Denying Market Entry Through Advertising

 

Brick By Brick

          Robert Smile surveyed over three hundred companies on their use of entry-deterring strategies. His findings are reproduced in Besanko et al. (2013). Smile examined the use of these firms in terms of the learning curve, advertising, patent acquisition, limit pricing, and excess capacity. All of these were examined in terms of the use for new products and existing products. The data are pretty clear in that use of advertising is the predominate entry-deterring strategy used by companies in the sample. Companies use intensive advertising in 62% of cases with a new product and in 52% of cases with existing products (p. 219).

Use of entry barriers exist because there is a profit advantage in controlling market share. Entrants to a market move the supply curve to the left but do not necessarily move the demand curve. This means that ceteris paribus, the equilibrium price of the product under consideration will be lower than it was before a rival firm’s market entry, and the quantity demanded will be divided between the incumbent and the new entrant. This drives down both profit and revenue. A rational actor will work to limit entry to their market.

The main problem with some of the options in limiting market entry is that they do not necessarily work in a dynamic system. If a firm either tries to keep prices low to prevent entry or maintain excess capacity, they may seem to make sense in a toy model with two time periods, but the actual market is changing and exists in a world of infinite time periods. Over time, if a firm were exercising limit pricing as a monopoly with limit pricing, it would see zero economic profit. If it were instead willing to share the market, as an oligopoly, then they would be able to see some profit above zero (Besanko et al. pp. 208). The same applies for holding excess capacity. A firm cannot be expected to hold that capacity forever. And as the saying goes, what cannot go on forever, will not.  The fact that these options do not necessarily work ties in with the fact that in many countries such theoretically anti-competitive practices are illegal.

The other side is looking at what works and what is used. Firms predominately use advertising to create product differentiation and limit market entry. A look at the top advertisers will illustrate this. Of the top twenty-five advertisers, several industries stand out. The cell phone industry’s big four are all represented. The list also includes five automakers, three insurance companies, five large retailers, two fast food companies, and three tech companies. The only real surprise is that there is only one beer company (“America's 25 Biggest Advertisers”). The common feature is that these are some of the biggest companies in America, so they can afford to spend a lot on advertising, but they all compete in fairly concentrated markets. Advertising is not just a way to maintain and steal market share from competition firms, but it creates a barrier to entry. To be fair, some of these industries have high barriers to entry for a new firm, but it also impedes other nation’s companies from market entry because the brands are part of the environment in a way that a new entrant could only hope to be. In terms of protecting market-share, advertising and marketing is the smart move for any executive.

References

Advertising Age. (2013, July 8). Infographic: Meet America's 25 Biggest Advertisers. Advertising Age. Retrieved from http://adage.com/article/news/meet-america-s-25-biggest-advertisers/242969/

Appleby, J. (2014, May 2). New hepatitis C Drugs’ Price Prompts an Ethical Debate: Who Deserves to Get Them? Washington Post. Retrieved from http://www.washingtonpost.com/business/new-hepatitis-c-drugs-price-prompts-an-ethical-debate-who-deserves-to-get-them/2014/05/01/73582abc-cfac-11e3-937f-d3026234b51c_story.html

Besanko, D., Dranove, D., Shanley, M., & Schaefer, S. (2013). Economics of Strategy (6th ed.). New York: Wiley.

Innovate or Die

Clear to blue. Breakthrough!

Over time, a firm competing in an industry that is competitive will tend towards zero economic profits. Over the long term, that means there will be exit from firms that have higher marginal costs, as they will lose money as a price taker.

If a firm wants to remain a going concern and they are not just a commodity producer, they should ideally become a monopoly, so that they can set their price and quantity. That task is too easily said but is difficult to accomplish. Any monopoly at a large scale will face regulation and excessive attention from the state in terms of prices and quantities produced.

Instead, what a firm needs to do is to be constantly innovative. By being constantly innovative, they can use first mover advantage to gain a temporary monopoly on their new concepts. Even better is if a firm can use state protections like patents, which grant a temporary monopoly on a product. One example is Viagra. Viagra was the first drug that was popularly used to treat erectile dysfunction in the United States. Its introduction was unlike any other drug in recent memory, and it led to jokes and magazine covers. It also led to sales. Though there are now competing drugs, Viagra is not just a chemical compound; it is a brand in itself. It still controls almost 50% of its market, and in 2012 brought in over two billion dollars for Pfizer (“Viagra”).

