The reason for this essay is to use game theory and barriers to entry to analyse strategic business decisions in the US ready-to-eat breakfast cereal industry.
An industry analysis was done using different published journals. An overview of the oligopoly industry was also done for a broader understanding of the ready-to-eat breakfast cereals industry.
Bertrand competition was used as the oligopoly model adopted by the industry. Game theory was used to analyse the strategy companies on the market will adopt and a discussion on barriers to entry as it applies to the industry was done.
This essay will discuss the united states ready-to-eat breakfast cereals industry.
An overview of oligopoly, discussions on Game theory, Nash equilibrium, Bertrand Price Competition and Barriers to Entry will be used to analyse the industry and the strategic business decisions as they relate to the industry
Analysis of the Ready-to-eat Breakfast Cereals Industry
Connor (1999) described the ready-to-eat breakfast cereal industry as a capital intensive industry requiring huge capital investments in production plants. To a large extent, it has contributed to Barriers to Entry on the market. This industry market structure though having a number of quantity of suppliers, is dominated by four major companies which can be Kellogg Company, General Mills, Quaker Oats and Kraft. According to Nevo (2000) these companies have constantly continued to create high profits in comparison to the other food industries.
A key characteristic feature of this industry is product differentiation.
Brand specific knowhow is apparently present since established firms are sometimes struggling to duplicate each other's brand. The existence of the however, will not prevent them from producing, promoting and distributing successful new brands. "Existing brands differ in such potentially relevant dimensions as sweetness, protein content, shape, grain base, vitamin content, fibre content and crunchiness" (Schmalnesee, 1978)
Connor (1999) has argued that competition in this industry will not involve the use of price war and therefore not a competitive strategy. Different researches conducted on the industry show that there is a level of collusion amidst the top businesses though not openly done. This assumption was made popular by the case of anticompetitive complaint by the U. S. Federal Trade Commission against the most notable three manufacturers Kellogg, general Mills & Post in the 1970s (Aviv Nevo, 2000) Because of the lack of price wars in the industry, the utilization of other non-price ways of gain competitive advantage are employed by companies in this industry. The consistency of zero price wars over the years, however was broken when in the late nineties, a price reduction by Kraft led the other big three Kellogg Company, General Mills and Quaker oats to respond by also reducing their prices as suggested by ( Nevo, 2000). This pricing strategy by Kraft significantly afflicted the overall industry price forcing its competitors to reduce their prices as well.
Innovation through the launch of new products and aggressive media advertising are strategies utilized by businesses in the ready-to-eat cereals industry to compete for market share. This is a major factor adding to the regular high profits in the industry. The result of Connor's (1999) research revealed that the rivalry in the breakfast cereals industry tends towards "the choreographed grunts of televised wrestling than a cutthroat dual to the death which the best weapon, steep price cuts, is rarely unsheathed".
According to Connor (1999), media advertising and new product introductions are intimately related. New product introductions are one of the main mechanisms for effecting rapid price increases in the breakfast cereals industry. His research revealed that the new cereals introduced by the top four companies between 1981 and 1987 in the first year of sales, were priced 12% above the company's existing brands' average prices.
Connor (1999) in his research further showed that "the extraordinary attachment of consumers to branded cereals (or at least to the boxes they come in) has made entry by private-label products extremely difficult". This high degree of brand loyalty on the market has significantly posed a threat to any firm considering entry into the industry. Invariably, the more a firm's brand is recognised, the bigger the sale of any newly introduced cereal will be.
The cereal industry has oligopolistic tendencies and characteristics and will be classified as one. A synopsis on oligopoly below highlights the characteristic nature of oligopoly.
Overview of Oligopoly
Lipsey + Chrystal (1999) defined oligopoly as the idea of imperfect competition on the list of few. The industry is characterised by way of a few organizations selling differentiated products. Because there are just few firms, each firm realises that its competitor may respond to any move it makes and takes that into consideration because each firm's decision influences the other companies in the industry.
Earl and Wakeley (2005) described firms in the Imperfect competition as having differentiated products which can be close substitutes. These differentiated products are supported heavily by advertising. Advertising will persuade consumers to patronise a particular brand over other brands of the other competitors. Advertising can be used as a crucial weapon to create brand loyalty in the industry as consumers are assumed to be highly mobile. The existence of strong brand loyalty makes entry difficult because individuals are likely to have strong preferences for the already existing brands.
