The U.S. Automotive Industry –
An Analysis Based on Porter’s Five Forces Model
Jason Ruby
ECON600
American Military University
Executive Summary
This analysis of the U.S. automotive industry has been conducted based on Michael Porter’s Five Forces Model, and focuses primarily on the three major American manufacturing companies – Ford, General Motors, and Chrysler. The U.S automotive industry is a huge facet of the American economy, with a historical average of 20% of U.S manufacturing resources tied to automotive manufacturing, supplies, and logistics. While these three corporate giants have been the traditional backbone of the U.S automotive market, globalization has blurred the line between what may be considered foreign and domestic companies. The analysis here will demonstrate how intense rivalry, competition, barriers to market entry, and the influence of power or buyers and sellers all impact this dynamic American industry.
This report also describes the early development of the U.S automotive industry in the late 1800’s through early 1900’s, gives an overview of its current state, and provides an outlook for the future. The primary focus is on the growth and development of Ford, General Motors, and Chrysler and how they reached their current status as among the largest automakers in the world. This report also discusses the impact of the global economic recession on these companies and in turn the impact on the U.S economy as a whole. The reasons for the $25 billion bailout are addressed, as well as how “The Big Three” were able to use this funding to restructure their organizations and recovery from near bankruptcy. The report concludes by explaining the trend by all major automakers toward globalization into the growing economies of Asia and South America.
The history of the automobile did not begin with gasoline-powered engines in the late 19th Century, as many people have come to believe. Rather, the first self-propelled vehicle designed for transportation on roads was a steam-powered invention by French engineer and mechanic Nicholas Joseph Cugnot in 1769. In fact, the roots of this invention date back much father, as both Leonardo da Vinci and Isaac Newton both has designs that inspired Cugnot. In the 1820’s and 30’s, several inventors in Hungary, Holland, Scotland, and the U.S. built the first electric automobiles, though it is not clear who’s design was actually the first. In 1842, non-reusable batteries were first used, but their short life span made electric cars impractical.
The history of the automobile industry, and the automobile markets themselves, began with the wide-spread use of gasoline-powered internal combustion engines in the 1880’s. In 1885, German engineer Karl Benz designed and built the first gas-powered internal combustion engine that was practice for use in automobiles. The first commercial producers of automobiles were French partners Rene Panhard and Emile Levassor in 1890. The automotive industry began in the United States in 1893 when brothers Charles and Frank Duryea established the Duryea Motor Company, and by 1896 “had sold thirteen models of the Duryea, an expensive limousine, which remained in production into the 1920s” (About.com, 2011).
Mass-production of American automobiles began with Ransom Eil Old’s design, the Oldsmobile, selling more than 2000 in 1902 and 5000 by 1904. These early cars had very simple designs, like motorized carts or horse carriages, and were very slow. Over the next decades, new modifications like the steering while, shock absorbers, and electric starters became standard features. Despite these innovations, automobiles were expensive luxuries that were far out of reach of the average citizen during this period, compounded by the drain on manpower and natural resources during World War I. In addition, maintenance and reliability problems plagued early automobile designs. Axles and shocks could not stand up to extended use and poor road conditions, and “cylinder heads had to be removed to dig carbon out of the chambers, and oil sludge could be scooped out of crankcases by the handful” (Motorera.com, 2011).
Although mass-production of automobiles began with the Oldsmobile in 1904, the first effective assembly-line was not developed until 1913 by Henry Ford. Mr. Ford began established the Ford Motor Company in 1903, and first began producing the legendary Model T in 1908. Although the Model T was not the most reliable or innovative car available in its time, it was by far the most produced and the best-selling, making the Ford Motor Company the first automotive industry giant. The reason for Henry Ford’s success was his use of assembly lines, the use of standardized parts, and division of labor at his production facilities, enabling economies of scale. Model T’s were cheap and easy to produce in large quantities, making them affordable to the average citizen in the United States and elsewhere.
By 1918, half of all automobiles being produced in the United States were Ford Motor Company’s Model T’s. To meet this growing demand, Henry Ford began work on a huge new factory complex in Dearborn, Michigan I the late 1918 which was eventually completed in 1927. This sprawling complex on the Rouge River, the largest in the world, was nearly seven million square feet and employed over 80,000 workers. Most importantly, Ford was able to build on his proven assembly line techniques and even greater economies of scale to reduce costs and generate greater profits. Not only were parts standardized, and assembled by workers who stayed at the same station, but the Rouge River factory, “included all the elements needed for automobile production: a steel mill, glass factory, and automobile assembly line” (Hfmgv.org, 2003).
By 1920, several new companies had been established to take advantage of the new and growing market for automobiles – General Motors, Chevrolet, Chrysler, Lincoln, and Dodge. Mergers soon followed, with General Motors acquiring Chevrolet in 1918, the luxury car manufacturer Lincoln acquired by Ford in 1922, and the purchase of Dodge by the Chrysler Corporation in 1927. While Ford continued to focus primarily on the production and sale of the Model T, General Motors “adopted a new production strategy for providing greater product variety, which helped the company increase their market share by 20% and reduce Ford’s by 24%” (Gatech.edu, 2006). The other large American manufacturers later followed suite, including Ford, taking advantage of acquisitions to produce new models like the Dodge Six and Ford Mercury.