The problem is that those temporary monopolies lapse. Drug companies have to keep drugs in their research and development pipeline because Viagras are few and far between. Many promising compounds flame out somehwhere between the lab and human testing. Therefore, to maintain its market position, drug companies have to innovate. Alternately, they buy smaller companies working on promising compounds. The reality is that the monopoly granted by a patent is temporary. The patent for Viagra will run out in 2019 (“Viagra”), and Pfizer will have to replace that two billion dollars with something else. Other companies will be able to make the chemical equivalent of Viagra and the profit on Viagra will be lowered. There are other strategies that drug companies use to extend their monopoly on drugs: they will reformulate the delivery system and then rebrand it as something like “Viagra Extended Release”. Moves like this stem the fall of economic rents from the patent protection and the fading brand, but they are no substitute for new innovation and differentiation.

A final thing to consider is the pricing on your temporary monopoly. If a drug company has created some potentially life-saving compound, the price of that compound would perhaps have a perfectly inelastic demand curve. No matter what price the company charged, the demand would be everyone who had the disease. Something close to this has happened recently. Gilead released Sovaldi. It is a twelve-week regime that has a much higher cure rate for Hepatitis with few side effects than current treatments. Gilead used its monopoly to set the price high: 84,000 for the twelve-week-course. That comes out to about a thousand dollars a pill when the marginal cost of the making those pills is much less. This pricing has brought out extra-market forces to bring pressure on the company. (“Who Deserves to Get Them?”). A quirk of the pharmaceutical industry is that many of its products are not paid for by the end user, instead it is government agencies and insurance companies. Around the world, they are imposing various forms of political pressure and price controls on the drug. In spite of this pressure, Gilead realized over ten billion dollars in revenue on Sovaldi alone (“Sales of Sovaldi”). Even though there was much clamor, the company made the profits by their innovation. In addition, they are not done. Gilead has more drugs in the pipeline for when Sovaldi is tapped dry.

References

Appleby, J. (2014, May 2). New hepatitis C Drugs’ Price Prompts an Ethical Debate: Who Deserves to Get Them? Washington Post. Retrieved from http://www.washingtonpost.com/business/new-hepatitis-c-drugs-price-prompts-an-ethical-debate-who-deserves-to-get-them/2014/05/01/73582abc-cfac-11e3-937f-d3026234b51c_story.html

Pollack, A. (2015, Feb 3). Sales of Sovaldi, New Gilead Hepatitis C Drug, Soar to $10.3 Billion. The New York Times. Retrieved from http://www.nytimes.com/2015/02/04/business/sales-of-sovaldi-new-gilead-hepatitis-c-drug-soar-to-10-3-billion.html

Wilson, J. (2013, March 27). Viagra: The Little Blue Pill That Could. CNN. Retrieved from http://www.cnn.com/2013/03/27/health/viagra-anniversary-timeline/index.html

Tit-for-Tat Pricing

How Much is that Seat?

 

The smoke-filled room of lore, with big cigars and big men setting prices in their waistcoats and pocket watches drinking scotch, is over – if it ever existed at all. Instead, there is much more transparency about prices that are set and more sophisticated theories of firms and how they should act to maximize profit.

            That said, the best way to maximize profit would be to act as a price and quantity setting monopoly. Since that is not allowed, the second best option is for the market as a whole to act as if it were a single monopoly or a cartel (Besanko et al. p. 235).

            The disconnect can be solved in that pricing decisions are made all the time, based on different inputs. Every firm in a monopolistically competitive market will want to maintain the price that they would be able to get in a monopolistic market. The same firm also wants as much market share as possible to gain market share, the firm would have to drop its price. The issue with this is that if one firm drops its price, the next firm can also drop its price up to their marginal cost. A situation where all firms have dropped their prices to their marginal costs leads to much lower profits for the market as a whole, even if sales are greater. In this situation, what firms want to do is play a game of follow the leader to the point where the price is back to where it would be in a monopolistic environment. One firm can raise their price, and sacrifice market share. Once one firm has increased its price, there are two things that can happen. Either the competing firms in the market can raise their prices to the level the first firm did, or they will not. If prices are not followed, the first firm can lower its prices to the level of the other firms. If the other firms follow the first firm, all the participants in that market benefit from the increased revenues. This process can be repeated up to the point where the price level is at the monopolistic price. This is considered “tit-for-tat” pricing (Besanko et al. p. 238).

