Coca Cola Company and Pepsi Company Oligopolistic Market Structure - Case Study Example

Coca Cola Company and Pepsi Company oligopolistic market structure Summary The behavior of companies in the market is influenced by market structures. There are two market structures: perfect and imperfect. The imperfect market structure is made up of monopolistic competition, oligopoly, duopoly and monopoly. In this paper we discuss Coca Cola Company and Pepsi Company product oligopoly competition. Oligopolistic behavior is full of complexity and fun. Any action by one firm in regard to pricing, advertising, quantity or product development will have a dire effect on the profitability of the other competing firm. Thus the actions of one firm will influence the demand curve of the competing firm. This results in the change of the strategy employed by the affected firm. This may lead to retaliation or a response aimed at reducing the negative effect of the competing firm that initiated the changes. We explore the influence of each firm’s behavior in the market and its effect on its rivalry. This will give us a clear picture of oligopolistic market structure. Table of Contents Table of Contents 3 Introduction 4 Oligopoly 4 Kinked demand curve 6 Game theory 8 The pay off matrix 9 Sticky prices 10 Coordination problems 13 Price fixing 13 Price leadership 13 Barriers to entry 14 Conclusion 14 Reference 15 Introduction The organization of a market constitutes market structure. Market structures are very important in influencing the behavior of firms, their customers and the performance of the market. There are various structural features which influence the conduct and performance of the market. First is the concentration of sellers and buyers, that is, are sellers/buyers many, a few or only one and how are they distributed (Coca cola, 2010). The second feature consists of the effect of prevailing conditions on entry of new players, that is, to what extent do established firms have advantage over new entrants. The next feature is the nature of the products offered by the firms, that is, are products homogenous or do product differentiation exist. Another feature is the extent to which the organization produce their own distribution channels or own input requirements for their products (Norman & Thisse, 1996). Another feature is to what extent the firms operate in different markets instead of a single market. The final feature is the effect of market performance and conduct on market structure (McManus, 2007). When these features are considered two market structures result. These are perfect competition and imperfect competition. The imperfect competition comprises the monopolistic competition, oligopoly, duopoly and monopoly (McManus, 2007). In this paper we discuss Coca Cola Company and Pepsi company product oligopoly competition. Oligopoly Oligopoly is characterized by few firms. Of these firms, each of them is large enough such that its behavior has large impact on the demand for products of other rivalry companies. Thus players in oligopoly lack stable demand curves. Coca Cola Company and Pepsi Company are examples of firms in oligopoly (Erickson, 2009). When Coca cola changes the prices of its products, the demand curve for products of Pepsi Company will shift as a result of the price changes in Coca cola products. Due to instability in the demand curves in oligopoly, the profit maximization method using comparison of the cost of the firm to the demand curve of the firm is usually complicated or even unworkable. For instance Coca Cola Company could decide on its best output and price but Pepsi Company can react to this by changing its output or price for its products (Coca cola, 2010). This will in turn shift the demand curve of Coca cola which will lead Coca Cola Company change its best strategy. Since the demand curve of one company in oligopoly market structure is dependent on the behavior of the other company, the ordinary model of the company has little applicability (McManus, 2007). When Coca Cola Company lowers prices of its products, the Pepsi Company will lose a considerable numbers of the customers. On the other hand if Coca Cola Company raises the prices of its products, the demand curve of Pepsi will shift out (McManus, 2007). Pepsi Company will not mind, however coco cola is likely to experience a drop in the quantity of products it sells (Metcalf and Norman, 2003). If Coca cola decides to lower the prices of its products, it is likely to attract a surmountable number of customers from Pepsi and this can increase its total revenue (Norman & Thisse, 1996). The demand curve of Pepsi will shift in sharply as a result of this and this will lead to unhappiness to the Pepsi Company. It is very unlikely that Pepsi will just standby as Coca Cola undercut the prices of its products. In case Coca cola insists on cutting the prices of its products, then Pepsi will likely be forced to cut the prices of its products (McManus, 2007). If Pepsi decide to match the price cuts of Coca Cola Company then the other things equal assumptions will not hold. Coca cola price cuts will result in equally large changes in the prices of Pepsi products and thus the demand of Coca cola product will not rise nearly so much. Kinked demand curve A kinked demand curve is produced when the competing firm in oligopolistic market structure ape the price reductions commissioned by one firm (Coca cola, 2010). Such a curve is not produced by price increase. The curve below illustrates a kinked demand curve of Coca Cola Company when other companies such as Pepsi adopt price reduction