This means that the behaviour of oligopolists are strategic with each firm taking explicit account of the impact of these decisions on competition and the expected reactions from them (Lipsey + Chrystal, 1999, page 176). Besanko et al (2004) also defined oligopoly as "market in which the actions of individual businesses materially affect the industry price level".
The strategic behaviour of oligopolists is attributed to the highly competitive nature of the industry. For these firms to make strategic decisions that can give them comparative advantage, they use oligopoly models and game theory (Besanko et al, 2004).
Game Theory and Bertrand Price Competition
Besanko et al (2004) defined Game theory as the branch of Economics that deals with the analysis of optimal decision making when all decision makers are presumed to be rational and each is wanting to anticipate the actions and reactions of its competition (Besanko et al, 2004, page 36)
Game theory is a strategic business decision making tool in areas such as pricing and capacity expansion.
Bertrand Price competition Model
Besanko et al (2004) has described Bertrand competition as a style of competition in which each firm selects a price to increase its profit given the price it anticipates its competitor will select. Each firm views its competitor's price as fixed and believes that its own pricing practices won't affect the pricing of the competitor. Within an oligopolistic industry with differentiated products, price competition is usually mild. When products are differentiated, a firm won't lose most of its business to opponents that embark on a price cut. This is majorly attributed to competition being based on a variety of product parameters such as its quality, availability and advertising.
The US ready-to-eat- breakfast cereal industry like all oligopolistic industries is highly competitive. The strategy of each firm will be to maximize profits and outputs given its rivals strategy.
To use game theory to analyse what choice is most beneficial for a company at any given point, two companies will be utilized; Kellogg Company and General Mills as they are one of the top four and are each other's competitors.
Game theory and Nash equilibrium will be used to analyse the best technique for profit maximization considering that each firm sets a price because of its cereals.
A Nash Equilibrium is the strategy combination where each player is doing its best given the strategies of its competitor.
An assumption is made that every firm sets a price that maximises its profit and that a price cut by either of these to achieve a more substantial market share will impact their profits given the strong influence of brand loyalty. The results of every firm's actions are described in the overall game matrix below;
In the overall game above, the strategy (Co-operate, Co-operate) is both a Nash equilibrium and a dominant strategy because each firm maximises profit at this time. It is a Nash equilibrium because with the pay-off of ($120, $120) no firm will unilaterally want to deviate realizing that it'll achieve a lesser pay-off by doing so. Furthermore, co-operate strategy is a dominant strategy because whatever the other firm chooses, to co-operate will usually yield an increased pay-off.
Barriers to Entry
According to Earl and Wakeley (2005), "barriers to entry exist when potential opponents find there are obstacles which hinder their proposed entry into an otherwise attractive industry. Typical barriers to entry include: incumbents owning all resources of essential recycleables; incumbents' patents; economies of scale providing incumbents with a cost advantage; and incumbents past expenditure on advertising (which gives them a higher profile in the minds of buyers relative to newcomers). Quite indicate note about barriers to entry is that they protect every one of the industry's incumbent firms from the threat posed by competition from beyond the industry"
As fierce as rivalries are so that highly competitive as the oligopolistic industry may be in nature, Lipsey + Chrystal (1999) stated that we now have determining factors that make a few large firms dominate in the industry. According to Lipsey + Chrystal (1999), a few of these factors are natural or structural, plus some are firm-created or strategic. These same factors are deterrents to businesses seeking entry into an oligopolistic industry.
The natural/structural barriers as it pertains to the cereal industry include economies of scale, cost of introduction of new brands and economies of scope, and marketing benefits of incumbency, while firm-created/strategic barriers include capacity expansion.
