The Game Theory

Game theory is a process of modelling the strategic interactions between two or more players containing a set of rules and their outcome. A move by one player sparks off moves by others which ultimately communicates in strategic thinking. The firms fight for a market share and customer retention in real world. The actions performed by firms mimic the actual strategic behaviour, as modelled in the game theory. As stated in the book “Principles of Microeconomics” (Sayre & Morris), game theory is “a method of analysing firm behaviour that highlights mutual interdependence among firms”.

An article in The Economist observes “For John von Neumann and Oskar Morgenstern, the two economists who developed the idea, strategy was “a complete plan: a plan which specifies what choices [the player] will make in every possible situation”. Over the years, the idea was further developed and presented in tabular form. A payoff matrix shows the pros and cons of a decision in tabular form. The matrix highlights positive or negatives associated with the decisions under the decision makers’ controls or external conditions not under the decision makers’ control. Evidence of game theory exists in the real world; the perfect example is the nations are stockpiling nuclear weapons. Each nation is playing a strategic game with each other.

Collusion is an informal agreement between two or more parties to fix prices or output to maximise profits in order to gain a market share without the knowledge of their competitors or official bodies. By controlling prices and output, the parties create an artificial monopoly. A cartel is an association of sellers acting in unison and under a formal agreement of cooperation among firms. The association is visible to the whole market. The main difference between collusion and cartels is the legality of the agreements. Cartel is an official association whereas collusion is unofficial.

Source:
http://www.economist.com/node/12669299

Monopolistic Competition

Monopolistic competition is between perfect competition and pure monopoly in real world. The most distinguishing feature of monopolistic competition is that the products and services offered are not same as other firms but close enough to be as substitutes for each other. The value can be added to the product by offering warranties, courteous service and convenient location where the product is sold. Branding also differentiate products from their competitors. The close enough products are also differentiated by design, colour logo, material used. There are large a number of firms in the market and they can enter and exit freely. The firms have some control over the price by adding extra value by service associated with the product or attracting customers by lowering the price. Advertisement is another way of attracting customer without reducing the prices.

The following table shows most of the features present in the monopolistic competitive market.

Monopolistic Competitive Companies

Size:	Small Company	Medium Company	Large Company
Features:	(Local) Corner food store	Calgary Co-op	Costco
Differentiated products	Personal service, location	Location, service	Brand name, service, price
Control over price	some	Some	Some
Mass advertising	Local Flyers, Local radio Ads, Word of mouth, yellow pages	Local Flyers, Radio and TV ads, Company website, yellow pages	Mass advertisements nationally, Company web sites
Brand name goods	Very few	few	many
Interdependence	None	some	some
Freedom of exit and entry	yes	yes	yes

Competing As Starbucks

In the book “Principles of Microeconomics 6Ed”, (261) by Sayre Morris States that for a firm to be considered in perfect competition, the following four features of perfect competition must be met:

·         Many small buyers and sellers all of whom are price takers.

·         No preferences shown.

·         Easy entry and exit by both buyers and sellers.

·         Same market information available to all.

Starbucks does not seem to be in a perfectly competitive market because the four features of perfect competition, as stated above, are not met in entirety. Clearly the feature “no preference shown” is not met. Some customers prefer Starbucks coffee either due to the experience they provide or the taste.

Starbucks needs to get back to the core business values as they have shifted away from it.  Chairman Howard Schultz stated in the memo that “due to the commoditization of the Starbucks experience” decisions, “have lead to watering down of the Starbucks experience, and, what might call the commoditization of our brand”. La Marzocca coffee machines were installed to provide faster service and cut costs. The installation of these machines blocked customers from watching the drink being made and removed the intimate experience with the barista. The memo also confirms that the sum is much greater but much more damaging than individual pieces. Due to deep recession, especially in the US, customer income dropped and customers started to look for alternative products and the demand for Starbucks dropped.

The drop in demand for Starbucks coffee and the decline in revenue forced the company to close stores. As company noted that “many of the unprofitable stores were being cannibalized by nearby Starbucks locations”.  The company decided to shut those stores which were not profitable where the total losses are greater than total fixed cost. Starbucks claimed that store closures will lead to pre-tax charges of about $328 million to $348 million, including severance pay and lease termination costs (mostly short term costs). Instead of dipping more into the red, the firm decided to close those stores and increase the sales of nearby stores.