After the end of World War II, automotive factories that had been converted to support the war effort returned to the commercial production. With the industrial infrastructures of Germany and Japan in ruins, and American industrial capacity at its peak, the U.S. automotive industry established itself as the world’s leader. Ford Motor Company, the Chrysler Corporation, and General Motors, or “The Big Three”, held the largest market shares and continued to acquire smaller companies. Dozens of smaller companies like Jeep, Mercury, Continental, and DeSoto were absorbed by the big three U.S automakers, enabling increased product diversification and brand recognition. President Dwight Eisenhower signed Federal-Aid Highway Act into law in 1956, establishing the U.S interstate system and the Federal Highway Administration, and the U.S. automotive industry continued to thrive throughout the 1950s and 60s (fhwa.dot.gov, 2011).
The American automotive industry faced a significant challenge in 1973 when the primarily Arab Organization of Petroleum Exporting Countries (OPEC) banned petroleum exports to the United States in response to its support of Israel in the Yom Kippur War. Manufacturers and consumers alike were faced with the realization that the U.S automotive industry, and in fact its entire industrial infrastructure, was particularly vulnerable to oil shortages. Until the 1970’s, American cars had been manufactured with little regard to fuel efficiency. Typical models by Ford, Chrysler, and GM were large, steel framed designs that took advantages of the wide American road systems. But by the mid-1970’s, the OPEC embargo “marked the beginning of the decline of the American auto industry, as Japanese firms associated with smaller cars grew rapidly” (american-business.org, 2010).
Throughout the 1980s and 90s, many automotive companies adapted their business models to those used by the Japanese, including “Just in Time” production, but in 2008 faced their greatest challenge to date with the global economic downturn. Many factors contributed to global economic downturn, which began with the collapse of the U.S housing market and cascaded into the banking and automotive industries. The “Big Three” U.S automakers had already experienced a decline in market share from 70% in 1998 to 53% in 2008, giving ground to companies in Europe and Asia. The global-scale recession in 2009 greatly reduced demand, particularly for traditional gas-powered automobiles, and the banking crisis made it difficult for companies to secure loans. At the same time, labor costs had reached record highs, with salaries, benefits, and health care costs increasing dramatically.
By mid-2008, “The Big Three” were all on the verge of bankruptcy without the intervention of the U.S government. Gas prices had risen to more than four dollars a gallon, and the large American SUVs that had been popular until this time were now sitting unsold on lots across the country. U.S automakers had failed to keep pace with Japanese automakers that had shifted their focus to smaller, more fuel efficient cars, and more recently to hybrid electric models. As a result, the American automotive industry was impacted more heavily than their overseas rivals. Many economists and leaders recognized the severity of situation, with automakers accounting for 2.3% of U.S economic output in 2008, down from 5% in 1999, and “20% of the entire national manufacturing sector is still tied to the automobile industry” (aaat.com, 2011).
In October of 2008, the U.S. Senate approved a 700 billion dollar bank bailout fund, and allocated 24.9 billion dollars to Chrysler, and General Motors to prevent the imminent collapse of the American automotive industry. The Ford Motor Company did not receive funds from the federal bailout package, but rather requested a 9 billion dollar line of credit from the U.S government and a 5 billion dollar loan from the U.S Department of Energy. These loans to “The Big Three” were intended to allow for alignment of resources and production facilities to produce more fuel-efficient and hybrid models. GM and Chrysler both pledged to streamline operations and introduce electric vehicle, while Ford “accelerate development of hybrid and battery-powered vehicles, retool plants to increase production of smaller cars, close dealerships, and sell Volvo” (USEconomy.about.com, 2011).
In 2011, the automotive industry in the United States faces significant challenges. Increased globalization, high oil prices and operations costs, and pressure to produce viable hybrid and electric models that are affordable to American consumers in a faltering economy are just some of the hurdles. For the CEOs, senior leaders, and strategic planners in these organizations, it is critical to examine the current state and dynamics of the U.S automotive industry, and to predict future trends, to be profitable and to prevent future crises. In 1979, Michael Porter of the Harvard School of Business introduced a method of analysis and business development strategy termed “Porter’s Five Forces Model”. Along with SWOT analysis (Strengths, Weaknesses, Opportunities, Threats), Porter’s Five Forces Model is the current standard for industry analysis and estimating the viability of entering or continuing to operate in given market.
Before an effective assessment of the U.S. automotive industry may be conducted, it is important to define the key aspects of the industry itself. First, the market structure of automotive industry is considered an oligopoly, in which a small number of companies dominate the market. In the United States, this oligopoly is comprised of “The Big Three”, while the key players outside the U.S are Honda and Toyota. Production and distribution of automobiles requires major investments in facilities, transportation, technologies, research and development, raw materials, and labor. Suppliers play a significant role is the automotive industry, supplying all types of components, including aluminum, steel, tires, and increasingly advanced electronics. Automakers release monthly sales reports are key indicators when analyzing market trends, as are inventory levels.
The first of Porter’s Five Forces is “The Bargaining Power of Buyers”. In an analysis of the American automotive, the bargaining power of the consumer, or buyer, is somewhat limited. The United States is a large country, and the contiguous 48 states are covered with an extensive highway system. Alternative such as public transportation is limited to the large urban centers, making private automobiles a necessity for most American citizens. In addition, the oligopoly created by having only three major manufacturers in the U.S results in many consumers having only a few purchasing options. Because of this, a consumer may bargain with a car dealer and reduce their cost a small percentage, but this amount is usually factored into the dealer’s sticker price in anticipation. Over the past few decades, however, consumers have been empowered by websites that help locate the lowest price without the need to haggle, and sites like eBay and Craig’s List eliminate the need for the dealership altogether.