            The most common example of an industry that uses tit-for-tat pricing is the airline industry. Though they differentiate themselves on service, the large airline companies have a relatively homogeneous product. What they do is take a person from point A to point B. There are also a limited number of routes that can be flown, as most cities have only one airport and these airports have a finite number of gates. Planes are also expensive and there are regulations on the routes foreign carriers can fly in the United States, so the domestic carriers can price as if they were a monopoly fairly easily. This is helped by the fact that their pricing is not transparent (“Airlines reveal ticket pricing strategies”) and two seats on the same plane in the same section may have sold for vastly different prices. The airlines can and do monitor price changes of their competitors in order to maximize the profit from each flight. As the industry consolidates, coordination will be aided by fewer market participants and lower marginal costs as merged companies exploit back office synergies.

References

Besanko, D., Dranove, D., Shanley, M., & Schaefer, S. (2013). Economics of Strategy (6th ed.). New York: Wiley.

Sumers, B. (2013, June 30). Airlines Reveal Ticket Pricing Strategies. San Jose Mercury News. Retrieved from http://www.mercurynews.com/ci_23572144/airlines-reveal-ticket-pricing-strategies

Taxes Are Awesome: Leviathan 2.0

I came across the line last night that “taxation is theft,” and I rolled my eyes, almost instinctually. It made me think of the overly reductive view I have of libertarian political philosophy. To me the libertarian is the two-year-old of political discourse: “Q: What is your view of the role of the state? A: NO! MINE!”. Again, overly reductive but instructive.

That got me thinking -- what is the role of taxation? I know I have been putting off mine for last year. Even though I am anticipating a refund, there is a time cost I’m not looking forward to spending. (As an aside, it was a genius who came up with automatic withholding. The perception is that you get money when you do your taxes. What a nudge!)

In a closed economy, with a commodity money and an unelected autocratic ruler, taxes could be seen as “theft” if all the taxes were was corn you owed to a landlord and you received nothing in return. But as long as you received something in return then its no longer theft but a quid pro quo. The cost of whatever it is you receive and if you wanted it my be at issue, but it is no theft if it is not just 100% expropriation. Even then you would still need some basic services and there are public goods that exist so that you would need to obtain those somehow because no man is an island. Then you’re paying fees to the service provider and taxation-as-theft to your autocratic ruler. It’s all rent in some form. I guess the chafing is that one feels much more coercive than the other. We can choose the service providers, but not the autocrat.

The problem is that we live in a world with a republican government at the federal level with fiat money and floating exchange rates. The simplest refutation to the idea that “taxation is theft” is to go look at a dollar bill. Right at top it says “Federal Reserve Note,” and right below that it says “The United States of America”. Nowhere do any of mine say “One Edgar Buck,” as much as I would like them to say “Edgar Buck” and be accepted at retailers of my choice, that is not the world I live in. Basically, no one can steal from you what never was yours in the first place. You are a temporary custodian of that dollar until you pass it along.

Instead there is a fiat currency with a slowly decreasing value. That because the monetary base is growing, and this is called inflation. Basically, inflation is the general rise of the price level. Stuff’s getting more expensive, but as the Federal reserve gets better data it is more controlled. The only time that should be a problem is if the cost of your labor is not increasing (Also if you have some sort of nominal fixed income). The Fed can influence the interest rate through policies of buying and selling bonds and other financial instruments. The basically have their hand on the tiller of how much a dollar is worth.