for its products. If the initial price of Coca cola products is P and Coca Cola Company decides to increase the price most customers will switch to Pepsi products leaving only true loyalist of Coca cola to buy Coca cola products (Erickson, 2009). Thus Pepsi Company will be happy in this case to let this situation prevail (Pepsi, 2010). However, if Coca cola cuts its prices, Pepsi cannot watch as it loses its customers who would have come to prefer Coca cola products since preference results partly from habit (Hendricks & Mcafee, 2009). Consequently Pepsi will reduce the prices of its products to match the price reductions of Coca cola. In case the prices of Pepsi becomes as cheap as those of Coca cola, then customers are most unlikely switch the products they buy. Due to reduced prices of Pepsi products and the dangers of price wars the total amount of products (quantity) demanded will rise. As a consequence both companies are most likely to suffer heavy losses. To avoid such losses, Coca Cola Company and Pepsi Company will strive to avoid competition based on prices. As an alternative, they will use advertisement to compete each other while prices remain relatively stable (McManus, 2007). The behavior of most oligopolies takes such strategies in the market to compete each other. However, some oligopolies behavior may be influenced by the prevailing legal environment. As a result most firms may adopt common behavior in such cases. The common behaviors adopted by such companies include the following. First, the companies may fix the prices of their products and act like a monopolist. In certain countries, such oligopolistic companies may sign a contract and lead to formation of a cartel which sets a price for the competing products and assign the output of each of these products by individual firms. Since firms are interested in profits, cartels are often unstable since one firm may cheat and try to increase the quantity of its sales even through lowering of prices (Coca cola, 2010). The second common behavior of oligopolies is entering into a competition which leads to reduction of products. In such cases the company’s expenditures on product development, packaging and advertisement are likely to be high. The final common behavior adopted by oligopolies is competition based on non price characteristics (Hendricks & Mcafee, 2009). These include packaging and advertisement and any other characteristic that may increase the sales volume of a company. Such behavior enables oligopolistic companies to avoid competition based on prices which results in reduction of profits. This kind of behavior is the most stable one as compared to formation of cartels (Norman & Thisse, 1996). In most markets where coca cola operates together with Pepsi, this is the common strategy employed (Pepsi, 2010). This has seen Coca Cola Company spent significant amount of money on advertisement to increase its sales. Game theory This is a method which is used to analyze the behavior of an oligopoly. It provides the competition strategies of each company. Each company strives to plot out best behavior that will make it increase sales of its products and at the same time remain profitable. This is usually dependent on the actions of competing firms. The most common strategy employed by firms in oligopolistic market structure is cutting product prices (Hendricks & Mcafee, 2009). The company which cuts the prices of its products first is most likely to make great gains in the market. If the other firms decide to maintain fixed prices for its products, then it is likely to incur great losses (Coca cola, 2010). Thus if there are no prior agreements to maintain certain fixed prices all firms in oligopolistic market structure will rush to cut the prices of their products to enjoy the advantages of being the first one to initiate price cuts in the market. Prior agreements may inhibit price cuts in the market for the products of each firm (Norman & Thisse, 1996). Big and strong firm with lowest cost is likely to hurt the small, weak firm through price cuts in its native home. Continued low prices offer by such big and strong firm is likely to make weak firm to become bankrupt. In spite being disadvantageous to the big firm, this may discourage smaller firms from cutting the prices of its products (Erickson, 2009). The pay off matrix Any firm which wants to initiate a price cut for its products should carry out risk assessment (McManus, 2007). To be able to ascertain the risk involved in such move the following equation can be used. Expected value= (size of loss from price cuts X probability of rivals matching) + (gain from lone price cut X probability of rivals not matching) The oligopoly payoff matrix for coca cola and Pepsi Company will resemble the one below. Coca cola options Pepsi actions Reduce price for its products Do not reduce price for its products Reduce price for its products Limited loss for both coca cola and Pepsi Company Huge gains for Coca Cola Company as Pepsi incur loses Do not reduce price for its products Huge loss for Coca Cola Company while Pepsi incurs huge gains No change for the revenue of both coca cola and Pepsi Company To maximize profits various issues as indicated on the graph below will have to be considered by both Pepsi and coca cola companies. Sticky prices Price wars in oligopolistic market structure are very rare. For the case of coca cola product prices and those of Pepsi have remained considerably stable (Norman & Thisse, 1996). This is because just like any other producers oligopolistic firms aim at maximizing the profits through production of