2. How important is it for management to secure cost leadership advantage in the product market? Examine the extent to which the production-cost relationship, for example, can help management achieve...

December 2010
1 (b)"The ability of managers to pursue goals other than profit maximisation is severely limited
y internal and external constraints; both Baumol and Ma
is provide an alternative set of models
in the search for the best explanation of firms' behaviour " Critically evaluate this statement by
eference to either the Baumol or the Ma
is model.
Answer:
Any existing business organisation has an internal and an external environment. The internal
environment is formed by the employees and other members of the organisation. The external
environment, however, is very wide consisting of shareholders, customers, suppliers,
distributors, competitors, financial market, government etc. Together they are called the
stakeholders of a business. All business activities revolve around the stakeholders. While the
management has substantial control over its internal environment, it is the external environment
which is critical to managerial decision making.
The management ca
ies out the crucial task of setting organisational goals. The organisational
goals need to be in accordance with the expectations of the various stakeholders. The
stakeholders expect the organisation to maximise their interests. The management would be
expected to maximize firm‟s profits such that the same can be used to maximise stakeholder‟s
utility. The traditional business models focused more on capability of the management to
maximize profitability but in the modern world earning high profits is not enough for long term
survival of the business. The managers aim to expand business operations and grow as and when
market opportunities arise. Thus they set goals other than profit maximisation. The aim to ensure
long term sustainability and a balanced growth path for the business. In order to achieve this,
they set their goals as maximizing sales or revenues, maximising shareholder‟s returns, growth
through expansion or diversification, maximizing market share and achieving highest standards
of customer satisfaction. All these goals will ultimately add to the firm‟s profitability in the long
un but in the short run they will have different implications for different stakeholders. For
example a self-financed expansion plan might require the company to restrict dividends to
shareholder and also similar cu
s in employee‟s remuneration scheme. But the management is
equired to gain the support of both the external and the internal stakeholders to successfully
implement expansion plans. Similarly the goal to maximize shareholder‟s value will be
advocated by them but such a policy will minimize the possibility of financing future growth
plans through retained earnings. This is generally not good for the business according to the
management.
Gaining unanimous support from all the stakeholders while setting goals other than profit
maximization can be a strenuous exercise. The stakeholders will constrain managers from getting
involved in risky business ventures or manipulating the business resources for their own selfish
gains. The managers are held responsible for whatever happens in an organisation. They are
accountable for their decisions and are expected to justify how they plan to serve the interests of
the stakeholders. If the management fails to do so they are likely to face a lot of challenges in the
usiness environment.
Ma
is Model of Management decision making
The Ma
is model of management compares the goal of maximizing shareholder‟s value against
the goal of growth and expansion. According to the model there is a possible trade-off between
the goals of higher value and higher growth. While the management would generally prefer to
divert business profits towards growth plans, the shareholders would expect to be the rightful
gainers from the higher profits. A shareholder benevolent policy will be praised in the external
circles and will add to the firm‟s credibility but the managers seem to behave differently while
making a choice between the two goals. They chose higher goals for reasons such as higher
income, prestige and job satisfaction besides the opportunity of career enhancement. But they
might face opposition from the shareholders as they would be apprehensive about the future of
their funds. Also the government policies and the competitors might put hurdles in the smooth
implementation of expansion plans. The dynamic nature of customer‟s behaviour is also a
concern. Thus a decision to grow has to be well supported by the stakeholders to minimize risk.
The internal constraints comes from the members of the organisation who might refuse to take
up the extra burden or changes in the work environment. They need to be motivated through
monetary and non-monetary incentives to go the extra miles. Thus the ability of the managers to
cope up with the internal and external constraints will determine how successful the growth plans
will be.
2. How important is it for management to secure cost leadership advantage in the product
market? Examine the extent to which the production-cost relationship, for example, can help
management achieve cost leadership.