Starbucks coffee is very expensive compared to its competitors. The company was able to charge the higher prices by providing good service and an experience above and beyond its competitors. The brand name is also valued highly by the customers.  According to businessinsider.com “11 Things Starbucks Does Better Than Almost Any Competitor”. (http://www.businessinsider.com/starbucks-does-better-2011-7?op=1)

If Starbucks reduces the price of their coffee, their profits will increase. The upper half of the demand curve is elastic and the lower half is inelastic. We can see from the graph that revenue starts rising when the price drops from $5 to $2.5. At $4.5 the quantity sold is 1 million so the revenue is $4.5 million. Revenue keeps rising until the price drops to $2.5. When the price drops below $2.5 then revenue starts falling.

Long Run Costs and Economies of Scale

If I had the resources to open a business, then I would choose to open an organic food store. Organic foods are becoming more popular day-by-day because the public is becoming more educated and knowledgeable about the benefits of eating a healthy diet. Due to increased awareness and market development, more organic food stores are opening up.

I will open a small business, possibly one store in the local community and then expand the business by opening more stores later on when business picks up. The expansion can be handled either by franchising or managing on my own from a central location. The size of the market is large. The main customer base will be families, single adults and couples who have a slightly higher income than the average consumer and are health conscious.

The short run costs are, also known as fixed costs, are costs which cannot be changed. The short run costs include building lease, employee wages, bank loans, utility expenses and business taxes. The long run costs will be merchandise which can be changed by bulk buying or changing the supplier.

As the business expands, the internal economies of scale should be exploited first. The products will be bought in bulk at discounted prices which will reduces the cost of factors of input. As the business grows, it will have a favourable rate of borrowing compared to smaller firms and raising capital becomes less challenging.

Calgary Co-op is a perfect example of a local food retailer. The Co-op web site (http://www.calgarycoop.com/about_us) states that “Calgary Co-op’s root’s run deep in the heart of the community as the only truly Calgarian food retailer”. The Calgary Co-operated Association bought the business from ACWA in 1956 for $58,000 (http://en.wikipedia.org/wiki/Calgary_Co-op). Now Calgary Co-op has over $288 million in assets with 23 food stores, 26 gas bars,17 liquor stores and 7 travel offices. The Co-op management team realized the potential of healthy options and created a small section for healthy choices. The main advantage the Co-op has as a business are the ability to buy products in bulk, diversified product selection with gas bars, travel shops and liquor stores; and providing yearly rebates to members based on the purchases to retain customers. Although they provide healthy options, the Co-op has failed to expoit the market for organic products, which I see as a weakness.

In the food industry, it is crucial to serve the customer with healthy products that taste good or provide value for money. As the people become more educated on health issues, they want to buy healthy food and are willing to pay a bit extra for it.

The Law of Diminishing Return

The article “The Diminishing Returns to Tobacco Legislation” by Pierre Lemieux ( The Laissez Faire City Times , March 19, 2001) discusses the law of diminishing returns in relation to the consumption of tobacco products by government intervention in the cigarette industry.

The article makes some interesting and valid observations. Government intervention is required to reduce consumption of tobacco products. From 1985 to 1995, the consumption of cigarettes is reduced by 18 percent by raising taxes to 52 percent. From 1995 to 1999, prices jumped by 48 percent but consumption was reduced by 11 percent. The taxation on the tobacco industry has reduced the use of cigarettes. The government also decided to use a different strategy to reduce consumption. The Canadian federal government passed regulation to put large panic pictures of diseased lungs, hearts, gums etc. on cigarette boxes. By making people aware of the health risks associated with smoking, the government tried to persuade those smokers who were not persuaded by the tax increases.

Lemieux also points out that government intervention becomes less effective and resistance will develop. People who can be easily persuaded have already quit with initial intervention. It will take a lot more effort to persuade the remaining consumers and some may not be persuaded at all. The author also states that too much information may also kill information. With information saturation, people will start to ignore the warning messages. Consumers are aware of the health risks of smoking from independent sources which are highlighted by the images on cigarette packs.

