Managerial Economics

Managerial Economics

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C HAPTER 1

Introduction to Managerial Economics

S ECTION 1

Introduction to Managerial Economics

Video 1.1.1: Introduction to Economics by Prof Dennis Meyers

Economics is the study of how economic agents, individually and collectively, make choices regarding the use of scarce resources that can often be put to different uses, in order to satisfy wants which are of relatively higher priority from among the unlimited wants they face. It is the study of how entities try to make the best possible use of the limited resources they have. Economic analysis, like any other scientific analysis, can be either positive or normative. The analysis is positive when it describes how things are and how things will be. It is normative when the focus is on how things ought to be. Positive economics explains economic phenomena according to their causes and effects. It says nothing about what is right or wrong; it is not concerned with moral judgments. On the other hand, normative economics involves making

value judgments. There is a desired end which is deemed to be subjectively better than the alternatives and normative economics is about using the right means to reach that desired end. A positive statement is based on facts. A normative statement involves ethical values. Economics can be broadly divided into microeconomics and macroeconomics. Microeconomics is the study of how individual economic units, be it an individual agent or household or firm, tries to optimize when faced with resource scarcity. Microeconomics studies economic decision-making from the perspective of households and firms; it focuses on the conduct of individual consumption and production units within a particular market structure. The broad framework of microeconomics revolves around the allocation of resources,

Video 1.1.2: Micro Vs Macro Economics

production and distribution of goods and services and consumption. Broadly, microeconomics deals with the consumer behavior, theory of demand and supply, theory of firm, pricing and market structure, and theory of distribution. Microeconomics deals with consumption and production, and uses notions of surplus to explain a sense of economic wellbeing. Change in these measures are used to understand the overall implications of economic policies on the welfare of the people. Much of welfare economics is based on price theory as microeconomics also deals with how to minimize inefficiencies in allocation and production. When economic efficiency is improved, wastage of scarce resources is minimized, which has significant effects on improving economic welfare. Macroeconomics deals with the overall performance of the economic system; it focuses on issues such as unemployment, inflation, economic growth and other problems, which affect the economy as a whole. It deals with aggregates and the overall economic environment. The framework of macroeconomics broadly covers sustained economic growth, price stability, growth and development, balance of payment, etc.

Keynote 1.1.1: Differences Between Micro & Macro Economics

Managenomics

rial Eco-

Managerial economics is the application of economic theory and decision science tools and techniques to the problems of
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managerial decision-making. While microeconomics provides theoretical framework and tools that help optimally utilize the firms resources, macroeconomics plays an important role by providing an understanding of the economic environment in which managerial decision-making takes place. To that extent, one can say that managerial economics is the application of microeconomic theory by practicing managers in running their business and developing it. According to Dominic Salvatore, "Managerial Economics is the application of economic theory and the tools of analysis of decision science to examine how an organization can achieve its aim or objectives most efficiently. Spencer and Siegelman define Managerial Economics as "The integration of economic theory with business practice for t h e purpose of facilitating Keynote 1.1.2: Dimension of Managerial Economics decision making and forward planning b y

management" Managerial Economics is a discipline which integrates economic theory, decision science and fundamental areas of business administration. Managerial Economics thus serves as a bridge between economics and business management. Theories are important for any science. Theories provide a framework for explaining reality and making predictions. There are several economic theories. Consumption Theory and the Theory of the Firm are two of the most important components of microeconomic theory. A model is an abstraction or simplification of the real world, based on economic theory. A model with its assumptions is often analogous to the control experiments that are done in the basic sciences. These models may be explained in words, or with numerical tables, graphs or algebra. Models often make use of assumptions. Most microeconomic theories assume that economic agents are rational and other factors, not in consideration, remain unchanged (Ceterius paribus). Such assumptions often may not hold true. However, if the model retains its predictive capacity, the invalidity of assumptions are not a matter of concern. Even in basic sciences, by definition, control factors in laboratory experiments may not remain the same outside the laboratory environment, but this does not make the experiment irrelevant in any fashion. The science of economics renders a technical help to the manager in making optimal and rational economic decisions particularly in situation involving risk and uncertainty.
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Nature and the Scope

Managerial economics helps the consumers and managers of a firm in reaching various managerial decisions such as decisions on buying different combinations of goods and services, what products and services to be produced, producing a level of output by using different combinations of inputs and techniques of production, how much output to be produced and at what price output to be sold, etc. It also helps the managers in taking marketing decision, cost decisions, advertisement decisions, budgetary decisions and investment decisions. Managerial economics deals in detail with the below-mentioned managerial decision problems faced by consumers and firms. Thus managerial economics is the application of economic analysis in evaluating decisions having economic content and intent. Some of the business decisions which have economic content are as follows: Profit Decision: Profit maximization is assumed to be the most principal objective of any business firm. In reality, a firm may not aim for maximizing profit, but they do have a profit policy. The entrepreneur constantly examines the profit position of the company so as to take the corrective timely measures in an advance. Hence the decision concerning the level of profit and reinvestment of profit are relevant and in turn influences the business greatly. For instance, Managerial economics

explains rules for selecting the profit maximizing output for firms in all types of market structure - perfectly competitive market, monopoly, monopolistic competitive market, oligopoly market, etc. Demand Decisions Profits are functionally related to the volume of sales and the revenue earned thereby. Demand for the firms goods or services and revenues in turn depend on the nature of individual and market demand. Demand decision of the firm needs to take into account the nature and dynamics of demand for its goods or services and accordingly arrange the factor inputs to organize the production in efficient manner. As such, demand decisions which can be evaluated through an analysis of consumer behavior are crucial. Managerial economics helps an organization to understand how changes in price and income affect demand for their products and helps to take appropriate production decisions. Production Decisions Analysis of demand decisions is naturally followed by that of production decisions. Production function is a statement of technological relation between input and output. Any decision concerning output has, therefore, a natural bearing on the decisions concerning input. The business firm, whether it produces goods or services, has to decide about factor combinations and factor proportions. The choice of techniques of production, use of economies of scale and scope, and least cost combination constitutes the dimension of production decision. For an examination of such decisions,
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production analysis must be combined with loss analysis. Firms have to decide how much of each input to be used in producing its output given the resource constraint. Price-Output Decisions Profit decision depends on two attributes, i.e., cost of production and revenue received from the sale of the product. It can be further inferred from the cost of production attribute that at what price and in what quantity are the productive factors obtained from the factor market. From the second attribute we can infer the meaning that at what price and what quantity are the products sold in the commodity markets? Answers to such questions are possible through an analysis of the market structure, i.e., the form of competition which the business firm faces in the commodity and factor market. Investment decisions The investment decision is also part of the production and capital budgeting decision of the firm. If the firm is operating for the long haul, the firms capital needs to be arranged at the least cost so as to enjoy the financial economies of scale. The various types of economic decisions taken by a business enterprise can be evaluated only through an extensive use of various types of economic analysis. Thus the scope of managerial economics tends to be wide. The main objective of managerial economics is the analysis of business decision of a firm with the help of microeconomic concepts, tools and techniques.

Thus Managerial economics is the application of economic theory and decision science tools and techniques to the problems of managerial decision-making. It helps the firm in reaching various managerial decisions such as profit decisions, demand decisions, production decisions, priceoutput decisions, marketing decisions and investment decisions for achieving optimal solutions. The next chapter will throw light on the theory of demand and supply. References Positive and Normative Economics Macro and Micro Economics

R EVIEW 1.1
Question 1 of 4 Who among the following supplies the various factors of production?

A. Households B. Firms C. Industry D. Government

Check Answer

S ECTION 2

Scarcity and Choice

Scarcity is what necessitates making choices. Problems of choice arise at all levels - at the individual level, at the household level, at the firm level and at the overall economy level. The challenge is to make choices that maximize the level of satisfaction, with the available resources. The allocation of scarce resources between competing requirements is the main economic problem in any society. The individual also faces similar problems of choice as multiple wants have to be satisfied with a limited amount of money. To e n s u r e e ff i c i e n t a l l o c a t i o n o f resources, microeconomics advocates a free-market economy where demand and supply determine the allocation of resources. If demand is high for a particular product, and supply is less than the demand, its price will increase. Producers in a market economy will automatically produce more of the product, to reap the profits from the higher price. Consequently, supply increases and prices drop till the point where there is neither shortage nor surplus in the market. Thus in a free market economy, there is no agency or intermediary planning or controlling the market or fixing the price. Instead, consumers and producers make their choices based on the market forces of demand and supply. In market economies, both consumers and producers face trade-offs; trade-offs between consuming more and saving more or between earning more money and having more leisure.

Video 1.2.1: Scarcity & Choice

It is important to remember that, in reality, markets may be competitive or non-competitive. Most benefits of market economy are benefits derived from competition. Since not all markets are equally competitive, the degree of economic efficiency which exists in various markets are likely to differ. Opportunity Cost The opportunity cost of using a resource is the benefit that one could have got had the resource been put to its next best possible alternative use. The opportunity cost is an important concept; by making a choice to produce one type of good, the next best alternative good cannot be produced. For the consumer, deciding to spend a certain amount of money on a particular good is also about deciding not to spend that amount on another good which satisfies some want. It should be obvious that if scarcity was not there, opportunity cost would hardly matter. Consumers typically make their decisions based on two considerations - budget constraints and personal preferences. A budget constraint is the difficulty a person faces when he tries to satisfy his unlimited wants with a limited income. Since the budget constraint is a function of income and price, one can say that any purchase decision is based on income, price, and personal tastes and preferences. A consumer can have a choice of alternative products with a limited income if he can find a person with whom he can exchange goods or services. By means of such exchanges, he can increase his level of satisfaction.

Such exchanges are also possible for producers. Although two producers may both be capable of producing two products, each can also choose to produce the one product in which she has a comparative advantage over the other and exchange products.

Fundamental Economic Problems

All societies face three fundamental economic problems which arise out of scarcity. These are questions about choices related to the use of scarce economic resources. They are: What to produce? At the societal level, scarcity of land, labor and capital implies that all the wants in the economy cannot be satisfied. Since all wants cannot be satisfied, society must determine which wants are more important at a given point in time. Accordingly, they have to choose which goods and services are to be produced with the limited resources available. How to produce? This is about choosing the combination of resources and the quantity of each resource to be used to produce a certain quantity and quality of output. From a societal perspective, the best combination is one which fully employs the available resources to produce the maximum output. Depending on the resources available, techniques of production may be labor intensive or capital intensive.

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For whom to produce? This refers to the distribution of goods and services between different sections of the population. Scarce resources are to be used appropriately to cater to the needs of all income groups. These three questions are indeed interrelated. A society, which decides to produce more of highly sophisticated aircrafts and less of cycles, is also deciding to use more of capital and less of labor. In turn, since aircraft mechanics are likely to belong to a much higher income group than, say, cycle mechanics, the decision to produce more aircrafts has direct implications on the distribution question as well.

Decisions made by producers and consumers are influenced greatly by price. Any increase in the price of a product without a corresponding increase in cost increases profit; as a result, producers allocate more resources to that particular product. On the other hand, if consumers do not like to buy a product, supply would exceed demand and price would fall, resulting in a lower profit or even a loss to the producers. Thus price plays a major role in a market economy. The role of the government is negligible: consumers choose the goods they want and producers allocate their resources based on the market demand for different products. The United States of America is an example of a market economy. In the US, firms decide the type and quantity of goods to be made in response to consumer demand. An increase in the price of one good encourages producers to switch resources to the production of that item. Consumers decide the type and quantity of goods to be bought; a decrease in the price of one good encourages consumers to switch to buying that item. Command Economy In a command economy, answers to the three fundamental questions are decided by the government. So, what to produce, how to produce and for whom to produce are all decided by the people in power. The role of the government is all pervasive here, while consumer and producer choice is very limited. In this system, efficiency can be achieved only when demand is accurately forecasted and resources allocated accordingly. The former USSR was an example of a command economy. The government had complete control
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Economic Systems
How these fundamental questions are answered will depend on the extent of government control on the economy. Based on the role of the government in addressing these questions, there are three broad types of economic systems in the world - the market economy, the command economy and the mixed economy. Market Economy In a market economy, the freedom of individuals as consumers and suppliers of resources, allows market forces to determine the allocation of scarce resources through the price mechanism. Based on market demand and supply, consumers are free to buy goods and services of their choice and producers allocate their resources based on the demand.

over the economy and consumers were just the price takers. The government set output targets and allocated the necessary resources. The biggest challenge for a command economy is the massive requirement of real-time economic data, far beyond the technological and infrastructural capabilities of any government anywhere today. Mixed Economy A mixed economy is an economic system, which combines the features of a free market economy and a command economy. While consumers and producers enjoy freedom and choice, the government usually sets limits to such freedom. Government controls price Video 1.2.2:Economic fluctuations beyond a range, Systems while interfering in the economy in order to achieve a few set national goals. Mixed economies often have some unregulated sectors and some highly regulated sectors. Governments in mixed economies generally attempt to plan the course of their countries development and use cost-benefit analyses to answer the fundamental economic problems of what, how and for whom to produce. In principle, decisions or projects affecting the economy as a whole are taken or accepted only when the social benefits from the decision of project are greater than the social costs. Theoretically, a cost benefit analysis helps to assess the full costs and benefits to society arising from a particular decision or project, but sometimes in practice, the cost of collecting

and processing the massive amount of information required results in lags and inefficiencies. In a mixed economy, often the government organizes the provision of certain goods and services such as education and health care, which are considered essential.

Production Possibility Curve

The production possibility curve (PPC) helps us understand the problem of scarcity better, by showing what can be produced with given resources and technology. The production possibility curve can be defined as a curve which shows the maximum combination of output that the economy can produce using all the available resources. Technology is the knowledge of how to produce goods and services. A PPC tells us that to increase the production of one item, we have to forgo the production of some units of the other item. As resources are scarce, producers deciding to produce a certain good have to sacrifice the next best alternative good that could have been produced with the same resources. The value of the good given up is the opportunity cost. Opportunity costs are a result of scarcity. There is always an opportunity cost when production choices are determined. Since the slope of the PPC shows how much of one good has to be sacrificed in order to produce another good, we can say that the curve explains the opportunity cost. If we concentrate on producing more and more of a particular
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good, the opportunity cost keeps on increasing. As a result, the PPC is concave to the origin. Let us look at an example of the production possibility curve. Consider the production of two goods, say rice and cloth. Figure 1.1 shows different combinations of the two goods that can be produced. From the figure, we can see that production possibility C, with the resources available, we can produce two tons of rice and 12,000 meters of cloth. However, if we want to increase the production of rice to three tons, resources have to be diverted to the production of rice from the production of cloth. As a result, the production of cloth will drop to 9000 meters. In fact, if we want to produce 5 tons of rice, all our resources will have to be utilized for this, which means that we will not be able to produce any cloth at all (production possibility F). Thus to increase the production of one item, we have to forgo the production of some units of the other item. Looking at the figure 1.1, we can Keynote 1.2.1: see that to increase Production Possibility Curve rice production by one ton (from two tons to three tons), we have to forgo the production of 3000 meters of cloth. In this case, the opportunity cost of the additional ton of rice is the value of the 3000 meters

of cloth forgone. An increase in the production or consumption of one good can be achieved only through the opportunity cost of the other good. From the figure, we can see that increasing the production of rice from one ton to two tons causes a fall of 2000 meters in cloth production; and moving from two tons to three tons of rice production results in a 3000 meter drop in cloth production. So the opportunity cost of the second additional ton of rice is greater than the the opportunity cost of the first additional ton.
Video 1.2.3: Production Possibility Frontier with constant marginal opportunity cost

The PPC does not give the desirable point of production; it only indicates the possible combinations of the two goods that can be produced with the available resources. In other words, the PPC only helps us find out the combinations of outputs that can be produced with the available resources in an economy. All the points on the curve represent points at which
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the economy operates at its full productive capacity, that is, all the factors of production are fully employed. However, in any economy, actual production may fall short of the capability. In such a situation, we obtain a point inside the curve, which indicates that resources are not completely utilized, i.e., there is unemployment in the economy. The PPC illustrates the notion of scarcity by showing that, given the available resources and technology, production possibilities are limited; and at a given level of output of one good, once the maximum production possibility of the other good is reached, any increase in the production of the second good can come about only with a reduction of output of the first. In the long run, given increases in the availability of resources and improvements in technology, the PPC can shift outward. This outward shift of the curve represents growth of the economy. The three main sources of economic growth are: Increase in the quantities of economic resources available. Improvement in the quality of resources. Advances in technology. Technological developments enable higher productivity even with other factors of production remaining constant.

References Scarcity Opportunity Cost Market Economy Command Economy Mixed Economy Production Possibility Curve

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REVIEW 1.2.3
Question 1 of 8 Opportunity costs are a result of

REVIEW 1.2.2
Question 1 of 4 Which type of economy gives rise to the most efficient allocation of resources and capital in the standard microeconomics framework?

A. Scarcity A. Free market economy B. Overproduction B. Command economy C. Technology obsolescence C. Mixed economy D. Abundance of resources D. Marxist economy

Check Answer

Check Answer

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S ECTION 3

Case Study: Switzerland, Cuba and India: The Troika of Economic Problems in Three Economies
All the economies of the world face the problem of scarcity of resources, which limits the production activities. Scarcity of resources makes an economy face tradeoffs as producing more of one commodity means producing less of another commodity. Such trade-offs compel an economy to answer the three fundamental questions: What goods will be produced? How will the goods be produced? And for whom will the goods be produced? Economic Systems (Market, Command and Mixed) are the ways through which countries address these three fundamental posers. Each type of economic system has its own way of deciding what commodities are to be produced, how and for whom.

Switzerland A Market Economy

Switzerland comes closest to the idea of market economy or capitalism. Private entrepreneurship forms the basis of the Swiss economic policy. By the year 2000, most of the government enterprises were privatised in Switzerland. Friedrich A. Hayek, the Austrian economist, opined, Private property is the most important guarantee of freedom.1 Property rights are important for the proper functioning of an economy. People in Switzerland are guaranteed

This case study was written by Hepsi Swarna under the direction of Akshaya Kumar Jena, IBSCDC . It is intended to be used as the basis for class discussion rather than to illustrate either effective or ineffective handling of a management situation. The case was compiled from published sources.

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private property rights, and they do not fear unjust dispossession. Switzerland has one of the best property rights regimes. It was ranked 8th out of 115 countries with a score of 8.2 in the 2009 International Property Rights Index (IPRI) .
Table 1.3.1: Index of Economic Freedom (2009): Top 10 countries

Most of the countries figuring in the index, Hong Kong, Singapore, UK, US, Finland, Ireland, Denmark, Netherlands and Switzerland, are free market economies and these economies also have higher per capita income (Table 1.3.2). According to UNDPs 2008 statistical Table 1.3.2: Nations with high Per Capita Income, World Bank (revised in 2008) Rank
1 4 5 6 9 10 12 13 17 19 24 25 31

Rank 1 2 3 4 5 6 7 8 9 10 12 17

Country Hong kong Singapore Australia Ireland New zealand US Canada Denmark Switzerland UK Netherlands Finland

Score 90.0 87.10 82.6 82.20 82.0 80.70 80.50 80.00 79.40 79.0 77 74.5

Country
Liechtenstein Kuwait Norway Brunei Darussalam Singapore US Hong kong, China Switzerland Netherlands Ireland Denmark Finland UK

Per capita Income (PPP* International $)

63590 49970 53320 49900 48520 45850 44050 43870 39310 37090 36300 34550 33800

Compiled by the author from: 2009 index of economic freedom Ranking the Countries, http://www.heritage.org/Index/ Ranking.aspx

Switzerland is an international banking centre with many Multinational Corporations (MNCs). It is one of the worlds freest economies. Switzerland was ranked 9th (Table 1.3.1) with a score of 79.4 in the 2009 Index of Economic Freedom

Purchasing Power Parity. The most common way of presenting the per capita income data is PPP gures. Compiled by the author from: Gross national income per capita 2007, Atlas method and PPP, http:// siteresources.worldbank.org/DATASTATISTICS/Resources/ GNIPC.pdf, October 17th 2008

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update, Switzerlands GDP per capita for a population of 7.5 million people is $37,3962 . Switzerland has also some of the highest wages in the world. Thus, a high standard of living prevails in the country. The market economy of Switzerland has earned it a Human Development Index (HDI) of 0.9555, ranked 10th out of 179 countries3. In market economies, the means of production are owned by private individuals and most cost-efficient techniques of production are used. Holderbank, Switzerlands largest cement company, attributes its success to the best production technology and low production costs. Switzerlands market economy is based on international trade and banking. Swiss banks are known for very high standards of banking and financial services. The Swiss are the leaders in private banking. In 2003, it was reported that Switzerland with its 400 banks manage ... one-third of the worlds wealth that resides outside its country of origin.4 The Swiss banks are not subjected to any legal scrutiny. That is why the money (legal/ illegal) from the entire world is deposited in Swiss banks. In September 2008, the UBS of Switzerland revealed to the US that it held 47,000 secret accounts for Americans. Capitalism results in generation of wealth the Swiss banking business is an attestation to this fact. The Swiss are also known for their world-class watches, pharmaceuticals, electronics, chemicals, metals, precision instruments, chocolates, cheese and also for their ground breaking research and advances in organic agriculture and poultry production. Chemicals and engineering products are the biggest exports of Switzerland. Watches occupy third
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place in the countrys exports. About 95% of Switzerlands watches are exported and it stands as the world largest watch exporter in terms of value. In 2006, Swiss watch exports were valued at 13.7 billion francs6. The average export price of a Chinese watch in 2006 was $1, in Hong Kong it was $8, while Switzerlands export price of a watch was on an average $410.7 Switzerland has extremely well-developed infrastructure for scientific research. The Research Institute of Organic Agriculture is the worlds leading information and documentation centre for organic agriculture. Swiss companies spend a lot of money on Research and Development due to which they come up with very innovative products. Swatch, the famous Swiss watch company has always flirted with technology. Besides manufacturing watches, Swatch is into manufacturing microprocessors, smartcard technology, portable telephones, and other futureoriented designs, such as wristwatches that double as telephones, credit cards, even concert tickets.
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The innovation in the field of technology in Switzerland, along with other factors like first-rate infrastructure and efficient markets, has boosted Switzerlands global competitiveness, and it has been featuring among the top ten economies in the Global Competitive Index (GCI) for many years (Table 1.3.3). Switzerland was ranked as the second most competitive country in the global economy for the years 2007 and 2008. The other capitalist countries like UK, US, Finland, Denmark, Netherlands, Singapore and Hong Kong have also been featuring in top ten countries of the GCI index.
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Table 1.3.3: Global Competitiveness Index: 20002008

Rank 1 2 3 4 5 6 7 8 9 10 2000 US Singapore 2001* Finland US 2002 US Finland Taiwan Singapore Sweden 2003 Finland US Sweden Denmark Taiwan 2004 Finland US Sweden Taiwan Denmark Norway 2005 Finland US Sweden Denmark Taiwan Singapore Iceland Norway Australia 2006 US UK Denmark 2007 US 2008 US

Switzerland Switzerland Denmark Denmark Sweden Singapore Finland Germany Netherlands Japan

Netherlands Canada Ireland Finland Canada Singapore Australia Norway

Switzerland Sweden Japan Finland Germany Sweden Germany Finland Singapore Japan UK

Switzerland Singapore

Hong Kong Taiwan Australia SAR UK Netherlands Canada Switzerland Sweden Taiwan New Zealand Norway Denmark

Switzerland Singapore Iceland Norway Australia Japan Iceland

Switzerland Switzerland Singapore

Hong Kong Netherlands Canada SAR

* Switzerland for the year 2001 ranked 15th Compiled by the author from Global Competitiveness Reports 20002008

Trade has been the key to Switzerlands prosperity and growth. It has very liberal trade and investment policies, with minimum trade barriers (Table 1.3.4). In Global Enabling Trade Index released by World Economic Forum for the very first time in 2008, Switzerland was ranked 9th among 118 countries signifying its business-friendly environment and openness to international trade and investment. Exports generate lot of income and bost the economic growth. The Swiss economy

earns roughly half of its corporate earnings from the export industry, and 62% of Swiss exports are destined for the EU market.9 Government has a very limited role to play in Switzerland. The new agricultural policy of Switzerland, which came into effect from January 1st 1999 began eliminating detailed market regulations and reducing direct government intervention in setting up of market prices . Most of the Swiss
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government activities are confined to provision of public services like defence, railways, infrastructure and post office. The government policy aims at maintaining macro-economic stability in the country. Corruption is less in market economies than in command and mixed economies. Even though the US financial crisis was alleged to be a result of corruption and greed, most of the

of 180 countries in Transparency International Corruption Perceptions Index 2008 (Table 1.3.5). In contrast, command economy of Cuba was ranked 65th and the mixed economy of India was ranked 85th, which shows a very high level of corruption in these economies. The biggest drawback of Switzerland is that it is characterized by inequality of income and wealth. A study by the World Institute for Development Economics Research in 2006 using Table 1.3.4: Transparency International Corruption Perceptions Index* 2008 Country Rank 1 1 1 4 5 5 7 7 9 9 65 85 Country/ Territory Denmark Sweden New Zealand Singapore Finland Switzerland Iceland Netherlands Australia Canada Cuba India CPI Score 2008 9.3 9.3 9.3 9.2 9.0 9.0 8.9 8.9 8.7 8.7 4.3 3.4

Keynote 1.3.1: Trade Barriers-2008

Source: 2008 World Trade Indicators published by the World Bank, www.economist.com

market economies are characterized by low levels of corruption. In a market economy, the scope for corruption is pre- empted to a great extent. Switzerland was ranked 5th out

* A country or territorys CPI score indicates the degree of public sector corruption as perceived by business people and country analysts, and ranges between 10 (highly clean) and 0 (highly corrupt)
Source: Transparency International Corruption Perceptions Index 2008, http://webcasts.acc.com/handouts/ TI_CP_Index_2008.pdf, pages 4 and 5

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the statistics for the year 2000 came up with the data on wealth distribution for the whole world. According to the study, Switzerland had the highest concentration of wealth in the top 10% of the adult population (Table 1.3.6). Other capitalist countries like US, Denmark, France, UK, Germany and Finland also have concentration of wealth in few hands. According a World Resources Institute report, Switzerlands Gini coefficient is 0.33. The percentage of total income earned by the richest 20% of the population in Switzerland is 40.3% and the percentage of total income earned by the poorest 20% of the population is 6.9%11. Table 1.3.5: Percentage of Wealth Held by the Top 10% of the Adult Population in Various Countries Country Switzerland US Denmark France Sweden UK Canada Norway Germany Finland Wealth Owned by the Top 10% 71.3% 69.8% 65.0% 61.0% 58.6% 56.0% 53.0% 50.5% 44.4% 42.3%

Cuba Command Economy

There is the Cuban joke that in the socialist paradise, there are only three minor economic problems left to solve: breakfast, lunch and dinner.
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Cuba, Iran, Libya and North Korea are some of the countries where command economy still exists. Around 90% of the Cuban economy with a population of 11.4 million people is controlled by the state. The government controls all means of production and determines prices for most of the goods in the economy. It interferes heavily in the day-to-day economic lives of the Cuban people. Private entrepreneurship is thoroughly discouraged in Cuba. Laws governing private property are very complex in Cuba. Even though the constitution of Cuba allows Cubans to hold private property, they cannot buy or sell property. This shows that Cuba does not have proper property rights in place and that could be one of the reasons why it did not feature in 2009 IPRI. The government controls all the spheres of life in Cuba. The governmental spending for the year 2008 equalled 72.6% of GDP
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Source: Domhoff William G., Wealth, Income, and Power, http:// sociology.ucsc.edu/whorulesamerica/power/wealth.html, September 2005 (Updated on December 2006)

Cuba, once a colony of US, gained its independence through the Cuban Revolution in 1959. Fidel Castro (Fidel) overthrew Fulgencio Batistas US-backed army and established his empire. On account of the ongoing friction between Cuba and US, in 1960, Cuba nationalised three US oil refineries namely, Texaco (on June 29th 1960), Esso (on July 1st1960) and Shell (on July 1st1960). Thus, on July 3rd 1960, US suspended trading sugar
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with Cuba, by passing the Sugar Act in the Congress. Nearly 80% of the Cuban sugar exports to US were cut off. Cuba retaliated by nationalising all US businesses and commercial property on July 5th 1960. The following day, the then US President Dwight David Eisenhower cancelled the 700,000 tonnes of sugar remaining in Cubas quota for 1960. USSR decided to buy the 700,000 tonnes of sugar cut by US, and thus the sugar-for-oil exchange between Cuba and USSR was born. It was estimated at that time that Cuba was doing 85% of its trade with USSR. In September 1960, Cuba nationalized all US banks. On October 13th 1960, Fidel nationalized local firms, which included large agricultural estates, sugar refineries, banks, mining firms, large industries and privately owned urban property. Following this, US imposed a trade and economic embargo on Cuba excluding food and medicine on October 19th 1960. Cuba defended itself against the US invasion at Bay of Pigs on April 17th 1961 and defeated the US army after 3 days of fighting government 14. Fidel established a centrally planned system and nationalised all means of production. Even after the imposition of US embargo, Cuban agricultural production remained high, with USSR buying sugar from it at more than the market price. But in early 1990s, as the USSR collapsed, so did Cuban economy and its agricultural production. Instead of choosing to open up its markets and agricultural production to the forces of free markets, Cuban government continued to control agricultural production and marketing. As a result of the socialist management, the sugar

production started falling, and hence the once prosperous sugar industry lost all its glory. It was opined, Inefficient planting and cultivation methods, poor management, shortages of spare parts, and poor transportation infrastructure combined to deter the recovery of the sector. Sugar industry fell from 8.1 million metric tonnes in 1989 to 3.5 million metric tonnes in 1995. In June 2002, Cuba announced it would have to close half of the countrys 156 decrepit sugar mills16. Shortages are common in Cuba, due to poorly run state factories and firms. Command economies result in the formation of shadow or black markets. Cubas black market has been flourishing because when the government controls the distribution of goods and services, producers start selling things illegally. Cubans have been increasingly buying the needed food and clothing from the black markets at very high prices. The black markets bypass all the government restrictions. Moreover, Cubans get to buy the very essential items which are not available at the government ration shops. In Cuba, government exercises control over employment issues. As per the Government statistics, about 75% of the labour force is employed by the state. The actual figure is however, closer to 93%17. A meagre 3% of the total workforce (4.87 million) is allowed to be self-employed. If a foreign company intends to hire workers, it can be done only through the recognised state agencies. Workers are paid only a fraction of the amount that is charged to foreign companies. Cuba has a very hostile business and investment environment characterised by dense regulations and impenetrable communist bureaucracy. Trade is non-transparent and the
22
15

government controls imports and exports. The non-tariff barriers to trade are very restrictive. All these put together are deterring foreign investment in Cuba. Most of the foreign investment in Cuba, takes place through joint ventures with state companies, which have majority of the ownership. A paper titled The Legal and Administrative Framework for Foreign Trade and Investment by European Companies in Cuba, given to the Cuban government by the European Union in July 2002 contained the problems that were encountered in the operations of joint ventures in Cuba. The paper pointed out the difficulty in obtaining work permits for foreign employees. It also complained that EU joint venture partners had no say in hiring employees and often they were forced by the Cuban government to hire employees who were professionally not suitable and securing finance was also very difficult18. The Cuban government did not respond. Cuba has been witnessing fall in foreign investment due to such difficult investment environment Of the 540 joint ventures formed since the Cuban Government issued the first legislation on foreign investment in 1982 ... 287 remained at the close of 2005 ... Foreign direct investment flows decreased from $448 million in 2000 to $39 million in 2001 and were at zero in 2002.
19

ranked Cuba 177 out of 179 countries. The two countries ranked after it are Zimbabwe and North Korea; both of them are command economies. Command economies are characterized by equitable distribution of income and wealth. Cuba under Fidel in 1960s witnessed more equitable wages. The income gap between the farmers and the urban workers decreased as wages were controlled by the government. Fidelss agenda, employment for all, brought all the classes on the same platform. All Cuban children go to school and even a remote village has a school in Cuba. It has a literacy rate of 99.8%. Cubans also enjoy a good healthcare, and they have achieved many breakthroughs in the field of biotechnology. And that is why HDI ranked Cuba 48th out of 179 countries (Table 1.3.7). By 1986, Cubas Gini coefficient of 0.25 was among the lowest in the world. Cuba has set an example of an egalitarian economy. But in 1990s, following the collapse of USSR, Cuban economy was in a deep crisis. To alleviate the crisis, Cuba introduced some market reforms, like legalisation of dollar, allowing foreign investment, opening of the country for tourism, legalisation of some private enterprises and self-employment for 150 occupations. Following the legalisation of dollar, the Cuban Peso became worthless and inequalities between the Cubans rose. The Cubans who had access to dollars earned higher incomes. Jobs like driving taxis and working at restaurants which earned salaries/tips in dollars from foreign businesses and tourists became highly desirable. Cubas Gini coefficient of 0.40 in 1999 turned up similar to US. The Cuban government
23

The citizens of Cuba are denied the freedom of expression the freedom of speech and press. Cuban jails contain prisoners of conscience, who have been detained just because of their beliefs. Cubans are denied the right to change their government. Assembly of more than three persons is punishable under the law in Cuba. Access to internet and outside media is heavily controlled. It is illegal in Cuba to own a TV satellite dish. The 2009 Index of Economic Freedom,

tightly controlled the small private sector that evolved during 1990s. Fidel in his Cuba established Soviet-style rationing of housing, goods and food20. Cubas rationing system started in 1962,which severely limited the quantity and choice of Cuban consumers. People of Cuba for many decades have been surviving on ration books that provide limited amount of essential products like rice and beans. Cuban parents can buy subsidised milk powder (which comes to one glass a day) for children less than 7 years of age. Once a child turns 8 years old, it is not available. Fresh fruits and meat are scarce and beyond the reach of ordinary Cubans. the ration, which the Table 1.3.6: Cubas Human Development Index 2006 Life expectancy at birth (years) 2006 Combined GDP primary, per secondary and capita tertiary gross (PPP in enrolment ratio $) 2006 (%) 2006

provisions for the remaining half of the month in the expensive Cuban black markets. In October 2008, it was reported that the Cuban government was putting a limit on how much fruits and vegetables Cuban people can buy in farmers market. Lettuce was limited to two pounds per person21. Command economies have a very low unemployment rate compared to market and mixed economies. Cuban government has been committed to provide employment to each of its citizen. Cuba also has a moderate level of inflation (Table 1.3.8). There are very few markets in Cuba and many of the farmers are prohibited from selling their extra produce in the markets. In February 2008, Fidel Castros nearly five decades of rule came to an end when his brother Raul Castro (Raul) was appointed the President of Cuba. President Raul in 2008 announced that farmers will be allowed to sell their extra produce in local markets and also, there will be large scale distribution of land to private farmers. However, farmers still face rules about what and how much they can plant, and risk losing their land if they fail to meet government production quotas. They are also required by law to sell any surplus to farmers markets.
22

HDI value 2006

Adult literacy rate (ages 15 and above (%)) 2006

0.855

77.9

99.8

94.8

6876

Source: 2008 statisical update Cuba

government provides, lasts only 10-15 days and many Cuban women, in a desperate attempt to feed their families, have turned to prostitution so that they get enough money to buy

With the coming of Raul to power, some are hoping that Cuba may open up and witness some changes in the economic realm. But many analysts believe Cubas transition to a market economy is not possible as long as Fidel is alive. However, to make a start in loosening the Cuban economy, Raul in February 2008 made some announcements (Table 1.3.9). Countries like Canada, Spain, China and Russia are emerging as prominent foreign investors in Cuba. Many analysts agree with the notion
24

that Cuba will slowly make a transition to a conventional market economy. Jawaharlal Nehru, Indias first Prime Minister introduced the concept of mixed economy in India. He intended to incorporate the best features of market and command economy in India. Till 1990s, the government occupied a very important role in the economy and private sector was severely regulated and thoroughly discouraged by excessive bureaucratic controls. State was actively involved in providing for healthcare, education, defence and development of infrastructure in the country. All the other major industries like mining, banking and Table 1.3.7: Inflation and Unemployment Figures of Switzerland, Cuba and India-2008 Country Switzerland Cuba India Inflation (CPI) (%) 0.9 3.6 6.4 Unemployment Rate (%) 2.5 1.8 7.2

Airlines, Air Deccan, Go Air, Jet Airways, Kingfisher Airlines, etc. Private sectors also started having a firm grip on educational and healthcare sectors. Indias financial sectors have (as on 2009), 28 state-owned banks controlling about 71% of commercial banking, 29 private banks, and 31 foreign banks23. In the recent times, development of infrastructure has been opened to private sectors also. There is private property in India, but it needs improvement in the area of protection of Table 1.3.8: Announcements made by Raul Castro (february 2008)

Expanding access to public land for private farmers Permitting some Cubans to own their homes Increasing wages and retirement pensions Licensing private taxis to operate Limited deregulation of the construction industry Expanding access to certain previously restricted consumer goods (like cell phones, computers, microwaves, toasters, DVD players, motorcycles, air conditioners, electric ovens, agricultural supplies and tools) Launching a new 24-hr television station to include mostly foreign produced content.

insurance, communications, transportation, manufacturing and construction were also under government control. In 1990s, there was a paradigm shift in the Indian economic policy. Private sector was invited to take on sectors like education, communications, civil aviation, healthcare, banking and insurance. As a result, government and private players were present in most of the sectors simultaneously. In the civil aviation sector, there have been governments Indian Airlines and Air India, co-existing with private airlines like East West

Compiled by the author from Background Note: Cuba,http://www.state.gov/r/pa/ei/ bgn/2886htm, August 2008

25

property rights. India was ranked 46th in 2009 IPRI with a score of 5.6. The private sectors role in the economy has raised overall production and efficiency. Telecommunication sector, after the entry of private players became very efficient and costeffective. The advent of private sector in civil aviation increased the comfort in travelling and the airfares got slashed due to the healthy competition between the air carriers. Private sector in India has set very high India Mixed Economy standards in the education, healthcare, banking and tourism segments. Since private sectors aim is maximisation of profit, they venture only into those avenues which will increase their revenues. Therefore, the government provides services to rural and low-income people who are largely untouched by the private sector. Indian government has retained the ownership over the strategic sectors like defence and artillery, maintenance of law and order and railways. Thus, in India, government controls the sectors which are important for its growth and stability. The total government expenditure in India is moderate, equalling 27.2% of GDP24. India has a huge consumer base. It is the second largest consumer market in terms of population. While production of goods and services are carried by both private individuals and government, the decision about consumption of goods and service rests entirely on the consumers. Indian consumers decide what to buy out of all the choices given.

And incomes of the consumers and prices of goods and services also play an important role in determining consumption. In the recent years, Indian consumers have become environment friendly and eighty-eight percent of Indian consumers are prepared to pay more for goods that are environmental friendly25. Prices in Indian markets are determined by the interaction of demand and supply forces of goods and services. Even though Indian government does not tell people what to buy or sell, it is actively involved in regulating the market. Corruption is very highly prevalent in India (Table 1.3.6). In India, the difference between the public and private sector is clearly visible. Public sector undertakings have become the property of a few politicians. Despite being run by the government, Indian economy is characterised by a great disparity between the rich and the poor. Indias Gini coefficient is 0.38 where 46.1% of the total income is earned by the richest 20% of the population, and just 8.1% of the income is earned by the poorest 20% of the population26. Compared to market economies, mixed economies have a low standard of living measured in terms of HDI and per capita GDP. Indias HDI value is 0.609 with a rank of 132nd and its GDP per capita28 is $2,489. India is ranked 123rd in the 2009 Index of Economic Freedom. Out of all the three economies, Switzerland is the freest economy followed by India and Cuba (Table 1.3.9) Most of the market economies of the world like Switzerland, US, Singapore, Hong Kong have relatively open market systems in their respective countries. Neither market
26
27

economy nor command economy exists in pure form. The basic difference between the two is that while in a market economy buyers and sellers decide the three basic questions of the economy, in a command economy the government pulls the string. In some degree or other, all the economies of the world are mixed economies, with market features and government controls existing simultaneously. The question that remains to be answered is how much mixed an economy should be?

TABLE 1.3.9: 2009 INDEX OF ECONOMIC FREEDOM OF CUBA, INDIA AND SWITZERLAND A COMPARATIVE ANALYSIS Country Name Cuba India Overall Score 27.9 54.4 Business Trade Fiscal freedom freedom freedom 10 54.4 64.4 51 45.9 73.8 Governm ent Size Monetary freedom Investment Freedom Financial freedom 10 40 Property rights 10 50 Freedom from corruption 42 35 Labour freedom 20 62.3

Switzerland

79.4

82.9

85.4

67.5

COUNTRY NAME 67 10 OVERALL SCORE BUSINESS FREEDOM 77.8 69.3 30 TRADE FREEDOM FISCAL FREEDOM GOVERNMENT 65.3 83.9SIZE 70 MONETARY FREEDOM INVESTMENT FREEDOM

80

90

90

79.2

27

Footnotes 1.Dedigama C. Anne, INTERNATIONAL PROPERTY RIGHTS INDEX (IPRI) 2009 Report, http:// www.internationalpropertyrightsindex.org./atr_Final1.pdf, page 11 2.2008 Statistical Update Switzerland, http://hdrstats.un dp.org/2008/countries/country_fact_sheets/cty_fs_CHE.html , December 18th 2008 3.2008 Statistical Update Switzerland, op.cit 4.Beng Kim Phar, Capitalisms Mistress: Private Banking, http://www.globalpolicy.org/socecon /crisis/2003/0625 mistress .htm, June 25th 2003. 5.A i y a r S h a n k k a r , M i n t i n g p o l i t i c a l c a p i t a l , http://in.elections.yahoo.com/articles.html?feed=http://in.ne ws.yahoo.com/ 248/20090422/1585/tnl- mintingpolitical-capital_1.html, April 22nd 2009. 6.The Swiss watch industry, http://www.swiss world.org /en/ switzerland/ swiss_ specials/swiss _watches/ the_swiss_watch_industry/ 7.Ibid. 8. T h e S w a t c h G r o u p S A , h t t p : / / w w w. f u n d i n g universe.com/company - histories/ The-Swatch-Group-SACompany- History.html 9. Background Note: Switzerland, http://www.state.gov/ r/pa/ ei/b gn/3431.htm, January 2009.

10. S w i t z e r l a n d , h t t p : / / w w w . u s t r . g o v / a s s e t s / D ocument_Library/Reports_Publications/2003/ 2003_NTE_Report/ asset_ upload_file346_6225.pdf, page 354 11.Economics, Business, and the Environment, http://earth trends.w ri.org/te xt/economics - business/country-profile174.html 12.Roberts M. James, Cubas Phony Transition: Fidel Resigns, Raul Reigns, http://www.heritage.org/Research/ LatinAmerica/wm1820.cfm, February19th 2008. 13.Cuba, http://www.heritage.org/Index/Country/Cuba 14.JohnsonStephen,TimeForConsensusOnCuba,http:// www.heritage.org/research/latinamerica/bg1579.cfm,Augus t 30th 2002. 15.Cubas Phony Transition: Fidel Resigns, Raul Reigns, op.cit 16. Ibid. 17.Background Note: Cuba, http://www.state.gov /r/pa/ei/bgn/2886.htm, August 2008 18.Ibid. 19.Ibid 20.Cubas Phony Transition: Fidel Resigns, Raul Reigns, op.cit

28

21.Garcia Anne-Marie, Cuba Begins Rationing Food, http://www.infowars.com/cuba-begins-rationing-food/, October 12th 2008. 22. C u b a g i v i n g l a n d t o p r i v a t e f a r m e r s , http://economictimes.indiatimes. com/articleshow/msid-2929895,prtpage-1.cms, April 6th 2008. 23.India, http://www.heritage.org/Index/Country/India, 2009. 24.Ibid. 25.Indian consumers favour eco-friendly products: study, http://www.thaindian.com/ne wspo rtal/business/indian26.c o n s u m e r s - f a v o u r - e c o - f r i e n d l y - p r o d u c t s - s t udy_100129834.htmlCountry Profile India, http://earth trends.wri.org/text/economics business/country-profile-85.html 27.2008 Statistical Update India, http://hdrstats.u ndp.org /2008/countries/ country_fact_sheets/cty_fs_IND.html, December 18th 2008 28.Ibid

29

C HAPTER 2

Theory of Demand and Supply

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Nisl rhoncus turpis est, vel elit, congue wisi enim nunc ultricies dolor sit, magna tincidunt. Maecenas aliquam est maecenas ligula nostra.

S ECTION 1

Introduction to Demand & Supply

Multinational companies such as McDonalds and Kelloggs entered the Indian market in mid 1990s. Initially, McDonalds offered products which were not customized to the Indian tastes. The company seemed to have overestimated the demand for its products and hence almost all its operations ran into losses. McDonalds was able to capture a reasonable market share in the Indian fast-food segment when the company made some changes in its menu during the late 1990s, which were more suited to the tastes and
http://www.truckertotrucker.com/wp-content/uploads/2011/03/gas-1.png

preferences of the Indian customers. Similarly, Kelloggs planned to replace heavier Indian breakfast with an alternative like cornflakes. However, the company was not able to estimate the right demand for its products. Kelloggs was unsuccessful due to wrong demand forecasting and premium pricing of its products. In the case of both McDonalds and Kelloggs, there were cheaper alternatives available. This was one of the reasons

31

why the Indian customers did not readily switch to the products offered by the multinationals. The above examples suggest the significance of analyzing the forces of demand and supply of any goods or service. The objective of a firm is to maximize its profits. The demand for its product(s) plays a major role to achieve this objective. Those firms whose products have inadequate demand are not able to generate sufficient revenues, and hence, are forced to close down their operations. Therefore, demand analysis is very important for a firm to determine the price of a product and the quantities to be produced. Firms market entry decision hinges crucially on profit. The demand for the goods is not the only factor that ensures firms profit, but the price of the input factors as well as the price of the output of the firm are also equally important. Therefore, supply analysis is also very important for a firm to optimally and efficiently produce the output so as to compete in the market. This chapter will extensively discuss the theory of demand and supply. First segment of the chapter will discuss the basic concepts and laws associated with demand and supply, key determinants of demand and supply. The second section will throw light on market equilibrium and the government intervention in the market. Measurement of elasticities of demand and supply will be covered in the third section of this chapter.

32

S ECTION 2

Theory of Demand
In economic theory, demand and supply has a great significance since the wants are unlimited and resources are limited. In economics the demand is defined as desire backed by ability and willingness to buy a product or service at alternative prices other things being constant. Law of Demand The law of demand explains the relationship between the price and the quantity demanded in a particular period. The law refers to the direction in which the quantity demanded changes with change in price. The law of demand states that other things being constant (ceteris paribus) the quantity demanded increases with a fall in price and quantity demanded decreases with a rise in price. The quantity demanded of the product not only depends on the price of the product alone, but also a host of other factors which determine the quantity demanded of the product, such as the taste and preferences of the consumer, seasonal changes, income of the consumer, price of alternative product and services, etc. Demand Schedule Listing of the various quantities that the consumer is willing to buy at different prices in a given period of time in a tabular form is called the demand schedule. The demand schedule is usually represented in a tabular form where it depicts the alternative prices of the product and the corresponding quantities demanded at a given period of time (Table 2.2.1).

Video 2.2.1:Theory of Demand

33

Table 2.2.1 DEMAND SCHEDULE FOR CHOCOLATES PRICE 10 12 14 16 18 20 Demand Curve When we represent the demand schedule in the form of a graph we get the demand curve. In the figure below, we have plotted the data given in the demand schedule. Here, it is a typical downward-sloping demand curve. The following diagram shows that at very low price, the consumers want to purchase higher quantities of chocolates, keeping other factors unchanged and vice versa. Demand Function Demand function: A function that depicts the relationship between how much of a good will be demanded at alternative prices of that good and alternative values of other non price variables affecting demand. The demand function for the good X can be written mathematically as: Qx= f( Px , Py, Y, e ) QUANTITY DEMANDED 20 18 16 14 12 10

Where, Qx: quantity demanded of good X Px: own price of good X Py: prices of the related goods Y Y: income of the consumer e: Other non-price factors that influence demand. The nature of the demand function differs from goods to goods. However, the simplest form of demand function is the linear demand function. The linear demand function is a function where the demand of a good is a linear function of its own price and other variables influencing demand. Factors determining demand There are wide array of factors which influence demand. Price is considered to be the most important factor that determines demand. There are also many no-price factors which influence demand. Some of the non-price factors which influence demand are discussed hereunder: Income of the Consumer: Other things being constant, if the income of the consumer increases the demand for the product increases and vice versa.

