Introduction
The strategic planning for the successful operation of a firm pivots on the market structure in which the firm operates. The market structure determines the market power that the firm possesses or can command into. If the market power is low or absent as in case of a competitive market the firm has to follow the industry determined price. But if the market power is high as in the case of a monopoly the firm can earn substantial amount of profit by its pricing strategies. In the previous exercise we had derived the price and output of a firm under competitive situation. In this article we are going to discuss how the firm takes a strategic shift with the change in the market structure. The first step would be to determine the market form in which the firm is operating and investigate the causes of such transition in the structure. The next important step would be to frame the policy decisions under the changed circumstances. Finally the firm should decide upon future course of action to stay profitable in a changing environment.
Effectiveness of the Market Structure
In a perfectly competitive market each firm faces an infinitely elastic demand curve . The monopolist on the other extreme faces a highly inelastic demand curve. Similarly an oligopolist also faces inelastic demand. In case of a monopolistic competition the firm faces a moderately elastic demand curve. In our previous analysis we had computed the price elasticity of demand for our firm’s product. We have found the priced elasticity of demand of the product to be -0.44. Thus the demand is quite inelastic to the change in price. Thus the firm seems to be either a monopolist or an oligopolist. But the firm has a competitor and we had also calculated the elasticity of demand with respect to the price of the competitor’s product. The cross price elasticity was found to be 0.17. The elasticity is low but still it shows that the demand is positively affected by the change in the price. But the effect is very small. This implies that the product of the firm is differentiated from that of its competitor. Thus we conclude that the firm is an oligopolist producing differentiated goods.
In the real world situation also we observe that the market for frozen foods is characterized by differentiated oligopoly. There are a large number of sellers but few large firms dominate the market. Nestle’ is a major player with 19% of the market share . Schwann is another big firm with around 9% market share. The differentiation in the products is evident from the difference in the consumer group that each firm sells to. While Nestle’ mainly produces family meals and kids’ food Schwann delivers its products to hospitals, restaurants and schools. Face with falling demand Nestle’ has reacted with major changes in the quality of its products with more nutrition packed in every meal and more healthy options. Schwann had also faced a downturn in its revenue. To counter this downslide it has launched an n array of new products. The result was an impressive rise in its earnings.
In our previous analysis the firm had been in a competitive market. So the pricing strategy was simple enough. The equilibrium price and output was found from the intersection of the demand and supply curve for the firm. Now the firm has experienced a transition in the structure of the market it is operating in. The market is oligopolistic in nature. By microeconomic theory the output at which the firm maximizes profit will be determined by the cost and revenue functions of the firm. The firm will attain maximum profit at the output for which the marginal cost (MC) equals the marginal revenue (MR). The demand function that we had derived in the earlier analysis will give us the price at which this output will be sold. So we can arrive at the equilibrium price and output level from the demand and cost functions of the firm.
Causes of Change in the Market Structure
The discussion so far has concentrated on the fact that the firm has experienced a change in the market structure from competition to oligopoly. That means the firm has gained considerable market power to influence the market and take its own price and output decision. We can identify two factors that might have caused this change. First, the firm must have invested heavily in product innovation techniques. It has come out with new and improved products that are quite different from the products offered by other firms in the industry. Another strategy taken by the firm could be effective advertising and other promotional techniques . Effective product promotion techniques can shift the market demand in favor of the firm’s product. This can be the cause of the increased market power of the firm.
Analysis of Production Cost
Given below are the Total Cost (TC), Variable Cost (VC) and Marginal Cost (MC) functions as provided to us:
TC = 160,000,000 + 100Q + 0.0063212Q2
VC = 100Q + 0.0063212Q2
MC = 100 + 0.0126424Q
Let us derive the average cost (AC) function and the average variable cost (AVC) function as shown below:
AC = TC/Q = 160,000,000/Q + 100 + 0.0063212Q
AVC = VC/Q = 100 + 0.0063212Q
The TC function can also be written as:
TC = 160,000.000 + VC.
The above equation clearly reveals that, $160,000,000 is the fixed cost (FC) of the firm as TC = FC + VC
We can also write the AC as:
AC = 160,000,000/Q + AVC
Or, AC = AFC + AVC
Thus, Average Fixed Cost (AFC) =160,000.000/Q.
