Anas Alam Faizli, Doctor of Business Administration, Assignment Advanced Managerial Economics,...

SEPTEMBER SEMESTER 2011

BPME7103 – ADVANCED MANAGERIAL ECONOMICS

ASSIGNMENT (50%)

LECTURER

PROF. DR. MOHD GHAZALI MOHAYIDIN

STUDENT

ANAS BIN ALAM FAIZLI

Cure for all ilnesses

BPME7103 – Advanced Managerial EconomicsSeptember Semester 2011 Prof. Dr. Mohd Ghazali MohayidinStudent Name: Anas Alam Faizli Student ID No.: CGS00621129Centre of Graduate Studies DBA Intake: September 2011

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___________________________________________________________________________

Read the following case and answer the questions given at the end of the case.THE GLOBAL FOODS SDN BHD (GFSB)___________________________________________________________________________

The Situation

The last of the color slides was barely off the screen when Bakar, the CEO of Global Foods Sdn Bhd, turned to his board of directors to raise the question that he had been waiting all week to ask. “Well, ladies and gentlemen, are you with me in this new venture? Is it a ‘go’? Shall we get into the soft drink business?”

“It’s not that easy, Bakar. We need some time to think it over. You’re asking us to endorse a very major decision, one that will have a long-term impact on the direction of the company.” “I appreciate your wish to deliberate further, Dr. Salleh,” Bakar responded, “but I would like to reach a decision today. As the president of a major university, you have been especially valuable in advising this company in matters relating to social and governmental policies. But we must diversify our business very soon in order to maintain the steady growth in profits that we have achieved in recent years. As my presentation showed, the manufacturing and marketing of our own brand of soft drink is one of the best ways to do this. It represents a significant diversification, yet it is very closely related to our core business: food.

“The economics of the soft drink market tell us that we would be foolish to pass up the kindof investment return that the market offers to those newcomers willing to take the risk. The food business is generally a mature one. On the other hand, our forecast indicates that there is still a lot of room for growth in the soft drink market. To be sure, there is a tremendous amount of competition from the ‘red team’ and the ‘blue team.’ But we already have expertise in the food business, and it should carry over into the beverage market.”

“That’s just it, Bakar,” interjected another board member, “Are we prepared to take this risk?You yourself acknowledged that the market power wielded by the two dominant companiesin this business is not to be taken lightly. Others have tried to take market share from themand have failed miserably. Moreover, the projections that you have shown for a growing softdrink market are based on the assumption that the growth rate will remain the same as it hasbeen in the past ten years or so. As we all know, the soft drink market has been growing, butis has also been very fickle. Only recently, Malaysians were on the health kick, and fruitjuices and bottled water along with health foods were in fashion. Now it seems that softdrinks are back in style again. Who knows what people will want in the future? Maybe we’llall go back to drinking five cups of coffee a day. And, what about all the money that we’regoing to have to spend up front to differentiate our product? As you well know, in theprocessed-food business, establishing brand recognition - not to mention brand loyalty – canbe extremely difficult and costly.”

“Well, ladies and gentlemen, all our concerns are certainly legitimate ones, and believe me; Ihave given much thought to these draw-backs. This is one of the biggest decisions that I willhave made since becoming CEO. My staff has spent hundreds of hours analyzing allavailable data to arrive at a judgment. Our findings indicate a strong probability of earning anabove-average return on an investment in the soft drink business, a return commensurate with


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the kind of risk we know exists in that market. But if we could make all our decisions with 100 percent certainty simply by feeding numbers into a computer, we’d all be out of a job. To be sure, details on production, cost, pricing, distribution, advertising, financing, andorganizational structure remain to be ironed out. However, if we wait until all these detailsare worked out, we may be missing a window of opportunity that might not appear again inthis market for a long time. I say that we should go ahead with this project soon as possible.And unanimity among the board members will give me greater confidence in this endeavor”.

The QuestionsFor all the questions below,a. Deliberate on the situation;b. Ask yourself the key question;c. Identify related theories and concepts;d. Determine data, facts, and information needed; ande. Answer the key questions.


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1. INTRODUCTION:

a. The Firm and Its Goals. What should be the goals of GFSB?

b. The Value of the Firm

How GFSB can improve the value of the company, especially when analysts are judging

a company primarily on its ability to grow its revenue and profit?