34

Price of Substitutes Other things being equal if the price of the product increases the demand for that product decreases and the demand for the substitute product increases and vice versa. Changes in government Policy The demand for a product may also depend upon government policies. For instance, if the government increases taxes on products, prices increase and hence the quantity demanded decreases in the short run. Government may also prohibit the consumption of a product or set limits on its consumption. Tastes and Preferences of the consumer The tastes and preferences of the consumer also affect the demand for a product. To an extent, prevailing fashion, advertising and an overall increase in standard of living influence consumer tastes. For example, when multinational Quick Service Restaurant (QSR) chains like Pizza Hut and McDonalds entered India, they found that their products did not cater to the Indian tastes. These companies had to not only change their pricing, but they also had to alter their menu to make it more suitable to the tastes and preferences of Indian consumers. Expectation Regarding Future Price Changes If a consumer expects a fall in the price of a product in the near future, the present consumption of that product may come down. This, however, depends on the nature of the product. If the product is essential or perishable, the consumer cannot postpone the purchase of that product. Even if the price of

a staple food like rice (or wheat) was expected to fall, there is a limit to the consumers ability to postpone its consumption. Special Influence Demand may also be influenced by other factors like climate change, demographic changes, population migration and technological progress. Change in quantity demanded vs Change in demand There is a need to understand the difference between change in quantity demanded and change in demand. Change in quantity demanded The change in quantity demanded indicates the relationship between price and quantity demanded which is the movement along the demand curve, keeping other things being constant. Ceteris paribus, higher is the price, lower is the quantity demanded and vice versa. Change in quantity demanded is also known as variations in demand (shown in the following Keynote 2.2.1) Change in demand The non-price factors will have an influence over the demand for the product. These factors may cause shift in the demand curve either rightward or leftward. Some of the non-price factors are discussed below. A change in demand, whether an increase or a decrease, refers to the shift in the demandcurve, towards the right or towards the left, caused by a change in any of the non-price determinants of demand (shown in the Keynote 2.2.1).
35

tity demanded. The sign of

Keynote 2.2.1 Change in quantity demanded V/s Change in Demand

depends on goods X and Y, If both

whether they are complements or substitutes. the goods are substitutes and plements. The sign of modities. If

, if both goods are com-

depends on the nature of the com,

, the good X is a normal good and if

the good X is an inferior good. The nature of the goods will be discussed in detail under the indifference curve analysis. However, the following diagram is showing the shape of different goods with relation to the change in the income of the consumer (Keynote 2.2.2). Nature of Demand The nature of demand differs from goods to goods. The simplest form of demand function is the linear demand function through which an attempt is made hereunder to demonstrate how the factors influence demand. Linear demand function shows the linear functional relation between the quantity demanded of good X (Qx) and own price of good X (Px), prices of the related goods(Py,), income (Y) and other non price factors (O) that determines demand. The linear demand function can be presented as follows: 1. Normal good: Goods for which demand goes up when income is higher and for which demand goes down when income is lower. 2. Inferior goods: Goods for which demand tends to fall when income increases. 3. Substitutes: Goods that can serve as replacements for one another; when the price of one increases, demand for the other goes up. 4. Complementary goods: Goods that go together; a decrease in the price of one results in an increase in demand for the other and vice versa. 5. Giffen good: When the price of a commodity increases the demand for this type of good will increase and vice versa. Giffen good is also treated as an inferior good, but all inferior
36

The signs of of demand,

depict how the changes in determinants <0 as increase in price will decrease the quan-

of demand will influence demand for the good X. As per the law

goods are not Giffen goods. Giffen good violates the law of demand. Keynote 2.2.2 Income vs. Demand of a Product REVIEW 2.2.1 Question 1 of 4 Which of the following is true about demand?

A. Existence of wants References Demand Theory Law of Demand B. Need without which one cant do without C. Desire, not satisfiable by anything else D. Desire backed by ability and willingness to pay

Check Answer

37

S ECTION 3

Case Study: Do Soaring Price and Mounting Demand in Indian Gold Market Speak of Paradox
Demand for gold is a widespread observable fact across the world. However, the major demand for gold comes from five countries, namely India, Italy, Turkey, US and China. Among these countries, which account for 55% of the total gold demand, Indias share alone comes to around 25%. Cultural and religious traditions involving wearing of jewellery play a major role in influencing Indian gold demand. Around 75% of the world demand for gold is jewellery-based and the rest 25% is investment based. Speaking about Indias fondness for gold, Lord John Maynard Keynes is alleged to have remarked, Indias gold consumption reflects the ruinous love of a barbaric relic.
1

In India, there is a huge mismatch between demand for and supply of gold. Hutti Gold Mine Company located in Karnataka is the only company in India, which produces gold by mining and processing the gold ore. It produces around 3 tonnes of gold per year. Another source of supply of gold in India has been coming from recycled jewellery/scrap jewellery. In 2006, it was reported that, Over the past five years, Indians have recycled an average of 105 tonnes of gold per annum.2 To meet

This case study was written by Hepsi Swarna under the direction of Akshaya Kumar Jena, IBSCDC . It is intended to be used as the basis for class discussion rather than to illustrate either effective or ineffective handling of a management situation. The case was written from published sources.

38

the bulk of the demand, India imports gold. India imports around 700 tonnes of gold a year.
3

In October 2008, demand for gold increased. While this increase in demand for gold was attributed to the falling gold price from $900 to $712 per oz. , some were of the view that it
5 4

is because of the festivity of Diwali , which requires people to purchase gold ornaments without taking price situation. into account. However, the weakness of the latter argument was shown up by citing the instance of the same Diwali festival of 7 2009. India is reported to have imported zero gold in February 2007 when the price registered a rise and surged above $800 2009; imports during March 2009 has also been zero. The per oz. mark and the demand for gold jewellery decreased. relationship between gold price The very high price is alleged to and Indian gold demand seems have dampened the demand for Exhibit I to be negative during some years gold, especially in the jewellery and positive in some other years sector. Experts, however, pointed (Exhibit I). to real estate and the Bombay Stock Exchange as better The price of gold and the investment havens for Indians in quantity demanded of gold in October 2007 to switch their India for the above time series funds to away from gold when plotted against each other bullion. However, back in 2005, in a tabular form, give rise to a as the gold prices went up straightforward demand schedule demand also went up, making (Exhibit II). The graphical the analysts comment that the translation of it gives rise to demand curve for gold in India is demand curve. 6 inverted. The higher the gold While the periods 19921993, price rises in rupee terms, the 1996 1999 and2003 show up stronger becomes the conviction the negative relationship of Indians that gold is the best Source:www.gold.org/assets/file/rs_achieve
39

means of preserving and enhancing ones wealth. This conviction started manifesting itself again towards the last quarter of 2008 when the US-originated worldwide recession drove investors to park their funds in the safe haven of gold, thus keeping the investment demand for gold high. But the jewellery demand for gold saw huge dip in India due to the price increase. Indias demand for gold is met through imports and recent gold import figures highlight the demand destruction that has taken place. Imports of gold are reported to have fallen by 83% in December 2008 and by 91% in January

between price of gold and the quantity supplied of it, the periods 19911992, 19931996 and 20032005 reveal a positive relationship.

Exhibit II Demand Scheduled of Gold (1991-2005)

time even in the face of rising gold price because as more and more workers moved from low income to middle and highincome groups, their demand for gold also increased. A World Gold Council study in 2006 conducted across six key gold markets, including India, revealed that, gold has become a more relevant and desirable product to a greater number of women , thanks to increasing economic independence of women in developing countries. In order to disintegrate the various factors influencing the quantity demanded, the economists have employed the technique of showing the price factor alone and its influence on quantity demanded by means of a demand curve. The influence of non-price factors such as income on the quantity demanded is shown by a shift of the whole demand curve itself. Besides income, other non-price factors include prices of related goods, size of the population, consumer tastes and preferences, expectations about future conditions, etc. In February 2009, it was reported that platinum was nearly half the price it was in 2008. When the gold prices were steeply climbing and the price of platinum was falling during the first 2
9

Compiled by the authors from The Role of Gold in India,http://www.gold.org/assets/le/ rs_archive/the_role_of_gold_in _india.pdf.September2006, page 2

Exhibit III: Non-price Determinants of Demand 1 2 3 4 5 Income of the customer Price of related good Consumers taste and preference Population Expected future price of the good
40

The apparent positive relationship between price of gold and its demand is often due to the presence of the non-price factors (Exhibit III). In 2004, it was reported that, Indians are enjoying a rapid acceleration in income growth, which is supporting discretionary spending on consumer goods, including gold. The demand for gold increased during that
8

months of 2009, Indians started substituting platinum for gold due to near parity of prices between gold and platinum. Vijay Jain, chief executive of leading jewellery chain Orra, opines, there is a new-found love for platinum among Indian buyers because the precious metal has lost around 30% of its value in comparison to gold. He further says, A 10-gm platinum ring is now priced around INR 22,000 as against INR 35,000 a year-ago. The high gold price accompanied with declining platinum price made Indians dump gold and embrace platinum as reflected by the increase in the market share of platinum from previous 15%40% as on January 2009. The size of the population in India being so large, demand for gold in India also sums up to a huge quantity. Rising rate of population growth calls for increasing demand for gold. Tastes and preferences represent a variety of cultural, religious and historical influences. Indias demand for gold has its roots in cultural and religious traditions. In India, gold is seen as a symbol of status and it also plays a major role in a girls wedding. Festivals like Diwali and Akshaya Tritiya are regarded as auspicious occasions to buy gold. Thus, demand for gold is associated with cultural and religious beliefs in India. Another factor that affects the demand for a good is the expectations about future. The continued expectation about rising trend in gold prices has swayed the investors into purchasing more of gold even if its price is on the rise. In February 2009, as gold crossed INR 15,000 mark, investors increased their demand for gold, as they expected the gold prices to go up to INR 20,000. The uncertain economic conditions resulting from the global recession in 2008 has also made investors switch their funds from distressed financial
12 11 10

assets to ever- alluring gold. This increased investment demand for gold has sent the gold prices soaring. And the higher the gold price, the higher will be the investment demand for gold since it creates stronger expectations of continuing optimistic trend, especially when business scenario all around is pessimistic. But some analysts counter argue that the worlds demand for gold being no more money based but majorly jewellery based, high gold price will eventually lead to destruction of jewellery demand and overall gold demand. Seventy Five percent of the worlds demand for gold is for making jewellery while nowhere in the world the monetary system is based on gold. The simultaneous exertion of various forces on the quantity demanded of gold often masks the lone influence of the price of gold. But a disaggregated careful analysis would reveal the actual relationship between price and quantity demanded of a good. Whether this relationship is positive or inverse depends upon the combined strength of the substitution effect and income effect of the price change of gold.
14

41

Footnotes 1.Kannan R. and Dhal Sarat, Indias demand for gold: some issues for economic development and macroeconomic policy, http://findarticles .com/p/articles/mi_m1TSD/is_1_7/ ai_n28026379/, June 2008. 2.Dempster Natalie, The Role of Gold in India, http://www.go ld.org/ass ets/file/rs_ archive/the_role_of_gold_in_india.pdf, September 2006, page 6 3.India 200809 platinum consumption seen at 932 kg, http://in.reu ters .com/artic le/businessNews/idINIndia34148820080620, June 20th 2008. 4.Gold Demand Trends Full year, http://www.gold.o rg/as sets/file/pub_archive/pdf/GDT_Q4_2008.pdf, February 2009, page 11 5.Diwali is an Indian festival, celebrated in the month of October or November and buying gold is considered auspicious on that day. 6.Hamilton Adam, Global Gold Highs, http://www.zea lllc.com/2005/glogold.htm, October 14th 2005. 7.M e h r a C h a n d , I s i n v e s t i n g i n g o l d r i s k y ? , http://www.rediff.com/c ms/ print.jsp? docpath=//money/2009/mar/ 16guest-is-investing-in- gold-risky.htm, March 16th 2009. 8.The Role of Gold in India, op.cit., page 5 9.The Role of Gold in India, op.cit., page 5

10. I n d i a n b u y e r s d u m p g o l d , e m b r a c e p l a t i n u m , http://www.commodity online. com/news/Indian-buyersdump-gold-embrace- platinum-15342-3-1.html, February 19th 2009. 11.Ibid. 12. P l a t i n u m - G o l d p r i c e d i ff e r e n t i a l a l m o s t z e r o , http://www.commodity online .com/news/Platinum-Gold-pricedifferential-almost -zero - 15558-3-1.html, February 27th 2009. 13.Is investing in gold risky?, op.cit.

42

S ECTION 4

Theory of Supply

Video 2.4.1:Law of Supply

In economics the word supply implies the various quantities of a commodity offered for sale by producers during a given period of time at various prices. Like demand, supply is also influenced by price as higher price positively impacts the sellers willingness to sell, and often, the ability to bring the goods and services to the market as well. LAW OF SUPPLY: The Law of Supply states that other things being equal (ceteris paribus), lower the price lesser the quantity supplied and vice versa. It indicates the positive relationship between price and quantity supplied. The supply curve will be upward sloping. Supply schedule: Listing of the various quantities that the seller is willing to supply at different prices in a given

period of time is called the supply schedule. The supply schedule is usually represented in a tabular form where it depicts the price of the product and the corresponding quantity supplied at a given period of time (Table 2.4.1). Table 2.4.1: Supply Schedule of Chocolates Situation Price (Rs per Quantity Supplied box) (boxes) 50 40 30 20 10 22 15 9 4 0

A B C D E

43

Figure 2.4.1: Demand Curve

S: Supply P : Price of the products C: Cost of production S: Availability of substitutes T: Technology G: government Policies O: Other factors Factors determining supply Price is the most important determinant that influences the supply of goods and services. The supply of a good or service is not only influenced by its own price, but also by other non price factors. Even when price remains unchanged change in non- price factors may bring change in supply of the goods and services. Some of the major non-price factors include cost of production, availability of alternatives, climatic conditions, technological progress and government policies. Cost of production Cost of production can vary due to several reasons. Variations in cost may occur due to changes in input costs or due to technological advancements. Other things remaining the same, an increase in the cost of production leads to a decrease in supply and a decrease in the cost of production leads to an increase in supply.

When we represent the supply schedule in the form of a graph, we get the supply curve. In the figure below, we have plotted the data given in the table. Here, it is a typical upward-sloping supply curve. At very low prices, the chocolate manufacturers might want to use their factories for producing other types of related products. But as the price of chocolates increases, the manufacturers find it more profitable to shift to chocolates. Thus higher the price of chocolates, the greater the amount of chocolates supplied. The supply curve here is represented by a smooth upward-rising curve (Figure 2.4.1). Supply Function The supply function can be written as: S = f(P, C, S, T, C, G, O)

44

Availability of alternatives The supplier can switch production to any related product depending on the economic viability of producing them. For example, Bajaj Auto, which was once the largest scooter manufacturer in India, has now stopped the supply of scooters and is focussing on motor cycles due to the stagnant demand for scooters and the high growth in the motor cycles segment. Climatic changes Climatic conditions also affect the supply of products, especially of agricultural output. When the climatic condition is favorable, production is usually more. Since most agricultural products are perishable, higher production results in higher supply. Technological advancements Technological advancements can result in using the available inputs more efficiently as well as in reducing the cost of production. Technological advancements can also make available new alternatives, which did not previously exist. Hence technology can significantly alter supply. Changes in government policies A rise in direct or indirect taxes has an immediate effect on the prices of commodities, and thus, on supply as well. Similarly, changes in export and import policies will also affect the availability of inputs for production, which, in turn, will have an impact on supply.

Change in Quantity Supplied vs. Change in Supply We need to clarify two important concepts associated with the supply, i.e., change in quantity supplied and change in supply. Change in Quantity Supplied The movement along the supply curve due to the change in price is called as change in quantity supplied. Ceteris paribus, higher is the price, higher the quantity supplied and vice versa. A change in quantity supplied, whether an extension or a contraction, refers to an upward or downward movement along the supply curve caused by price changes in the same direction, other things remaining the same. Changes in quantity supplied are also known as variations in supply. Change in Supply A change in supply, whether an increase or a decrease, refers to the shift in the supply-curve, towards the right or towards the left, caused by a change in any of the non-price determinants of supply. This distinction between a change in quantity supplied and a change in supply is important. Extension of supply is seen in the figure below by the increase in the number of units supplied at a higher price (OQ1 at price P1) and contraction of supply is seen when fewer units of the product are supplied at a lower price (OQ2 at price P2). A change in supply means that there is an increase or decrease in supply even though the price remains unchanged. We see this in the figure below, where at the same price level, an increase in supply is shown by a shift in the supply curve to the right from S0S0 to S1S1, while a decrease in supply is shown by
45

Figure 2.4.1:Quantity suppled

product at that price. If we sum up the quantities demanded by each of the buyers, we get the total demand at that price. However, if the price varies, each of the buyers will now be willing to buy a different quantity. In other words, each buyer has an individual demand curve. By summing up all these demand curves, we get the market demand curve. How do we do this? At each price, every individual buyer will be willing to buy a particular quantity. Summing up those quantities will give us the market demand at that price. We can thus calculate the market demand at various prices and plotting these corresponding quantities. The market demand curve, therefore, gives us an idea of the total quantity demanded by all the buyers in the market at different price levels.

a shift of the supply curve to the left from S0S0 to S2S2. At price P0, OQ0 quantity is supplied when the supply curve is S0S0, while OQ01 and OQ02 quantities are supplied when supply curves are S1S1 and S2S2, respectively.

Market Equilibrium
We now know that the demand and supply of any product depends on its price. Let us now see how demand and supply determine the equilibrium price. The equilibrium price is that price at which the total quantity demanded equals to its total quantity supplied. Let us assume that the market is highly competitive, with large number of buyers and sellers there. Each buyer takes the price as given and demands a certain number of units of the

In the same way, each seller in a competitive market takes the price as given and decides to offer a certain quantity for sale in the market. However, each of these sellers are willing to sell different quantities if prices vary, implying that each seller has an individual supply curve. By summing up the individual supply curves of all the sellers in the market, we get the market supply curve. From the market supply curve, we get to know the total supply by all sellers at different prices. In the Keynote 2.4.1, we plot price along the vertical axis, and market demand and supply along the horizontal axis. DD represents the market demand curve and SS represents the market supply curve. The market demand curve slopes downward while the market supply curve rises upward. The demand and supply curves intersect at the point E, where the price is equal to OP. This is the equilibrium price at which the total amount of demand equals total supply, i.e. PE.
46

Keynote 2.4.1: Market equilibrium

the price, which will result in higher demand from consumers. Again, this process will continue till the price reaches OP and all the excess supply is cleared. In short, therefore, if the price i s n o t O P, then it will m o v e towards OP. Video 2.4.2: Market Equilibrium
by Prof Dennis Meyers

N o w, if the price in t h e market is greater than OP or less than OP, total demand will not be equal to total supply. For example, if the price is OP1, then total demand is P1D1 and total supply is P1S1. Thus total supply is greater than total demand and D1S1 is the amount of excess supply. At the price OP2, total demand is equal to P2D2 and total supply is equal to P2S2. In this case, total demand exceeds total supply and excess demand is equal to S2D2. Hence if the price is greater than or less than OP, then there will be either excess demand or excess supply. If there is excess demand, then there will be competition among the buyers to get the available units, forcing them to outbid each other. This will push up the price, which will also encourage the sellers to supply more. This process will continue till the price reaches OP and the gap between demand and supply is wiped out. Similarly, in the case of excess supply, there will be competition among the sellers to clear the excess stock, forcing them to undercut each others prices. This will lower

Let us assume that D represents total demand, S represents total supply and P represents the price. Then, keeping other things constant, the demand function can be written as: D = f (P) ...... ........Eq 1

Similarly, keeping other factors constant the supply curve can be written as: S = f (P) ............ Eq 2

For equilibrium, total demand should be equal to total supply. This means:
47

D = S.... ..........Eq 3

So if non-price factors are assumed to be constant, we get three equations with three unknowns, D, S and P. By solving these three equations, we can get the values of the three unknowns. Example: Given the demand function of good X as Qd=100-

-4p and the supply function of good X given as Qs = 4+8P, estimate the equilibrium price and output of good X. At equilibrium

initial quantity demanded and supplied is OQ0 at the initial equilibrium point E0. If the market demand curve shifts to the right to a new position D1D1 while the market supply curve remains the same, then the new equilibrium point is E1 and the new equilibrium price is OP1. The new equilibrium quantity is OQ1. If we compare the two equilibrium levels, we find that the equilibrium price as well as equilibrium quantity has increased. In the same way, if the demand curve shifts to the left, while the supply curve remains the same, then both the equilibrium price and the equilibrium quantity will fall simultaneously. Fig 2.4.2: Shift in Demand v/s Unchanged Supply

Qd = Qs

Thus

100-4p = 4+8P 12p= 96 p=8

Substituting the value of p in either demand or supply function, we arrive at the equilibrium quantity as 68 units.
Effect of Shift in Demand and Supply If any of the non-price factors change, the demand curve, or the supply curve or both may shift positions. As a result, the equilibrium point will also then be shifted. Let us assume that the supply curve remains the same, while the demand curve shifts to the right. The effect of a rightward shift of the market demand curve is shown in the figure below. In the Figure, D0D0 is the initial demand curve and S0S0 is the initial supply curve. The initial equilibrium price is OP0 and the

Let us now suppose that it is the supply curve which is shifting while the demand curve remains unchanged. If it is an increase in supply, then the supply curve shifts to the right,
48

while if it is a decrease in supply, then the supply curve shifts to the left. If the supply curve shifts to the right while the demand curve remains the same, the equilibrium price will fall and the equilibrium quantity will increase. This is shown in the next figure. Here, D0D0, the initial demand curve, and S0S0, the initial supply curve, intersect at E0 where the equilibrium price is OP0 and the equilibrium quantity is OQ0. Let us assume that the supply curve shifts to the right, to S1S1. The new equilibrium position is now E1, where the equilibrium price is OP1 and the equilibrium quantity is OQ1, we find that the equilibrium price has fallen while the equilibrium quantity has increased. Similarly, if the supply curve shifts to the left, the equilibrium price will increase and the equilibrium quantity will decrease. Figure 2.4.3: Shift in Supply v/s Unchanged Demand

In the real world, several forces act simultaneously on supply and demand. In such situations, the demand and supply curves may change their positions at the same time. In that case, the new equilibrium quantity may be greater than, or less than the initial equilibrium levels, depending on the magnitude and the direction of the shift of the two curves. However, the price may remain same, or increase or decrease due to the simultaneous shift in demand and supply curve that depends on the magnitude and direction of the shift in demand and supply. For example, if both the demand and supply curves shift parallel to the right by the same amount, the equilibrium point shifts to the right by the same amount and hence the equilibrium price remains unaffected, but quantity will be increased . If the shift of the demand curve is greater than the shift of the supply curve towards right, then the equilibrium price and equilibrium quantity both will increase (Keynote 2.4.2). If the shift of the demand curve is lesser than the shift of the supply curve t o w a r d s Keynote 2.4.2: Simultaneous shift in r i g h t , Demand and Supply then the equilibrium p r i c e will decrease a n d equilibrium quantity will increase. These three situations a r e shown in the figure below (Keynote 2.4.2).

49

Government intervention
In a free market, it is assumed that the equilibrium price and output is the outcome of the market forces. But in the real world, there is no existence of free market. Absence of free market mechanism results in imbalance between demand and supply of goods and services. Whenever there is such imbalance, it gives scope for few players to exploit the market that reduces the social welfare. In this situation, there is a need for government intervention to regulate the market so as to restore or enhance the social welfare. The government can regulate the price with the help of two policy instruments such as price ceiling and price floor. Price Ceiling Price ceiling is a cap where the government fixes the price below the equilibrium price. It is done for the wider benefit of the society. In order to put a check on the rise in the prices of essential goods and services in terms of creating

artificial shortage in the market, the government intervenes in the form of price ceiling. Some examples to quote include like Rent Control Act. Rent Control Act put ceiling on rent amount to be raised from tenants. Normally, the amount fixed is on the basis of area of the property and also below the market equilibrium price. This ceiling is good for the protection of tenants, but tenants have to suffer in terms of scarcity of houses and maintenance problems. Ceiling on rent can cause scarcity of houses. It is because rent is fixed lower than equilibrium price. Another example that is appropriate in this instance is the cap imposed by the government on pharmaceutical companies. The price ceiling practice adopted by the
Keynote 2.4.3: Price Ceiling & Price Floor

government is shown in the following diagram. At point E, equilibrium is achieved where Quantity demanded is equal to Quantity Supplied. Equilibrium Price is OP and OQ is the equilibrium quantity. Price ceiling is fixed at point below the equilibrium price OP and at this price quantity supplied is
50

OQ while quantity demanded is OQ. In this instance, quantity demanded is greater than quantity supplied (OQ-OQ), thereby leading to shortage of goods and services and results in the increase in the price till equilibrium (Interactive 2.4.3).

price ceiling creates shortage. It is because as floor price is above equilibrium price, supply will be higher as compared to
REVIEW 2.4.1

Question 1 of 4 Supply in economics refers to

A. Production B. Actual sales But at the same time, price cap reduces the supply of the good as less number of suppliers are willing to supply at lower price. Price Floor Floor price is a minimum price level for a g o o d . Normally, floor price is maintained a b o v e equilibrium price. M i n i m u m support price for agriculture crops and m i n i m u m w a g e s declared by government are examples of floor pricing. Floor pricing generates surplus just like how
Video 2.4.2 on price ceiling

C. Output remaining after self-consumption by producers D. Output brought to the market for sale

Check Answer

demand. The price ceiling practice adopted by the government is shown in the above diagram.

51

S ECTION 5

Case Study:Would Housing be a Dream in the Dream City of India?

Mumbai, the financial capital of India, is one of the most expensive places to rent or buy a house. Buying a new house in Mumbai is beyond the reach of middle income group. Renting a flat in affluent neighbourhoods like Bandra, Juhu, Worli, Santacruz and Khar pinches the purse by around INR 3,000 per sq.ft./month. Both commercial and residential property prices in Mumbai have been on a steady rise. Mumbai has witnessed very high rentals especially since 2006. Mumbai turned to be one of the

most expensive cities in the world to buy or rent a condominium unit in 2007 (Exhibit I). Thousands of people go to Mumbai every year in search of jobs, as big national and international companies, which account for 70% of business transactions in India are headquartered there. Bollywood and many serial production houses are situated in Mumbai; this inspires many people to come and try their luck in the city of dreams. Thus, such huge

This case study was written by Hepsi Swarna under the guidance of Akshaya Kumar Jena, IBSCDC. It is intended to be used as the basis for class discussion rather than to illustrate either effective or ineffective handling of a management situation. The case was compiled from published sources.
52

inflow of people into the city has kept on pushing up the residential as well as commercial property prices. In Mumbai, housing supply was less than 20,000 units between 1950s and 1970s. It has since been steadily increasing in response to the increase in house prices. During 1980s, the supply of housing units crossed over 40,0001. The rich speculators of Mumbai have also added fuel to the fire of skytouching housing prices in Mumbai. In 1990s, they made huge investments in property, anticipating that in future they would reap huge profits by selling the property. The idea was to hold large amount of purchased land in their hands till the land prices increased as a result of the artificial shortage created by them. Prices have been rising unceasingly in Mumbai compared to other prominent Indian cities (Exhibit II). This has driven the builders to undertake many housing projects to reap the benefits of high property prices. Mumbai and its suburbs in 2008 witnessed more than 12 crore sq.ft. of projects going in full2throttle.

Table 2.5.1: Growth in Residential Property prices in some of the cities of India
CITY 2001
*

2002 2003

2004

2005

2006

2007

Delhi Bengaluru Mumbai Bhopal Kolkata

100 106 100 133 100 116 100 120 100 115

129 170 132 136 129

150 224 149 154 148

201 275 178 179 172

269 272 224 192 180

298 313 268 260 237

*2001 is the base year at 100 Source: Compiled by the author from National Housing Bank website http://www.nhb.org.in/

53

A BBC estimate3 in 2006 has put the annual requirement of houses for Mumbai at 84,000, while the combined offer by government and private players can at best be 55,000. This Keynote 2.5.1 City Center Condo Prices inUS$

Most of the supply is targeted towards higher-income household so that the builders and contractors can secure high margins on supply of high-end houses. This makes housing unaffordable for 56% of people in Mumbai, who have an annual income below INR 2 lakh. The shortage in housing has led to the emergence of poor quality housing like slums. Dharavi , a slum in Mumbai is Asias largest slum, and it is situated right next to Bandra-Kurla Complex Mumbais prime business districts. This is the ultimate paradox in the city of Mumbai, coexistence of slums and posh penthouses side by side. The demand for more houses in Mumbai and its suburban areas resulted in appreciation of property prices, which incentivised the property developers to scout for new land sites for construction of more houses. Navi Mumbai is the result of such an endeavour. From 2005, several IT and Information Technology Enabled Services (ITES), financial services, pharma, telecom companies and other commercial projects started expanding their operations in Mumbai. This resulted in the increase in Central Business Districts (CBDs) rentals. Nariman Point witnessed an annual rental growth of 60% in 2008. The Economic Times reported that Mumbai continues to be plagued by a surge in demand accompanying the lack of vacant space at required locations. This has led to a phenomenal increase in rentals similar to what was witnessed in the early 1990s.
6 5 4

deficiency in supply keeps on propelling the property prices to new heights every year. One of the reasons behind deficiency in supply is that Mumbai is densely populated (Exhibit III) and this leaves not much land to build houses.

In November 2008, Housing Development Infrastructure Limited (HDIL) predicted that property prices of Mumbai will fall in the range of 10%15% on account of the onset of the global
55

recession.7 The Keynote 2.5.2 Supply of Mumbai rentals have House already been hit hard. On an average, rents have dropped by nearly a quarter in the last quarter of 2008. In some prime commercial properties in the erstwhile mill land enclave of CentralMumbai,the drop is as huge as 50%8. Such drops in property values in Mumbai arediscouraging developers from expanding their construction activities. In November 2008, leading real estate developers of Mumbai held a meeting and decided against launching new residential projects in view of the slowdown.
9

also some non-price factors, which influence the supply of housing units (Exhibit IV) In Mumbai, developers make a lot of money, which is far above the cost of producing a house. The cost of constructing a flat is around INR 1,000 to INR 2,000 per sq.ft., but the sale price of a flat is multiples of the cost of producing a flat. Moreover, builders sell flats on the basis of super built-up area , which is around 30%40% over the carpet area and in some cases it is even 60%. This enables them to make enormous profits. There have been growing complaints from the consumers who had been cheated by the builders, as there is no law or regulation, which defines the minimum carpet area to be delivered by the builder. In order to clarify the concept of carpet area and make the builders in Mumbai more accountable, the State government is most likely to bring in the necessary legislation for the purpose in 2009. Steel, cement and labour account for nearly 40% of a projects costs. In August 2008, these costs increased by 50% over the last 12 months. The high interest rates have also increased the production costs of the real estate companies all over India. Such increases in the input prices have forced real estate companies to source cheaper materials, use more advanced technology to reduce construction time and slash overheads
12 11

Sanjay Dutt, CEO of Jones Lang LaSalle Meghraj, a global real estate services and money management firm, revealed in March 2009 that lot of upcoming projects, both in commercial and residential real estate have been put on hold due to the recession. There is at least 15 million square feet of commercial real estate blocked across Mumbai and Thane. In the retail space work on around 23 million sq. ft. of space has been stalled while residential projects are in go-slow mode.10 Non-pricing Factors Influencing Supply of Houses in Mumbai Besides the change in housing prices and rentals that bring about a change in quantity supplied of housing units, there are

so that the supply of houses is not hindered.

The spurt in demand for commercial property has increased its price phenomenally. More and more MNCs and foreign investors are showing interest in setting up companies in Mumbai due to its strategic location. Continuous growing
56

demand for office space is prompting builders to set up huge number of premium commercial establishments. Commercial property in peak times can fetch up to 34 times the rate of residential property, and not less than twice in stable times. Government policy also influences the supply of houses in Mumbai. Registering property transactions in India is slow and cumbersome as many properties lack clear titles. Property valuation is not standardised. Urban Land Ceiling and Regulation Act (ULCRA), which was constraining the housing supply in Mumbai, was repealed in November 2007 and as a result around 500 hectares (1,234 acres) of land was made available for development including housing development. The density regulation in Mumbai has a bearing on available built space. This results in a reduction in the supply of housing units. Rent Control Act of Mumbai has put another limitation on the rental housing supply in Mumbai. Analysts feel that amending the Rent Control Act will help in solving the housing problem in Mumbai in a big way. While some opine that a reduction in the supply of housing will spike the price of housing units, some others cling on to the hope that spike in the housing prices will eventually promote supply of more houses and supply of more houses will lead to drop in their prices. Behind these variations in reasoning, lie a lot relating to ones understanding of the shape and shift of the supply curve Footnotes 1. Nallathiga Ramakrishna, The Impacts of Density Regulation: A Case Study of Mumbai,

http://www.europaforum.or.at/site/ Homepageifhp2003/downloads/FullPaper_Nallathiga.pdf, October 5thOctober8th 2003, page 5 2. I m p a c t o f r e l e a s e o f M i l l L a n d i n M u m b a i , http://www.accommodationtimes.com/25thmay/studentproj ects/ impact_of_release_of_mill_land_i.htm, August 14th 2008 3. Chadha Monica, Mumbai houses priced out of market, http://news.bbc.co.uk/2/hi/south_asia/6132846.stm, November 11th 2006 4. Affordability of houses in Mumbai down 50% in 3 yrs: study, http://www.financialexpress.com/news/Affordability-ofhouses-in-Mumbai-down-50-in-3-yrs-study/277323/, February 26th 2008 5. UnniKrishnan Rajesh, Mumbai ahead of Paris & New Yo r k i n o f f i c e r e n t a l s , http://economictimes.indiatimes.com/PersonalFinance/Property/Commercial/Mumbai-ahead-of-Paris New-York-in-office-rentals/articleshow/2781326.cms, February 14th 2008 6. Ibid. 7. Gonigal George, The Ups and Downs of Mumbai Properties, http://www.buzzle.com/articles/the-ups-and-downs-of-mu mbai- properties.html, November 8th 2008
57

S ECTION 6

Measurement of Elasticity
Elasticity measures the responsiveness of one variable with respect to changes in the other variable. Elasticities are often used in demand analysis to measure the effect of changes in demand determining variables. The concept of elasticity is also used in production and cost analysis to determine the effect of changes in input on the output and the effect of output changes on costs. It is also extensively used in the context of advertisement to examine the effect of changes in advertising expenditure on sales volume. The concept of elasticity of demand is also used in the contexts of international trade, government taxation policies, etc. The elasticity can be measured in two ways, i.e., point elasticity and arc elasticity. Methods of measuring elasticity There are mainly 3 methods of measuring elasticity such as Percentage method, Point method and Arc method. Percentage method: It measures the percentage changing dependent variable (Y) due to the percentage changing independent variable (X). Usually the formula used for calculating elasticity (E) is:

Point Elasticity measures the elasticity at a given point on a function. The point elasticity is used to measure the effect on a dependent variable (Y) due to a very small change in independent variable (X).

Arc Elasticity is the measure of coefficient of elasticity between two points on a curve. In other words, Arc elasticity measures the percentage change in dependent variable

58

(Y) due to a percentage change in independent variable(X). However, the point elasticity measures the effect of change on Y due to a small change in X, while Arc elasticity measures the effect on Y due to a large scale change in X. The Arc elasticity formula eliminates the problem of deciding which end of a given range is to use as a base, and measures the relationship between the two variables over a range of data.

Price Elasticity of Demand

The price elasticity of demand measures the responsiveness of change in quantity demanded due to change in price keeping, other things being unchanged. The price elasticity of demand is also otherwise called as Own Price Elasticity of Demand. The own price elasticity of demand for a good X, normally denoted by ed, is defined as:

When a change in dependent variable is equal to the change in the independent variable, then elasticity is equal to one (E = 1) and it is called Unit Elasticity. When elasticity is greater than one (E >1), it is said to be relatively elastic, implying that the resultant change in x is greater than the change in y which caused it. When elasticity is less than one (E < 1), it is said to be relatively inelastic, indicating that the resultant change in x is less than the change in y. When elasticity is equal to zero (E = 0), it is said to be perfectly inelastic and changes in y will have no effect on x. Elasticity can be infinity (E = infinity) or perfectly elastic when a unit change in y will have infinite effect on x.

Since price and quantity are Video 2.6.1: Elasticity of inversely related as per the law Demand of demand, the coefficient of the price elasticity of demand is a negative number. Thus to avoid the negative value, a minus sign is often introduced into the formula of the price elasticity of demand. Hence the absolute value of the price elasticity of demand can be greater than 1 or less than one. The own point price elasticity of demand for a good X is mathematically expressed as:

59

The formula of the Arc Price Elasticity of demand is given hereunder:

Keynote 2.6.1: Type of Price Elasticity

Type of Price Elasticity of Demand (see also Interactive 2.6.1) Perfectly price elastic demand (ed = ): The demand is said to be perfectly price elastic if the the absolute value of own price price elasticity is infinite. Relatively Price elastic demand (ed > 1) : The demand is said to be relatively price elastic if the the absolute value of own price price elasticity is greater than one. Unitary Price elastic demand (ed= 1) : The demand is said to be unitary price elastic if the the absolute value of own price price elasticity is equal to one. Relatively price inelastic demand (ed < 1):The demand is said to be relatively price inelastic if the the absolute value of own price elasticity is less than one. Perfectly price inelastic demand (ed = 0): The demand is said to be perfectly price inelastic if the absolute value of own price price elasticity is zero. Example: 18,000 duplexes were sold in Hyderabad at Rs. 30,00,000 per unit in March 2012. Two months later, price of duplex in Hyderabad surged to Rs.32,00,000 per unit. As a result, the number of duplexes sold declined to 16,000 units. During the above period, all the determinants of demand for housing in Hyderabad city were stable. Given the above information, estimate the point price elasticity of demand and arc price elasticity of demand. In the above example P1=30,00,000 P2=32,00,000 Q1=18,000 Q2=16,000 Q= -2000 P=2,00,000 Inputting the above values in the point price elasticity formula, we have,

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Point price elasticity of demand=

( 6 )

Keynote 2.6.3: Price elasticity and Revenue Relationship

product and habit formation (Keynote 2.6.2).

Inputting the above values in the arc price elasticity formula, we have, Arc Price Elasticity=

Factors Determining Price Elasticity of Demand There are a Keynote 2.6.2: Factors Determining wide array of Price Elasticity of Demand factors determining price elasticity of demand. The major factors which are affecting the price elasticity of demand are: (1) availability of substitutes (2) Closeness of substitutes (3) Proportion of income spend on the product (4) time period (5) uses of the
TABLE 2.6.1:RELATIONSHIP BETWEEN PRICE ELASTICITY OF DEMAND AND TOTAL REVENUE PRICE ELASTICIT Y Elastic Demand Unitary Elastic Demand Inelastic Demand DIRECTION OF PRICE CHANGE Increase Decrease Increase Decrease Increase Decrease EFFECT ON TOTAL REVENUE Decrease Increase Remains Unchanged Remains Unchanged Increase Decrease REASONS MR>0 MR>0 MR=0 MR=0 MR<0 MR<0

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Relationship between Price elasticity of Demand & Revenue

to its own price, then an increase in the price of that product reduces its consumption more than proportionately, resulting in a reduction in the overall revenue of the firm from that product. On the other hand, if the own-price elasticity of demand is inelastic in nature, then, an increase in price will have a positive effect on the total revenue of the firm from that product. If the own-price elasticity of demand is equal to one, then it should be clear by now that neither an increase in the products price nor a decrease in its price will change the revenue that the firm gets from that product. Pricing Regulation by Governments In India, government bodies do play some role in the pricing of products in some sectors such as agriculture and infrastructure. For instance, government fixes floor prices, called Minimum Support Prices, for farmers to ensure that their incomes do not fall below a certain minimum even if market prices fall. Due to inelastic demand, a fall in prices do not lead to consumers buying more grain. Hence falling prices could severely affect the farmers income in the absence of floor prices fixed by the government. One step further, if the government wants to encourage higher supply of grains and more farmers, it can raise the minimum support price even higher. Due to inelastic demand, even at high prices, quantity demanded will not fall significantly, thus raising the income levels of the farmers. Currency Devaluation and International Trade When a country faces a highly unfavorable balance of payments position due to rising imports and stagnant exports,
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The table depicts that, in the price elastic demand range, total revenue increases with reduction in price, as marginal revenue is positive. While in the price inelastic demand range, total revenue decreases with price reduction, as MR is negative, total revenue attains its maximum, where price elasticity of demand is unitary and the marginal revenue contribution after that point is negative (Keynote 2.6.3 and Table 2.6.1).

Applications of Price Elasticity

Price elasticity of demand plays an important role in the pricing decisions of business organizations. The government too has to take it into consideration when it regulates certain prices. It even helps in judging the effect of a depreciating currency on export earnings of a country. Decisions of Business Organizations Before taking any decision regarding the price of a product, one of the crucial factors to be considered is the price elasticity of demand for that product as the change in the price of that product changes its quantity demanded depending on its price elasticity. If a product has relatively elastic demand with respect

the government of that country may eventually decide to devalue its currency. One of the factors that the government should take into consideration here is the price elasticity of demand for the goods that the country exports. If the demand for that countrys exports is price-inelastic, currency devaluation will only further reduce the foreign-exchange value of that countrys exports as only the foreign price of the exported products will fall and there is no comparable increase in the quantity exported. On the other hand, if the demand for a countrys exports is elastic, a reduction in the foreign price due to devaluation increases the demand. This may result in an increase in foreign exchange inflows, helping the country reduce the gap in the balance of payments. Fiscal Policy The government mainly raises its income through imposing taxes. Taxes are, broadly, of two types direct and indirect. Often, the government tries to raise income through indirect taxes such as excise duty or sales tax, which raise the price of the product for the consumer. If the government is increasing the tax on an elastic good, the rise in price reduces the demand for that commodity, which will not help the government increase its revenue. The government can increase its revenue through raising indirect taxes only when the taxes are imposed on those products whose demand is inelastic.

Cross-price elasticity of demand is the percentage change in the quantity demanded for one product to a percentage change in the price of a related product, other factors remaining unchanged. Cross-price elasticity can be positive or negative, based on the change in the price of a substitute or complementary products. If the two products are substitutes, the value of cross-price elasticity will be positive. If they are complements, the value of cross-price elasticity of demand will be negative. For example, let us assume that Pepsi and Coke are close substitutes for many consumers. If the price of Pepsi increases, some of these customers may switch to Coke. The change in the price of Pepsi and demand for Coke are now moving in the same direction, and hence, the cross-price elasticity is positive. On the other hand, complementary products like petrol-run cars and petrol have negative cross elasticity. If the price of petrol significantly increases, the demand for petrol-run cars fall, while the demand for diesel-run cars may increase. Since the price of petrol and the demand for petrol-run cars move in opposite direction, their cross-price elasticity would be negative. Let us assume that the quantity demanded for two products X and Y are Q1 and Q2 and they are priced at P1 and P2 respectively. The cross-price elasticity of demand of product X with respect to price of Y is the % change in the quantity demanded due to the % change in price. This can be mathematically denoted as:

Cross-Price Elasticity of Demand

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like may increase. So considering the cross elasticity of demand, HUL will fix appropriate prices for all its soaps. Firms operating in the same industry will have products with a positive cross elasticity of demand, as these products are likely to compete with each other for market share. For example, Procter & Gamble (P&G) and HUL have products in fabric and home care segments, which have a positive cross elasticity of demand between them. Hence if HUL plans to increase the price of Surf Excel, a washing detergent, the demand for P&Gs products like Ariel and Tide may increase.

Application of Cross-Price Elasticity of Demand: The knowledge of cross-price elasticity of demand is very important in managerial decision-making for developing an appropriate price strategy. Cross-price elasticity helps the firm to understand the degree of substitutability and complementarity exist within the firms own products or services. The Cross-price elasticity of the firm with its competitors products or services helps in measuring the degree of competition in market place. If Cross-price elasticity of the firms products or services in the related industry is large and positive, the firms may face stiff competition in the market Firms selling multiple products use cross-price elasticity of demand to analyze the effect of change in the price of one product to the demand of others. For example, Hindustan Unilever Limited (HUL), the leading fast-moving consumer goods manufacturer, offers several soaps Breeze, Dove, Hamam, Lux, Liril 2000, Lifebuoy, Pears, Ponds and Rexona. Many of these soaps are good substitutes for each other and therefore, cross-price elasticity of demand among them is likely to be high. If HUL increases the price of Lux significantly, the demand for Lux may go down while the demand for other soaps

Income Elasticity of Demand

An increase in real income increases the demand for products, other factors, especially price, remaining unchanged. Income elasticity of demand for a product is the percentage change in demand for that product divided by the percentage change in the consumers income. It is presented as follows:

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Food and other necessities are likely to be income-inelastic. According to Engels law, the proportion of income spent on food products declines as the level of income increases, even if the actual expenditure on food products rise. On the other hand, luxury items are highly income-elastic. Products and services having income elasticity of demand above one are called income elastic. In other words, those goods and services which tend to be in greater demand with rising incomes are income elastic. For example, air travel, fine-dining, movies at multiplexes and other such services are ones on which people spend more as incomes rise. Products and services with income elasticities between zero and one are called income inelastic goods. For example, consumers are not likely to spend much more on newspapers even if their incomes rise significantly. On the other hand, the demand for certain products and services actually reduces when the consumers income levels rise. These are known as inferior products and the income elasticity of demand for such products and services is negative. Inferior goods are any goods which are given up in favor of better ones as the better ones become affordable. Most low-end brands of household products and coarse cereals are inferior products. These are goods that consumers eventually will stop buying as their income increases. Income elasticity of demand depends upon several factors like the nature of the product, the existing level of development in the country and the time-period taken into consideration. Hence income elasticity of demand can be used to classify products into luxuries or necessities. If the income elasticity of a product is greater than one, it can be called a luxury, while if the income elasticity of a product is less than one, it can be called a necessity. Products for which the income elasticity is around one are called comfort goods, which may be necessities in some contexts and luxuries in some other. The categorization of products into luxuries or necessities depend on the level of development of the country. A mobile phone, which can today be considered a necessity in India, is still a luxury in most of Indias neighboring countries. On the other hand, ownership of a car is considered a luxury in India, but in many cities of the United States, a car is almost a necessity. A crucial fact to be kept in mind, while looking at the income elasticity of demand, is that consumption patterns of consumers generally adjust with a time lag to changes in income and not immediately. It is also seen that, in general, consumers adjust their consumption to rising incomes more quickly than to falling incomes. Since it is always more difficult for the consumer to adjust to a fall in income, demand may be seen as income-inelastic in the short-run, whereas in the long-run, the full effect of fall in income may be seen. In the case of a rise in income, demand may be seen as highly
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income-elastic in the short-run and the elasticity may marginally come down as consumption pattern stabilizes. Application of Income Elasticity of Demand The demand for luxury products fluctuates much during different phases of economic cycles. During a period of growth and rising incomes, demand for luxury products increases significantly, while during an economic slow-down, the demand for these products decline. The firms producing products, which have a high income elasticity, have great potential for growth in a growing economy. The concept of income elasticity of demand also helps a firm to decide its location and develop its marketing strategies. For example, the firms producing goods having high-income elasticity of demand will try to locate its retail outlets where the incomes of consumers are increasing rapidly. Moreover, these firms will direct their advertisement to those segments of people having high incomes and who are part of sectors which are growing faster than the average. Advertising or Promotional Elasticity of Demand One can have measures of elasticity of demand with respect to each of the determinants of demand. Advertising is a determining factor, the effect of which on demand is of utmost interest to most firms. While advertising plays an important role in the competitive market economy, it also involves costs. Hence having a measure of the advertising elasticity of demand for a particular advertising campaign or with respect to annual advertisement expenditure is extremely useful. Advertising elasticity of demand measures the extent of

change in the quantity demanded of a product with respect to the change in expenditure on advertisements and other promotional activities. The advertising elasticity of demand can be measured in the following manner:

where,

Q = Quantity of a product Z sold, and

A = Units of advertising expenditure on the product Z Like all the other measures of elasticity of demand that were discussed earlier, the above measure of advertising elasticity of demand is also an example of point elasticity. In all the previous cases too, we have considered elasticities at a particular point on the demand curve. However, this throws up a particular problem when calculating percentages. An increase from 80 to 100 will be a 25% increase, whereas a decrease from 100 to 80 will be a 20% decrease. Since elasticities are measured using percentage changes, this could result in two different measures of elasticity over the same range, only depending on the direction of movement. Especially since advertising expenses are regularly changed, this could be a serious concern. This can be solved by measuring the arc elasticity of demand, which is elasticity calculated over the range. The advertising elasticity of demand can be measured as arc elasticity using the following formula:
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where, the subscript 1 denotes the initial values and the subscript 2 denotes the end values. It must be noted that arc elasticity measures can similarly be calculated for each of the determinants of demand that have been discussed earlier. Advertising elasticity of demand is likely to vary from segment to segment and product to product. In fact, even the same product may not respond in the same manner to different levels of advertising expenditures. There are several determinants of advertising elasticity. Advertisements of durable products usually take longer time to have an impact because the consumers will buy new products usually only when the ones they currently own becomes unusable or obsolete. Similarly, a product which is new in the market may see results of advertisement much later than an established product. Advertising elasticity of demand also depends upon how a firms competitors react to its advertising campaigns. The extent of impact on the advertising and its revenues of a firm will depend on the past and present advertisement campaigns carried by that firms competitors.

Price Elasticity of supply refers to the percentage change in quantity supplied of a product due to a one-percent change in its price. This can be denoted in an equation form:

ES = Elasticity of supply of a product, Q = Original quantity supplied of the product;

Q = Change in the quantity supplied; P = Original price of the product;

P = Change in the price. When the change in the quantity supplied changes more than proportionate change in price, the supply is elastic. On the other hand, if the change in the price leads to a less than proportionate change in quantity demanded, the supply is inelastic. we can also calculate Arc price elasticity of supply by using the arc elasticity formula. References Elasticities of Demand

Price Elasticity of Supply

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REVIEW 2.6.1
Question 1 of 8 __________ indicates the changes in consumers purchasing habits, depending on the price variation of a particular product.

A. Total utility curve B. Demand schedule C. Production possibility curve D. Purchasing power parity

Check Answer

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S ECTION 7

Case Study: Mobile Telephony in India Mobile Telephony in India: Would Cheaper Rates Bring More Profits?

GALLERY 2.7.1 Mobile Penetration

On August 23rd 1995, Jyoti Basu, the then Chief Minister of West Bengal, made Indias first cellular phone call to Telecom Minister, Sukh Ram, from Kolkata on Modi Telstra network at INR 16/minute. I n i t i a l l y, I n d i a n g o v e r n m e n t imposed a heavy license fee for providing mobile services. To recover such huge license fee, mobile operators had no choice but to keep very high tariff rates. Thus, the growth of cell phone services was sluggish in the first few years due to high price of

handsets and high tariff structure. An average handset was costing around INR 15,000; outgoing and incoming call rates were INR 16/ minute and INR 8/minute respectively. Because of these reasons very few customers at that time were willing to jump on to a new revolution, called the mobile telephony. Up to mid1990s mobile phones were used only by the affluent. Only 3,000 people possessed mobile phones in 199596 (Keynote 2.7.1).