The second of Porter’s Five Forces is “Bargaining Power of Suppliers”. Nearly every town in America has some type of car dealership, with the number being relative to population and in some cases the income of the customer base. These suppliers rely very heavily on the major automotive manufacturers to provide their inventory of new cars and trucks. Dealerships are under great pressure to maintain good relationships with “The Big Three”, which results in a similar situation as buyers where there is little power of influence. Another form of supplier in this market are those that provide the components of automobiles, like fenders, seats, tires, navigation systems, etc. Here again, the few number of manufacturers, or buyers, greatly influence price and quantity, limiting the power of these suppliers.
The third of Porter’s Five Forces, the “Intensity of Competitive Rivalry”, may be considered the most dynamic of the five. There is intense rivalry among the major U.S automakers, and in fact between all major manufacturers including those in Europe and Japan. With overseas companies opening facilities on U.S. soil and taking U.S market share, this rivalry is increasing. The result is huge investments in advertising, so much so that it has become part of the fabric of American media. In addition, the “degree of rivalry in the automotive industry is further heightened by high fixed costs associated with manufacturing cars and trucks and the low switching costs for consumers when buying different makes and models” (Gatech.edu, 2006).
The fourth of Porter’s Five Forces is “Threat of New Entrants”. Based on the Wall Street Journal’s year-to-date report on sales and market share of the automotive industry, “The Big Three” are the world leaders, with General Motors holding approximately 20% of market share, Ford holding 16.8%, and Chrysler with 12.1%. Small U.S. automakers like Tesla and Commuter hold less that 1% of market share, and larger, more successful automakers like Jeep, Ram, and Saturn being absorbed into “The Big Three” to be distributed as branded models. For a new automotive manufacturer to reach the level of production that would make the company a desirable acquisition option for General Motors, Chrysler, or Ford, there are very significant challenges (Wsj.com, 2011).
In fact, to even enter the automotive manufacturing industry in nearly impossible, with extremely high “barriers to entry” being a defining characteristic of an oligopoly. Automobiles are expensive to manufacture, with very high costs associated with production facilities, suppliers, logistics, and labor. The result is that global automotive industry experiences more mergers than new entrants. However, over the last few decades the trend has been for automakers to open production facilities in overseas markets. For example, Toyota and Honda have large production facilities in the United States. Toyota Motor Sales USA, Inc. currently holds the fourth largest share of global automotive sales with 15.3%, an increase of 2.8% from 2010. The American Honda Motor Company holds 10.2% with an increase of 1.2%, the fifth largest share of the global automotive market (wsj.com, 2011).
The last of Porter’s Five Forces is “Threat of Substitutes”. In the context of the automotive industry, substitutes may take the form of choosing a car or truck from a different manufacturer, or the potential customer that choose to use buses, trains, or airplanes. The purchase of an automobile is a major financial decision for most consumers, second only to purchasing a home or other larger ticket item. In metropolitan areas where public transportation is efficient and readily available, this is a strong alternative to owning a car. This is not an option for large parts of the United States, however. High gas prices and ongoing maintenance costs are the primary considerations when purchasing a vehicle, resulting in high demand for reliable, fuel-efficient cars and trucks.
In addition to the costs involved in purchasing and maintaining an automobile, marketing, branding, and customer loyalty are all important influences when evaluating the threat of substitute products or services. For example, many Americans continue to purchase less fuel efficient vehicles like trucks and SUVs despite the availability of alternatives. Loyalty to a manufacturer like Ford make compel some consumers to purchase a Ford Explorer over the smaller Honda CRV, and the desire to own a luxury brand name helps drive sales luxury SUVs like the Lincoln Navigator. Increasingly, customers are drawn toward new designs that incorporate technological innovations. All major automotive manufactures invest heavily in marketing and advertising in order to reinforce these influences, particularly through television commercials and Internet advertisements.
It is widely agreed that the combined $34 billion bailout and loans of “The Big Three” by the U.S. federal government in 2008 saved these companies from bankruptcy. While many believed these companies should have been left to fail, the cumulative losses to American GDP and the effect on the unemployment rate may have been catastrophic for the U.S economy that was already reeling. With these funds, GM, Ford, and Chrysler launched extensive restructuring efforts to focus on cheaper, more fuel-efficient vehicles and on more centralized production techniques. U.S. automakers “have started to reduce the number of technological platforms with a greater diversity of models produced from each platform in order to remain cost competitive” (Zacks.com, 2011).
Thanks to the U.S government bailout and subsequent restructuring, “The Big Three” of General Motors, Ford, and Chrysler are now each turning a profit. Between September, 2010 to September 2011, General Motors experienced an increase in total sales of 19%, while Chrysler saw a 27.2% increase, and Ford had an increase of 9%. Of the domestic line of cars and trucks produced by “The Big Three”, only Ford posted a decrease in sales of its cars, but did report an 18.2% increase in light truck sales. During the same period, General Motors increased its global market share from 18% to 20%, while Ford increased their market share from 16.6% to 16.8%, and Chrysler increased their market share from 10.4% to 10.6%. (wjs.com, 2011).
The future outlook for the U.S automotive market is a similar strategy that Japanese automakers have been following for several years by relocating production facilities overseas. The benefits of this strategy are two-fold. First, countries like China, India, and several in South America provide large workforces and cheap labor relative to the high costs of the salaries and benefits expected in the United States. Second, these countries are experiencing radical growth in population and in the sale of automobiles. For example, “China and South America together are projected to represent more than 50% of growth in global light vehicle production from 2008 to 2015” (Zacks.com, 2011). Moving manufacturing to these regions reduces the logistical costs of shipping cars and trucks overseas, and positions “The Big Three” to take advantage of these emerging automotive markets.