This report is written succinctly to elaborate Global Foods Sdn Bhd (GFSB) decision making

process, methodologies and strategies executed prior to investment into a new market of

carbonated soft drink. It will address the goal and value of the firm, demand analysis,

production and cost of production, the market structure, the pricing strategy and the reasoning

behind the decision made after considering all these factors. The Encyclopaedia of Global

Industries (EGI) (2007) stated that the term soft drink was coined to distinguish flavoured

drinks from hard liquor. However, for this report, the product will only be considering on

carbonated soft drinks only and not the entire range of soft drink beverages. This report is an

important instrument as it forms the basis and the decision support for GFSB to enter the

carbonated soft drink market with its new honey cola taste carbonated soft drink. The 1

Malaysia cola drink proposal has been taken out from this as it carries its own economic

merit and can be evaluated as a separate project.

GFSB primary goals and objective is shareholder wealth-maximization which can be

achieved through profit earning. Shareholder wealth is the measure of the value of a firm,

which is measured by the present value of all future cash returns expected to be generated by

the firm for the benefit of its owners (McGuigan et al., 2011). Hence, it is imperative and is

most beneficial to GFSB to ensure shareholder wealth is maximized and eventually results in

maximizing the value of the firm. This will emulate Berkshire experience where its book

value has growth from $19.46 to $91,845.00 per share in 41 years period. This is achieved

by among many others, maximizing shareholder’s wealth where Berkshire’s managers and

directors own over 47% of the firm’s stock.

Shareholder wealth maximization implies that a firm needs to be forward looking, dynamic

with a long term outlook, anticipate and manage changes, and also acquire strategic

investment opportunities (McGuigan et al., 2011). This will contribute and continue growing

GFSB’s business and support the diversification initiatives. The new venture into the soft


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drink market business and the economics that it offers is substantial and will be a strategic

investment opportunity. The return of investment is higher than the cost of capital which will

definitely support the decision. Thus, such decision will directly support the overall firm

objective in maximizing shareholder wealth and the end result will without no doubt increase

the value of the firm. It also promotes long term growth and firm survival, having taken into

account the interest of the shareholders. This will also ensure shareholders loyalty to the

firm.

The value of the firm is measured by the present value of expected future profits or cash

flows. It takes into account discounted rate at the shareholder’s required rate of return before

tax. Let us take a look at The Coca-Cola Company (TCCC) which is the world’s number one

leading soft drink brand. TCCC owns four of the top five soft-drink brands (Coca-Cola, Diet

Coke, Fanta, and Sprite). Its other brands include Minute Maid, Powerade, and Dasani water.

In North America it sells Groupe Danone's Evian; it also sells brands from rival Dr Pepper

Snapple Group (Crush, Dr Pepper, and Schweppes) outside Australia, Europe, and North

America. (The Coca-Cola, 2011)

Key numbers for fiscal year ending December, 2010 for TCCC:

Sales: $35,119.0M

One year growth: 13.3%

Net income: $11,809.0M

Income growth: 73.1%

These numbers are a good Key Performance Indicators to show TCCC values of the firm.

The formula use to calculate the form is shown below:

V = 8

1

)1/( te

t

kt

where,

V = present value of future profits

= expected future profits or cash flow

ek = discount rate or required rate of return

t = time (number of years)


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Based on this formula it can be seen that if firm reduce the perceived risk of a firm, which

will result in a reduced in the required rate of return, ek this will increase the value of the

firm. In conclusion, there are two ways which will eventually increase the value of the firm,

one is to grow its revenue and profit as economic analysts like to point out, secondly is by

reducing the risk of a firm and the required rate of return. This investment decision can

support to achieve this objective. Investments can always be sorted in the list of highest risk

and the highest return. These two factors can be considered prior to making any investment

decision.

How GFSB will make decisions to invest in a new market? Boundaries and limitation to the

decision will be problems related to the three (3) key focus areas namely to incomplete

markets, asymmetric information, and unknown re-contracting costs. These complications

will be addressed in this report and will be among the many decision support instrument to

allow GFSB make an informed decision for this new venture and allow the maximization of

the present value to equity owners through the new strategic investment opportunity.

Figure 1.1 - The Decision Making Process (McGuigan et. al., 2011)


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GFSB adheres to ensuring that decision making in the firm are made through a structured six

step decision making managerial economics process as illustrated in Figure 1.1. Each

decision seeks to support the firm’s primary objective. All managerial decision will be made

after carefully going through alternatives and opportunity costs and will select the best

decision that support the objective in the most efficient manner and taking into account all

risks and constraints.