This case study was written by Hepsi Swarna under the direction of Akshaya Kumar Jena, IBSCDC. It is intended to be used as the basis for class discussion rather than to illustrate either effective or ineffective handling of a management situation. The case was compiled from published sources.
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Keynote 2.7.1: Growth in Mobile Subscriber Base in India

million to 90 million within a span of 7 years from 19992006 (Exhibit 2.7.1). An estimate at the end of 2008 shows the mobile subscriber base in India at 346.9 million.1 Exhibit 2.7.1

Source: Singh K. Sanjay,The Diffusion of Mobile Phones in India.

Even 4 years later, when the Government planned to introduce a new telecom policy called NTP 99, mobile subscribers in India numbered less than 2 million. The mobile phone industry was in heavy losses. In 1999, with the introduction of a new telecom policy by the Government of India, the telecom industry moved to a revenue sharing regime. The license fee was reduced, which helped in the reduction of call rates by 60%. More importantly, incoming calls were made free. The fall in call rates increased the number of mobile subscribers in the following years. The mobile subscriber base in India has risen from less than 2

The fall in prices of mobile handsets also contributed to the increase in mobile usage. In 2005, 32 million handsets were sold in India, as handsets were available for as low as INR 2,000. It was reported that from July 2006 onwards 5 million handsets2 were sold monthly and in 2008, India stood as the second largest market for handsets in the world, when handsets were available for even INR 1,000. In March 2008, India had the second highest minutes of usage per month, only next to US (Keynote 2.7.2). Thus, the mobile phone, which once was a rich mans toy became affordable even by the common man. International Telecommunications Union opines, The ever-growing rate of subscriber base in India is driven by cheap call rates, low-end handsets and network expansion spree.3

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Keynote 2.7.2 Minutes of Usage per Month (2008)

households by 5% increases mobile phone services to the extent of 0.638%6, which makes mobile a normal necessity rather than a luxury good. With the rise in their income, by the beginning of 2005 the Indian customers started demanding for stylish phones.The trend continued over the years and in 2008, it was reported that Indians with income patterns rising, were increasingly wishing to be seen with smart mobile handsets. As mobile service providers turned innovative, offering tariff plans like lifetime validity pre-paid cards (aimed at low-income group), cheap handsets with loads of features, internet and online payment facilities, more and more Indians started demanding more and more mobiles. The tremendous growth of mobile phones has adversely affected the subscriber base of fixed phones in India. Fixed phones per mobile decreased from 5.87 in 20012002 to 0.25 in 20062007 (Keynote 2.7.3).
Keynote 2.7.3: Fixed Phones per Mobile Phones in India

Source: Brahmadhandi Vivek and Soans John, Indian Telecom Industry.

An estimate by Vodafone Public Policy series in January 2009 revealed that demand for mobile phones is highly sensitive to price with a negative relationship. The own-price-elasticity of mobile phones is minus 2.12, which implies that a 10% price increase would reduce demand by roughly 21%.4 Price elasticity of demand is a negative number because of inverse relationship between price and quantity demanded. The above Vodafone estimate also showed that demand for mobile phones in India is positively correlated with increase in income. The income elasticity of demand for mobile phones is estimated to be 2.455 and this makes mobile a luxury in the technical sense of economics. A study using household sample survey data from Karnataka, a state in South India has, however, found out that a rise in monthly income of

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A study7 using household sample survey data from Karnataka estimated that an increase in access price8 of fixed phones by 5% would increase subscriptions for mobiles phones by about 0.3% while increase in usage price9 of fixed phones by equivalent percentage would increase subscriptions by 10.6%. Thus, the increase in usage price of fixed phone has a larger impact than the increase in access price. The cross price elasticity between fixed and mobile phones is positive, implying substitutability. On the count of access price, the magnitude of cross price elasticity is, however, very small implying that the prices of fixed phones do not have much impact on the demand for mobile phones. Demand for mobile phones is thus almost independent of fixed phone prices. There are many reasons for this. It is very easy to get a mobile connection. More importantly, one can be contacted anytime, anywhere. Airtel, Indias largest mobile service provider, underscored this point by flashing an advertisement where a girls plane crashes in a jungle; and when she thinks there is no way of contacting anybody, she looks at her mobile, sees Airtel signal still strong and then makes the life saving call. Mobile comes with loads of features, which an ordinary fixed phone does not have. Price Elasticity of Demand for Mobile Phones and Revenue Demand for mobile phones in India is price-elastic as a 10% price increase is found to have reduced demand for it by roughly 21%. When mobile service was introduced in India, only the affluent could afford it, owing to high call rates. All the

mobile players were incurring huge losses, and then it became very clear that volumes only could bring profitability. And volumes in a price conscious country like India could be achieved by reducing the call rates. Gradually mobile carriers started shifting their focus to mass markets by reducing the tariffs by around 93%. A call that used to cost INR 16/minute now costs INR 1/minute and sometimes even less than that. This has resulted in decreasing Average Revenue Per User (ARPU) for the companies. But in spite of decreasing ARPU, the telecom sector in Indiagenerated total revenue of INR 867.2bn in 2004-05, an increase of revenue by 21% from 2003 to 200410. Manoj Kohli, Joint Managing Director, Bharti Airtel opines, at a tariff of one and half cents per minute, it offers a reasonable margin, which has flabbergasted the world.11 The falling tariffs of sms have increased the sms volumes in India from Keynote 2.7.4 SMS Volumes in India (2004-2010)

12.3bn in 2004 to 89.4 bn 2008 (Keynote 2.7.4). It is being predicted for 2009 and 2010 that sms volumes will continue this increase in trend and rake in increased revenue.
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With falling call rates, the subscriber base has increased exponentially. This has given the carriers the benefits of economies of scale and ensured them profits. Still a large part of Indias consuming power, like the rural areas remain untapped. The declining ARPU during the period March 2007 March 2008 indicates that India is tapping a large market of low-income households by reducing the tariffs (Exhibit 2.7.2) Exhibit 2.7.2 Declining ARPU (March 2007-March 2008)

Footnotes 1. India welcomes 2009 with 346.9Mn mobile sub scrib ers,http://www.itu.int/ITU-D/ict/newslog/India+Welcomes +2009+With+3469Mn+Mobile+Subscribers. aspx, January 28th 2009 2. Mani Sunil, Growth of Indias telecom Services (1991 -2007): can it lead to emergence of a Manufacturing Hub ?,http://poverty.development gateway.org /uploads/ media/poverty /Griowth%20of%20Indias%20Telecom%20 Services.pdf, page 45 3. India Welcomes 2009 with 346.9 Million Mobile Sub scribers,http://wireless federation.com/news/ 14151-india-welcomes-2009-with-3469mn-mobile- subscribers/, January 22nd 2009 4. I n d i a : T h e I m p a c t o f M o b i l e P h o n e s , http://72.14.235.132/search?q=cache:iIcMvHoqhCgJ:www .vodafone.com/etc/medialib/public_policy_series.Par.5657 2.File.dat/public_policy_series_9.pdf+india,+impact+of+m obile+phones&cd=1&hl=en&ct=clnk&gl=in, January 2009, page 16 5. Ibid., page 17

Whether further lowering of call rates will ring profits for the mobile telephone sector of India remains an open-ended issue. While the key to understanding this issue lies in measuring the elasticity of demand and probing its relationship with the revenue, this is often forgotten, leading to faulty reasoning and false debates.

6. Narayana Ranganathan Muttur, Substitutability between Mobile and Fixed Telephones: Evidence and Implications for India, http://www.e.u-tokyo.ac.jp/cirje/research/dp/2008/2008cf5 50.pdf, March 2008, page 14
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7. India:The Impact of Mobile Phones, op.cit., page 16 8. Access price comprises onetime installation charges and monthly rentals. 9. Usage price refers to the call rates. 10. Mobile Phones India, http://www.factsabout india.org/mobile-phones-india.htm

11. Gopalan Krishna, Action hotting up once again in In dian telecom, http://www1.economictimes. india times. com/ articleshow/msid-3606382,prtpage-1.cms, October 17th 2008

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C HAPTER 3

Theory of Consumer Behavior

This chapter discusses the utility maximizing behavior of the consumer both in the context of Marshallian utility analysis and Hicksian indifference curve analysis. Under Marshallian utility analysis, the concept of total utility, marginal utility, the law of diminishing marginal utility and the law of equimarginal utility are discussed. Under the Hicksian ordinal utility analysis, the concept of indifference curve, its properties, budget constraint, marginal rate of substitution and consumers equilibrium are discussed.

http://www.senature.com/wp-content/uploads/2012/03/shopping-supermarket3.jpg

Section 1

Marshallian Utility Analysis

The consumer, the basic economic unit of consumption, is assumed to reveal the tendency of allocating the given resources among the different alternatives so that maximum utility is obtained. Hence the most important objective of a consumer is to choose the good or goods which yields maximum satisfaction. It is accomplished through the use of Marshallian utility analysis. The Marshallian utility analysis is based on the following assumptions: Consumers must be rational Consumption must be continuous Units of the commodity must be homogeneous Utility is expressed in monetary terms Constant marginal utility of money.

Video 3.1.1: Choice and Utility Theory

The concept of utility refers to the level of satisfaction derived from consumption of a good. However, utility does not always mean satisfaction. Even though utility is a psychological phenomena, it has been treated cardinally by Alfred Marshall and hence known as Marshallian utility analysis.

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is the change in consumption of commodity X by one Measurement of Utility From millions of things that are available, the consumer manages to sort out a set of goods and services to buy. While making choices, the consumer makes specific judgment about the relative worth of things that are very different. During Nineteenth century, the weighing of values was formulated into a concept called utility. Alfred Marshall has measured utility in cardinal terms. The measuring unit of the utility is termed as Utils under the Marshallian utility analysis. In short utility can be quantified in cardinal terms such as 1,2,3, ..n etc. In the cardinal approach, the magnitude of differences in utility is significant. This approach assumes that the utility derived from a particular good is not dependent on the utility derived from other goods. In other words utility from each unit is additive. It is important to distinguish between Marginal Utility (MU) and the Total Utility (TU). MU is defined as the additional utility gained by the consumption of one more unit of a good or service. In other words marginal utility is defined as the rate of change of total utility with respect to change in consumption by one unit. It can be written as unit. Total utility is the total amount of satisfaction obtained from the consumption of all units of good or service during a given period of time. In other words, total utility is the sum of all the marginal utilities. It can be written as

Table: 3.1.1 Total and Marginal Utility schedule Quantity of a Good Consumed (X) 0 1 2 3 4 5 6 Marginal Utility (X) 5 3 2 0 -1 -2 Total Utility (X) 0 5 8 10 10 9 7

is the change in total utility.

Here, in the table 3.1.1, when the first two units of a good are consumed total utility increases. When the the third unit is consumed, total utility reaches its maximum point 10. The utility remains constant even after the consumption of the
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fourth unit. But when the consumer starts consuming the fifth and sixth unit of the good, total utility reduces. In the figure 3.1, it shows point A and B with increasing total utility. Total utility reaches its maximum at the point D. A further increase in consumption (fifth and sixth unit) shows that the total utility diminishing and TU curve starts declining. The relationship between TU and MU is shown graphically in the figure 3.1.1. The theoretical relationship between TU and MU can be summed up as follows: At zero consumption, TU is zero and MU is undefined As consumption increases MU for each unit diminishes, but TU increases

TU becomes maximum when MU is zero. TU diminishes when MU is negative.

Law of Diminishing Marginal Utility

As seen from the above Video 3.1.2: Diminishing example, the marginal utility Marginal Utility from each successive unit consumed goes on diminishing. In 1980, Alfred Marshall called this familiar and fundamental tendency of human nature the law of diminishing marginal utility. It states that when a consumer consumes more and more identical units of a commodity during a particular time period, the marginal utility from each successive unit goes on diminishing. Consumers Equilibrium: The law of diminishing marginal utility is used to explain the consumers equilibrium position in case of One commodity is consumed More than one commodity is consumed. Consumers equilibrium refers to a unique position from where the consumer does not want to change his/her consumption. In other words, at equilibrium point the consumer, by allocating
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Table:3.1.2 Consumers Equilibrium (One Commodity) Units of Commodity X Price of X (Px) 0 1 2 3 4 5 5 5 5 5 5 5 MU (x) (In Rupees) 15 10 5 0 -3

Equi-Marginal Utility The consumers resource allocation problem for more than one commodity case can be explained with the help of law of equi-marginal utility analysis. Equi-marginal utility principle states that a consumer will attain equilibrium in allocating his/ her given money income on different goods (say two goods) given the market prices of these goods when the ratio of marginal utility to the price will be equal for each commodity. For the two commodity X and Y.

the given resources among different goods at given market price yields maximum utility. For one commodity case, the utility maximizing principle states that the consumer will attend equilibrium position when MU derived from the unit of the good equals to the price of that unit. In the Table 3.1.2, it is seen that the price per unit of the commodity (x) is Rs.5. The MU of the commodity is measured in monetary terms. The consumer in the beginning derives more MU than the price, i.e., MU > P. Hence the consumer continues the consumption till the point MU equals price, i.e., MU(x) = P(x). Beyond that the consumer does not go because MU < P. According to the example, the consumer attains equilibrium by consuming 3 units of the commodity X. He does not go beyond that because marginal utility will be less than price.

Table:3.1.3 Consumers Equilibrium (Two Commodity) Units of X 0 1 2 3 4 5 6 7 Price of X (Px) 5 5 5 5 5 5 5 5 Price of Y (Py) 4 4 4 4 4 4 4 4 MUx 25 18 15 8 -2 0 -6 MUy 40 31 27 20 12 2 0

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The conditions of equilibrium is MUm is marginal utility of money. For n commodity, the condition is = MUm

= MUm

Criticisms of Cardinal Utility Analysis: Utility, being a psychological concept, cannot be measured. Utility analysis does not explain the components of price effect . Cardinal utility cannot be applied if consumption is not continuos. Marginal utility of money does not remain constant in many cases.

And the consumer must spend all of his income. This condition is also exactly same as in case of ordinal utility analysis. The schedule is presented to substantiate the analysis. Suppose, the consumer consumes various units of two commodities, X and Y. The price of X is Rs.5 and price of Y is Rs.4. The consumers MU is given in monetary terms. Again it is assumed that the consumer has Rs.35. As shown in the table, the consumer attains equilibrium when 3 units of X and 5 units of Y is consumed. Hence, the ratio of (MUx/Px) and (MUy/ Py) is equal to Rs.3 (Table:3.1.3). If (MUx/Px) is more than (MUy/Py), then the consumer consumes more of X until (MUx/Px) equals (MUx/Py). To put it differently, we can say that the consumer reaches an equilibrium where (MUx/Px) = (MUy/Py). This is known as the principle of equi-marginal utility.

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REVIEW 3.1.1
Question 1 of 4 A consumer stops consuming a good when _________.

A. Total utility is equal to marginal utility B. Marginal utility reaches its maximum C. Marginal utility is equal to price D. Marginal utility becomes negative.

Check Answer

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Section 2

Indifference Curve Analysis

In the previous section, consumers resource allocation problem was explained in terms of Marshallian utility analysis. The present section discusses the indifference curve analysis as developed by J.R Hicks. The ordinal approach, often referred to as the Hicksian approach, assumes that utility cannot be measured in any absolute manner and any numerical value assigned to utility has no economic significance, except in ranking a consumers preference of goods and services. The magnitude of difference in numerical value is irrelevant. Utility can be ranked in order of preference as consumer can rationally compare different degrees of satisfaction. This approach assumes that the consumer is consistent in ranking, and that the preferences of the consumer are based on the choice-set available. Modern consumer theory assumes three important characteristics of a consumer such as the Consumption Set, Budget Set and Preferences Relation.

Consumption Set: The set of all individually feasible alternative or consumption plans is called Consumption Set (X) or choice set. It is assumed that the X is non empty, closed and convex. The convexity of consumption set means that every good is divisible and can be consumed in fraction units. Budget Set: Budget Set is the set of all those commodity bundles that the consumer can afford with the given budget. Preference Relation: The consumer is assumed to have preferences on the consumption bundles in the consumption set (X) so that he/she can compare and rank various goods available in the economy. Given any two consumption bundle, the consumer can rank them as to their desirability. The consumer can determine that one of the consumption bundles is strictly better than the other or decide that he/she is indifferent between the two bundles. If the consumer prefers or is indifferent between the two bundles, we say that the consumer

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weakly prefers one bundle to another. However, these relations of strict preference, weak preference and indifference are themselves related. Assumptions about Preferences Consumer behavior theory is based on certain assumptions about the consistency of consumers preference. Consumers are rational: It is assumed that consumers can make a well thought-out choice between consumption bundles, which are sets of specific quantities of one or more goods, and that they make the choice which makes them better-off than any other. Consumers always prefer more to less (monotonicity): It is assumed that consumers prefer more of any good to less and are never so content that they have had enough of a good. Bads like pollution are ignored in this assumption. Consumer preferences are complete: The consumer is able to rank every consumption bundle available and is not helpless in this regard. For any two bundles, the consumer either prefers one over the other or is indifferent between them. Consumer preferences are transitive: If a consumer prefers bundle 1 to bundle 2 and bundle 2 to bundle 3, then it is assumed that bundle 1 is preferred to bundle 3. Essentially, we are assuming that consumer preferences are consistent.

Diminishing marginal rate of substitution: It is assumed that keeping the total level of satisfaction constant, as a consumer moves from one consumption bundle to other, the rate at which a good is given for another comes down.

Indifference Curve and its Properties

The graphical form of representing preference of the consumer is called indifference curve. In other words, it is the locus of all such combinations of commodity bundles which provide equal level of satisfaction to the consumer. Each indifference curve represents a certain level of satisfaction. A set of indifference curves representing different levels of satisfaction plotted on a graph is called an indifference map. Higher is the indifference curve higher is the level of satisfaction and vice versa. In general, indifference curve slopes downward from left to right and convex to the origin(shown in Figure 3.2.1). The negative slope of the indifference curve essentially indicates that consumers face trade-offs that is if the consumers wants to consume more of one commodity (say X) then the quantity of other commodity (say Y) has to decline in order to attain same level of satisfaction. For a well behaved indifference curve economists assume monotonicity, i.e., more is better. It implies negative slope for indifference curve. Second, we assume strict convexity that is the consumer always prefers averages to extremes. Further, two indifference curves can never intersect each other.

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While indifference curves are negatively sloped, the slope of the curve becomes less negative as we move down along the curve. If the consumer is currently consuming far higher number of units of Y compared to X, then the consumer may be willing to give up more units of Y for an additional unit of X. But as the consumer keeps making this substitution, the consumers willingness to give up Y starts reducing and so will the attraction for X. This is called the principle of diminishing marginal substitution. Rising MRS or an indifference curve with a non-convex shape is a rare possibility when one or both of the goods considered are addictive. In such cases, even after more of an addictive good is consumed, its marginal utility may not reduce and the consumer may want even more of it. It is sometimes useful to describe the shape of indifference curve by describing the behavior of MRS. If two goods are such that the MRS of one for the other is a constant through out, then those two goods are perfect substitutes for each other and the indifference curve will be a perfect downward straight-line and MRS will be constant at -1. On the other hand, if the MRS is zero or infinity, then such goods are perfect complements and the indifference curves will be L-shaped. Budget Constraint Budget constraint is used to describe what a consumer can afford, given the consumption set and the prices of the goods. In other words, budget constraint in graphical form represents all those commodity bundle which the consumer can purchase

Marginal Rate of Substitution We now focus on the slope of indifference curve at a point. The maximum number of units of one commodity that the consumer is willing to give up in order to get an additional unit of another commodity while remaining on the same indifference curve is called the Marginal Rate of Substitution (MRS) or Marginal Rate of Commodity Substitution (MRCS). MRS, therefore, is the magnitude of the slope of an indifference curve. It is defined as

(It measures the MRS of good x for y). Since the rate of substitution for additional consumption goes on diminishing, it is called the Diminishing Marginal Rate of Substitution (Indicated by minus sign in the MRSXY equation).

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by disposing his/her entire income. The mathematical equation of budget constraint is: M= PxX + PyY Where, M is the money income of the consumer and Px is price of the commodity Y. The budget line is downward sloping straight line with a slope of -Px/Py. The slope of budget line, i.e., ( ) measures the rate at which the market is willing to

curve. In other words, the slope of indifference curve must be equal to the slope of the budget line, i.e.,

This condition does not guarantee unique equilibrium point; hence the sufficient condition for unique equilibrium is that the indifference curve must be strictly convex to the origin. The optimal quantity of goods X and good Y are nothing but the demand for these two goods. The following diagram (Figure 3.2.2) explains the attainment of consumers equilibrium.
Figure 3.2.2 Consumer;s Equilibrium (Utility Maximization)

substitute good X for good Y. The negative sign is there since and must always have opposite signs.

A budget line is a simplified representation of the budget constraints faced by the consumer. If a consumers choices are limited to various combinations of good X and good Y, then a budget line represents all possible combinations of X and Y the consumer can buy by exhausting the consumers entire income. Any increase in the consumers income will shift the budget line to the right, while any increase in relative price of one good over the other will make the line steeper or flatter. If the price of both the goods increase proportionately, the budget line will shift to the left, indicating a fall in the real income of the consumer. Consumers Equilibrium A rational consumer wants to maximize the utility subject to the budget constraint. Since utility function represents the preferences of the consumers and budget line represents the budget constraint, the consumers equilibrium is attained at the point where the budget line is tangent to the indifference

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PL is the budget line showing all the combination of X and Y the consumer can purchase. The consumer can purchase OL of good X if entire income is spent on X. OP of Y is purchased of all income is spent on good Y. Only point E is the equilibrium point where indifference curve is tangent to budget line. If consumer selects either A or B, then less utility than that at E is obtained by spending same amount as at point E. Criticisms of Indifference Curve Analysis: It does not explain how preference relation can be derived from observed data on demand for goods. It also utilizes the concept of diminishing marginal utility to explain the diminishing rate of substitution. Reference: Consumer Choice
Check Answer

REVIEW 3.1.1

Question 1 of 4 __________ refers to the effect of a change in the price of a product on the consumers purchasing power

A. Law of equi-marginal utility B. Income effect C. Substitution effect D. Consumer surplus

The next Chapter will through light on theory of production of cost.

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Section 3

Comparative Statics of Demand

This chapter deals with how the demand for goods changes due to change in its prices and income of the consumer. Studying how choice responds to changes in economic environment is known as comparative statics. The following section focuses on changes in equilibrium due to changes in income and income consumption curve; change in equilibrium due to changes in price of good and price consumption curve. Finally, the decomposition of price effect into income and substitution effect (both Hicks and Slutsky) is explained. Price Consumption Curve (PCC) Price consumption curve is the locus of all the equilibrium points due to change in price of one commodity. It reflects the changes in the optimal quantity demanded of the commodity whose price changes. This is depicted in Keynote 3.3.1. Lets assume that the consumer deals with only two goods, such as X and Y (even many commodity can be considered). With a given income and given the prices

of two goods, the consumer attains equilibrium at point A. If the price of X falls the budget line becomes flatter and the consumer subsequently moves to the new equilibrium point (say B). By joining all the equilibrium points resulting from the change in the price of one good, keeping income and prices of the other good constant, we get the Price Consumption Curve. Individual Demand Curve - From PCC the demand curve for the commodity X is derived directly (as shown in the Keynote 3.3.1). An individual demand curve represents the relation between the quantity of a good that a particular individual demands and its price. On every point of the individual demand curve, the consumer is in equilibrium. It is also possible to derive the PCC for Giffen Goods and corresponding demand curve which is upward sloping to right. It means the price is positively related to the quantity demanded.

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Keynote 3.3.1 PCC and Demand Curve

origin. As shown in Keynote 3.3.2, in the context of two goods X and Y, the consumer initially attains equilibrium at point A. Suppose consumers income increases, as a result, the budget line shifts to the right and a new equilibrium point is attained at B. Connecting all the Keynote 3.3.2 ICC and Demand Curve equilibrium points resulting from increase in income, we get ICC.

I nCurve (ICC)

come Consumption

Now we consider how a consumers demand for a good changes as his income changes. Any change in income level of the consumer with prices remaining unchanged will also shift the budget line as well as the optimal consumption bundle. ICC is the locus of all the equilibrium points resulting from the changes in the income of the consumer, prices of the goods remains unchanged. It is noteworthy that the income consumption curve for perfect substitutes is the horizontal axis. In case of perfect complement ICC is diagonal through the

The shape of the ICC no longer remains same for different goods. The following section discusses the shape of ICC for inferior goods. ICC for Inferior Goods

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If the increase in income income of the consumer leads to decrease in consumption of goods, the said good is called inferior goods. Inferior goods Keynote 3.3.3 ICC - Inferior Good have a negative i n c o m e e l a s t i c i t y. Often, with limited increase in income, the demand for these goods may initially rise. However, as incomes further rise, the demand for these goods start falling. The income-consumption curve in such cases bends backwards after an initial upward sloping section. The Keynote 3.3.3 presents income consumption curve for the inferior goods.

Keynote 3.3.4 Derivation of Engel Curve

Engel Curve The income consumption curve traces all utilitymaximizing combinations of X and Y that the cons u m e r chooses at various levels of consumers income. If we were to map the changes in the consumers income with the quantity of X in each of the resulting equilibrium consumption bundles, then we get the Engel curve with respect to good X. The Engel curve represents the relationship between the quantity of a good that a particular individual demands and the income of the individual keeping prices of two goods constant.
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On every point of the Engel curve too, the consumer is in equilibrium. It is shown in Keynote 3.3.4.

Decomposition of Price Effect (Hicksian)

Generally, the fall in the price of a good leads to rise in its quantity demanded and vice versa. The change in quantity demanded for a good due to change in its own price, keeping other things constant, is known as price effect. It can be decomposed into two parts such as substitution effect and income effect. More clearly, the price effect consists of substitution effect and income effect. The decomposition of price effect is explained in two ways; decomposition by J.R. Hicks and decomposition by Slutsky. When price of a good falls, the good becomes cheaper than its substitutes. Other things remaining the same, a cheaper good will be preferred more. However, income effect doesnt always work in the same direction. For example, in case of normal goods, a rise in purchasing power due to a fall in prices, lead to higher demand. Keynote 3.3.5 Substitution and Income Effect (Normal Good) Where as for inferior goods, even i f price falls and the real i n c o m e increases still the demand declines. For normal goods, since b o t h
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The nature of good can be judged from the Engel curve. If the increase in income leads to increase in the consumption in same proportion then it is called Normal Good.If the proportion of increased in consumption is more than the proportionate increase in income it is called Luxurious good. If the increase in income induces the consumer to reduce the quantity consumption of the good is called inferior good.

substitution effect and income effect work in the same direction, the price effect is clear: If prices of normal goods rise, their quantity demanded will fall and vice versa. For inferior goods, substitution effect and income effect work in the opposite direction, canceling each other partially. So for inferior goods, the total effect depends on the relative strength of income effect over substitution effect. In most cases, since consumers spend a very small fraction of their income on any given good, the income effect is likely to be relatively insignificant compared to the substitution effect. For inferior goods, still the law of demand is not violated. When their prices rise, the quantity demanded falls and when their prices fall, the quantity demanded rises. However, in certain cases income effect may be very large. For instance, consumers, especially poor individuals, spend a substantial part of their limited income on a particular inferior good, usually coarse grains. In such cases, the income effect tends to be large. When the negative income effect tends to be large enough to more than offset the substitution effect, then the good even violates the law of demand. In such cases, the quantity demanded of the good actually falls with fall in price only because the price fall has resulted in significant increase in purchasing power that allows the consumer to purchase costlier goods. Such inferior goods, which violate the law of demand, are known as Giffen goods. The Hicksian decomposition of price effect is presented in the Keynote 3.3.5.

The consumer attains initial equilibrium where the budget line is tangent to the indifference curve ( point A). Suppose price of X falls, the budget line becomes flatter and the consumer reaches at new equilibrium (point B). The movements from A to B is price effect (QX1 to QX2). This is explained into two parts such as substitution effect and income effect. Since the price of X falls, the real income of the consumer increases. To keep the real income at the initial level, the consumers income is reduced to such a bound that the consumer can purchase the commodity bundle lying on the initial indifference curve(IC1). Since good X is cheaper, the consumer will substitute more of X by moving down along IC1 to the point B. The movement from A to C is known as substitution effect (QX1 to QX3). If the consumer is given the amount of income withdrawn he will move from C to B. Hence it is called income effect (QX3 to QX2). The movement from A to B is due to price effect. Since X is a normal good, both income effect and substitution effect move in same direction.
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The price effect for inferior good and Giffen Good is also presented in the interactive diagram 3.3.6 and 3.3.7 respectively.

Keynote 3.3.6 Substitution and Income Effect (Inferior Good)

D e c o mposition of Price Effect (Slutsky) In case of S l u t s k y,

Keynote 3.3.8 Decomposition of Price effect (Slutsky)

Keynote 3.3.7 Substitution and Income Effect (Giffen Good)

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Table:3.3.1 Summary of Decomposition of Price Effect for Different Goods (Price of X falls)
Effect Good Substitution Effect (SE) Income Effect (IE) Price Effect (PE)

attained at Q2. The movement from Q to Q1 (price effect MM1) is broken off into two parts ( substitution and income effect).

Net Effect

Normal

Nagative(-)

Positive (+)

SE Negative outweighs (-) IE

Inferior

Negative(-)

SE Negative Negative(-) reinforces (-) IE Negative (-) Positive (+) IE outweighs SE

Giffen

Negative(-)

decomposition of price effect the consumers income (in case of fall in price) is reduced to such an amount that he can purchase the same commodity bundle which he had purchased before the price change. The two steps used to decompose the price effect are as follows. First, we will let the relative price change and adjust the money income so as to hold the purchasing power constant, then we let the purchasing power adjust while holding the relative price constant. This is best explained in the interactive 3.3.8. Suppose consumer is in equilibrium at Q. Now the price of X falls. Hence the budget line become flatter and a new equilibrium is

The first is the movement where the slope of budget line changes, but purchasing power remain constant. Now draw line to the new budget line in such a way that it will be parallel to it and it will give same purchasing power to consume the original bundle. Although the original bundle is still affordable. The consumer will choose the optimal bundle at Q2. The movement from Q to Q2 is called substitution effect(MM2). Now lets keep the relative price constant and allow the consumers income to change by the amount which will suffice his/her to choose the bundle at Q2. The movement from Q2 to Q1 is called income effect(M2M1). Income effect can be positive or negative, depending on whether the good
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is normal or inferior good. In case of Hicks substitution effect, the utility level remains constant but in case of Slutsky substitution effect, purchasing power remains constant. Now the decomposition of price effect into income effect and substitution effect for Normal goods, Inferior goods and Giffen Goods are summarized in a in a tabular form given in table: 3.3.1.

the market demand cannot be calculated as a mere sum of independent individual demands. Such a situation is referred to as a network externality. A network externality is positive if individual demand increases with growing demand for the good from others, while it is negative if individual demand decreases when the individual notices that others are purchasing the same good. An example of a positive network externality is the desire to do what is in fashion, also known as the Bandwagon effect. The market demand curve is flatter in this case than what one would get by a summation of individual demand curves. An example of a negative network externality is the desire to be in a select group or own something not many others have, known as the Snob effect. The market demand curve is steeper in this case than what we would get by a horizontal summation of independent individual demand curves. Typically, network externalities are considered special scenarios, and hence, are not taken into consideration for most general purposes. Consumers Surplus Consumers surplus is a very useful concept in economics. Precisely because it indicates the net benefits the consumers obtain from the market place. Consumers purchase goods to get utility. A rational consumer will not pay for a good more than its worth. However, since a consumer continues to consume till the point where the marginal utility from the additional unit is equal to price, he is paying less price for the initial units than the price actually he is willing to pay. The differ94

Market Demand In addition to the derivation of individual demand curve, the concept of market demand and market demand curve is presented below. Market demand is the sum of the demands of all individuals for a good or service in a given period of time. Market demand curve is the horizontal summation of all individual demand curves. Hence, the market demand curve will keep shifting to the right with new consumers entering the market. But, as was mentioned earlier, this possibility of arriving at the market demand curve through a horizontal summation of individual demand curves is only if we assume that individual consumers demands for a good is independent of each others demands. There are many situations where each individuals demand depends on the consumption pattern of others. In such cases,

ence between what a consumer is willing to pay for a good and what is actually paid for it is called individual consumers surplus.

3.3.1 Video REVIEW 3.3.1:Calculation of Consumers Surplus

Question 1 of 6 Intersection of two indifference curves implies __. i. Higher indifference curve yields lower level of satisfaction. ii. Lower indifference curve yields higher level of satisfaction. iii. Higher indifference curve yields lower level of satisfaction.

Keynote 3.3.9 Consumers Surplus

Keynote 3.3.10 Change in Consumers Surplus due to change in price

A. Both i. and ii. above B. Both i. and iii. above If the c o nsumers demand curve is given, then the calculation of consumers surplus is straight-forward. The area below the demand curve and above the price line indicates consumer surplus. If we have to find out the aggregate consumers surplus, then we need to measure the area below the market demand curve and above the market price line. Consumer surplus is an indicator of consumers welfare and it also contributes the social welfare of the economy. Therefore, it is used to evaluate the economic policies and changes in market conditions. C. Both ii. and iii. above D. All the above.

Check Answer

We can consider the change in consumers surplus when policy changes. Suppose the price of good rises from P to P1 ,then the change in consumer surplus is denoted by the re95

Section 4

Case Study: A Small Peek into Big Bs Car Collections:Does Law of Diminishing Marginal Utility Hold Good?

International automobile giants like Toyota, Ford, Chevrolet, Mercedes, Suzuki and Hyundai have carved a niche for themselves in the Indian market. The plausible success factor of these foreign players in the Indian fourwheeler market is the widespread research of the c o n s u m e r b e h a v i o u r. A l l aspects of the behaviour

International Automobiles Giants

This case study was written by Hepsi Swarna under the direction of Akshaya Kumar Jena, IBSCDC. It is intended to be used as the basis for class discussion rather than to illustrate either effective or ineffective handling of a management situation. The case was compiled from published sources.
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pattern of the Indian consumer across all socio-economic strata, regions and towns are extensively studied. These include lifestyle, personal tastes and preferences, receptiveness for an effective good, credit availability, income growth, exposure to media, etc. Utility and Rationality People demand goods because the latter satisfy the wants of the former. A car manufacturer, like any other firm operates in order to create something for the satisfaction of some wants. An automobile company produces car to serve as a safe and comfortable means of commutation. Car has utility for people who desire to have a car. While a person staying near the office place does not show much desire to own a car, one residing away from the work place has much more desire to possess one. The 2008 four-wheeler Total Satisfaction Survey by TNS Automotive, a comprehensive automotive study in India covers over 45 models with evaluation of consumer behaviour in key areas of sales satisfaction, good quality, vehicle performance and design, after-sales service, brand image and cost of ownership. The Total Consumer Satisfaction (TCS) index provides a measure of satisfaction the consumers derives from a model (Annexure I). The high scores of small and low-priced cars reflect its traditional dominant position. The consumers have given a score of 95 on a scale of 100 to Maruti Alto. In the premium mid- size segment, Skoda Octavia (Petrol variant) has been rated the best, scoring 100 out of 100.

Utility derived by different people from these cars depends on their taste and preferences. Some consumers love to have Hyundai i10, some gun for Maruti Wagon R while others may prefer Maruti Zen Estilo. However, comparison of utility across consumers is not appropriate, as utility is a personal and subjective concept. Establishing a brand in the market requires adapting to the consumers tastes and preferences. Identifying a consumers want and corresponding to these factors has become the prerequisite of the firms for ensuring that their good would be receptive. Rich people buy flashy cars to project an image of success and status. Consumers seek to imitate whom they admire and may buy the same brands. Thus, car manufacturers choose famous personalities as their brand ambassadors. Hyundai had the tennis star Sania Mirza, the latest teen sensation of India to promote their Hyundai Getz vehicle. The consumer is at an advantage due to competition. There are wide varieties of goods and services at his disposal and thus he tends to choose those which he values most. Given the budget constraints, the consumer intends to rationally allocate scarce resources among alternatives in order to satisfy his wants. A perfectly informed, rational consumer faces a range of price-quality combinations. He chooses a combination that would give the preferred level of quality at the lowest price or vice versa. Consumers do not make their decisions in a vacuum. A rational consumer is characteristically a prudent human being who makes detailed enquiries about the reasonableness of the price, quality, safety, after-sales service, etc., before choosing a service or a
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good. Consumer is rational, he or she can be relied on to act in their own best interests. This is the core assumption of modern economics. Freakonomics, by Stephen D. Levitt and Stephen J. Dubner, is all about justifying the apparent irrational behaviour. It proves that consumers are indeed acting in their own best interests. Law of Diminishing Marginal Utility Whether or not the car collections by the Indian movie legend Amitabh Bachchan (Big B) is an instance of acting on ones own best interests, has buzzed many a minds. The Big B has one of
Exhibit I: Amitabh Bachans Car Details Car Rolls Royce Bentley Continental GT Mercedes S 350 BMW 7 Series Porsche Cayman S Range Rover Mercedes E 350 Lexus LX 470 Ford Mondeo Mercedes SL 500 * prices are approximate figures compiled by author from carwale.com Prices*(INR) 35,000,000 16,500,000 7,784,849 7,360,000 5,000,000 3,922,500 3,793,399 1,955,000 1,492,000 1,300,000

the best collections of cars in India.(Exhibit I) He has at least 11 cars; a Rolls Royce Phantom, a Bentley Continental GT, a

Amitabh Bachans Car Collection

Mercedes SL500, a Porsche Cayman S, a Range Rover, a Lexus LX470, a Mercedes E 240, a BMW X5a, BMW 7 Series, a Mercedes S320 and a Ford Mondeo.1 Celebrities command high degree of public and media attention. It is obvious that people indulge themselves in discussions about their life, background, etc. Big Bs fascination for cars also could
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not escape the public eye. Two students of Economics, Aryan and Helen were caught in a discussion about Big Bs car collection. Having read the principle of diminishing marginal utility recently, their discussion was imbued with a sprinkling of their understanding of the principle. Aryan: Wow, thats great! Big B has such a fabulous collection of cars. Helen: Yeah; may be, I would also have a collection of my own once I start getting a huge pay cheque. ( N o r e s p o n s e f r o m A r y a n ) Helen: Eh, why arent you responding? What are you lost in? Aryan: I am into a small dilemma and am trying to figure out what is it that I am missing. Helen: Why dont you tell me? May be I can help you. Aryan: See, we learnt in the last economics class that Marginal Utility (MU) is the increase in Total Utility (TU) caused by additional unit of the commodity. Marginal utility of a good diminishes as an individual consumes more units of it. The extra satisfaction, which he derives from an extra unit of the good goes on falling. The consumer, being rational is not expected to consume a good if he derives negative utility from a good or if the price he/she pays is greater than the utility he/she receives. However, Big Bs possession of cars does not seem to gel with this rational behaviour of the consumer. Helen: Yeah, you are right. Even after possessing the first few cars, he has not stopped adding more to his collection. Aryan: Should this behaviour of his be treated as an exception

to the law of diminishing marginal utility? Helen: I heard that the first two cars, Rolls Royce & Bentley are gifted ones. Is that the reason why he seems unaffected by the law? Aryan: Thats fine. There may not be any clarity about the ownership about a couple of them but what about the rest? Helen: Right, you seem to have a point. (Both remained silent for some time and decided to think over it and discuss their viewpoints next day. Next day when they were in their group, Helen came running to Aryan to resolve his dilemma.) Helen: Aryan, I cracked the problem. Aryan: So have you confirmed that Big Bs is a case of paradox? Helen: No. Though you have understood the law well, you have missed one of the most important assumptions of this law. All the units of consumption should be identical. This means that the nature of the good should remain the same. If units of consumption differ in their characteristics, this law would not be applicable. All the cars Big B owns are of different varieties. They differ in their looks as well as their features and specifications. They differ with respect to engine strength, maximum power, maximum torque, suspension system, steering, and brake system, interiors and exteriors and in functional requirement. Aryan: Good. Thats right. It is great that you know a lot about the cars. By the way, I could remember another assumption
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Annexure I Total Customer Satisfaction Rankings Four-wheeler (2008)

O D
5

T O

O C

Y P

Source: 2008 four- wheeler Total Customer Satisfaction (TCS) study, http://www.tnsglobal.com/_assets/files/ TNS_Market_Research_2008_TCS_Press_Release.pdf, December 31st 2008

that might not apply to Big Bs possession of cars. He might not have purchased all the cars in one go. Thus, both of them drew self-satisfaction from this analysis about Big Bs cars and the resolution of the apparent deviation from the law of diminishing marginal utility. Footnotes 1. Sanskriti R., Unplugged: Amitabh Bachchan, http://timesofindia.indiatimes.com/People/Unplugged-Amit abh-Bachchan/articleshow/ 4141217.cms, April 4th 2009.

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Section 5

Case Study: Tata Nano: A small Car with Large Consumer Surplus

Video 3.5.1: Tata Nano Launch

Since, promise is a promise the standard dealer version will cost Rs 1 lakh, Ratan Tata, Chairman, Tata Sons1 We designed the Nano to offer a new form of transport to the people of India and maybe later, to the rest of the world.2 Ratan Tata, Chairman, Tata Sons ...if economists are to play their part in shaping the canons of economic policy fit for a new age, they will have to build on the foundations of consumers surplus.3 J.R. Hicks, Nobel Laureate British Economist

Ta t a M o t o r s , s e t u p i n 1 9 4 5 t o manufacture locomotives, is Indias largest automobile company. With over 4 million of its vehicles plying in India, it not only stands out as the market leader in each segment of commercial vehicles but also takes rank among the top three passenger vehicle producers of the country. Indias first fully indigenous passenger car Indica came from its stable in 1998. Though derided as the truck mans idea of what is a car, Indica came up as the largest selling car in India in segment B compact cars within 2 years of the launch. Tata Motors also earned kudos for developing Indias first indigenous mini-truck Ace in 2005. It

This case study was written by Akshaya Kumar Jena IBSCDC. It is intended to be used as the basis for class discussion rather than to illustrate either effective or ineffective handling of a management situation. The case was compiled from published sources.
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spread its operations in the UK, South Korea, Thailand and Spain through subsidiaries and associate companies. Its classic steadfast alliance with Italys Fiat and heroic acquisition of two iconic British brands Jaguar and Land Rover have served as templates for emulation. It is GALLERY 3.5.1Tatas Alliance the fourth largest with Fait, Jaguar and Land truck manufacturer Rover and the second largest bus manufacturer in the world.4 Tata trucks, buses and cars find good foreign markets in countries across Europe, Africa, Middle East, South Asia, South East Asia and South America as well. However, what has become the buzz and nudged the Source:www.topnews.in global auto industry to take a big look of Tata Motors is its small car Nano, lovingly nicknamed The Peoples Car, thanks to its endearingly accessible price of INR 100,000. People who were previously been unable to afford a car have now the exciting prospect of driving one.

First unveiled at the ninth Auto Expo in New Delhi on January 10th 2008, Tatas Nano is perhaps the worlds most awaited car since the Model-T of Ford Nano Mania

Video 3.5.1:Tata Nano at the Delhi Auto Expo

As Tatas Nano was launched in Mumbai on March 23rd 2009 marking a finale to an endeavour that started 6 years ago, Tata Nano website received around 30 million hits during the period ending April 25th 2009 (the date of the closure of the booking), implying almost 1 million hits a day. The day of its commercial launch has generated among thousands of families a new hope of ushering in a four-wheeled transportation in their driveways. Nano has come to represent a pleasant break from the past. It has allowed people, who could hitherto afford up to a motorcycle, to dare to dream of buying a car. In India, millions often convey on motorbikes and scooters their entire families, perched precariously, often with luggage. This common observation inducing heartfelt sensibility and pragmatic business sense that there is a crying need for a peoples car prompted Ratan Tata to take initiative in manufacturing one. When others had nodded No to signal its impossibility, Ratan Tata came to conjure up Nano to make the mass-aspired small car a smashing hit. Tata was proved right when people went crazy in their quest for the conquest of Nano to satisfy their want for a convenient, safe and allweather affordable personal family transport. So much was the mania for Nano that for the first time in its history, Tata Motors
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had to gladly charge an application fee (INR 300). The number of bookings registered during the prescribed period of 17 days from April 9th 2009 to April 25th 2009 more than doubled the initial goodion capacity. 2.03 lakh bookings for Nano, which fetched Tata Motors nearly INR 25,000 million5 , have necessitated the selection of the first 1 lakh owners through a lottery. Among the three variants of the car (Annexure I), the base version accounted for 20% of the bookings, the mid-level CX variant 30% and the top-end LX variant remaining 50%. The delivery of Nano is expected to commence in July 2009. Tata Nano gives a warranty of 18 months or 24,000 km whichever is earlier. It provides the usual three rounds of free service based upon distance and time whichever is earlier. The first round of free service is for 1,000 km or 1 month, the second for 5,000 km or 6 months and the third for 10,000 km or 1 year. Subsequent rounds of service are paid ones and are recommended to be done on every 10,000 km covered. The three variants of Nano come with various colour options. While the low-end Nano base is available in three colours such as Bright red, Ivory white, Summer blue, the high-end Nano LX is also available in three colours but different from the above such as Champagne gold, Lunar silver, Sunshine yellow. The medium version Nano CX is available in five colours, which include all the above mentioned colours except Sunshine yellow. Nano is the cheapest car, only in terms of cost and price but not in terms of quality and consumer satisfaction. Its technical specifications (Annexure II) are no way inferior. Its emission norms are Euro-IV, Bharat Stage-III compliant and its safety norms have tested frontal crash. With a turning radius of only 4 metres, Nano can cutely execute a 360- degree turn

GALLERY 3.5.1:Three Variants of Nano

even in its own tiny shadow. Nano has a luggage space of 80 l provided behind the rear seat. The rear seat of Nano being a 100% bench seat, it lends itself to folding to create an additional luggage space of 420 l.6 With its body made of sheet metal and engine innovatively mounted in the rear, Nano offers

Source: www.tatanano.com

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not only fuel economy but also proportionately more interior space (Exhibit I). As compared to Maruti 800, it is 8% smaller on outside but 21% larger inside. Even though it is the most affordable car of the world (Exhibit II), Nano has presented features some of
Exhibit II Price Comparison of Nano with Its Nearest Rivals Standard Version of the Car Titan Nano Maruti 800 Maruti Alto Hyundai Santro Compiled by the author Starting ex-Show Room Price (exMumbai) (in INR) 1,34,000 1,99,000 2,40,000 2,67,000 Plus Body Control Bumper, Door Handle & ORVM Plus Central Locking Plus Front & Rear Fog Lamp Nano LX Plus Front Power windows Nano LX Plus Heater Plus Tinted Glass Fully Loaded Nano CX/LX Nano Base Model Plus AC Nano Nano CX/LX

Exhibit III Comparison of Nano Against Maruti 800, Alto and Santro Maruti 800 M800 Std M800 AC Features not Available M800 AC M800 AC Features not Available Features not Available Features not Available Features not Available Alto Alto Alto LX/LXi Alto LX/LXi Santro Santro Non-AC Santro GL/GLS Santro GL/GLS

Nano CX/LX Nano LX

Alto LX/LXi Alto LXi Features not Available Features not Available Features not Available Features not Available

Santro GL/GLS Santro GLS Santro GLS Santro GLS (Only Body Coloured Bumper)

which are not available in Suzukis Maruti 800 and Alto or even Hyundais Santro (Exhibit III) Tata Motors is poised to revolutionise the face of automotive industry. Not only would many two- wheeler users switch to four wheels, but alEo the companies that are planning to launch a budget family car have to relook and recast their cost-pricing structure. Consumer surplus is a deciding factor in purchasing a good. What the consumers would be willing to pay over and above what they are actually asked to pay marks this surplus. The masses have been mesmerised by the low offer price of Nano, which has incredibly not gone low on style quotient thanks to Tatas highly innovative cost-cutting approach. One windshield wiper, a single piece shiny hard plastic dashboard and 12-inch

Nano LX

Santro GLS

Nano LX

Features not Available

Source: Indian Automobiles, http://www.surfindia.com/automobile/tatanano.html

steel rims for tyres are some of these quickly noticeable costcutting measures. Nano is frugally equipped but brilliantly engineered.7
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This is reflected in Tata Motors filing of several patents relating to the design of Nano. Its power train design alone has 34 patents.8 Incidentally, Nano also received a long drawn free publicity because of the political controversies surrounding the land acquisition methods at West Bengals Singur from which the project was finally shifted to Gujarats Sanand. While many go gaga over Nano, eulogising its potentiality to generate a lot of consumer surplus and well-being for Indians, there is no dearth of cynics who conjure up a scary scene of traffic congestion and environmental hazards that the little Nano is greatly capable of perpetrating by promoting mass private transport. Apologists for Nano, however, point to greater per capita harm coming from two wheelers and auto rickshaws that Nano is all set to supplant. Moreover, the bare bone features of Nano may drive away the potential consumers into the market for better featured second-hand cars. Whether Nano will be a means for pollution or solution only the future will tell. And there hangs the poser whether Indias societal consumer surplus will be raised or reduced.