We should note that AFC falls with the increase in the output Q. But AVC increases with the increase in Q. AC can fall only when the AFC falls more than the AVC. But the coefficient of Q in the AVC function is quite low (0.0063212). Thus is Q increases to a sufficiently high level the AC can fall. Thus the production technique exhibits economies of scale. If the firm can expand the scale of operation it can experience fall in the AC due large scale economies. Thus in the long run the firm should strive to expand its scale of operation.
Shut Down and Break Even Situations
We have seen in the previous section that the fixed cost faced by the firm is quite high. Thus it is likely that the firm will not be able to cover this huge fixed cost in the short run from its revenue. If the firm incurs a loss it has to analyze whether it is being able to cover its variable costs. In the short run even if the firm is incurring some loss it should continue with its operations if it is earning enough revenue to cover the variable cost . This is the break-even point for the firm. If the revenue falls short of the variable cost as well the firm reaches the shut-down point. Thus the firm should continue to operate as long as it can cover the variable costs and should shut down if it is unable to cover the variable cost along with the fixed cost.
Profit Maximizing Pricing Policy
We have already stated that the new strategy of the firm would be to equate the MR to the MC to arrive at the profit maximizing level of output . The MC function has been provided to us. We can derive the MR function from the demand curve. The demand curve obtained in our previous exercise was:
QD = 65100 -100P
The inverse demand function can be written as:
P = 651 – Q/100
Total Revenue (TR) is given by:
TR = P*Q = 651Q – Q2/100
The first derivative of the TR function gives us the Marginal Revenue (MR):
The profit maximizing condition is:
Or, 100 + 0.0126424Q = 651 –Q/50
Q = 16879.8863 units.
Thus we have obtained the profit maximizing output level. We have to substitute this value of Q in the inverse demand function to get the equilibrium price:
P = 651 – Q/100
Substituting Q = 16879.8863 we get:
P = 651 – 16879.8863/100=651-168.798863
= $482.20
Since now we have obtained the P and Q for the firm we can calculate the total revenue (TR) as:
TR = P*Q = 482.20*16879.8863 = $8139500.37
The cost of producing the profit maximizing output is:
TC = 160,000,000 + 100*16879.8863 + 0.0063212*(16879.8863)^2
Or, TC = $163489092
The profit can be found from the TR and TC as:
π = TR-TC = $8139500.37- $163489092= -$155349592
The negative value of the profit implies that the firm is incurring a loss.
Let us compare the price and output with the previous scenario. We observe that the price at present has increased to $482.2 from the previous price $407.65. The output has been reduced from 24335 to 16879.8863, so that price increases.
An Analysis of the Financial Performance of the Firm
The firm is incurring loss. We have to find whether the firm is being able to cover the variable cost:
The VC for Q= 16879.8863 is given by:
VC = 100*16879.8863 + 0.0063212*16879.8863 = $3489092
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
The firm should continue its operations in spite of the loss as it is being able to cover the variable cost.
Comparing the price, output and profit of the current scenario to the previous one we can understand how the change in the market structure can alter the strategies of the firm:
Previous Situation: Current Situation:
P = $407.65 P = $482.20
Q = 24335 Q = 16879.8863
Π = -$156256703 π = -$155349592
We observe that the firm has been able to reduce the loss by $907111 from the previous scenario.
In the long run other firms will be able to enter the industry in the absence of effective barrier to entry. All firms are expected to earn normal profit in the long-run. The market will become competitive again. If entry can be restricted then the firm will retain its market power.
Strategies to Improve Profitability
The loss making firm should introduce cost reducing production technique so that the average cost come. In addition to that it should take up steps to increase the demand for the product through product innovation.
Conclusion
In this paper we have discussed how the change in market structure has resulted in a change in the strategic planning of the firm both for the near term and the long term. We have also suggested ways to retain market power in the face of increased competition in the long run.
References
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Pindyck, R., & Rubinfield, D. (2009). Microeconomics (7th ed.). Prentice Hall.
Varian, H. R. (2010). Intermediate Microeconomics A Modern Approach (8th ed.). New York: W. W. Norton & Company.
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