This investment decision will also help establish GFSB brand name in the soft drink

industry and assist to continue growing the firm value. As a result of this expansion, capital

investment will be made, new manufacturing plant would be opened, more employees would

need to be employed and the opportunity will be made available to further grow the firm

value. This can be considered as a catalyst for improving the firm value by expansion and

diversification to soft drink industry which would lead to new business opportunities and

potentials.


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2. DEMAND ANALYSIS:

a. State the relevant managerial objectives.

b. How do you use demand analysis to serve the managerial objectives?

Demand analysis plays important role in delivering three key relevant managerial objectives

as follows:

i) Provides insight and information necessary for GFSB to manipulate, control and

benefits from demand.

ii) Helps GFSB forecast and guess estimate an accurate potential sales and revenue.

iii) Projects revenue stream portion of a firm’s cash flow stream for financial planning.

Prior to committing to a new strategic investment opportunity these three managerial

objectives and functions are required to effectively conclude the economics of any market,

new or old. The same goes to the soft drink industry. Prior to commitment to the business, a

demand analysis is required which will provide the required information for supporting the

decision. It is pivotal that the management of GFSB is made aware of the potential

forecasted unit sales the new business will be able to generate and hence the revenue which

will be critical for financial planning both capital and operational expenditures of the new

business.

Demand analysis also confirms the price elasticity of demand, which is required to accurately

measure a range of responsiveness of any change in the quantity demanded. Simply said,

price elasticity of demand gives the percentage change in quantity demanded when there is a

percentage change in price and vice versa. This remains true where all other determinants

constant of demand remain unchanged.

Figure 2.1 Law of Demand showing price in relation to Quantity demanded in Litre


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The law of demand is governing to all products without exceptions and carbonated soft drinks

also are unable to shy away from this law. The higher the price, the lower the quantity of

demanded for the soft drink would be and vice versa, as reflected in Figure 2.1.

The carbonated soft drink market has grown tremendously over the past 100 years. The EGI

(2007) stated that the global soft drink industry is exclusively a marketing phenomenon. The

product is only a simple blend of water, sweeteners, flavors and other additives, yet however

the EGI (2007) complimented that the industry’s genius lies in getting billions of consumers

to drink soft drink instead of plain water or other beverages. Furthermore, from 1960 to 1990

the growth of soft drink outpaced the population growth for the period and per capita

consumption of soft drinks increased 2.5 times (Muris et al., 1993).

According to Euromonitor (Euromonitor International, 2011), F&N Coca-Cola hold the

biggest soft drinks share in Malaysia at 72% of the total market. This is contributed directly

by the Coca-Cola brand. There is strong determination from consumer to live better and

choose healthier drinks which is expected to give halt to the growing consumer base for soft

drinks. However, it is projected that the growth for soft drinks will continue to soar

contributed by two factors, the increasing number of working Malaysians which is expected

to reach thirteen millions by the year 2013 and the global economic downturn which leads to

professionals going for fast foods and soft drinks (Just the facts, 2011). Being a product of

modest price, the cost of soft drinks will remain non criterion for consumer to continue

consuming the product. Furthermore, in Malaysia, it is reported that 1000 cans of soft drink

is being drink every minute (Bernama, 2007).

GFSB adheres to the demand estimating using marketing research techniques, i.e consumer

surveys, consumer focus groups and market experiments. Surveys have been done to

understand consumer’s needs better and assist in gauging demand on soft drinks. A

consumer focus group and market experiments with the intention to experiment and test

market demand condition has also been executed. Soft drinks with GFSB logo that imitates

Coca-Cola red and white colour has been tested at various stores and indicates positive

results.


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Consumer surveys and statistics from statistic department has been collected. These data will

then be analyzed through marketing analysis technique, to name a few, i.e deterministic time

series analysis, barometric technique, econometrics models, forecasting output with input,

and polling techniques.

Table 2.1 Soft Drinks quantity demanded in litres for 2000-2010 and its growth, Adapted

from United Nations Report on Soft Drink for Malaysia

Table 2.2 Soft Drinks forecasted quantity demanded in litres using two techniques

Table 2.1 and 2.2 shows where statistical data can be used for forecasting. Table 2.2 shows

where the first forecast using technique a, called time series model is used to quantify the

quantity demanded for the next five years.