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Annexure I Variants and Features of Tata Nano Features/Variants AC with Heater Front Power Windows Cup Holders in Front Console IRVM Gear Shift Console Magazine and Coin Holder on all doors Map Pocket Integral with Driver & Co-driver Seat Front Seat Headrests Rear Seat Headrests Sun-visor on Driver & Passenger Side Driver Seat with slider Passenger side Seat with Slider Front assist grips Rear assist grips Head lamp levelling Low Fuel Warning Lamp Rear Seat Folding Intrusion beam Radial Tubeless Type Yes Yes plain Basic Fabric Pocket Integrated Yes Yes Nano Base Yes Plain Basic Fabric Pocket Integrated Integrated (with Nap Rests) Yes Yes (With Recliner) Yes (With Recliner) Yes Yes Nano CX Nano LX Yes Yes Yes Antiglare High End Console with provision for Mobile Charger/Cigarette lighter Moulded Door Trim Separate plastic trim Integrated Integrated (with Nap Rests) Yes Yes (With Recliner) Yes (With Recliner) Yes Yes

I n t e g r a l f e a t u r e t h r o u g h I n t e g r a l f e a t u r e t h r o u g h Integral feature through innovative innovative suspension design innovative suspension design suspension design Yes Yes Yes Yes Yes Yes

I n t e g r a l f e a t u r e t h r o u g h I n t e g r a l f e a t u r e t h r o u g h Integral feature through innovative innovative suspension design innovative suspension design suspension design Yes Yes Yes

Source: Indian Automobiles, http://www.surfindia.com/automobile/tata-nano.html

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Annexure II Technical Specifications of Tata Nano Car Length Width Height Engine Capacity Power Fuel Injection Fuel Type Body Type Seating Capacity Seating Capacity Mileage Mileage Top Speed Emission Norms Safety Norms Versions Compression Ratio Power to weight ratio Acceleration Transmission 3.09 1,495 mm 1,652 mm 2 cylinder 624 cc 35 ps Multi point Fuel Injection (MPFI) Petrol, Diesel versions 4 (Four) 20-22 kmpl (City drive) 26 kmpl (Highways) 105 km Euro-IV, Bharat Stage-III compliant Frontal Crash Tested One Standard and Two Deluxe 9.7:1 0.58 0-60 kmph; 8 secs Sysnchromesh on all forward gears, sliding mesh on reverse gear with overdrive on 4th gear contd..

Gearbox Suspension Front Suspension Rear Brake Type Front Brake Rear Brake Tyre Type Front Tyre Size Rear Tyre Size Min. turning circle radius Ground Clearance Fuel Tank Capacity Battery Position

4 forward speed, 1 reverse, all forward gears synchronised Independent mcpherson strut, shock absorber Semi trailing arm, coil spring with gas filled shock absorber Dual Circuit, Vertical Split operated by tandem master cylinder 180 mm drun 180 mm drun Radial & Tubeless 135/70 R 12 155/65 R 12 4m 180 mm drun 15 L Semi sealed under the drivers seat

Source: Indian Automobiles, http://www.surfindia.com/automobile/tatanano.html

Footnotes

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1.

Tata unveils Rs-1 lakh Peoples Car Nano, http://ibnlive.in.com/news/tata-unveils-rs1-lakh-peoples-ca r-nano/56046-7.html, January 10th 2008 Njoroge John,The Nano the Worlds Cheapest Car,http://www.independent.co.ug/index.php/news/ todays-news/90-todays-news/ 905-the-nano-the-worldscheapest-car, May 7th 2009 Currie John Martin, et al., The Concept of Economic Surplus and Its Use in Economic Analysis, http://www.jstor.org/pss/2230317

2.

3.

4. T a t a M o t o r s : P r o f i l e , http://www.tatamotors.com/our_world/profile.php 5. N a n o G e t s o v e r 2 L a k h B o o k i n g s , h t t p : / / www.thehindubusinessline.com/2009/05/05/stories/20090 50551820100.htm 6. N a n o G i v e s Yo u a To p - G e a r P a c k a g e , http://economictimes.indiatimes.com/articleshow/4307684 .cms, March 24th 2009 Darukhanawala Adil Jal, Nano Against Established Indian Brat Packhttp://www.zigwheels.com/SpecialFeatures/ Nano-against- established-Indian-brat-pack/ Nano11_20090323-2-3 N a n o Te c h n i c a l s p e c i f i c a t i o n s www.mytatanano.co.in/nan-technical-specifications.html

7.

8.

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C HAPTER 4

Theory of Production and Cost

Most firms and managers operate in competitive markets and understanding the behavior of other firms is certainly critical to success. It is in this context that production theory, often referred to as the theory of the firm, is discussed in this chapter. A firm has to make various decisions with regard to production. It has to decide what is to be produced, how it has to be produced, how much has to be produced and in what quantity. Production is the transformation of inputs into outputs. Inputs are generally categorized into four basic factors of production as described in section one. The know-how of such transformation, how inputs can be transformed to output, is referred to as technology. Different combinations of inputs can be used to produce the same output. However, how much to produce using which technology cannot be decided ignoring cost constraints and available inputs. This optimization problem is the essence of production theory.

S ECTION 1

Thoery of Production
The production function is the technical relationship between inputs and output that indicates the maximum possible output a firm can produce using various combinations of given inputs with given technology. In its simplest form, it is generally represented in an equation form as Q = f(K, L), where inputs are assumed to be only Labor (L) and Capital (K). Short Run and the Long Run Production functions may be short-run or long-run. Short-run refers to a period within which the quantities of at least one input cannot be changed so as to increase the production. Hence in a short-run production function, there will be at least one fixed input. In very short time-periods, unskilled labor might be the only input that a firm can change. In any case, to increase plant capacity or change factors, the time required will be much longer. Hence the broad distinction between short-run and long-run is important. Long-run refers to any extent of time which is required to make changes in the quantities of all inputs so as to increase the level of production. Hence in a long-run production function, all inputs considered are variable inputs.

Production Function in Short run

In the short-run, it is more likely that capital in terms of plant and machinery is fixed and labor is variable. Earlier, we stated the simplest form of a production function as Q = f (K, L). If we now assume that capital is a fixed input and only labor is variable, then this production function takes the form,

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Q = f (L K )
What this implies is that, with a given quantity of limited capital, output can be changed only by changing the units of labor used. If output has to be increased at short-notice, then the firm has to hire additional labor or make existing laborers work extra hours. Given, it should be obvious that there are limits to increasing output by only adding labor. In an office space which can accommodate

The Three Stages of Production

When a single-variable production function is used, any increase in output is the result of changing the only input that is variable. Keeping other inputs constant, an increase in the variable input will initially increase the output. As more units of the variable input are added, the addition to the output starts coming down till it reaches zero. Beyond this point, any further addition of units of the variable input results in the total product declining. These stages are usually referred to as the three stages of production, which is shown in Figure 4.1.1. Stage I The first stage is called the stage of increasing returns to the variable input. In this stage, average product (AP) increases throughout while marginal product (MP) increases at first and then decreases. AP keeps increasing till the end of the stage I, where it reaches its maximum and MP cuts AP from above. Why do average returns to the variable input increase during this stage? This is because variable input is highly scarce relative to the abundance of fixed input. The fixed factor can be better utilized by an increase in the variable factor. Stage II The second stage is known as the stage of diminishing returns. In this stage, AP is beyond its peak and begins to decrease, while MP, though positive, continues to decrease till the end of the stage where it becomes zero. TP increases at a diminishing rate throughout the stage until it reaches its peak, where the second stage gives way to the third.
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Laws of Production in Short run

In the short-run, input relations are studied with one variable input (labor), and the other inputs held constant. The laws of production under these conditions are called, The laws of Variable Proportions. This law is also called, Laws of Returns to a Variable Input. Coming to the laws of variable proportions, there are three important concepts associated with it, they are: Total Product, Average Product and Marginal Product. Total Product refers to the total amount of output produced using a variable input, assuming other inputs to be constant. Average Product is nothing but output per unit of variable input, i.e., APL = Q/L. The marginal product of a variable input is the change in output by using an additional unit of that input, keeping other inputs constant. marginal product of labor, i.e., MPL = Q/L, where, q is the change in total product and L is the change in labor units.

Stage III This stage is the stage of negative returns. In this stage, TP is now declining, AP continues to decrease and MP turn negative. In this stage, too many units of the variable input is used. The severe scarcity of the fixed input prevents the proper utilization of the variable inputs. Figure 4.1.1

Rational producers do not operate within stage I and stage III. In stage I, any increase in the number of units of the variable input will result in a more than proportionate increase in the output. Not increasing the variable input will lead to the wastage of fixed inputs. On the other hand, in stage III, since TP decreases and MP is negative, any use of additional units of variable input will lead to wastage of variable input. In a sense, from the perspective of relative scarcity and abundance, if the variable input is scarce and fixed input is overabundant in stage I, it is the fixed input which is scarce and variable input, overabundant, in stage III. Stage II is, therefore, the suitable stage for operation. While AP and MP are falling, TP is still rising, enabling the firm to properly utilize the fixed input, without excessively using variable input. Video 4.1.1 :Production Function

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Production Functions in Long run

Production Function with two variable inputs In the long-run, the quantities of all inputs can be increased or decreased. In other words, there are no fixed inputs, but only variable ones. Hence to use the production function in its simplest for, Q = f (K, L) where both capital and labor can be changed. Output can now be increased by increasing either of the factors or both. Suppose the inputs are labor and capital, one can state in a tabular form the various combinations of labor and capital that can produce different quantities of output. Here, the output mentioned is the maximum possible output given the technical know-how. Isoquants (Equal Product Curve) When both capital and labor inputs are variable, the analytical techniques applied to determine optimal input rates must be completely different. The problem of efficient resource allocation in production can be solved in different ways some of which include: (1) maximize production for a given rupee outlay, on labor and capital, (2) minimize the rupee outlay of labor and capital inputs necessary to produce a specified rate of output, and (3) produce output that maximizes profit. The first two problems mentioned above are called constrained optimization problems. In problem (1), the

constraint is a fixed rupee outlay for capital and labor. In problem (2), the constraint is the specified rate of output that must be produced. In problem (3), however, the firm would like to have an output level that maximizes profit. There are no constraints on the available budget or the output to be produced. Isoquants are similar to the indifference curves in the theory of consumer behavior. An isoquant shows all the input points required to produce same level of output. Therefore, isoquants are contour lines that trace the locus of same outputs. As isoquants represent the combinations of inputs that can produce same quantity of output, producers will be indifferent between them. Hence another name for isoquants is production- indifference curve. This can further be explained through the example shown in Table 4.1.1. It is assumed that two factors of production labor and capital - are required to produce a product. The various factor combinations shown in Table 4.1.1 produce the same level of output. Factor combination A consisting of 1 unit of labor and 12 units of capital produces the required output of 100 units. Similarly for other factor combinations B, C, D and E, the required labor and capital are shown in Table 4.1.1. Various combinations of the factors labor and capital for the isoquant Q are shown in Keynote 4.1.1.

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Table 4.1.1: Factor Combinations to Produce a Given Level of Output

Factor Combinatio ns A B C D E Labor 1 2 3 4 5 Capital 12 8 5 3 2

Though isoquants are similar to indifference curves in the theory of consumer behavior, there is one significant difference. Indifference curves show the combinations of two goods that provide the same level of utility but they do not specify the level of utility in quantitative terms. But each isoquant represents a specified level of production. Marginal rate of technical substitution Marginal Rate of Technical Substitution (MRTS) is similar to marginal rate of substitution in the indifference curve of consumer's demand. MRTS of labor for capital is defined as the number of units of capital that can be replaced by one unit of labor while the level of output remains unchanged. It can be further explained by Table 4.1.2. Input combinations shown in Table 4.1.2 produce the same level of output. When we move from combination A to combination B, 4 units of capital are replaced by 1 unit of Table 4.1.2: Marginal Rate of Technical Substitution

Keynote 4.1.1 : Isoquant

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No two isoquants intersect or touch each other: If two isoquants touch or intersect each other, it means that there is a common point on two curves, and for one set of land and capital two levels of outputs are possible, which is quite unrealistic. Isoquants are convex to the origin: Convexity of isoquants implies that as we move down the curve, smaller units of capital are required for substituting a given increment of labor to keep the output level constant. Therefore, the convexity of isoquant curves is due to the diminishing marginal rate of technical substitution of one factor for other. Convexity of isoquants also implies that it becomes more difficult to substitute one factor of production by other as we move along isoquant and increase the use of one factor to substitute the other factor. Isoquant denotes different ways to produce a given rate of output. After determining the optimal combination of capital and labor, the next step is to add information on the cost of these inputs. The information regarding costs is introduced by a function called production isocost. An isocost line is defined as the locus of various combinations of factors which a firm or an organization can buy at a given level of output. As the isocost line also shows the prices of various combination, it is also referred as price line.

labor. Therefore, marginal rate of technical substitution is 4 at this stage. Similarly, for factor combinations C and D, and D and E, the marginal rates of technical substitution are 2 and 1 respectively. The marginal rate of technical substitution on a point on an isoquant is the slope of the isoquant at that point. Consider the small movement down the isoquant from G to H in Interactive 4.1.1, where small change in capital K is replaced by an amount in labor L without any change in output. Therefore, the slope of the isoquant at point G or marginal rate of technical substitution of labor for capital is K/L. Properties of isoquants Following are the properties of isoquants: An isoquant is downward sloping to the right: It implies that if one factor of production is used more, the other factor is used less for same level of production. A higher isoquant represents a higher output: When one factor is kept constant and other factor is increased, the output level increases.

Isocost
An isocost line (Figure 4.1.2) provides various combinations of labor and capital that a firm can hire at a given level of cost. The isocost line plays a crucial role in determining the
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combination of inputs. To derive an isocost line, only two factors of production are assumed variable. For example, keeping all other factors of production constant and by changing only the capital and labor, isocost curve shows the various levels of cost combinations of labor and capital at a given level of output. Here, in the isocost line, we assume that the prices of the factors of production are constant. A shift in the prices of the factors of production changes the isocost curve. Thus the isocost line represents the cost a firm incurs at a given level of factor combination. Figure 4.1.2 - Isocost Line

minimum cost. This can be achieved at the output where the isoquant touches the isocost line which shows the least cost combination available for a particular firm. Thus we can say that the equilibrium point is where isocost line is tangent to isoquant curve. The salient feature of this equilibrium point is that a specific isoquant is tangent to an isocost line. Thus the least cost input combination is that combination where the slope of the isoquant is equal to the slope of the isocost. The equality of these two slopes is necessary for least cost input combination. It should be clear that the least combination of input mix depends on production function (isoquant) as well as factor prices (isocost lines). If any change takes place in either of them, the equilibrium point will change. This combination can be explained with the Figure 4.1.3. The Y axis of the curve represents capital and X axis represents the labor. It has also been assumed that the producer wants to produce 500 units of output. This level of output can be produced by various combination of labor and capital on the isoquant curve R, S, E, T, and J. From Figure 4.1.3, it is quite evident that cost will be minimum at point E where the isocost line CD is tangent to the isoquant Q. All other points R, S, T, J on isoquant Q are on higher isocost lines than CD. At these points, higher costs are incurred in producing the given output. Figure 4.1.3 - Minimizing Cost for a Given Level of Output

The slope of the isocost line shows the ratio of the price of labor to the price of capital or price of capital / price of labor. Least Cost Combination An isoquant curve is the combination of various factors of production that gives the same level of output. On the other hand, isocost lines show the combination of prices that a firm incurs. A firm requires a maximum level of output at the

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The factor combination E is the optimum combination under the given. It can therefore be concluded that tangency point of an isoquant with an isocost line represents the least cost combination of factors for producing a given output. Expansion Path When a firms expenditure increases without increase in the price of input, there will be a parallel shift in isocost line. Each isocost line gives a new tangency point and new equilibrium point. The curve we get after joining all equilibrium points, is called the expansion path (P) as shown in Figure 4.1.4. Therefore, expansion path is the locus of different equilibrium points when the firms expenditure increases without any change in the price of the inputs. It shows the change in factor combinations when output and expenditure changes, however, input prices remain unchanged. Figure 4.1.4 - The Expansion Path

RETURNS TO SCALE In short run, we study the returns to a factor. But in long run, we study returns to scale. In the long run, all factors are variable and scale of production can be changed. Returns to scale refers to the responsiveness of total product when all the inputs are changed proportionately. There are three different cases of returns to scale. They are: Increasing returns to scale Constant returns to scale Decreasing returns to scale Increasing returns to scale: When an increase in all inputs leads to more than proportional increase in output or viceversa, it is called increasing returns to scale. In a small scale chemical plant, let us assume that labor, material, capital all factors of production - are increased by 10%. Output will
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increase more than 10% in case of increasing returns to scale. Constant returns to scale: When an increase in all inputs leads to proportional increase in output or vice-versa, it is called constant returns to scale. For example, there are two factors of production land and labor and they are doubled, the output will also double in case of Keynote 4.1.2: Returns to Scale constant returns to scale. Decreasing returns to scale: It occurs when an increase in all inputs leads to less than proportional increase in output. When processes are scaled up, they reach a point beyond which inefficiencies set in. It may happen due to either costs of management or ineffective control. For example, it has been found that in electric generation plants, when the plant grows too large, risks of plant failure increase disproportionately. The laws of returns to scale is shown in Interactive 4.1.2 !

REVIEW 4.1.1

Question 1 of 18 Which of the following statements regarding production function is false?

A. It just shows the relationship between output and input B. It does not provide any information on the least-cost capital labor combination C. It reveals the output that yields the maximum profit D. Both A and C

Check Answer

References Short and Long Run Diminishing Marginal Returns

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S ECTION 2

Theory of Cost

Video 4.2.1 : The Relationship between Cost and Output

If profit-maximization is the key objective of a firm, it should be obvious that cost minimization will be a major concern for it. In the previous section, concepts related to production were discussed. Now, we look at concepts related to costs from both short-run and long-run perspectives. In a sense, cost is a simple concept. All expenses incurred on hiring factors of production add up to the cost of production. Put differently, cost refers to the cost of using inputs. The cost of production is an important factor that influences the firms decisions regarding the quantities to

produce, expansion or contraction of production capacity and so on. Hence, the concept of costs plays a significant role in the price and output determination. In this section, we will discuss the relationship between cost and production function, types of costs and economies of scale. Costs are of various types. Not all costs are equally relevant for all decision-making. Which costs are relevant may vary from situation to situation. A manager should be clear about the different types of costs. We discuss some key concepts below.

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Types of Costs
Accounting cost The cost that accountants measure, i.e. actual costs as well as depreciation for capital equipment, is referred to as accounting cost. Calculation of depreciation usually depends on the tax laws of the country. Accountants usually look at costs after they are incurred. Economic costs Economic costs refer to the costs of all factors of production, irrespective of whether the costs are explicit or implicit, which should be taken into consideration during economic decisionmaking. Economic costs are the costs of utilizing economic resources in the production process, including opportunity costs. Opportunity cost The opportunity cost of a resource can be defined as the value of the resource in its next best use, that is, if it were not being used for the present purpose. The opportunity cost is the benefit of using a resource for the next most attractive alternative. Explicit and Implicit costs Explicit cost are those which fall under the actual or business costs entered in the books of accounts. The payments on account of wages, salaries, utility expenses, interest, rent, purchase of materials, license fee, insurance premium and

depreciation charges are the examples of explicit costs. These costs involve cash payments and are clearly reflected by usual accounting practices. In contrasts with theses costs, there are certain other costs which do not take the form of cash outlays nor do they appear in the accounting system. Such costs are known as implicit or imputed costs. Marginal costs It is the addition to the total cost on account of producing one additional unit of product. Or, marginal cost is the cost of marginal unit produced. Incremental costs Incremental costs are the total additional costs that are incurred in the execution of a major change in the nature of business activity or due to a key managerial decision. The change can take several forms such as extension of a product line or replacement of a machine. Sunk costs Sunk costs are costs that cannot be recovered but have already been incurred in the past or have to be incurred in the future, perhaps, due to a contractual obligation. Sunk costs are not to be part of a firms economic costs and hence, they shouldnt influence current decision-making. Variable costs Variable costs are the costs that vary with output. These include cost of raw materials, costs of production, wages of daily labor, etc. Variable costs are nil at a zero level of output and they rise with increase in output.
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Fixed costs Fixed costs are the costs that do not vary with the changes in the output of a product. Fixed costs include interest on borrowed capital, rent for equipment or factory building, depreciation charges on machinery, and salaries of permanent employees. Direct and Indirect costs Direct costs are costs that are associated with the production of output. These are also called as traceable costs. Indirect costs are the overheads incurred in the production. For example, office and administrative expenses, stationery, etc. These costs are not directly associated with the production of the output. These are also called as nontraceable costs. Break Even Analysis Break-even analysis is a very useful and relatively simple tool for managerial decision making. It can be used for dealing with unknown variables like demand. By specifying the levels of known variables, such as cost or profit, a required or minimum level can be found for the unknown variable. The revenue-output and cost-output functions form the basis of break even analysis (Ref figure 5.3). Total revenue is the product of the number of units sold and the price per unit. If the firm is able to sell more units by reducing the price, the total revenue (TR) curve will be concave. The total cost (TC) function is a short run function, which shows the relationship between costs and output for a production process in which

one or more of the factors of production are fixed. Short run cost comprises of both fixed and variable cost components. The difference between the total revenue and the total cost is the profit generated by the firm. In Figure 5.3, the vertical distance between the curves of total revenue (TR) and total cost (TC) determines total profits at any level of production. The point where the total cost equals the total revenue is known as the break-even point as explained earlier. In Figure 5.3, the TR=TC points can be seen at two different levels of production i.e. Q1 and Q3. Output below Q1 will lead to losses, as the total revenues are less than total costs. The firm earns profits between the Q1 and Q3 level of production, where the total revenue is more than the total cost. The firms attains the break-even at Q1 level of output. The total profits are maximum at point Q2 as the vertical distance between the total revenue and the total cost is maximum at this point. Therefore, to achieve the maximum level of profits, the firm should retain the same price-output structure. Merits of Break-even Analysis The advantages of break even analysis are as follows: It is an inexpensive method. It helps the managers to decide whether its worthwhile to go in for a more intensive (a costly) analysis. It helps in designing product specifications as each design has its own implications for cost.

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It serves as a substitute for estimating the unknown factors that may arise in the future. By deciding that operating profit must at least be zero i.e. the break-even point a fair demand can be estimated.

REVIEW 4.2.1
Question 1 of 4 Which of the following can be defined as the extra cost that is incurred to increase the quantity produced by one unit?

Keynote 4.2.1: Break-even Analysis

A. Marginal cost B. Incremental cost C. Sunk cost D. Explicit cost

Check Answer

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S ECTION 3

Short Run and Long Run Costs

Video 4.3.1:Short Run and Long Run costs

The functional relationship of costs and output is referred to as a cost function. The costoutput relationship plays a significant role in resource allocation and price determination. The cost function can be shown in several forms like a schedule, graph or a mathematical relationship. Specifying the functional form helps in

identifying the least possible costs for production of various quantities of output. Typically, a cost function can be expressed as: C = f ( Q ) Where C is total cost and Q is level of output, and f indicates a functional relationship.

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Short Run Cost Functions

Keynote 4.3.1 Short-run Cost Curves of a Firm In the short-run, the cost-output relationship is explained by the Short Run (SR) cost functions. The cost-output relationship in the short-run can be described in terms of total, average and marginal costs. Total Cost (TC) refers to the sum of fixed and variable costs. Average Total Cost (ATC) is the average per-unit cost of production, arrived at by dividing the total cost with the number of units of output produced. Similarly, average fixed cost (AFC) and average variable cost (AVC) are calculated by using the number of units of output produced to divide the fixed cost and variable cost respectively. Marginal cost (MC) refers to the cost of producing one additional unit of output. The total, average and marginal costs can all be plotted as curves on a graph. The curves representing short-run average total costs (ATC) and average variable costs (AVC) are generally U-shaped. The marginal cost (MC) curve intersects both the average variable cost curve and short-run average total cost curve at their lowest points. The output level where the average total cost is minimum is known as the short-run capacity of a firm, which is considered as optimum level of output from the perspective of cost minimization. See shapes of the short run cost curves in Keynote 4.3.1

Numerical Example The total cost function of a firm is given as TC = 36Q-6Q2+3Q3. Can we find the output (Q) which minimizes average cost? At this level of output, average cost must be equal to marginal cost.

MC = 36 -12Q +9Q2 Average cost is at its lowest when, AC= MC Equating AC & MC

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 Q = 1 Hence, when output is equal to one unit, AC is at its lowest. Relationships among the Various Cost and Production Curves To investigate further the properties of and relationships among the various cost and production curves, assume now that the cost and production curves can be represented by smooth continuous functions, as shown in Figure 8.3. Also assume that in put L is the variable factor, with an associated variable cost VC; that the per-unit price of Keynote 4.3.3: Short-Run Cost and each of the Production Functions factors of production (i.e. CL and CK ) is constant over all usage levels; and that input K is the fixed factor, with an assoicated fixed cost FC. First, note that variable costs ( and total costs) initially increase at a decreasing rate as output Q is increased up to Q1 . Correspondingly, the marginal cost function MC is declining. Over this range of output, the marginal product of the variable input L is increasing. Because it has been assumed that the unit cost of L is constant, an increasing marginal product for input L necessarily implies that the marginal cost function must be declining. The minimum point on the MC curve at Q1 corresponds to the maximum point on the MPL curve at L1 .

Beyond Q1 variable ( and total) cost increase at an increasing rate and, correspondingly, the marginal cost curve is increasing. Over this rang of output, the marginal product of L is decreasing and, for reason analogours to those just noted, marginal cost must necessarily be rising. Examining the average variable cost curve, AVC, in Figure 8.3 note that it is declining over output levels to Q2 and is increasing thereafter. The shape of the average variable cost function, like the shape of the marginal cost function, is closely rated to the production function defined in Chapter7 . Given that the unit cost of the variable input inconstant, an increasing(and then decreasing) average product for input L necessarily implies that the average variable cost will be decreasing(and then increasing) . The minimum point on the AVC curve at Q2 corresponds to the maximum point on the APL curve at L2 . Note also in Figure 8.3 that the marginal cost curve intersects the average variable cost function at its minimum value. This necessarily follows because the marginal product curve interests the average product curve at its maximum value. The average total cost curve, which is equal to the sum of the vertical heights of the average fixed cost and average variable cost curves, likewise initially declines and subsequently beings rising beyond some level of output . At a level of output of Q3 the average total cost curve is at its minimum value. As discussed in the previous chapter, more intensive use of the variable inputs(specialization) in combination with fixed inputs to the production process is believed to yield initially more than proportionate increase in output. Subsequently, due to the law
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of diminishing returns, more intensive use yields less than proportionate increases. This reasoning is used to explained the U-shaped pattern of the ATC, AVC, and MC curves. Initially, specialization in the use of the variable resources results in increasing returns and declining average and marginal costs. Eventually, however the gains from specialization are overwhelmed by crowding effect, and then marginal and average costs being increasing.

Keynote 4.3.2 Short-run and Long-run Cost Curves

Long-run Cost functions Optimum Combination of Factor Inputs

The long-run is the period in which a firm is capable of changing the quantities of all inputs used. The firm is able to adjust the amount employed of each of the factors of production in a way that best suits it. So, if the market demand for the productincreases, the firm is able to increase the production in response, keeping in place the appropriate inputmix that minimizes the cost of production. The long-run (LR) curves are distinct from the short-run curves. The long-run average cost (LRAC) curve is thus like an envelope encompassing successive short-run cost curves. There is no lower-cost combination of inputs at each level of output than the points on the long-run average cost (LRAC) curve. This is shown in Keynote 4.3.2 How should a firm decide upon the optimal combination of inputs to produce a given output at minimum cost? For simplicity, if we assume that only labor (L) and capital (K) are used for producing the output, we can say that wage rate (w) and interest (r) are the key determinants of the output. We know by now that an isocost line shows all possible combinations of labor and capital that can be purchased for a given total cost. The concept is analogous to the concept of budget line that we discussed in the chapter on consumer behavior. We assume now that the producer will try to attain the highest possible isoquant curve, given the budget constraints that are faced. This constraint implies that optimum input bundle for the producer has to be on the isocost line. Hence one can then logically say that the producer will be in equilibrium at the point where the isocost line touches the highest possible isoquant curve. Put differently, producer equilibrium will be at the point of
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tangency between the isocost line and the highest attainable isoquant curve. At that point, the slope of the isocost line is equal to the slope of the isoquant curve. The slope of the isocost line is nothing but the ratio of relative prices of inputs, i.e. -(w/r). We already know that the slope of the isoquant curve is MRTSLK. Therefore, given the cost constraints, the producer is in equilibrium when -MRTSLK = -(w/r). MRTSLK is the negative of the slope of the isoquant and hence, it indicates the number of units of capital that will be given up to add one unit of labor without changing the output. This will be the ratio of the factors respective marginal products, i.e., MRTSLK = -MPL/MPK. Since in equilibrium, -MRTSLK = -(w/r) and since -MRTSLK = MPL/MPK, hence in equilibrium, MPL/MPK = w/r. Re-writing this we get, MPL/w = MPK/r, MPL/w is the additional output that is generated when the firm spends an additional rupee on adding labor. Similarly, MPK/r is the additional output that is generated when the firm spends an additional rupee on adding capital. Therefore, an input optimizing firm must choose an input mix such that the additional output generated by adding one more rupee to any input should be the same.

Keynote 4.3.3: Expansion Path and Long-run Cost

Keynote 4.3.4 Inflexibility of short-run expansion

Thus producer attains the equilibrium where the isocost line is tangent to the isoquant. The producers equilibrium in the longrun as well as short-run are shown in Keynote 4.3.3 and Keynote 4.3.4 respectively.

Economies and Diseconomies of Scale

When the firm expands in scale, the ability to plan and optimally utilize resources allows it to reduce average cost of production. There could be various factors at play here. One
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could be that with bigger scale of operations, division of labor and specialization can increase. Another could be that a bigger firm could have better bargaining power with suppliers of inputs as well as with buyers of its output. All such factors contribute to what is referred to as economies of scale. Economies of scale exist when output can be increased with less than proportionate increase in cost of production. If a doubling of cost results in more than double output, we can say that economies of scale is operating. Increasing the scale of operations beyond a point could result in increasing average costs again. This could be because the large size of plant and machinery could wear out the workers soon. This could also be because the organization has become too large and difficult to manage easily. Yet another possible reason could be that the need for large volume of inputs beyond a limit has reduced the number of potential suppliers, thereby reducing bargaining power. When such factors are in play, we say that diseconomies of scale are operating. In this context, it is important to distinguish between returns to scale and economies of scale. In general, when we talk about returns to scale, we assume that inputs are increased without affecting the proportion between various inputs. Hence we say that when inputs are doubled and output more than doubles, increasing returns to scale is in operation. It should be clear that we are discussing how change in output happens with reference to change in all physical inputs. On the other hand, when we talk about economies of scale, there is no assumption about input proportions. Input

proportions are variable. Hence here we dont talk about physical inputs, but rather about the cost of production. This solves the problem of aggregation of different types of inputs. Therefore, when costs are doubled and output more than doubles, it is economies of scale, which is in operation. Economies of scale are often classified into real and pecuniary economies of scale. Real economies of scale Real economies of scale refer to a reduction in the quantity of inputs per unit of output. Put differently, real economies enable a firm to increase production capacity without increasing inputs proportionately. There are four types of real economies. Production economies of scale: Production economies of scale may be due to labor, technical and inventory economies. Labor economies occur when the output is increased through division of labor. Division of labor enables a worker to improve skills and abilities, which raise the companys productivity. Technical economies are the result of using improved techniques and advanced technology, which has become viable with increased scale of operation. Inventory economies refer to a firms ability to maintain a large inventory that enables a firm to gain quantity discounts, reduce ordering costs, prevent interruption in production and supply, avoid delayed deliveries, lost sales and customer dissatisfaction. Selling economies: Selling economies refer to the advantages of scale in the promotion and distribution activities of the firm.
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For instance, advertising economies, which is a part of selling economies, are achieved when the costs of advertising are spread over far more units of goods. Similarly, the average costs of managing sales force and distributing the product also gets reduced when the firm scales up. Managerial economies: The Video 4.3.2:Resources of Economies of Scale efficiency of management may increase with an increase in the size of the company, at least till a point. A smaller firm may not be able to afford separate managers for finance, marketing, operations and human resource functions, which limits the managerial efficiency. Specialized managers can improve managerial efficiency, at least till a point. Storage and transport economies: Storage and transportation costs fall per unit of output with economies of scale. While an increase in the capacity of warehouses increases the total cost, the average costs are likely to be lower for a larger output. Similarly, transportation costs can also be reduced through the full utilization of vehicle capacities.

Pecuniary economies may be because of: Reduction in cost of raw materials due to bulk buying discounts or long-run contracts Lower costs of external finance by banks and other financial bodies due to perceived stability and lower risk Discounted advertising rates due to regular and high volume advertisements Lower transportation rates due to bulk booking and longrun contracts. Economies of Scope Often, firms produce more than one product. This could be because the products share large parts of the production process. Sometimes firms produce unrelated goods too. However, in most cases, a firm is likely to have cost advantages in producing more than one product either due to sharing of premises, production facilities or inputs or due to possible managerial economies or joint marketing programs. Such cost reduction due to producing an additional product is referred to as economies of scope. In general, we say that economies of scope are present when the average cost of producing two products jointly is lower than the average cost of producing these products separately by two different firms. If the production of one product adversely affects the production of another, then there could exist diseconomies of scope. If one of the products is highly inflammable, while the other product is produced using significant heat, then it may not make sense to produce both the product in the same premises.
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Pecuniary economies of scale

Pecuniary economies of scale refer to monetary benefits arising from operating on a bigger scale. These may be obtained by gaining discounts on bulk-buying. Essentially, larger firms have better bargaining power when dealing with suppliers of inputs, labor force, and even suppliers of its output.

Degrees of economies of scope refer to the percentage reduction in cost due to producing two or more products jointly than separately. With diseconomies of scope, degrees of economies of scope is negative. Learning Curve The average cost of production of a firm may fall over time as managers and workers learn on the job effective ways to save time and resources. As workers become experienced in using the plant and machinery, the average time required to produce a unit of output is likely to fall, reducing costs along with it. Learning curve is a graphical representation of by how much the average number of labor hours required to produce a unit of output falls as the cumulative output increases over time. This is shown in Figure 4.3.1 Figure 4.3.1

REVIEW 4.3.1

Question 1 of 8 The shape of short-run average total costs (SRATC) is_____________

A. L shaped B. Falling downwards C. U shaped D. Rising upwards

Check Answer

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S ECTION 4 Case Study: Mittal Steel-Consolidating US operations

INTRODUCTION
L N Mittal (Mittal), chairman Ispat International, had grown from a wire rod manufacturer with a single plant in Indonesia in 1976 to being the owner of a steel company with a market capitalization of roughly $3 billion and net sales of $2.7 billion in 1996.This impressive growth, which had attracted media attention all over the world, had been driven by a series of acquisitions in Mexico, Canada, Trinidad, Germany, Ireland, and Kazakhstan between 1992 and

1996. Most of these acquisitions followed a similar pattern. As governments around the world privatised their steel industries, Ispat bought underperforming mills, maximized production, and upgraded the product mix. As soon as Mittal acquired a firm, he redirected sales and purchasing internationally in order to fetch the best prices. Mittal had realised that the price of the steel scrap, the raw material for mini-mills, would rise as more minimills were constructed. He had

This case was written by Mridu Verma, IBS Center for Management Research. It was compiled from published sources, and is intended to be used as a basis for class discussion rather than to illustrate either effective or ineffective handling of a management situation
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therefore invested in a substitute for scrap known as directreduced iron (DRI), and was soon producing more of it than any one else. DRI cost about $95 a tonne in 1996, compared with $155 a tonne for the high-quality scrap that mini-mills mostly used, and $125 a tonne for the pig-iron used to make steel in blast furnaces. DRI was not a proprietary technology, but it was complicated and hard to copy. Ispat had two decades of experience and analysts believed that Ispats lead in DRI technology was ``virtually insurmountable for the foreseeable future''.1 By acquiring underperforming mills at bargain prices, Ispat was investing less for each tonne of steel-making capacity than any other firm in the world. Taking into account the needs of his business, Mittal had divided his steel empire into two parts. Ispat International, which traded on the New York and Amsterdam Stock Exchanges, owned most of the slower growing plants in the industrialised regions of the US and Western Europe. The privately held LNM Holdings owned faster-growing steel mills in developing countries as well as 80% of Ispat. Mittal believed it was important to keep assets in places like Kazakhstan and Algeria out of the balance sheet of the listed company because investors would not be comfortable. LNM paid Ispat a management fee for running its plants. In October 2004, Mittal announced a $4.5 billion deal to buy International Steel Group (ISG), a group of five once-bankrupt steel companies assembled by Wilbur Ross. Mittal also announced that Ispat would be merged with his private holding company, LNM Holdings, to form Mittal Steel Co, which would take over ISG. The share price of Ispat International, jumped 27% after the announcement. With the news of the ISG deal,

Mittal's net worth soared to around $22 billion. Mittal was on the verge of becoming the head of the world's largest steel company with annual sales of $32 billion, annual shipments of 52 million metric tons, and 2004 pro forma profits in excess of $6.8 billion ISG was Mittals second acquisition in the US and fifth in North America. Mittal already owned steel mills in Trinidad and Tobago (Carribean Ispat Limited), Mexico (Imexsa), and Canada (Ispat Sidbec). Inland Ispat, which Mittal had acquired in 1998, had marked the groups entry into the US. Mittal hoped that the ISG plants would serve as a ready market for the surplus DRI produced in the other three North American units. The ISG acquisition was also expected to give Mittals strategy of building regional economies in scale and taking costs out of its businesses in the region a fillip "The cost base goes down with a larger company, because of consolidation [of resources and suppliers]." Mittal2 THE INLAND ACQUISITION World War II was boom time for the US steel industry with many new facilities being set up to meet the rising demand. By 1960s however, the profits of the US steel majors started declining. Since 1965, more than 400,000 jobs were eliminated in the steel industry. Between 1980 and 1992, U.S. steel producers reduced their capacity by 30%. The industry saw a series of mergers and acquisitions. In the mid-1990s, the US steel industry was fragmented, financially weak, and plagued
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by oversupply. On one hand, suppliers raw material like coal and iron ore became stronger, while the customers like car manufacturers dictated terms. Not surprisingly, with each cyclical downturn, a number of steel companies went into the red. Over 35 steel and steel-related companies in the U.S. had sought protection under Chapter 11 of the United States Bankruptcy Code since the beginning of 1997. Many of these companies continued to operate even after filing for bankruptcy. In addition to obtaining concessions from their labor unions and suppliers, these companies also reduced prices to maintain volumes and cash flow. Some companies even expanded and modernized while in bankruptcy. Upon emerging from bankruptcy, these companies, or new entities that purchased their facilities through the bankruptcy process, were relieved of many obligations, including environmental, employee and retiree benefit and other obligations, commonly referred to as "legacy costs". This enabled such companies to have a more competitive cost structure, particularly for their fixed costs, than they did before entering bankruptcy. The situation was ripe for consolidation. While US Steel acquired National Steel, Nucor acquired Birmingham Steel and Trico, and Steel Dynamics acquired Qualitech Steel and GalyPro. In the US, the consolidation has been as a direct result of bankruptcies and this serves to reinforce our belief that low cost, high quality and good customer service are a prerequisite for long-term viability in our industry. Mittal3

In July 1998, Ispat acquired Inland steel for $1.4 billion, the biggest steel acquisition in USA. The acquisition was financed by a debt of $1.1 billion, of which $700 million was through secure term loans, while $400 million was raised by a group company, Ispat Sidbec. Inland Steel Co was renamed Inland Ispat after the acquisition. As part of the acquisition, Ispat Inland entered into an agreement with the Pension Benefit Guaranty Corp (PBGC) to provide financial assurances with respect to Ispat Inland's pension plan. Ispat Inland agreed to provide the PBGC with a $160 million letter of credit and contribute $242 million towards the Employees Pension Trust. When Ispat International decided to acquire Inland Ispat in 1998, it was considered to be Mittals boldest move till then. The deal, which evoked surprise from the US steel industry, was called Ispats giant step into the most competitive steel market in the world. Inland Steel was the sixth largest integrated steel producer in the US and accounted for about 5% of the nation's steel production. Founded in 1893, the company manufactured a range of high-value-added flat-rolled and bar products, which were considered to be of the highest quality by customers. Inland Steels flat products accounted for more than 85% of the companys revenue. The company produced carbon and highstrength low-alloy flat-rolled steels for virtually all automakers in the US, as well as for leading manufacturers of appliances, office furniture, electrical motors and other market segments. It made special quality carbon, alloy and free machining bar products for the automotive, cold-finishing, fastener, forging, industrial machinery, off-highway and agricultural- equipment markets. Ispat Inland was a leading producer of ultra-high134

strength steels (UHS) with ratings of 800 mpa and higher. Some of this was galvanized. Most vehicle bumpers made in the U.S. used Ispat Inlands high strength steel (HSS). After announcing the acquisition of Inland Steel, Mittal indicated that he would pump in the much- needed investments to increase Inlands rolling-mill output. "We intend to invest in Inland's assets to further maximize its production capacities to fully realize its potential. We also believe that Ispat International's size, global reach and expertise will allow us to work together to enhance Inland Steel Co.'s global competitive position." He also outlined plans that included supplying semi-finished steel from his other operations and replacing premium scrap with direct-reduced iron (DRI) at Inlands electric arc furnace (EAF). The US steel industry had witnessed a series of mergers and acquisitions in the mid and late 1990s. With the increase in size, the merged entities enjoyed better bargaining power vis-vis suppliers and consumers. Robert Darnall (Darnall), CEO Inland Steel, was concerned about the future competitiveness of a standalone U.S. integrated steel mill, like Inland. In a statement to the press, "In evaluating strategic alternatives for increasing shareholder value, it became clear that steel companies with an international production capability and global market reach will have a major edge over other producers." - Darnell5.

Darnells concerns were valid as the auto giant, General Motors whose steel purchases amounted to more than $5 billion in a year, was opening up its steel contracts to competitive bids. Apart from putting intense on U.S. steel producers, the move was expected to lead to other major changes in the integrated industry. The acquisition of Inland marked a departure of sorts for the Mittal group. Mittals previous acquisitions involved bargain deals with government-owned under performing steel companies with archaic equipment and facilities. Unlike several of Ispats other acquisitions, Inland had been earning money, although its profit margins had been thin. The company already had top-notch equipment, including mills at I/N Tek and Kote. The Inland acquisition gave Ispat direct access to the worlds largest and most sophisticated steel market. Mittal also hoped to learn much from Inland, which had expertise in producing the highest-quality steel for the automotive and appliance customers at its mini-mills.

Mittal Steel-Consolidating US Operations

We expect to derive numerous benefits from Inlands technological and marketing leadership at our other units. Inland already is one of the worlds top-quality producers. - Mittal6

Ispat managers also believed they would infuse Inland with a mini-mill culture that emphasized cost consciousness, increasing volume, and continuously moving up the value chain.
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Mittal decided to retain Inland Steels top brass. Darnall continued to run Ispats North American operations with his team of managers. Before Mittals acquisition, the operating costs at Inland stood at a mammoth $2.6 billion. Mittal brought in his key Indian managers, who together managed to drastically reduce the operating costs to $127 million by various means. By reducing Inlands non-union, white color workforce by 17%, Mittal saved $22 million a year. Mittal also reduced raw material costs by $35 million annually through centralized purchasing process. By the end of 1998, production costs were reduced by $12 per tonne of steel. By using DRI and semi finished slabs from Ispat Mexicana (a Mexico based Ispat group company), the total output was increased by 5.5 million ton to 6.5 million ton. Ispat Inland contributed $50 million in July 2003, $21 million in September 2003, $82.5 million in 2004 (and was required to contribute $27.5 million in 2005) towards the pension fund. Additionally, Ispat Inland pledged $160 million of non-interest bearing First Mortgage Bonds to the PBGC as security. Inlands sales amounted to $2.12 billion and $2.38 billion on with operating margins of ($-127 million) and $33 million in 2001 and 2002 respectively. In 2003, sales came down to $2.34 billion while operating profit was (-4 million). Total capital expenditure at Ispat Inland between July 1998 and December 2003 was $355 million. In October 2003, Inland completed the relining of its Blast Furnace No. 7, enhancing its production capacity and efficiency. Ispat Inlands annual shipments remained unchanged at 5.3 millions tons during this period.

THE ISG DEAL ISG had been formed in April 2000, through the acquisition of Bethlehem Steel, LTV and Acme Steel. It later acquired the assets of bankrupt Weirton Steel in early 2004. ISG was the second largest integrated steel producer in North America7. The company had the capacity to cast more than 18 million tons of steel products annually. It shipped a variety of steel products from 11 major steel producing and finishing facilities in six states, including hot-rolled, cold-rolled and coated sheets, tin mill products, carbon and alloy plates, rail products and semi-finished shapes serving the automotive, construction, pipe and tube, appliance, container and machinery markets. Since 2000, ISG management had undertaken several measures to turn around the ailing steel mills. However, it was only in 2003, that the company achieved some significant success. Our accomplishments were significant in 2003. We purchased Bethlehems assets, resulting in the largest acquisition in the domestic steel industry, and thus far we have been successful in integrating the assets and the employees of Bethlehem. In addition, we completed a very successful initial public offering. The proceeds of the IPO were used to reduce our debt and make significant progress toward our goal of achieving investment grade credit metrics. During the fourth quarter, our results improved as compared with our third quarter as production and shipments increased significantly. This led to a 20% rise in revenues from the third quarter to the fourth quarter while operating incomeimproved to $53.2 million in the fourth quarter from a $15.7 million loss in the third quarter. We
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are pleased to have ended the fourth quarter and year with profitable results. - ISGs CEO Rodney B. Mott. 8 In the fourth quarter of 2003, ISGs average price realization was $405 per ton for the fourth quarter of 2003 and $391 for the full year. While ISGs prices improved over the course of the year and relative to 2002, most of this improvement was the result of the richer product mix due to the Bethlehem acquisition. The product mix improved as shipments of coldrolled steel and other value-added products increased to 54% of total shipments in 2003 from 29% in 2002. Shipments in the fourth quarter increased by about 600,000 tons to 3.5 million tons as compared with the third quarter of 2003. ISGs initial public offering yielded $493 million. This money was used to reduce bank borrowings related to the Bethlehem acquisition. As on December 31, 2003, ISG had a liquidity of $423 million, consisting of $194 million in cash, with available borrowing capacity of $229 million. Liquidity as on December 31, 2002 totaled about $103 million. At the end of 2003, longterm debt to total capitalization was approximately 32%. The improved domestic economy (US) allowed ISG to further increase prices and improve its operating profit margins during 2004 though raw material costs, principally for coke and steel scrap, continued to increase in early 2004. In February 2004, ISG acquired the assets of Weirton Steel Corporation for $255. ISG seemed to be keen on the deal with Ispat International because it had not made much headway in integrating the steel plants. Major capital outlays were required at the steel mills for

overhauling the archaic computer systems and replacing coking batteries among other things. Mittal wanted to integrate his eight U.S. mills -- mostly clustered around the Great Lakes -- to achieve regional economies of scale, a formula he had been applying in Eastern Europe as well. By running the facilities as a single unit, he hoped to extract better terms from suppliers of iron ore, coal, and electricity. And with the plants no longer competing against each other for customers, Mittal expected to negotiate better prices and guarantee clients a stable source of supply. "Our customers and suppliers are very happy that we are consolidating the business in the U.S. This kind of merger sees strong and financially healthy companies emerging," - Mittal9.

Mittal Steel would control about 40% of the U.S. market for flatrolled steel extensively used in automobiles. The US government was also not averse to the takeover, for higher concentration in the industry meant reduced need for government intervention for protecting U.S. steel companies from imports. When Mittal announced his decision to buy ISG for $4.5 billion and merge it with his other assets, the shares of Ispat and ISG surged. Under the terms of the deal, Netherlands-based Ispat International NV, 77% of which was owned by Mittal, would buy the Mittal familys LNM Holdings in a reverse takeover by issuing $13.3 billion in shares to form Mittal Steel. Mittal Steel would then pay about $42 per share in cash and stock to the shareholders of ISG. The deal was considered a financial coup
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for ISG chairman Wilbur Ross, a former Rothschild & Co. banker who had built ISG by buying troubled companies, including Bethlehem Steel, LTV Corp. and Weirton Steel, at very low prices. Ispat officials believed that scope existed for more than $1 billion a year in cost savings and revenue gain. Some industry insiders wondered, whether Mittal would be able to realize such huge savings as ISG had already gone through a major cost-cutting exercise under Ross, who had bought bankrupt companies and offloaded their (the companies) retiree liabilities onto the government. Moreover, Mittal would be spending about $3 billion over the next five years to upgrade and maintain ISGs aging plants around the world. But ISG had logged margins of only 8.6% for the first nine months of 2004, compared to a combined 27.5% at Ispat and LNM Holding. Upgrading ISG looked relatively easy to Mittal and his executives, who had performed similar tasks earlier, believed ISGs margin could be significantly improved. THE ROAD AHEAD Outlining the future plans (after becoming a part of the Ispat group) Rodney Mott, who would head Ispats U.S. operations mentioned 10, "We're looking for opportunities to increase capacity. Mott added that no plant in North America would be targeted for cutbacks or shutdown. In fact, immediately after the deal

announced, ISG managers sought to let their 12,000 employees in eight states know that the takeover could mean more work, not another round of industry job cuts. ISGs suburban Richfield headquarters would become the headquarters for Mittal's North American operations. The workers at ISG steel mills had faced years of uncertainty with US steel companies going bankrupt and often changing hands. Given Ispats size and its track record of turning around ailing companies and holding on to them, the merger spelt security for the workers. They drew comfort from the fact that Ispat had honoured Inlands pension and social security commitments after taking over the company.

Product Mix (43 Mn Tonnes)

Flat 74%

Long 26%

North America
As one analyst commented 11,

Europe

RoW

"They're would no longer be subject to the whims of the U.S. market."

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Despite its size, Mittal l would still control only 6% of global output. This fuelled speculations that Ispats acquisition spree would continue. But acquisitions were getting tougher with the low hanging fruits having already been plucked. There were also doubts whether the ISG deal would be successful in the long run. Had Mittal outstretched himself? That was the question that analysts pondered over as 2005 dawned.

