Questions and Answers on Economics and Market Strategies
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- What are the main features of an oligopolistic market? With the aid of examples, show collusion between firms in such markets may be determent to consumers and explain briefly what governments can do to control the worst abuses of such a situation.
An oligopolistic market is characterised by a few organisations in competition with each other to supply goods to a market. Their strength is not quite that of a monopoly, but there are typically a small number of relatively powerful operators, creating barriers to entry for potential competitors.
The UK market for chocolate is largely oligopolistic, with 90% of purchases being manufactured by Mars, Cadbury or Nestlé (Marcousé et al 2003: 429). Branding is strong, reflecting the product name and often the manufacturer (Cadbury’s Dairy Milk, for example).
The substantial investment put into product development creates a barrier to entry for the competition, and competition is predominantly product-based, thus for chocolate, the aim is to create the products most popular with consumers. Laidler (1982: 202) notes that firms operating in an oligopoly tend to assume that if they raise their prices, their competitors will not follow suit, leaving them disadvantaged, but that if they lower their prices, competitors will copy the strategy, eroding margins across the market sector. As far as chocolate is concerned, the three main manufacturers price their bars similarly and rarely use price promotions. Marketing activities are structured to encourage consumers to choose one brand ahead of another when they make a purchase, rather than to instigate the purchase in the first place.
The tendency of oligopolies to follow similar strategies to their competitors is also recognised as affecting the groceries market (Office of Fair Trading 2008: 151) and referred to as tacit co-ordination: there is no formalised plan or discussion between parties, but the effects are to make the industry less inclined to be competitive (ibid), at the expense of the consumer who continues to pay high prices.
There are examples of price competition among oligopolistic companies, such as between the Mirror and Sun newspapers in 2002 (Marcousé et al 2003: 429), but the aim is more often to preserve relatively high margins. Collusion emerges as one of the techniques to do this.
Although collusion is illegal in most countries (Koutsoyiannis 1983: 237), it may operate informally: for example, trade magazines often publish information on what companies within a particular industry are doing with the implication is that a particular pricing practice is de rigueur within that industry (ibid). It was perhaps notable that when oil prices fell recently after a significant rise earlier in 2008, savings were not initially passed on through the price charged at the pump, and only dropped when supermarket petrol stations began cutting their prices. This kind of situation, where organisations in an oligopoly behave consistently with each other, may have similar effects to colluding, but is not in breach of any regulations.
Cartels have a similar effect: for example, OPEC standardises oil prices across thirteen different member nations. Such a situation may deter consumers as prices may be kept artificially high. If there is little choice for the price-sensitive consumer, then reductions in purchase may occur. For example, as petrol prices rise, car users may be less inclined to make unnecessary journeys.
OPEC is international, with government involvement to promote stability within the oil industry and operates through formalised agreements, contrasting with the kind of collusive approaches which are widely outlawed. The UK government uses the Office of Fair Trading and the Competition Commission to help control collusion (Marcousé et al 2003: 429) as it has a detrimental effect on consumers through fixing prices artificially high.
The UK framework includes legislation prohibiting cartel-type activities, and this enables civil and criminal actions to be brought. Additionally, activities which are not illegal but may nevertheless compromise competition in the markets can be investigated and action taken, affecting monopolies and oligopolies: for example, the requirement for BAA to sell some of its airports because of its dominant position reflects issues regarding competition between airports.
The UK Competition Act 1998 forbids the setting up of cartels and facilitates civil sanctions, enforced by the Office of Fair Trading (Office of Fair Trading 2008: 148). The 2002 Enterprise Act criminalises those who take part in cartels (Office of Fair Trading 2003: 2). The Competition Commission investigates mergers and market activities which may compromise the competitive environment (Office of Fair Trading 2008: 148).
A recent example is price-fixing on fuel surcharges by British Airways and Virgin, who discussed and established the strategy together. Virgin alerted the relevant authorities, resulting in the airline escaping prosecution despite participation, although certain personnel from within Virgin are having actions taken against them (Milmo 2008). The investigation has resulted in large penalties for both companies, who have also set up a large compensation fund for passengers affected, and the issue has caused particularly bad publicity for British Airways (ibid). The individuals involved have been prosecuted under the 2002 Enterprise Act (ibid).
