Assignment Two: Operations Decisions
ECO 550- Managerial Economics and Globalization
Assignment 2: Operation Decisions
In today’s retail food service industry there is a large demand for convenience food. People take less time to cook and with the increase of health issues related to weight management, low calorie options are becoming very popular. Consumers have become more knowledgeable, tech-savvy, and have higher incomes; all of which create a competitive atmosphere in the convenience food market. Microwavable meals have come a long way since their early days and are now considered by many to be a staple in the freezer. Low calorie options in these meals are being sought by the health conscious buyer who demands the combination of ease of cooking with higher nutritional value. Two companies that currently offer a wide selection in this market are Lean Cuisine and Adkins.
Plan for Market Structure Effectiveness
In the first assignment a regression model was developed that helped determine what factors contributed to price changes in these meals.
QD = -2,000 – 100P + 15A + 25PX + 10 I
se = (5.234) (2.29) (525) (1.75) (1.5)
R2= .85 n = 120 F = 35.25
The R2 value in this model is high, which shows that the independent variables chosen in the analysis are indeed cause fluctuations in the demand of this product. The explanatory variables used to measure demand are per-capita income, product price, competitor’s price, and advertising. In addition to the regression results above, the model provided elasticity values for each variable. For example, the elasticity for advertising expenditure was 0.21, which shows that consumers respond strongly to advertising. The remaining variables proved to impact consumer’s demand as well.
In our previous model we worked under the assumption that our product was in a perfectly competitive market. Perfect competition is designated as an industry that has a large number of buyers and sellers marketing a homogenous product (Ferguson, C. E., & Gould, J. P., 1966). Furthermore, the members are price takers and do not have the power to influence price changes. We now understand that perfectly competitive markets are very rare and that in reality our product exists in a different type of market. The four types of markets are: Monopoly, Oligopoly, Monopolistic competition, and perfect competition. Our company has gained enough power in the market to influence price and allow it to choose its own optimal price. This means that establishing an equilibrium where QD = QS does not necessarily apply. Perhaps our company has developed an innovation that makes the quality of our microwave meal much better than our competitors or we have developed a process than drastically lowers the cost of processing the ingredients for our product. Regardless of the reason, our company now has a competitive advantage and we must take advantage of it in order to become dominant in our industry.
Short-Run and Long-Run Functions
Going back to the four types of market structures we can now say that our company is approaching a monopolistic competition structure, in which there are still many buyers and sellers of products, but we have set ourselves apart from our competition with our innovations and there is no longer perfect substitution of products (Harris, McGuigan, Moyer, 2014, p. 352). In this type of structure a firm can earn profits, break even, or suffer losses. In the short run a new entrant into the market that has a differentiated product or that can offer the same product as ours but at a lower price will cause the demand curve to shift. If our firm is earning profit in this scenario then we cannot shift the market price very much. Thus, the demand curve will shift to the left. If our firm is initially operating with a loss then there are low exit and entry barriers and some other firms may exit the business due to being undercut on price. This will cause the demand curve to shift to the right. In the long run, however, our monopolistic competition firm can only earn profit (see graphs to the right and below).
In mopolistic competition firms typically charge orices that are higher than marginal cost because they are offering differentiated products and have more control over their priceing. It should be noted that differntiation can come in many ways including adding or modifying features, changing marketing strategies, adding unique distribution channels, changing the packaging, or adjusting flavors. Essentially, any act that creates a measurable difference between our firm’s product and the competitions is differentiation. Unlike perfect competition where our firm is forced to price the product in line with our competition, this allows our firm gain market power and have more control over our price. Market power is essential and can be defined through Lerner’s Index.
(L) = = – [Where, e = price elasticity]
The Lerner Index measures our firm’s level of market power by relating price to marginal cost. When exact prices or information on the cost structure in difficult to find, the Lerner index uses price elasticity of demand to measure market power (Policonomics, 2012).
Today’s working professionals like convenient and easy dishes to cook that also provide the nutritional value they desire. If we assume that our firm is making a normal profit then demand for these products increases and new firms enter the industry. These firm’s products will probably have some sort of differentiation in order to set themselves apart. As a result, existing firms will eventually lose the advantage that their differentiation provided unless they make changes (Jhingan, M. L., 1984). When this occurs, our firm will invest in research and development in order to create more differentiation and gain back market power. This is necessary because as more firms enter the market, it gradually returns to perfect competition. Our firm is forced to somehow differentiate our products in order to maintain our monopolistic competition so we do not become a price taker again.
