Case study ‘Understanding the Market’

You represent a large Korean firm called Proteus. Your firm manufactures cars, hi-fi, and computer equipment. Recently senior management at Proteus have become concerned about entering Russian markets. If Proteus sets up in Russia, it will be in full competition with other producers such as Ford, Nissan, Sony, Panasonic, Sega, and Nintendo, to name but a few of the foreign-owned companies already operating in Russia. Proteus are aware that price of its products will be a key factor in its success. As a first step, Proteus intends to begin the production of computer games and game consoles in Russia. If they are able to break into the market, they will then begin to produce their entire range of goods. Proteus management have little knowledge of the market for computer games products in Russia and have asked you to report. Your document should be written using a word processor and include computer-generated graphs and diagrams where appropriate.

Tasks:

1. What are the main influences on the demand for computer games in Russia?

2. Draw a demand curve for computer games and explain some of the factors that might cause the curve to shift, giving examples relevant to the computer games industry.

3. Sega, Nintendo, and 3DO games and consoles are rather expensive. Proteus could enter the market in the same price range or lower. Management would, therefore, like to know how sales revenues are likely to respond to a higher or lower price. This requires knowledge of the elasticity of demand for computer products. Explain the meaning of elasticity of demand and its relevance to business decision-making.

4. What are the main influences on the elasticity of demand for a product? List these and consider how they apply to the case of computer games and consoles.

5. Investigate the supply of computer games and consoles in Russia:

• Who are the main producers?

• What prices do they charge?

• How much competition will Proteus face in the market?

• How have prices changed recently and why?

6. What will be the likely impact on the market supply and price of computer games following the entrance of Proteus into the Russian market? Draw a market supply curve for computer games in Russia before and after this event.

7. What other factors may affect the market supply of computer games and consoles? Give examples, where possible, with relevance to the computer games industry.

8. Discuss why the management of Proteus need to be aware of influences on the market demand and supply of computer games in Russia when deciding what price to charge for their products?

Alternative: Analyse the market demand and supply of a product of a local business with which you are familiar. Complete the same tasks above.

1.2. The Operation of Markets

Key words: price and non-price competition, market share, market structure, price taker, price maker, monopoly, pure monopoly, legal monopoly, natural monopoly, oligopoly, duopoly, product differentiation, branding, cartel, collusion, barriers to entry, private costs and benefits, social costs and benefits, negative and positive externalities

Competition

The goods and services produced by business organizations to satisfy consumer wants and needs are sold in markets. The level and strength of consumer demand and producer supply in a market are known as market conditions. If the market for a particular good or service is expanding, this means that consumer demand is growing and a growing number of firms, attracted by the potential for profit, is competing to supply the market. Competition is the process of active rivalry between producers of a particular product. Competitors seek to win and retain consumer demand for their products. As a result, competition tends to force market prices down but expand the quantity traded. Sales revenues can be expected to grow if demand for the product is price elastic.

Firms will compete to supply a market to achieve a number of objectives. These are:

• To increase their customer base. Firms will compete with each other on price, product quality and through promotional strategies to increase the number of customers buying their products.

• To increase sales. Not only will firm seek to increase their customer base but they will also hope that existing customers will buy more. Cutting prices can increase sales revenues from products for which demand is price elastic. Advertising and other promotions, such as free gifts, can help to expand sales without the need for price cuts.

• To expand market share. The market share of a firm can be calculated as its proportion of total sales. The larger an organization's market share, and the more widely established its product, the better able it will be to withstand new competition from new products and firm.

• To achieve product superiority. This has two meanings. On the one hand, it refers to making a product that is clearly better than rival products for reasons of prestige and/or profit. A superior product will help a firm to achieve its objectives of generating sales and expanding market share. On the other hand, product superiority also means that the product dominates a market by outselling all others - which is not necessarily because it is the best product on the market. A firm that is able to dominate the supply of a product to the market is able to have some influence over determination of the market price. It is also well placed to fight off competition from smaller rivals.

• To enhance image. Firm will also compete on image. Customer perception of an organization will be reflected in its sales. A poor image will reduce sales; a good image will help to expand sales and market share. In response to the growing awareness of environmental issues among customers in the 1990s, many organizations are trying to present themselves as caring and environmentally friendly.

