Introduction
Knowing the market is very important for a firm as it has to base its policies and profit maximizing decisions based on the market characteristics. In a perfectly competitive market the firms follow the price determines by the industry. On the other hand a monopolist sets the price and quantity based on the profit maximizing conditions. The monopolist earns higher profit than the firm under a competitive sitation. In a monopolistic competition the firms have to innovate so that the products can be differentiated from the products of the consumer. The oligopoly form of market is characterized by the existence of few firms who are strategically interdependent. A move by a rival firm can reduce the market share of a firm. In that case the affected firm will have to take appropriate counter strategies. In this paper we discuss how a low calorie frozen food producing firm takes decision in changing market situations. We also suggest some short and long term strategies for the firm to improve its market share
Market Structure
In our previous analysis we had identified the firm as a competitive one as the price was determined by the intersection of demand and supply curves. Now the market in which the firm is operating has changed. Let us now identify the market form in which the firm is operating. We know that a firm in a perfect competition faces a perfectly elastic demand curve whereas a monopolist and also an oligopolist faces an inelastic demand curve. A firm in a monopolistic competition faces a moderately elastic demand curve. The own price elasticity of demand for our firm’s product is 0.44. This is highly inelastic. But we cannot conclusively say that the firm is a monopolist because it has a competitor. The price elasticity of demand with respect to the price of the close competitor’s product is 0.17. The demand responds positively to the price of the close competitor’s product but the elasticity is quite low. The low cross price elasticity implies that the firm has some market power which may be due to the highly differentiated product that the firm sells. Thus we conclude that the firm is in an oligopolistic market.
In the real world also the market for frozen foods possess somewhat oligopolistic character. Nestle occupies a leading position in this market with around 19% of market share. Another major player in the industry is Schwan which enjoys 9% of the market share . Both the companies command some amount of market power as their target group of customers are different. The range of goods offered by these two companies is also different. The market bears the features of differentiated oligopoly. Nestlé’s specialty lies in the ready to eat family meals whereas Schwan caters to the demand in schools, hospitals and restaurants. Nestle had faced a fall in demand in 2010. It launched some innovative products which offer more healthy options to the consumers for their low sodium content. Schwan has offered an array of new products to capture a higher market share. It now offers over 200 new food products. Consequently, it has been able to increase its profits in the past two years.
Till now we have discussed about the market structure in which our frozen food company is operating. The firm was in a competitive situation before. A competitive firm is a price taker and has to adhere to the industry determined price. The price was determined by the demand and supply curve. Now we find our firm in an oligopolistic situation. The firm has been able to command some market power for itself. Thus, it can no longer be a price taker and can influence the market price by altering the quantity it supplies. A reduction in supply on the part of the firm will lead to an excess demand situation that will cause a rise in price as it has some monopoly power. Thus the firm can now earn higher profit by restricting output and raising the price.
The profit maximizing principle requires the firm to produce that quantity of output for which the marginal cost (MC) equals marginal revenue (MR). The firm no longer has a supply curve now. The MC function and the MR function has to be equated to get the profit maximizing level of supply. Thus, there is a shift in the strategy by the firm. The change in market structure gives it an opportunity to earn a higher profit.
Change in Market Structure
Now the question is how has this change in market structure occurred. This can be because of some exogenous factors. Due to government policies some barriers can be created which prevents other firms to enter the industry. Some firms might have left the industry facing fall in demand for their product. This change can also be brought about by the firm’s own policies. Let us discuss two of them.
The firm must have launched a new range of innovative products that appeals to the tastes of a large section of the population. This very strategy was taken up by Schwan which has experienced a surge in its profit because of the increase in product varieties. This kind of strategy demands large investments in product innovations.
An efficient sales campaign can also increase the market share . In our previous exercise we have seen that the demand is not much responsive to advertisements , but carefully crafted promotional strategies can have impressive effects on the consumers. Effective advertisements can make the consumers realize the value and speciality of the products. Thus the two strategies might have complemented each other to increase the market power of the firm and convert a competitive market to that of an oligopolistic structure.
An Analysis of the Short-run and Long-run Cost Functions
Given below are the Total Cost (TC), Variable Cost (VC) and Marginal Cost (MC) functions of the firm:
TC = 160,000,000 + 100Q + 0.0063212Q2
VC = 100Q + 0.0063212Q2
MC = 100 + 0.0126424Q
The average cost is the cost per unit of output. We can obtain this by dividing the total cost function by the output Q. Similarly, we can find the average variable cost by dividing the variable cost function by the quantity of output produced . The average variable cost and the average cost functions has been derived as shown:
AC = TC/Q = 160,000,000/Q + 100 + 0.0063212Q
AVC = VC/Q = 100 + 0.0063212Q
We can also write the total cost function as:
TC = 160,000.000 + VC.
We observe that $160,000,000 is the fixed cost (FC) of the firm as it is not related to the quantity of output produced .
TC = FC + VC
We further note that
AC = 160,000,000/Q + AVC
That is, AC = AFC + AVC
Average Fixed Cost (AFC) =160,000.000/Q.
