Nescafe_Oligopoly

MANEGERIAL ECONOMICS PROJECT BY: NAKUL SAGAR PG 2009-2011 Introduction The type of market that Nestle would have to operate on would be an oligopoly market. In reality, this the type of market which exists, having a high degree of market concentration. This indicates that a huge percentage of the Oligopoly market is occupied by the leading commercial firms of a country (AMUL, BRITANIA etc.). These firms require strategic planning to consider the reactions of other participants existing in the market. This is precisely why an oligopolistic market is subject to greater risk of connivances. In order to be a successful oligopolistic firm in the long run managers must be aware of a number of complex economic interactions such as; producer interdependence, the prisoner’s dilemma, price leadership, non-price adjustments, and the correct use of barriers to entry. These models and their factors need to be taken into account when making decisions for the firm. One of the defining features of an oligopolistic market is interdependence. Oligopoly involves few producers, which means more than one producer as it is in pure monopoly but not so many as in monopolistic competitions or pure competition where it is difficult to follow rival firms’ actions. Therefore, due to the small number of producers in an oligopolistic market, the price and output solutions are interdependent. The firm must be aware of its competitors’ movements and through applications of game theory determine the way in best to maximize their profits. The prisoner’s dilemma is a particularly important model for the oligopolistic market. It analyzes the competitors’ possible actions, and how they will affect the gains or losses from any move on behalf of the firm. Game theory is a mathematical approach to strategic behavior. Game theory is used in analyzing the actions of the competitors and the pricing and output decisions of oligopoly firms, it helps determine whether firms cooperate or conflict. Moreover, firms involved in oligopoly should be aware of price leadership. Price leadership has three models. First one is the price leadership of a low cost firm, which sets price according to its low costs. Other firms in that industry must follow it to prevent price wars because they realize that they will lose their customers attracted to the lowest price set by the low cost firm. Second model is price leadership of a dominant firm, very large and well established in the market. “Because of the size of the dominant firm’s production/selling capabilities compared to those of the smaller firms that surround it, the smaller firms act as a competitive fringe and follow the dominant firm’s price changes either out of fear of convenience”. The dominant firm wants to behave like a monopoly by ignoring the fringe; however, antitrust laws do not allow this to occur. Some examples of dominant firms are American Tobacco, General Motors, and Coca-Cola. And the third model is barometric price leadership. Unlike the other two, in this model it is the other firms’ choice whether to follow the price or not. Some reasons not to follow the price that is set could be “cost disadvantages or fear of retaliation”. Generally however it will make sense for them to follow suit. Other firms respect and trust the barometric firm a lot. However the barometric firm should be prepared, that it could lose respect at any time and another firm could become the price leader. Examples of barometric firms are some U.S. firms such as U. S. Steel and Bethlehem producing steel, American Tobacco and R.J. Reynolds producing cigarettes, as well as Firestone and Good-year producing tires. To solve problems of dominant and barometric price leadership, some firms decide to form cartel, “formal collusive agreements on price and relative market shares” that behaves like unreal pure monopoly organized by several firms. However the act of cartelization is illegal as outlined in the MRTP act. Non-price adjustments must also be carefully considered for the oligopolistic market. Instead of price issues sometimes it is better to concentrate on non-price issues in oligopoly because the producers are interdependent. In order to be more successful than the firm’s competitors, the firm tries to stand out by changing product quality or advertising that brings an increase in demand and personal market shares. The quality changes can be achieved by research and technology. Advertising is also very helpful as a non-price adjustment. Its policy focuses on different factors than the price policy. The price policy of a firm is to concentrate on making the demand more elastic. They do it in order to increase total sales at the same or increased prices. Therefore, the firm should show while advertising that its product is better than other products on the market in its industry giving other reasons than a low price of the product. Finally managers must factor in barriers to entry for their market into their decisions, and use them to the firm’s advantage. It’s hard for the firm to be economically profitable, even though the number of competitors is constant. Therefore, it is harder when new firms enter the market. Consequently, it is better to make barriers to enter their industry. This action will eliminate their rivals. There are different types of barriers: conditions of the demand and cost, legal barriers such as copyrights, patents, or trademarks, or illegal such as different kinds of forces or collusion. Different theories about Oligopoly Pricing: 4 main theories involved with oligopoly pricing are as follows: * The prices and profits associated with the concept of Oligopoly is impossible to determine, owing to problems arising from modeling mutual prices and output decisions * The oligopolistic business houses join hands in charging the monopoly prices and incur monopoly profits * Oligopoly prices and profits exist between the monopoly and competitive endpoints of the scale * Commercial oligopoly firms compete on the prices in an effort to equalize both the factors like in the competitive industrial sectors. PRICE DETERMINATION UNDER OLIGOPOLY: The price and output behavior of the firms operating in oligopolistic or duopolistic market condition can be studied under two main heads:   1. Price and Output Determination under Duopoly: (a)    If an industry is composed of two giant firms each selling identical or homogenous products and having half of the total market, the price and output policy of each is likely to affect the other appreciably, therefore there is every likelihood of collusion between the two firms. The firms may agree on a price, or divide the total market, or assign quota, or merge themselves into one unit and form a monopoly or try to differentiate their products or accept the price fixed by the leader firm, etc. (b)   In case of perfect substitutes the two firms may be engaged in price competition. The firm having lower costs, better goodwill and clientele will drive the rival firm out of the market and then establish a monopoly. (c)    If the products of the duopolists are differentiated, each firm will have a close watch on the actions of its rival firms. The firm good quality product with lesser cost will earn abnormal profits. Each firm will fix the price of the commodity and expand output in accordance with the demand of the commodity in the market.   