Price competition

Cutting price can expand consumer demand. Hence, competition between firms on price is often vigorous. Ultimately the ability of a firm to undercut rivals to increase sales will be constrained by market conditions and production costs. Cutting prices to expand sales will reduce the margin between revenues and costs. If a firm is to be in a strong position to compete on prices, it must try to reduce its costs by increasing the productivity of its resources.

There are a number of short-term pricing strategies an organization might use in an attempt to expand sales and market share:

• Penetration pricing involves setting product price low to encourage sales. This is especially important for a new or existing firm trying to establish a new product.

• Expansion pricing is similar to penetration pricing. Product prices are set low to encourage consumers to buy. As demand increases, the firm can raise output to meet demand and take advantage of economies of scale which will lower the average cost of producing each unit. Lower average costs can either be passed onto consumers as lower prices, or, if prices are held steady, the lower costs will increase the firm's profit margins.

• Destruction pricing is a more drastic version of penetration pricing, usually practiced by larger firms when threatened by new competition from smaller organizations. The objective is to destroy the sales of competitors by setting price very low – even below costs – and sustaining a loss for a short period of time. Smaller firms, unable to take a loss, will be pushed out of the market.

• Price war. In markets where supply side is very competitive, price wars may develop among rival firms employing the various pricing strategies discussed above. Price wars are not popular among firms even though they frequently occur. This is because engaging in a price war is a very high-risky strategy. Gains tend to be short-term as rival firms continually slash prices in an attempt to steal customers from each other. Only the customer benefits in the long run, as firms' profit margins are drastically reduced by successive price cuts without a sustained increase in demand for their products.

• Market skimming, also known as price creaming, involves charging a high price for a new product to yield a high initial profit from consumers who are willing to pay extra because the product is new and unique. As competitors enter the market, the price is reduced to expand the market.

Non-price competition

When consumers buy a product, they are looking not just for low price but also for value for money in terms of the quality of the good or service, its size or shape, colour, smell, or taste. Consumers also look for after-sales care in case anything should go wrong and the want to exchange their product. Firms can compete on all these facets of a product.

Promotion is also very important if consumers are to be tempted to buy one product rather than another. Free gifts, money-off coupons, attractive in-store displays, and publicity in magazines – these are all methods that can be used to persuade consumers to buy. Advertising, through media such as television or newspapers, is one of the main ways firms compete for sales. Advertising can be used to present features of a product in an attractive way and to persuade people that a product is better than its rivals. By creating an image for a product in the mind of the consumer, advertising can manipulate consumer wants. Organizations are willing to spend a lot of money on advertising because, if used effectively, it can create a want among customers for a new or existing product. By creating a want and increasing the demand for their product a firm will generate sales and may be able to charge a higher price.

Competition: good or bad for the consumer?

Both price and non-price competition are good for consumers because they can reduce prices and increase the quality and availability of different products. However, advertising and excessive packaging is sometimes considered wasteful. Prices will reflect the costs of these activities and will, therefore, tend to be higher than they might otherwise be.

Market structure

Different markets are organized or structured in different ways. It is tempting to believe that, where there are a large number of firms producing the same product and equally large number of consumers wanting to buy it, no one producer or consumer has the power to influence market price. This suggests that markets are highly competitive and that, if a firm did try to raise price, it would lose custom to rival producers and soon go out of business.

In reality, very few markets display such a very competitive structure. Perhaps the world agricultural market is the closest example of ‘near perfect’ competition. Because there are so many producers of wheat, barley, and other arable crops of such similar quality worldwide, individual producers are forced to sell their produce at prevailing market prices. That is, in competitive markets there are numerous consumers and producers such that no one can influence market price – they are all price takers.

Competition in a market affects an individual firm's ability to influence the market price for their product. In general, the more competition a business faces from firms making similar products, the less scope it will have to influence price. The focus of an analysis of market structure is therefore on the degree of competition in individual market.

In general, markets are grouped into four broad categories:

1. ‘Perfect competition’ markets

2. Monopolistic competition markets

3. Oligopolistic competition markets

4. Monopolistic no-competition markets

Monopolistic competition

In reality, most markets display some restriction on competition. Individual producers will often attempt to modify their own products to distinguish them from their rivals. This is called product differentiation and is a feature of ‘monopolistic competition’. It can be achieved by branding – making differences in the design and packaging of products – as well as the creation of different trade names and product images through advertising. In this way an organization can create and maintain consumer demand for their product. Building consumer loyalty to a product reduces the effectiveness of price cuts and advertising as ways to lure customers away from rival firms.

