Module 5: The Company and the Market

5.1. The Market

Markets serve to allocate resources. Issues relating to markets include: (1) What markets should
we be in and (2) What prices should we charge?

5.2. The Demand Curve

The demand curve plots the effect of a change in price on the quantity sold, cet. par. Demand is
elastic if a relative change in price leads to a relatively greater change in quantity. Decreasing the
price, then will increase revenue:

Revenue (1)= P(1)*Q(1)

Revenue (2)= P(2)*Q(2)

Factors influencing the total market are outside the control of the company and they include (1)
product life cycle, (2) business cycle, (3) exogenous shocks, (4) GNP elasticity, and (5) exchange
rates.

The company can control the price and its marketing strategy.
All factors except price lead to a shift in the demand curve. It is important that companies predict
these shifts, so that they can adjust prices accordingly.

Most companies face a sloping demand curve, they have thus some choice as to which price to
change.

There is a revenue maximizing point on every straight line demand curve.

Market share is related to the demand curve in two ways:

(1) The demand curve will indicate how large a price reduction is needed to achieve the
desired market share.
(2) Large price reductions are bound to be noticed by competitors and may cause them to
act-leading to a shift in the demand curve.

For this kind of analysis it is sufficient to have a rough idea of what the demand curve looks like.

Where a price change does not change the total market and competitors do not follow suit, a
movement along the demand curve is associated with a change in market share. The company
will have to decide whether an increase in market share is worth sacrificing revenue.

It is possible to relate other variables to sales quantity, e.g. marketing expenditure. In deciding
whether to step up marketing the company would have to know (1) the response curve and (2)
its position on the curve.

Alternatively, marketing expenditure may shift the demand curve:

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Marketing shifts a demand curve by decreasing the scope for substitution.

Thus, shifts in the demand curve are caused by both extraneous effects (changes in prices of
substitutes and complements) and the company’s marketing decisions.

Extraneous effects will influence the size of the total market while marketing expenditure will
affect market share.

Demand curves are difficult to estimate, because they tend to shift over time.

5.3. Competitive Reaction

Game theory is a mathematical tool for analyzing the best decision in a situation where it is
uncertain what the other party may do.

The prisoner’s dilemma is a dominant strategy equilibrium, because no matter what the other
party does, it is always best to be un-cooperative.

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This equilibrium leads to a situation where both parties are worse off than they would have been
had they been cooperative. This will only change if the situation will be repeated an unknown
number of times.

Many markets, like the cigarette market, are like zero sum game where price reductions may
have all parties worse off. If agreements cannot be maintained and policed (or are illegal per se),
dilemmas may ensue.

A kinked demand curve results in markets with few competitors

Elastic part
where competitors will match price reductions, but not price
increases. The revenue- maximizing price will be at the kink. Kink

If the demand curve is kinked, if you have to adjust prices, make

Inelastic
partis always the
a significant price change and stick with it. But there
danger of a price war.

The following forms of competitive pricing exist:

(1) Price Leadership: relies on smaller firms matching the leaders’ price. But this would
have to be policed.
(2) Limit Pricing: occurs when a low-cost incumbent sets prices below the profit-
maximizing point to defer entry.
(3) Predatory Pricing: attempts to destroy existing competition.

5.4. Segmentation

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A market segment is a group of consumers within a market with similar characteristics who will
respond to changes in the marketing mix (e.g. a price increase) in a similar way.

Thus, demand curves in various segments may be quite different from their sum which is the
market demand curve.

Where segments are not geographically represented, the only way to change higher prices for
some segments is to alter the product to better fit the needs of the various segments.

Segments need be (1) identifiable, (2) demand related, (3) of adequate size, and (4) attainable
or responsive to the company’s marketing mix.

A segmentation analysis works like this: (1) identify the segmentation variables; (2) construct a
segmentation matrix and identify gaps; (3) analyze segment attractiveness; and (4) identify the
key success factors.

