A firm has to be well aware of the market structure in which it is operating so that it can take appropriate pricing and output decisions that maximizes its profit and market share. If the market is competitive in nature the firm would follow the price determined by the overall industry demand and supply. On the other hand a monopolist would decide the price that would maximize her profit or the price that would keep potential entrants into the industry at bay. The demand analysis that we had made previously can give us some idea about the market structure in which our frozen food producing firm is operating. We have computed the price elasticity of demand to be -0.44. The value of the elasticity suggests that the demand is quote inelastic. Thus an increase in price will not reduce the demand significantly and a fall in price will not increase it significantly either. The inelastic demand suggests that the firm has some market power. Looking at the cross price elasticity we see that its value is -0.17 which is quite low. The price of the close competitor’s product affects the demand for the firm’s commodity to quite a negligible proportion. Thus the firm’s product has some unique characteristics which gives it considerable amount of market power. The market has monopoly characteristics amidst competitive set up.
Major Players in the Frozen Food Industry
There are a number of companies operating in the frozen food industry at present. Heinz, Nestle, ConAgra are well known names in this segment. Interestingly each company has its unique set of items and appeals to different segments of the population. So each company has market power in its own segment. Here we are going to discuss two major players in the frozen food industry the Nestle and the Schwan. Nestle is a well known name in kids food products like instant noodles, health drinks, confectionaries etc. Its frozen food segment is also quite wide constituting around 15% of its total revenue earnings (IBISWorld, 2013). Nestle has a wide market share of almost 20%. The major items that it produces mainly consist of family meals. It is quite clear about its target population that it caters to. It has faced a surge in sales during the recession of 2008. But surprisingly the sales weaned away when the economies worldwide started recovering. The main reason for this was a rising notion among the consumers that frozen food lose their nutritional value and also contain harmful elements that are used to give them a longer shelf life. This change in consumer attitude towards frozen food is affecting the demand for other companies’ products in the industry. Some companies have jointly launched advertisement campaigns to remove such prejudices from the minds of the consumers. Heinz, Nestle and ConAgra are some of the companies who have joined this campaign .
In contrast to Nestle who mainly cater to the family platter Scwan has a completely different sort of clientele mainly commercial centes. Schools, restaurants, and hospitals are the major consumers of Schwan’s products .Unlike Nestle it had actually faced a downturn n its earnings during the recession of 2008. It has come back with glory taking new marketing strategies. It has launched 200 new products that can find popularity among different age groups and and social strata. Its profit has seen a steady upward movement since 2010 .
Plan Outline for the Firm
We had arrived at the firm’s pricing and output decision in the previous analysis by simply finding the price at which the demand equals supply. We had the demand function and the supply function. The point of intersection of the demand and supply function gave us the equilibrium price and the quantity for the firm. Our firm in the previous analysis was behaving as a competitive firm. In our present analysis the market structure has changed to monopolistic competition. The firm has an inelastic demand curve and the cost functions are also provided to us.
According to microeconomic theory a firm will maximize its profits at that output level where the marginal revenue earned from the last unit sold would equal the marginal cost of producing the last unit . From the demand curve that we have already derived in the previous exercise we can find the marginal revenue function. The marginal cost function has been provided to us. By equating the two functions we can get the profit maximizing output. From the demand function we can find the price at which this output can be sold. We can find the corresponding revenue and profit and decide on the future course of action for the firm accordingly.
Factors Causing Change in the Market Structure
In our previous analysis our firm was in a competitive market set up. Now it has gained considerable amount of monopoly power. There are a number of factors behind this change in the competitive structure. We are going to discuss two major changes that have made the firm gain market power.
The firm has undergone massive product innovation that has increased the array of products offered by it. In this context let us cite the example of Schwan that has increased its earning by increasing the variety of products offered by it. The wide variety of products differentiated form the items offered by the competitors has been responsible for increasing the demand for the firm’s product .
The firm has also launched aggressive advertisement campaigns to popularize the array of products that it has brought into the market. We have seen in the previous analysis that advertisement was unable to produce any major change in the demand as the elasticity of advertisement expenditure was low. Now the firm has taken up innovative marketing strategies that has increased its market size.