Oligopolistic competition

Today, most markets can be described as ‘oligopolistic’. An oligopoly exists if a small number of large firms dominates the supply of a particular good or service to a market.

Price leadership is a feature of many oligopolistic markets. In order to avoid price wars, the firms that dominate the market will tend to price their products in line with each other. In extreme cases they may even collude to ‘fix’ prices. Sometimes however agreements to fix prices or play ‘follow my leader’ break down, and price wars can develop among rival firms.

Cartels are formal agreements between firms to regulate prices and/or output, thereby effectively creating a monopoly. The best-known cartel is OPEC (Organization of Petroleum Exporting Countries) which attempts to restrict the world supply of crude oil in order to hold up its market price. Collusion to fix prices at artificially high levels is illegal in many countries, for example in the UK under the terms of the 1956 Restrictive Trade Practices Act.

Because of the relative price stability in oligopolistic markets, they tend to be characterized by aggressive non-price competition for consumers and market share. For example, the growth of shops on petrol station forecourts and the giving of tokens towards free gifts are attempts at non-price competition by a handful of large petrol companies. Similarly, despite the existence of numerous branded products, the washing-powder market is supplied chiefly by two very large producers (a duopoly) – Unilever and Procter & Gamble. Their competition concentrates on the creation of strong brand images and customer product loyalty through heavy advertising.

Monopoly

A firm is a pure monopoly if it is the sole supplier of a good or service wanted by consumers. However, as defined by UK law, a legal monopoly is any firm, or group of firms acting together, supplying 25% or more of a market. A monopoly faces little or no competition and is therefore able to keep profit levels high by setting a high price for its product. Monopolies are often described as price makers because they can restrict the supply to a market to force up the market price. However, in order to do this, the monopoly must prevent new firms from entering the market. Any increase in supply from new firms will force prices and profits down. Barriers to entry used by monopolies (and oligopolies) to prevent the entry of new firms into their markets can occur naturally, or can be deliberately created by the dominant firms to force new and smaller competitors out of business.

Types of market structures

Type of market structure	Number of producers	Can producers influence market price?	Do firm compete on aspects other than price?	Can existing producers prevent new firm entering market?
‘Perfect competition’	Many	No. All firms are price takers	No. Products of individual producers are exactly the same	No
Monopolistic competition	Many	A little	Yes. Producers try to differentiate their product using brand image	No
Oligopoly	Few	Yes, by agreeing to fix prices and/or outputs	Yes. Fierce competition on product image	Yes
Monopoly	One	Yes. A monopoly can be a price maker	No. No competition, so not necessary	Very much. Almost impossible for new firms to enter market

Natural barriers to entry

New firms may be unable to compete with a monopoly because of the advantages a large firm has simply because of its size:

• Economies of scale. By increasing in size, a firm may be able to reduce the average cost of producing each unit of output below the costs of smaller organizations. If one firm is able to produce the entire market supply at a lower average cost per unit than a number of smaller firms put together, then it is known as a natural monopoly. The gas, electricity and water supply systems are natural monopolies. This is because it does not make economic sense to have more than one set of gas or water pipes or electricity cables supplying each house, office, or factory.

• Capital size. The supply of a product may involve the input of such a vast amount of capital equipment that new competing firms find it difficult to raise necessary finance to buy or hire their own.

• Historical reasons. A business may have a monopoly because it was first to enter the market for a product and has built up an established customer base. For example, Lloyds of London dominates the world insurance market primarily because of its established expertise dating back to the 18th century.

• Legal considerations. The development of new production methods and product can be expensive but can be encouraged by granting innovative patents or copyright, so as to prevent other firms copying their ideas and thereby reducing their potential profits. Also, some monopolies are government-owned, for example, the Post Office.