Footnotes 1. Scott, Morrison. An analyst with Donaldson, Lufkin & Jenrette, an American investment bank, commented 10th January 1998, Vol. 346, Issue 8050, pp.55-56. 2. Tomilson, Richard. Metal Man, Fortune (Europe), 7th February 2005, Vol. 151, Issue 2,pp.28-32. 3. I s p a t I n t e r n a t i o n a l A n n u a l R e p o r t 2 0 0 3 , www.mittalsteel.com 4. Winter, Drew. Ispat/Inland Deal Promises Lower Costs--Cheaper raw materials key to strategy Ward's, Auto World, 1st June 1998.

Geographical Mix (43mn Tonnes)

25% 45% 30%

5. ibid. 6. Ritt, Adam. Ispats big deal, www.newsteel.com, April 1998 7. Based on steelmaking capacity. 8. ISG announces fourth-quarter and full-year 2003 results, ISG Annual Reports 2003. 9. Mittal buys Ohio-based ISG to form steel giant, Reuters, 25th October 2004. 10.Milicia, Joe. ISG Goes From Savior to Sold in Two Years, Associated Press, 26th October 2004. 11.Milicia, Joe. ISG Goes From Savior to Sold in Two Years, Associated Press, 26th October 2004.
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Keynote 4.4.1

11. Bibliography 1. 2. 3. The Carnegie from Calcutta, www.economist.com, 8th January 1998. Ritt, Adam. Ispats big deal, www.newsteel.com, April 1998. Winter, Drew. Ispat/Inland Deal Promises Lower Costs--Cheaper raw materials key to strategy Ward's, Auto World, 1st June 1998. 12. 13. 14.

11. Annual Reports 1999, 2000, 2001, 2002, 2003. http://pittsburgh.bizjournals.com/pittsburgh/stories /2004/12/20/daily7.html. www.intlsteel.com. www.mittalsteel.com.

4. 5. 6. 7. 8. 9. 10.

Andrea, Holecek. Ispat negotiating with PBCG, North West Indian Times, 3rd July 2003. Dutch Steelmaker Cements Deal for ISG, InTech, 12th January 2004. ISG expects Mittal deal done by Q1 '05, Pittsburg Busi ness Times, 20th December 2004. Mittal buys Ohio-based ISG to form steel giant, Reuters, 25th October 2004. Milicia, Joe. ISG Goes From Savior to Sold in Two Years, Associated Press, 26th October 2004. Reed, Stanley and Arndt, Michael. The Raja of Steel, Business Week, 20th December 2004. Tomlinson, Richard. Metal Man, (cover story) Fortune (Europe), 7th February 2005, Vol. 151, Issue 2, pp.28-32.
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S ECTION 5

Case Study: Business Viability of Dish TV Would it break or breakeven?

Indian Television viewership with 115 million households is among the largest in the world. This figure is projected to increase to 132 million by 2012 at 3%1 growth rate, with DirectTo-Home (DTH)s ground breaking broadcasting service majorly accounting for this. DTH service involves distribution of multi-channel TV programmes by using a satellite system that provides TV signals directly to the subscribers premises. The need for an intermediary such as a cable operator is evidently dispensed within the DTH service.

However, the transition of DTH digital entertainment services in India was not very smooth. It was first proposed in 1996. However, approval was denied on grounds of national security and cultural invasion. In 1997, the Indian government imposed a ban when the Rupert Murdochowned Indian Sky Broadcasting (I Sky B), which about to launch its DTH services in India. Finally, DTH service was allowed by the Government with the relevant notification towards this end on January 9th 2001

This case study was written by Nitu Gupta under the direction of Akshaya Kumar Jena, IBSCDC, Hyderabad. It is intended to be used as the basis for class discussion rather than to illustrate either effective or ineffective handling of a management situation. The case was compiled from published sources.
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Dish TV is the pioneer and leader of DTH services in India. Dish TV, formerly known as ASC Enterprises Ltd., is a part of renowned Essel Group. It has improved TV viewing with digital technology for enhanced picture quality and stereophonic sound effects. Dish TV has changed the Indian television technology by bringing it on par with the global entertainment industry with exclusive features such as international channels, uninterrupted viewing, electronic programme guide, parental lock and geographic mobility. Various futuristic features of Dish TV like interactive TV, movie on demand, video games, etc., have taken television viewing to a higher level of sophistication Since the DTH industry in India is in its nascent stage, its license does not allow a broadcaster to offer content exclusivity to any particular player, thus disallowing differentiation, either on technology or in programming. Successful acquisition of maximum number of subscribers is, therefore, directly linked to the advertisement and marketing budgets and customer acquisition skills. Dish TVs biggest cost lies in the process of customer acquisition, which involves large amount towards subsidising the Set Top Boxes (STB) and first year subscription prices. It hardly makes any money on the hardware. Therefore, the key area of focus of Dish TV is subscriber addition and a good

market share in a market, which is gradually attracting more competitors (Exhibit I)

It plans to expand its infrastructure with 9,000 outlets to sell its wares, 100 vans to sell the kits and 150 Dish Care centres.3 Dish TV platform includes 225 channels with 21 audio channels. It has a huge distribution network of about 650 distributors and 45,000 dealers spanning around 6,500 cities and towns across the country. Highly service-oriented, Dish TV has a 24X7 call centre with 1,600 seats in 11 different languages4 across cities to take care of subscriber queries at any point of time and ensure a timely solution to problems. Its registered subscriber base has crossed 5 million5. Indian DTH industry is perhaps the first instance of a crossmedia restriction in India. There is 49% cap on foreign investment. DTH industry, being a capital intensive industry, this restriction hampers its progress.
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The capital intensive nature of the DTH industry necessitates long gestation period to reap results. DTH licenses in India cost $2.14 million and are valid for 10 years.6 The Indian DTH policy requires all operators to set up earth stations in India within 12 months of getting a license. Being the first mover, Dish TV has incurred huge expenses on spreading awareness of the product and launching brand building on a pan-India basis. The company entails cost on some major heads like software and its implementation cost, Customer Premises Equipment (CPE) and content cost. There is capital and incidental expenditure and advances incurred during the preoperational period .The Subscriber Acquisition Cost (SAC) is a key cost factor and takes on the characteristics of the variable cost. The rest of the cost the expenditure towards operations is the fixed cost. The license fee, transponders fee, uplink charges, content charges, etc., are components of the fixed cost (Exhibit II)
Exhibit II Distributing of Operating Cost of Dish TV (FY2007)

The universal goal of any business enterprise is to remain viable. The business viability depends on the maximisation of profit or minimisation of loss. If a firm is making profit, it implies total revenue is greater than total cost. Hence, it is undoubtedly advisable to be in business. When a firm is making loss, it will have to decide whether to continue production or not. This decision will, in fact, depend on the different cost levels. The firm incurs loss if Total Cost (TC) is greater than Total Revenue (TR). In case of Dish TV, its total revenue for FY2008 is INR 4,130 million while the total cost is accounted for INR 6,310 million. Hence, the negative differential of INR 2,180 million constitutes the loss for FY2008. The total fixed cost of Dish TV being INR 4,980 million, its total variable cost is INR 1,330 million (Exhibit III).

Exhibit III Dish TV Financial Year 2008 Report (INR Million)

Source: Compiled by Author from Dish TV India Limited, Investor Presentation Q3FY09, http;//www.dishtv.in/Static/pdf/Dish%20TV%20Investor%20Presentation%20Jan%2023%2023%202009. pdf,page14

Source: Umapathy Sivasundaram, Industry Analysis-DTH Industry in India, http://sivasundaram.com/wp-content/uploads/2007/08/dth-industry-in-india.pdf, page13

Total revenue of INR 4,130 million being greater than Total Variable Cost (TVC) of INR 1,330 million, Dish TV prefers to remain in business instead of shutting down. Even if it closes its operations, it cannot escape the fixed costs, which have already

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been sunk. Dish TV is continuing its operations with the expectation of breaking even very soon. Dish TV has 1-year lead over its nearest competitor and around 3-year lead over others. As there is no limit on the number of companies that can apply for the DTH license, the number of competitors is increasing. By leveraging its first mover advantage, it has, however, ensured continued market leadership through aggressive subscriber acquisition strategy (Exhibit IV).

losses are set to crossINR 20,000 million in 20082009. As per analysts, each connection sold, entails loss for every DTH player due to provision of subsidised hardware to consumers. However, Dish TV intends to focus on improving its business economics. Dish TV, which was famous for price curtailment in favour of subscribers, has started initiating the process of increasing charges of its connection and offerings. It intends to revamp its entire price structure. The service tax which was being absorbed by the Dish TV would be passed to its customers resulting in around 12%12.5%8 hike in monthly subscription. Jawahar Goel (Goel), managing director of Dish TV, has clarified that as the fixed cost of the company has increased radically, the price cutting trend has to be put to an end. Dish TV intends to pass on the cost to the customer without affecting them immensely .Hence, it is focusing on innovative ways where price increase is to be assuaged with value added services. There are industry level initiatives which might help Dish TV achieve its goal. The license fee is reduced from 10% to 6%9 with retrospective effect from April 1st 2008. There is an attempt to pass on the entertainment tax to the subscriber through consensus. Central Value Added Tax (CENTVAT) is reduced from 14% to 10%10 leading to lowering of CustomerPremises Equipment (CPE) cost. Dish TV is in the sixth year of its operation. In a recent interview to the Business Standard in March 2009, Goel sounded optimistic, We will turn EBITDA positive within the current, or at the most within the next quarter, much ahead of our targets.11 EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortisation) is thus, a measure of a firms
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The cut throat competition in the DTH industry had promoted fierce price war that told upon their margins. Media Partners Asias (a consultancy that specialises in analysing Asian media markets) recent report reflects thatthe DTH industrys combined

gross income. Being EBITDA- positive implies the company is heading towards break-even. In 20082009 fiscal, Dish TV crossed the 5 million subscriber mark. Having set aggressive targets for 20092010, it aspires to achieve gross subscriber base of over 7.5 million subscribers12 through addition of yet another 2.5 million subscribers. Advertising, generated on the clean-feed of select foreign channels and carriage fees seem to be the additional source of revenue for Dish TV. It expects the carriage fees to increase from INR 250 million13 in 20082009 to around INR 500 million in the current fiscal 20092010. Whether or not Indias No.1 DTH company should remain in business if it undergoes loss is a matter which has recently gained traction from the experts who are evenly divided in their opinion.

References 1. Annual report 2007-08,The Undisputed Leader in DTH, http://www.dishtv.in/static/pdf/AnnualReport- Full Download.pdf, page 41 Guidelines for DTH Broadcasting Service in India, http://www.indiantelevision.com/dth/dth11.htm, March 16th 2001 Khandekar Kohli Vanita, Life Beyond Cable,http:/ wwwbusinessworldin/index. php/Media-Entertainment/Life-beyond-Cable-2.html, page 2 Reduction of Centvat: Imapct on DTH,http:// www.dishtv.in/Static/pdf/Dishtv%20Cenvat.pdf, December 8th 2008. Sinha Ashish, Dish TV May Break even Before target, http://www.business-standard.com/india/news /dish-tvmay-break-even -before- target/351678, march 13th 2009. Bharti Airtel gets LoI for rolling out DTH services, www.newsoneindia.in, august6th 2009. Dish tv may break even before target op.cit Bajaj Vipin, Dish TV to Increase Prices of its DTH Offerings http://www.televisionpoint.com/news2008/ newsfullstory.php?id= Dish TV India Limited, Investor Presentation Q3FY09, http://www.dishtv.in/Static/pdf Dish%20TV%20 Investor%20Presentation%20Jan%2023,%202009. Reduction of Centvat: Impact on DTH, op.cit.
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2.

3.

4.

5.

6. 7. 8.

9.

10.

S ECTION 6

Case Study: Gujarat Ambuja: Cost Leader in the Indian Cement Industry

INTRODUCTION Gujarat Ambuja Cement Ltd (GACL), which had grown tenfold during the late 1990s, was the third largest producer of cement in India in 2004 next only to Birla Groups (consisting of Grasim Cements and Larsen & Toubro Cements) and Associated Cement Companies (ACC) &. In 2003, GACL had a capacity of 12.5 mn tonnes and generated revenue in excess of Rs. 2,500 crores. The company had posted a net profit of Rs 221.73 crore for the year ended June 30, 2003. GACL was the

lowest cost producer in the Indian cement industry. GACLs quest for cost leadership had been driven by productivity improvement and cost cutting measures. The company had won various awards for management excellence, quality, and environment management. Ever since its inception, the company had believed in doing things in innovative and unconventional ways. GACLs modern plants, large kilns, high degree of automation, low manpower costs, low power tariff

This case was written by Manoj Kumar Singaravelu, IBS Center for Management Research. It was compiled from published sources, and is intended to be used as a basis for class discussion rather than to illustrate either effective or ineffective handling of a management situation.
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and low fuel costs had helped it to become the cost leader in the industry. GACL had cut energy costs by reducing the usage of coal through use of substitutes like crushed sugarcane. GACL operated most of its plants at above 100% capacity utilisation. The company had pioneered the use of ship transportation to cut freight costs and also established the necessary infrastructure like ports, freight and handling terminals. Low-cost funds had helped GACL to cut the cost of capital. The company's engineers had picked up best practices during visits to overseas plants in countries like Japan and Australia. GACL had also reduced pollution levels at its cement production plants and complied with the Swiss standards of 100 milligrams per cubic nanometer BACKGROUND NOTE GACL was established as Ambuja Cements Private Ltd. (ACPL) in 1981 by Narotam Satyanarayan Sekhsaria (Sekhsaria), a businessman from Gujarat in western India. Originally a cotton trader, Sekhsaria liked the cement business because of its stable demand, lack of substitutes and limited competition. With the support of Gujarat Industrial Investment Corporation (GIIC), Sekhsaria and his two partners, Suresh Neotia and Vinod Neotia, set up APCL. Suresh Neotia was appointed Chairman while Sekhsaria took charge as the Managing Director. In 1983, the company floated a public issue and its name was changed to GACL. The same year, production started at a 0.7 million tons per annum (mtpa) plant, named Ambuja Cements,

in Ambuja Nagar, Gujarat. GIIC sold its stake in GACL in two tranches to Sekhsaria in 1987 and 1990. In 1993, GACL commissioned its second cement plant at Ambuja Nagar (capacity 1 mtpa), named Gujambuja Cements. Attracted by buoyant cement demand in the northern regions, GACL set up a 1.5 mtpa plant at Suli in Himachal Pradesh (HP), named Ambuja Cements Himachal Unit in 1995. In the same year, GACL floated a wholly owned subsidiary in Mauritius - Cement Ambuja International Ltd. (CAIL). In 1996, GACL floated another subsidiary, Ceylon Ambuja Cements (Private) Ltd., through which it acquired a small company, Midigama Cement, in Sri Lanka. In 1996, GACL set up its third plant at Ambuja Nagar, named Guj Line - II (capacity 1 mtpa). GACL also established grinding and packing units at Ropar (Punjab) and Panvel (Maharashtra). In 1997, GACL acquired Modi Cements' sick 1.4 mtpa plant at Raipur (Madhya Pradesh) for Rs 1.66 billion. This plant was renamed Ambuja Cement Eastern Ltd. After the acquisition, GACL revamped its processes to bring them on par with the standards of its other plants. In 1998, GACL acquired the Nadikudi (about 100 kms from Guntur) and Proddatur (near Cuddaph) limestone mines in Andhra Pradesh to strengthen its presence in southern India.

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In December 1999, GACL paid Rs 3.5 billion to acquire a 51% stake in Delhi based DLF Cement. DLF Cement had started its operations in 1997 in Rajasthan with a plant capacity of 1.4 mtpa. After this merger, GACL became the fourth largest cement manufacturer in India after ACC, L&T and Grasim. In the same month, GACL also acquired a 7.2% stake in ACC for Rs 4.55 billion. With 14 manufacturing units in India, ACC had a total capacity of over 11 mtpa. It was one of the largest integrated cement companies in the world. In December 2001, GACL began trial production at a new 2 mtpa plant in Chandrapur, Maharashtra, taking its total capacity to 12.5 mtpa. In FY 2003, the company recorded a sales figure of Rs 2173 crores and a PAT of Rs 293 crores. THE INDIAN CEMENT INDUSTRY In 2003, with a total capacity of 144 mn tonnes (including mini plants), the Indian cement industry was the second largest in the world, after China. Indias cement capacity had increased from 3 mtpa in 1950-51 to around 130 mtpa in 2003, at a growth rate of 7.6% per annum. Between FY1992 and FY2001, the capacity increased at an average 7.8% per

annum (67 mtpa to 130 mtpa) while production and despatches grew at 6.9% per annum (54 mt to 98 mt). Indian cement companies had produced 111.35 million tonnes of cement, an increase of 8.7% and dispatched 111.06 million tonnes of cement, an increase of 8.5% for the fiscal year ending March 2003. The domestic consumption growth had been marginally lower at 6.8% per annum, with the balance being made up by an annual growth of 27.3% in cement exports.

Rivalry in the Indian cement industry was intense with over 50 c o m p a n i e s o p e r a t i n g a r o u n d 1 2 0 plants. The top five companies accounted for over 48.5% of the total capacity. The rest of the companies, typically, were operating single-location plants with capacities ranging from 0.5 to 2.0 mtpa. Leading cement companies like Grasim, Larsen & Toubro, Gujarat Ambuja, ACC, India Cement, Madras Cement and Shree Cement alone had added over Rs 20,000 crore to their market capital as the combined market capital had touched Rs 31,724.40 crore in Dec 2003.

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Holcim and Cemex were waiting for a favourable opportunity to do the same. Gujarat was the largest cement producing state with a capacity of around 15 million tonnes in end 2003. The total cement demand was, however, only around 6 MT. The excess output was sold in states like Maharashtra, Rajasthan and Kerala. The demand for cement was closely linked to the performance of the Indian economy. Cement was consumed in large quantities by the infrastructure sector. Hence, cement demand in emerging economies was much higher than in developed countries. The demand for cement in India was roughly split between the urban and rural areas. In rural areas, penetration levels were still low as cement was substituted by cheaper building materials like mud, lime, etc for building cheaper nonpermanent structures. The Indian government was a major consumer of cement.

In view of the huge market potential, some foreign multinationals had entered the country. Companies like Lafarge and Italicementi had made acquisitions and other majors like

The performance of cement companies was dependent on infrastructural investments made by the government. The National Highway Development Project (NHDP) had been initiated to upgrade the existing highways to connect the four metropolitan cities Delhi, Mumbai, Chennai and Kolkata by the Golden Quadrilateral and the North-South and East-West Corridors. This project involved upgradation to four/six lanes of about
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13,000 kms of National Highways. Almost 25% of these roads were expected to be concretised. These road projects were expected to generate a demand for cement of 4-5mn tons pa (i.e. 4-5% incremental growth) over the next two years. MANUFACTURING In 2003, GACL had manufacturing plants in five different locations (Exhibit: IV). GACL also had three grinding mills at Ropar (Punjab). GACL along with ACC had plants in Karnataka, Tamil Nadu, Andhra Pradesh, Madhya Pradesh, Maharashtra, Uttar Pradesh and Bihar. The basic raw materials used in cement manufacturing were limestone, clay, silica and gypsum. The cement manufacturing process involved four stages: quarrying and crushing; grinding and blending of raw materials; clinker production; and finish grinding. The raw materials after grinding and blending were fed into a pre-heater followed by a kiln, which typically completed one revolution per minute. The material flowed towards the hot end of the kiln and was heated to a temperature of 1300-1400 degree centigrade for 1 hour. Crushed and pulverized coal was used as the fuel. The heating process in the kiln resulted in dehydration (removal of water vapour) and calcination (removal of carbon dioxide). The product formed in the kiln was a dark and hard nodule, which was cooled to form clinker. After air cooling, clinker was mixed with retarders such as gypsum, plaster or calcium lignosulfonate. Then air entraining, dispersing and water proofing agents were added. The mixture was fed to the grinding mills, which produced cement. When mixed with water, cement formed a hard mass due to the hydration of the constituent compounds.

Video 4.6.1: Cement Manufacturing Process

Source: Lafarge Group

Three types of processes wet, semi-dry and dry were used to produce cement. In the wet process, the raw material was

Cement Manufacturing Process

prepared by mixing limestone and water (called slurry), and blended with soft clay. The slurry had 30 to 40 % water content. Before it was powdered, the slurry was evaporated to remove water content. The wet process consumed more energy compared to the dry process.
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the wet process. However, the dry process required high capital investment. The vertical shaft technology employed by minicement units used the wet process whereas the rotary kiln technology employed by the large plants used the modern dry process

There were different varieties of cement based on their composition and use. Some of the popular ones were Ordinary Portland cement, Portland Pozzolona cement, Portland Blast Furnace Slag cement, and White cement. These grades differed in the percentage of clinker used in making cement. Ordinary Portland Cement (OPC) required 95 percent clinker, the balance being mostly gypsum. It accounted for 70 percent of the total consumption of cement in the country. OPC was the most common cement used in general concrete construction when there was no exposure to sulphates in the soil or groundwater. It was capable of bonding mineral fragments into a compact whole when mixed with water. This hydration process
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The dry process had become popular over the years. It reduced fuel consumption from 330 kg (in the wet process) to 250 kg of coal for a ton of cement. Also, for a given kiln size, the output in the dry process was two and a half times to three times than in

resulted in a progressive stiffening, hardening and strength development. Portland Pozzolona Cement (PPC) required 80 percent clinker, 15 percent pozzolona and 5 percent gypsum. It accounted for 18 percent of the total cement consumption in the country. Pozzolona materials were siliceous and aluminous materials that did not possess cementing properties but developed these properties in the presence of water. Portland Blast Furnace Slag Cement (PBSF) required 45 percent clinker, 50 percent blast furnace slag and 5 percent gypsum and accounted for 10 percent of the total cement consumed in India. It was useful in marine construction. White cement was a slight variation of OPC. It contained a small quantity of iron oxide to act as a filler between ceramic tiles. The cement was used for decorative purposes like rendering of walls, flooring, etc. The ash content in white cement had to be low. Hence, gas was used as fuel instead of coal. Relatively small amounts of white cement were produced in the country, because it was almost three times more expensive than ordinary cement. Normally about 1.2 1.5 tons of limestone, 0.25 ton of coal, 120 kwh of power, and 0.05 ton of gypsum were needed per ton of cement. Limestone was the key raw material. The quality of limestone significantly affected the operating efficiency of the plant. GACLs total cost management (TCM) drive had concentrated on two key areas productivity and consumption of coal and

power. In 2003, GACLs average production cost was Rs. 1316 per tonne, significantly lower than any of its nearest rivals. GACL had achieved more than 100 % capacity utilization from 1999. While its total installed capacity was around 5 mtpa, the company produced almost 6 mtpa (excluding the Modi Cements plant). GACL consumed only 96 kwh of power per ton of cement against the industry average of 110-115 kwh per ton. Its captive power plants (40 MW and 12 MW added in Gujarat and Himachal Pradesh respectively during 1998) had reduced dependence on the more expensive power supplied by State Electricity Boards and supplied around 60.3% of its total power requirements. In the early 2000s, GACLs captive power generation cost was only Rs. 1.30 per kilowatt (excluding interest and depreciation), compared to Rs. 4.50 per kilowatt for power supplied by Electricity Boards. GACLs coal consumption of 170 kg per tonne of cement was also the lowest in the industry against an industry average of 250 kg per tonne. In terms of calorific value, it was 743 kcal per ton of clinker compared to the industry norm of 850 kcal. Since the Kodinar plant was located in the agricultural belt of Saurashtra area, husk was available in plenty. GACL engineers attempted to reduce coal consumption by using groundnut husk to fire the kilns. In the second plant in Ambuja Nagar, GACL replaced coal with crushed sugarcane. The use of sugarcane created problems because water content differed with every batch, leading to fluctuations in the kiln temperature. GACL designed a special mechanical system that could adjust the rate of feeding to ensure a stable temperature in the kiln. In the process, GACL brought the energy bill down by Rs. 20 for every tonne of crushed sugarcane used.
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GACL replaced V belt drives (which consumed more energy due to friction) by flat belt drives. Even though mechanical conveyors gave problems like spillages and breakdowns, GACL did not shift to pneumatic conveyors, which consumed more power. Instead, the company devised an improved version of the mechanical conveyor to eliminate the drawbacks.

Cement plants often overcooked the clinker. In the early 1990s, during a visit to a plant in Japan, GACL engineers observed that clinker pieces were being extracted from the kiln and scanned under the microscope to examine their crystal structure. By studying the structure of the crystal, the Japanese engineers determined whether the clinker had been heated to the right temperature. Learning from this experience, GACL engineers successfully reduced the power costs, from 120 units/ton to 90 units/ton, by adjusting the retention time, maximum temperature and the rate of cooling. GACL had made coordinated efforts to reduce mining expenses. It was a normal practice for cement companies to operate their own limestone mines.

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Mines were not only extremely destructive environmentally, but were also expensive to operate. Explosives used in mining were on the negative list of imports and substantial costs were involved in implementing safety measures. In 1997, GACL sent its engineers to Australia to study the extraction of metals. On their return, GACL implemented the ripping technology that could access limestone in smaller areas where blasting was not possible. To reduce the noise and vibration, which occurred during the conventional drilling, blasting and crushing process, GACL introduced an Australian device called Surface Miner. The Surface miner was not only energy efficient, but also recovered more material from a given area. GACLs information system facilitated easy access of data by different departments. The entire plant was monitored by a computerized process control system from a central control room, which had visual display screens, and an interlocking system connecting crucial stacks. The input of raw materials into the kiln was also regulated from the control room. Over the years, GACL had streamlined its quality control practices. The earlier practice had been to report quality control data once a day. Later, GACL introduced the practice of reporting the data 48 times a day. Starting with the optimum raw material mix, the computerized control over 3,000 operational
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parameters helped in improving quality at each step of the production process. Machines were also continuously monitored for any malfunctioning. Improvement in efficiency and lower shutdowns rate led to an increase in capacity utilization from 143 percent in 1991-92 to 149 percent in 1992-93. GACL had attempted to ensure that bags contained the right quantity of cement. The company used Zero Error Electronic Rotary machines, which checked the quantity of cement in randomly picked bags. In the case of 50 kg bags, GACL permitted a maximum variation of 200 gm. LOGISTICS Cement, being freight intensive industry, various initiatives had been taken up by GACL to streamline its logistics. GACL was one of the first cement producers of the country to introduce an Integrated Logistics System (ILS). At each manufacturing unit, a cross functional committee was responsible for the efficient management of logistic functions. The committee met at regular intervals and reviewed the working of the total system. The recommendations were forwarded to the top management for immediate action. Order Processing Systems Order Processing Systems involved the flow of information about the orders from generation to order fulfilment. Orders once received, had to be processed quickly and accurately. GACL had linked all the major offices through a Wide Area Network (WAN). Electronic Data Exchange (EDE) and Material Resources Planning (MRP) systems facilitated timely and accurate processing of orders.

Effective order processing systems involved transmission of customer order, paper processing, retrieval from the warehouse, dispatch to the transporters, adjustment of the inventory level and transmission of information to the department of production planning. GACL had adopted a fully computerized system, including Electronic Data Exchange (EDE) and MRP systems. INVENTORY MANAGEMENT Inventory decisions involved knowing both, when to order (timing) and how much to order (quantity). Management had to balance the cost of carrying larger inventory against resulting sales and profit. GACL linked its inventory management process to most of the functions such as production planning, raw material planning, ordering etc. Online ordering, not only reduced time, but also transaction costs. Limestone, Coal, Gypsum, Iron Ore and Red Ochre were the basic raw materials needed for the production of cement. GACL had a well-developed system for inbound raw materials. Limestone extracted from near by mines was transported to the production site with the help of Overland Belt Conveyer (OBC) and in some cases with the help of trucks. This process ran for sixteen hours a day and provided sufficient stocks to enable the plant run smoothly round the clock. This helped GACL to cut inventory carrying cost drastically. It sourced other raw materials from various places across India. (Coal, one of the basic raw materials, was sourced all the way from Bihar and some times from Meghalaya). At the production site, the company maintained a buffer of about 10 to 20 days depending upon the location of the production unit.
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PACKAGING Cement was usually packed in 25 kg or 50 kg bags. Traditionally, packaging was done using jute bags. This frequently caused problems like pilferage and leakage. From 1987 to 1994, the cement industry had to pack 70 per cent of the production in jute sacks as per the provisions of Jute Packaging Materials (Compulsory Use in Packing Commodities) Act, 1987 (JPMA). In 1995, it was reduced to 50 per cent. The industry was freed from the controls of JPMA in 1998 after intense lobbying. GACL was the first to use paper bags for cement packaging. Paper bags offered a significant advantage over traditional jute bags, through low pilferage, better preservation, and appearance. Cement packaging at GACL followed the international norms of specific colours of packaging for different types of cement. It also gave total information about the quality, date of manufacturing and location of plant (manufacturing unit). Each bag of cement contained the brand name, the ISI logo with identification number, price of the bag, and net weight of the bag. TRANSPORTATION Cement was highly freight intensive in nature. Manufacture of each tonne of cement involved the transportation of 1.6 tonnes of limestone, 0.25 tonnes of coal, 0.05 tonnes of gypsum and 1 tonne of the finished product. Freight accounted for about 18 % of the total cost. Raw materials were transported either by rail or road. Since road transportation beyond 200 kms was not economical, 55 % of cement was moved by the railways. There

was the problem of inadequate availability of wagons especially on western railways and southeastern railways. In this scenario, manufacturers were looking seriously at sea routes. In 2003, 70% of the cement movement worldwide was by sea compared to only about 1% in India. GACL became the first cement company in India to use water transportation for domestic as well as export consignments. This reduced the transportation cost dramatically. In 2002, GACLs freight mix was Road 40%, Rail 30% and Sea 30%. For a 10,000-tpd plant in India, it took 1,000 dispatches per day using 10-tonne trucks or 250 dispatches using 40-tonne trucks. In 1997, a single ship could carry 40,000 tons, at a cost of only Rs. 190/tonne as against Rs. 580/tonne for rail and Rs.670/ tonne for road transport. When the government allowed the privatisation of ports, GACL set up ports and freight handling terminals at Muldwarka (about 8 kms from the companys plant at Ambuja Nagar), Surat (South Gujarat), and Vashi (near Mumbai). In 2003, the terminal in Muldwarka, was equipped to export clinker and cement and import coal and furnace oil. GACL also had plans to build a bulk terminal at Kochi in Kerala. It entered into an agreement with the Cochin Port Trust for building cement storing and packing infrastructure in Wellington Island (Kerala). To improve the transport infrastructure, GACL set up captive breakwater and jetty facilities in Gujarat, Maharashtra and Kerala. The company had also acquired five ships for transporting cement in bulk. To facilitate movement by ships, GACL transported cement in sealed road tankers from the plant site to the shipping terminal, where it was transferred to silos. From these silos, it was
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poured into airtight holds in the ships. At the destination, the cement was unloaded from ship holds, and again placed in silos, before being pumped into the sealed road tankers. Customers were provided small storage tanks into which cement was pumped from the sealed tankers by a fluidisation process. For a customer who preferred to have bagged cement, GACL arranged special packing facilities at the unloading terminals. GACL had conveyor belts running up to the dispatch yard for loading trucks and wagons. A fleet of around 350 self-financed trucks and a railway siding in its factory premises provided flexibility in the mode of transportation. Routing and scheduling decisions were important in the cement industry. GACL conducted route surveys periodically to arrive at the best possible route for each destination. Key inputs that went into scheduling of the dispatch of the material were the location and distance of the destination, the road conditions, the receiving party, the unloading facilities available at the destination point etc., apart from scheduling instructions given in the order. WAREHOUSING & DISTRIBUTION GACL had recognized the importance of effective warehousing. The company used two types of warehouses, the Dumps and Trans-shipment point storage. The warehouses were connected online with the marketing office and the production units to facilitate efficient delivery of goods. The Bulk Cement Terminal in Surat had a storage capacity of 15,000 tonnes and it also had a bulk cement unloading facility. In Panvel (strategically located near Indias biggest cement

market Mumbai), GACL had a storage capacity of 17,500 tonnes and a bulk cement unloading facility. GACL also had a bulk cement terminal in Galle, 120 kms from Colombo, Sri Lanka. The locations of the dumps and trans-shipment points, were decided taking into account various factors like transportation facility, availability of packing space, availability of trained and cheap manpower, etc. FUTURE OUTLOOK In line with the company's vision to become the leader in Indian cement industry, GACL had been pursuing a combination of strategies like strategic alliances, capacity expansion, new plants, and aggressive takeovers. The company had set up a two million ton Greenfield cement unit in Maharashtra at an investment of Rs. 500 crores. It had expanded capacity at the existing Gujarat Site from three million to four million at an incremental cost just of Rs. 100 crores. It had also set up one million ton grinding units, one at Bhatinda and another in West Bengal. To enhance its presence in the south, the company planned to set up a Rs. 600 crores, two million ton greenfield project in Andhra Pradesh. GACL had also started offering ready-mix cement, the demand for which was expected to grow in the future. As 2004 got under way, GACL looked well placed in the Indian cement industry. But the management realised it could not be complacent, in the wake of competition from multinationals like Lafarge, which were eyeing to enter into Indian Cement Industry.

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Bibliography 1. 2. 3. Lakshmi Narasimhan, Gujarat Ambuja Cements all set for expansion, www.domain- b.com, 13th February 1999. Kasturirangan,Cement selling gets imaginative, ' www.domain-B.com, July 1999. Katja Schumacher and Jayant Sathaye, Indias Cement Industry: Productivity, Energy Efficiency and Carbon Emissions,' A Report by Environmental Energy Technologies Division of International Energy Studies Group, http://ies.lbl.gov, July 1999. Namrata Datt & Surendar, Cementing its position', Business World, 10th January 2000, p. 48 52 Chetan Parikh, Utpal Sheth and Navin Agarwal, Investment Ideas From Indias Money Masters - Interview with Vipul Mehta', www.capitalideasonline.com, 25th March 2000. Bala Gopal Menon, Gujarat Ambuja - I can, I can, I can,' www.5paisa.com, July 2000. Sandeep Banzai, Cementing its hold,' Business India, 16th October 2000, p. 70 75 P. N . V. N a i r, S t r a d d l i n g t h e I n d i a n m a r k e t , ' www.projectsmonitor.com, 16th September 2001. Anirudha Dutt,Leader Speak Interview with Anil Singhvi, www.indiainfoline.com, 28th November 2001.

10. 11.

Abha Singh, An interview with Anil Singhvi ' , www.myiris.com, 30th September 2002. Parag Parikh Financial Advisory Services Ltd Report on Gujarat Ambuja, www.ppfas.com, 23rd May 2003. Vaidya Nathan, Efficiency, cost-control key to viability Interview with Anil Singhvi', The Hindu Business Line, 04th May 2003. Arun Agrawal, ICRA reaffirms high safety ratings assigned to Gujarat Ambuja Cements Limited, www.icraindia.com, 18th June 2003. Roshni Jayakar, Cementing the future, Business Today, 20th July 2003, p. 62 - 66 Kohinoor Mandal, Mandatory jute packaging Ministry yet to pin down errant cement, The Hindu Business Line, 09th August 2003. A n i n t e r v i e w w i t h A n i l S i n g h v i , C E O Ta l k , www.hdfcsec.com, 23rd September 2003. Sangeetha Singh, 0Is 'India Shining' or is it mere hyperbole?,' Financial Express, 07th April 2004. CMIE Database (Centre for Monitoring Indian Economy) ICRA Ltd, India (Investment Information and Credit Rating Agency). Datamonitor.
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12.

13.

4. 5.

14. 15.

6. 7. 8. 9.

16. 17.

18. 19. 20.

Websites 1. 2. 3. 4. 5. 6. 7. 8. www.gujaratambuja.com Company Website. www.naviamarkets.com www.indiainfoline.com www.financialexpress.com www.moneypore.com www.utisel.com www.hdfcsec.com www.myiris.com

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C HAPTER 5

Market Structures and Perfect Competition

economics mainly deals with the market structures from the stand point of the sellers in the factor market and perfectly competitive market in commodity market. The major forms of market structures analyzed in this chapter are perfect competition, monopolistic, oligopoly and monopoly. The competition continuum of these market structures are given here under. The competition continuum describes how the market concentration and market power changes from a perfectly competitive firm to monopoly firm. Further it also gives a snap shot view of the changing features of the different forms of the market.
Figure 5.1 Major Market Structures and Competition Continuum

The price and output decision of a firm or an industry is largely influenced by the form and the structure of the market for goods and services. The market structure is determined by the nature and pattern of the competition which prevails. In the literature of economics there are some standard classifications of market structure. Broadly market structure is classified as perfectly competitive market and imperfect market. The market structure is also classified from the stand point of the buyer and seller, from the stand point of sellers only and from the stand point of the buyers only. However ,managerial

Very Low Concentration

Low Concentration

Moderate Concentration

Very High concentration

Uniform price

Differentiated price Concentration of the Firm

Low Fixed Cost Perfect competition No entry barrier Monopolistic Oligopoly Monopoly

High Fixed Cost

High Entry barrier

Market power of the Firms No entry barrier

Large no. of producers homogenous products & no market power Many firms with differentiated products thus low market power A few producers with high market power A single seller with high market power

Single firm

No social Cost

High Social Cost

No Govt. intervention

Govt. intervention

http://www.youtube.com/watch?v=qqWiaTA3PMU

S ECTION 1

Price Output Decision: Perfect Competition

Video 5.1.1:Perfectly Competitive Market

A Perfectly competitive market is one in which there is a large number of buyers and sellers of a homogeneous product and neither a seller nor a buyer has any control on the price of the product. As mentioned above, perfect competition of economists perception is a rare phenomenon. Nevertheless, analysis of price-and output determination lays the foundation of pricing theory. This kind of market is therefore crated by assumption for theoretical purpose. A perfectly competitive market is assumed to have the following characteristics. Large number of buyers and sellers. Homogeneous product.

Perfect mobility of factors of production. Free entry and free exist. Perfect knowledge. No government interference. Absence of collusion and independent decision-making by firms. No Transportation cost. Normally perfect competition will not exist, only pure competition will exist in the market. Excluding perfect mobility of factors of production and perfect knowledge from the characteristics of perfect competition is pure competition.

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Demand Curve in perfect competition The demand curve in perfect competition is infinitely elastic which means that the firm can sell any amount of a good at the prevailing market price. The demand curve of a firm in a perfectly competitive market is horizontal at the market price (P). Market price is determined by supply and demand forces. For a perfectly competitive firm, P =AR =MR; where, AR is the average revenue and MR is the marginal revenue. (Keynote 5.1.2 ) Short Run Equilibrium of a Firm Under Perfect Competition There are two types of approaches to asses the profit maximization of firms in general. First method is Total cost and Total Revenue method and second is Marginal Cost and Marginal Revenue method. First method : perfect competition, since the firm is a price taker, the total revenue curve is a straight line. The fixed costs remain constant and cannot be changed. The firm gets maximum profits where the distance between TR and TC is maximum. (Keynote 5.1.1).
Keynote 5.1.1 : Profit Maximization under Perfectly Competitive Market in Short Run

Second Method: The demand curve of a firm in perfect competition is horizontal as the price is determined by supply and demand forces in the industry. Therefore the equilibrium price will be P= MR=MC. Thus the first order condition for profit maximization will be MC=MR=AR=P where MC is the marginal cost, MR is the marginal revenue, AR is the average cost and P represents the price (Keynote 5.1.2). The second order condition for profit maximization is that the slope of MR curve should be less than the slope of the MC curve. In perfect competition, MR=P is constant. Hence the slope of MR equals zero. The second order condition implies that the slope of the MC curve should be positive or MC must be on the rise. (Keynote 5.1.2) To analyze the demand and supply conditions of a firm in a perfectly competitive market in the short run, we have to take a look at the aggregate supply of industry. The aggregate supply curve in the industry helps us to calculate the aggregate supply of all the firms during a particular period of time. In the short run, factors of production (inputs) cannot be changed or altered and so no new firms can enter the market. But in the long run, since all inputs are variable, firms can enter and exit the market freely. Prices are fixed and the demand and supply curves intersect each other. In the long run, if a new firm enters the industry, the supply curve shifts to the right indicating a price fall. On the other hand, if an existing firm exits, the supply curve moves to the left showing a rise in price. In the short run, where the marginal revenue cuts the marginal cost curve, equilibrium is established. Here there is always a tendency for the firm to make profits.
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Keynote 5.1.2 Short-run Equilibrium for a Competitive Firm

irrespective of the total level of output. Even if the firm stops production, it will have to meet the total fixed costs. Now, if the firm is losing, but the loss is less than or equal to total fixed cost of the firm, the firm will continue its production process. In other words, if the firm can just cover its total variable costs, the firm will continue production in the short run. But if the firm fails to recover its total variable costs, it will stop production altogether. The maximum amount of loss that the firm is willing to bear in the short run is equal to the total fixed cost of the firm. Total cost has two components TVC and TFC. Now, suppose that total revenue cannot cover TVC. Then the uncovered portion of the TVC and the entire portion of TFC will be the loss of the firm. If the losses exceed total fixed cost, the firm will stop production. But if the total revenue covers TVC and a portion of TFC, then the uncovered part of TFC is the loss of the firm. In this case the firm will continue production.
Figure 5.1.1 : Shut Down Point of the Competitive Firm

Therefore, we can say that profit in the short run is attractive and makes the firm stay in the market. But in the long run, profits attract new entrants, and this continues till the profits become zero. In this situation, no firm will enter or exit the industry and there is no profit and no loss for the firms. Shut Down Point In the short-run, the firm may continue its production process, even if it incurs loss, to recover the losses in the long run. In the long run the firm may be capable of compensating the losses. In the short run there are some fixed costs that have to be met
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In figure 6.3 suppose that the price is OP. Then at point E, the first and the second order conditions of profit maximization are fulfilled. But at point E, the firm is losing. Here total revenue is equal to the area OPEQ, while total variable cost is equal to the area and the total fixed cost is equal to the area RE1S. Here total revenue is greater than the total variable cost, i.e. total variable s cost is covered and a part of the fixed cost is covered. Hence total loss is equal to the area PEE1S and it is less than the total fixed cost. Hence at the price OP the firm will continue its production process in the short run. What happens if the price falls below P1? If price falls below P1, the firm does not even cover the variable costs. That is, the loss will be equal to fixed cost plus the unrecovered portion of variable cost. This is not in the interest of the firm, since it can reduce losses by stopping production. This is because the firm will limit the loss to only FC if production is stopped. P1 in figure 6.3 is the lowest point on the AVC curve. As we know, at lowest point on AVC curve, the MC = AVC. Therefore, E2 in figure 6.3 indicates the lowest point on AVC, the point below which if the price falls the firm would be better off by closing down operations. This point is called shutdown point. In the same way, the lowest point on AC, E1 indicates the point below which if the price falls will result in losses and if the price rises above will result in profits. Point E3 indicated no abnormal profits and is called break even point: that is, no profit no loss situation. Demand and Supply curves of the Industry: In perfect competition, the demand curve is also the firms average revenue curve. In the industry, the demand curve (average revenue curve) slopes downwards to the right. This

implies that demand increases as price falls. On the other hand, if we analyze the supply curve, it slopes upwards to the right indicating that as price increases, supply increases automatically. Price is determined at the point where the demand and supply curves intersect each other (Keynote 5.1.3). LONG-RUN EQUILIBRIUM OF THE COMPETITIVE FIRM In perfect competition, long-run equilibrium plays a crucial role in deciding the existence of the firm. In the long run there is enough time period for the firm to cover its losses and earn normal profits. This is because in the long run, all inputs are variable and the firm can have the most profitable level of output i.e. the profit maximization level of output. The profits that the firms earn would attract others to enter the industry. With the entry of new firms aggregate output would expand and there will be a shift in the short-run industry supply curve to the right until it intersects with the market demand curve at the price at which all firms make zero profits in the long run. It is then that the industry will be in equilibrium. In Figure 6.6, the industry and the firm are in long-run equilibrium at point E where short run marginal cost (SMC)=long run marginal cost (LMC)=long run average cost (LAC)=short run average cost (SAC)=price (P)=marginal revenue (MR). The firm produces at the lowest point on its LAC curve and earns zero profits. Resources are used most efficiently to produce goods and services at the minimum cost (Figure 5.1.2)

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REVIEW 5.1.1
Interactive 5.1.3

Question 1 of 5 Which of the following is not a characteristic of a perfectly competitive market?

A. Large number of buyers and sellers B. Homogeneous product C. Free entry and exit of firms D. Presence of high transportation costs

Check Answer

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Section 2

The Efficiency of Perfect Competition

The Efficiency of Perfect Competition: Allocative efficiency, Pareto efficiency or simply efficiency is a condition achieved when resources are allocated in ways which allow maximum possible net benefit from their use. Three properties are observed in a freely competitive market mechanism to fulfill the conditions of allocative efficiency: a) Efficient allocation of resources among firms: Efficiency holds good when firms can produce their products using the best available, that is, lowest cost technology. b) Efficient distribution of output among households: Competitive markets ensure that firms do not end up with the wrong inputs, open, competitive output markets ensure that households do not end up with the wrong goods and services.

c) Efficient combination of products: The condition that ensures that the right things are produced is: P = MC in both long run and short run. A perfectly competitive firm will produce at the point where the price of its output is equal to the marginal cost of production. Long-Run Competitive Equilibrium and Allocative Efficiency It is easy to show that a competitive market has the potential to achieve allocative efficiency. Let us take the example of the single competitive industry that produces bread. Net gains are possible if the maximum price someone is willing to pay for more bread exceeds the minimum price a seller is willing to accept to make that bread available. Efficient Output of a Good In Figure 5.2.1, the efficient output of bread per day corresponds to point E, at which the marginal benefit of

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bread just equals the marginal cost. The maximum price a buyer will pay for another unit of a good is called the marginal benefit of the good. The minimum price a seller will accept for making another unit available is its marginal cost. The marginal cost represents the value of the resources necessary to make one more unit of a good available. Figure 5.2.1 plots the marginal benefit of bread, together with the marginal cost of making it available. The marginal benefit is assumed to decline with the consumption of bread, while the marginal cost is assumed to increase with the consumption.

A net gain is possible from making more bread available as long as the marginal benefit of bread exceeds its marginal cost. If we start at the point on the horizontal axis that corresponds to 50,000 loaves of bread per day and follow the vertical line from that quantity up to both the marginal benefit and marginal cost curves. This line intersects the marginal benefit curve at point B and intersects the marginal cost curve at point A. The marginal benefit of 50,000 loaves of bread per day is Rs.15 and the marginal cost is Rs.5. It is now easy to show that net gains are possible from making more than 50,000 loaves of bread per day. The marginal benefit of bread exceeds its marginal cost which means that the maximum price consumers will pay exceeds the minimum amount of money needed to compensate the owners of resources for making that bread available. The difference between the marginal benefit of Rs.15 and the marginal cost of Rs.5 is the net gain for making another loaf of bread available when 50,000 loaves of bread per day are currently produced. When one more loaf is produced, that extra loaf is worth more to the buyers than it is to those whose resources are used to make it available. This is the basis for the gains from the exchange. If consumers were to get the loaf for Rs.15, they would be not worse off from exchanging their rupees for the bread. Those who made the bread available would be better off because they would receive more than the opportunity cost. Similarly, if the bread was made available for Rs.5, those who made it available would just cover their opportunity cost and would be not worse off. Consumers, on the other hand, would now be better off because they would obtain bread they value at Rs.15 for Rs.5.
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Figure 5.2.1

If the bread were made available for a price anywhere between Rs.5 and Rs.15 when 50,000 loaves per day are produced, mutual gains would be possible. This is because consumers will get the bread at a price below the maximum they would be willing to pay. Similarly, those whose resources were used to produce the bread, will receive a sum that exceeds the minimum they would accept. Additional mutual gains from exchange by producing more of a good are possible whenever the marginal benefit of the good exceeds its marginal cost. The output of 50,000 loaves of bread per day is not efficient because, as per the analysis, at that output it is possible to make consumers better off without harming the producers. Similarly, the analysis also shows that at that output it is possible to make the producers better off without harming consumers. Finally, because mutual gains from more daily output are possible, both consumers and producers can be made better off by making more bread available each day. As long as the marginal benefit of bread exceeds its marginal cost, a net gain will be possible by making more bread available. Efficiency requires that bread be produced just up to the point at which its marginal benefits equals its marginal cost. In Figure 6.7 the marginal benefit just equals its marginal cost when 75,000 loaves per day are produced. The marginal cost of making more than this amount available will exceed the marginal benefit of the added amount. The maximum sum a consumer would pay for one more loaf would fall short of the value of the resources necessary to provide that loaf. The loaf could not be made available without making the resource owners worse off. The efficient output of bread is therefore 75,000 loaves of bread per day.

The generalized result of this example is that efficiency requires that all goods be made available just up to the point at which their marginal benefit equals marginal cost. A system of competitive markets in which all useful goods and services are treated under conditions of perfect competition is capable of achieving efficiency. The market demand curve is the marginal benefit curve because each point on a market demand curve reflects the maximum sum a consumer will give up, to get more of a good, given its current availability. The portion of the marginal cost curve lying above the average variable cost curve is the short run market supply curve for bread produced by a competitive industry. If bread is traded in a competitive market, the equilibrium would therefore occur at point E in Figure 5.2.2 (a). The marginal benefit and the marginal cost curves intersect at that point. The market equilibrium price of bread would be Rs.10 per loaf. The quantity of bread demanded at that price would equal the quantity supplied, which would be 75,000 loaves per day which is also the efficient output.