Answer:
Cost leadership strategy to gain competitive advantage aims at achieving minimum possible cost
in an industry. This will help the firm to maximise his market share by charging the lowest
market price. This strategy works really well in a price sensitive market where the competitive
goods are not really differentiated from each other and offer some standard benefits to the
consumers. The cost leader has the advantage of charging below the market average and drive
away demand in highly price elastic product markets. This type of competitive strategy involves
minimum risk as compared to other strategies like product differentiation where extra cost is
involved with no assurance of increase in revenues.
Advantages of being a Cost leader
The most immediate benefit of cost leadership is increased profitability and flexibility in pricing
policy. The cost leader firm can cut through the competition by charging low prices. Usually
lower pricing would also mean lower profit margins. But a cost leader can enjoy higher profits
along with low pricing by capturing the market and enjoying economies of scale. Economies are
achieved not only in input usage but also in the usage of human personnel, transportation and
storage, advertising costs etc.
Cost leadership offers advantage of making use of market opportunities. Instead of adopting a
policy of blanket cost leadership, a firm can chose to focus on few markets that are more prices
sensitive and use the profits from these markets to invest in new markets or building up core
competencies.
Cost leadership offers long term protection from uncertainties in the product market like
increasing competition, government‟s price regulations, rise in input costs and government duties
etc. Such regulations usually increase cost. For example some firms with low profit margin,
might be forced to quit when their costs exceed revenue due to sudden spurt in input prices. A
cost leader firm remains immune to such risks for a long time as it has already achieved
minimum possible cost.
Being the cost leader, a firm has more bargaining power over suppliers than his competitors. He
has the advantage of choosing the most appropriate suppliers and pushes them to enter in long
term contracts. A supplier would also wish to enter in long term relations with cost leader due to
the regular demand of supplies. A market leader will buy in bulk and regularly to meet his input
demand.
The low pricing policy of the cost leader will be a ba
ier for the potential entrants who will face
difficulty to create demand for their goods. The existing firms also are inclined to follow the
footsteps of the cost leader firm in order to survive.
In order to become an efficient cost leader, the cost cutting program of the firm should be
ationalised. The most common method adopted to reduce cost per unit is by achieving
economies of scale. When a firm expands its production judiciously, the fixed costs like the cost
of machinery, factory rent, rent of warehouses, transportation and storage costs etc. are
substantially reduced. Also would offer trade discounts on bulk purchasing. Besides reaping the
enefits of economies, a firm can review its production process to find out areas where wastage
of resources or any leakages can be checked. Firms can reengineer their production processes to
increase productivity of its resources. This might require adoption of some new technology or
methodology. Other areas which might require reengineering can be inventory management,
length of the production cycle, dealing with suppliers etc. The aim of reengineering initiated in
various processes would be to maximize output from the given inputs or reduce the input
equirements for a given level of output.
3. Critically examine the factors that may facilitate player collusion in an industry. Be specific
and support your answer with different examples and case studies.
Answer:
Collusion is defined as the situation where competition is suppressed. There are many factors
that facilitate player collusion in an industry and these factors are:
1. Concentrated industry: The collusion is more likely to occur in a concentrated industry with
low number of competitors than fragmented ones; if number of competitors are large, then it
coordination becomes more difficult and unsustainable because reaching to an agreement
ecomes difficult when number of competitors are large. Also, with large number of competitors,
each firm will get smaller share of collusive profit, which would increase their temptation for
deviation. Thus collusion is more likely in concentrated market.
2. High Entry ba
iers: Collusion is more likely to an industry characterized by high entry
a
iers. This is because in the absence of entry ba
iers, the supernormal profit associated with
collusion might trigger large market entry and therefore might erode profitability associated with
collusion. For example, OPEC is a group of Oil producing nations and is the largest cartel in the
world. The oil production industry has high entry ba
iers due to geographical reasons which
mean all nations cannot supply/produce oil (only nations with oil reserves can supply the oil).
Such advantage in terms of high entry ba
iers has allowed OPEC to continue as cartel for so
long.