The AFC function shows AFC as a decreasing function of Q. But AVC is a rising function of Q. Thus, as Q increases AFC tends to reduce AC whereas AVC tends to raise AVC. But the coefficient of Q in the AVC function is 0.0063212, which is quite small. What we can infer from this discussion is that if the output increases to a sufficiently large extent the firm may face point of diminishing average cost. That means the production technology involves large scale economies. If the firm can attain a high scale of operation, it can reap the benefits of economies of scale. But such a large scale is not achievable in the short run. This is because of two reasons. First of all the demand needs to grow ad that can happen in the long run. Secondly, to attain the high scale the firm has to increase the fixed factors, which is possible only in the long run. Thus , even if the cost is too high in the short run scale expansion in the long run can lead to a fall in the average cost allowing the firm to reach the optimal scale of operation.
Should the Firm Shut Down if it incurs a loss?
The cost analysis we did in the previous section suggests that the initial costs of setting up the firm is quite high. Thus, it is likely that the firm may not be able to cover its total costs from the revenue that it earns. It is likely that the firm incurs some loss in the short run. Now the question that we face at this juncture is should the firm continue its operation even if it is running into losses? To answer this we must understand the break even point and the shut down point for the firm.
When the firm is just earning enough revenue to cover its total cost it is at the break-even point. At this point it is earning just normal profit. If the price falls below the average cost, the firm will be unable to cover the total cost. This is the break even situation. The firm is being able to cover the variable cost, but not the fixed cost. In the short run if the firm faces such a situation it should not shut down. In the case of our frozen food firm, we have already observed that the firm can reap the benefits of scale economies in the long run. So it can hope to have lower average cost in the long run and thereby earn a profit.
If the price of the product equals the average variable cost the firm reaches the shut down point. At this point the firm is just being able to cover its variable costs. If the price falls, the firm will no longer be able to cover the variable costs. The will have to shut down even in the short run if it reaches the shut-down point. Thus we conclude that the firm will continue its operations as long as it can cover its variable costs . If it fails to cover the variable costs it should shut down.
Determining the Profit Maximizing Output and Price
We have already mentioned in this paper that the firm is now an oligopolist. So its pricing decision will not be based on the intersection of the demand and supply curves. It can attain the profit maximizing level of output by equaling the marginal cost to marginal revenue. We have discussed the firm’s cost functions in the previous section. We have been provided with the MC function of the firm. Now our task is to derive the MR function and then equate MR to MC to find the equilibrium output. To derive the MR we need to have the demand curve, which is also the AR function for the firm. The Demand function is given as:
QD = 350000 -100P
We need find the inverse of the function because the inverse demand function gives us the average revenue function of the firm. The inverse demand function is:
P = 3500 – Q/100
Total Revenue (TR) is the product of price and quantity:
TR = P*Q = 3500Q – Q2/100
Marginal Revenue (MR) is the first order derivative of the AR in terms of quantity Q:
We have already states the condition for profit maximization as:
Or, 100 + 0.0126424Q = 3500 –0.02Q
Q = 104159.008 units.
We have obtained the output level at which the firm maximizes profit by equating the MR and MC functions. Now the firm has to determine the price at which this output can be sold. This can be obtained from the demand functions. Let us compute the equilibrium or profit maximizing price:
P = 3500– Q/100
Substituting Q = 104159.008 we get:
P = 3500 – 104159.008 /100=$2458.41
We have found both P and Q. Now we can compute the total revenue (TR):
TR = P*Q = 2458.41*104159.008 = $256065542
The total cost incurred by the firm to produce the profit maximizing level of output can be found out from the total cost function:
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= $92576450
The firm is earning a profit the tune of $92576450
Let us now compare the price and output in the present situation to that of the previous scenario. We observe that the price in the present situation has increased to $2458.41from the previous price of $407.65. The firm has also increased the output from 24335 units to 104159.008 units.
Evaluating the performance of the firm
We have already calculated the profit of the firm in the previous section. We have observed that the firm earns a profit. In the short run the firm has been able to reach the optimal level of operation. But the revenue earned is high enough to ensure super normal profit for the firm. The price is above the average cost. We also know that the firm is operating at the optimum level where it is producing at the minimum possible average cost in the short run. It can continue to enjoy the high profit in the short run.
In the long-run the super normal profit will attract other firms into the industry. If there is no effective barrier to entry there will be host of firms entering the frozen food business. The industry supply will increase leading to a fall in price. If the price falls below the minimum average cost the firm will incur a loss. This will result in an exodus of firms from the industry leading to a fall in the industry supply and rise in price. Ultimately the price will settle at the minimum average cost where the firm earns a normal profit.
Strategies to Improve Profitability
We have found that though the firm earns super normal profit in the short run the entry of competitors in the long run will reduce the profit to normal level. To retain the super normal profit the firm should put effective barriers to entry. We have seen that the firm produces at the minimum average cost. That is, it has reached the optimum scale of operation. If it can reduce the price to a level which will be unsustainable for a new entrant it can keep competitors at bay. A firm needs to attain a sufficiently large scale of operation to offer the low price that the incumbent firm has set. This will not be possible for a new entrant. So the price can limit the entry of potential competitors.
Another strategy can involve the innovation of new products. If the other firms cannot produce the new product because of patent rights then our firm can enjoy monopoly power in the market. It can raise the price of the newly innovated products and enjoy super normal profit.
Conclusion
In this paper, we have studied how a competitive firm has increased its market power to become an oligopolist with differentiated products. We have also discussed the possible fall in profit in the long run due to entry of competitors. We have suggested some strategies that can restrict entry of potential competitors or make the firm enjoy monopoly power even if entry occurs.
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