2. Price and Output Determination under Oligopoly: (a)    If an industry is composed of few firms each selling identical or homogenous products and having powerful influence on the total market, the price and output policy of each is likely to affect the other appreciably, therefore they will try to promote collusion. (b)   In case there is product differentiation, an oligopolist can raise or lower his price without any fear of losing customers or of immediate reactions from his rivals. However, keen rivalry among them may create condition of monopolistic competition. PRICE DETERMINATION MODELS OF OLIGOPOLY: 1. Kinky Demand Curve: The kinky demand curve model tries to explain that in non-collusive oligopolistic industries there are not frequent changes in the market prices of the products. The demand curve is drawn on the assumption that the kink in the curve is always at the ruling price. The reason is that a firm in the market supplies a significant share of the product and has a powerful influence in the prevailing price of the commodity. Under oligopoly, a firm has two choices:   (a)    The first choice is that the firm increases the price of the product. Each firm in the industry is fully aware of the fact that if it increases the price of the product, it will lose most of its customers to its rival. In such a case, the upper part of demand curve is more elastic than the part of the curve lying below the kink. (b)   The second option for the firm is to decrease the price. In case the firm lowers the price, its total sales will increase, but it cannot push up its sales very much because the rival firms also follow suit with a price cut. If the rival firms make larger price cut than the one which initiated it, the firm which first started the price cut will suffer a lot and may finish up with decreased sales. The oligopolists, therefore avoid cutting price, and try to sell their products at the prevailing market price. These firms, however, compete with one another on the basis of quality, product design, after-sales services, advertising, discounts, gifts, warrantees, special offers, etc. | | |                               In the above diagram, we shall notice that there is a discontinuity in the marginal revenue curve just below the point corresponding to the kink. During this discontinuity the marginal cost curve is drawn. This is because of the fact that the firm is in equilibrium at output ON where the MC curve is intersecting the MR curve from below. 2. Price Leadership Model: Under price leadership, one firm assumes the role of a price leader and fixes the price of the product for the entire industry. The other firms in the industry simply follow the price leader and accept the price fixed by him and adjust their output to this price. The price leader is generally a very large or dominant firm or a firm with the lowest cost of production. It often happens that price leadership is established as a result of price war in which one firm emerges as the winner.   In oligopolistic market situation, it is very rare that prices are set independently and there is usually some understanding among the oligopolists operating in the industry. This agreement may be either tacit or explicit. Demand Estimation under Competitive Pricing Behavior Discrete choice models of demand have typically been estimated assuming that prices are exogenous. Since unobservable (to the researcher) product attributes, such as coupon availability, may impact consumer utility as well as price setting by firms, we treat prices as endogenous. Specifically, prices are assumed to be the equilibrium outcomes of Nash competition among manufacturers and retailers. To empirically validate the assumptions, we estimate logit demand systems jointly with equilibrium pricing equations for two product categories using retail scanner data and cost data on factor prices. In each category, we find statistical evidence of price endogeneity. We also find that the estimates of the price response parameter and the brand-specific constants are generally biased downward when the endogeneity of prices is ignored. Our framework provides explicit estimates of the value created by a brand, i.e., the difference between consumers' willingness to pay for a brand and its cost of production. We develop theoretical propositions about the relationship between value creation and competitive advantage for logit demand systems and use our empirical results to illustrate how firms use alternative value creation strategies to accomplish competitive advantage. CONCLUSION Nestle would have to consider all the above factors and models in the introduction of their new product. Since brands such as Amul and GSK already have cold coffee products, Nestle’s pricing and marketing will have to take into account their competitors’ actions, pre-existing pricing models, and marketing strategies. Since they are new to the market, it is most likely that will not be a price leader, but follow suit with Amul and GSK, unless they have significantly lower costs and are able to undercut them. To help promote and convert current competitors’ consumers Nestle will have to consider what non-price market actions it can undertake, maybe an offer or free trials could be put in place. Nestle will also have to overcome some of barriers to entry, Amul and GSK already have established customer bases, and are known for their cold coffee. Although since Nestle is a large corporation, such boundaries shouldn’t matter to much, as there is a high brand value attached to them. Lastly they firm must combine all the above factors in making estimations as to the demand for the product, and factor this into pricing and production of the product. By being aware of and considering these factors, Nestle can help ensure a successful product launch, and long term profitability. -demand estimation