Business Economics - Long Run Profit in Monopolistic Competition - Assignment Example

Business Economics Contents Task A 3 Consumer Equilibrium in Ordinal Utility Approach 3 Long Run Profit in Monopolistic Competition 6 Task B 8 Introduction: Tesco PLC 8 Market Structure of U.K. Super Market Industry 8 Market Power of Tesco PLC 9 Pricing Strategies 10 Profitability 11 Strategy Optimality 12 Economic Rationality of Tesco’s Strategy 12 Conclusion 13 Reference List 14 Task A Consumer Equilibrium in Ordinal Utility Approach The theory of consumers’ utility maximizing equilibrium is based on the principles of rationality, which states that consumer equilibrium for a rational buyer takes place at a point, where utility of a consumer is maximized subjected to given budget constraint (Keller, 2001). Figure 1: Indifference Curve Good A Indifference Curve d(A) d(B) Good B (Source: Author’s Creation) The above figure shows an indifference curve, which depicts the various combinations of two products (A and B) that consumers may choose to purchase with given resources. The slope of an indifference curve resembles the marginal rate of substitution (MRSAB). Therefore, MRSAB= - d(A)/d(B) The slope is negative due to diminishing marginal rate of substitution, which states the diminishing utility derived by a consumer from consumption of good B by way of sacrificing every extra unit of good A (McEachern, 2013). A budget line shows the various combinations of two products (A and B) that a consumer can purchase subjected to given prices of the products (PA and PB) and income of the consumer (M). Figure 2: Budget Line Price of A Budget Line Price of B (Source: Author’s Creation) The equation of budget line: M=PA*(A) + PB*(B) The slope of the budget line is= - (PA/PB) Figure 3: Consumer Equilibrium Price of A Indifference Curve Equilibrium Price of B (Source: Author’s Creation) Hence, at the equilibrium, (PA/PB) = MRSAB= d(A)/d(B) Rise in income If the income ( M) of a consumer increases by 5%, then consumer’s utility maximizing equilibrium moves upward and the aggregate utility derived increases. Figure 4: Rise in Income Price of A Indifference Curve New Equilibrium Price of B (Source: Author’s Creation) The above graph shows that due to rise in income, the budget line shift upwards. Rise in Price of One Good Figure 5: Rise in Price of Good A Price of A New Equilibrium Price of B (Source: Author’s Creation) If the price of only one good (PA) increases by 10%, then the rational consumer would demand more of good B and less of good A with the given amount of resources. The budget line flattens due to rise in price of one good (McEachern, 2013). Rise in Price and Income Figure 6: Rise in Income and Price PA Indifference Curve New Equilibrium PB (Source: Author’s Creation) As shown in the above graph, owing to increase in income by 5%, the budget line shifts upwards. Then again, due to rise in PA by 10%, the budget line rotates downward. Such an effect results in an improved utility maximizing consumers’ equilibrium due to income and substitution effect (McEachern, 2013). Long Run Profit in Monopolistic Competition The characteristic features of a monopolistically competitive market structure are provided in the table below. Factors Monopolistic Competition Number of Buyers Infinite Number of Sellers Finite Type of Products Differentiated (qualitatively different) Nature of Business Profit Maximizing Short Run Outcome Loss, Supernormal Profit or Normal Profit Long Run Outcome Normal Profit Entry and Exit Free Price Making Decision Each Producer is a Price Maker Advertisement Costs High Each firm conducting business in a monopolistic competitive market earns normal profit in long run. Long run is the time period when all the factors of production are variable and the firms are subjected to economies of scale in production. Normal profit is the minimum returns that a seller expects against the risk undertaken for production (Keller, 2001). So, at normal profit level: Total Revenue = Total Cost Firms experience normal profit in long run because of free entry and exit allowance within the industry. In short run, if a monopolistic market yields economic profit, then the new firms are attracted to enter within the concerned industry. However in long run, as several firms enter in the market, the share of each firm declines, thereby leading to normal profit generation. On the other hand, if each firm earns loss in the short run, then firms will exit the market in long run (Keller, 2001). As a result, each firm earns normal profit in long run, given that their market shares increase. In the long run, the marginal revenue curve (MR) = long run marginal cost curve (LRMC) At the same time, price (P) = average revenue (AR) = average total cost (ATC) = long run average cost curve (LRAC) Figure 7: Long Run Equilibrium (Source: McEachern, 2013) The above figure shows the normal profit earned by a monopolistic firm. Task B Introduction: Tesco PLC Tesco PLC is a popular British multinational public limited company founded in 1919. The headquarters are located in Cheshunt, Hertfordshire, England, United Kingdom (Tesco PLC, 2014). It is known as the second largest retailing company after WalMart, both in terms of profit and revenue. Though the company operates across various countries of the world, yet its primarily business is based in England. It is a well-known grocery retailing firm in U.K., which also sells books, electronics, clothing, software, financial services, telecom and music downloads, apart from grocery items. The aggregate revenue of the company was £70.894 billion in 2013 and its net operating profit was £3.054 billion (Tesco PLC, 2014). The company conducts business in a highly competitive market and hence, marketing as well as profitability strategies are crucial business components (Tesco