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The formula used is as follows:

Xt+1 = Xt + (Xt – Xt-1)

Technique b however used the average growth of the data for 10 years which is 6.44% and

assumes the same for the next five years.

Demand analysis can be used to serve the three key managerial objectives as mentioned

earlier. These will assists in sales forecasting, making financial decisions, setting the price,

making marketing decision and deciding the quantity of the production.

The soft drinks market consists of retail sale of bottled water, carbonates, functional drinks,

juices, RTD tea and coffee, and smoothies. The Malaysian soft drinks market generated total

revenues of $1.3 billion in 2010, representing a compound annual growth rate of 4.5% for

the period spanning 2006-2010. Carbonates sales proved the most lucrative for the Malaysian

soft drinks market in 2010, generating total revenues of $407.5 million, equivalent to 30.9%

of the total soft drink market's overall value. (Soft Drinks, 2011). These figures presented

shows promising space and room for more players and firms to engage and enter the

carbonated soft drinks market.

The market demand function for a product can be expressed as:

Product X = Qx = f (Price of X, Prices of Raw Materials, Price Changes Expectation,

Consumer Incomes, Population, Taste and Preferences, Advertising Expenses, etc)

The demand function illustrated above shows variables which are commonly used to run

regression to see the inter-relations between each variable. In the case of carbonated soft

drink industry the demand function can be as below:


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Q = x1P + x2RM + x3CI + x4Pop + x5TP + x6AE

The equation above is a linear function that will try to evaluate the inter-relationship between

each variable, where a change in one variable will affect the outcome of the quantity

demanded to the soft drink.

The variables representation is shown below:

x1 = Price

x2 = Price of Raw Materials

x3 = Consumer Average Income

x4 = Population

x5 = Taste and Preference

x6 = Advertising Expenses

A 10 years historical data from the customer survey and statistics will be used to run the

regression analysis; as a result the previously unknown inter-relationship has been identified

as follow:

Q = -1000P + 100RM + 500CI + 50,000Pop + 20TP + 500A

The equation can be read as the quantity demanded for soft drink (litres) will fall by 1000 for

each RM 1 increase; rises by 100 with each change in raw materials (RM), increase by 500

for each RM 1 increase in average income (CI), and the quantity demanded increase by

50,000 with each additional 1 million persons in the population (Pop), and it increase by 20

upon enhancement of taste and preferences (TP) and increase by 500 with each RM 1 million

spent on advertising (A).


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3. PRODUCTION AND COST OF PRODUCTION:

a. Managers are required to make resource allocation decisions. Identify the relevant

production theory for the above case.

b. Discuss the analysis that you would carry out to assist in the decision making.

Production and cost production remains one of the most important steps, in making a

managerial economic decision for a strategic investment opportunity. This is more important

if the decision revolves in entering a new market. A good historical data and market survey

is thus required to ensure that production can be done in the most efficient or the least cost

manner. There are many tools which will be deliberated further where these tools will assist

in recognizing how to produce at the most least cost. A production function will relate the

highest output which can be produced from a given input, namely the variables. These

outputs can assist in measuring the average and marginal product of each input. Some inputs

are fixed while some follows the Law of Diminishing Marginal Returns.

Another important factor to cost in is the time frame. A production function give different

results and is required to be calculated differently depending on the time frame which can

either be a short-run or a long-run production function.

Figure 3.1 – Data and Graph for Production Function


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The input to a production function will be cost and labour. Output can be increase by either

increasing cost or labour or both. If both inputs can be changed to increase the production

that means the production function is in the long-run period. However, if one input is keep at

constant and while the other input is changed to increase production that means that the

production function is in the short-run period.

Figure 3.1 reflects in theory the most standard linkage showing total product (TP), marginal

product (MP) and an average product (AP) and also proven the law of diminishing marginal

returns. It is like a bell curve, it may vary from a production function graph to another, but in

essence it will always follow the same essential rules. The relationship in the graph is

summarised as follows (Mohayidin, 2011):

If MP is positive then TP is increasing.

If MP is negative then TP is decreasing.

If MP > AP then AP is rising.

If MP < AP then AP is falling.

MP=AP when AP is maximised.