Short-run and Long-run Cost Functions
In this section we are going to discuss the cost function of the firm. The Total Cost (TC), Variable Cost (VC) and Marginal Cost (MC) functions of the firm are:
TC = 160,000,000 + 100Q + 0.0063212Q2
VC = 100Q + 0.0063212Q2
MC = 100 + 0.0126424Q
Let us find the Average Cost (AC) and Average Variable Cost (AVC) from the above functions as shown below:
AC = TC/Q = 160,000,000/Q + 100 + 0.0063212Q
AVC = VC/Q = 100 + 0.0063212Q
We can write the total cost function as:
TC = 160,000.000 + VC.
Thus we can see that, $160,000,000 is the fixed cost (FC) of the firm as TC = FC + VC
We can also write the AC as:
AC = 160,000,000/Q + AVC
That is, AC = AFC + AVC
Average Fixed Cost (AFC) =160,000.000/Q.
Circumstances that may lead to Shut-down
It is important for a firm to identify the break-even point and the shut down point in the short run. In that way it can plan its long run strategies as well. If a firm incurs loss in the future it has to compute whether it is being able to cover its running costs that is, the variable costs. If the variable costs can be covered from the revenue that it is earning it should continue with its operations . We term this situation as the break even situation. A firm reaches the break-even point when the price equals the minimum point of the average cost curve. If the price falls further the firm can cover its variable costs but not total costs. If the price falls to the minimum point of the AVC the firm reaches the shut down point as any further fall in price will make it unable to cover its variable costs. The firm has to shut down once its revenue earning falls below the AVC.
So long as the firm is able to cover the variable costs in the short run the firm should continue with its operations. Its endeavor should be to expand and reap the benefits of economies of scale in te long run so that average cost falls in the long run. Moreover it should also follow promotional measures for its products to increase its revenue earning so that it can earn profits in future.
Profit Maximizing Pricing Policy
The profit maximizing output of the firm is determined at the point where the MR equals the MC. The MC function has been provided to us. Out task is to compute the MR function. We have the average revenue function which is nothing but the demand function which we have derived in our previous analysis as:
QD = 65100 -100P
The inverse of the demand function can be written as:
P = 651 – Q/100
Total Revenue (TR) can be found out as follows:
TR = P*Q = 651Q – Q2/100
Marginal Revenue (MR) can be obtained by differentiating the TR with respect to Q :
The condition for profit maximization is:
Or, 100 + 0.0126424Q = 651 –Q/50
Q = 16879.8863 units.
P = 651 – Q/100
Substituting Q = 16879.8863 we get:
P = 651 – 16879.8863/100=651-168.798863
The value of P and Q that we have obtained will give us the total revenue as given below :
TR = P*Q = 482.20*16879.8863 = $8139500.37
We can find the total cost of producing this level of output from the cost function:
TC = 160,000,000 + 100*16879.8863 + 0.0063212*(16879.8863)^2
Or, TC = $163489092
The profit is the excess of TR over TC. The profit in our case is:
π = TR-TC = $8139500.37- $163489092= -$155349592
We have obtained a negative figure implying that TC>TR. That is the firm is incurring a loss.
We can see that the price in the present situation has increased to $482.2 compared to the previous price $407.65 that we have obtained in our previous analysis. The output has been reduced from 24335 to 16879.8863, to achieve this price.
Financial Performance of the Firm
Our analysis has shown that the best that the firm can do given its cost and demand situation is to minimize loss. The firm will continue its operations if it earns enough revenue to cover its variable costs. Let us find the variable cost as:
VC = 100*16879.8863 + 0.0063212*16879.8863 = $3489092
TR – VC = $8139500.37– $3489092= $4650408.37
The difference is positive indicating that TR>VC by $4650408.37
Thus the firm is able cover its variable costs. So it should continue with its operations.
Let us now compare the price, output and profit of the previous competitive structure with the present imperfectly competitive operation mode of the firm:
Previous Situation: Current Situation:
P = $407.65 P = $482.20
Q = 24335 Q = 16879.8863
Π = -$156256703 π = -$155349592
Assuming that the firm remains in a competitive situation in the long run we can compute the long run profit from the price and output obtained in the above analysis. We know that in the long run the firm incurs only variable cost. So the profit earned will be the difference between revenue and VC. The long-run profit will thus be $4650408.37. The firm loses some of its monopoly power in the long run as new products come into the market and the firm loses some of its market share. To regain its monopolistic position the firm has to launch newer products.
Strategies to Improve Profitability
We have seen that the firm in our analysis is incurring a loss in the present scenario. It still should continue with its operations as it is able to cover the running costs. Its endeavor should be to reduce the cost in the future and increase the revenue earnings so that the loss is converted into profit.
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