PLC, 2014). This essay will attempt to analyze the internal and external business aspects of Tesco PLC in order to assess strategic optimality in business. Market Structure of U.K. Super Market Industry Tesco PLC conducts business in the grocery industry of the U.K. Over time, the per capita spending on consumer use goods and services has enhanced in the U.K. Increased demand have further heightened the degree of market rivalry among firms operating in the U.K. grocery industry. In 2013, estimated value of the U.K. grocery industry was £169.7 billion (IGD, 2014). The aggregate excess value of the industry has also increased by 3.7% from 2012 to 2013. It is anticipated that value of the industry would rise to £205.9 billion by 2018 (IGD, 2014). Even so, increased demand has increased the number of entrants within the grocery industry in the U.K. Figure 8:U.K. Grocery Market (Source: IGD, 2014) The above pie graph shows that grocery industry of the U.K. is primarily dominated by the hypermarkets or supermarket chains therein. Figure 9: U.K. Supermarket Structure (Source: EconomicsOnline, 2014) From the above pie graph, it can be stated that grocery industry of the U.K. is primarily dominated by few firms such as, Tesco, ASDA, Sainsbury and Morrison. So, the five firms’ concentration ratio of the industry is 81.75% (EconomicsOnline, 2014). The market structure of the industry is Oligopolistic in nature. These markets are characterized with few (2 to 10) sellers and infinite buyers. The firms therein sell heterogeneous or homogeneous products. Though the number of sellers in the industry is low, the market share earned by each firm is high. Furthermore, the firms conduct business on the basis of strategic behaviour through which they determine pricing and profitability strategies after analyzing strategies of their market rivals (EconomicsOnline, 2014). The cost of promotions and advertisement in such industries are high and each firm experiences cut-throat competition. Market Power of Tesco PLC Since Tesco PLC operates in an Oligopolistic market, the company owns a considerable market share in the industry. From figure 9, it is evident that the market share of Tesco is 30.46% in the U.K. The company sells a large number of product lines under its brand name such as, Tesco Basics, Tesco Finest, Tesco Mobile and Tesco Bakery (Defra, 2006). The company sells differentiated products in the market and has adequate power to set prices of the products offered. The company often establishes low prices for its products and services and provides several discounts and incentives on purchases to the loyal buyers (European Union, 2012). This is because it experiences low cost in business due to economies of scale that is not easily experienced by the market rivals. The company is considered to be the largest private employer in the U.K., which enjoys immense market power in order to manipulate the prices of its biggest suppliers. The dairy farmers of the U.K. had once protested against the price pressures imposed on them by Tesco PLC (Winterman, 2013). The firm also owns adequate financial reserves to offer insurance, loan and credit card services in the U.K. market. Scholars have often proclaimed the massive market power of Tesco as “Tescopoly” in the U.K.’s supermarket industry (Winterman, 2013). Pricing Strategies Tesco PLC does not practice the method of outsourcing in business for lowering the manufacturing cost. The company procures its raw materials or final products from numerous suppliers, which lowers the bargaining power of the latter (European Union, 2012). The company gets superior promotional price offers from suppliers who prefer to deliver supplies to Tesco because of its massive trading scale. However, intense threats of market competition have forced to lower the profit margin earned by supermarket companies such as, Tesco PLC. The customers’ switching costs experienced by the company are higher for standardized products and lower for differentiated items sold (Wood, 2011). As a result, Tesco quotes high prices for its unique product categories such as, Tesco Finest and establishes low prices for products under the Tesco Basics category. Tesco implements competitive pricing strategies in business in order to capture higher market demand within the highly competitive business world. In 2011, the company openly declared to introduce price cutting programs worth £500 million (Wood, 2011). The company claimed to lower the prices of nearly 30% of its regular grocery products in 2011 (Wood, 2011). Furthermore, the firm also declared that it would establish lower prices of its product lines relative to those supplied by other companies. Richard Brasher, the head of Tesco U.K., stated that the price cutting program was introduced for catering to the interests of customers. Brasher said that living costs and real income level of the consumers in the U.K. had declined after the recession in 2008. Hence, it was necessary for Tesco to lower the prices of products sold for ensuring affordability for most individuals in the country. Previously, Tesco’s pricing strategies concentrated on promotions and customer Clubcards (Wood, 2011). Since 2011, the price cutting strategy of Tesco had replaced its existing customer loyalty and promotional strategies. Figure 10: Revenue (Source: Tesco PLC, 2013) The above figure shows that the gross revenue earned by Tesco PLC is increasing with time. Profitability In order to gain increased demand and higher revenue in the market, Tesco has implemented a price cutting program 2011 onwards. Under this strategy, the company has started to lower prices of its product lines, especially the less differentiated ones (European Union, 2012). The cost of this program was estimated to be £500 million. The aggregate profit generated by Tesco has declined