What Is a Firm and How Do Firms Set Prices - Example

What is a Firm and how do Firms Set Prices? Total Number of Words 784 Introduction The term ‘firm’ is basically an organization that purposely makes full use of the available human and non-human resources in order to manufacture or produce goods and services that is intended for sale (Jain and Khanna, 2010, p. 14). In line with this, IKEA is a good example of a firm that is composed of a group of multinational companies that specializes in the design and selling of ‘ready-to-assemble’ home and office furniture (IKEA, 2014). As compared to the private sector, most public sectors have more advantages particularly when it comes to receiving tax exemption or subsidies directly from the government (Auerbach et al., 2013, p. 121). Basically, IKEA belongs to the private sector. Therefore, using various economic theories such as the basic law of supply and demand, this study will focus on analyzing how internal and external factors would affect the price settings of IKEA. Application of Relevant Economic Theories that Could Explain IKEA’s Price Setting In reality, the main objective of each firm is to benefit from profit maximization (Jain and Khanna, 2010, pp. 14-15). It means that all companies including IKEA will focus on developing and implementing business strategies that can help them increase their sales, profit, and revenues. In real-world practice, it is common for firms such as the case of IKEA to set the price at a point wherein the company can have profit or revenues. This further explains why most of the firms’ pricing strategy considers the costs of production when determining the point of profit margin (Keeney, Lawless and Murphy, 2010). In relation to the theory of profit maximization, it is given that profit can be computed by deducting the ‘total cost of production’ (TC) from the ‘total revenue’ (TR) (Jain and Khanna, 2010, p. 16). Therefore, it is pretty obvious that the firm will not gain profit in case the firm would decide to sell furniture at a price wherein the TC is more than TR. In case IKEA would sell piece of furniture at a price wherein TR is greater than TC, then, it is more likely that the company will be able to reach profit maximization. (See Figure I – Diagram of Cost, Revenue, and Profit below) Figure I – Diagram of Cost, Revenue, and Profit Source: Jain and Khanna, 2010, p. 16 It is given that there are quite a lot of internal and external factors that can affect the firm’s long-term business profitability including the managers’ decision when it comes to price settings (Sloman, Hinde, & Garratt, 2013, pp. 4-5). To closely examine external factors that can significantly affect IKEA’s pricing strategy, it is best to conduct Porter’s five forces analysis for this purpose. Porter’s Five Forces Analysis The Porter’s five forces analysis framework is very useful in terms of analyzing the degree of market competition when it comes to selling home and office furniture (Porter, Magretta and Kramer, 2008). In UK, home and office furniture are widely sold in other large-scale department stores such as Debenhams, Marks and Spencer (M&S), and Selfridges & Co. on top of other direct sellers or retailers of furniture such as the Furniture Village (http://www.furniturevillage.co.uk/), Home Base (http://www.homebase.co.uk/), and Harveys Furniture (http://www.harveysfurniture.co.uk/) among others. Therefore, rivalry among the existing firms is very high. In general, the kind of market structure can affect a firm’s pricing (Sloman, Hinde and Garratt, 2013, p. 3). For instance, the market structure of furniture sellers in UK is oligopolistic competition. It means that on top of so many small-scale firms that manufacture and sell home and office furniture, few large-scale furniture manufacturers are present within the UK furniture industry (Dunne, Lusch and Carver, 2014, pp. 134-135). Since IKEA is technically selling homogeneous item, the presence of alternative product substitute is very high. For this reason, IKEA cannot sell its furniture items with prices way more than what its close competitors are selling the same or similar product. Another way to understand the how firms set prices is to learn more about the basic law of supply and demand (Sloman, Hinde and Garratt, 2013, p. 3; Keeney, Lawless and Murphy, 2010). It is given that anybody today with ready access to the Internet can freely sell new and old furniture. For this reason, the threat of new entrants can be very high. In normal cases, each time the number of furniture manufacturer and seller increases, the available supply of furniture also increases. On the contrary, when the supply of furniture decreases far more than the actual demand for furniture (S to S1), there is a strong tendency wherein the market price of furniture would increase (P to P1). Since not all people are willing to spend more money on furniture items, increase in the market price of furniture would eventually cause demand for furniture to decrease (F to F1). (See Figure II – Effects of Supply and Demand on Price Setting below) Figure II – Effects of Decrease in Supply on Price Setting Assuming that IKEA would decide to sell some of its old stock of furniture, this particular company should sell the old items at a discounted price. In the process of decreasing the market price of old furniture item or items that IKEA would want to get rid of, demand for these items would definitely increase. This can be noted with the