3. Quicker interaction between firms: if firms are interacting more frequently, then collusion is
easily sustainable because in this case, they would be able to react quickly to any deviation. On
the other hand, if the interaction and thereby reaction is not frequent, then each firm will have
incentive to deviate and earn higher profits.
4. Marker transparency and ability to detect deviation: For a quicker reaction in case of any
deviation by one party, it is necessary that other participants are able to identify/detect such
deviation on time. Failing to readily observe individual behaviour through market data would
make the collusion difficult to sustain.
5. Symmetricity: it is easier to sustain collusion among similar firms than among asymmetric
firms. Collusion among asymmetric firm causes lots of disputes on issues such as, market
sharing, profit sharing or cost/loss sharing and therefore often results in
eaking of
cartel/collusion. For example, there were six price wars in
omide industry during the period
1885 and 1914, a period when industry was largely dominated by cartel. These price wars were
not basically due to the reasons such as, high deviation profit prompting deviation; rather it was
due to strong disagreement among cartel members over the profit sharing. Had the firms been
symmetric, these types of disagreement would not have arisen and normal solution would have
een equal distribution of profit but the asymmetry between firms created many disputes which
ultimately led to these price wars and
eaking of these cartels.
6. Inelastic demand: An industry whose product has inelastic demand provides strong case for
collusion. Inelastic demand means firms can earn higher profits by charging higher price but
higher price is possible only if the industry has less competition. So firms in this market would
like to collude with each other to make higher profits.
References:
http:
ooks.google.co.in
ooks?id=1diOmC8t0fgC&pg=PA137&lpg=PA137&dq=factors+that+
may+facilitate+player+collusion+in+an+industry&source=bl&ots=kInLCU7r_L&sig=Mw3ZLD
wO2LjaavlCyUd0hICZ20&hl=en&sa=X&ei=yXrET8rtF4m0rAeUzszpCQ&ved=0CFAQ6AEw
Aw#v=onepage&q=factors%20that%20may%20facilitate%20player%20collusion%20in%20an
%20industry&f=false
4. Either (a) Explain how and when low pricing by a competitor may induce a potential entrant
competitor to delay entering the market.
Answer:
In order to drive out weak competitors from the market and prevent the new competitors from
entering the market, sometimes a firm may indulge in charging very low prices. This is called
predatory pricing and is a short run tactic of the firm to avoid competition in the market and
ecome a monopolist in the long run. Some believe that this low price is actually very low, may
e lower than the marginal cost of producing the good. While others believe that the price is
lower than the average total cost under predatory pricing. Whatever may be the case; this low
price can induce a potential entrant competitor to delay entering the market. This is because if it
enters, it will incur losses because customers will always buy from low priced firm. The new
entrant cannot charge such low prices as charged by its existing competitor. Moreover, such low
price by one firm can drive out the other already existing firms from the market. So, predatory
pricing is anticompetitive in nature creating ba
iers to entry for new competitors and rapid exits
y existing ones.