References
About.com. (2011). The History of the Automobile. Retrieved Sept 10, 2011 from: http://inventors.about.com/library/weekly/aacarsassemblya.htm
Motorera.com. (2011). First Century of American Cars. Retrieved Sept 10, 2011 from: http://www.motorera.com/history/hist02.htm
Hfmgv.org. (2003).The Life of Henry Ford. Retrieved Sept 10, 2011 from: http://www.hfmgv.org/exhibits/hf/
Gatech.edu. (2006). Automotive Industry Analysis. Retrieved Sept 12, 2011 from: www.srl.gatech.edu/Members/bbradley/me6753.industryanalysis.teamA.pdf
Fhwa.dot.gov. (2011). History of the Interstate Highway System. Retrieved Sept 12, 2011 from: http://www.fhwa.dot.gov/interstate/history.htm
American-business.org. (2010). Arab oil embargo of 1973. Retrieved Sept 14, 2011 from: http://american-business.org/2300-arab-oil-embargo-of-1973.html
Aaat.com. (2011). Automotive industry crisis of 2008–2010. Retrieved Sept 15, 2011 from: http://www.aaat.com/automotive-industry-crisis.cfm
USeconomy.about.com. (2011). The Auto Bailout. Retrieved Sept 17, 2011 from: http://online.wsj.com/mdc/public/page/2_3022-autosales.html#autosalesD
Wsj.com. (2011). Auto Sales Overview. Retrieved Sept 17, 2011 from: http://online.wsj.com/mdc/public/page/2_3022-autosales.html#autosalesD
Zacks.com. (2011). Auto Industry Outlook and Review – March 2011. Retrieved Sept 22, 2011 from: http://www.zacks.com/stock/news/48851/Auto+Industry+Outlook+and+Review+%96+March+2011
Monday, October 24, 2011
Thursday, September 8, 2011
Variations in Price Strategies across Market Structures
Variations in Price Strategies across Market Structures
Jason Ruby
ECON600
American Military University
Abstract
Companies that operate in one of the four market structures must adapt their pricing strategies to meet their primary objective, which is to maximize profits. Markets structures that operate in perfect competition, monopolistic competition, or are monopolies or oligopolies are all influenced by various factors that are defined by environments. These factors include price whether the products are unique, if there are exact substitutes, if there are close substitutes, and what barriers exists for firms to enter or exit the market. When companies operate in perfect competition or monopolies, the demand curve plays a critical role in price strategy. When companies operate in monopolistic competition or oligopolies, competing firms attempt to differentiate themselves from competitors in the market through advertising, branding, and gaining customer loyalty. Some companies may even for alliances, like OPEC, that control price and output of a product and thereby increase profits for all parties.
Optimal pricing is a key consideration for private and commercial organizations, whose primary object is always to maximize profit. In different market structures, like monopolies with no competition, oligopies with much competition, and monopolistic competition markets with few producers, the strategic approchaes to optimal prices will mecissarily vary. In these very different types of market environments, product differentiation play a critical roles in the valuation of products by customers, as does cost, competition, and the customers themselves. With this in mind, the different forces at work in these varied market structures create challenges for executives and strategic planners, requiring different strategies for optimal pricing.
If a market may be said to be in perfect competition, also referred to as pure competition, four or five specific factors must be present, depending on the source of reference. The five common criteria are that all companies must sell the same, standardized product or service, must all be price takers, must have a small non-majority share of the market, must convey their prices to the buyer, and the market itself must have free entry and exit to these companies. The term price taker refers to a condition in which a “firm that can alter its rate of production and sales without significantly affecting the market price of its product” (Investopedia, 2001). It is a rare occurrence for a market to meet these criteria to be considered in perfect completion, but more often a benchmark used for comparison with other market types.
There are many companies, however, that partially meet all the criteria to be considered in perfect competition or come close enough to be based their pricing strategies on this type of market structure. While real-world examples of perfect or pure competition are difficult to find, many academic sources cite agricultural markets as being close, like wheat, soy, etc. The reason for this is that agricultural products are produced by many companies, and the products they produce are essentially identical. In addition, there are generally no barriers to entry or exit into these markets, and both the producers and consumers are price takers because their actions have effect in the price of the product. This is not a perfect example, however, because the products themselves may be differentiated by quality, and some barriers to entry may exist like startup costs.
In contrast to markets that may be considered to have pure or perfect competition with companies that each produce the same, standardized product, markets that are monopolies are characterized by companies that each produce a unique product or service. In markets that are considered to have monopolistic competition, companies produce products that are similar yet have differentiating aspects. The three primary criteria for a monopolistic competition market are that all companies must produce similar but differentiated products, there must be many companies in the market, and that there are no barriers to entry. As such, products within this market types are said to be close substitutes of one another, which usually results in efforts to establish product differentiation in terms of price, quality, and branding.
Markets that are considered in monopolistic completion differ from those in pure or perfect competition in other significant ways besides product differentiation. Probably the biggest consideration for executives and strategic planners is demand elasticity, or the affect of price on demand. As previously mentioned, markets in perfect competition have perfect elasticity, which means that changes demand for products is extremely sensitive to changes in price. In contrast, markets that are considered to be in monopolistic competition operate in an environment with relatively elastic demand, meaning that “the firm has some discretion in raising price without losing its entire market to competition” (Samuelson, W. & Marks, S., 2010, pg. 314). The automobile industry would be an example of companies operating in a market with monopolistic competition, as products are similar but differentiated, and companies have some control over price.
