Ch5 The Company and the Market.docx

Module 5 – The Company and the Market 5.1 – The Market The market mechanism is the principal method by which resources are allocated in industrialized economies. 5.2 – The Demand Curve Elastic curve – quantity changes by a larger percentage than the price. Inelastic curve – quantity changes less than the price Assumption: other things do not change with price (tastes remain the same, income of buyers do not change) 5.2.1 – Demand Factors What affects demand for a product: Determinants of Market Size: Product life cycle Business cycle Exogenous shocks (like new regulations) GNP elasticity Exchange Rates Determinants of Market Share: Price Marketing The factors which influence the total market are usually outside the control of the company. The product life cycle could lead to a reduction in market size because the market had become saturated and demand only remained for replacement. The curve can shift itself. It is useful to think of the direction in which the demand curve is likely to be shifted by a particular change, and the possible order of magnitude. 5.2.2 – Demand Curve and Revenues If the company is operating in a highly competitive market (perfect market) it has no choice on which price to charge; it is a price taker. Most companies, however, are able to exercise some choice on price. In every demand curve, there is a point where revenue is maximized, a certain combination of price and quantity that will maximize the company’s revenue. 5.2.3 – Demand Curve and Market Share The emphasis in marketing strategy is on market share, as it is an important determinant of competitive advantage. The shape of the demand curve might indicate which reduction in price will give the company a higher market share. Reduce price -> demand increases -> market share increases It is revealing to translate market share objectives into demand curve terms, because doing so may reveal that the market share objective implies a demand curve which common sense suggests is impossible. Take for example two companies who both wish to increase their share of the total market by 2.5%, starting from rather different market shares: Company Current Market Share Increase desired Increase in demand A 5% 2.5% 50% B 50% 2.5% 5% Company A will have to think in terms of a much larger price reduction to achieve its objective than Company B. The objective of maximizing the revenue might contradict the market share strategy. For some companies the increase in market share will only come with a decrease in revenues. Always remember the expressions: Revenue = Total_Market * Market_Share * Price And the demand curve is: Revenue = Total_Units_Sold * Price 5.2.4 – Demand Curve and Marketing Expenditure The relation of Market Expenditure (y) and Quantity Sold (x) is a positive slope curve. But there is a certain point where more marketing expenditure will only cause minimal increase in sales (diminishing return). On the other hand, it might be predicted that after a marketing campaign more of the product will be sold at each price than before. Marketing expenditure shifts the demand curve to the right. In order to shift the demand curve it is necessary to change people’s preferences; to persuade people to buy more of this product and less of something else (or save less) Decrease of price + increase of marketing expenditure -> more market share (if the company is not near the top of the response curve of marketing expenditures). The position of the demand curve can also change because of several factors, many of them outside the control of the company: falling prices of substitutes. The increase of the price of a substitute might increase the total market. It is important to distinguish between a shift along a demand curve and a shift of the demand curve: a) It is necessary to focus on the potential impact of a price change on its own. b) A shift of the demand curve can be caused by factors outside the control of the company c) It is difficult to change the position of the demand curve. 5.2.5 – Estimating the Demand Curve It is difficult to estimate the demand curve, even when we take examples of past performance. Many factors might have changed between each observation on price and quantity, and attempting to draw a line may be misleading. It does not mean we should not try to determine the demand, but a healthy cynicism of statistical approaches to the demand curve is necessary. 5.3 – Competitive Reaction The attempt to predict competitive reaction presents many dilemmas, and the important point is to be aware that such dilemmas exist, rather than attempt to prescribe complex gaming rules. 5.3.1 – The Game Theory Zero sum game – any gain made by one party is at the expense of the other (if you increase market share, someone looses it). An industry with few competitors may find it of mutual benefit to have a tacit agreement on prices. In this way, they all make an acceptable profit, avoiding a price war, where both lose. It is useful to have information about competitors: estimates of financial reserves, attitudes to uncertainty, company morale, strength of the marketing department, previous successes and failures in new ventures, efficiency of the market intelligence department. However, the dominant characteristic of competitor reaction is unpredictability, and the company must be prepared for a variety of responses to any competitive action. 