due to the new price minimizing strategy. In 2014, the company has openly declared that its gross profit has declined by 6% from that in 2013, amounting to £3.3 billion (Wood, 2011). At the cost of falling profitability, the company has enhanced revenue by 11%. In order to compete with the other discount stores in the market, Tesco has lowered the prices of essential products such as, milk, bread and egg, by 24% (Wood, 2011). Lower prices have helped to increase demand for the products of Tesco and enhanced its aggregate revenue. Even so, the costs incurred by price cutting programs have lowered profitability of the organization. Figure 11: Profit (Source: Tesco PLC, 2013) The above figure shows that the aggregate profit earned by Tesco in the U.K. is declining over time. Strategy Optimality Tesco PLC sells most of its products and services at low prices for attracting larger number of potential customers. However, the Competition Commission of the U.K. has claimed that Tesco covers up the expenses of discounts by transferring the burden on its suppliers and other product prices. Since the company is a large retailing firm, it makes bulk purchases from the suppliers and gains power to manipulate their procurement prices. The company sells diversified product categories and often lowers the price of one category to raise that of another category (Defra, 2006). Promotion and customer loyalty were the two primary pillars of Tesco’s marketing strategy. Over time, the organization has replaced such strategies with the new price cutting strategy in business. The company had undertaken this decision on the basis of its strategic behaviour as a typical Oligopolistic firm because the price reduction strategy has proved highly successful for other retailing firms such as, WalMart and ASDA (Wood, 2011). The price cutting strategy of Tesco is highly rational because it is directed towards countering the negative impacts created by falling real income level of the U.K. customers, post-recession. The price cutting program has helped to increase the revenue and market share of Tesco PLC, but has considerably lowered its aggregate profitability (Wood, 2011). The new pricing and profitability strategy adopted is optimal because the organization is rationally behaving as that of a typical Oligopolist in the market. Economic Rationality of Tesco’s Strategy According to the theory of consumer behaviour, the buyers maximize their utility subjected to given budget constraint. The market exuberances in the real estate sector of certain European countries had caused the recession in 2008 (Defra, 2006). The aggregate price level of most goods and services has gradually enhanced in the market. Such circumstances have ultimately lowered discretionary spending powers of the U.K. consumers. The buyers are presently fond of purchasing less expensive product categories. Furthermore, the degree of market rivalry among the Oligopolistic supermarket industry of the U.K. has aggravated with time. In response to such factors, Tesco has decided to lower the price of its standardized product lines. These products face elastic demand in the market and experience low switching costs. This is a rational strategy because the consumers experiencing lower purchasing power are able to sustain their demand for the less expensive products of Tesco. At the same time, inexpensive products of the company are highly competent in the market. Hence, similar to a typical Oligopolistic firm, price cutting has helped to create a competitive edge for Tesco PLC. Conclusion From the above research, it can be claimed that Tesco PLC operates in an Oligopolistic market because the five firms based concentration ratio of the industry is above 80%. Tesco is a prominent public limited organization, which owns a considerable proportion of market share. However, subjected to the changing income trends of consumers and increasing rivalry within the industry, Tesco has incorporated new price cutting strategy so as to improve the aggregate revenue and market share (Tesco PLC, 2014). The gross profitability of Tesco appears to be declining with time under such circumstances. At this juncture, the company can increase its profit with enhanced product or service differentiation, innovation and efficient resource allocation. This is because the rational consumers would be willing to pay premium prices for differentiated products. Increased innovation would help to lower operational cost of the company. Also, if the company’s productive resources such as, labourers, are efficient, then the operational cost would fall due to increased specialization and productivity (Tesco PLC, 2014). All such aspects would contribute towards improving Tesco’s profit as well as revenue in long run. Reference List Defra, 2006. Economic note on UK grocery retailing. [pdf] GOV. Available at: [Accessed 16 July 2014]. EconomicsOnline, 2014. Supermarkets. [online] Available at: [Accessed 16 July 2014]. European Union, 2012. The relationship between supermarkets and suppliers: What are the implications for consumers? [pdf] EU. Available at: [Accessed 16 July 2014]. IGD, 2014. UK grocery retailing. [online] Available at: [Accessed 16 July 2014]. Keller, K., 2001. Mastering the marketing communications mix: Micro and macro perspectives on IMC programs. Journal of Marketing Management, 17(1), pp. 819-847. McEachern, W. A., 2013. Microeconomics: A contemporary introduction. Connecticut: Cengage Learning. Tesco PLC, 2013. Five year record. [online] Available at: [Accessed 16 July 2014]. Tesco PLC, 2014. Tesco PLC. [online] Available at: [Accessed 16 July 2014]. Winterman, D., 2013. Tesco: How one supermarket came to dominate. BBC News, 9 September. Wood, Z., 2011. Tesco declares war on rivals with £500m price cutting offensive. The guardian, 22 September. Read More