But what is a dollar worth? Is a million a lot of money? This is only realized through what a million can be exchanged for in the market. Will a million by a nice house or a hamburger? This is seeing money as a medium of exchange, where the worth of a dollar is realized in the terms of the goods and services that can be received for every dollar that you have. Inflation over the years makes each dollar able to buy a little less. It is hard to see the effects of low inflation on a day-to-day basis, but it can be exaggerated over a longer time period. I remember reading concern about fiat currency decreasing the value of the dollar 94% since the creation of the Federal Reserve a century ago. That would only be an issue if workers were receiving wages at a 1914 level. Low, persistent inflation is good, because that means contracts can be written taking it into account, and investments can be figured based on forward-looking projections on what inflation will be. It also has the effect of stimulating the economy because there is a disincentive to holding onto cash. In an economy where 70 of the GDP is consumer driven, that helps growth.

So if a dollar is a claim on resources that the government can make an infinite amount of, why does it have to take yours? Even a de minimis state needs institutions that protect property in some sort. I have argued elsewhere for much a larger state, but the same principles apply even if the state is just a police force and an army. In theory the state could monetize what it needed, printing the money for the paychecks to the policemen and the soldiers. The problem with that is that it makes fiscal policy (taxing and spending) into monetary policy (the amount of money out there).  As long as this happened at steady state, it would not be an issue. The problem is if there is variation in the spending needs of the state. If your country needs to go to war and it monetizing spending then suddenly there is a lot more money out there and the value of your money has gone down suddenly and without notice through a spike in inflation. Taxation is thus a social good because it makes inflation and the larger economy more manageable. Everyone chipping in protects the working and investing classes by stabilizing the economy and creating stable future expectations (though larger issues exists on who pays, for what, and how much?).  Taxation separates the fiscal and monetary realms and keeps inflation at bay by helping control the spikes in spending that would otherwise be monetized. The same argument can be said for government debt as well. As long as it is growing a consistent rate, the economy should be able to avoid shocks. An argument exists that it is the same as strict monetization of spending, but that is not true, Debt creates a liability, but it also creates an asset. It is, as I have seen it put, money that we owe to ourselves.

Chess and the Machine-Mediated Future of Work

I’ve been thinking about chess a lot lately. I blame a couple of authors – Tyler Cowen in “Average is Over,” and Jacob Morgan in “The Future of Work”. Both authors look to the future economy and what it will look like. Cowen’s seems more like a dystopia, but Morgan’s future has a smaller time line. For him the future of work will look like it does now, only more so. The real commonality is that they both really like Chess. Cowen uses it as a metaphor throughout his book, in that today’s chess matches mediated through computer help are tomorrow’s work situations. Morgan named his consulting firm after the game. I think it is a powerful metaphor for strategy, but a limiting one.

                I say that as someone who had chess thrust on me a lot when I was a kid. I was one of the smart kids, and in several environments, I was in a sort of “gifted” program it was anticipated that the smart kids would necessarily gravitate to the game. I was never particularly interested in it for whatever reason. That meant that I was beat by people who were more interested in that particular game. Here’s the thing, though. Researchers in artificial intelligence like chess because it is very bounded. There are only sixty-four squares, and there are sixteen pieces on each side. Each piece moved to set rules. There are, if I’m counting right, only twenty possible initial moves, and twenty possible second moves.  All the possible position and piece combinations can be mapped. It is a very large but finite number, but not so large if you have a perfect computer that can have all those possible positions in their memory that they can access. Each move is one more step along a decision tree that makes one side more or less likely to win. You could set a program up that maps out a route down the decision tree that makes the computer more likely to win in response to its opponents moves. You set two of these programs up against each other and you get white with a slight edge but the end would be mostly draw games?

                You know why I never really got into chess? Because chess is boring, and that scenario I drew out makes it even more so. Humans are not perfect computers. We play the game sub-optimally, where we often make choices that may make our opponent more likely to win. We operate with opening heuristics and planned end games that we try to get to because we know how they are supposed to go.  Strategy is interesting in the same way. If you are in either a cooperative or a zero-sum game, you have to anticipate your opponent’s moves in terms of all possibilities, not just the ones that may improve his lot. This is true for both bounded games like chess and for real life. As we move forward to Morgan or Cowen’s future, this is what I am afraid of – that mechanical mediation will make even the mindful jobs boring and that the workers of the machine will get more productive, but they will also become more machine-like. It would then be the owners of the machine who reap the benefits of that future, and the vast majority of the workers are just pawns on the board.