Another type of market type structure that is relative to both perfect competition and monopolistic competition is an oligopoly. An oligopoly has significantly different characteristics than those of markets with perfect and monopolistic competition, and is defined by three characteristics. There are three generally accepted criteria for a market to be considered an oligopoly, which are that companies are “characterized by a small number of large firms that dominate the market, selling either identical or differentiated products, with significant barriers to entry into the industry” (Amosweb.com, 2011). Oligopolies are also characterized by significant barriers to entry, as these are generally large, international companies, and the market is very sensitive to the effects of substitutes.
Market structures that are considered oligopolies, as previously stated, are those that generally consist of a small number of very larger, international companies. Because of this, these companies usually have significant, but not total, control over the price of the good or service being sold. Oligopolies do share some of the characteristics of both perfect and monopolistic markets, in that companies that are part of an oligopoly may produce identical products, differentiated products, or both. Some examples of markets that operate in an oligopoly would be the oil industry, with companies like British Petroleum and Shell, and the market for wireless phones, with major service providers like Verizon and AT&T.
The fourth type of basic market structure is a monopoly, which is the most familiar to people and is generally understood to be an environment where one company sells a specific product, and where no substitutes are available. Pure monopolies have only one seller, and like markets with pure or perfect competition are extremely rare. More common are near monopolies, in which one company sells 90 percents of all products or services in the market. Other than the common characteristic of a monopoly having one seller, the other criteria of this market type is a very high barrier or barriers to entry and that substitutes are not easily obtainable. High barriers to entry are commonly due to patents, copyrights, licenses, and other legal obstructions.
Some examples of pure monopolies would be pharmaceutical companies where there is no generic alternative to the drug, or a software vendor which develops a new application where nothing similar exists. Some examples of near monopolies would be companies that harvest natural resources like diamonds and lumber in one country, and public utilities like that provide water, electric, and Internet service to specific geographic regions. Because of the market control that is demonstrated in a monopoly, the selling company is larger enough “to influence its own price, such that it is the price setter rather than taker, unlike a perfectly competitive market where each firm faces a perfectly elastic demand curve (BasicEconomics.info, 2011).
Companies that operate in markets with perfect or near perfect competition, like agricultural products, have little or no influence on price and as a result are highly sensitive to demand and the supply curve. The demand curve in perfect or near perfect competition “shows the total quantities that consumers are willing and able to purchase at various prices,” and the supply curve “shows the total quantities that producers are willing and able to supply at various prices, other factors held constant (Samuelson, W. & Marks, S., 2010, pg. 314). The pricing strategy for companies in a perfectly competitive market would be to determine the equilibrium price, which is where the supply and demand curves intersect, or where Price = Marginal Cost.
Pure or perfect competition is used as a benchmark when evaluating effective price strategies because it’s Price = Marginal Cost model is inherently efficient. This equation determines the company’s optimal output, which is profitable if marginal costs remain constant. Because there are no barriers to entry, however, “the existence of positive economic profit will attract new suppliers into the industry, and as new firms enter and produce output, the current market price will be bid down (Samuelson, W. & Marks, S., 2010, pg. 272). When this occurs, over the long term, market equilibrium results in no economic profits for companies within the market. Companies no longer have reason to increase or decrease production, nor reason to enter or exit the market.
Compared to markets that have characteristics of an oligopoly or of monopolistic competition, the pricing strategies of a monopoly are defined solely defined by the demand curve. With no alternatives to the product being produced by a single company, monopolies are not affected by production from new entrants to the market. Monopolies maximize their profits by setting both the price and the level of output. Optimal pricing is determined by the marginal revenue equally marginal cost, MR = MC, based on the demand curve. Companies that hold the position of a monopoly in a market generally earn more profit than would be made if there were other sellers, but there may be close alternatives that reduce the demand, and as a result, the overall profit.
The influence of a monopoly on price and output is demonstrated in very clearly in the sale of name brand drugs from pharmaceutical companies. When new drugs are released, and where no generic alternative exists, the price is usually very high because consumers will pay the high costs out of necessity. It is common for a pharmaceutical company to hold a monopoly on one type of drug for a period of time and see large profits. Price will be as high as demand allows and if the product is a cancer or other life-saving or life-extending drug, demand will be nearly limitless. However, when generic alternatives begin arriving on the market as close alternatives, demand drops and as a result profits are greatly reduced.
Markets that may be considered to be in monopolistic competition are similar to both monopolies and those in perfect competition, in both characteristics and in pricing strategy. Companies that meet the criteria of monopolistic competition each produce a unique product, but there are many companies and each is a close alternative to the others. The result of these market influences is that companies but differentiate their products from the others based generally on cost, competition, and customer preference and need. Firms invest considerably in the efforts, commonly in “advertising and marketing, aimed at creating product or brand-name allegiance” (Samuelson, W. & Marks, S., 2010, pg. 314). These factors create a more complicated approach to pricing strategy.
Other similarities between firms operating in a monopolistic competition market in perfect competition is that both have easy entry and exit into the market, which contributes to long term profits declining until profit no longer exists. As in perfect competition, new firms enter the market and drive down long-term profits for all companies which are competing. Some companies operating in monopolistic competition may continue to see long term profits, however, due to increased advertising, branding, and a loyal customer base. Use of advertising must be planned and used efficiently, as “too much spending will result in higher cost, and lower profit. Price, product attributes, and advertisement are three main factors that producers have to consider” (FullColl.edu, 2010). Because of these factors, average cost is high than in perfect competition or monopolies.