Economies of Scale
According to Besanko et al (2004) production process for a particular product exhibits economies of scale over a range of output when the common cost drops over that range. Economies of scale exist when the machine cost of production declines as the quantity of output increases. When production becomes standardised and highly specialised, the concept of division of labour must be applied. Lipsey + Chrystal (1999) described division of labour as occurring when the production of a product is split up into a huge selection of simple, repetitive tasks. They further explained that "the division of labour is, as Adam Smith observed way back when, dependent on how big is the market. If only a few units of products can be sold every day, there is no point in dividing its production into a number of specialised tasks". Lipsey + Chrystal (1999) further stated that larger organizations have advantage in industries which have potentials for economies based on the division of labour because the bigger the scale of production, the low their average costs of production. Economies of scale also lead to minimum efficient scale. According to Besanko et al (2004) and Earl and Wakeley (2005) minimum efficient scale is the tiniest level of output of which economies of scale can't be sustained further. Minimum efficient scale can only be achieved in the long run. Predicated on this, it'll be difficult for a firm considering entry to attain MES as a result of costly nature. The cereal industry is capital intensive which is dominated by a large few with the long years of existence. As a strategy to deter entry, the incumbent businesses may decide to increase the level of output to further lower their costs and achieve a higher rate of economies of scale. Because economies of scale can be found on the market, the incumbents average cost of production will be less than that of a new entrant who will have difficulties trying to achieve MES which can only be achievable in the long-run. Doing so will entail acquiring excess capacity and increasing production output that will both be costly and unprofitable as brand loyalty is extremely saturated in this industry.
Costs of Introducing A FRESH Product and Economies of Scope
The cereal industry is categorised by the introduction of new brands. It will be difficult for a company attempting entry to recuperate such costs in a brief time frame considering that it'll need to break even prior to making profits. Economies of scope are associated with lower cost scales derived from having multiple production lines within a plant. According to Besanko et al (2004) "The ready-to-eat breakfast cereal industry offers a good example. For many decades, the industry has been dominated with a few organizations including Kellogg, General Mills, General Foods and Quaker Oats, and there has been nearly no new entry since World War II. There are economies of scope in producing and marketing cereals". Besank0 et al (2004) further explained that for an entry to reach your goals in the ready-to-eat breakfast cereals industry, the newcomer should introduce 6 to 12 successful brands. This requires heavy capital and makes entry a risky proposition.
The introduction of new brands is associated with a high cost of advertising. An incumbent firm in the cereal industry can consistently employ the utilization of introduction of new cereals to deter further entry by new firms. You won't be as expensive for the incumbent firm to advertise its new cereal product as it will be for a fresh entrant as a result of high brand loyalty on the market and the economies of scope cost advantages.
C) Marketing advantages of incumbency
Umbrella branding has been referred to as a situation whereby a firm sells different products under the same brand name (Besanko et al, 2004). According to Besanko et al (2004), an incumbent firm can exploit the umbrella effect to offset uncertainty about the quality of a new product that is been introduced. The umbrella effect also may help the existing firm negotiate the vertical chain. Retailers are more likely to devote scarce warehousing and shelf spaces to the firm's services more than it could for a new entrant. Likewise, suppliers and distributors may be more willing to transact businesses with the incumbent firms more than the new entrant in the regions of credit sales and relationship-specific investments (Besanko et al, 2004). Incumbent organizations in the cereals industry can use umbrella branding as a technique to deter new entry or force new entrants out of the industry. Umbrella branding also has an impact on consumers. The likelihood of an newly introduced brands been widely accepted by consumers is higher for businesses enjoying umbrella branding than for new entrants. Umbrella branding has the ability to reduce uncertainties associated with the introduction of a new cereal brand. Furthermore, the development of close relationships by an incumbent firm using its vertical chain is another technique for barriers to entry.
The incumbent firm should embark on capacity expansion. A new entrant will see it difficult to complement up its plant size with the plant size of existing organizations and may incur losses at entry. Using the expansion of capacity and more sales, the incumbent will continue steadily to enjoy economies of scale thereby forcing new entrants who cannot achieve such low unit cost of production out of the industry as their average cost of production may regularly be greater than the market price of the cereal brands and the purchase price.
The ready-to-eat breakfast cereal industry is an oligopolistic industry requiring the companies to employ non-pricing ways of maximize profits and sustain competitive advantage.
Because the ready-to-eat breakfast cereal industry has natural barriers to entry, companies in this industry do not need to do much in the region of strategic barrier to entry to avoid of or force new entrants from the market. However, the regular introduction of new cereals is crucial to earning higher profits.
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