5.3.2 – The Kinked Demand Curve When there are relatively few competitors in a market, the shape and position of the demand curve might depend on competitive reaction (example: air lines). There is a point where sales revenue is maximized. From this point on the curve is almost inelastic. It means that if we reduce the price, the competitor will also reduce the price. At the end, both keep their market share but revenues are lower for everybody. 5.3.3 – Competitive Pricing Price setting can be used as a competitive tool and short term revenue flows may be sacrificed in the pursuit of wider strategic objectives. Three main forms of competitive pricing: Price leadership – the dominant firm in the industry announces its price changes before all other firms, which then match the leader’s price. Limit Pricing – it is an attempt by a firm to create an entry barrier by charging a low price in order to deter entry. This is only worthwhile if it has a cost advantage and can set the price low enough to deter entry but still make a profit. Predatory Pricing – a firm sets a price with the objective of driving new entrants or existing firms out of business. 5.4 – Segmentation It is the attempt to charge a different price for each segment of the market. It maximizes revenue for each segment. There are four main characteristics which a segment needs to have if it is to be potentially exploitable: Identifiable – there must be sufficient common features that enable the segment to be identified in the market place. Demand related – the identified segment must have at least one characteristic which translates into demand terms, such as the willingness to pay more for a high quality product. Adequate size – it needs to be large enough to generate a potentially attractive return on the investment required to exploit it. Attainable – the segment must be reached by available marketing and advertising approaches. 5.4.1 – The Effect of Product Differentiation Some products are difficult to differentiate (wheat). But it may be possible to change the characteristics of a product in ways which will have particular appeal to different types of segment (car). There are times when differentiation may be more apparent than real. Differentiation may simply be a perception on the part of potential buyers (aspirine is sold under several brand names). Real or perceived differentiation has implications for marketing strategy and pricing policy. A product with low perceived differentiation and high perceived relative price is likely to fail. A product with high perceived differentiation and low perceived relative price is likely to succeed. 5.4.2 – Pricing in Segments We can have different prices for each segment. The monopolist will charge a higher price in a market with a low demand elasticity than in a market with a high demand elasticity. The theory is concerned with finding the price in each market for which revenue minus cost is maximized. Steps: Carry out research to determine the characteristics of different segments of the market and product characteristics to match them. Derive estimates of price and income elasticities. 5.5 – Product Quality Several approaches to the definition and measurement of quality. Transcendent Quality: the Platonic definition relates quality to high standards of excellence and achievement which can only be recognized in the light of experience. Product Base Quality A product is a bundle of characteristics, most of which are susceptible to some form of measurement. Characteristics are not determinant of product quality; this is because quality may be dependent on how well the characteristics are produced or combined together. Sometimes manufacturers incorporate characteristics which have little relevance to consumers, but which are thought to enhance the quality image of the product (watches 100m under water). In service industries, quality and consistency are closely linked. There can be very high costs associated with improving dimensions of quality. Example: electricity without interruption. It is impossible to guarantee 0% of interruptions. A company will try to balance the marginal costs for improvement with customer satisfaction. Used Based Quality There is a precise combination of characteristics and “design” that will be perceived as “quality” by consumers. Production Based Quality Production in conformance with especification. Value Based Quality Hybrid notion which combines the price, or production cost, with the quality. It is the value perceived by consumers in relation to the price. It is possible that a great deal of what is thought of as quality rests on a perception which is reinforced by the norms of society. An expensive running shoe might be merely a standard running shoe with an exclusive label attached. 5.5.1 – Dimensions of Quality Garvin suggests: Performance Features Reliability Conformance Durability Serviceability Aesthetics Overall perceived quality It is not claimed that these dimensions can be defined precisely; but it is possible for informed consumers to rate these dimensions to reflect their own perception. People with different backgrounds will attribute different weights to different dimensions. 5.5.2 – Quality and Strategy Quality and price may be expected to be positively related, other things being equal, because of the additional production costs associated with higher quality. However, when different dimensions of quality are taken into account, the price-quality relationship is obscure. This means that a company cannot assume that it will e able to charge a higher price after having improved the perceived quality of its products. Quality is positively related to market share, suggesting that investment in perceived quality has paid off in the past in marketing terms. There is also some evidence that quality and profitability (ROI) are correlated. One of the effects of TQM was to demonstrate that there was not necessarily a trade-off between quality and cost, and many companies which successfully implemented TQM programs reported simultaneous increases in productivity and quality. However, it may be that successful TQM programs have merely eliminated inefficiencies in companies and after this has been achieved there is no such thing as a costless improvement in quality. 