The fourth type of market structure, the oligopoly, is very similar to the monopoly in many respects. A monopoly is characterized by one seller and high or no barriers to entry, while the oligopoly is characterized by a small number of companies that produce standardized, differentiated products. A monopoly that does manage to gain additional sellers of a product becomes an oligopoly. Also like monopolies, oligopolies tend to be very large companies, requiring a very large investment to enter the market. Companies like BP, Exxon, and Shell generate more wealth than annual gross domestic product of many of the nations of the world. As a result, relatively large amounts of capital are available for differentiation strategies like research and development, advertising, branding, and even political lobbying.
Because there are very few sellers, each company in oligopoly is very sensitive to changes made by the other companies, including those of price, advertising, and production output. Because of this, some companies in oligopolies form alliances or cartels in which price strategies are agreed upon for the benefit for all the firms involved. For example, “The Organization of Petroleum Exporting Countries (OPEC) is a cartel. The eleven countries agreed on the output amount and working together to control the world’s crude oil supply” (FullColl.edu, 2010). When all firms that have formed a cartel within an oligopoly market raise their prices, all members benefit.
This strategy of cartels in an oligopoly market, to raise prices so that all members profit, is an example of a optimal pricing strategy of any of the members. OPEC, rather than being controlled by commercial companies, is actually an intra-government organization founded in 1960 and consists of the largest oil-producing countries in the world including, Kuwait, Iraq, Iran, Saudi Arabia, Qatar, and Venezuela. OPECs goal is is to coordinate the petroleum pricing and policies of member nations, and thereby control the price of oil worldwide. There is a minimum set of criteria for entry into the OPEC cartel, one being a minimum required production of oil each year.
Because OPEC controls the price and production levels of oil, the most important natural resources for national economies, it may be the most powerful non-governmental organization in the world. OPEC is able to raise prices as high as demand will permit, but has made mistakes. In 1979, OPEC double the price of petroleum, “but the price elasticities of demand and non-OPEC supply were much higher than anticipated, so that OPEC did very poorly--not only in absolute terms, but also relative to what it could have achieved if it had set its price more cautiously” (Highbeam.com, 2011). Within a few years OPEC was forced to cut this price by more than half, and today the OPEC lets the market dictate price to some degree, but rather controls output more closely.
The four common types of market structures – perfect competition, monopolistic competition, monopolies, and oligopolies, - each have specific criteria that differential each one from the other three, so companies in each market type have their own approach to optimal pricing strategy. Companies that operate in a market with pure or perfect competition are very rare, and this market structure is more commonly used as a benchmark with which to analyze other companies. Pricing strategies for the other three types of market structures are more complex, however, and factors such as cost, competition, and customer preference and loyalty all play importance parts.
References
Samuelson, W. & Marks, S. (2010). Managerial Economics. Wiley & Sons, Inc. New Jersey USA: Wiley.
Investopedia. (2001). Perfect Competition. Retrieved Sep 1, 2011 from: http://www.investopedia.com/terms/p/perfectcompetition.asp#axzz1X6Nj2dBw
Amosweb.com. (2011). Oligopoly. Retrieved Sep 3, 2011 from: http://www.amosweb.com/cgi-bin/awb_nav.pl?s=wpd&c=dsp&k=oligopoly
BasicEconomics.info. (2011). Monopoly Companies. Retrieved Sep 5, 2011 from:
http://www.basiceconomics.info/monopoly-companies.php
FullColl.edu. (2010). Strategies for OPEC's pricing and output decisions. Retrieved Sep 5, 2011 from:
http://staffwww.fullcoll.edu/fchan/Micro/4oligopoly.htm
Jason Ruby
ECON600
American Military University
Abstract
Companies that operate in one of the four market structures must adapt their pricing strategies to meet their primary objective, which is to maximize profits. Markets structures that operate in perfect competition, monopolistic competition, or are monopolies or oligopolies are all influenced by various factors that are defined by environments. These factors include price whether the products are unique, if there are exact substitutes, if there are close substitutes, and what barriers exists for firms to enter or exit the market. When companies operate in perfect competition or monopolies, the demand curve plays a critical role in price strategy. When companies operate in monopolistic competition or oligopolies, competing firms attempt to differentiate themselves from competitors in the market through advertising, branding, and gaining customer loyalty. Some companies may even for alliances, like OPEC, that control price and output of a product and thereby increase profits for all parties.
Optimal pricing is a key consideration for private and commercial organizations, whose primary object is always to maximize profit. In different market structures, like monopolies with no competition, oligopies with much competition, and monopolistic competition markets with few producers, the strategic approchaes to optimal prices will mecissarily vary. In these very different types of market environments, product differentiation play a critical roles in the valuation of products by customers, as does cost, competition, and the customers themselves. With this in mind, the different forces at work in these varied market structures create challenges for executives and strategic planners, requiring different strategies for optimal pricing.
If a market may be said to be in perfect competition, also referred to as pure competition, four or five specific factors must be present, depending on the source of reference. The five common criteria are that all companies must sell the same, standardized product or service, must all be price takers, must have a small non-majority share of the market, must convey their prices to the buyer, and the market itself must have free entry and exit to these companies. The term price taker refers to a condition in which a “firm that can alter its rate of production and sales without significantly affecting the market price of its product” (Investopedia, 2001). It is a rare occurrence for a market to meet these criteria to be considered in perfect completion, but more often a benchmark used for comparison with other market types.