L1, L2 and L3 are identified as three stages of production. Stage 1 indicates AP rising from

zero to maximum AP and this also equates elasticity as one. Stage 2 is when the AP is

declining while the MP remains positive. It starts from where AP is in its maximum until MP

is zero. Elasticity in this stage is between zero and one. Stage 3 is where the MP will

become negative and the TP starts to decline and the elasticity becomes less than zero. This

concludes that for a production cost in short run, it should only best to be operating in Stage

2. There are then other production functions in the long run, and with more than one variable

input and etc.

However, the most common used form of function used in empirical studies to affectively

understand GFSB resource allocation strategy and identify the labour and capital required

would be the two-input model used by Cobb and Douglas as per the following formula:

Q = αLbKc

Where,

Q = total production (can be presented as the monetary value of goods produced, RM)

L = labour input


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K = capital input

a = total factor productivity

b and c = output elasticities of labour and capital respectively.

Output elasticity will measure the effect for an output to a change of either labour or capital

used in production, ceteris paribus. For example, if b = 0.8, a 1% increase in labour would

lead to a 0.8% increase in output.

To get value of b and c, see following equation:

Q = αLbKc

Log Q = Log ( α LbKc)

Log Q = Log α + Log Lb + Log Kc

Log Q= Log α + b Log L + c Log K

A regression run will derives the value of b and c.

In supporting GFSB firm’s objective and part of the shareholder wealth maximizing efforts,

an efficient pricing and output strategy is important as it will in return maximize the present

value of the future profit stream to the firm. There are many factors which will determine the

best strategy to maximizing wealth. It depends on the production capacity, cost levels,

demand characteristics and the potential for long term competition and anything immediate.

The most important step prior to being able to do this is first to understand the market

structure. This is the most important information to support all the other managerial decision

related to economics.


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4. MARKET STRUCTURE:

a. Determine the market structure this particular firm is in.

b. Support your answers.

c. How would you determine the optimal quantity and price under this market

structure?

Porter noted in his book in 1980 titled Competitive Strategy and followed by another, called

Competitive Advantage in 1985 offered Porter’s model of competitive analysis which

concluded that a business strategy in pricing or output should be based on the market

structure in which firms operate. Understanding the market structure supports in identifying

target markets, in this case the soft drink industry. The strategic investment opportunity can

only be successfully implemented if a proper market understanding is gained and recognizing

the changes it will make to the firm’s resources, capabilities and core competencies, which in

this case is the foods industry.

Pure Competition

Pure Monopoly Monopolistic Competition

Oligopoly

Number of firmVery large number of firms

One firm Many firms Few firms

Product typeStandardised products

Unique product Differentiated products

Standardised or differentiated products

Price controlNo control over price

Much control over price

Some control over price in a narrow range

Control over price circumscribed by mutual interdependence

Entry obstaclesNo obstacles to entry

Entry is blocked Relatively easy entry

Many obstacles to entry

Price competition

No non-price competition

Public relations advertising

Much non-price competition

Much non-price competition

Table 4.1 Market Structure Types and Comparison between Pure Competition, Pure

Monopoly, Monopolistic Competition and Oligopoly

Table 4.1 exhibits the attributes and characteristics between the four market structures

category namely pure competition, pure monopoly, monopolistic competition and oligopoly.

Going through the four characteristic of soft drink market will inevitably identify the market


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structure of the soft drink industry. The soft drink market share in Malaysia is in short

divided between few major firms, F&N, Coca-Cola Company and PepsiCo, Inc. with the

latter having a smaller share of the market (Datamonitor, 2011). Globally, the soft drink

industry is dominated by give big companies, Coca-Cola, Cott, Cadbury, National Beverage

and Pepsi which in total accounted for 95% of soft drink sales worldwide (John and Carl,

2010).

Soft drink industry market structure is a monopolistic competition. Comparison and further

deliberations will be made further to prove this point to show why a soft drink market is not

an oligopoly. An oligopoly is the domination of the market by a few firms. Some might

argue that a soft drink market structure is a duopoly where only two firms dominate a market

which is not the case for the soft drink industry as there are more than two players but not as

many dominant more than the big five. Furthermore, there is no standardised product in a

soft drink market, hence a monopolistic competition.

Where an oligopoly exists, a few large suppliers will be dominating the market and industry

leading to a high degree of market concentration. This means the market share is taken by a

few leading firms as in the case of the soft drink industry. An oligopoly market offers high

barriers to entry. It will be difficult to make an entrance into the market. Consumer loyalty

and brand recognition has already been embedded in the market and will make it difficult for

new players to enter the business, and which is not the case for the soft drink industry as

shown in Table 4.2 where 36% consumers surveyed opt to try on new beverage.