quantities of products that will ensure that marginal revenue equals marginal costs. Kinked demand curve is made up of two separate demand curves (Coca cola, 2010). Marginal revenue curve for oligopolistic market structure has a gap. Marginal revenue is the resultant revenue from a single unit increase in the quantity sold. Due to the gap, changes in the cost curve are unlikely to have any effect on the production decisions of oligopolistic companies. Thus in this case, changes in the cost curve will have no impact on the production of different products by Coca Cola Company and Pepsi Company (Erickson, 2009). The marginal revenue curve for soft drinks produced by Coca Cola Company and Pepsi Company will resemble the one shown below. Coordination problems Conflicts exist in individual and joint interests of players in oligopolistic market structures. For instance in our case both coca cola and Pepsi wants to maximize profits in the soft drink industry. In addition Coca Cola Company and Pepsi Company want to maximize their own market share. To cushion themselves from self destructive behavior both coca cola and Pepsi Company need to coordinate their production decisions (Hendricks & Mcafee, 2009). This will ensure that prices and outputs of their products will be maintained at a level where profits are maximized. In addition, this will ensure that each of the two players (coca cola and Pepsi) will be content with their respective market share. Price fixing Coordination problems may be alleviated through price fixing. This involves explicit agreement between the players in the industry in regard to the prices of products (Coca cola, 2010). In our case such an agreement will involve both coca cola and Pepsi to fix prices for their competing products. However this price fixing behavior is illegal and can lead to court proceedings. For instance the Coca Cola Bottling Company of North Carolina conspired to fix prices for soft drinks between 1982 and 1985 (Metcalf and Norman, 2003). The company was fined and agreed to give its customers discount coupons to settle the charges in addition to paying fine. Price leadership This is a pattern of pricing in oligopolistic market structure where one player establishes the market price for other players in the industry (Erickson, 2009). For instance Coca Cola Company being the largest market share holder in the soft drinks may be allowed to set prices for products that can be used by other firms to sell their products (Metcalf and Norman, 2003). Barriers to entry These are obstacles which inhibit or make it impossible for producers intending to enter a certain market. This is usually aimed at maintaining above normal profits over a prolonged period of time. In the case of soft drinks, barriers to entry include scale of economies, patents, technology and name recognition (Erickson, 2009). Coca cola and Pepsi companies are large companies which enjoy economies of scale world wide and are likely to offer lower prices for their products to restrict entry of new players in the soft drink industry. Coca Cola Company is in possession of patents for the formulation of its products and thus it is not possible for new players to use its formula to produce the same products as it does. The technology used by Coca Cola Company is superior and any new comer is likely to face challenges to acquire a state of art technology like that used by Coca Cola Company. Coca cola is also a renowned brand name world wide and thus entry of a new player is unlikely to attract customers from such well established firm. Conclusion Oligopolistic behavior is full of complexity and fun. Any action by one firm in regard to pricing, advertising, quantity or product development will have a dire effect on the profitability of the other competing firm. Thus the actions of one firm will influence the demand curve of the competing firm. This results in the change of the strategy employed by the affected firm. This may lead to retaliation or a response aimed at reducing the negative effect of the competing firm that initiated the changes. Therefore, firms in oligopolistic market structure ought to consider the reactions that could be taken by its rival on its behavior. As seen in our discussion, Coca Cola Company and Pepsi Company are oligopolistic companies in soft drink market. The actions of one firm will directly influence the behavior of the other. Since these are well established companies, non pricing competition exists and thus prices of these products are considerable stable. Much resource of these companies is directed toward advertisement, product development and quantity of the product to maximize on profitability. The two companies have various barriers which bar new entrants into the soft drink market. Reference Coca cola. 2010. Home. Available at www.cocacola.com [Accessed 20 Sept. 2010] Erickson, G. 2009. An oligopoly model of dynamic advertising competition. European Journal of Operational Research, 197(1): 374-388 Hendricks, K. & Mcafee, R. 2009. A theory of bilateral oligopoly. Economic Inquiry, 48(2): 391-414 McManus, B. 2007. Nonlinear pricing in an oligopoly market: the case of specialty coffee. The RAND Journal of Economics, 38(2): 512-532. Metcalf, G.E. and Norman, G. 2003. Oligopoly Deregulation and the Taxation of Commodities. Contributions to Economic Analysis & Policy, 2(1), Article 12. Norman, G. & Thisse, J. 1996. Product Variety and Welfare under Tough and Soft Pricing Regimes. Economic Journal, Royal Economic Society, 106(434); 76-91. Pepsi. 2010. About Us. Available at www.pepsi.com [Accessed 20 Sept. 2010] Read More