Artificial barriers to entry

While some monopolies occur naturally, others may achieve and retain their powerful market position by creating their own artificial barriers to competition:

• Supply restrictions can be used to prevent new firms obtaining the supplies of materials necessary for production. If suppliers rely heavily on the orders of a monopoly firm, a threat by the firm to obtain supplies from elsewhere is likely to be very effective in deterring them from supplying rival organizations.

• Predatory pricing occurs when the dominant firm in a market cuts its prices – at the risk of losing revenue in the short run – in order to force new and smaller competitors out of business. New firms are unlikely to be able to withstand trading at a loss for as long as the larger, established monopoly. Once new competitors have been forced to close, the monopoly can once again raise prices.

• Exclusive dealing involves a monopoly preventing retailers from stocking the products of competing firms. This method of restricting competition is particularly effective if the product supplied by the dominant firm is very popular and the retailer would lose too much trade if they did not sell it.

• Full line forcing occurs when large firms refuse to supply retailers unless they stock and sell their full range of products.

Because monopolies and oligopolies have the ability to restrict competition, many governments have passed a number of laws which can regulate monopoly activities and in the extreme cases prevent their formation.

Social costs and benefits of economic growth

Economic growth refers to an increase in the total volume of goods and services produced in an economy. Economic growth, therefore, suggests that people are better off because they have more goods and services to enjoy. More people are also likely to be employed and earning incomes. However, there are also costs of growth wider than those faced by industry in buying or hiring the necessary resources to produce more goods and services. Here is an example.

The production of electricity allows us to satisfy our needs and wants for light and warmth, televisions, VCRs, and microwave ovens among many other devices. It also satisfies the wants of other producers for power to drive machinery enabling them to supply other goods and services to various product markets.

However, the production of electricity has helped to cause acid rains, radioactive waste, and may even have created health problems. Acid rains have been blamed for killing fish and damaging forests and crops. These are costs additional to the payment of wages, purchase of nuclear fuels, oil and coal, rent and rates paid by electricity generating companies. The costs of environmental damage are borne by other people and organizations. A growth in the total supply of goods and services in an economy can have the following costs and benefits:

The benefits of growth

• There are more goods and services for people to enjoy.

• Higher levels of output may be achieved by using less labour input so people may enjoy more leisure time.

• More resources are employed by organizations to produce goods and services.

• Firms may invest more money in new premises, machinery, and staff training, providing further jobs and incomes.

• Increases in incomes generate more tax revenue for the government which can be used to produce more roads, schools, hospitals, and other goods and services that can increase the standard of living.

The costs of growth

• Growth may only be achieved by producing more capital goods, such as machinery, at the expense of consumer goods.

• Growth may use up scarce resources more quickly. Natural resources such as oil, coal, and other mineral deposits are finite and cannot be replenished.

• Space is limited. Using land to build more factories and offices leaves less for parks and woodland.

• Waste can increase, for example, as a result of unnecessary packaging.

• Technical progress may replace workers with machines. People may remain unemployed for long periods of time, often on limited incomes.

• Increased production may increase pollution and health problems.

Externalities

Producing goods and services to satisfy consumer wants can involve the production of economic bads such as pollution and destruction of the environment. The drive to increase output may also result in less compassionate production methods, for example, battery farming and testing on animals.

When making production decisions, private firms will normally only consider their private costs, such as wages, electricity bills, rents and materials, and their private benefits or revenues. They will be concerned with the amount of profit they can expect from the activity but will tend to ignore the external costs of production. These are costs borne by people and firms not directly involved in the activity that causes them.

When the decisions of one person or firm, or group of persons or firms, affect others, there arises an externality. Rivers and seas polluted by industrial waste can kill stocks of fish and reduce revenue of fishing industry. Atmospheric pollution causes acid rain which can damage crops and forests. Buildings may need to be cleaned more often. People can suffer respiratory problems which can result in higher medical bills, paid from higher taxes or medical insurance premiums. These are all examples of negative externalities which result in external costs.

However, some productive activity may result in positive externalities which give external benefits. For example, a large firm may train workers in particular skills which can benefit other firms who employ them at some future date. Firms may also contribute to charities or sponsor sports events which provide wider benefits beyond that of improving the image of the firm.

The total cost to society, or social cost, of an organization's decision to produce a particular good or service includes both the private costs of the organization and any external costs. This must be compared to the social benefits of that decision before we can judge whether or not it is in the general interest.