A firm cannot expect to be able to change a higher price for its product if consumers do not
perceive it as different. Product differentiation (real or perceived) refers to a bundle of
characteristics incorporated in a product. One consequence is that prices have to be reduced (a
product abandoned) as competitors develop similar products.

Segmentation reduces the scope for substitution and this will result in a discriminating monopoly.
Prices in segments will vary (even though costs are the same) because different demand
conditions lead to different profit maximizing prices: Orange move in price inelastic segments.

The potential benefits from segmenting the market have to be offset against the costs of
segmentation.

5.5. Product Quality

Product-based quality: links quality to some product or service attribute. It is important that
the marginal costs of improving quality (such as a reduction in down time) do not outweigh the
perceived marginal benefits.

User-based quality: would manifest itself in a shifter demand curve. Ideal points represent an
attempt to measure user-based quality.

Production-based quality: defines quality as conformance to some production standard.

Value-based quality: relates quality (marginal benefit) to price (marginal cost). A producer
may feel that materials or production processes add to quality (hand-made) but consumers may
not be willing to pay for it.

Quality is multi-dimensional and can be seen as the weighted average of (1) performance, (2)
features, (3) reliability, (4) durability, (5) conformance, (6) sensitivity, (7) aesthetics, and (8)
perceived quality.

The same process can be applied to the price a consumer would be willing to pay, called a
hedonistic price. This makes the purpose and outcome of differentiation explicit.

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There is empirical evidence for a relationship between higher quality and competitive advantage
and profits. But companies cannot always charge higher prices for higher quality and high
perceived quality is no guarantee for success.

TQM is an approach trying to incorporate quality into all business processes. But it appears that
quality into all business processes. But it appears that quality training, process improvement, and
benchmarking do not in themselves produce competitive advantage. Rather, it seems to be in
employee empowerment and executive commitment.

Companies need to assess how improving quality affects market share, prices and costs.
Improving quality can lower some costs, as TQM has shown, but improving on some quality
dimensions will lead to an increase in costs.

5.6. Product Life Cycles

Product-life cycles provide a structure within which market information can be interpreted. For
example, an increase in the pace of innovation may have shortened product life cycles.

Products (or entire industries) go through (1) introduction, (2) growth, (3) maturity, and (4)
decline.

Stage Strategic Issue Interest in… Cash flow

Introduction First-mover R&D, marketing Negative
advantage, insecurity
about prospects
Growth First-mover Productive capacity, Negative
advantage, increase marketing
market share
Maturity Protect market share Cost reduction Positive
Decline Divest, harvest,
substitutes

Factors likely to affect the product-life cycle include (1) the advent of substitutes, (2) the pace of
technological change, and (3) durability and replacement demand.

The product-life cycle is easily confused with the business cycle.

5.7. Portfolio Models

The portfolio model seeks to incorporate market dynamics.

The BCG relative share/growth matrix focuses on relative market share and stage of the product
life cycle.

Relative market share results in lower unit costs because (1) of economies of scale and (2) the
experience effect.

Product-life cycle stage has strategic implications: during growth costs are high because
(1) the company needs to capture new customers via low prices and high marketing expenditure
and (2) production capacity needs to stay ahead of demand. During the mature stage the
company no longer has to charge lower prices than its competitors to protect its market share.

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Star: maintain share until Question mark: company
growth ceases share be increased in time?
High

Economies of scale: cash cow Economies of scale: dog;

Barriers to entry
else: niche product Product
differentiation
Market
segmentation

Relative market share

The portfolio model takes the long view, profit maximization in the short-term is not an objective.

Limitation of the BCG portfolio model lie in it assumptions: (1) market share may be a
poor indicator of competitive strength if there are no economies of scale or if the learning curve
begins to flatten; (2) market growth may not lead to high costs of winning customers if there is
under capacity in the market (but under capacity will not last!).