5.6 – Product Life Cycles Four phases: Introduction: company will be investing in new productive capacity and spending relatively high amounts on marketing to bring the product to the notice of consumers. Negative cash flow. Growth: sales start to increase, more investments in productive capacity (ahead of market demand), meet challenge of new entrants. Aggressive marketing and competitive prices. Still no big profits as: marketing expenditure is high, prices are low, capacity in underutilized. Maturity: productive capacity matches demand. If they don’t have enough market share it will be difficult to increase now. Marketing expenditure is reduced, prices are not so competitive any more. Positive net cash flow Decline: company has to decide whether to exit the industry or phase out its productive capacity. Any information about the shape or duration of the product life cycle would be of immense value to the company. Some product characteristics can help to generate a rough idea of what the life cycle might look like: Substitutes: can the want which the product satisfies be performed in some other way which has not yet been marketed? Technology: if there is rapid change a product may soon be superseded by something superior and probably cheaper. Durability and replacement: some goods are bought for immediate consumption (food) while others are bought for the services they will generate some time into the future (TV). Once everyone who wants a TV set has one then sales will be dependent on replacement demand. The product life cycle model needs to be seen in the context of the business cycle. If consumer incomes are increasing, this may cause an increase in market size during the ‘mature’ part of the life cycle. 5.7 – Portfolio Models The economic approach (demand analysis, differentiation and segmentation) are important but they are static. The portfolio model approach incorporates dynamics into the interpretation of product positioning. 5.7.1 – The BCG Relative Share Growth Matrix Focuses on: relative market share, and the stage of the product life cycle. Relative market share is defined in terms of the company’s market share compared to that of its leading competitors. The importance of relative market share comes from: Economies of scale: the higher the market share, implies bigger the company, more economies of scale (if they exist). Experience effect: the company with higher market share, the higher the cumulative output to date than its competitors, and hence its labor force has the potential to be higher up the learning curve, resulting in lower costs (fewer rejects, better designed production lines). High Market Growth Rate Star Question Mark Low Market Growth Rate Cash Cows Dog High Relative Market Share Low Relative Market Share Product Cycle Growth Stage: Total market is increasing; customers are increasing their orders. To maintain or increase market share, firm has to get new customers because they are now choosing which company to buy from. It needs aggressive selling strategy, lower price than competitors, relatively high marketing expenditures. There will be excess capacity (build capacity ahead of demand). The economies of scale will not be reflected in profits. Product Cycle Static Stage: Market stops growing; no new customers appearing; competitors have to increase marketing efforts of lower price to induce customers to change their allegiance. To keep market share, prices do not need to be lower than competitors, marketing expenditure can be reduced. Lower selling costs and economies of scale generate the potential for substantial positive net cash flows. The Dog - Low market share in a stable market, not making profits currently. There is little change of making profits in the future, as the costs of increasing market share are likely to outweigh the potential gains. To divert customers from other brands it is necessary increased marketing expenditure or price reductions. It will lead to competitors reaction and this adds uncertainty of the exercise. Abandoning dogs will release scarce resources which could be put to more profitable use. The Question Mark - It may become either a dog or a star depending if market share can be increased before the growth in the market stops. The Star - The objective is to maintain market share until market growth ceases. The product incurs relatively high marketing costs because of the competition for new customers as market size increases. Cash Cow - This is the product which is achieving economies of scale, is further up the experience curve than competitors, and has relatively costless competition. From time to time the company may have to take action to ward off competition against a cash cow but, by and large, this is the product which makes the company money. Back to the Demand Curve – in the growth stage demand analysis can be used to provide indication of the price which would sales volumes which would maintain or increase market share. The objective is not to maximize profit but to lay the foundation for a cash cow. Once the market has stabilized, the question of the optimum market share is addressed to determine the price where profits are increases, even if the company has to set for a lower market share. 