Table 4.2 Surveys of Reasons for Trying New Beverage, Oct 2011


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This often leads to a lack of price competition as the big players in the industry would be very

sensitive to play with the price. Any changes in price can lead to an informal collusion as

firms try to match their price and can lead to a price war. As an oligopoly market structure

involves few firms, any action by another firm will be noticed by the other competitor and the

competition will be more towards advertisement and marketing rather than through price. If

a firm cut the price, the other firms has to follow, this is an unhealthy practice in the business.

However, if a firm increase the price, other firms might not follow which can leads to losing

the market share and profits as per the law of demand and supply.

The soft drink carbonated industry is unquestionably the best example of monopolistic

competition structure. It is either a Coke or a Pepsi and perhaps a Sprite or 7-Up. It is a

much branded industry where every brand is recognized by the consumer. Any moves by any

of these firms are also likely to evoke a countermove by its rivalling competitors. The

famous Cola Wars is a classic example of this rivalling competition where each firm try to

outdo each other via advertisement and marketing (“Cola Wars,” 2011).

In conclusion the soft drink industry is in a monopolistic competition market structure due to

the reason that there are many firms, relatively easy entry, differentiated product, there is

some control over price in a narrow range and much non price competition.

Table 4.3 to 4.5 is a comparison of price summary statistics which is carried across the board

for various carbonated soft drink products.

Uri (1986) has undertaken a study to calculate beverage price elasticity where the result

shows all own-price elasticity were negative and significant at 1% level and demand for

whole milk -0.69, juice -0.52, soft drinks -0.80, coffee and tea -0.89 was inelastic.


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Table 4.3 Price Summary Statistics for Carbonated Soft Drinks, 1 RM for each 2 litres

Table 4.4 Own Price Elasticity Results and Share Equation Summary Statistics for

Carbonated Soft Drink New Product Introductions, 1 RM for each 2 litres

Table 4.5 Own Price Elasticity Results and Share Equation Summary Statistics for

Carbonated Soft Drink Sector Leaders, 1 RM for each 2 litres


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It is important that an optimal pricing strategy is adopted for the new product in dynamic

monopolistic competition market. The two major factors which will influence GFSB’s new

product pricing would be diffusion effects on the demand side and the cost experience

effects. The demand side and diffusion effects refer to increase or cause the likelihood to buy

to increase. This includes words of mouth, improved reputation of the products via

advertisement and other factors. As more units of the new products are sold, the remaining

untapped market potential decreases. On the cost experience effects, it implies on the

learning curve effects. The unit production costs will decrease as cumulative output

increases, ie experience. Optimal price determination as discussed previously is in reality

more difficult, complex and complicated from the one presented in the literatures. The two

most important characteristics of real world markets are dynamics and competition. These

two characteristics have continuously shaped the pricing strategy required for new products

which however has always been neglected or treated inadequately in the pricing strategy.

Kalish (1983) pointed out that the main direction for future research in the area of dynamic

pricing is the incorporation of competition and competitive interdependencies. Thus, in order

to derive pricing for a new product, a marketing survey, a customer preference regressions

engulfed with the demand side and cost experience effects can determine the most optimal

pricing of the product.

An optimal pricing technique can be made by following several steps where GFSB would be

required to develop the market strategy, marketing decisions, estimate the demand curve,

calculate the cost for the product, understand the competitor, the pricing requirement and

objectives (revenue and profits) and finally with all the steps would be able to finalize the

best price for this new product.

Pricing methods that can be used includes cost-plus pricing, target return pricing, value-based

pricing and psychological pricing. Cost plus is where the production cost plus an agreed

profit margin would be the set price. Target return price is where the price would be the price

which allows return on investment. Value based pricing would where the price is based to

customer relative to other brands. Psychological pricing is based from consumer perspectives

where the consumer feels that the set price is fair.


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5. PRICING STRATEGY:

a. In reality, price determination is more complicated than the one discussed in

Question 4. Why?

b. Would you consider a more complex pricing technique for your product?

The demand curve in an oligopoly market structure will look like a peculiar demand curve

often called kinked demand curve. The curve is a downward sloping demand curve and the

price elasticity might depend on the reaction of rivals to changes in price and output. This

also suggests that demand curve is not straight. An increase or reduction in price will be very

sensitive and will take into consideration what other competitors might react. A price cut will

only if the potential that other firms will not follow. A price increase will however be done if

there are the potentials that other firms will follow to ensure prospects of losing market share

does not occur. In conclusion, an oligopoly market structure has little incentive to change

price.