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Figure 5.2.2(a)

Figure 5.2.2(b)

Buyers can gain whenever their marginal benefit exceeds a goods market price. Buyers would therefore continue to purchase bread until the marginal benefit they receive falls to equal the market price: Price = Marginal benefit= Rs.10 In this case the marginal benefit equals Rs.10. Because both the buyers and the sellers adjust their respective marginal benefits and marginal costs to equal the market price of Rs 10, both marginal benefit and marginal cost will equal Rs.10, resulting in the efficient output of 75,000 loaves per day. In the long-run, competitive equilibrium prices equal the minimum possible average cost of a good. Therefore, in the long-run price equals minimum possible average cost which is equal to marginal cost. Consumers can buy goods at the lowest possible price that covers both the average and the marginal costs of production. A typical bread producers cost curves are drawn in Figure 5.2.2(b). The Rs.10 market price just covers both the marginal cost of bread and its minimum possible average cost at point F. In a system of competitive markets, the greatest net benefit will be squeezed from available resources because the marginal benefit of each good equals its marginal cost. Finally, assuming that perfect competition prevails in the markets for the production of each and every good, the price of each good will reflect its minimum possible average cost. The system will economize on resource use because each good will be produced at the minimum possible unit cost. This outcome is quite remarkable because it results from competition in a system in which each producer seeks nothing more than to
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The market price of a good in a competitive market equals both its marginal cost and its marginal revenue. We have seen that each seller can make more profits by producing more of a good whenever price exceeds marginal cost. Each seller therefore adjusts the output of bread until the marginal cost increases to equal the goods market price: Price = Marginal cost = Rs.10 Efficiency in Competitive Markets In competitive markets, prices equal the marginal benefits and marginal cost of goods. In the long-run, these prices also equal the minimum possible average cost. In this case the marginal cost equals Rs 10.

maximize profits. However, the outcome is a resource allocation for which net benefits are the maximum possible from using the available resources and prices are just high enough to cover the opportunity cost of sellers. EFFECT OF TAXES ON PRICE AND OUTPUTS In this section we shall discuss the effects of the imposition of taxes by the government in the form of lump sum tax, a profit tax, and a specific tax, i.e., a tax per unit of output. Imposition of a Lump Sum Tax The analysis of the effects of a lump sum tax is similar to that of an increase in the fixed cost, since the lump sum tax is like a fixed cost to the firm. The imposition of a lump sum tax will result in an upward shift of both the average fixed cost (AFC) and the average total cost (ATC) curves, as shown in Figure 5.2.3(a). However, the AVC and the MC curves are not affected, since the tax is in the form of a fixed cost to the firm. Given that the MC curve is the supply curve of the firm, the equilibrium position of the firm is not affected in the short run. However, it will not now cover its higher (shifted) average total costs and will go out of business in the long run. Consequently in the long run, the market supply curve will shift upwards to the left; in the new equilibrium the output will be lower, the price will be higher, and there will be fewer firms in the industry (if the higher price does not cover the increased costs (Refer Figure 5.2.3(b)).

Thus we see that in the short-run, lump sum tax will not affect the MC curve and the firm will continue to produce the same output as before the imposition of the tax.
Figure 5.2.3(a) Shift in Average fixed Cost and Total Cost Figure 5.2.3(b) Change in Output Level in the Longrun

Imposition of a Profit Tax This tax forms a percentage of net profit of the firm. The effects of the profits tax are the same as those of a lump sum tax. The profits tax, while reducing the profits (by adding to the cash expenses of the firm), will not affect its MC. Hence in the short run the equilibrium of the firm and the industry will not change.

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However, in the long run, exit of firms becomes inevitable if in the pre tax period, firms were earning only normal profits. In the long-run the supply in the market would shift to the left and a new equilibrium would be reached with a higher price, a lower quantity produced and there would only be a few firms in the industry. Imposition of a Specific Sales Tax This takes the form of a given amount of money (e.g. Rs 5) per unit of output produced. Such a tax clearly affects the MC of the firm. The MC curve, which is also the supply curve of
Table 5.2.1: Marginal Cost, Marginal Revenue Approach

price increase: will the increase in P be smaller, equal, or greater than the specific tax? This is an important question because it relates to who is going to bear the specific sales tax: the consumer, the firm or both? The answer to this question is that the burden of specific tax that will be borne by the consumer (buyer) depends on the price elasticity of supply, given the market demand. In general, the more elastic the market supply, the higher is the proportion of the specific tax that the consumer will bear and less the burden of the firm from the specific tax. So long as the market supply has a positive slope, the specific tax will be paid partly by the buyer and partly by the firm. The greater the elasticity of supply the smaller the burden of the firm. In other words, the firm will be able to pass on to the consumer more of the specific tax, if the market supply is more elastic. In Figures 5.2.4(a) and 5.2.4(b), the demand curve is identical and the initial (pretax) price is the same, but the supply in Figure 6.10 (b) is more elastic. Imposition of a specific tax equal to ab raises the price by P in the Figure 5.2.4 (a) and by P1 in the Figure 5.2.4(b). Clearly P1>P, that is, the tax burden of the consumer is greater in case of a more elastic supply curve (given the market demand). In the limiting case of a market-supply curve with infinite elasticity, the increase in price is equal to the specific tax and the entire tax is borne by the consumer. In Figure 6.11, the demand is the same as in Figures 5.2.4(a) and 5.2.4(b), but the supply curve is parallel to the horizontal axis, showing infinite price elasticity.
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Output Marginal Margin & revenue al cost Sales / Price 1 2 3 4 5 6 7 8 9 10 10 10 10 10 10 10 10 10 10 10 4 3 2 2.5 3 4 6.5 10 16 24.5

Averag e total cost 34 18.5 13 10.38 8.9 8.8 7.86 8.12 9 10.5

Unit profit -24 -8.5 -3 -0.38 1.1 1.92 2.14 1.88 1 -0.5

Total profit -24 -17 -9 -1.5 5.5 11.5 15 15 9 -5

the firm, will shift upwards to the left and the amount produced at the prevailing price will be reduced. The market supply curve will shift upward to the left and price will rise. The important question here is by how much will the

Figure 5.2.4(a): Lesser Elasticity of Supply

Figure 5.2.4(b): Greater Elasticity of Supply

Keynote 5.2.1 Short-run Equilibrium in Perfect Competition

The imposition of a specific tax equal to ab (same as before) leads to an equal increase in the price: P2 = ab. If the supply curve has a negative slope (Figure 5.2.5) the imposition of a specific tax results in an increase in the price which is greater than the tax. In Figure 5.2.5, the demand is identical as in the above cases, but the supply is negatively sloping (with its slope smaller than the slope of the DD curve). Under these conditions, a specific tax of ab leads to an increase in the market price, equals to P3 which is obviously larger than the unit tax. Figure 5.2.5

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REVIEW 5.2.1
Question 1 of 5 Which of the following is not a characteristic of a perfectly competitive market?

A. Large number of buyers and sellers B. Homogeneous product C. Free entry and exit of firms D. Presence of high transportation costs

Check Answer

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S ECTION 3

Case study: Perfect Competition under eBay: A Fact or a Factoid?

Figure 5.3.1:ebay page live

The online auction giant eBay is an American website, headquartered in San Jose, California. It is the worlds online marketplace facilitating largescale trade of varied items ranging from cars, real estate to collectibles, clothing, DVDs, and artwork. eBay was founded in September 1995 by Pierre Omidyar (Pierre), a software developer. Earlier, he had worked in Claris, a spin-off of the famed Apple Computers. eBay started in lines of something like a garage sale and the first product that it sold was a broken laser pointer. Pierre knew that he had created something big,

when the broken laser pointer sold for $14.83. When the winning bidder was contacted to check if he understood that the laser pointer was broken, the buyer replied that he was a collector of broken laser pointers! Pierre, a French-born IranianAmerican, acknowledged that he alone cannot put eBay into the corporate big leagues. In 1996, Jeffrey Skoll, with a MBA from Stanford, was hired. Soon in 1998, Meg Whitman (Meg), a Harvard Business School graduate, followed as the president and CEO. Meg had

This case study was written by Nitu Gupta under the guidance of Akshaya Kumar Jena, IBSCDC. It is intended to be used as the basis for class discussion rather than to illustrate either effective or ineffective handling of a management situation. The case was compiled from published sources.
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learned the crucial importance of branding from her enriched association with Hasbro, a worldwide leader in childrens and family leisure time products and services. She took the company public (Exhibit I), expanded it and successfully exceeded earnings predictions. Exhibit I: eBays IPO Information Date went public Proposed Offer Price Actual Offer Price First Day Open
First Day Close

September 24th 1998 $14.00 to $16.00 $18.00 $53.50 $47.38 3.5 $62.8 Goldman Sachs & Co The Marketplaces segment of eBay comprises online commerce platforms that allow buyers and sellers to interact and trade with one another globally. It intends to bring them together from any place in the world at any time through fully automated online websites, available 24/7. The platforms have as a feature, software tools and services, some of which are available free of cost and others for a fee to ensure efficient trading. The Marketplaces segments core online commerce platform is eBay.com and its local counterparts are in 39 countries. Its adjacent platforms consist of eBays classifieds website, as well as Half.com, Rent.com, Shopping.com and StubHub. The revenue for eBays Marketplaces platforms are raised from the fee paid by sellers for listing, feature,
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Shares Offered (million) Offering Amount (million) Underwriters

Compiled from the author from eBay reignites IPO market with 197% surge at opening, find articles.com

Meg created an experienced management team by gathering her senior staff from companies such as Pepsico and Disney, and built a strong vision for the company. eBay intended to be a company that is in the business of connecting people. eBay has three business segments: Marketplaces, Payments and Communications (Exhibit II).

subscription and final value fee. Apart from this, there are lead referral fee, transaction fee, advertising fee, etc., which act as the source of revenue. eBay.com had initially followed only its traditional auction-style format. However, when it realised that an obscure website called Half.com with its fixed-price system could become a potential threat to its floating-price auction model, it bought the company and brought into being, the latters fixed-price formats. In the traditional auction-style format, a seller is allowed to set a reserve price for the item the minimum price at which the seller is willing to sell the item. In the fixed-price format, buyers and sellers experience an accelerated transaction process in comparison to traditional auction-style format, which necessitates waiting for the auction period to expire. eBay introduced fixed-price option to its auction listings with items with a Buy It Now logo, which can be bought immediately for a set price. eBays classifieds website are designed to help people meet, share ideas and trade on a local level, and are available in lot of cities and regions of the world. Rent.com concerning rental-housing industry is a US listing website, aimed at bringing together apartment seekers and apartment managers. Shopping.com, which features products from thousands of merchants across the Internet, is a comparison shopping destination. StubHub is a US ticket marketplace, which facilitates fans to buy and sell tickets of various sports, entertainment events, etc. eBays Payments segment, PayPal, allows individuals and businesses to send as well as receive payments online. Its Communications segment, Skype Technologies S.A. (Skype), enables Voice over Internet Protocol (VoIP) communications

and offers low-cost connectivity to traditional fixed- line and mobile telephones. In November 2008, eBay acquired USbased online payments business, Bill Me Later.

eBay and Perfect Competition

eBay is a place to buy, sell and window-shop. The products on the website are available at prices better than those one can find in traditional or online stores. Though there may be a few instances of bad deals on eBay, but careful buyers can always gain from this. Hence, there are large numbers of buyers on eBay. Individual seller, small retailer, or a big company anyone can sell nearly anything by listing their items on eBay, if they are flexible enough regarding the price. eBays global approach ensures saleability of unusual items that arent in demand in their vicinity. This facilitates large number of sellers. eBay serves as one of the best places in the world to window- shop and compare. As huge variety of things are available with enormous details like what each one sold or is selling for, photos, detailed descriptions, owner experiences, etc., a lot of information is gained about the items offered at eBay. At eBay, transaction by individual buyer and seller is very small compared to the total volume of transactions. Both buyers and sellers at eBay are price takers. No individual buyer and seller can do anything to change that price. The eBay user agreement limits each user to 10 simultaneous listings for identical goods. Thus, there is no possibility for economies of scale, which has the potential to turn the largest firm into a monopoly. As of December 31st 2008, eBays Marketplaces had around 86.3 million active users globally.
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On eBay, every second, $2,000 worth of goods are traded by users across the world. In Q4-2008, 732 million new listings were added to eBay.com worldwide. About 113 million existing listings are available on eBay worldwide, and approximately 7.1 million additional listings per day, are freshly included.2 In the eBay market, competitive advertising does not occur because the products are categorised and sub-categorised into homogeneous ones. Competitive advertising would be simply redundant. However, generic advertising bereft of brand names, benefiting the industry as a whole, often does occur. Though within the different categories of goods available there are subcategories where the items are homogeneous, product differentiation is inherent in used goods. Goods are differentiated by wear. Entry or exit as a business in eBay is quite easy. Anyone who is computer literate and knows how to use Internet and has the desire, can sell or buy product from eBay. Several sellers of common products and several potential buyers are features of eBay. No cost is entailed for browsing and bidding on auctions, but sellers are to pay two kinds of charges. In order to list an item on eBay, a non-refundable insertion fee is charged. For optional upgrades to boost the listing such as premium picture services and format enhancements through bold subtitles and highlighting additional charges are levied. These are included in the insertion fee. A final value fee is charged if the listing ends

with a winning bid. No final value fee is charged if there are no bids on an item, or if the reserve price is not met. Information costs are trivial under eBay. Comparison of prices by visiting different internet sites is quite easy. There are no browsing costs for buyers and the eBay fee schedule ensures identical selling costs for all sellers. Shipping and handling charges, signifying the travel costs generally differ depending on the good. However, in some instances, travel costs are cheaper than local sales taxes. Auctions under eBay, however, can be highly unpredictable instigating strange buyer behaviour. For instance, in late 2006, the new PlayStation 3 video-game system attracted a huge mass queuing for days outside retail stores to purchase it. For people who bought the playstation from stores and sold it on eBay, it fetched thousands of dollars for the $600 machines. However, resale prices of Apples iPhone, which drew similar crowds in mid-2007, were not lucrative enough on eBay.3 Ulrike Malmendier (Malmendier), an economist at the University of California at Berkeley, conducted quite an extensive research on eBay to reveal the mystery of such contrasting consumer behaviour. For example, she picked CashFlow 101, a personalfinance-themed board game, and tracked 166 auctions offering. Prior to this, during the 7-month trial, the game was sold online for $195 by the game designer. The researcher observed that eBay sellers offered an opening price of about $45 and buy it now price of about $125, which may be interpreted as a cool deal for the buyers. But some bidders grew so excited about winning the auction that instead of paying less than retail, to end the auction immediately or bidding in the hope of fetching an
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even lower price, they sometimes ended up paying more than $185. In 43% of the auctions, the bidders apparently paid more than the buy it now price. The economist found similar result in her extended research as well. Malmendier and her co-author, Stanford University economist Hanh Lee, refer to such buyer behaviour as bidders curse. The Romans term it as calor licitantis meaning bidders heat.4 eBay simulates many important features of perfect competition like large number of buyers and sellers, information symmetry, low barriers to entry and sub-categorisation of products on the basis of homogeneity. eBay is often cited as an eminently apt real world example of a perfectly competitive market. However, critics point out that products sub- categorised on the basis of homogeneity are strictly not homogenous products because of variation in period of original use as well as degree of wear and tear. Moreover, the products transacted under eBay do not affect resource allocation, the way the products usually do when they are produced to address the original demand. Prices, therefore, do not truly dictate the supply of products listed on eBay. While there are all these hair-splitting nobody has come up with a better instance of perfect competition that would comprise a host of items touching modern life.

References: 1. 2. 3. Our History, http://news.ebay.com/history.cfm,1995 eBay India Fast Facts,http://pages.ebay.in/community/ aboutebay/news/infastfacts.html, December 31st 2008 Gaylord Chris,Economists puzzled by irrational eBay buyers,http://www.usatoday.com/tech/techinvestor/ 2007-07-17-economists- study-ebay-buyers_N.htm, July 17th 2007 . Gaylord Chris,Economists puzzled by irrational eBay buyers,http://www.usatoday.com/tech/techinvestor/ 2007-07-17-economists- study-ebay-buyers_N.htm, July 17th 2007.

4.

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S ECTION 4

Case study: Should Energy be Subsidized?

The Dutch government will renew subsidies for green energy next year but only for producers that can prove their energy is really green and does not deprive people of food.1 - Jacqueline Cramer, the Environment Minister of Netherlands, in May, 2007.

Jacqueline Cramer

http://www.rnw.nl/english/article/sceptical-mps-try-deraildutch-climate-policy

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INTRODUCTION Not only should global economies end energy subsidies which encourage excessive use of energy, they should also agree on a common higher price for energy.2 - Lawrence H Summers, Former US Treasury Secretary, in April, 2007. Awrence H Summers In January 2007, the US House of Representatives passed legislation seeking to cut US$ 14 billion in oil and gas subsidies over the next ten years and instead to pass on the amount to companies engaged in the development of renewable energy technology and the production of renewable energy.4 However, as of June 2007, the bill was still languishing in the US Senate, with lobbyists working hard to ensure that it did not become law. If the bill did become law, it was expected to give a boost to the renewable energy industry. Some analysts were, however, apprehensive that this step might have a negative impact on the domestic oil industry in the US. A reduction in oil subsidies was expected to lead to an increase in the domestic price of oil, forcing the government to increase oil imports. Analysts also argued that in order to maintain their competitiveness, US oil companies would look to cut costs, including through layoffs, and this would have a negative impact on employment in the oil sector. The increase in international energy prices in 2006-07 brought energy subsidies into focus. According to economists, energy subsidies resulted in inefficient use and over-consumption of energy in addition to being a drain on the exchequer. They felt that while it was true that subsidies allowed the poor access to energy, the government would have to keep in mind the longterm impact of extending these subsidies on the economy and on the environment. Even so, around the world, there were many countries that continued with subsidies which promoted the indiscriminate use of non-renewable energy. This not only affected the finances of these countries but also caused harm to the environment.
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http://www.harvard.edu/history/presidents /summers

Encouraging reforms of subsidies that have considerable negative effects on the environment and are incompatible with sustainable development, inter alia by establishing a list of criteria allowing such environmentally negative subsidies to be recorded, with a view to gradually eliminating them.3 - An action suggested in the Sixth Environment Action Program 4, in July, 2002.

In this context, proposals to shift subsidies from the nonrenewable energy sector to the renewable energy sector were gaining currency. Some analysts were of the view that giving subsidies to develop energy from renewable sources would not only help save the environment but also improve the finances of many oil-importing countries, besides providing energy security. However, others felt that diverting subsidies from the non-renewable energy sector (especially fossil fuels) was not a good idea as it would lead to sudden increases in the price of fuel. Considering that the per unit cost of generating energy from renewable sources was higher than the cost of generation from non-renewable sources, the social cost of removing energy subsidies would be high, with reduced access to energy for the poor and increase in unemployment, they said. On the other hand, with climate change becoming an important issue, analysts felt that there was an urgent need to control greenhouse gas (GHG) emissions. It was argued that the money that was being used to subsidize non-renewable energy could now be effectively used to develop more efficient forms of renewable energy (Refer Exhibit I for a brief note on renewable energy). However, even as of 2007, renewable energy continued to be expensive vis--vis fossil fuels. Also, there were experts who felt that renewable energy too had certain drawbacks and could not be branded as fully ecofriendly. ENERGY SUBSIDIES: THE WHYS AND THE HOWS Subsidies, a type of government financial assistance which could be in the form of grants, tax breaks/exemptions, or price

controls, kept prices below the market level for consumers or kept costs down for producers. Subsidies such as grants and tax breaks had a direct impact on price, while other forms of subsidies like government-sponsored technology or research and development (R&D) affected prices or costs indirectly. In many countries, the energy sector was a beneficiary of government subsidies. Most countries introduced energy subsidies in order to secure domestic energy supplies; ensure that power supply was sufficient to meet demand; provide access to energy for low-income households; maintain employment or slow down the loss of employment in mining communities; or preserve the international competitiveness of the domestic industry.5 Energy subsidies, though common, came in different guises. For example, some OECD members gave subsidies in the form of cash transfers to producers of energy from fossil fuels and nuclear power. Others helped provide reduced-rate loans to energy producers while still others built infrastructure such as power grids and gas pipelines to distribute energy. Subsidies in the form of quotas and trade restrictions were also extended to protect the domestic energy industry from competition from imports or to ensure energy-supply security (Refer Table I for different types of energy subsidies). Although it was not possible to accurately determine the total quantum of subsidies extended to the energy sector globally, some estimates were available. For example, a study carried out by the World Bank (WB) in 1992 estimated the global annual fossil-fuel consumption subsidies to be at around US$ 230 billion. Very few studies have been carried out since then
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Should Energy be Subsidized?

to assess the extent of global energy subsidies. Although some governments moved to reduce their levels in the late 1990s and the early 2000s, energy subsidies continued to be high. Several regional studies indicate that subsidies continued to be extended to the energy sector. In 1997, the WB estimated annual fossil fuel subsidies at US$ 10 billion in the OECD and US$ 48 billion in twenty of the largest countries outside the OECD6.In 1999, an International Energy Agency (IEA) study estimated the total value of energy subsidies in eight of the largest developing countries at around US$ 95 billion.7 In 2001, energy subsidies in the EU were estimated to be around 6.3 billion to the coal sector, 8.7 billion to the oil and gas sector, and 2.2 billion to the nuclear sector. According to the IEA, consumption subsidies in non-OECD countries were running at an annual rate of approximately US$ 250 billion and the largest subsidies existed in Russia US$ 40 billion (based on 2005 data).8 The US government too extended subsidies to its energy sector (Refer Exhibit II for US energy subsidies in 2007). SUBSIDIES, RISING ENERGY PRICES, AND THE ENVIRONMENT With rising energy prices, the issue of energy subsidies became important to policy makers. Some environmentalists too began raising the issue due to the damage to the environment caused by faulty energy policies. There were arguments both for and against energy subsidies.

Table I

Types of Energy Subsidies

Government Intervention Example How the Subsidy Usually Works Lowers Raises cost Lowers cost of of price to production production consumers Direct financial transfer Grants to producer Grants to consumer Low interest or preferential loans to producer Preferential tax treatment Rebates or exemptions on royalties, duties, producer levies and tariffs Tax credit Accelerated depreciation allowances on energy supply equipment Trade restrictions Quotas, technical restrictions, and trade embargoes Direct investment in energy infrastructure Public research and development Demand guarantees and mandated deployment rates Price controls Market access restrictions Source: Reforming Energy Subsidies, www.uneptie.org, 2002. Although it was not possible to accurately determine the total quantum of subsidies extended to the energy sector globally, some estimates were available. For example, a study carried out by the

Energy related services provided directly by government at less than full cost Regulation of the energy sector

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ENERGY SUBSIDIES ARE USEFUL The supporters of energy subsidies argued that since energy was essential for all economic activities, it needed to be subsidized so that everyone could afford it. In developing countries, it was common for governments to provide subsidized kerosene, LPG, and/or electricity to make them affordable to even poor households. Energy subsidies had a direct impact on inflation. A reduction in energy subsidies was expected to increase energy prices, which in turn would increase the direct energy expenditures of households. Higher energy prices would also increase the production cost of most goods and services, which would contribute further to inflation (Refer Exhibit III for the inflationary effect of reducing energy subsidies in Iran in 2000). Therefore, in many countries, the domestic prices of petrol and other fossil fuels were contained with the help of energy subsidies. The impact of increases in international oil prices was also cushioned through subsidies. Politics, both regional and international, played an important role in the continuation of energy subsidies. Energy subsidies in the developing world were usually intended to benefit the poor, who also usually formed the largest vote banks. And as governments did not want to be seen as anti- poor, they continued with the subsidies. Subsidies on cooking and heating fuels were considered necessary to improve the living standards of the populace, especially the poor. For example, providing affordable LPG to the rural poor meant that women and children did not have to spend time gathering firewood. It also reduced air pollution, as evidenced in Senegal when the

government there started providing subsidized LPG to the poor. With fewer trees being cut for cooking and heating, the pressure on forests in rural areas also went down. Some countries preferred cross-subsidies to government subsidies. For example, commercial customers of Korea Electric Power Corporation (KEPCO), a state-owned monopoly electricity company, paid 34% more than the cost of service. On the other hand, the industrial sector paid 96% of total costs and the agricultural sector paid only 48% of total cost. Some analysts favored such cross-subsidization as it reduced the financial burden on the government. In this case, KEPCO earned enough from its commercial customers to build grid extensions to supply electricity to remote areas.9 However, the OECD was not in favor of KEPCO continuing with crosssubsidies as the energy prices that different sections of the population paid were not market- determined. ENERGY SUBSIDIES ARE WASTEFUL Energy subsidies came in for criticism from many economists. It was argued that subsidies made energy, especially fossil fuels such as petroleum, coal, and natural gas, cheaper, leading to their increased consumption. Further, it was believed that energy subsidies, especially in the developed world, led to irresponsible usage of energy. For example in the US, the relatively low gasoline price encouraged the use of Sports Utility Vehicles, which were also referred to as gas-guzzlers. Energy subsidies, therefore, contributed to the faster depletion of fossil fuels, a finite resource, and to increased GHG emissions.
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It was also charged that energy subsidies distorted the costs and prices. Analysts argued that by removing energy subsidies, the true cost of production of energy from nonrenewable sources could be ascertained. The nuclear energy sector was a major recipient of energy subsidies in many countries. Nuclear power was believed to be one of the most uneconomical energy sources and critics said that it was only because of subsidies that energy generated from nuclear power was viable. For example, the mandatory insurance coverage for damage caused by a nuclear accident was miniscule in comparison to the potential damage from a nuclear accident. In other words, the mandated insurance coverage levels were usually too low to effectively address the potential loss. In the US, the Price-Anderson Act specified the coverage requirements. Here too, the total third party liability coverage was lower than the coverage that US companies usually took to insure against damages caused by natural events. Analysts pointed out that most nuclear power companies did not include nuclear waste disposal costs in their price structure. This too contributed to the distortion of costs in the nuclear sector. In many countries, the government took the responsibility for managing nuclear waste for a small fee. In the US, surcharges on nuclear power were too low to cover anticipated disposal costs. Nuclear companies paid the US government a one-time fee for using storage areas, which were built and managed by the government. If insurance and capital costs were properly included, then the true price of electricity sourced from nuclear plants could be correctly calculated. Though the subsidies extended to the nuclear

industry could not be assessed accurately, it was estimated that on a global level, they could be around US$ 10 billion per year.10 Electricity generation from fossil fuels caused substantial environmental damage, but most costs associated with such damage were not included in the pricing system. This kind of subsidy was referred to as the allowance of external cost. In the EU, cost of electricity generation on an average was 4 cents/kWh; if external costs were included, the price of electricity from coal would double and that from gas would increase by around 30%. Around the world, the ethanol and bio-diesel sector received a large amount of subsidies. In the US, the Volumetric Ethanol Excise Tax Credit (VEETC) indicated the magnitude of the subsidy (Refer Exhibit IV for US support for ethanol and biodiesel). Agricultural subsidies combined with energy subsidies distorted the real costs incurred by ethanol producers to make ethanol. In many countries, consumers were provided with subsidized electricity. For example, farms in California paid very little for using electricity for irrigation. Russia too extended subsidies on electricity to consumers. In India in 2000-2001, the average price of electricity was 212 Paise (around 5 US cents) per/ kWh, which was 30% below the average cost. In the same year, the average price paid by the consumers in the agricultural sector was 28 Paise/kWh, and the average household price was 174 Paise/kWh. Since the State Electricity Boards (SEBs) in India could not cover their costs, they faced financial problems and were unable to invest in new power stations and distribution networks to improve the reliability and quality of their service.
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Some analysts were of the view that if subsidies on nonrenewable energy were removed, renewable energy would become cost competitive and this could promote its use. Reduction in the use of non-renewable energy would also lead to considerable reduction in GHG emissions. Analysts cited Chinas efforts to eliminate fossil fuel subsidies and their impact on consumption of renewable energy. Between 1990 and 1997, China reduced its annual fossil fuel subsidies from US$ 24.5 billion to US$ 10 billion. It cut its coal subsidies from US$ 750 million in 1993 to US$ 240 million in 1995. It also imposed a tax on high-sulfur coals. The combination of subsidy reductions and the imposition of tax on high sulfur coal contributed to Chinas coal consumption falling by 14% (or 411 million short tons) between 1996 and 2000. With coal becoming dearer, producers and consumers in China started using more renewable energy. The direct impact of this was that carbon dioxide emissions fell by 17% (between 1997 and 2000).11 In 1995, Chile too removed subsidies on coal. While the macroeconomic effect of removing the coal subsidy in Chile was negligible, it generated several positive environmental effects such as a drop in carbon monoxide (CO) emissions (by nearly 8% in 1996). Analysts argued that removing subsidies would help save the environment. The environmental damage caused by the use of petroleum and other fossil fuels had been well documented. Environmentalists blamed the excessive use of fossil fuels for climate change. The air pollution caused by burning fossil fuels was believed to contribute to several respiratory illnesses among the general population. Nuclear power too had many

adverse environmental effects such as radiation and soil contamination. Energy subsidies, as they distorted the costs of non-renewable energy, discouraged research on new technologies. Despite the renewable energy sector receiving subsidies, on a per unit basis, subsidized fossil fuels were cheaper than renewable energy. Analysts argued that as long as subsidies were extended to oil companies, producers of renewable energy would find it difficult to find a ready market. As a result, R&D in the renewable energy sector did not move at the pace that it should. One of the arguments in favor of energy subsidies was that removing them would seriously affect the underprivileged. However, in response to this argument, analysts suggested redirecting the money previously spent on energy subsidies to income support, health, environment, education, or regional development programs so as to minimize the impact. Energy subsidies were believed to place a heavy burden on government finances. With the increase in world energy prices, the fiscal cost of keeping domestic fuel prices low also increased. It was also argued that countries that had negligible reserves of fossil fuels had to meet a large proportion of their total energy needs through imports. But by extending subsidies to fossil fuels, the governments were implicitly encouraging their consumption. With increase in consumption, the countrys fuel imports too increased, which would worsen its fiscal situation. Subsidies in the form of tax exemptions reduced tax revenues, which contributed to increasing budget deficits.
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International criticism against energy subsidies was also growing. In 1997, the Kyoto Protocol suggested the phasing out of fiscal exemptions and of subsidies on GHG emitting sectors. In September 2002, at the United Nations World Summit on Sustainable Development (WSSD), held in Johannesburg, South Africa, the Plan of Implementation (PoI) suggested ...action, where appropriate, to phase out [energy] subsidies...that inhibit sustainable development, taking fully into account the specific conditions and different levels of development of individual countries and considering their adverse effect, particularly on developing countries.12 RENEWABLE ENERGY SUBSIDIES Renewable energy was considered to be the solution to the problem of growing GHG emissions. Also, countries which were dependent on oil imports could ensure energy security by investing in renewable energy. The renewable energy sector could also generate employment and foreign exchange for the economy. For example, the renewable energy sector in countries like Denmark, Australia, Japan, etc., earned foreign exchange revenue by selling renewable energy technology and products. Some analysts were in favor of energy subsidies to the renewable energy sector. They argued that providing subsidies to clean, renewable energy would save billions of dollars through reduced health care costs, and pollution and waste cleanup costs (Refer Exhibit V for environmental impact of different sources of electricity).

Subsidies for renewable energy had increased in response to environmental concerns. In some cases, governments subsidized these technologies to provide access to electricity in remote areas These subsidies generally took the form of favorable tax treatment, grants and soft loans, regulations that favored a particular technology, and R&D grants. In Germany, there was a feed-in tariff arrangement which guaranteed renewable energy producers up to 90% of the retail domestic electricity price. In 2001 in the EU, the energy subsidy to the renewable energy sector was 5.3 billion. In Norway, the government subsidized wind energy with a 25% investment grant and a production support of NOK 0.12 per kWh.13 China gave financial subsidies and tax incentives for the development of sources of renewable energy. In the US, wind energy project owners received tax credits only for the energy produced, thus encouraging them to use better technology to harvest the maximum energy possible from each wind turbine. Spain had a fixed tariff of 0.063/kWh for wind energy. The US and many European countries gave subsidies for solar energy. In Australia, there were subsidies of up to AUD 0.05/kWh for energy retailers to source specific quantities of power from new renewables (Exhibit VI for information on direct support extended to renewable electricity supply). In the Netherlands, the bio-fuel sector was supported with grants for R&D. In 2006, a tax relief system was introduced. The Netherlands also gave production subsidy or MEP on electricity from renewable energy sources.

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Despite general support for renewable energy, subsidies to the renewable energy sector too came in for criticism from some quarters. It was pointed out that the capital costs of establishing renewable energy plants was prohibitive and sometimes not justified, considering the fact that they eventually did not produce much energy (compared to fossil fuel power plants). Some analysts argued that some renewable sources of energy might even have adverse environmental consequences. For example, the dams built for hydro-electric power plants were believed to have disturbed regional ecosystems in some areas. Regarding ethanol and other bio-fuels, there was a view that their production was a major threat to the worlds remaining rainforests, especially in Brazil. It was pointed out that policy makers rarely took into account the negative impact of ethanol and other bio-fuels in the form of land erosion and water pollution when they decided to give subsidies. Moreover, the subsidies were the same even if the ethanol plant relied on coal rather than on cleaner energy sources to convert the corn/sugar into fuel. However, supporters of ethanol argued that air quality has improved in every city, county, and state that has switched from straight gasoline use to ethanol-blended fuel.14 FUTURE OUTLOOK A study by the OECD indicated that if all subsidies on fossil fuels used in industry and the power sector were removed everywhere in the world, then global carbon-dioxide emissions would fall by more than 6%, and real income would increase by 0.1% in OECD countries and by 1.6% in non- OECD countries by 2010.15

A report released by the Intergovernmental Panel on Climate Change (IPCC) in May 2007, listed reduction of fossil fuel subsidies, imposition of taxes or carbon charges on fossil fuels, and extension of producer subsidies and feed-in tariffs for renewable energy technologies as effective policy measures to help control environmental damage.16 The authors of the report argued that if renewable energy would get subsidies in the form of financial contributions or tax credits from national governments, it had the potential to meet a significant proportion of the energy needs of the world. According to a report by the American Solar Energy Society, renewable energy had the potential to provide 40% of the US electric needs projected for 2030. With efforts to improve efficiency of renewable energy sources, they could one day provide 50% of USs energy needs by 2030.17 In the late 1990s itself, Greenpeace had demanded that the EU and European governments immediately remove subsidies on fossil fuel and nuclear energy industries; transfer these funds to programs that accelerated the commercialization of solar renewable energy technologies and the uptake of energy conservation; and ensure full public disclosure of all direct and indirect energy subsidies18. However, governments were unwilling to phase out fossil fuel subsidies fearing economic recession. Even as of 2007, the trade-offs between the economic and environmental benefits of removing energy subsidies and the short-term social costs of higher fuel prices or of higher unemployment in local energy industries remained. It was estimated that as of 2006, subsidies to the nonrenewable energy sector (nuclear power/fossil fuel) consumed US$ 250 billion-US$ 300 billion of government money globally.
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Analysts felt that energy subsidy reform required strong determination to take decisions that benefited society as a whole and in the long term. While society might have to initially pay a price in terms of loss of employment in the conventional energy industry and increase in the price of fuel, redirecting the money previously spent on subsidies to income support, health, environment, education, or regional development programs could minimize the impact of the move on the poorer sections of society. Exhibit I: A Brief Note on Renewable Energy Renewable energy comes from sources that are essentially inexhaustible such as the sun, wind, and heat from the earth, or from replaceable fuels that are derived from plants. During the past 150 years, modern civilization has become increasingly dependent on fossil fuels oil, coal, and natural gas. Fossil fuels form so slowly in comparison with the rate of energy use that they are considered finite or limited resources. Using renewable energy can provide many benefits, including Making use of secure, local, and replenishable resources Reducing dependence on non-renewable energy Helping to keep the air clean by contributing to the reduction in the production of carbon dioxide and other GHGs Jobs being created in renewable energy industries. Wind, solar, geothermal, hydel, and biomass are some examples of renewable energies. WIND ENERGY

Wind power is a significant form of renewable energy. It is converted to electricity by a wind turbine. Over the past 10 years, the cost of generating electricity from wind has fallen substantially. However, wind power is still not as cost-effective as energy from conventional sources. Also, wind farms require large tracts of land, which are getting more and more difficult to find. In a 2006 report, the US Department of Energys Energy Information Administration said that a wind plant entering service in 2015 could make electricity from wind for 5.58 cents a kilowatt hour compared to 5.25 cents for natural gas, 5.31 cents for coal, and 5.93 cents for nuclear power.19 However, with the rapid advances in technology, experts believe that the cost of wind power would come down further. For example, scientists are coming up with new materials to make wind turbines, blades, etc., which could make them more efficient. SOLAR ENERGY The energy released by the sun is called solar power. Humanity has been using the power of the sun for centuries. In recent times, the development and refinement of photovoltaic cells has led to the generation of electricity from solar power. However, solar power accounts for a very small percentage of the total power generated in the world. A major drawback of solar power is the high cost of generating electricity with solar panels. At 35 cents to 45 cents per kilowatt hour (as per IEA, in 2007), solar power is quite expensive. Also, since solar panels stop generating electricity at night, the total energy output falls. Backup energy sources would also be required.
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However, the future generation of solar plants would be able to produce electricity at more competitive rates. The new plants would use concentrating solar power (CSP) and would be able to generate hundreds of megawatts of power. These plants would be able to generate one kilowatt hour of electricity at a cost of 9 to 12 cents. Major solar power companies in Europe such as Abengoa SA of Spain and Enel SpA of Italy are spending billions of Euros on new solar plants that are expected to bring down the costs even further. BIOMASS ENERGY Biomass is a renewable energy resource derived from several sources such as the byproducts from the timber industry, agricultural crops, household waste, wood, etc. As of 2007, biomass was the biggest source of renewable electricity in the US, surpassing solar, geothermal, and wind power. In 2007, the cost of generating power from biomass was high 5 cents to 10 cents per kilowatt hour, without subsidies. This was because the biomass plants were small (less than 50 megawatts in capacity). Experts were, however, optimistic about biomasspowered plants gaining popularity because more and more industries wanted to make electricity out of their waste. In 2007, a study by California Biomass Collaborative concluded that there were 80 million tons of plant materials produced in California each year that could be diverted to biomass plants for generating electricity.

GEOTHERMAL ENERGY Electricty generated from geothermal heat is called geothermal power. The development of Enhanced Geothermal Systems (EGS) has improved the prospects for geothermal power. A Massachusetts Institute of Technology (MIT) report estimated that around 100 GWe (Gigawatts of electricity) could be generated globally through EGS by 2050 more than enough to meet the energy needs of the entire world. Geothermal power would be around for several millenia because the Earths mantle had vast heat reserves. Geothermal energy made electricity round the clock, unlike solar or wind power that required backup sources. In 2007, the cost of geothermal energy was 6 cents to 10 cents per kilowatt hour, without subsidies. In 2007, there were about 8,000 megawatts of installed geothermal capacity globally.

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The Inflationary Effect of Reducing Subsidies in Iran in 2000

Sales Prices (Rials/Unit) Exhibit III
The Inflationary Effect of Reducing2000 Subsidies in Change Iran in 2000 Inflationary Unit 1999 1999-2000 (%) effect (%)
Sales Prices (Rials/Unit)

Kerosene Fuel oil

Should Energy be Subsidized?

Liter
Unit Liter Liter Liter Liter Liter Liter KWh Liter Cubic Meter KWh

100

110

1999 50 100 350 50 100 350 80.3 100 47.2 80.3

2000 55 110 385 55 110 385 88.5 110 53.8 88.5

Change 10.0 (%) 1999-2000 10.0 10.0 10.0 10.0 10.0 10.2 10.0 14.0 10.2

10.0

Inflationary 0.07 effect (%) 0.14 0.29 0.07 0.43 0.29 0.18 0.43 0.05 0.18

0.14

Kerosene Gasoline Fuel Gas oil oil Gasoline Electricity Gas oil gas Natural Electricity

Contd

BIOMASS ENERGY Biomass is a renewable energy resource derived from several sources such as the byproducts from the timber industry, agricultural crops, household waste, wood, etc. As of 2007, biomass was the biggest source of renewable electricity in the US, surpassing solar, geothermal, and wind power. In 2007, the cost of generating power from biomass was high 5 cents to 10 cents per kilowatt hour, without subsidies. This was because the biomass plants were small (less than 50 megawatts in capacity). Experts were, however, optimistic about biomass-powered plants gaining popularity because more and more industries wanted to make electricity out of their waste. In 2007, a study by California Biomass Collaborative concluded that there were 80 million tons of plant materials produced in California each year that could be diverted to biomass plants for generating electricity. GEOTHERMAL ENERGY Electricty generated from geothermal heat is called geothermal power. The development of Enhanced Geothermal Systems (EGS) has improved the prospects for geothermal power. A Massachusetts Institute of Technology (MIT) report estimated that around 100 GWe (Gigawatts of electricity) could be generated globally through EGS by 2050 more than enough to meet the energy needs of the entire world. Geothermal power would be around for several millenia because the Earths mantle had vast heat reserves. Geothermal energy made electricity round the clock, unlike solar or wind power that required backup sources. In 2007, the cost of geothermal energy was 6 cents to 10 cents per kilowatt hour, without subsidies. In 2007, there were about 8,000 megawatts of installed geothermal capacity globally.
Compiled from various sources.

Natural gas Cubic Meter 47.2 53.8 14.0 0.05 On December 31, 1999, 1 US Dollar was equal to 1,741.25 Iranian Rial.41 Total 1.15 Source: Energy Subsidies: Lessons Learned in Assessing their Impact and Designing Policy Reforms, On December 31, 1999, 1 US Dollar was equal to 1,741.25 Iranian Rial.41 www.greenleaf-publishing.com, February 2004.
Source: Energy Subsidies: Lessons Learned in Assessing their Impact and Designing Policy Reforms, www.greenleaf-publishing.com, February 2004.

Total

1.15

Exhibit IV US Support to Ethanol Exhibit IVand Bio-Diesel

US Support to Ethanol and Bio-Diesel Bio-diesel Ethanol Ethanol

Total support (Annualized Total support estimate, 2006-2012) estimate, (Annualized

2006-2012)

$ billions
$ billions

(Low) Ethanol (Low) 6.3

6.3

(High) Ethanol (High) 8.7

8.7

(Low) Bio-diesel (Low) 1.7

1.7

Bio-diesel (High) Bio-diesel

(High) 2.3 2.3

Subsidy per gallon $/GGE gasoline equivalent $/GDE or gasoline equivalent $/GDE (GGE) or gallon diesel (GGE) or gallon diesel equivalent (GDE) equivalent (GDE)

Subsidy per gallon

$/GGE or

1.44

1.44

1.96

1.96

1.24

1.24

1.70

1.70

(Annualized estimate. 2006-2012) 2006-2012) Source:Ronald Ronald Steenbilk, Steenbilk, Born Born Subsidized: Subsidized: Biofuel Biofuel Production Production in in the the USA, USA, www.gem.sciences-po.fr, www.gem.sciences-po.fr, Source: January2007. 2007. January

(Annualized estimate.

Source: www.csmonitor.com. 12
41

191
As of mid-2007, 1 USD = 9,307 Iranian Rial.

Footnotes 1. Dutch Government to Renew Green Energy Subsidies in 2008,www.planetark.com, May 7, 2007. 2. End Energy Subsidies by 2025, Says Summer, www.business-standard.com, April 18, 2007. 3. Sixth Environment Action Program, http://eur-lex.europa.eu, July 22, 2002 4. M a r k C l a y t o n , U S H o u s e Ta k e s o n B i g O i l , www.csmonitor.com, January 18, 2007. 5. Climate Change 2001: Mitigation, www.grida.no,2001. 6. Focus on Energy Subsidies, www.iisd.org, November, 2006 7. Focus on Energy Subsidies, www.iisd.org, November, 2006. 8. Doug Koplow, Ten Most Distortionary Energy Subsidies, www.eoearth.org, January 26, 2007. 9. Energy Subsidies: Lessons Learned in Assessing their Impact and Designing Policy Reforms, www.greenleaf-publishing.com, February 2004. 10. Doug Koplow, Ten Most Distortionary Energy Subsidies, www.eoearth.org, January 26, 2007. 11. A Case Study of Chinas Policy to Eliminate Harmful Fossil Fuel Subsidies,www.geni.org. 12. www.globalsubsidies.org

13. E n e r g y S u b s i d i e s a n d E x t e r n a l C o s t s , www.world-nuclear.org, February 2007. 14. ACE Responds to Stanford University Report on Ethanol Emissions, www.ethanol.org, April 29, 2007. 15. Energy, www.globalsubsidies.org 16. IPCC,Climate Change 2007:Mitigation, Contribution of Working Group III to the Fourth assessment of the Intergovernmental Panel on Climate change, Cambridge University Press, www.ipcc.ch, May 2007 17. Renewable Energy can Curb Global Warming, www.greenfuture.blogspot.com, February 9, 2007. 18. The Subsidy Scandal, www.archive.greenpeace.org, 1997. 19. T h e N e w M a t h o f A l t e r n a t i v e E n e r g y , www.globalenvision.org, April 2, 2007. References and Suggested Readings: 1. Dutch Government to Renew Green Energy Subsidies in 2008, www.planetark.com, May 7, 2007. 2. Michael Hopkin, Tackling Greenhouse Gases Looks to be Affordable, www.nature.com, May 4, 2007. 3. ACE Responds to Stanford University Report on Ethanol Emissions, www.ethanol.org, April 29, 2007.

192

4. End Energy Subsidies by 2025, Says Summer, www.business-standard.com, April 18, 2007. 5. T h e N e w M a t h o f A l t e r n a t i v e E n e r g y , www.globalenvision.org, April 2, 2007. 6. E n e r g y S u b s i d i e s a n d E x t e r n a l C o s t s , www.world-nuclear.org, February 2007. 7. Doug Koplow, Ten Most Distortionary Energy Subsidies, www.eoearth.org, January 26, 2007. 8. Jerry Taylor and Peter Van Doren, Oil Subsidies in the Dock, www.cato.org, January 19, 2007. 9. M a r k C l a y t o n , U S H o u s e Ta k e s o n B i g O i l , www.csmonitor.com, January 18, 2007. 10.Ronald Steenbilk, Born Subsidized: Biofuel Production in the USA, http://gem.sciences- po.fr, January 2007. 11.Wind Energy and U.S. Energy Subsidies, www.awea.org. January 2007. 12. Bettina Meyer, Subsidies to Energy Consumption with Special Focus on Energy Intensive Industries in Germany, www.ec.europa.eu, December, 2006. 13.Focus on Energy Subsidies, www.iisd.org, November, 2006. 14.Highlights from Greenhouse Gas (GHG) Emissions Data for 1990-2004 for Annex I Parties, www.unfcc.int, 2006.

15.I n d o n e s i a s O i l S u b s i d y D i l e m m a , www.radioaustralia.net.au, September 20, 2005. 16. Energy Subsidies: Lessons Learned in Assessing their Impact and Designing Policy Reforms, www.greenleaf-publishing.com, February 2004. Reforming Energy Subsidies, www.uneptie.org,2002. Climate Change 2001: Mitigation, www.grida.no,2001. Intervention and Subsidy Basics, www.earthtrack.net. A Case Study of Chinas Policy to Eliminate Harmful Fossil Fuel Subsidies,www.geni.org.

17. 18. 19. 20.

21. http://www.epa.qld.gov.au/register/p00401aa.pdf. 22. www.awea.org. 23. . www.globalsubsidies.org 24. www.ucusa.org. 25. www.geni.org.

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C HAPTER 6

Monopoly

Source:http://c3026172.r72.cf0.rackcdn.com/finance-markets8.jpg

S ECTION 1

Introduction

Video 6.1.1: Monopoly

Monopoly is a market structure in which there is a single seller, there are no close substitutes for the commodity it produces and there are barriers to entry. Market demand curve of any product is likely to be downward sloping. In a monopoly, the firms demand curve is the market demand curve. Since it is a downward-sloping demand curve, the firm can either fix the price or choose the quantity it wants to sell. A monopolist can either sell a smaller quantity at a higher price or sell a larger quantity at a lower price. A monopoly exists because of barriers to entry, which prevent the entry of new firms into the market. Monopoly can be classified on the basis of price setting and output decisions. The classification of monopoly is

195

Natural Monopoly: The size of the market may not allow the existence of more than a single large plant. In these conditions it is said that the market creates a natural monopoly, and it is usually the case that the government undertakes the production of the commodity or of the service so as to avoid exploitation of the consumers. This is the case of the public utilities.

Figure 6.1.1: Natural Monopoly Box : Natural Monopoly

The main sources of monopoly are: ownership of strategic raw materials: Example Arab countries oil reserves. exclusive knowledge of production techniques. Patent rights for a product or for a production process. Government licensing or the imposition of foreign trade barriers to exclude foreign competitors.
The demand curve for electric power is D and the average total cost curve is ATC. Economies of scale exist over the entire ATC curve. One firm can produce a total output of 4 million kilowatt-hours at a cost of 5 paise a kilowatt-hour. This same total output costs 10 paise a kilowatt-hour with two firms and 15 paise a kilowatt-hour with four firms. So one firm can meet the demand in this market a lower cost than two or more firms can and the market is a natural monopoly.

Keynote 6.1.1: Classification of Monopoly Economies of Scale: In some sectors like transport, electricity, communications, etc., substantial economies of scale can be realized only with large scale operations. In these conditions it is said that the market creates a natural monopoly,(above box) and it is usually the case that the government undertakes the production of the commodity or of the service so as to avoid exploitation of the consumers. This is the case of the public utilities. High entry costs: The entry into the industry involves huge expenditure in terms of economic barriers. There by restricting entry of potential firms. Example Indian railways
196
2

AR = Demand curve of Monopolist A monopolists individual demand curve (Figure 6.1.2) is an aggregate of the demand curves of individual consumers and is assumed to be negatively sloped. Figure 6.1.2: Demand Curve

= P. Thus we see that AR is nothing but the

price per unit of output. Marginal revenue is the additional revenue which the seller obtains by selling one additional unit of output. In other words it can be defined as the incremental revenue per unit of incremental output. Thus we have: MR = TR / Q.