A further area of concern has been the operations of supermarkets, particularly with regard to activities with dairy processing companies, and they have been found to be in breach of Chapter 1 of the Competition Act 1998 and article 81 of the EC treaty (Office of Fair Trading 2008: 148-9), with a number of parties fined. The power of supermarkets has been widely questioned (Blythman 2005), but the Office of Fair Trading’s 2008 report into their activities found that while their practices may be detrimental to smaller grocers operating nearby, the overall effect is beneficial for the consumer. This demonstrates how, overall, the impact of the activities of organisations is considered on the basis of its effect on consumers, not on other businesses trying to compete within the same market.
While collusion, co-operation and co-ordination between oligopolies may be detrimental for consumers who pay unnecessarily inflated prices, the determent factor of such practices may be limited, since if there is a demand and the oligopolistic market will not lower its prices, consumers have little choice: they must purchase at high prices or go without.
- Why might the objectives of the managers (agents) of large companies differ from those of shareholders (principals)? Explain how the corporate governance scandal at Enron in 2001 showed clearly the problems of ‘corporate governance’ within large firms.
An organisation typically has a wide range of stakeholders, from employees, suppliers and customers to shareholders and community groups, all with different interests and agendas. Traditionally, it was considered that the shareholders’ interests, as owners of the company, should take precedence, but this view has been largely superseded by the idea of the stakeholder concept (Marcousé et al 2003: 489), which takes into account the wishes of the broader stakeholder groups. This may seem to conflict with shareholders’ interests, but the stakeholder concept should result in a more profitable company through, for example, higher employee morale and productivity and lower staff turnover through investment in employee welfare, resulting in increased dividends for shareholders. However, shareholders may see these benefits as being long-term, and wish to invest in shares with a greater short-term return.
Shareholders’ aims vary according to whether they perceive their holding as a short- or long-term investment. In the short term, they will be interested in the organisation having a strong profit with substantial returns in dividends to shareholders, rises in share price and potential profits on the disposal of shares in the near future. For longer term investment, the ongoing strategy and investment carried out by the organisation becomes more important. Investment may come at the expense of dividends, and while it should result in a more profitable enterprise in the long-term, the short-term returns are affected and the share price may drop, decreasing the worth of the shareholders’ assets. It may make more economic sense to sell shares to realise profit sooner, rather than hold them for longer periods of time and assume their price will recover.
Managerial concerns, while recognising the issues confronting the organisation in the short term, must be focused on its long term survival, through investment, employee development and knowledge management, key attributes which are considered to help gain competitive advantage. However, such initiatives may impact on the profit of the company in the short term, potentially conflicting with shareholders’ wishes.
The idea that shareholders are looking for dividends at the next payout and short term profitability, while long-term planning is better for the organisation (Grant 1995: 40) may be an oversimplification. Indeed, Grant suggests that cash flows, which affect share price and the continuing viability of the organisation, are key (ibid).
Enron provides an example of problematic corporate governance leading to a collapse in share price and the failure of the organisation. The size of Enron has been presented as a difficulty for its corporate governance (Cohan 2002: 280), with the suggestion that departmental managers had agendas to pursue for the benefit of their department rather than the interests of the organisation (ibid: 281). It has also been suggested that senior managers were oblivious to questionable practices within the organisation. Thus in the following enquiry, a senior executive, Sherron Watson, described how she met with Enron’s former chairman and outlined her concerns but he “didn’t get it” (ibid: 276).
While the role of managers is partly to take a long-term strategic view and facilitate the organisation’s continued trading into the future, the motivations of managers can affect this. Particularly significant at Enron was the structure of bonuses for top-performing employees. A substantial part of the bonuses was made up of stock options, the options to buy stock at a particular price in the future (Joint Committee on Taxation 2003: 13-14). For many, the preference was to dispose of such shares relatively quickly, and Enron’s auditors and accountants, Arthur Andersen, advised on setting up systems to minimise tax payments on such sales, through partnerships set up with spouses (Joint Committee on Taxation 2003: 661), an indicator of the predilection for disposal rather than keeping shares in the long term. The effect of such bonus schemes would arguably be for managers to focus on short-term increases in share values rather than consider the long-term picture for the organisation.
This is perhaps why Enron’s activities were so focused on income, often through business not relating to its core activities but allowing it tax benefits (Joint Committee on Taxation 2003: 21). This approach generated favourable financial reports on the organisation, helping inflate its share prices. It also led to the setting up of a number of companies to hide losses so that the positive image of Enron could be maintained. The financial affairs of the organisation became highly complex as a result.