Oligopoly market structure however has a different approach when it comes to pricing and

output determination as it needs to compare with its competitors. It is not as straight forward

as a monopoly market where the monopolist will need not to worry about pricing strategy by

its competitor as it has no rivals. The same goes in a pure competition market where pricing

by a firm is independent decision and does not affect other firm as there is no single firm that

is influential enough to bring effect to the market price. In order to maximize shareholder

wealth, it is important that in an oligopoly market structure, all rival responses remain an

important factor in decision making and especially in the pricing and output strategy.

The demand curve for a monopolistic competition will however looks differently. It slopes

downward due to product differentiation. The demand curve slopes downward from the left

to the right. In the short run, the demand curve for firms in the monopolistic competition

might vary. The profits can be categorized as super profits, normal profits or subnormal

profits as illustrated in Figure 5.1 to 5.3.


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Figure 5.1 – Monopolistic Competition Firm’s Super Normal Profit

Figure 5.2 – Monopolistic Competition Firm’s Normal Profit

Figure 5.3 – Monopolistic Competition Firm’s Sub-Normal Profit

In the long run however, a firm in the monopolistic competition would only earn normal

profit. This is due to normalization. Whenever a firm in a monopolistic competition indulges

A,B,R,F,C = Intersection PointsMC = Marginal CostMR = Marginal ReturnATC = Average Total CostAR = Average RevenueQe – Optimum Qty at the PointPe – Price at Point


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in super profit scenario, this will indefinitely attracts a number of new firms to make entrance

to market. This would normalize the super profit firms to normal profits. In the event of sub

normal profit, some firm would leave the industry and again normalizing the other firms to

normal profits. Notice that the change from Figure 5.1 to 5.3 is only on the ATC which is

shift either upward or below which result in different intersection of the ATC with MR at Qe.

In a monopolistic competition market, the price determination can be more complicated as

there are many numbers of firms and due to the condition of easy entry and exit attribute.

Product differentiation also plays a major role which contributes to a difficult price

determination. Further factors which lead to difficulties in price determination are as follows:

1. Excess capacity.

2. Average cost equal to price (long run).

3. Product advertising (lead to non price competition).

As a result of all this factors, it is difficult to identify Marginal Return (MR) and Marginal

Cost (MC), and also the price point where MR = MC. Furthermore, the profit will be only

maximized at short-run profits.

Thus, a more complex pricing technique is required to further enhance the profits. Suggested

techniques include product bundling and the loyalty program. Price can means differently

under different context, it can be rent, tuition, fee, fare, interest, assessment, retainer fees,

salary, wages, and income taxes (Schwartz, 1981). It is also defined as the quantity or

amount of thing exchanged in sale or barter for another at the cost at which the object is

obtained. The pricing strategy is dependent on the very nature of the product, and in this case

a new product introduction of a different taste. A honey taste carbonated cola drink.

In the case of honey soft drink, market skimming and market penetration can be the pricing

strategy that should be employed for this product as it is innovative and new. This product

will need to be positioned in the marketplace in order to acquire profit. Kotler and

Armstrong (1991) noted that this kind of product can employ some of these options: product-

line pricing, optional-product pricing, captive-product pricing, by-product pricing and

product-bundle pricing. In economics, pricing strategy is objectively understood as a method

on how to set price under certain assumptions to maximize profits.


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Product bundling is a business strategy that packages physical product together, prices and

sells it as a single entity. This strategy is an effective instrument for price discrimination

which also presents opportunities to enhance revenue without increasing the input or raw

materials required to produce the end product. This is already a common practice across both

service and manufacturing industries. Bundling satisfy customers who many not be

interested in buying the individual product but might be keen to buy the either one of the

product in the bundle. GFSB can use this product-bundle pricing strategy to bundle its food

range of products with the new introduced honey drink.

Another strategy that can be adopted is loyalty or reward program. Soft drink industry is a

market with repeated purchases, it is common for a firm to offer different or special discount

to its repeat customers. This will also help entice customers to switch from their existing

brand and become GFSB customers.


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6. CONCLUSION:

Should Global Foods (GF) enter the soft drink business?