The idea behind the portfolio model is that a company can fund its stars and question marks with
its cash cows.

But unrelated diversification is dangerous and the various SBU need to be linked so as to benefit
from the corporation’s strength.

The model has strategic implications. A company may want to attack a competitor’s cash cow to
protect its own star.

The idea behind the growth vector matrix is to make explicit the direction the
company intends to go and to incorporate this in design of the portfolio:

Products

Current New

Penetration: increase market Product Replacement: capitalize

share. on market knowledge & brand. Current

Markets

Market Development: new (Unrelated) diversification. New

Countries or segments.

5.8. Supply

Movements along the industry supply curve are important because the shape of the supply curve
indicates what happens to quantity an price as the demand curve shifts. Inelastic supply would
result in an increase in price.

Shifts of the supply curve occur as costs change.

5.9. Markets and Prices:

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Transactions take place around the equilibrium price, the intersection of supply and demand
curves.

Rough knowledge of supply and demand conditions can help to make predictions. For example,
in the shipping industry supply is highly price-inelastic because it is impossible to add vessels in
the short-rum. Demand is price elastic and volatile (demand curve shift), resulting in large price
savings.

5.10. Market Structures

Under perfect competition each firm is a price taker, i.e. it will sell nothing if it charges above the
going rate and not earn its cost of capital if it charges above. This is so because (1) the product
is homogenous, (2) there are no barriers to entry, (3) no economies of scale, (4) perfect
information on prices, and (4) a large number of buyers and sellers.

The strategic implication would be that firms want to capitalize on market imperfections such as
perceived differentiation or barriers to entry.

The monopolist’s demand curve is the industry demand curve and it is sloped as the monopolist
is not a price taker.

Structural barriers to entry include (1) size of the market and natural monopoly, (2) suck costs
and barriers to exit, (3) legislation and tacit agreement (patents), (4) economies of scale and
long-run average costs, and (5) the experience effect.

Strategic barriers do not deter entry where exit is costless. A market where entry costs are not
sunk and exit can be achieved costlessly is known as contestable. In contestable markets
monopolists do not earn monopoly profits.

Oligopoly often leads to a kinked demand curve and market participants may not be able to
exploit market inefficiencies.

5.11. The Role of Government

Government sets the rules of the game. That might include (1) employment law, (2) breaking up
of monopolies, (3) health and safety legislation, and (4) corporate governance legislations.

Government regulations seeks to connect the misallocation caused by externalities. This might
take the form of internalizing the externality, tradable emission rights and legislation.

Public goods are characterized by non-rivalry and non-excludability. Without government

intervention, too little of public goods is produced. Companies producing public goods, such as
defense, need be aware of the government decision-making process in setting the right quantity.

5.12. the Structural Analysis of Industries

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Porter’s five forces model attempts to explain whether an industry will be able to earn profits
above the cost of capital. The five forces are:

Force Determinant
(1) Competitors’ rivalry Number of firms in industry
Degree of differentiation.

(2) Threat of new entrants Economies of scale

(3) Threat of substitutes
(4) Suppliers’ bargaining power
(5) Buyers’ bargaining power
Regulation
Entry price
Technological factors
Technological progress (substitutes affect market size)
Monopoly (e.g. a trade union) vs. monopoly
Price elasticity of demand
Income elasticity
Education about competing products
Brand identity
Buyer groups

Strategic Groups:
The concept of strategic groups is used to identify near and distant competitors.

Strategic groups are sets of firms within an industry which are similar to each other on key
dimensions of their attributes and strategy.

Cluster analysis can be used to identify strategic groups.

5.14. Environmental Threat and Opportunity Profile

An ETOP might now include (1) international aspects (interest rates, exchange rates), (2)
macroeconomic factors; (3) supply and demand conditions; (4) socioeconomic factors; (5)
industry structure and the five forces; and (6) an in depth analysis of suppliers and customers.