Clearly, this low pricing strategy is not followed permanently by the firm. If it is followed on a
permanent basis then the firm will incur large losses and whole point of charging low prices to
http:
ooks.google.co.in
ooks?id=1diOmC8t0fgC&pg=PA137&lpg=PA137&dq=factors+that+may+facilitate+player+collusion+in+an+industry&source=bl&ots=kInLCU7r_L&sig=Mw3ZLDwO2LjaavlCyUd0hICZ20&hl=en&sa=X&ei=yXrET8rtF4m0rAeUzszpCQ&ved=0CFAQ6AEwAw#v=onepage&q=factors%20that%20may%20facilitate%20player%20collusion%20in%20an%20industry&f=false
http:
ooks.google.co.in
ooks?id=1diOmC8t0fgC&pg=PA137&lpg=PA137&dq=factors+that+may+facilitate+player+collusion+in+an+industry&source=bl&ots=kInLCU7r_L&sig=Mw3ZLDwO2LjaavlCyUd0hICZ20&hl=en&sa=X&ei=yXrET8rtF4m0rAeUzszpCQ&ved=0CFAQ6AEwAw#v=onepage&q=factors%20that%20may%20facilitate%20player%20collusion%20in%20an%20industry&f=false
http:
ooks.google.co.in
ooks?id=1diOmC8t0fgC&pg=PA137&lpg=PA137&dq=factors+that+may+facilitate+player+collusion+in+an+industry&source=bl&ots=kInLCU7r_L&sig=Mw3ZLDwO2LjaavlCyUd0hICZ20&hl=en&sa=X&ei=yXrET8rtF4m0rAeUzszpCQ&ved=0CFAQ6AEwAw#v=onepage&q=factors%20that%20may%20facilitate%20player%20collusion%20in%20an%20industry&f=false
http:
ooks.google.co.in
ooks?id=1diOmC8t0fgC&pg=PA137&lpg=PA137&dq=factors+that+may+facilitate+player+collusion+in+an+industry&source=bl&ots=kInLCU7r_L&sig=Mw3ZLDwO2LjaavlCyUd0hICZ20&hl=en&sa=X&ei=yXrET8rtF4m0rAeUzszpCQ&ved=0CFAQ6AEwAw#v=onepage&q=factors%20that%20may%20facilitate%20player%20collusion%20in%20an%20industry&f=false
http:
ooks.google.co.in
ooks?id=1diOmC8t0fgC&pg=PA137&lpg=PA137&dq=factors+that+may+facilitate+player+collusion+in+an+industry&source=bl&ots=kInLCU7r_L&sig=Mw3ZLDwO2LjaavlCyUd0hICZ20&hl=en&sa=X&ei=yXrET8rtF4m0rAeUzszpCQ&ved=0CFAQ6AEwAw#v=onepage&q=factors%20that%20may%20facilitate%20player%20collusion%20in%20an%20industry&f=false
keep the entrants away from the market gets lost. The firm charging very low prices (generally
elow its cost) should have reserves maintained and other sources of finance should be available
to it so as to cover its short term losses due to predatory pricing. In the long run, it raises its
prices so as to earn higher profits and make up for the losses it incu
ed in the short run. It
indulges in monopolist practices reducing quantity and increasing the price charged. At that time,
the potential entrant can enter the market. If competitors enter at this point of time, the market
ecomes competitive driving down the prices and increasing the total quantity supplied to the
consumers.
However, sometimes it may not be feasible for competitors in the long run due to high ba
iers
on entry. Thus in this case, the existing firm will earn very high revenue. The reason for high
a
iers to entry may be patent rights which are exclusively with that firm. Also, sometimes the
consumers may not want to switch over their demand to different firms if they enter the market
in the long run. In such a situation, new entrant will not enter even in long run and the existing
single firm grabs the entire market share. Thus consumers become worse off because of high
prices and lower quantity. If all this does not happen, then when the competitors enter, price goes
down as compared to high monopolist price but not as much as low predatory price. Consumer
surplus increases because of lower price and larger quantity available.
Therefore, in short run, under predatory pricing strategy, the potential new entrants think that the
existing firm is much more efficient in its working, so it has reduced its prices to such low levels.
So they do not enter the market in fear of earning high losses and also loss of market share.
4 (b) Explain the similarities and differences between Cournot competition and Bertrand
competition. Provide one or two examples of each type of competition. Examine the key
economic assumptions and results of each model.
Answer:
Cournot Competition and Bertrand Competition are the two strategic models through which
firms in the Oligopoly market can compete. Oligopoly market is a market characterized by
having small number of big sellers each having significant market share, large number of buyers,
homogeneous or differentiated products, large selling cost, ba
iers to entry and interdependency
among firms. Under both the models and competitive market structures, firms move
simultaneously and take their action by assuming the action of other player as being constant or
given. When firms compete in terms of quantity, the implied competition is called Cournot...