Introduction
The market structure in which a firm operates determines the strategies that the firm should follow to maintain steady growth in revenue and profit. The market structure influences the pricing decision and also the decision to innovate and diversify in the product. The sales promotion activities are also a great deal dependent upon the market structure in which the firm is operating. To know the market structure we have to understand the degree of competition existing in the market. If there are a large number of firms producing similar products and none of the firms have the power to influence the market price then it is competitive kind of market. In this form of market the firms face an elastic demand curve. On the other extreme is a monopoly form of market where the single seller alone decides the market price. The firm in this situation faces an inelastic demand curve. In case of an oligopolistic market there will be a few firms with stiff competition among them. But this competition will mainly be non-price in nature. The firms will have their own market share which they try to enhance. In case of a monopolistic competition there are a large number of firms facing inelastic demand selling differentiated products. In this paper we try to assess the market structure in which the firm is operating. Based on the market structure we make analysis and suggest short term and long-term policy for the firm.
Market Structure
Leading Competitors in the Microwaveable Frozen food industry
Studying the frozen food market we have chosen two major companies in the industry for our market analysis. One is Nestle and the other one is Schwan. Nestle is a well known company for producing baby food and kids’ food products like instant noodles, health drinks and such others. Nestle is also a major player in the frozen food section which constitutes around 15% of the company’s revenue (IBISWorld, 2013). The market share enjoyed by Nestle SA is around 20% which is quite high compared to 9% by it close competitor Schwan. Nestle has enjoyed a surge in its sales during the recession of 2008 when it faced a rise in its profits. But after 2010 the sales has come down and so has profits. Recently there has been a general shift in demand from frozen food to fresh food. Nestle is launching new marketing strategies with an array of new products along with effective campaigns. The other companies in this product segment have made a joint campaign to bring back consumer confidence to the frozen food products. Companies like Heinz, Nestle a ConAgra are making joint campaigns to spread the message that frozen food retain their nutritional quality and are more faster and convenient to cook
The target group of the Schwan frozen food company is quite different from that of Nestle.While Nestle specializes in kids and family meals Schwan’s clientele is composed of restaurants, hospitals and schools .It had faced a major downturn in its sales during the recession of 2008. But it recovered immediately after that with well crafted marketing strategies. It has introduced an array of products with more than 200 options to choose from. This new marketing campaign has earned it considerable amount of revenue. Its product has taken an upward turn since 2011 .
In our previous analysis we had arrived at the equilibrium price and quantity by equating the demand and cost functions, that is, we considered the point of intersection of the demand and the supply curves. The firm’s behavior was that of a competitive market structure. Our analysis above suggests that the firm is no longer in a competitive situation. It has gained some market power. The market has some element of competitiveness but within that framework the firm has some monopoly power. It is a situation of monopolistic competition. The firm’s pricing and output decision can no longer be determined by the simple intersection of the demand and the supply curves. The firm faces an inelastic demand curve. The firm will now take its profit maximizing output decision based on the demand curve and the cost functions.
Microeconomic theory tells us that a firm under imperfect competition will maximize its profits at the output level where the Marginal Revenue (MR) equals the Marginal Cost (MC) . We can derive the MR from the demand function and MC from the cost function. The point of intersection of the MC and MR will give us the profit maximizing level of output. We can find the price from the demand function by substituting the value of output obtained from MR-MC analysis.
Factors Causing Change in the Market Structure
The firm has undergone a change from the previous market structure. It was in a competitive situation but now it has gained monopoly power. This shift in the market situation can occur due to a number of reasons both endogenous and exogenous. Let us cite two of such factors here that might have possibly altered the competitive mode the firm was operating in.
First of all, the firm might have gone through a major product innovation operation by investing heavily on research and development. This innovation technique has given rise to new products that can appeal to the tastes of different sections of consumers hence the goods produced have become unique in the market. We have observed this situation in case of Schwan food products who have introduced an array of products in the market that has catapulted its profit growth within a span of few years.
Secondly, the firm might have introduced innovative sales promotion schemes that has increased the market appeal for its products. The increased sales have been responsible for the increase in its market power. Improved awareness programs also tend to increase the demand for such products and increase the market size. In our study of some frozen food products we have seen how some companies have jointly launched campaigns to promote such products.
Short-run and Long-run Cost Functions
The Total Cost (TC), Variable Cost (VC) and Marginal Cost (MC) functions of the firm have been provided to us as shown below:
TC = 160,000,000 + 100Q + 0.0063212Q2
VC = 100Q + 0.0063212Q2
MC = 100 + 0.0126424Q
AC = TC/Q = 160,000,000/Q + 100 + 0.0063212Q
AVC = VC/Q = 100 + 0.0063212Q
We can write the total cost function as:
TC = 160,000.000 + VC.
