a large company that is taking advantage of economies of scale, to brand loyalty, geographical barriers (the mining industry), high switching costs, sunk costs, high cost for research and development or to patents (Sullivan, A; Steven, M. S., 2003, p.153)..
An excellent example for entry barriers is the market of desktop operating systems, which currently is occupied by Microsoft. Since its founding in 1975 the company has walked a long way from a simple garage firm to a global computer giant that, at the present moment, has a monopolistic position on the desktop OS market with more the 90% of it belonging to the Windows operating system (OS) (“Desktop Operating System Market Share”, 2014). With the recent announcement of the newest member of the Windows family – Windows 10, Microsoft aims to strengthen even more its position and along with that to keep the status quo. Hence, any other company, which wants to enter the market and successfully compete with Microsoft, needs to make a huge investment. Several reasons lie behind that: there is a significant market loyalty to the Windows OS, the know-how for making an OS with such proportions is concentrated within the company and the brand itself is highly recognizable. All those factors are barriers for the other companies to enter the market and in order to compete efficiently, they have to apply a lot of effort to popularize their new brand. Moreover, Microsoft has many patents in the software sector, which restrict major part of the information accesses for the rival firms. Furthermore, the switching costs (the cost for switching from one product to another) for a company, which uses the Windows OS, are significantly high. They consist of expenses for buying the new OS, integrating it and teaching its employees to use it and generally such migration will not be undertaken/ launched lightly or even at all.
Entry barriers do not always have a positive effect on the market due to the fact they stimulates the creation of a monopolies in a specific sector, which may lead to unreasonably high prices and low quality. This stems from the lack of competitors able to challenge both price and quality of the products offered to the public. With Microsoft, this is not the case, but the probability is always there.
To summarize, the barriers of entry are an efficient way for a firm to restrict access to a market segment and generate maximum profit.Microsoft’s monopolistic position in the sector of desktop operating systems is largely attributed to the various imposed entry barriers, which have assured their future dominant position on the market.
Thirdly, we are going to look at the following economic concepts - economies of a scale and economics of a scope. Economies of a scale is a way for a company to reduce the average cost of its products by distributing the fixed costs onto a larger amount of production (Baye, 2010, p. 185 - 186). Normally, this is done by increasing the size of the company (growing horizontally – expanding in the current market segment). Economies of a scope, on the other hand, is achieved by expanding the company in other market sectors, where its current know-how can help to produce goods at a relatively lower prices then it normally would do (Baye, 2010, p. 187).
Facebook is a company that applies simultaneously both economies of a scale and scope. Since its founding in 2004, the company has spent roughly 22 billion dollars for the goal of acquiring other businesses that range from small companies focused on web or mobile development, through startups that have an astonishing growth rate (WhatsApp), to innovators that are promising to bring a whole new experience to their users (Oculus Rift).
Buying small and medium sized companies that can be directly integrated into the development process of Facebook, is clear example of economies of a scale. By doing that, the company is reducing its fixed costs by spreading them onto a larger amount of users. Another benefit from this is the company’s employees specialization into a specific field (social media) and along with that they become more efficient, which increases the general productivity and reduce costs.
Another aspect of Facebook’s policy is that of acquiring companies in sectors related to social media. A good example of that is the Oculus Rift deal that happened in the beginning of 2014. Through buying the company, Facebook can combine the virtual reality technology provided form Oculus Rift with its know-how of brining real life social experience, online and the result will be a totally new way that we experience the web. This implies that the Social Media giant will be able to reduce its total cost in the view that it already has experience in the field of software development and social media. Developing applications for the new virtual reality platform or developing the platform itself will be less expensive than for other companies that do not have such experience.
Avoidlessly, economies of scale and scope come at a price. Larger firms often experience problems such as miscommunication between its separate parts, difficulties in coordination and their owners loose part of the control over the company due to the necessity to delegate part of their responsibilities to managers, hence they may not always make the most adequate decisions for the best of the company.
