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
A
B
Current Market Share
5%
50%
Increase desired
2.5%
2.5%
Increase in demand
50%
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
Low Market Growth Rate
Product Cycle Growth Stage:
Star
Cash Cows
High Relative Market Share
Question Mark
Dog
Low Relative Market Share
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:
a) maybe there are not economies of scale in this industry, there even might be
diseconomies of scale.
b) The experience advantage may soon disappear as other companies catch up with the
leader.
c) 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:
Currently Operating Markets
Current Products
Penetration
New Products
Product Replacement
New Entry Markets
Increase Market Share
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
International
Macroeconomic
Microeconomic
Socioeconomic
Market
Supplier
Discuss each item.
+
+
Threat or Opportunity
Expected appreciation of exchange rate
Growth in Eastern Bloc economies
Tax rate increase to fight inflation
Prospect of reduced inflation rates