Thus we know that, $160,000,000 is the fixed cost (FC) of the firm as TC = FC + VC
We can also see that
AC = 160,000,000/Q + AVC
That is, AC = AFC + AVC
Average Fixed Cost (AFC) =160,000.000/Q. We can see that AFC falls as the output (Q) increases. As output increases both AVC and MC increases as they are increasing functions of Q. This suggests that it is an increasing cost industry. But we also observe that AFC falls with output. For AC to fall the output has to be huge. In the short run when the output is low the rise in output will lead to rise in costs as the AVC dominates the AC. If the output can be raised to quite a high level in the long-run then the AFC will fall considerably leading the AC to fall. That means the industry exhibits considerable economies of scale which can be reaped in the long-run. If the market size increases considerably the firm gets room to expand and reap the gains from economies of scale.
Circumstances that may lead to Shut-down
In the short-run a firm may not be able to cover its total costs. In such a situation the firm will incur losses. This does not mean that the firm has to close down. If the revenue earned is greater than the variable cost that is as long as the firm can cover its variable costs it should continue with its operations even if it cannot cover its entire costs . Such a situation is known as the break-even situation. To say it in other words, so long as the price is equal to or less than the average cost the firm, it can continue with its operations even if it cannot cover its fixed costs.
If the revenue earned by the firm falls short of the variable costs the firm has to close down. That means if the price falls below the AVC the firm can no longer continue with its operations. Thus when the price is just equal to the minimum AC we say that the break-even point has been reached as any further fall will mean that the firm covers its variable costs but not its fixed costs . When the price reaches the minimum AVC we say that the shut-down point has been reached because any fall in price will make the firm unable to cover the variable costs and the firm has to shut down.
We know that in the long-run all costs are variable. We have also discussed in the previous section that the firm enjoys economies of scale. If the firm can expand its operations in the long –run so that it gets the advantage of economies of scale it can reach the optimum point of the long-run average cost. If it can keep the price considerably high then it can earn significant amount of profits in the long-run. So the key to the firm’s survival in the long-run is market expansion and retention of market power so that demand is high and inelastic so that output can be raised to the efficient scale.
Profit Maximizing Pricing Policy
QD = 65100 -100P
Let us fin the inverse of the function as:
P = 651 – Q/100
Total Revenue (TR) is given by:
TR = P*Q = 651Q – Q2/100
We differentiate TR in terms of Q to get the Marginal Revenue (MR):
The condition for profit maximization is:
Or, 100 + 0.0126424Q = 651 –Q/50
Q = 16879.8863 units.
P = 651 – Q/100
Substituting Q = 16879.8863 we get:
P = 651 – 16879.8863/100=651-168.798863
= $482.20
The Total Revenue (TR) for the above values of P and Q will be:
TR = P*Q = 482.20*16879.8863 = $8139500.37
The total cost incurred to produce the profit maximizing level of output is:
TC = 160,000,000 + 100*16879.8863 + 0.0063212*(16879.8863)^2
Or, TC = $163489092
We have found the TR and TC. Let us now find the profit as:
π = TR-TC = $8139500.37- $163489092= -$155349592
Profit is negative implying losses.
Comparing with the previous scenario we find that the price in the present situation has increased to $482.2 compared to the previous price $407.65. The firm has reduced output from 24335 to 16879.8863, to increase the price.
A note on the Financial Performance of the Firm in the Current Situation
We have seen that the firm is incurring a loss. As discussed earlier the firm can continue its operations if it can cover its variable costs:
The VC for Q= 16879.8863 is given by:
VC = 100*16879.8863 + 0.0063212*16879.8863 = $3489092
Our next step is to find out whether the revenue earned covers the variable costs. Let us subtract the VC from the TR:
TR – VC = $8139500.37– $3489092= $4650408.37
We can see that the TR exceeds VC by $4650408.37
Since the firm can cover its variable costs it should continue with its operations.
We can get interesting results if we compare the price, output and profit of the previous competitive structure with the present operation mode of the firm:
Previous Situation: Current Situation:
P = $407.65 P = $482.20
Q = 24335 Q = 16879.8863
Π = -$156256703 π = -$155349592
We can see that the firm has been able to reduce the loss by $907111 from the previous scenario.
In the long run the fixed cost vanishes. Only variable cost remains. So the profit in the long run will be $4650408.37 which is the amount by which the TR exceeds the VC. We have assumed that in the long run the firm will be quite competitive because the market power that it has gained through product innovation and advertisements will lose its effect in the long run. The products will no longer remain unique and new products will reign into the market.
Strategies to Improve Profitability
Our analysis has shown that the firm is incurring a loss in the short run but it is covering its variable costs. To earn profit in the long run the firm should take up two major strategies. The firs should first of all improve the production technique so that the cost of production comes down in the long-run. Secondly, the firm should invest in product innovations so that new products increase its market appeal. The demand inelasticity will be reduced and revenue will increase with increased price. Thus the firm can ensure long term profitability.
Conclusion
In this paper we have studied how a firm in a monopolistic competition or differentiated oligopoly may behave. We found the profit maximizing level of output when the firm has some market power. We have also suggested some strategies to retain and enhance the market power in the long-run.
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