5.7.3 – Limitations of Portfolio Models The assumption for the BCG model may not be valid: maybe there are not economies of scale in this industry, there even might be diseconomies of scale. The experience advantage may soon disappear as other companies catch up with the leader. Barriers of entry, product differentiation and market segmentation must be taken in account. 5.7.4 – Portfolio Models and Corporate Strategy An optimum portfolio could be defined as one in which the Cash Cows generate sufficient cash flows to produce adequate returns to shareholders and the cash necessary to develop the potential of Question arks and Stars to replace the Cash Cows in time. A systematic approach to identifying the components of the portfolio strategy was developed by Ansoff, and he defined what he called the growth vector which interpreted the direction in which the company intended to develop its portfolio. Components of a growth vector: Current Products New Products Currently Operating Markets Penetration Increase Market Share Product Replacement New Entry Markets Market development New uses, segments, etc. Diversification Penetration: If the company wishes to grow relative to competitors on the basis of the products which it sells in existing markets it can only do so by increased penetration, and hence by an increase in market share. If the market is mature it follows that sales can only be gained at the expense of incumbents, while if the market is growing the company must continuously acquire a larger share of market growth than competitors. Product Replacement: It may be concluded that no further penetration by the current version of the product can be achieved, and it is necessary to add characteristics and perhaps abandon some existing characteristics; it could also be due to the product approaching the end of the product life cycle. The replacement can be an enhancement of an existing product or a totally revised version with a different set of characteristics, but it is important that it at least fulfils the requirements of the replaced product, and / or satisfies changing consumer preferences. Market Development: The search for new markets for existing products can take a number of forms, such as finding markets in new geographical locations and identifying unexploited segments or niches. Diversification: Company enters new markets with a new set of products (unrelated diversification). There is no direct experience of marketing strategy which can be applied, while the company has no experience of production (cars – tractors). The idea is to make explicit the direction of change in which the growth strategy will take the company, and incorporate this into the design of the portfolio. 5.8 – Supply The supply curve for an industry shows the amount which companies in total would be willing to sell at different prices. The curve is upward sloping. 5.8.1 – The Industry Supply Curve and Strategy Increase of demand: a relatively steep sloping supply curve will result in an increase in price, whereas a more horizontal supply curve suggests that there will be relative little price increase and that the increase in demand will lead to a relatively large increase in quantity sold. Inelastic supply curve: the response to an increase in demand (shift to the right of the demand curve) is do nothing and expect price increases. Elastic supply curve: price will not increase much, it is necessary to ensure that adequate productive capacity is available and that market share is at least maintained at its current level. 5.8.2 – Shifting the Industry Supply Curve Change of costs will affect the supply curve, shifting the industry supply curve to the left. Companies will be willing to supply less for the same price. 5.9 – Markets and Prices Prices are determined by the interaction of demand and supply. Production of goods and services depends on the costs which companies incur in supplying different quantities. Demand for goods and services depends on what people are willing to pay for different quantities. Any factor which alters the position of the industry demand or supply curves will have an impact on market prices. 5.10 – Market Structures Market structure is the main determinant of long term profitability; and an understanding of market structures is central to developing strategy. Example: market for wheat is comprised of many relatively small producers, none of which can individually affect the price. Other companies are in a monopoly business. 5.10.1 – Perfect Competition Perfect market: product is homogeneous, there are no barriers to entry, no economies of scale, universal availability of information on prices and quantities and a large number of sellers and buyers. No firm can charge more than the market price and the demand curve is horizontal. Profit maximizing will happen when marginal cost equals marginal revenue. At this output no monopoly profits are made. 5.10.2 – Monopoly Profit maximizing output is where marginal cost equals marginal revenue (as before). In a perfect market, however, the marginal revenue curve is horizontal, as the company is price taker. In a monopoly situation, the marginal revenue curve is sloped negatively. We match marginal revenue and marginal cost, and then determine through the demand curve what is the price that should be charged. 