There are many companies, however, that partially meet all the criteria to be considered in perfect competition or come close enough to be based their pricing strategies on this type of market structure. While real-world examples of perfect or pure competition are difficult to find, many academic sources cite agricultural markets as being close, like wheat, soy, etc. The reason for this is that agricultural products are produced by many companies, and the products they produce are essentially identical. In addition, there are generally no barriers to entry or exit into these markets, and both the producers and consumers are price takers because their actions have effect in the price of the product. This is not a perfect example, however, because the products themselves may be differentiated by quality, and some barriers to entry may exist like startup costs.
In contrast to markets that may be considered to have pure or perfect competition with companies that each produce the same, standardized product, markets that are monopolies are characterized by companies that each produce a unique product or service. In markets that are considered to have monopolistic competition, companies produce products that are similar yet have differentiating aspects. The three primary criteria for a monopolistic competition market are that all companies must produce similar but differentiated products, there must be many companies in the market, and that there are no barriers to entry. As such, products within this market types are said to be close substitutes of one another, which usually results in efforts to establish product differentiation in terms of price, quality, and branding.
Markets that are considered in monopolistic completion differ from those in pure or perfect competition in other significant ways besides product differentiation. Probably the biggest consideration for executives and strategic planners is demand elasticity, or the affect of price on demand. As previously mentioned, markets in perfect competition have perfect elasticity, which means that changes demand for products is extremely sensitive to changes in price. In contrast, markets that are considered to be in monopolistic competition operate in an environment with relatively elastic demand, meaning that “the firm has some discretion in raising price without losing its entire market to competition” (Samuelson, W. & Marks, S., 2010, pg. 314). The automobile industry would be an example of companies operating in a market with monopolistic competition, as products are similar but differentiated, and companies have some control over price.
Another type of market type structure that is relative to both perfect competition and monopolistic competition is an oligopoly. An oligopoly has significantly different characteristics than those of markets with perfect and monopolistic competition, and is defined by three characteristics. There are three generally accepted criteria for a market to be considered an oligopoly, which are that companies are “characterized by a small number of large firms that dominate the market, selling either identical or differentiated products, with significant barriers to entry into the industry” (Amosweb.com, 2011). Oligopolies are also characterized by significant barriers to entry, as these are generally large, international companies, and the market is very sensitive to the effects of substitutes.
Market structures that are considered oligopolies, as previously stated, are those that generally consist of a small number of very larger, international companies. Because of this, these companies usually have significant, but not total, control over the price of the good or service being sold. Oligopolies do share some of the characteristics of both perfect and monopolistic markets, in that companies that are part of an oligopoly may produce identical products, differentiated products, or both. Some examples of markets that operate in an oligopoly would be the oil industry, with companies like British Petroleum and Shell, and the market for wireless phones, with major service providers like Verizon and AT&T.
The fourth type of basic market structure is a monopoly, which is the most familiar to people and is generally understood to be an environment where one company sells a specific product, and where no substitutes are available. Pure monopolies have only one seller, and like markets with pure or perfect competition are extremely rare. More common are near monopolies, in which one company sells 90 percents of all products or services in the market. Other than the common characteristic of a monopoly having one seller, the other criteria of this market type is a very high barrier or barriers to entry and that substitutes are not easily obtainable. High barriers to entry are commonly due to patents, copyrights, licenses, and other legal obstructions.
Some examples of pure monopolies would be pharmaceutical companies where there is no generic alternative to the drug, or a software vendor which develops a new application where nothing similar exists. Some examples of near monopolies would be companies that harvest natural resources like diamonds and lumber in one country, and public utilities like that provide water, electric, and Internet service to specific geographic regions. Because of the market control that is demonstrated in a monopoly, the selling company is larger enough “to influence its own price, such that it is the price setter rather than taker, unlike a perfectly competitive market where each firm faces a perfectly elastic demand curve (BasicEconomics.info, 2011).
Companies that operate in markets with perfect or near perfect competition, like agricultural products, have little or no influence on price and as a result are highly sensitive to demand and the supply curve. The demand curve in perfect or near perfect competition “shows the total quantities that consumers are willing and able to purchase at various prices,” and the supply curve “shows the total quantities that producers are willing and able to supply at various prices, other factors held constant (Samuelson, W. & Marks, S., 2010, pg. 314). The pricing strategy for companies in a perfectly competitive market would be to determine the equilibrium price, which is where the supply and demand curves intersect, or where Price = Marginal Cost.
Pure or perfect competition is used as a benchmark when evaluating effective price strategies because it’s Price = Marginal Cost model is inherently efficient. This equation determines the company’s optimal output, which is profitable if marginal costs remain constant. Because there are no barriers to entry, however, “the existence of positive economic profit will attract new suppliers into the industry, and as new firms enter and produce output, the current market price will be bid down (Samuelson, W. & Marks, S., 2010, pg. 272). When this occurs, over the long term, market equilibrium results in no economic profits for companies within the market. Companies no longer have reason to increase or decrease production, nor reason to enter or exit the market.
Compared to markets that have characteristics of an oligopoly or of monopolistic competition, the pricing strategies of a monopoly are defined solely defined by the demand curve. With no alternatives to the product being produced by a single company, monopolies are not affected by production from new entrants to the market. Monopolies maximize their profits by setting both the price and the level of output. Optimal pricing is determined by the marginal revenue equally marginal cost, MR = MC, based on the demand curve. Companies that hold the position of a monopoly in a market generally earn more profit than would be made if there were other sellers, but there may be close alternatives that reduce the demand, and as a result, the overall profit.