In conclusion, by using economies of a scale and scope companies such as Facebook can significantly reduce their total costs, optimize productivity and increase production power.
Headline: GitHub announces free developer tools for students
The last economic concept that we are going to look at is price discrimination. In its core, price discrimination is a type of pricing strategy, in which the same or largely similar products are sold at different prices depending on various factors.
There are several degrees of price differentiation - first, second and third, in addition to that, diverse combinations among them can be formed. Typical for the first degree is that a monopolistic company charges the absolute maximum price (reservation price) for its goods or services (perfect price discrimination). The second degree is closely related to quantity demand - the larger it is, the lower the prices are (it does not depend on customer’s personality). Conversely, third degree price discrimination can be based on a specific market group (students, teachers, workers etc.), on geographical location or even more in some cases on a specific customer, but not on quantity (Cabral, 2014).
A good example of price discrimination, is the recent release of free developer packages from GitHub for people belonging to educational sector - students, teachers, administrative staff and researchers, which include waiving of subscription taxes for a private GitHub account and free educational software (third degree discrimination).
By taking this step, GitHub attracts more people form the target sector. For instance, students overall have more restricted incomes, making them more price sensitive to changes and the demand they form, relatively elastic (from the graphic bellow: changes in price from P1 to P2 are met with significantly greater change in demanded quantity – Q1 to Q2). In other words, small price changes can have a great impact on the total demand of a certain item. Similarly, GitHub offers the same packages for teachers – which allows them to better educate their students and hence produce a better qualified future workers for the market, benefiting the economy as a whole. Despite the fact that those packages are now free, in long term they can bring more clients and create customer loyalty, which will result positively on the company’s revenue.
Moreover, this price discrimination tactic has a beneficial influence on the whole software development sector due to the fact it provides free access to private accounts and free development tools. This contributes to students to develop their ideas, which can eventually grow in startups a effect on the economy.
However, attempts for reselling the software provided within the free packages can occur and in order to prevent this the company has taken measures. For students to request such an account, they need to provide their unique university email or school ID as a proof. Teachers and researchers on the other hand need to present a “proof of affiliation”* in order to install the software on their computers. Providing proof of affiliation is a way of verifying the involvement the academic status. Such packages are allowed per person/ an email account and in addition to that most of the software is licensed under conditions that permit its usage only for academic purposes and any other attempts are punishable by international law. Undoubtedly, ways around such rules exist but generally speaking the company is relatively safe against reselling of their products.
To conclude, price discrimination is an efficient way for companies to specifically tailor their products for a particular group of customers. Being one of those companies, GitHub combines the benefits from that, with the opportunity to stimulate the academic process around the world.
- BAYE, M. R. (2009) Managerial economics and business strategy – 7th edition, New York, McGraw-Hill/Irwin
- CABRAL, L. M. B. (March 10, 2014) Introduction to Industrial Organization – 2th edition, Price Discrimination
- Sullivan, A; Steven, M. S. (2003). Economics: Principles in action, Upper Saddle River, New Jersey: Pearson Prentice Hall, ISBN 0-13-063085-3.
- Desktop Operating System Market Share (October 2014) (online). Available from: http://www.netmarketshare.com/operating-system-market-share.aspx?qprid=10&qpcustomd=0 (Last Accessed 14/11/2014)
- James Rogerson, Matthew Hanson (13 November, 2014) (online). Android Lollipop 5.0 update: when can I get it? Available from: http://www.techradar.com/news/phone-and-communications/mobile-phones/android-l-5-0-release-date-when-can-i-get-it--1257804 (Last Accessed 15/11/2014)
- Luke Johnson (7 November, 2014) (online). Nexus 6 release date, rumors, news, specs and price round-up. Available from: http://www.trustedreviews.com/news/nexus-6-release-date-rumours-news-specs-and-price (Last Accessed 15/11/2014)
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