5.10.3 – Barriers to Entry Barriers to entry are very important to maintain a monopoly. They can give a competitive advantage. The current monopolist will try to find ways in which barriers to entry can be erected or how to keep them. Barriers to entry can be structural (outside the control of the firm) or strategic (dpend on specific actions undertaken by the firm to deter enter). Examples of structural barriers: Size of the market – because of investment and infrastructure cost it may not be feasible for more than one company to operate in the industry (electricity generation). Sunk costs – not only the costs of entry are important, but the costs of exit. An airline can sell its airplanes if goes out of business, but in other industries this might not be possible. Control by legislation or tacit agreement – like patent protection for a fixes period. Economies of scale- Experience effect – reductions in unit cost occur as the labor force learns by doing, more effective practices are adopted, material wastage is reduced and so on. There are limitations of the experience effect, and it cannot give a firm a permanent barrier in the form of cost advantage. Strategic barriers include: limit pricing and predatory pricing (doubtful long term effectiveness) 5.10.4 – Contestable Markets It is a market where entry costs are not sunk, and exit can be achieved costlessly. The ability to exit without having made any capital commitment guarantees freedom of entry, and the fear of hit-and-run raids forces incumbents to set prices lower than they would have done otherwise. 5.10.5 – Competition among the few: oligopoly When there are relatively few competitors in a market the likely reaction of competitors to changes in pricing and marketing strategy must be taken into account. It is the kinked curve. The outcome cannot be predicted because it depends on the reaction of the individuals. 5.11 – The Role of Government 5.11.1 – Government and Rule Making Gov determines the framework of rules within which markets function: employement law monopoly health and safety separation of management and ownership 5.11.2 – Government and Regulating Example: reduce pollution. Pollution is an externality. The cost paid by the company is known as private cost, and the cost to the company plus the cost to the environment is known as social costs. Since producers do not bear the costs of pollution, the industry supply curve is derived from private cost, not social cost; in other words, it lies too far to the right, and too much is produced, resulting in a misallocation of resources. 5.11.3 - Government and Allocating Another area of market failure is when it is not possible to exclude non-payers from consuming a good or service (defense and other public goods). 5.12 – The Structural Analysis of Industries The degree of competition in an industry is the result of structural factors over which individual companies have little control (price taker, monopoly, oligopoly) Porter identified five forces that determine competitive conditions. Threat of new entrants Threat of substitutes Suppliers’ bargaining power Buyers’ bargaining power Industry competitors’ rivalry The collective strength of these competitive forces determines the ability of firms in an industry to earn rates of return on investment above the opportunity cost of capital. 5.12.1 – Industry Competitors’ Rivalry Assess the number of competitors: large number of small companies: almost perfect competition few large firms: competition among the few one dominant firm: monopoly or price leadership Another aspect: the extent to which firms are able to segment the market by differentiating their products. 5.12.2 – Threat of New Entrants Depends on the barriers to entry, and also addresses: economies of scale (is there any size advantage?) regulation: are competitors allowed? Can it change in the future? Technological factors: high R&D costs 5.12.3 – Threat of Substitutes The emergence of substitutes depends on technological progress. The substitutes reduce the total size of the market, as opposed to the entry of competitors who attempt to achieve a market share at the expense of existing firms in the industry. 5.12.4 – Suppliers’ Bargaining Power Depends on the degree of competition in supplier markets. monopoly monopsony some firms are large enough to act as monopoly buyers and can ensure that they pay no more than the competitive price, and may pay less than smaller competing firms. 5.12.5 – Buyers’ Bargaining Power Depends on: price elasticity (is the curve kinked?) Income elasticity – how dependent are sales on the level of economic activity? Will customers buy more if income increases? Information – are customers informed about characteristics of competing products? Can it change in the future? Brand identity: is market share dependent on brand loyalty or relative prices. Buyer groups: are there few large buyers who can exert an influence on price? 5.12.6 – Profiling the Five Forces For each one, classify in high or low. 5.13 – Strategic Groups Not all companies in an industry are direct competitors. Many variables can be used to classify competitors, like organization (scale, degree of vertical integration or diversification, distribution channels), products characteristics (quality, image, level of technology) or even financial structure (return on assets, gearing). 5.14 – Environmental Threat and Opportunity Profile – Part 2 Example: Sector Threat or Opportunity International - Expected appreciation of exchange rate + Growth in Eastern Bloc economies Macroeconomic - Tax rate increase to fight inflation + Prospect of reduced inflation rates Microeconomic Socioeconomic Market Supplier Discuss each item.