However, the culture within Enron was highly targeted and conducive to a focus on covering one’s back rather than alerting management to problems, aggravating corporate governance difficulties: employees who noted such issues were motivated to conceal them due to concerns that they would lose their jobs otherwise (Cohan 2002: 281). Cohan identifies the main assumption of corporate governance being that employees are “autonomous and rational beings” (ibid: 282), suggesting that psychological factors had a significant impact on Enron’s corporate governance, creating cognitive biases (ibid: 283) where the individual is less willing to believe evidence that causes cognitive dissonance with their current beliefs.
Overall, the situation at Enron was one of highly complex transactions, many outside its core business, widespread practices to maximise income for the highest earning executives and a culture which helped perpetuate questionable approaches to running the organisation. As a large firm, the complexities of its corporate governance enabled both managers and the auditors to engage in self-preserving activities. When senior figures were alerted to problems, they had little awareness of many of their executives’ activities and the massive structure of the organisation helped those executives cover up their actions.
- Explain the various types of pricing strategies which companies can adopt in the face of competition in the marketplace. How would a knowledge of elasticity of demand help companies decide how to price their products?
At the most basic level, pricing needs to take costs into account as prolonged sales which fail to cover costs will result in a loss. However, true costs can be very complex to establish (Christopher and McDonald 1995: 183): for example, if an organisation produces two products, it is quite subjective as to how its marketing costs, electricity costs and directors’ salaries should be allocated to overall production costs. Establishing costs of services may be particularly difficult (O’Connor and Galvin 1997: 177) because of the predominance of intangible elements. Pricing thus becomes quite subjective.
It is therefore common to adopt a particular strategy with pricing: cost-plus pricing is used as an initial indicator of the minimum viable price to set, and then the organisation can focus on how they wish to position their product within the market and against that of the competition. Price may be integral to product and brand image, and may eventually be set very much higher than production costs.
For new products a lower price, reflecting a market penetration strategy (Kotler et al 1999: 721), may help entrants compete with existing products. However, to avoid starting a price war with competitors (Marcousé et al 2003: 77), product costs must be low and barriers to other entrants high, or competitors may be in a position to lower their prices and the strategy could then fail (Hooley et al 2004: 382). For luxury products, the brand image may be cheapened by this approach and the product perceived as low quality, reducing demand.
If product features are clearly differentiated from those of competitors, market skimming (Kotler et al 1999: 720), where prices are high and the product has kudos with customers who wish to be technologically ahead of their competitors (for businesses) or friends (for consumers), may be more appropriate. This also helps the organisation cover research and development costs of bringing a new product to market.
Premium pricing strategies, whether price-skimming with a new product or charging a high price for an established product, are dependent on strong differentiation (Hooley et al 2004: 383): luxuries such as spa treatments or designer handbags may lose their appeal and impression of exclusivity if not highly priced. Supply of such goods may also be restricted, increasing demand and thus increasing the prices which can be charged.
Items such as computer printers can be priced very cheaply and profits then made through consumables with a captive product pricing strategy (Kotler et al 1999: 723). Purchasers can compare the printer features and price easily with competing products, but cost of consumables will be very much harder to assess as it will depend on ink consumption. Margins on the printer may be very small, but comparatively large on the consumables: razors and razor blades provide a similar example.
Price signalling (O’Connor and Galvin 1997: 177) involves sending a strong message to competitors regarding the organisation’s low costs and efficiencies, deterring them from trying to compete, although this can be a high risk strategy if competitors can copy the organisation’s model.
Pricing strategy has perhaps been neglected in some of the literature: Hooley et al (2004), for example, writing on competitive strategy, discuss pricing only very briefly. Because of widespread increases in efficiency in recent years, trying to gain competitive advantage on cost may be a particularly risky strategy for any organisation. However, the current economic downturn may result in consumers focusing increasingly on price rather than product features.
Within pricing strategy, the ideal price is that which maximises profit. A low margin with high demand may generate as much profit as a high margin with low demand. The concept of price elasticity of demand reflects how much a change of price affects demand (Marcousé 2003: 58), with each measured in per cent:
Price elasticity of demand = change of demand (%) (Mercer 1996: 246)
change of price (%)
If the price elasticity is known, prices can be set to maximise profits. However, its measurement is difficult. Analysing existing data on price and demand can give some indication (Mercer 1996: 249), but it is not possible to isolate data from other factors. For example, the current economic concerns are leading to UK shoppers switching to lower priced supermarkets, even though the premium supermarkets are not increasing their prices. Other factors which may affect demand when price is not changed include the availability of substitutes, consumers’ loyalty to particular brands and the extent to which the product is a necessity. Technically, such factors are not price elasticity, but a more general elasticity (ibid: 246), but they limit the applicability of available data.