Figure 6.1 GFSB Revenues and Forecast, 2001-2010

Figure 6.1 exhibits the potential revenue generation by diversification into the soft drink

market. Data is presented based on the projected sales of the new product at a growth rate of

8% per year. The decision to expand into the soft drink market via honey cola which is

illustrated in Figure 6.2 will also enable future potentials and tap into potential new markets.

This would also assist in introducing other new products in the future, ie 1 Malaysia Cola.

GFSB revenue is forecasted to grow from the current RM 85 Million (2010) to RM 204

Million for year 2020.

Figure 6.2 Proposed Honey Cola Can Packaging

Cure for all ilnesses


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The capital requirement for soft drink industry necessitates a USD 50 Million initial outlays

(McGuigan, 2011). This would be enough for the plant, bottling, manufacturing and

operations, transportation and distribution. GFSB budget for expansion as approved by board

is at USD 200 Million.

Table 6.1 New Carbonated Soft Drinks Products by Flavor, 2005-2010

Table 6.2 New Carbonated Drinks Products by Company

Carbonated soft drink industry is distinguished by product differentiation at attribute and

ingredient level. Anderson (2008) has noted that the pivotal key for beverage companies for

their product is differentiation. This is the most important factor of success for soft drink

products. Product differentiation can be driven by brand, flavour, calorie content, taste and

others. Ulrich and Eppinger (2000) noted that it is critical to understand customer

preferences, short product life cycles and fast technology changes for a successful

introduction of a new product. Furthermore, if multiple firms are producing similar products

pricing decision would become more complicated in such a dynamic environment.

Lazim & Hasliza (2011) concluded that in Malaysia there are four major factors in

consumer’s preferences over the selection of their soft drinks: branding, validation and prices,

packaging and taste, respectively while branding is proven to be the dominant factor in


26

customer preferences. Understanding these factors would be pivotal key decision factors to

make entrance to the soft drink market. As mentioned earlier, soft drink growth will continue

as working Malaysians reach thirteen millions by the year 2013 and the global economic

downturn which leads professionals going for fast foods and soft drinks (Just the facts, 2011).

The cost of soft drinks will remain non criterion for consumer to continue consuming the

product. The Malaysian soft drinks growth rate is 4.5% for the past five years where

carbonated sales are 30.9% of the total soft drink market's overall value. (Soft Drinks, 2011).

These figures presented shows promising space and room for more players and firms to

engage and enter the carbonated soft drinks market.

GFSB acknowledge that a product should be different and thus after concluded the consumer

survey and would introduce a honey taste carbonated soft drink which will have cola and also

caffeine in the ingredient. The new honey carbonated soft drink proposed to be introduced to

the new market by GFSB is unique, appealing and is very different. Plus, it has the health

catchphrase which can be used as ‘honey is the cure for all illnesses’. This goes very well

with the latest public health trending. Table 6.1 and 6.2 illustrated that such taste (honey) has

never been introduced and it also show how the big player in the industry is trying so hard to

introduce new product every year to capture the ever growing market, where others have

failed, GFSB will succeed.

It is identified that the main feature of the soft drink industry is that the product is either

bottled or in can and GFSB will package the honey drink in the same method. While

economics of scale remain an issue, GFSB will leverage on its existing manufacturing

capacity for its food production and will be able to optimize and produce within this

constraint for large scale production and reduce the average cost for each amount of litre

produced.

Access to raw materials would not be an issue to GFSB as it already has existing price

agreement contract with supplier of sugar, caffeine, cola, aluminium cans, bottles and

plastics.


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Table 6.3 Profit Margin of Coca-Cola, PepsiCo and Nestle, 2006-2010

As part of GFSB promise to the shareholder wealth in achieving a minimum of 5% profit

margin for new investments, Table 6.3 exhibits that soft drink industry is returning a

minimum profit margin of 10% and above illustrated by the three giants in the soft drink

industry.

As a conclusion, it is suggested that GFSB enters the carbonated soft drink industry as part of

its diversification plan. It is an opportunity lost if GFSB do not venture into the soft drink

business as the return of investment offered is higher than the capital cost. The product

produces by GFSB would be very different, in fact, even to a global scale. It would be

something even new to the whole world; a honey taste carbonated cola soft drink.

The proposed 1 Malaysia Cola proposal will be presented in another report after concluding

with the studies and report expected to be out in six months time. Negotiations and

discussion with the government has been initiated and a subsidy formula from the

government is expected.


28

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