We know, TR = P.Q Differentiating both sides of the equation with respect to Q, we have MR = =P. + Q. = P + Q. eqn 1... P = f(Q), where Q/ P < 0. Since < 0, MR is less

The quantity of his sales is a single-valued function of the price which he charges: Q = f(P), where Q/ P < 0. The demand curve has a

than price. The demand and MR curves are given in figure 6.1.1 Demand is monotonically decreasing and MR is less than price for every output greater than zero. The rate of decline of MR is twice the rate of decline of price: Let us consider, the demand function of a monopolist. P = a bQ. So we have, TR = aQbQ2; MR = = a2bQ.
197

unique inverse, and price may be expressed as a singlevalued function of quantity. Total revenue (TR) is represented as the product of the quantity of output sold (Q) and the corresponding price per unit (P), i.e., TR = P.Q. Average revenue is defined as the Total Revenue (TR) per unit of output sold, i.e.,

The slope of demand curve is b and that of MR curve is 2b. That is, the slope of MR curve is double the slope of demand curve. Now we can rewrite equation 1 as:

= AR

, since AR = P

MR = P ... eqn.2

MR = AR

... eqn.3

We know that the price elasticity of demand is defined as ep = .

Video 6.1.2: Businesses call end to electric monopoly

It is always negative and its absolute value is represented as follows: |ep| = .

Equation 3 implies that when the value of |ep| = 1, then MR = 0; when |ep| > 1, MR > 0 and when |ep| <1, MR <0. This shows that the difference between AR and MR depends inversely on the absolute value of the elasticity of demand. As the elasticity of demand increases the difference decreases and the difference increases as the elasticity of demand decreases. In a limiting case, we may say that as the absolute value of elasticity of demand tends towards infinity, AR approaches MR. Measurement of Monopoly power By monopoly power we mean the amount of discretion which a producer or a seller enjoys in regard to the framing of his/her price and output policy. In other words, monopoly power indicates the degree of control which a seller or producer yields over the price and output of his product. It also indicates the deviation from perfect competition. The following are the popular forms of measures of monopoly power : Lerners Measure: Lerner takes perfect competition as the situation when there is no monopoly power. The greater the deviation from perfect competition the greater is, therefore, the degree of monopoly power. We know
198

Substituting the value of |ep| in eqn.1, we have MR = P , or P

since

that under conditions of perfect competition price is equal to MC. Hence the difference between price and MC indicates the deviation from perfect competition. The greater the difference the greater is the degree of monopoly power. As discussed earlier, the value of the index of monopoly power, as proposed by Prof. Lerner is equal to . The greater the elasticity of demand the

share of each firm in the market. The Herfindahls Index, H is given as

lower will be the degree of monopoly power and vice versa. Under conditions of perfect competition, Price = MC so that P- MC = 0 and therefore . This

where S1 in the formula is the percentage share of the largest firm in the market, S2 is the percentage share of the second largest firm, and so on. Each S can vary from 100 (a pure monopoly, with only one firm in the market) down to almost zero. For a pure monopoly, H = (100)2 = 10,000. This is the largest possible value of the Herfindahls Index. By contrast, if there are 100 firms in a market, each with an equal 1% share, then, H = (1)2 + (1)2 +.......+(1)2 = 100. The Herfindahl Index is a more sophisticated tool for measuring market power than is the traditional concentration ratio, which treats a market with four firms of equal size the same as a market with four firms, one of which has 70% of the market and three that have 10% each. The Herfindahl Index assigns the equal shares market an index of 2,500(4 x 252) and the unequal shares market an index of 5,200 (702 + 102 + 102 + 102), indicating the larger potential for market power when one firm has a 70 percent share of the market. Only the shares of the larger firms are needed to approximate the index, since firms with small
199

shows that the degree of monopoly power is zero. On the other hand, when the marginal cost of production of the monopolist is equal to zero, or when the total cost of production is constant, MC = 0 and the index of monopoly is equal to unity. When the marginal cost of production of the monopolist is more than zero, P MC will be less than P and therefore, (P MC)/P is less than unity. Thus it is clear that the Lerners measure of the index of monopoly power lies between zero and unity. It is zero when there is perfect competition and it is equal to unity for a monopolist. THE HERFINDAHLS INDEX The Herfindahls Index measures market concentration in a way that gives a great deal of weight to the share of the largest one or two firms in the market. It does so by squaring the percentage market

shares add. C4 - CONCENTRATION RATIO The concentration ratio is the percentage of total industry sales made by the four (or sometimes eight) largest firms of an industry. This ratio can vary from nearly zero to 100, with 100 indicating that the sales of the four largest firms comprise those of the entire industry. The concentration ratio can be thought of as a broad indicator of competitiveness. Higher the concentration ratio, higher will be the monopoly power. The ratio cannot be considered as a perfect measure of competitiveness. Since the sales of foreign producers are not included in this ratio, it overstates the degree of concentration in industries in which foreign firms compete. Neither does the concentration ratio reveal the elasticity of demand for products, even though concentration is not as great a problem if good substitutes for a product are available. For example, the market power of aluminum producers is partially limited by competition from steel, plastics, copper, and similar products. Similarly, the monopoly power of the Indian Airlines is substantially reduced following the entry of the private operators in the Indian skies. Concentration ratio tends to conceal such competitiveness among products.

References
Monopoly Natural Monopoly

200

REVIEW 6.1.1

Question 1 of 4 Downward sloping demand curve in monopoly, implies that

A. Producer is a price taker B. Producer is a price maker C. Producer sells differentiated product D. Producer sells homogenous product

Check Answer

201

S ECTION 2

Price and Output Determination under Monopoly

Keynote 6.2.1 Determination of Price and Output under Monopoly The equilibrium price and output of the monopolist can be understood with the help of two approaches namely ; Total Approach and Marginal Approach (Keynote 6.2.1). Total Approach Under monopoly the inverse demand function can be written as P = (Q). Total revenue (TR) is equal to P.Q and is a function of Q only. TC can be expressed as a function of the level of output. The total cost function can be written as TC = (Q) Total profit is the difference between TR and TC. It is given as follows: = TR - TC

202

W h e r e i s t h e p r o f i t TR is the Total revenue, TC is the Total cost Marginal Approach To maximize , the first order condition: MR=MC = = 0 or = Keynote 6.2.3 Long Run Equilibrium of a Monopolist

Long Run Price and Output Determination of a Monopolist In the long-run, because of the restricted entry the monopolist will earn abnormal profit (Keynote 6.2.3).

Second order condition: Slope of MR< Slope of MC = <0, or, < Keynote 6.2.4 Absence of Supply Curve

Short Run Price and Output Determination of a Monopolist Keynote 6.2.2 Short-Run Equilibrium of a Monopolist In the short-run, the nature of profit of a monopolist can be a supernormal profit, loss or normal profit (Keynote 6.2.2).

Does monopolist have a supply curve? In the case of monopolist, there is exact relationship between price and output. The
203

main reason for this is the shape of demand curve in monopoly does not trace combinations of price and output as found in the competitive firms (Keynote 6.2.4). Profit-maximization for multi-plant firms We now know that when a firm is facing different demand curves in different segments, the quantity of output to be supplied to each of these segments is decided by equating marginal revenue from each of these segments to the marginal cost of production. What if there is only a single market segment, but the product is produced in more than one plant? How do we divide the market demand between these different plants? What quantities should each of these plants produce? Again, the logic is the same. Since different plants are likely to have different cost curves, the firm needs to equate the marginal cost of producing units in each of these plants to the marginal revenue. Put differently, firms should divide the output between units such that MR = MC1 = MC2 = ... = MCn, where 1 to n represents the plants of the firm with monopoly power.

Review 6.2

Question 1 of 3 Which of the following industry in India resembles monopoly to a large extent?

A. Domestic airlines B. Car industry C. Railways D. Internet service providers

Check Answer

204

S ECTION 3

Price Discrimination (Monopoly)

Keynote 6.3.3 Degrees Of Price Discrimination

When the monopolist charges different prices from different buyers for the same good, he is known as a discriminating monopolist. Price discrimination is not possible under perfect competition because everyone knows the price at which the good is being bought and sold. A monopolist, however, can charge different prices for the same good.

205

Discrimination owing to consumers peculiarities Discrimination owing to the nature of the good Discrimination owing to the distance and frontier barriers. Let us discuss them one by one. Even if the good is homogeneous different prices can be charged to different buyers in different situations depending on the following: When consumer A is unaware of the fact that consumer B gets the same good at a different price. When the consumer has an irrational feeling that he is paying a higher price for better quality, though, in reality, it may not be true. When the price differences are so minute that the consumer is not worried about it. Let us now consider price discrimination due to the nature of the good. Since resale of certain direct services is not possible these provide enough possibilities of price discrimination, e.g. service of a doctor, a cinema show, etc. Price discrimination is also possible due to distance and frontier barriers. For example, when the monopolist is serving two markets: a home market with a tariff and a world market without a tariff, he can take the advantage of the protected market and can raise the price in the

home market. Price discrimination may also take place due to differences in the transport costs. Types of Price Discrimination Price discrimination can take three broad forms, which are commonly referred to as first-degree, second-degree and third-degree price discrimination. First-degree price discrimination: When every customer is charged a different price on the basis of the customers willingness to pay, it is called a first-degree price discrimination. If a firm manages to charge every customer that individuals willing price, which is the maximum price the individual is willing to pay for that good, then the firm is practicing perfect first-degree price discrimination. A more common practice though, especially among privately practicing doctors, lawyers and accountants, is to charge a customer what is perceived to be the individuals willing price for their service. Those professionals who know their customers really well would be able to get somewhat close to perfect price discrimination. Perfect first-degree price discrimination will eliminate consumer surplus completely. Second-degree price discrimination: When price of a product depends on the quantity bought, there is seconddegree price discrimination in operation. Firms often practice charging different unit-prices for different quantities of the same good. On the one side, with additional quantity, the consumers willingness to pay could be coming down because of diminishing marginal
206

utility and on the other hand, firms often enjoy scale economies. The latter is especially the case with most utilitysupplying agencies like electricity boards and gas supply corporations. The practice of charging different prices for different blocks or slabs is also called block pricing. Third degree price discrimination: This is perhaps the most common form of price discrimination in practice. Companies often charge different prices for the same product in different segments of the market. This clearly makes sense if each segment has a distinct demand curve, which is different from that of the other segments. This type of discrimination is based on the geography, time, nature of use, personal characteristics of consumers or any other factor, which is likely to affect the elasticity of demand for the same product. In some cases, third degree price discrimination is applied when markets are geographically separated. As far as the firm is concerned, if there are only two market segments, then it will maximize profits if its MR from the first segment is equal to the MR from the second segment is equal to the MC, which is common. So, the thump-rule is MR1 = MR2 = ... = MRn = MC, where 1 to n represents the distinct market segments to which the product is supplied to. Intertemporal Price Discrimination: It is a sort of thirddegree price discrimination, but the market segments are defined on the basis of time. The most common case is that of discriminating between customers who cannot wait to consume a product and customers who are in no hurry.

Table 6.3.1
TYPES OF PRICE DISCRIMINATION
First Degree Price Discrimination Second degree Price Discrimination

EXAMPLES
Professional services,i.e., doctors, lawyers, engineers Utility bills on the basis of units consumed eg., Electricity bills, Telephone bills, Income tax slabs Air Travel (economy class, business class) Train Travel (First class, Second class, Sleeper class) Movie Theatres (Price of the ticket) Electricity Consumption (Industrial use or domestic area)

Third Degree Price Discrimination

207

REVIEW 6.3.1
Question 1 of 2 In which form of price discrimination are the prices based on the quantities of output purchased by individual consumers?

A. First degree price discrimination B. Second degree price discrimination C. Third degree price discrimination D. Both in second and third degree price discrimination

Check Answer

208

S ECTION 4

Government Policy and Monopoly

Though the monopolist has the complete command over his price and output decisions, there are two ways in which monopolists decision can be affected by government. Government can influence the monopolists decision by imposition of taxes. Government can also control monopolists monopoly power by price regulation and antitrust Laws. Before discussing about these, understanding of the difference between Perfect competition and monopoly as well as the social cost of monopoly is extremely important. Perfect competition and Monopoly are the extreme form of market structures. Perfect competition is an ideal model which explains the concept of allocative efficiency with normal profits in the long run. Monopoly, on the other hand, enables us to understand the concentration of market power in a single hand in terms of setting up of the price and enjoying abnormal profits in the longrun. The differences between perfect competition and monopoly are presented in the table: 6.4.1

Video 6.4.1 School Choice Examples Shows Why Government Monopolies are Bad

209

Table 6.4.1
ASPECTS
Goals of the firm Profit Maximization Profit Maximization

PERFECT COMPETITION

MONOPOLY

Assumptions Product Demand Curve Firm Industry Supply of the Product Entry & Exit Conditions Horizontal (Price Taker) Downward sloping Large number of Firms Free Entry & Free Exit Homogenous Homogenous/Heterogenous Downward sloping (Price Maker) Absolutely there is no difference between firm & industry Single Firm Restricted Entry

Cost Conditions Short Run Long Run

U Shaped cost curves (Law of Diminishing Returns to variable} Flatter U Shaped cost curves(Returns to Scale)

U shaped cost curves (Law of Diminishing Returns to variable} FlatterU Shaped cost curves (Returns to Scale)

Equilibrium Condition MR = MC First order condition Slope of MR<MC Second order condition Profits Normal, Abnormal, Supernormal Profits Short run Normal Profits Long run Abnormal Profits Normal, Abnormal, Supernormal Slope of MR<MC MR=MC

210

this rise in the price can be analyzed in terms of social cost and deadweight loss. Social cost: This rise in the price above the equilibrium level will ensure shift in the income from consumer to monopolist and results in the increase in the profit to the monopolist. Deadweight loss: Rise in the price of the product may discourage the people to buy the product. Deadweight loss in the figure is represented by the shaded area. This shaded area indicates that the consumer surplus that would have been resulted by consumption of the good between Qm and Qpc, i.e., the output that is now neither produced nor consumed. Effect of Taxes on the output and Price of a monopolist due to the imposition of taxes Imposition of a Lump Sum Tax (per period): In the case of a monopolist we need not distinguish between the short run and the long run, as we did under perfect competition. This is because, in general, the monopolist realizes some excess profits both in the short run and the long run. Under these conditions the imposition of a lump sum tax will reduce the excess profits of the monopolist because it will increase its total fixed cost. However, the MC curve of the monopolist will not be affected, and hence the equilibrium in the monopoly market will remain the same even in the long run (provided that the lump sum tax does not exceed the supernormal profits of the monopolist).

Imposition of a Profit Tax: The effects of taxes on the monopoly profits on the equilibrium of the monopolist are the same as in the case of the lump sum tax. The profit tax reduces the abnormal (monopoly) profits, but the equilibrium in the market is not affected, so long as the profit tax does not bite into the normal profits of the monopolist.
Keynote 6.4.1: Effects of Specific Taxes on Monopolists output & Price

Imposition of a Specific Sales Tax: The imposition of the specific tax will shift the MC curve of the monopolist upwards, which will result result in a change of his equilibrium; in the new position, the price will be higher and the quantity smaller as com211

pared with the initial equilibrium. The change in the price of the monopolist may be smaller, equal or greater than the specific tax. However, in the monopoly market we do not distinguish between the short run and the long run, since the conditions of equilibrium are the same for both the periods (Keynote 6.4.1). Regulation of Monopoly: A monopolists power can be regulated in various ways such as regulating prices by imposing Keynote 6.4.2: Deadweight Loss due to Moa nopoly Power and Price Regulation

Price Regulation: A monopolist has control over their decisions as they are the sole producer of the product. A monopolist will choose the amount of output which is lesser and offer their product at a higher price as compared to the competitive market would have offered. By restricting the output and charging higher price the monopolist maximizes its profit but at the cost of the society (Keynote 6.4.2). Let us consider an industry like electricity which is of social importance. If the electricity is regulated by a single firm and it is allowed to exercise its monopoly power, the unregulated monopoly price charged will be higher than the marginal cost which leads to allocative inefficiency. Hence the government can fix a price ceiling as a regulatory mechanism. The new price can be set above or at the competitive price where Average revenue equals to Marginal Cost, where the output would be same as that produced by the competitive industry. If the price is set at a price less than the competitive price the output would be reduced and there would be a shortage. Antitrust Law: Another way to restrict monopoly power is to implement Antitrust Laws. Antitrust laws are the laws which restrain monopoly power to protect the consumers from the inefficiencies and abuses resulting from monopoly and to promote a competitive economy. One of the examples of Antitrust laws is Monopolies and Restric212

price ceiling on the monopoly price and by enactment of Antitrust Laws.

S ECTION 5

Case study: Mexican Telecom Industry (Un)wanted Monopoly?

Carlos Slim

Source:www.forbes.com

Mexicos telecommunications industry, to a large extent is dominated by wire-line operator Telmex and mobile operator Telcel. Both belong to Carlos Slim the worlds richest man as per Fortunes list in August 2007. Telmex provides local, domestic long-distance and international fixed-line voice services, Internet and data communications, while Telcel provides wireless services. Both Telmex and Telcel hold a mammoth portion of the market

share in the Mexican telecommunication industry. In this context, these companies have been constantly criticised that they take undue advantage of their dominance and thwart competition in the industry. It is also said that the weak regulatory authorities and flaws in regulations abetted the Mexican telecom giants in ensuring low competition. However, these companies defend themselves by arguing that they invest more than their competitors and provide good services throughout the country including lowmargined rural areas.

This case study was written by Hepsi Swarna under the direction of Saradhi Kumar Gonela, IBSCDC . It is intended to be used as the basis for class discussion rather than to illustrate either effective or ineffective handling of a management situation. The case was compiled from published sources.

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Mexican Telecommunication Industry A Overview Before privatisation, Mexicos national telephone company Telefonos de Mexico (Telmex), suffered from high operating costs, under-investment, service delivery shortcomings, low reliability and thus, tarnished image. The quality of its basic services was far below the normal standards, while valueadded services were non-existent. For instance, the wait for a new telephone connection was above 3 years and tariff structure was prohibitive. Amid these inefficiencies, voices were raised in favour of privatising the company. In 1989, President Carlos Salinas de Gortari decided to privatise the company. Once privatisation was decided upon...policymakers had to decide whether, to maintain Telmex as a vertically integrated or...separate it horizontally, that is, to sell the different telephone services separately: local services, long distance, cellular, value-added services.1 The key players involved in the policy reform were National Investors, Telephone Union, Telmex, Foreign Investors, World Bank, Secretariat of Communications and Transport (SCT) and Secretara de Comercio y Fomento Industrial (SECOFI)2. National investors, Telephone union, Telmex and SCT preferred vertically integrated firm, whereas foreign investors, World Bank and SECOFI favoured market segmentation.3 Policymakers believed that market segmentation would enhance social welfare. However, because of time constraint for formulating and implementing the same, government decided to maintain Telmex as a vertically integrated firm. An additional constraint, not openly acknowledged by policymakers, was given by the need to respond to

preferences from newly established alliances that favoured an integrated firm.4 In 1990, Grupo Carso Telecom, owned by Carlos Slim, acquired Telmex through a joint venture with Southwestern Bell and France Telecom for an exceptionally low price of $1.75 billion. Since foreign investment was limited to 49%, the two foreign companies teamed up with Grupo Carso Telecom. According to the agreement between the three, Grupo Carso possessed operating control of the company, Southwestern Bell was responsible for improving operations and developing paging and cellular divisions, and France Telecom concentrated on line expansion and modernisation. Although many foreign companies had offered higher amounts in the public auction, Grupo Carso Telecom won the bid. The fact that majority ownership would stay in Mexico, was a major determining factor than any specific business logic. After privatisation, Telmex was granted seven competition free years in both domestic and international telecommunications services on the condition that it invests at least $14 billion in upgrading the network and technology during that period. The company was given 5 years time to cut down waiting time for a new line to the maximum of 6 months. It was also asked to double the number of telephone lines in service. The decision to allow monopoly for Telmex, though temporarily, was based on three arguments. First, foreign investors would require it (monopoly) in order to purchase Telmex for a substantial amount. Second, monopoly facilitated pursuit of a universal service objective to serve households who could not afford service that was priced to recover its full cost, and to bring service to areas that were under-served because of difficult
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terrain, low population or generally low incomes. Third, monopoly was regarded as necessary to get private firms to commit to a major investment to improve service even to businesses and high-income households. Major investment would be required simply to eliminate the long waiting-list for service and the high rate of failure in completing or holding calls.5 After privatisation, services improved tremendously. Earlier, people had to wait on the streets for a Telmex car to pass and bribe the technician for a line repair. Telmex also did better than expected in reducing the waiting time for a new line by bringing it down to 3 months. The number of wire-line (fixed line) and wireless telephones in service has grown significantly. Although services improved, prices still remain high in Mexico. According to the Paris-based Organisation of Economic Cooperation & Development (OECD), Mexico remains one of the OECD countries with the highest telephone charges, especially for business use (Exhibit I). Eduardo Garcia, a business journalist in Mexico, observes, If not for those rates, Mexican businesses would have generated better profits and could have paid their workers better. Mexico would have been a more efficient economy.6 These high rates, in turn, resulted in low overall wire-line and wireless penetration (Exhibits II (a) & (b)) and a low broadband penetration rate (Exhibit III). In 2006, in Mexico, it was reported that, Only 18% have a phone line, phone calls costs 50% more than the OECD average, and only two in 100 have broadband, which puts the Latin American country second to last in the OECD rankings.7 Amidst all these spectacles and flaws, the Mexican telecom industry rests under the dominance of Telmex, even after expiry of monopoly period.

Few competitors have managed to break through the market share of 90% held by Telmex (by 2008). The necessary institutional and legal support to create a competitive market was absent during the reform process. Roger Noll (Noll) an economist at Stanford University, who advised Mexican government on privatisation of Telmex believes, the key error was not to set up an independent regulator in advance of the sale.8 Thus, a private monopoly replaced a public monopoly. In spite of Telmexs monopoly in wire-line, the Mexican government allowed Slim to enter the wireless market too. In 2000,Telmexs cellular operations in and outside Mexico were spun-off and the new company hence formed was named America Movil, which went on to become Latin Americas largest mobile phone operator. The Mexican arm of America Movil, named Telcel, enjoys a similar kind of dominance as, its fixed-line sister concern, Telmex does.

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Monopoly of Telmex and Telcel While Telmex got natural monopoly through privatisation, Slim implemented Gillette Plan to establish Telcels dominance in the mobile market. Following this strategy, mobile phones were sold at cheaper prices, as once the customer bought a mobile phone they needed prepaid phone cards to use it constantly. The strategy worked well and the company made huge profits. According to a report in 2008, America Movil, the largest cell phone operator in Latin America, provides service to 7 out of every 10 mobile users in Mexico, well ahead of the No. 2 operator, Movistar, the brand of Spains Telefonica.9 Telmexs direct competitors include fixed line companies such as Axtel, Alestra, Maxcom Telecomunicaciones and cable TV companies like Megacable Holdings. In 2006, Mexico had around 20 million fixed lines in service, out of which Telmex had 18.3 million fixed lines in service. The number of fixed line subscribers is going down in Mexico as customers are switching to wireless services. In the first quarter of 2008, Telmex had 17.8 million fixed lines in service with 90% of the market share while all the other operators having decimal share. Telcel operates on GSM technology, while the other operators Telfonicas Movistar is based on GSM and Grupo Lusacell (merged with Unefon) is into CDMA technology. Digital trunking operator Nextel de Mxico is emerging as a strong competitor for post-paid business customers. For the first quarter of 2008, Mexico had 71 million mobile subscribers out of its population of 109 million people. Telcel, Movistar, Lusacell and Nextel had 51.4 million, 13.3 million, (just under)
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4 million and 2.3 million subscribers, translating to a market share of 72.5%, 18.7%, 5.6% and 3.2% respectively. Having established their monopoly, both Telmex and Telcel have been charging high prices for all its services including Internet services. However, excessive charges are denied to such an extent that once, Slim even raised questions on the credibility of OECD. In an interview with BusinessWeek in 2007, he called the OECD charges false and denied hes a m o n o p o l i s t . 10 E v e n , t h e C o m i s i o n F e d e r a l d e Telecomunicaciones (Cofetel)11 denies the accusations of over pricing. It states that Telmexs charges have risen by less than inflation since 1998 and the prices were frozen since 2001. Further, it claims that local call prices are at or below international averages and it has forced Telmex to expand the network. But according to Professor Noll, the international comparisons are unrealistic, since many foreign companies offer packages including free long-distance calls or unlimited local calls.12 He opines, Prices were bound to fall because of the nature of technology in the sector. If there have been improvements, its because reductions in costs have caused the profit-maximising monopoly price to fall. Its still the profitmaximising monopoly price.13 Added to imposing higher prices on customers, Telmex is also accused of charging competitors high interconnection fees. In Mexico, the charges are said to be high above the average cost incurred for interconnection service. For instance, in 2000, Avantels 60% of the revenue directly went to Telmex in the form of interconnectivity fees. By all accounts, the revenues of Telmex and Telcel can be attributed to the fact that they have abused their dominant position, by over-

charging customers and competitors. Regulatory frame work and anti-competitive authorities are blamed for letting both the companies scot free. Regulation in Mexico Article 13 of the Federal Law of Economic Competition of Mexico defines a company as monopoly, by examining whether it can unilaterally set the prices or restrict the supply in the relevant market without the competitive agents being able to act or to potentially counteract that power. In 1993, to ban anti-competitive behaviour by companies, Mexico adopted Federal Law of Economic Competition (LFCE). The competition policy goals of LFCE are: to protect the competitive process and free market access by preventing monopolies, monopolistic practices and other restraints of the efficient functioning of markets for goods and services.14 Comisin Federal de Competencia (CFC)15 was created to enforce LFCE. CFC is responsible for investigating abusive monopoly practices of companies. It also determines the companies, which have dominant position in any sector. LFCE classifies monopolistic practices as absolute and relative. Absolute monopolistic practices are prohibited. This include four types of horizontal agreements between competitors such as price fixing, output restriction, market division and bid rigging. Whereas, relative monopolistic practices are not termed illegal unless a company is found to have substantial power in the respective market. Vertical agreements like vertical market division, resale price maintenance, tied sales, exclusive dealing and refusal to deal
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are considered to be relative monopolistic practices. Other horizontal practices are also termed as relative practices collectively treated as a catch-all provision that will unduly damage or impair the process of competition and free access to production, processing, distribution and marketing of goods and services.16 In conjunction with the above, the competition laws around the world also prohibit two types of monopolistic behaviours under abuse of dominance provisions. They are exploitative conduct and exclusionary conduct. However, Mexican competition law does not prosecute exploitative practices such as charging monopolistic prices, but encourages actions against exclusionary abuses. Unlawful conduct is defined solely in terms of exclusionary practices at the expense of competitors or other firms in the chain of distribution, and not in terms of exploitative practices at the expense of consumers.17 There is no provision for fair competition under this law, neither does it talk about protecting the interest of small enterprises and restricting business concentration. Even though both Mexican constitution and LFCE ban monopoly, no section of law deals with monopoly as such or with abuse of dominance. Competition and Regulation in Context of Mexican Telecom Industry You dont tug on Supermans cape, you dont spit into the wind, you dont pull the mask of that old Lone Ranger and you dont mess around Slim.18 Jim Croce

Until 1995, in Mexico the national telephone industry was regulated by SCT. In 1996, a Presidential decree created Cofetel as an autonomous entity from SCT to regulate and develop the Mexican Telecom Industry. Cofetel is responsible for implementing regulations and technical standards. It is also responsible for resolving the conflicts between competitors regarding interconnection fees. Cofetel has operational and technical autonomy but lacks political autonomy. It limits to suggesting on major issues to SCT and SCT retains the power to grant all concessions it is the final deciding authority. Once a decision is made, Cofetel implements it. Telmex is regulated through price cap. The price cap consists of a basket of five services installation charges; monthly rental fee; local measured services; national or domestic longdistance and international long-distance. Leased lines are not under the price cap, Telmex is not regulated in that aspect. From time to time, the value of basket is re-estimated by the government and it requires Telmex to pass the benefits of productivity and efficiency to the customers to reduce the real value of basket by a definite percentage. The reduction is equal to 4.5% per year. Annual price increase is calculated by deducting 4.5% from the rate of inflation for the respective year. Owing to technological improvements and augmented efficiency, Telmex has experienced productivity gains in excess of the 4.5% target, allowing it to earn increasing profits while not raising prices as fast as is allowed under the price-cap formula.19 Telmex sends a letter to the Cofetel with the rates, then Cofetel decides whether the rates have to be registered or not. Once the rates are registered, its a sort of consent that the rates are applicable.
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Competition entered the Mexican long-distance market in 1997 and later in other segments of telecommunications like local service and mobile market. Since foreign investment was limited to 49%, AT&T entered the long-distance market as a joint venture with Alestra. Worldcom followed suit by joining with Avantel, but Telmex retorted with patriotic marketing and advertising. In 1998, Avantel intended to introduce longdistance calls from public phones using prepaid cards. As majority of the public phones were operated by Telmex, Avantel was denied a free number by Telmex a prerequisite for longdistance calls and the initiative faced major obstacle. Avantel also faced high interconnection fees. When it took Telmex to court for monopolistic practices Telmex kept it at bay by getting a judge to issue an arrest warrant for the top lawyer of Avantel. Avantel eventually defaulted on its debt in 2001, much of which were scooped by Mr. Slim and later sold for a profit.20 Frank Voytek, AT&Ts representative on Alestras board says, Our expectation when we made our investment was that the regulator would enforce the regulations.21 Part of Cofetels problem in implementing effective regulation arises from its inability to convince the courts that its regulations are reasonable and necessary. An important aspect of judicial review in Mexico is the amparo 22. An amparo can result in obtaining a stay order in the implementationofa court decree for years. Even if the party, which filed the amparo, loses the lawsuit, much time elapses by then. In 1997, for example, CFC determined that Telmex had substantial power in five telephony markets namely, local telephony service; national long-distance service; international long-distance service; access or interconnection to local networks; and interurban transport. In

August 1998, Telmex filed an amparo. Telmex successfully challenged before court the authority of CFC to declare it dominant in five telecommunications markets. Time and again Telmex filed many amparos challenging the decisions of CFC and Cofetel, and this amparo abuse has costed Mexican economy dearly. Karina Duyich, former head of AT&T Mexicos legal department remarks, Since 1998, Slim has made use of more than 60 amparos to thwart decisions by Mexicos antitrust agency, the Comisin Federal de Competencia, ordering Telmex to reduce its interconnection rates the fees rivals must pay to use Telmex trunk lines. Telmexs very aggressive use of the amparo has ended any hope of an open telecommunications market in Mexico.23 In 2000, CFC once again came down on Telmex for its refusal to deal with the competitors. For instance a customer who called a toll free number (an 800 number) operated by other long- distant operator using Telmex public phone, had to buy its prepaid cards. But the toll free numbers operated by Telmex were accessible without any charges. Telmex refused to deal with the competitors regarding the issue. Because of this, a case was filed against Telmex and it was ordered to enter into an agreement with its competitors. As a result Telmex provided a free toll free number to competitors who concluded an agreement with it. But by then competitors had lost considerable amount of business. In the same year, Cofetel ordered a 63% reduction in interconnection fees, which Telmex charged its competitors for international calls. However, Telmex took advantage of Cofetels weakness and delayed in complying with the order by filing injunctions in various courts. In the meantime, there was a
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significant progress in the reduction of Mexican domestic interconnection fees, but international long-distance interconnection fee remained mostly unchanged. Mexico failed to address concerns of US telecom companies in regard to the high interconnection fees, which Telmex charged US carriers. In 2002, US requested a WTO panel to take up the matter. In 2004, US won the WTO telecommunications case against Mexico in particular against Telmex. It was estimated that Mexicos artificially high interconnection charges resulted in excess payments by US companies and consumers well over $1 billion since 2000.24 It has not been easy to compete in Mexican mobile market too. OECD referring to Telcel in its report (Economic survey of Mexico 2007: Improving infrastructure in Mexico) declared, In the mobile telephone market, in particular, the dominant firm is using its market power to squeeze out other players.25 But Slim has always maintained that he likes competition, and commented that, We have never opposed the entry of a competitor, let them come on in.26 In 2004, Movistar, the second largest mobile operator in Mexico, to increase market share, started selling mobile handsets at a cheaper price. But many of its sold phones were never used. Movistar discovered that Telcel purchased its handsets, replaced the chip and resold them. Movistar filed a case against Telcel. In 2006, CFC announced Telcel guilty of monopolistic practices as it refused to allow SMS exchange with Nextel. In November 2007, Movistar filed many complaints against Telcel and Telmex with CFC. It appealed CFC to compel both the companies to connect its competitors to their network on fair terms. In 2007, government started an investigation into dominance and

monopolistic practices of Telmex in broadband Internet. In 2008, as many as eight probes were initiated against Telmex and Telcel, of which six are investigating Telmexs dominance related issues, while one is into interconnection fee of Telcel and another to determine whether Telcel wields substantial power in Mexican mobile market. Eduardo Perez Motta, president of CFC said that these investigations would be concluded by mid-2008. All eyes are set on the results of the ongoing investigations, competitors are hoping that after investigations are through, both Telmex and Telcel will be made to reduce the interconnection fees. CFCs and Cofetels major constraint are their limited powers and the amparos filed against their rulings. These amparos delay regulatory rulings against the companies. Also, time and again, Telmex and Telcel have used skilful lobbying and legal battles to defend themselves against regulation and antitrust prosecution. Telmex has repeatedly delayed signing interconnection agreement with competitors. Due to its dominant position, it does not respect the interconnection fee fixed by Cofetel and continues to charge high tariff per minute. Mexicos constitution has always banned monopolies, but it is a country where corruption is widely spread. Nearly 62% of the companies have admitted to the fact that they reserve money to bribe government officials.27 Slim is alleged to have friends in high places. Actions to curtail Telmexs monopoly power during Carlos Salinas, Ernesto Zedillo and Vicente Fox administrations have not yielded desired results. There were rumours that President Carlos Salinas, who sold Telmex to Slim, secretly benefited from the sale. Critics believe Slim alone has not crushed competition; he had help from Mexican
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Presidents Ernesto Zedillo and Vincent Fox. In 2000, President Vincent Fox appointed Pedro Cerisola, a former employee of Telmex as Secretary to SCT. During his tenure (till 2006), he was alleged for protecting Telmexs interests. Denise Dresser, a political analyst and professor at the Instituto Tecnolgico Autnomo de Mxico says, Mexico has a dense, intricate web of connections and personal ties between the government and the business class, this ends up creating a government that doesnt defend the public interest, that isnt willing to go out and regulate in the name of the consumer, it is rather willing to help its friends, its allies and, in some cases, its business partners thrive at the expense of the Mexican people.28 Slims political connections combined with the weak regulatory system of Mexico enabled him to defend his companies against the accusations of monopolistic business practices. It is widely published that Telmexs and Telcels market dominance can be attributed to hands off policy of Mexican legislature and no British or US government would have allowed this. Perez Motta says, Mexicos telecommunications regulatory framework and regulator remain weak and have failed, to some extent, to foster access and competition, Telmex has challenged CFC and (Comision Federal de Telecomunicaciones, or Cofetel) decisions before the courts and has been successful in delaying enforcement. All these circumstances have allowed it to maintain and exercise its market power through relative monopolistic practices.29 Cofetel has been criticised for lacking teeth to enforce effective regulation. Researchers at Syracuse University note, Since its creation, Cofetel has assumed what can only be described as a pro-Telmex role in implementing its regulatory duties. As a

result, the incumbent enjoys a monopoly over local, long distance, cellular and Internet services in Mexico. Its highly dominant positionis largely because regulators have failed miserably.30 What ever the reason may be, the Mexican economy and Mexican people are facing the consequences.

Effects of Monopoly of Telmex and Telcel

The great evil in economics is not communism, not socialism, not capitalism, not landlords or bosses, not unions, not feudalism or industrialization or automation, not progress or lack of it, and not any scarcity of natural resources. No, the great evil in economics is COERCIVE MONOPOLY.31 Fred E. Foldvary In the bid to sell Telmex, Mexican government hiked telephone tariffs. In 1990, it eliminated indirect taxes on telephone services and allowed Telmex to absorb the remaining taxes into the prices. As a result local calls, which accounted for major part of the revenue for telecom companies, increased from 16 pesos per minute to 115 pesos.32 According to a 1992 World Bank report on Telmex sale, the biggest losers from the privatisation of Telmex were the consumers, who had to bare the additional burden of 92 trillion Mexican pesos in the form of higher charges. The government, domestic shareholders and employees gained 16, 43 and 23.5 trillion pesos respectively. The best gain was bagged by the foreign investors who captured 90% of the net benefits from the sale, translated into 67 trillion pesos. The privatisation of Telmex, along with its attendant price-tax regulatory regime, has the result of `taxing consumers a rather diffuse, unorganised group and then
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distributing the gains among more well-defined groups, (foreign) shareholders, employees and the government.33 However, the report projected that the consumers would benefit in the long run by reduced prices. The projection proved to be a rather far fetched imagination. The Mexican customers are saddled under high telephone charges since then. Owing to high charges, the usage rate (minutes of use per subscriber per month) is very less in Mexico, thus resulting in deadweight loss. Professor Noll opines, there is enormous loss of efficiency arising from the dominance of Telmex, especially with respect to the under utilisation of the network (low minutes of use) and the low penetration of the Internet.34 He also says, Mexico has low wire-line penetration, but many developing countries have low wire-line penetration. The big problem is that Mexico does not offset this with high wireless penetration. Moreover, wireless penetration is less than it seems because many intensive business users carry cell phones for multiple carriers in order to take advantage of the much lower within- system calling charges compared to the extremely high prices for intersystem calling.35 Economists opine that high costs of telephone and Internet services that resulted from lack of competition are hindering Mexican economys growth. In Mexico high telephone and electricity costs, blamed on monopolies, are driving many factories to countries like China.36 Felipe Caldern, who became the President of Mexico in December 2006, vowed to make Mexico more competitive by dismantling monopolies. In November 2007, he affirmed once more, that increasing competition in telecommunication industry was his priority. But,

till mid 2008, there were not any significant move against big companies. Some say that the telecom investigations which are ongoing will be a big test of whether President Caldern and CFC are up to the task.

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Annexure I Interview with Prof. Roger Noll Roger Noll is a professor of Economics University of Stanford. He has a Ph.D. from Harvard and B.S. California Institute of Technology. Prof. Nolls research interests include public policies towards business, rational actor models of public policy making, political behaviour and legal processes. He had been a consultant to the Government of Mexico during privatisation of its telecom sector. 1) It is reported in some quarters that Mr.Slim abuses his monopoly by over charging customers and the peers with higher interconnectivity fees. How do you read, rather what do you read into, such reports? Also is he correct in denying high charges saying he provides good services? I think it is not appropriate to attribute the pricing of Telmex solely to Mr. Slim. Telmex is a publicly traded corporation, and all of its owners and executives are responsible for its performance. In addition, Telmex is regulated by Cofetel, which bears some responsibility for its prices. Telmex is among the worlds most profitable telephone companies. These profits arise from high prices across the board, including interconnection charges that are above the marginal and average cost of interconnection service. The quality of service is irrelevant to whether prices exceed average and marginal cost and profits substantially exceed the competitive return on investment. In addition,using the standard measures

of service quality that are used by the International Telecommunications Union to assess the performance of telecommunications carriersthrough out the world,Telmex is not a leader among carriers in peer nations (that is, nations with roughly Mexicos per capita income, distribution of income, and geographic and demographic characteristics). 2)Is it therefore right to say that Mr.Slim is thwarting competition or is he playing fair?

Telemax certainly has not provided any assistance to its competitors, but to expect otherwise is misguided. The history of incumbent monopoly telephone companies in all nations after competition was made legal is similar. Incumbents always try to protect their monopoly. The difference between Mexico and other countries where the performance of the telecommunications industry is superior is that public policy in Mexico has not succeeded in promoting competition, partly because Cofetel is a very weak regulatory agency and partly because Mexico has not reformed its administrative procedures, including the standards and process for judicial review of decisions by Cofetel and the CompetitionCommission. Thus, the fault for the failure of the Mexican telecommunications industry to be reasonably competitive and to provide services at reasonable prices to its citizens rests with the government. 3) It is argued that privatisation of Mexican Telecom industry replaced a public monopoly with a private monopoly. Do you confer with this argu-

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ment? or is there any economic logic against this argument? This assessment overstates the problem. Competitors have become important in long distance, wireless telephony, private lines, and Internet services. The problem is that in all markets Telmex and its affiliates remain dominant, and in markets where competitors have secure footing, prices are too high and the penetration and use of service is too small relative to achievable goals and accomplishments in peer countries such as Argentina, Brazil and Chile. Among peer nations, only SouthAfrica performs as poorly. There is no reasonable economic excuse for this performance. 4) According to COFETEL, in 2006 tele-density of Mexico was just 18.9.Can such a low teledensity be attributed to excessive tariffs? As demand for telecom services is elastic, are high prices putting way customers. Mexico has low penetration of wire-line telephony, but many developing countries have low wire-line penetration. The big problem is that Mexico does not offset this with high wireless penetration. Moreover, wireless penetration is less than it seems because many intensive business users carry cell phones for multiple carriers in order to take advantage of the much lower within- system calling charges compared to the extremely high prices for inter- system calling. And because calling charges in Mexico are so high, Mexico has abnormally low usage rates (minutes of use per subscriber per month).

5)Telmex has been a monopoly for about 18 years(with around 90% market share)and Telcel for 8 years(with more than 72% market share).And neither would be facing serious competition in the near future. Do you see this as a market failure or a well orchestrated competitive dynamics? or is it the nature of the industry that lets this type of dynamics to operate? Telmex has been a monopoly for far longer than 18 years. Before it was a private monopoly, it was a public monopoly.Moreover, technically Telmex is not a monopoly for most services. Instead,it is a dominant firm that effectively can prevent its competitors from taking away most of its market share while charging high prices for ordinary service. There is no natural reason for the dominance of Telmex. Telmex is dominant because the Salinas ,Zedillo and Fox administrations and the Mexican legislature did not take the actions that were necessary to produce a more competitive industry 6)In some industries, for example in telecom, airlines and steel, there is no room for too many players and over the industry life cycle, a dominant player would emerge (assuming of course that the dominance hasnt been achieved out of anticompetitive policies) that would become a monopoly. Is it correct to term all such monopolies as competitive monopolies?
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The premise of this question is incorrect. In many other developing countries, these industries are competitive in most segments. While no nation has robustly competitive fixed wire-line access service, many nations have competitive, low-price wireless access and usage that competes effectively with fixed line service. Airlines can be and are competitive in many nations that are smaller and poorer than Mexico dominance of a single carrier arises only where policy favors it. The dominant technology for producing steel in developing nations is minimills that reprocess scrap, and there is no reason for this to be a monopoly. Moreover, steel is actively traded internationally, so a necessary condition for domestic monopoly is protective tariffs or import quotas. 7) Do you think such competitive monopolies should be dealt with stern action or should they be allowed to operate the way Telmex and Telcel do? What are the ramifications of each of these measures, the latter implying maintaining a status quo? What is the role of COFETEL in such episodes? I disagree that there is any such thing as a competitive monopoly. I agree that some firms inherit substantial market power, and that this power can not be eroded unless government adopts strong pro-competitive policies. The dominance of Telmex/Telcel arises from interconnection policies,and Cofetel

and the Competition Commission have proved to be powerless to deal with it. 8) Is there any dead-weight loss occurring because of this? if there is, how can we quantify the dead weight loss occurring due to this monopoly? Of course there is enormous loss of efficiency arising from the dominance of Telmex, especially with respect to the underutilization of the network (low minutes of use) and the low penetration of the Internet. 9) Across the world anti-competitive authorities are becoming stricter and stricter. The recent one being in Britain, OFT initiating an investigation into Britains retailers. In fact, in some countries the legal actions are initiated suo motto. And Mexico being very close to America, how should one look at such instances of market dominance? I do not fully understand this question. Mexico has strong competition policy judging from the goals established in its legislation, and the Competition Commission is competent, as is the Ministry of Transportation and Communications. But the details of the statutes in both competition policy and regulatory policy are poorly conceived and ineffective in achieving these lofty goals. Source: Exclusive interview of Prof. Roger Noll conducted by the author.
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Footnotes 1. Mariscal Judith, Telecommunication Reform in Mexico: and Institutional Perspective, http://www.telecomcide.org/documentos/ 008DTDAP-JMariscal-Telecommunication_Reform_Institucio nal-03.pdf, page 7 2. Ministry of Trade and Industrial Development 3. Telecommunication Reform in Mexico: and Institutional Perspective, op.cit., page 14 4. Ibid., page 15 5. Noll G. Roger, Priorities for Telecommunications Reform in Mexico, http://siteresources.worldbank.org/INTMEXICOINSPANISH/ Resources/noll-paper.pdf, pages 56 6. Padgett Tim, Carlos Slims Embarrassment of Riches, http://www.time.com/time/business/article/0,8599,1642286,0 0.html, July 11th 2007 7. Adams Greg, Why Mexican phones cost a bundle, http://www.nzherald.co.nz/topic/story.cfm?c_id=286&objectid =10377782, April 18th 2006 8. Authers John and Silver Sara, Slims pickings: Latin Americas richest man eyes up his next undervalued target MEXICO,http://search.ft.com/ftArticle?queryText=car%20 s l i m & p a g e = 4 & y = 9 & aje=false&x=15&id=050425001205&ct=0, April 25th 2005

9. Aspin Chris, Mexico widens power probe of Slims America Movil,http://www.reuters.com/article/marketsNews/ idINN302 2791220080430 ?rpc=44&pageNumber=1& virtualBrandChannel=0,April30th 2008 10.S m i t h G e r i , C a r l o s S l i m s F a t F o r t u n e , http://www.businessweek.com/globa lbiz/content/jul2007/gb2007073_887601.htm, July 4th 2007 11.Federal Telecommunications Commission 12.Slims pickings: Latin Americas richest man eyes up his next undervalued target MEXICO , op cit 13. Ibid 14.Competition Law and Policy in Mexico: An OEC D P E E R R E V I E W , h t t p : / / w w w. o e c d . o r g / d a t a o e c d 57/9/31430869.pdf, page 11 15. Federal Competition Commission 16.Competition Law and Policy in Mexico: An OECD PEER REVIEW, op.cit., page 19 17. Competition Law and Policy in Mexico: An OECD PEER REVIEW, op.cit., page 25 18.Friday Bill, Once Upon a Time in Norte America: The Rise of Carlos Slim,http:// www.losangeles.broowaha.com/article.php?id=962, March14th 2007 19.Priorities for Telecommunications Reform in Mex ico, op.cit., page 17

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20. Luhnow David, The Secrets of Worlds Richest Man,http://online.wsj.com/article/ SB118615255900587380.html?mod=US-BusinessNews, August 4th 2007 . 21. Preston Julia, INTERNATIONAL BUSINESS; Competitors of Telmex Say It Still Acts Like a Monopoly, h t t p : / / q u e r y. n y t i m e s . c o m / g s t / fullpage.html?res=9802E1DB163FF937A35757C0A9669 C8B63&sec=&spon=&pagewanted=2, April 4th 2000 22. Priorities for Telecommunications Reform in Mexico, op.cit., page 20 23. Roberts M. James and Ortega Israel, How Reforms in Mexico Could Make the U.S More Secure, http://www.heritage.org/Research/ LatinAmerica/bg2135.cfm, May 13th 2008 24. US wins WTO Telecommunications Case Against Mexico,http://www.america.gov/st/washfile-english/2004/ March/20040312162758ASrelliM7.784671e-02.html,March 12th 2004 25. Economic survey of Mexico 2007:Improving infrastructure i n M e x i c o , h t t p : / / w w w. o e c d . o r g / d o c u m e n t / 8 / 0,3343,en_2649_34569_39415560_1_1_1_1,00.html , October 4th 2007 26. Malkin Elisabeth, New Commitment to Charity by Mexican Phone Tycoon,http://www.nytimes.com/ 2007/06/28/business/worldbusiness/ 28slim.html?_r=1&scp= 5&sq=&st=nyt&oref=slogin, June 28th 2007

27. Varsavsky Martin, Carlos Slim is the richest man in the world: Should Mexicans be proud?,http:// english.martinvarsavsky.net/ general/carlos-slim-ist h e - r i c h e s t - m a n - i n - t h e - w o r l d should-mexicans-be-proud.html, July 21st 2007 28. C o s t e r H e l e n , S l i m s C h a n c e , h t t p : / / members.forbes.com/forbes/2007/0326/134.html, March 26th 2007 29. Why Mexican phones cost a bundle, op.cit. 30. Ibid 31. 32. Foldvary E. Fred, Natural monopolies,http:// www.progress.org /fold74.htm Hansen Karen, Privatization Of Mexico: Telmex,http:// www.50years.org/factsheets/telmex.html,April 1997

33.Hansen Karen, Privatization Of Mexico: Telmex, http://www.50years.org/factsheets/telmex.html, April 1997 34. Excerpt from an exclusive interview of Prof. Roger Noll conducted by the author. Please refer Annexure I for the full interview. 35. Ibid 36. Bremer Catherine, Stick to goals on monopolies, US tells Mexico,http://www.reuters.com/article/company NewsAndPR/ idUSN0127660320070202?sp=true, February 1st 2007
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C HAPTER 7

Monopolistic Competition

Source:http://www.peteranthony.org

S ECTION 1

Introduction
Video 7.1.1:Monopolistic competition
The concept of monopolistic competition has been introduced in the literature by Prof. Chamberlin in his famous book, The Theory of Monopolistic Competition. Product differentiation is an important aspect of monopolistic competition. about the distinctive features or the special characteristics of his own product. Hence selling and or advertising expenditures are necessary in monopolistic competition. The firms in the market do not consider the reactions of their rivals when choosing their product prices or annual sales targets. Relative freedom of entry and exit of firms exists in monopolistically competitive markets. Neither the opportunity nor the incentive exists for the firms in the market to cooperate in ways that decrease competition.