Our firm incurs fixed costs in the short run. Because time and capacity restraints we are not able to alter our output on the basis of demand alone. Short run analysis shows that we cannot immediately increase production due to existing equipment and labor limitations. Furthermore, our firm will have to continue production, even if demand drops, until production covers our fixed costs. Because of this the break-even point, equilibrium, in the long run is the minimum point on the average cost curve.
The cost functions below help us determine price and production quantity.
TC = 160,000,000 + 100Q + 0.0063212Q2
VC = 100Q + 0.0063212Q2
MC= 100 + 0.0126424Q
Profit is a function of total revenue and total cost. Total revenue involves price and quantity. In order to calculate marginal revenue we need variable costs and total revenue. Once we have that, we can determine the appropriate price and quantity in order to equal marginal cost.
If the price of our firm’s product drops below the minimum point on the average cost curve then our firm must consider halting production. Earlier we mentioned research and development. This option is recommended in order to develop innovative changes to the product and set that product above our competitors in quality, marketing power, nutritional value, and packaging. Another option is to reassess production processes and labor efficiency in order to improve variable costs for the sake of reducing the costs of production. Combined, these two actions should increase market power.
Profit maximization will occur when our firm operates where marginal revenue equals marginal cost. This is illustrated by the formula below.
Profit (π) = Total Revenue (TR) – Total Cost (TC)
= P×Q – TC
According to profit maximization, we get
= – (Here P is not fixed)
= MR – MC = 0
Therefore MR = MC
In a monopolistic competition structure our product’s price needs to equal variable costs in the short run and average costs in the long run (Varian, H. R., & Repcheck, J., 2010). If this is accomplished then our firm can continue operations. If we put values into our equation we can illustrate this.
P = 21100 -.10Q
TR = 21100Q – .10Q2
MR = 21100 -.20Q
21100 -.20Q = -115.56 + .0222Q
21215.56 = .0222Q
Q = 95470.97
P = 21100 -.10Q = 11552.90
P = 11552.9
So, the point where marginal revenue equals marginal cost that provides maximum profit is Q = 95470.97 with P = 11552, or $8.26 per package. This puts our quantity supplied and price higher than in our perfect competition model. In that model, a price of $8.26 shows a quantity supplied of approximately 60,000 units.
If a firm operates in a monopolistic competition environment and makes a profit, then new firms will enter the market (Kreps, D. M., 1990). In order to maintain market power we will need to focus on research and development and advertisement. While these options will reduce short term profits, they are necessary to combat the new firms that are entering the market with differentiated products or lower prices. The entries into the market will increase total market output and lower prices. Only by maintain a competitive advantage through differentiation can our firm remain profitable in the long run.
Recommendations to Improve Profitability Conclusion
Lowering variable costs are an effective way to increase profits and value to shareholders. There are many ways to accomplish this including increasing production efficiency, sourcing lower cost raw ingredients, and increasing distribution channel efficiency. These are short run fixes that can be implemented quickly, but will do little in terms of long run profitability. Research and development is the best and most effective way to maintain and grow long run profitability and market power. Creating innovations in the product itself as well as long term solutions to introduce advancements in technology in the processing, packaging, and distribution of the product are necessary for long term success.
Ferguson, C. E., & Gould, J. P. (1966). Microeconomic theory. Homewood, IL: Richard D. Irwin.
Harris, F., McGuigan, J., Moyer, R. (2014). Managerial Economics: Applications, Strategies, and Tactics. Stanford, CT, Cengage Learning.
Jhingan, M. L. (1984). Microeconomic Theory. Vani Educational Books.
Kreps, D. M. (1990). A course in microeconomic theory (pp. 577-660). New York: Harvester Wheatsheaf.
Mansfield, E., & Yohe, G. W. (1988). Microeconomics: theory, applications. New York: Norton.
Policonomics. (2012). Monopoly I: Lerner Index. Retrieved from: http://www.policonomics.com/lp-monopoly1-lerner-index/
Varian, H. R., & Repcheck, J. (2010). Intermediate microeconomics: a modern approach (Vol. 6). New York, NY: WW Norton & Company.