Surveys of consumers asking how much they would be prepared to pay for a product may give some indication of price elasticity (ibid: 249), but answers given in surveys may not be consistent with behaviour. Experimenting with prices may provide useful information (ibid: 249), but runs the risk of reducing profit by testing prices which are found to be unsuitable. Another option is to listen to anecdotal evidence from sales staff which may help indicate customer attitudes: however, sales staff may be motivated to have targets reduced and report high numbers of customers refusing to buy, or customers could be using a negative response to price as a negotiating tool.
Relatively inelastic price elasticity is ideal for companies as it gives them the freedom to raise prices without demand being significantly affected (Marcousé et al 2003: 60). This is easier to achieve if a product is perceived as being different from (and better than) competitors’ products.
- What have the main demand and supply factors that have determined the general increase in global food prices over the last years?
Food prices have risen considerably in recent years, not only in countries importing foodstuffs but also in areas where food production is high. There are a number of reasons for this.
As globalisation has increased, certain nations, notably the BRIC countries (Brazil, Russia, India and China) have seem rapid economic growth and increased demand for a wide range of products. These emerging economies are giving rise to newly affluent populations whose dietary habits are changing to reflect their higher incomes. This is seen, for example, in India: although vegetarianism is widespread, meat consumption has risen 40% in 15 years (FT.com 2008). Using grain to feed livestock and then using the livestock to feed humans is a less efficient way of utilising the grain than it going direct to feed humans, placing additional demands on agricultural production. Dairy consumption in India is also increasing, leading to supply problems as sufficient milk cannot be produced (ibid). Again, foodstuffs are needed for dairy herds, utilising agricultural land that might otherwise produce crops for human consumption.
The rise of supermarkets has led to changes in shopping patterns in India (ibid), but supermarket expansion has been global. Shopping in this way means that larger quantities are purchased but that shopping trips are typically made less frequently. Purchasing for several days ahead may result in over-buying, and concern has been expressed regarding the amount of food thrown away in the UK because of deterioration (Smithers 2007). Three-for-two and similar offers may increase impulse buys and over-purchasing (ibid), and high levels of wastage are also attributed to lack of meal planning by consumers prior to shopping and inadequate storage of perishable items (ibid). According to economic theory, increased demand pushes prices up, particularly as supplies become depleted, suggesting that more careful shopping could result in a price reduction.
The systems of subsidies offered to farmers have taken agriculture in a direction that further threatens food supplies by encouraging the planting of crops for bio fuels, particularly in the US where targets for bio fuels have been set (ibid). As an alternative to fossil fuels, bio fuels may offer an infinite source of energy: however, there are the costs and power associated with processing the crops before they can be used as fuel, and every processing stage in the food chain adds cost and inefficiency.
Where subsidies are available, it is in farmers’ interests to grow large quantities, but if the subsidy system does not reflect the demand for food, then the use of the land is inefficient at addressing rising food prices. Harvey suggests that the pattern of UK agriculture in the 1950s, with wide use of pasture to feed livestock and to help maintain nutrient reserves in the soil, with grain crops rotated to ‘rest’ each area of land regularly, produced smaller crop yields but required far less input, with overall food output per acre higher than through intensive methods used today (2008).
It should be noted that many food prices are coming down, particularly wheat which has dropped 50% in a year (Harvey 2008). The difficulty occurs because of unpredictable crops, and the reason for such volatility is climate-based.
Climate change has impacted on crops, with weather patterns increasingly more extreme (FT.com 2008). While this has enabled crop growth further north than ever before, it has limited production in, for example, Southern Europe where there has been a problem with heat waves, not only affecting crop growth but resulting in fires (for example, in Greece in 2007) which can destroy crops. Many areas of the world, from the UK to Bangladesh, experience regular flooding which can ruin crops and limit the use of land in floodplains which, in drier conditions, is particularly fertile. Conflict has also resulted in agricultural land being unavailable for use, for example in Sudan, where 80% of agricultural land is out of use (Rice 2008).
The increase in oil prices has affected the operation of agricultural machinery and transport costs in recent months; although the price has now fallen again, volatility in the markets can contribute to difficulties as producers struggle to plan and budget for production. Power to produce and process food has become increasingly expensive.
Overall, the rise in food prices can be seen as a consequence of increased global demand coinciding with increasing practical difficulties and rising costs of production.
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