movement in the number of furniture (a point between F1 and F). (See Figure III – Effects of Decreasing Market Price on Demand on page 6) Figure III – Effects of Decreasing Market Price on Demand In general, it is not always the supply and demand that dictates the actual price setting. For instance, there are cases wherein furniture sellers such as the case of IKEA, can sell a piece of rare-to-find furniture made of special raw materials or with a unique design at a premium price. Since very few furniture manufacturers can re-produce such item, furniture sellers such as the case of IKEA can have competitive advantage as compared to other furniture sellers in UK. For example, on top of its product design, other factors such as the quality of in-store services, the quality of fabric used in the furniture, the furniture design itself or customization option gives the company the competitive advantages to charge a higher price (Porter, Magretta and Kramer, 2008). Earlier it was mentioned that the threat of new entrants in the UK furniture industry is very high. For this reason, the presence of product substitute is also expected to be very high. This makes the level of bargaining power of buyers to be low-medium. Because of the presence of environmental policies such as the Tree Preservation Order (TPO) in UK (Gloucester City Council, 2014), the bargaining power of suppliers can be gauged as medium-to-high. (See Figure IV – Porter’s Five Forces: IKEA on page 7) Figure IV – Porter’s Five Forces: IKEA In case IKEA would sell its furniture items way more than the selling price of its competitors, this particular company may experience business opportunity loss since its target buyers can easily purchase similar furniture items from IKEA’s close competitors. For example, instead of purchasing ‘ready-to-assemble’ closet from IKEA, potential buyers can simply decide to purchase a non-portable closet from other furniture stores such as the Furniture Village, the Home Base, or at Harveys Furniture. In fact, IKEA’s target buyers can choose to purchase furniture from either local or international furniture sellers. Other Factors Affecting the Price Setting There are quite a lot of other factors that can affect the managers’ decision when it comes to pricing. Among the possible external factors include: movements in the exchange rates, interest rates, inflation rates or unemployment rates (Park, Rayner and DArcy, 2010; Greenslade and Parker, 2008), environmental policies such as the prohibition of cutting trees or government policies on minimum wage, and the excess or shortage of man power (labour) (Nakamura and Steinsson, 2008). For example, depending on age, the current UK minimum wage for working adults more than 21 years old is £6.50 (gov.uk, 2014). For working adults ‘between 18 to 20 years old’, ‘below 18 years old’, and ‘apprentice’ is £5.13, £3.79, £2.73 respectively (gov.uk, 2014). Assuming that IKEA is not able to increase the selling price of its furniture items, perhaps the next best thing its HR manager would do to increase the company’s profitability is to hire and train more apprentice than hire the older working adults. By doing so, IKEA’s opportunity cost would be lower as compared to hiring workers more than 21 years of age. In case the HR manager is not able to change much of its hiring policies because of the existing employment laws in UK, the managers of IKEA may end up selling its furniture items at a price higher than most of its competitors. However, the use of this particular pricing strategy can make IKEA’s products less interesting on the part of the price-sensitive consumers. In case of a bad economic condition such as a very high unemployment rate in UK, the potential market of firms is expected to decrease (Armstrong and Huck, 2010). When this happen, the best way for the company to encourage more people to purchase IKEA’s furniture is to sell some of its items ‘on sale’. Since the expected revenue would definitely increase, the only way for IKEA to increase profit maximization is to lower down the cost of production. This can be done by laying-off some of its current employees or talk to each employee about the need to put them into employment rotation basis. Only then would IKEA earn higher revenue in times of economic recession. Given that some of IKEA’s furniture items are manufactured in foreign countries, the continuous movements of the exchange rates can also affect the price setting of IKEA’s furniture items (Park, Rayner and DArcy, 2010). Therefore, the only way for this particular company to sell the item without losing its monetary value is to constantly review not only the movements of the exchange rates but also the market price wherein IKEA was able to purchase the item from its supplier. At all times, IKEA should sell the products at a price level higher that the total cost of production. In case of the central bank would set higher bank interest rates in UK, it is expected that most of the public consumers would decide to keep their extra money in the bank. To encourage more people to spend their money on IKEA products, this company should be able to offer attractive price discounts. Conclusion The main goal of each firm is to reach profit maximization. Given the tight market competition within the furniture industry, IKEA’s manager should be sensitive and knowledgeable to all internal and external factors that can affect its price setting. 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