The law of diminishing returns does not seem to have been reached.  The tax increase of 5.2 percent per year has reduced consumption by 1.8 percent per year over 10 years.  The tax increase of 4.8 percent per year has reduced consumption by 2.75 percent over a period of four years. As the law of diminishing returns has not yet been reached yet, the government has decided to use panic pictures on the cigarette packs.

Governments discovered a long time ago that tobacco products have inelastic demand. Although raising taxes, called Sin Taxes, will increase tax revenue due to inelastic demand, people will still buy nearly the same amount of cigarettes. Governments will neither make tobacco illegal nor create a public utility as proposed by David Kessler, former head of the U.S, Food and Drug Administration (Lemieux). By making tobacco sales illegal, governments will lose the tax revenue from tobacco sales and will face the task of controlling a black market of tobacco products.

Source: 

Lemieux, Pierre. “The Diminishing Returns to Tobacco Legislation.”  

Retrieved on Oct 10, 2012 from

http://www.pierrelemieux.org/artdiminish.html

Income and Cross Elasticity

Chart 1

Canada has the second largest crude oil reserve, most of it in Alberta. It is also the third largest producer of gas in the world. As the economy grows, the demand for energy resources, such as oil and gas, increases. The oil and gas industry has the largest share i.e. 54% of the economy in Alberta as chart 1 illustrates.

The state of the industry is improving, even though there is lot of noise about the environmental impact. More money is invested in development and production as long as the price of oil stays reasonably high and the projects remains feasible.

The measurable elasticity of oil and gas demand is inelastic in the short run but elastic in the long run. In the short run, oil and gas become necessities of life and not many substitutes are available. But in the long run, the other technologies like propane, electric and hybrid cars need to be developed to reduce the reliance on oil. Gas-powered power stations needs to be powered with other energy resources or should be converted to wind power or hydro-electric if possible.

Sources:

 “Demand for Canadian heavy crude is soaring”

                Retrieved on Oct 06, 2012 from

http://www.albertaoilmagazine.com/2011/11/demand-for-canadian-heavy-crude-is-soaring

 “ Importance of Oil and Gas Investment in Alberta”

                Retrieved on Oct 06, 2012 from

http://www.finance.alberta.ca/aboutalberta/spotlights/2011-0708-importance-of-oil-and-gas-investment-in-Alberta.pdf

Elasticity and Revenue

The advent of 3D TV is showing the same trends as HD-TV in terms of demand and pricing patterns. The price range of 3D-TVs is between $1300 and $6000+ depending on the size of screen and other features associated with it. Analysts are predicting the revenue growth of 3D-TVs from US $13.2 billion to US $67 billion worldwide and shipments of 3D-TV’s set to rise from 50.8 million to 226 million by 2019.



The price elasticity of demand is used to see how consumer demand is sensitive to price change assuming ceteris paribus (other things being equal). Consumer demand is extremely sensitive to higher price elasticity, whereas lower price elasticity results in a consumer demand with low sensitivity. The price elasticity of demand is the ratio of percentage change in consumer demand to the percentage change in price. The average value of price and quantity is used to calculate the change in percentage instead of lower or higher value. High price elasticity results in consumers buying less. Consumers buy more when price elasticity is at a low level. 

If we assume, the determinants of demand are ceteris paribus then the consumer demand for 3D-TVs will be sensitive to price changes. In a recent article, Mike Wheatley states that “auto-stereoscopic 3D, which is widely used on games consoles such as the Nintendo 3DS and does not require glasses, is some years away from becoming a reality in televisions due to the technology’s limitations in larger display sizes”. With the advancement of production techniques and advances in technology, the price of 3D-TVs will come down. Consequently, more people will buy 3d-TVs and sales will increase. In conclusion, the price elasticity of demand is elastic at higher price points and becomes inelastic at lower price ranges. The trends in graphs 1 and 2 make it evident that when prices are elastic, total revenue rises. When prices are inelastic, total revenue falls.

The following data illustrates the relationship between price elasticity of demand and total revenue.



The modified data is selected to show the points of elastic, unitary, and inelastic demand, although the data may not be as smooth as in the real world.



Graph 1



Graph 2

Source:

“3D TV Predicted To Spur 3-D Revenue Growth”

Retrieved on Oct 11, 2012 from

http://www.hdtvtest.co.uk/news/3d-tv-revenue-growth-201210012242.htm