The influence of a monopoly on price and output is demonstrated in very clearly in the sale of name brand drugs from pharmaceutical companies. When new drugs are released, and where no generic alternative exists, the price is usually very high because consumers will pay the high costs out of necessity. It is common for a pharmaceutical company to hold a monopoly on one type of drug for a period of time and see large profits. Price will be as high as demand allows and if the product is a cancer or other life-saving or life-extending drug, demand will be nearly limitless. However, when generic alternatives begin arriving on the market as close alternatives, demand drops and as a result profits are greatly reduced.
Markets that may be considered to be in monopolistic competition are similar to both monopolies and those in perfect competition, in both characteristics and in pricing strategy. Companies that meet the criteria of monopolistic competition each produce a unique product, but there are many companies and each is a close alternative to the others. The result of these market influences is that companies but differentiate their products from the others based generally on cost, competition, and customer preference and need. Firms invest considerably in the efforts, commonly in “advertising and marketing, aimed at creating product or brand-name allegiance” (Samuelson, W. & Marks, S., 2010, pg. 314). These factors create a more complicated approach to pricing strategy.
Other similarities between firms operating in a monopolistic competition market in perfect competition is that both have easy entry and exit into the market, which contributes to long term profits declining until profit no longer exists. As in perfect competition, new firms enter the market and drive down long-term profits for all companies which are competing. Some companies operating in monopolistic competition may continue to see long term profits, however, due to increased advertising, branding, and a loyal customer base. Use of advertising must be planned and used efficiently, as “too much spending will result in higher cost, and lower profit. Price, product attributes, and advertisement are three main factors that producers have to consider” (FullColl.edu, 2010). Because of these factors, average cost is high than in perfect competition or monopolies.
The fourth type of market structure, the oligopoly, is very similar to the monopoly in many respects. A monopoly is characterized by one seller and high or no barriers to entry, while the oligopoly is characterized by a small number of companies that produce standardized, differentiated products. A monopoly that does manage to gain additional sellers of a product becomes an oligopoly. Also like monopolies, oligopolies tend to be very large companies, requiring a very large investment to enter the market. Companies like BP, Exxon, and Shell generate more wealth than annual gross domestic product of many of the nations of the world. As a result, relatively large amounts of capital are available for differentiation strategies like research and development, advertising, branding, and even political lobbying.
Because there are very few sellers, each company in oligopoly is very sensitive to changes made by the other companies, including those of price, advertising, and production output. Because of this, some companies in oligopolies form alliances or cartels in which price strategies are agreed upon for the benefit for all the firms involved. For example, “The Organization of Petroleum Exporting Countries (OPEC) is a cartel. The eleven countries agreed on the output amount and working together to control the world’s crude oil supply” (FullColl.edu, 2010). When all firms that have formed a cartel within an oligopoly market raise their prices, all members benefit.
This strategy of cartels in an oligopoly market, to raise prices so that all members profit, is an example of a optimal pricing strategy of any of the members. OPEC, rather than being controlled by commercial companies, is actually an intra-government organization founded in 1960 and consists of the largest oil-producing countries in the world including, Kuwait, Iraq, Iran, Saudi Arabia, Qatar, and Venezuela. OPECs goal is is to coordinate the petroleum pricing and policies of member nations, and thereby control the price of oil worldwide. There is a minimum set of criteria for entry into the OPEC cartel, one being a minimum required production of oil each year.
Because OPEC controls the price and production levels of oil, the most important natural resources for national economies, it may be the most powerful non-governmental organization in the world. OPEC is able to raise prices as high as demand will permit, but has made mistakes. In 1979, OPEC double the price of petroleum, “but the price elasticities of demand and non-OPEC supply were much higher than anticipated, so that OPEC did very poorly--not only in absolute terms, but also relative to what it could have achieved if it had set its price more cautiously” (Highbeam.com, 2011). Within a few years OPEC was forced to cut this price by more than half, and today the OPEC lets the market dictate price to some degree, but rather controls output more closely.
The four common types of market structures – perfect competition, monopolistic competition, monopolies, and oligopolies, - each have specific criteria that differential each one from the other three, so companies in each market type have their own approach to optimal pricing strategy. Companies that operate in a market with pure or perfect competition are very rare, and this market structure is more commonly used as a benchmark with which to analyze other companies. Pricing strategies for the other three types of market structures are more complex, however, and factors such as cost, competition, and customer preference and loyalty all play importance parts.
References
Samuelson, W. & Marks, S. (2010). Managerial Economics. Wiley & Sons, Inc. New Jersey USA: Wiley.
Investopedia. (2001). Perfect Competition. Retrieved Sep 1, 2011 from: http://www.investopedia.com/terms/p/perfectcompetition.asp#axzz1X6Nj2dBw
Amosweb.com. (2011). Oligopoly. Retrieved Sep 3, 2011 from: http://www.amosweb.com/cgi-bin/awb_nav.pl?s=wpd&c=dsp&k=oligopoly
BasicEconomics.info. (2011). Monopoly Companies. Retrieved Sep 5, 2011 from:
http://www.basiceconomics.info/monopoly-companies.php
FullColl.edu. (2010). Strategies for OPEC's pricing and output decisions. Retrieved Sep 5, 2011 from:
http://staffwww.fullcoll.edu/fchan/Micro/4oligopoly.htm
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