The basic characteristics of monopolistically competition are : There are relatively large number of firms The product of each firm is not a perfect substitute for the products of competitive firms. The product is differentiated from any other product. The sellers in each product group can be considered competing firms within the industry. Since each firm is selling a differentiated product each firm informs the consumers

References Monopolistic competition

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S ECTION 2

Price and Output Determination Under Monopolistic Competition

Video 7.2.1: Prices & Markets: Product Differentiation - Real or Perceive

Monopolistic competition has a fundamental feature of product differentiation. The product differentiation can be classified as ; real or perceived (fancied) (Video 7.2.1). Real product differentiation occurs when the inherent characteristics of the products are different. For example, there are difference in the specification of the products or the factor input used or the location of the firm or services offered by the firm. And the fancied product differentiation means that when the products are basically same, but by advertising or selling activities the consumers are convinced that the products are different, such as differences in packaging, advertising and assigning different brand names.

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Table 7.2.1: Product Differentiation

EXAMPLES Product Quality
Differences in real terms in functional features, materials, design, and workmanship. Textbooks: presentation of core contents in different styles Pizza restaurants: differences in terms of services offered, such as home delivery, self service, strict adherence of timings of delivery of the pizza( e.g., Dominos) Supermarkets: differences in the location, whether located in a busy locality or convenient on the part of the buyers to access. Usage of different brand names, trademarks and the type of packaging by detergent companies (e.g, surf and Areal), use of celebrity names.

Figure 7.2.1

Services

Location Advertising and Packaging

Equilibrium of firm and industry: Monopolistic Competition A single firm may be regarded as a monopolist. Its equilibrium condition can, therefore, be determined by the same way as in the case of a monopolist. Its AR (same as the demand curve) curve is downward sloping and the MR curve lies below the AR curve. The firm will be in equilibrium when the following conditions are achieved ; First order condition M R = MC Second order condition Slope of MR< Slope of MC At the equilibrium point, the firm may be earning normal profits or more than normal profits or less than normal profits in the short run (Keynote 7.2.1 & 7.2.2).
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The Demand for a Monopolistically Competitive Firm The demand curve for a monopolistically competitive firm is downward sloping because of product differentiation. But it is quite elastic since there are close substitutes for the product of a firm. The revenue for any quantity will be less than the corresponding price because the demand curve is downward sloping (Figure 7.2.1). The slope of the marginal revenue curve will be twice that of the demand curve. The flatter downward sloping demand curve is because of product differentiation.

Keynote 7.2.1: Short and Long Run Equilibrium of a Firm under Monopolistic Competition

But under industry equilibrium, the equality of MR and MC is not the sufficient condition for profit maximization though it is the necessary condition. Industry equilibrium is possible only when each firm is earning only normal profits, that is, the point where AR = AC for each firm. This is so because, if the existing firms earn more than normal profits, new firms will enter into the industry. This will reduce the volume of abnormal profits of the existing firms. Entry will continue until all the firms earn only normal profits. Similarly losses can cause firms in a monopolistically competitive industry to exit. In the long-run equilibrium point under monopolistic competition must be at the falling portion of the AC curve because here AR is falling and such an AR curve can be tangent to the AC curve only at the latters downward sloping portion. Excess Capacity This property of equilibrium under monopolistic competition is known as the excess capacity theorem. This means that under monopolistic competition excess capacity remains in each firm in the sense that more output can be produced at a lower cost. Suppose that the number of firms is reduced but the output level of each firm is increased so that the total output of the industry remains the same. In this case, each firm will produce the output at a lower cost and hence total cost of obtaining the same level of output by eliminating some firms will be lower. Thus excess capacity remains under monopolistic competition and this capacity can be utilized by
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Keynote 7.2.2 Losses Cause Firms in a Monopolistically Competitive Industry to Exit

eliminating some firms from the industry. From social standpoint, monopolistic competition is inferior to perfect competition. Under perfect competition, capacity is fully utilized. Production takes place at the minimum point of the average cost curve. But this condition is not fulfilled under monopolistic competition. Advertising and Product Development in Monopolistically Competitive Markets Product differentiation is the hallmark of monopolistically competitive markets. In many cases firms incur costs either to make the unique characteristics of their products known to consumers or to convince consumers that their product really is different from those of their rivals. Monopolistically competitive markets are characterized by brand names and by continual product development and improvement. This long standing image allows the company to charge significantly higher prices for his product than those charged for the rival brands. Some of us are ready to pay more money for Sundrop than for any other brands of sunflower oil. A firm is often likely to compete by improving its products or developing new products than by cutting prices. It can enjoy temporary profits until its improvement is copied by existing rivals or new entrants. Product improvement is often criticized as being superficial rather than substantive. Nonetheless, firms do compete in this way, and many of us respond to changes in the quality and characteristics of products.

The Impact of Advertising and Other Costs of Production and Selling Advertising and other costs incurred to sell more of a product without reducing its price must be added to production costs to compute average cost of a product. Selling costs increase average cost and contribute to higher prices. Selling costs are all costs incurred by a firm to influence the sales of its product. These costs include advertising expenses, expenses for sales personnel, and other promotional expenses. Firms incur these expenses in the hope of increasing revenues from sales of their products. When selling costs are added to production costs, they increase the average costs of making goods available (Keynote 7.2.3). Keynote 7.2.3: Impact of Advertising and Selling Costs on Monopolistically Competitive Market

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References: Monopolistic competition: Product differentiation: Selling Costs: REVIEW 7.2.1 Question 1 of 3 In Monopolistic competition , the flatter downward sloping demand curve is due to the fact that the

A. Producer is the price taker B. Producer is the price maker C. Product is differentiated D. Product is homogenous

Check Answer

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S ECTION 3

Case Study: Branded Gold Jewellery Market in India

There is definitely a market for branded jewellery especially if something is aimed at the younger generation, which wants to buy fashionable real jewellery. This is the right time to get into the market, as it has just started to take off.1 Devika Gidwani, Director of Diamond Information Centre, India THE GOLD RUSH In the late 1990s, the Indian jewellery market witnessed a shift in consumer perceptions of jewellery. Instead of being regarded as only an investment option, jewellery was being prized for its aesthetic appeal. In other words, the focus seemed

to have shifted from content to design. Trendy, affordable and lightweight jewellery soon gained familiarity. Branded jewellery also gained acceptance forcing traditional jewellers to go in for branding. Given the opportunities the branded jewellery market offered; the number of gold retailers in the country increased sharply. Branded players such as Tanishq, Oyzterbay, Gili and Carbon opened outlets in various parts of the country. Traditional jewellers also began to bring out lightweight jewellery, and some of them even launched their in-house brands.

This case was written by D. Preethi, under the direction of Sanjib Dutta, IBS Center for Management Research. It was compiled from published sources, and is intended to be used as a basis for class discussion rather than to illustrate either effective or ineffective handling of a management situation
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However, the share of branded jewellery in the total jewellery market was still small (about Rs. 10 billion of the Rs. 400 billion per annum jewellery market in 2002), though growing at a pace of 20 to 30 percent annually. The branded jewellery segment occupied only a small share of the total jewellery market because of the mindset of the average Indian buyer who still regarded jewellery as an investment. Moreover, consumers trusted only their family jewellers when buying jewellery. Consequently, the branded jewellery players tried to change the mindset of the people and woo customers with attractive designs at affordable prices. GOLD JEWELLERY MARKET IN INDIA Before the liberalization of the Indian economy in 1991, only the Minerals and Metals Trading Corporation of India (MMTC) and the State Bank of India (SBI) were allowed to import gold. The abolition of the Gold Control Act in 19922, allowed large export houses to import gold freely. Exporters in export processing zones were allowed to sell 10 percent of their produce in the domestic market. In 1993, gold and diamond mining were opened up for private investors and foreign investors were allowed to own half the equity in mining ventures. In 1997, overseas banks and bullion suppliers were also allowed to import gold into India. These measures led to the entry of foreign players like DeBeers,3 Tiffany4 and Cartiers5 into the Indian market. In the 1990s, the number of retail jewellery outlets in India increased greatly due to the abolition of the Gold Control Act. This led to a highly fragmented and unorganized jewellery market with an estimated 100,000 workshops supplying over

350,000 retailers, mostly family-owned, single shop operations. In 2001, India had the highest demand for gold in the world; 855 tons were consumed a year, 95% of which was Branded used for jewellery. The bulk of the jewellery purchased in India was designed in the traditional Indian style.6 In the 1990s, the number of retail jewellery outlets in India increas the Gold Control Act. Thisin led to 22 a highly fragmented and unorg Jewellery was fabricated mainly 18, and 24-carat gold. estimated workshops supplying over 350,000 m (Refer Table I for 100,000 carat calculation) As Hallmarking7 was retailers, not operations. 2001, India had the highestwas demand for gold in the w very common in In India, under-caratage prevalent. year, 95% of which was used for jewellery. The bulk of the je According to a survey done by the Bureau of Indian Standards designed in the traditional Indian style. 6 (BIS),8 most gold jewellery advertised in India as 22-carat was Jewellery was Over fabricated mainly in 18, 22 and 24-carat gold. (Re of a lesser quality. 80% of the jewelers sold gold 7 Hallmarking was carats not very in India, under-caratage jewelleryAs ranging from 13.5 tocommon 18 carats as 22-carat survey done by the Bureau of Indian Standards (BIS), 8 most gold gold jewellery. 22-carat was of a lesser quality. Over 80% of the jewelers sold g carats to 18 carats as 22-carat gold jewellery.
Table 7.3.1: Karat Calculation

Table I

Karat Calculation
24 Carat 22 Carat 20 Carat 18 Carat 2 Carat 1 Carat 100 percent pure gold 91.66 percent pure gold 83.33 percent pure gold 75 percent pure gold 8.33 percent pure gold 4.166 percent pure gold

Source: IBS Center for Management Research

The late 1990s saw a number of branded jewellery players enteri jewellery under the brand name Tanishq, while Gitanjali Jew The lategold 1990s saw a number of branded jewellery players exporter, sold 18-carat gold jewellery under the brand name Gi entering the Indian market. Titan sold gold jewellery under the selling 24-carat gold jewellery in association with a Thai compa launched its collection of diamond and 22 -carat gold jewellery in 237 in In Beautiful, which marketed the Tiffany range of products

brand name Tanishq, while Gitanjali Jewels, a Mumbai-based jewellery exporter, sold 18-carat gold jewellery under the brand name Gili. Gitanjali Jewels also started selling 24-carat gold jewellery in association with a Thai company, Pranda. Su-Raj (India) Ltd.launched its collection of diamond and 22 -carat gold jewellery in 1997. The Mumbai-based group, Beautiful, which marketed the Tiffany range of products in India, launched its own range of studded 18-carat jewellery, Dagina. Cartiers entered India in 1997 in a franchise agreement with Ravissant.9 Other players who entered the Indian branded gold jewellery market during the 1990s and 2000-01 included Intergold Gem Ltd., Oyzterbay, Carbon and Tribhovandas Bhimji Zaveri (TBZ). Gili: In 1994, Gili Jewellery was established as a distinct brand by Gitanjali Jewels, soon after the abolition of the Gold Control Act by the Indian government. Gili offered a wide range of 18carat plain gold and diamond-studded jewellery, designed for the contemporary Indian woman. The designs combined both the Indian and western styles and motifs. With sales of Rs. 0.14 billion for the year 2000-01, Gili had a 0.03 percent share of the 400 billion jewellery market in India and a 1.4 percent share of the branded jewellery market. Tanishq: In 1984, Questar Investments Limited (a Tata group company) and the Tamil Nadu Industrial Development Corporation Limited (TIDCO) jointly promoted Titan Watches Limited (Titan). Initially involved in the watches and clocks business, Titan later ventured into the jewellery businesses. In 1995, Titan changed its name from Titan Watches Ltd. to Titan Industries Ltd. in order to change its image from that of a watch manufacturer to that of a fashion accessories

manufacturer. In the same year, it also started its jewellery division under the Tanishq brand.

GALLERY 7.3.1: Branded Jewellery

Among the branded jewellery players in the Indian market, Ta n i s h q i s considered to be a trendsetter. When it was launched in 1995, Tanishq began with 18-carat jewellery. Realizing that such jewellery did not sell well in the domestic market, the 18-carat jewellery range was expanded to include 22 and 24-carat ornaments as well. When Tanishq was launched, it sold most of its products through multibrand stores. In 1998, Tanishq decided to set up its own chain of retail showrooms to create a distinctive brand image. By 2002, Tanishq retailed its jewellery through 53 exclusive stores across 41 cities. To meet increasing demand, Tanishq planned to open 70 stores by the end of 2003 and offer a range of 'wearable' products with prices starting at Rs. 400. With sales of Rs. 2.66 billion in 2000-01, Tanishq had a 0.66 percent share of the total jewellery market and a 27 percent share of the branded jewellery market (Refer Table 7.3.2). Carbon: In early 1991, the Bangalore based Peakok Jewellery Pvt. Ltd., (Peakok) was incorporated and Mahesh Rao (Rao)
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was appointed director. Peakok realized that the Indian consumers relationship with gold jewellery would grow beyond an investment need towards a lifestyle and personality statement. In 1996, within the Peakok fold a new brand of 18carat gold- based jewellery called Carbon was launched. In 2000-01, with sales of Rs. 0.14 billion, carbon had a 0.03 percent share of the jewellery market and a 1.4 percent share of the branded jewellery market. The company expected Carbon sales to touch Rs. 1.5 billion by 2005-06 and exports to start by 2008. The brand was available at 40 outlets in 16 cities in 2002 and would be made available in 23 cities by 2005. Oyzterbay: Oyzterbay was founded by Vasant Nangia and his team in July 2000. It began operations in March 2001. By November 2002, the company had 41 outlets across the country. Oyzterbay seeks to build a national brand in the jewellery industry in India and aspires to be the largest branded jewellery company in the country with a chain of 100 stores and several hundred- distribution points by 2004. With sales of Rs. 0.17 billion in 2000-01, Oyzterbay had a 0.04 percent share of the Rs.400 billion jewellery market and a 1.7 percent share of the branded jewellery market. Trendsmith: Mumbai-based Tribhovandas Bhimji Zaveri (TBZ), which had been in the jewellery business since 1864, saw tremendous scope in the branded segment and opened its new concept store Trendsmith in Mumbai in December 2001. Encouraged by the response towards its first store, the Zaveris planned to take Trendsmith (India) Pvt. Ltd. all over the nation by opening as many as 50 stores by 2006. Trendsmith offered eight lines of exclusive designer jewellery from well-known

export jewellery manufacturers and designers from Mumbai and Delhi. GOLD JEWELLERY BECOMES FASHION ACCESSORY Till the early 1990s, the average Indian bought jewellery for investment rather than for adornment. Jewellery made of 18karat gold was not favored as it was considered a poor investment. Confidence in the local jeweller was the hallmark of the gold jewellery trade in India. A jeweller or goldsmith in a local area had a fixed and loyal clientele. The buyer had implicit faith in his jeweller. Additionally, the local jeweller catered to the local taste for traditional jewellery.

Table 7.3.2: Branded Gold Jewellery Market (Major Players) Brand Tanishq Oyzterbay Gili Carbon Source: IBS Centre for Management Research However, since the late 1990s, there was a shift in consumer tastes: women were increasingly opting for fashionable and lightweight jewellery instead of traditional chunky jewellery.
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Market Share (2000-01) in % 27.0 1.7 1.4 1.4

There was a rise in demand for lightweight jewellery, especially from consumers in the 16 to 25 age group, who regarded jewellery as an accessory and not an investment. The new millennium witnessed a definite change in consumer preferences. According to Samrat Zaveri, CEO of Trendsmith, Research shows that the Indian jewellery sector is in the transition phase with consumers desire for possession of jewellery for its aesthetic appeal and not as a form of investment.10 In October 2002, Trendsmith conducted a survey to understand the shifting needs, motivations and aspirations of consumers in the jewellery market, and to identify new trends and opportunities. The research study arrived at the following conclusions: The Indian market was witnessing an accelerated shift from viewing jewellery as an investment to regarding it as aesthetically appealing ornaments. The focus had shifted from content to design. The younger generation was looking at trendy, contemporary jewellery and clearly avoiding heavy, traditional gold jewellery. The consumer wanted a wider selection at a single convenient location and expected an international shopping experience. The Indian consumer was willing to experiment with new designs In the late 1990s and early 2000s, with the increase in the number of designers from design schools such as the National Institute of Fashion Technology (NIFT), a wide range of new

designs became available. In addition, the growing number of manufacturers needed a retailing platform with global and national reach. All these led to the proliferation of branded jewellery players. STRATEGIES FOR WOOI N G C U S TO M E R S TA NISHQ

Video 7.3.2:Tanishq Advertisement

In the late 1990s, players in the branded gold jewellery market formulated strategies for wooing customers. According to Jacob Kurian (Kurian), Chief Operating Officer of Tanishq, the challenges were many. As the jewellery market was highly fragmented, lacked branding, and allowed many unethical practices to flourish, Tanishq worked hard on a two-pronged brand- building strategy: cultivate trust by educating customers about the unethical practices in the business and change the perception of jewellery as a highpriced purchase. Said Kurian, We are changing the attitudes of customers from blind trust to informed trust.11 To increase its marketshare, Tanishq formulated a strategy for luring people away from traditional neighborhood jewellers. Tanishqs strategy was to create differentiation and build trust. According to Kurian, the first part of the strategy was to provide a point of differentiation in a highly commoditized category which is the whole point of branding.12 The second part of the strategy was to project Tanishq as an unimpeachable mark of
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trust. According to Kurian, If differentiation plays the role of primary attraction, trust takes care of lifelong loyalty.13 One way to create differentiation was through design. The emphasis had to be on design because local jewellers could offer to design any pattern according to the customer's specifications. For a national brand a generic design concept with regional variations had to be evolved. (Refer Exhibit I for Tanishqs design). For this, Tanishq set up a seven member inhouse design team and also outsourced designs from freelance designers. The designers travelled the length and breadth of the country to get feedback on Tanishqs designs and learn about customer preferences. On the basis of this feedback, each showroom could select the designs it would carry. To stay ahead of competition from local jewellers, Tanishq decided to focus on quality control. In 1999, it introduced caratmeters which showed the purity of gold. In fact, Tanishqs USP was the purity of its gold. Accordingly, the companys ad campaigns emphasised the purity aspect of all Tanishq ornaments. (Refer Exhibit II for Tanishqs Ad Campaign) In November 2002, Tanishq introduced a new collection of jewellery called Lightweights. The collection featured neckwear, earrings, bangles, rings and chains in 22 karat gold with prices starting at Rs 1,100. It also launched Lightweight Diamonds, with prices starting at Rs 3,000. Tanishq focused not only on urban markets, but small town markets as well. Real estate was less expensive in the small towns than in large urban centres. Besides, competition from stores in small towns was less stiff than competition from the

large jewellery stores in the metropolitan cities. According to Kurian, the best returns on investment came from small towns. CARBON Carbons focus had always been to move jewellery from the vault to the dressing table and bring the selling of jewellery out of heavily guarded jewellery stores. This was achieved by persuading a few lifestyle stores to add branded jewellery to their vast array of products. Besides selling from lifestyle stores, Carbon also sold its products as gift items over the internet. Like Tanishq, Carbon laid emphasis on design. Most of its designs were contributed by students at the National Institute of Fashion Technology (NIFT) through the diploma programme which the company sponsored. In addition, Peakoks team of six designers, (headed by Rajeswari Iyer, an alumnus of a German design school who had worked in the U.K., Germany and India) turned out around 180 to 200 styles in a year, with 75 designs per style. At any point in time, there were around 600 designs of Carbon on sale, and on an average, 300 to 400 pieces per design were sold. In 2002, Carbon launched its Sun Sign collection, which was based on the symbols of the Zodiac. This collection was a set of 12 pendants designed in a blend of 18 carat white and yellow gold (Refer Exhibit III). While 18 carat gold was commonly used in Carbon products, some of the designs also used white gold, titanium and steel. Diamond was the preferred precious stone, but other colored stones were also used. Comprising items of everyday use, (rings, chains, bracelets, ear studs, tie-pins and cuff links)
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Carbon items were an impulse purchases. (Refer Exhibit IV) The brand had no offtake cycles in the year, like the marriage season, unlike traditional jewellery. The creation, manufacture and marketing of Carbon was different from the making and selling of traditional jewellery. Said Rao, We are attempting here to eliminate the low productivity, quality inconsistencies and high precious metal loss associated with traditional jewellery making. We have instituted modern manufacturing practices such as self- contained small groups in the assembly area, self-inspection by the operators, the Japanese Kaizen approach to improvements in operational practices and the like. We have brought down our manufacturing loss of gold to 6.8 per cent. The average in the traditional Indian jewellery shop is as high as 22 per cent, while the world average is only 2 per cent.14 As the profile of the average customer likely to purchase a Carbon item was a well-paid urban professional, 24 to 38 years old, having a credit card, it was decided that Carbon should not be placed in the usual jewellery shops but made available at `shop-in-shop' outlets in large lifestyle stores (such as Shoppers Stop, Ebony, Globus, The Bombay Store, Lifestyle and Taj Khazana) and some premium boutiques (such as the Helvetica in Chennai). Said Rao, We are looking at cross-promoting Carbon jewellery with other branded lifestyle products such as perfumes, clothing and cosmetics.15 Carbon products were priced between Rs. 2,750 and Rs. 20,000 per piece. While the cost of traditional jewellery was negotiable, the cost of Carbon items was fixed and nationally uniform.

OYZTERBAY Oyzterbay, with its tag line Jewellery for the Living, had become synonymous with the entire gamut of occasions where modern young women would like to wear stylish and affordable jewellery. Oyzterbays collection comprised over 1200 designs in 18, 22 and 24 carat gold and sterling silver, with natural colored gemstones. The price of the jewellery ranged between Rs. 500 and Rs.30000. The initial focus of Oyzterbay was to give a lifestyle value to jewellery instead of the traditional investment value. In the second year of its launch, Oyzterbay emphasised on marketing and advertising strategies to give the necessary thrust for growth. In order to transform itself from a youth brand to a brand for all occasions, Oyzterbay launched media campaigns in August 2002 highlighting the new look. The new communication strategy focused on addressing the 18 to 34 age group instead of the earlier 18 to 24 age group. The new campaign focused on positioning Oyzterbay as jewellery for office wear, evening wear or even a fitness session. (Refer Exhibit V) The broadening of focus to include an older segment was the result of market research which showed that the brand appealed to middle-aged working women and affluent housewives. The investment in the new campaign was Rs 50 million. Where Oyzterbay scored over others was its simple and refreshing designs and affordability, making it distinct from the usual gold jewellery stocked in standard jewellery showrooms and contemporary jewellery offered by traditional jewellery houses trying to cater to the trend. Priyadarshi Mohapatra,
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Marketing Manager, Oyzterbay, said We began by selecting a completely different reach - everyday jewellery for the working woman and jewellery for the youth. We felt that jewellery should be brought out of the locker. So we positioned (it) to accessorize the dress of the young, college-going crowd, which otherwise sported junk jewellery. The second segment was the working woman for whom we sought to build a wardrobe of jewellery by making it affordable, so that she could pick up pieces regularly.16 Oyzterbay later extended the same brand values to diamonds too, the idea being to target a niche market. Oyzterbay refurbished its collection every few months, keeping in mind international trends. By so doing, they were able to offer exclusive products to clients. As part of the Oyzterbay Summer 2002 collection, it offered pendants, earrings, finger rings, bracelets, neckwear, and chains with natural gemstones set in white gold, as white gold was evolving as a fashion statement across the world. Although Ozyterbay was known for its jewellery in gold and sterling silver embellished with natural gemstones, it decided to launch Your First Diamond, a complete range of diamond jewellery set in white, pink, and yellow gold. The price of the collection started from Rs. 500 with the most expensive piece not exceeding Rs. 12,000. GILI Gili distributed its jewellery priced between Rs. 500 and Rs. 40,000 through lifestyle and department stores across the country to increase accessibility among its target segment, the

15 to 30 age group. The companys products were also made available through a mail-order catalogue. In 1997, Gili launched a collection of traditional Indian ornaments made of 18-carat gold. In 1999, the Gili Gold range was introduced. This range included rings, pendants, earrings, necklaces and bangles made of 24-carat gold. All Gili products came with a guarantee of diamond and gold quality. When research conducted in February 2000 showed that there was a big gap between the Rs. 1000 and Rs. 10000 price segment and keeping in view the teenage population, and the kind of pocket money they had, Gili brought out a collection targeting teens. In 2000, Gili launched its diamond heart collection targeted at teenagers and priced between Rs 500 and Rs.2500.17 The collection was promoted at college campuses with banners, pamphlets and a few advertisements targeted at teens. Gili soon realized that just pushing its product was not enough; it also had to customize its products for special occasions. Following this, it launched a Diamond Heart Collection specially designed for Valentines Day. This collection consisting of tiny, heart-shaped diamond jewellery was well received by teens (Refer Exhibit VI). Special packaging, catchy advertising and extensive press coverage contributed to the success of the collection. Gili also made special promotional offers during festive seasons like Christmas and Diwali. Having captured the low price point market of Rs.2000 to Rs. 10,000, in 2000, the company focused on penetrating the premium market of customized jewellery. For this, Gitanjali jewels opened a jewellery salon, Gianti, to provide customized jewellery to clients in India.
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TRENDSMITH Trendsmith specialized in premium, exclusive and modern looking jewellery distinct from TBZs traditional designs. The brands USP was that every piece of jewellery was exclusive and unique. There were different collections for babies, teenagers and weddings. Trendsmith stores had a comfortable ambience and a clutter free display of products. According to Samrat Zaveri, Managing Director, Trendsmith is a store for those with little time and big pockets. The stores also provided space for other premium jewellery and accessory brands such as Aashi,18 Blue Fire, Solange,19 Nakshatra, Aura 22, Mimansa,20 Brilliant and Moksh.21 The prices for these pieces of jewellery started from Rs. 10,000. The range comprised finger rings, pendants, bangles, bracelets and neckpieces. Trendsmith laid emphasis on affordable, fashionable jewellery. It changed its collection every season. Trendsmith also had a design studio where customers could design their own jewellery. The company advertised in womens fashion and lifestyle magazines since the readers of such magazines formed 80 percent of its clientele. To remain in the public eye, Trendsmith planned to host events whenever it launched a new collection. The company intended to spend Rs 30 - 40 million annually, on such events. ALL THAT GLITTERS IS NOT GOLD Branded jewellery players will continue to face lot of competition from local jewellers. In order to gain marketshare, they will have to come up with designs that customers want

and win the trust and confidence of consumers by hallmarking and demonstrating the purity of the gold used by them. To compete with traditional players, branded players must also find some way to differentiate themselves. While the success of a particular brand will depend on differentiation, affordability and quality will be a key element in sustaining a brand. In addition, branded players require focused advertising and astute salesmanship to compete with traditional jewellers. Besides the major brands- Tanishq, Carbon, Oyzterbay, Gili and Trendsmith- several regional players have opened branches to leverage the trust and reputation that they have built up over the years. This is going to add to the competition in the branded jewellery market. Most of the branded jewellery players in India focused on yellow gold; only a few of them experimented with the pink and white forms of gold. Some of the players also used diamonds and platinum, which appear to have a good future in the Indian jewellery market. (Refer Exhibits VII and VIII for information on the diamond and platinum markets in India). QUESTIONS FOR DISCUSSION: 1.In the late 1990s, there was a shift in demand for jewellery from traditional 22-karat jewellery to branded lightweight jewellery. This trend forced jewellers to go in for branding. Discuss why lightweight branded jewellery became popular with Indian consumers. 2.Though the branded jewellery segment is estimated to be growing at an annual rate of 20 to 30 percent, it is still a miniscule part of the total jewellery market. Analyze the
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structure of the gold jewellery market in India. Why do you think no single player has been able to corner a significant share of the market? Suggest some strategies that would help branded players increase their share in the jewellery market. 3.The branded jewellery market is dominated by a few players with each trying to differentiate its products from those of others. Tanishq has achieved a substantial lead in this market. Discuss the strategies adopted by Tanishq to lure customers away from traditional family jewellers to its stores. 4.Competition in the branded jewellery market is likely to intensify in the future. What are the key success factors for growth in the industry? Which of the existing players is best positioned to grow fast and exploit market opportunities?

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Exhibit VII: Diamond Jewellery Market in India

In 2002, India was the third largest diamond consuming country, next only to the US and Japan. Tanishq saw a 60 percent growth in diamond sales for the year 2001-02. Jewellery houses in India introduced new designs to cater to various segments of the market, like young working women or older affluent housewives. According to industry insiders, lightweight diamond jewellery in the Rs. 5000-20,000 price range was gaining popularity. In India, the world leader in diamonds, the DeBeers Diamond Trading Company (DTC) promoted diamond-studded jewellery through TV commercials. With collections such as the Diamond Vivaha (wedding) Jewellery, Celebration Diamonds, Nakshatra and Arisia, DTC was one of the leading players in the diamond jewellery market in India. According to the Diamond Information Centre, the public relations wing of DTC, diamond jewellery was increasingly becoming the jewellery of choice in India. Since research showed that in India, 65 per cent of jewellery is bought during weddings, DTC brought out a Diamond Vivaha Collection (wedding jewellery). The Nakshatra brand, which had the traditional seven-stone ear studs and pendants, catered to pre- and post-wedding purchases. The Arisia Solitaire Diamonds catered to a niche market- the super-rich, with an annual income of over Rs 20 lakh per year. Research showed that diamond ownership and diamond acquisition among this segment in India was the highest, and that there was no branded diamond jewellery product targeted at this segment. What was really catching up in the Indian market was the concept of fusion jewellery. In this kind of jewellery, the core

design concepts are Indian, but the styling, the finish and the metals used are Western. After carving a niche for itself in the jewellery market, by convincing consumers that diamonds are affordable and value-for-money, DTC plans to grow the diamond jewellery market substantially by launching more brands. Besides DTC, there are other diamond studded jewellery exporters who keep launching new brands across the country.
Source: The Economic Times, Business India, The Hindu Business Line

Exhibit VIII: Platinum Jewellery Market in India

Between 1998 and 2002, demand for platinum jewellery grew faster than for any other jewellery in key global jewellery markets. Worldwide, the metals rich white luster made it the preferred choice for premium designers and fashion conscious consumers. The year 1999 saw a 19% growth in the consumption of platinum by the global jewellery industry. The Platinum Guild International (PGI), established in 1975 by the leading producer of platinum Rustenburg Platinum Mines (located in the Bushveld complex of South Africa), is the jewellery-marketing arm of the worldwide platinum industry. PGI introduced platinum in the Indian market in 2000. In the same year, PGI teamed up with leading Indian designers, jewellery manufacturers, and retailers to bring an exclusive range of platinum jewellery to India. PGI has a select few dealers. Through these dealers, PGI educates the general public about platinum, the white metal often considered out of reach, befitting only royalty. Platinum is far denser and more durable than gold and hence is
246

synonymous with prestige, pride and class. Each individual piece of platinum jewellery comes with a guarantee card from PGI giving its description, identification number, weight and retailers name. Today, PGI sees the combination of the growing economy and the strong jewellery culture in India providing a potential market for platinum. Post-liberalization of the Indian economy, Indian consumers began to get in tune with evolving trends in jewellery across the world. Over time, PGI expects India to become a significant player in the platinum jewellery market.
Source: IBS Center for Management Research

Additional Readings & References:

1. Thakur, Punam, Shining Through, Business India, March 6, 2000. 2. Chuganee, Bhakti, Gili Goes Global, Business India, April 17, 2000. 3. Kapoor, Neha, Branded Jewellery Market Enroute to Gaining Maturity, The Hindu Business Line, May 5, 2000. 4. Verma, Sanjeev, Building a Brand in Jewellery, Business India, May 29, 2000. 5. Ghoshal, Raja, Sex No Bar, A&M, May 31, 2000. 6. Kurian, Boby, Ex-Tanishq Team in Oyzterbay, The Hindu Business Line, July 18, 2000. 7. Joseph, Mini, ICF Ventures Invests Rs 8 crore in Jewellery Start-Up Oyzterbay, Financial Express, August 9, 2000. 8. Battle for Lust, A&M, January 15, 2001. 9. Gold Marketing: How to Make a Ritual an Impulse, Business India, June 11, 2001. 10. Bose, Sushmita, The Midas Touch, The Strategist, July 31, 2001. 11. Sachitananda, N.N, Branded Jewellery as Fashion Accessory, The Hindu, October 4, 2001. 12. Sizzle of Sparkle, Business India, November 26, 2001.
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13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. 24.

Jewellery by Name, Business India, February 4, 2002. Shashidhar, Ajita, A Date with Carbon, The Hindu Business Line, March 7, 2002. Shashidhar, Ajita, Light on Person, Light on Purse, The Hindu Business Line, March 7, 2002. Chuganee, Bhakti, Building a Brand, Business India, May 13, 2002. Raghuram, Jyothi, Chic Jewellery in Sleek Designs, The Hindu, June 3, 2002. Babu, Venkatesha, Can Tanishq Make Titan Tick? Business Today, July 7, 2002. Oyzterbays New Brand, The Hindu Business Line, July 29, 2002. Alexis, Kavitha, Oyzterbay Looks to Reposition Itself, Financial Express, August 30, 2002. Mehta, Mona, Trendsmith to Expand Outlets, Financial Express, August 30, 2002. Reddy, Krithika, All Set to Roll Out Trends, The Hindu, October 9, 2002. Diamonds are for Everyone, The Hindu, Metro Plus, Bangalore, October 17, 2002. Trendsmith Plans 50 Outlets in Five Years, The Hindu Business Line, October 8, 2002.

25. 26. 27. 28. 29.

www.gili.com www.carbon18k.com www.titanworld.com www.tiffany.com www.indbazaar.com

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C HAPTER 8

Oligopoly

Source: http://www.fishmech.net/

S ECTION 1

Introduction

Video 8.1.1: Oligopoly

Oligopoly is a market structure, in which a few sellers dominate the sales of a product and the entry of new sellers is difficult or impossible. It is basically model representing the features of monopoly and monopolistic competition. More dominant are the features of monopoly. Oligopoly can be further classified as pure oligopoly or differentiated oligopoly.

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In pure oligopoly, the sellers will supply homogeneous products while in the differentiated oligopoly the sellers will supply differentiated products. Automobiles, cigarettes, beer and chewing gum are examples of differentiated products whose market structures are oligopolistic. Oligopolistic markets are characterized by high market concentration. In oligopolistic markets, at least some firms can influence price by virtue of their large shares of total output Keynote 8.1.1 Structure of Oligopoly

of all firms in the market Apple Vs.Microsoft will be affected. The sellers are aware of their interdependence. They know that a change in one firms price or output will cause a reaction by competing firms. The response an individual seller expects from his rival is a crucial determinant of his choices. In an oligopolistic market, few sellers dominate the market and entry of new sellers is difficult, costly and may even be impossible. Intense competition between few firms selling homogenous products leads to price wars. Thus, in practice oligopolists prefer to compete on the basis of product differentiation, advertising and services they offer. Technically this type of competition is called as non price competition (Keynote 8.1.1). What could be these barriers? We have seen some of these while discussing monopoly. Government issuing limited licenses or only a few having access to necessary raw materials could all prevent new firms from entering the markets. More than anything else, economies of scale may make it natural to have only a few firms operating in the market. Or, firms might strategically act to prevent new entry. Like, established firms may threaten to undercut prices till new entrants are bankrupt. In fact, it should be reasonable to conclude
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produced. Sellers in oligopolistic markets know that when they or their rivals change their prices of output, the profit

that more than the actual number of current sellers in a market, what matters is, perhaps, these barriers.

market demand curve is determinate and is clearly, a downward sloping curve.

Demand curve facing a firm in oligopoly In oligopolistic markets, firms enjoy monopoly power. At least some firms will be able to significantly influence price by virtue of their large shares in total production. Having said that, sellers in oligopolistic markets also know that when they or their rivals change output prices, the profit of all firms in the market will be affected. This interdependence of sorts also imply that firms in oligopoly react to each others strategic action. A change in one firms price is likely to lead to reactionary changes in prices by competing firms. Hence, the response an Individual firm expects from the rivals is a crucial factor determining the strategic decisions the firm will make. Firms in an oligopolistic market must assume that competing firms are equally smart as they are, if not better. This principle is the foundation of the game theory, which we will cover in the next chapter. Given the kind of interdependence we have discussed above, the demand curve facing a firm in an oligopolistic market is practically indeterminate, as the quantity that a firm can sell at any given price will depend upon the reaction of its competitors to the price set by the firm. Hence, there is no definiteness to the firms demand curve. However, the

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S ECTION 2

Case Study: The Price war in Gujarat Newspaper Industry

GALLERY:Newspapers Published in Gujarat

Gujarat Samachar

In Gujarat, an Indian state, about 2000 newspapers were published in various languages, primarily in Hindi, Gujarati, and English in 20011. Two Gujarati newspapers, Gujarat Samachar and Sandesh, were the market leaders. Gujarat Samachar, started in 1932, had a circulation of 1.47 million during the period July to December 2002. The circulation of Sandesh for the same period was 0.75 million copies2. These newspaper brands were well established in the market and they enjoyed customer loyalty.

At the beginning of 2002, the Dainik Bhaskar Group (Dainik), a leading business house in the country with a strong presence in the print media industry, decided to launch a Gujarati newspaper Divya Bhaskar in Ahmedabad, the capital of Gujarat. Dainik launched the newspaper in two phases. In the first phase, a consumer contact program through a door-to-door survey was initiated. The researchers surveyed about 1.15 million households in Ahmedabad and the districts of Mehsana and Anand. After the survey results were analyzed, Dainik decided to launch

This caselet was written by Linda D. Thenayan, under the guidance of B. V. Kiran, IBS Center for Management Research. It was compiled from published sources, and is intended to be used as a basis for class discussion rather than to illustrate either effective or ineffective handling of a management situation.
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the newspaper according to consumer expectations. Simultaneously, it conducted a mass media campaign to give publicity to the launch. The second phase of the launch, named chali tumhari marzi was done primarily with the objective of informing the audience that the newspaper was being launched in accordance with their expectations. In the second phase too, 0.75 million households in and around Ahmedabad were covered. Bookings for the newspaper were taken in the form of guarantee bonds. These bonds required customers to sign an order form of subscription for one year. However, the company did not collect any money in advance from the subscribers. Moreover, it assured them that the price of the newspaper would not be increased for one year after its launch. Sudhir Agarwal, (Agarwal), managing director of Dainik, said in this regard, The decision to enter Gujarat was taken in the beginning of 2002. For almost a year we studied the market, in terms of both product and advertising before we actually entered the state. Further, Gujarat is one market, which still has huge untapped potential.3 On June 22, 2003 Divya Bhaskar was launched in Ahmedabad. It had a promotional price of Rs. 1.50, with a freeze in rate for the next one year, at a time when the prevalent rate of major newspapers in the Gujarat market was Rs. 2. Divya Bhaskar was launched with a confirmed circulation of 452,150 copies, the highest in the country for any newspaper on its opening day. It was a 16-page newspaper with an additional features supplement.

For decades, the Gujarati newspaper market had been ruled by Sandesh and Gujarat Samachar. The launch of Divya Bhaskar led to many far-reaching changes in the Gujarati newspaper industry. The leading newspapers till that time were being run as family businesses and not by professionals. The entry of Divya Bhaskar forced these newspaper groups to employ professional help. They also started investing more on infrastructure and on promotional activities. The entry of Divya Bhaskar also led to the beginning of a price war between the major competitors. Ramesh Agarwal (Ramesh), chairman of the Dainik Bhaskar Group, said, We are not targeting existing readers. I foresee Gujarati dailies having a circulation of at least 50 lakhs. Divya Bhaskar will get at least 25 lakhs of this.4 An AC Nielson Org Marg report in August 2003 reported an expansion of the newspaper market in Gujarat by 30%. With the entry of Divya Bhaskar, the newspaper market in Gujarat began to expand. Immediately after the launch of Divya Bhaskar, Sandesh reduced its price to Rs. 1.50. It also increased the number of supplements and the total number of color pages. Besides, it started a novel scheme under which representatives from the newspaper would make surprise visits to households in Ahmedabad. If the residents were able to produce a copy of that days Sandesh, they were given gifts on the spot. The price reduction by Sandesh did not get the desired results. This was because many Sandesh customers started buying Divya Bhaskar too, as the combined price for the two newspapers was only one rupee more than what they used to pay earlier for Sandesh. Very soon, Sandesh increased the price again to Rs.2.
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Gujarat Samachar adopted a different strategy. When the news of Divya Bhaskars entry came in, the management of Gujarat Samachar strengthened its marketing team at the national and local levels. It also gave a face-lift to the newspaper with a new design and layout. After the launch of Divya Bhaskar, Gujarat Samachar launched a scheme wherein a customer who paid the monthly subscription of Rs.75 would get a plastic bucket worth Rs.75 free of cost. This meant that the customers were in effect, paying nothing for the newspaper. Gujarat Samachar also started a mala maal dhamaka coupon scheme under which the customers could redeem a certain number of coupons to get some guaranteed gifts. Further, it implemented various promotional schemes. In association with Ayur Herbals and Hindustan Lever Ltd. brand Active Wheel, it conducted beauty contests in various cities from where the newspaper was being published. More than the strategies adopted by competitors, Divya Bhaskars major problem was the difficulty in getting advertisements, especially from the government. It had to depend more on advertisements from private organizations as most of the government advertisements went to Gujarat Samachar and Sandesh. Dainik therefore had to attract the advertisers by proving its credibility in terms of Divya Bhaskars circulation. The circulation figures for Divya Bhaskar were not available from the Audit Bureau of Circulation (ABC). Dainik therefore sought the help of AC Nielson ORG Marg to conduct a customer survey to find out the circulation of Divya Bhaskar. The study conducted in Ahmedabad in August 2003 showed that Divya Bhaskars circulation had reached 0.486 million

copies. On getting the survey results, Divya Bhaskar launched a promotional campaign through various media channels like exchange4media.com. In October 2004 Divya Bhaskar increased its cover price to Rs. 2 on Sundays, Wednesdays, and Fridays5. It had plans to apply the new price for all days of the week6. Additional editions of the newspaper were started in Surat (March 2004), and Baroda (September 2004). In Surat, Divya Bhaskar was launched at Rs. 1.50. For the Baroda launch, the Bhaskar Group decided to fix the price at Rs. 2 as they felt that the Divya Bhaskar had become an established brand name in Gujarat and so it was not necessary to launch the newspaper at a reduced price as it had done in Ahmedabad or Surat. As a result of the promotional strategies adopted by the three newspaper giants, Gujarati Samachar, Sandesh, and Divya Bhaskar, ABC refused to conduct surveys to establish their circulation since such promotions were against its terms and conditions. Divya Bhaskar felt the need for audited figures to reinforce the point to advertisers and advertising agencies that it was one of the largest circulated dailies. It therefore approached Ernst & Young to conduct a survey to establish its circulation figures. The survey results in November 2004 established that Divya Bhaskar had a circulation figure of 1.13 million copies in Gujarat (Ahmedabad 0.566 million, Surat 0.252 million, Baroda 0.312 million.)7 Regarding the survey figures of Divya Bhaskar in Gujarat, Girish Agarwal, Director, Dainik Bhaskar said, This is just to authenticate the claims that we have been making. There are times when people have found it difficult to take our word and
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hence there was a need to authenticate these figures by a trustworthy third party. We took this step because we were sure of our numbers. To my knowledge, this is the first time that a publication firm is doing this.8 The latest National Readership Survey (NRS) 2005 also established the strong position of Divya Bhaskar in Ahmedabad with readership figures of 5.132 million. Commenting on this, Bharat Kapadia, Executive Director of Bhaskar Group, said, We have been able to grow the market since our first venture in 2003. Plus, we have a higher number of female readers than Gujarat Samachar and Sandesh.9 The Bhaskar Group was planning to come up with more editions and more printing centers to help Divya Bhaskar strengthen its position in the entire state of Gujarat. Questions for Discussion: 1. Divya Bhaskar earned the distinction of being the first newspaper in India to reach the number one position in a city on its opening day. How far do you think the price promotion strategy adopted by the newspaper helped it to gain this unique position? How did competitors respond to the entry strategy of Divya Bhaskar?

Footnotes 1. http://www.mica-india.net/micanvas/downloads/MICANVAS _ Reconnoitre _04.pdf 2. http://agencyfaqs.com/news/stories/2003/05/05/6169.htm 3. http://web.mid-day.com/news/business/2003/september/642 54.htm 4. http://www.agencyfaqs.com/news/interviews/data/24.html 5. http://www.agencyfaqs.com/cgi-bin/search/media_newslets _search.cgi 6. http://www.agencyfaqs.com/media/media_newslets/Media/3 043.html 7. http://www.exchange4media.com/e4m/news/Newfullstory.as p?section_id=5&news_id=14204&tag= 8939 8. http://www.exchange4media.com/e4m/news/Newfullstory.as p?section_id=5&news_id=14204&tag= 8939 9. http://www.newswatch.in/index.php?itemid=48&catid=12 Additional Readings & References: 1. Dixit, Sumita Vaid, Bhaskar launches three more editions in Gujarat; to invest Rs 125 crore in expansion, http://www.agencyfaqs.com /news/ stories/2003/09/06/7015.html Sept 6, 2003

2.

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2.

Susan Pinto, Viveat, Gujarat Samachar beefs up team and product, <http:agency fa qs .co m/ news/ stories /2003 /05/ 05/6169.html> May 5, 2003. Sirish, Nimmagadda, Bhaskar set to conquer G u j a r a t , h t t p : / / w e b . m i d - d a y. c o m / news/business/2003/september/64254.htm Sept 19, 2003 Kumar, Nirmalendu, Interview of the week. We are not unnecessarily worried about competition, http://www.agencyfaqs.com/ news/interviews/ data/ 88.html Divya Bhaskar celebrates 2 years with Divya Utsav, http://www.agency faqs.com/media/media_newslets/Media/4699.html June 22, 2005. http://www.bhaskar.com/ defaults/aboutusengnew.html http://www.agency faqs.com/media/media_newslets/Media/4699.html http://www.indiainfoline.com/bisc/jman.html

3.

4.

5.

6. 7. 8.

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S ECTION 3

Non-Collusive Oligopoly
In oligopoly , the predominant feature of this market is the interdependence among different firms. Due to this interdependence there is an uncertainty about the reaction patterns of rivals. A wide variety of reaction patterns become possible and accordingly a large variety of models of price-output determination may be constructed. The actual solution is, therefore, indeterminate unless we specify the particular reaction pattern of the rivals. When firms only compete and do not cooperate with each other for the sake of common goals, it is a clear case of noncollusive oligopoly.

Source: http://www2.aes.ac.in

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Non-collusive Oligopoly The common characteristic of non-collusive oligopoly is that they assume a certain pattern of reaction of competitors, in each period and despite the fact that the expected reaction does not in fact materialize, the firms continue to assume that the initial assumption holds. In other words, firms are assumed never to learn from past experience which makes their behavior at least naive. COURNOTS MODEL OF DUOPOLY A market with two sellers and a large number of buyers is called duopoly. It is a special case of oligopoly where there are only two sellers. The Cournots model of duopoly is based on the following assumptions: There are two interdependent sellers selling a homogeneous good. There are a large number of buyers in the market. Both the duopolists have identical cost curves. We assume that each duopolist has a zero cost of production. Each duopolist seeks to maximize his total profit in each period. Each duopolist makes an output plan during a period which cannot be revised in that period. Neither of the duopolist sets the price but each ac cepts the price of his product at which total planned output can be sold.

Though each duopolist is aware of the mutual interdependence between their output plans, each is quite ignorant of the direction and magnitude of the revision in his rivals plan that would be induced by any given change in his own. In the Cournots model it is assumed that each firm treats the output of its competitors as fixed and all firms decide simultaneously how much to produce. Both the sellers adjust the level of output to maximize profits. In this process, there are two reaction functions. The Keynote 8.3.1: Cournot Equilibrium equilibrium in the Cournot model of duopoly is also stable. This means that if the output levels of the two sellers are different from that at P, their actions and reactions will lead to the achievement of the output combination (OQ1, OQ2). However, we assume that when one firm changes its output level, it assumes that its rivals output level remains constant at the
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previous level. Such behavior of the two firms is called autonomous behavior. Equilibrium will be stable if the two firms behave autonomously (Keynote 8.3.1). Stackelberg Model In Cournot model, we assumed that the duopolists take their output decisions simultaneously. What if that is not true? What if one firm takes its output decision first and then, the other? As we have learned from the interactive on Cournot model, if firm A assumes that firm B is not producing anything, the market demand curve becomes the demand curve of firm A. Hence, the profit-maximizing output of firm A will be to supply half the market demand. When one firm has a starting advantage, the initial demand curve facing the firm will be the market demand curve. Hence, firm A will supply half the market. (All through, we are continuing to assume what we did in Cournot model, i.e. MC = 0) Firm B, which is subsequently entering the market, will have to take the output of A as given. Hence, the demand it is facing is only half the market demand curve. Given this, firm Bs profit-maximizing output will be equal to a quarter of the market demand, which is half of what firm A produces. Hence in Stackelberg Model, we see that there are some advantages in going first. The primary advantage is that no matter what your rival is planning, the rival has to take into consideration the output that you have already set. In

the short-run at least, your rival cant produce a large level of output without causing self-inflicted losses. Bertrand Model In the Cournot model, we assumed that the output level is the sole parameter of action. Both the firms adjust the level of output to maximize profits. In this process we get two reaction functions. Instead, we can assume that the prices are the parameters that are changed by the firms and not, output. Both the firms adjust price levels to maximize profit. In this case, we can get two price reaction functions at the intersection point of which equilibrium price levels of the two sellers are determined. Here also we can assume that the two sellers behave autonomously. Such a model is similar to the Cournot model and was first developed by another French economist, Joseph Bertrand. Bertrand model is similar to Cournot model except that competition between the firms is price competition. Here, each firm, while deciding on the price to charge, assumes that the other firm keeps its price constant at the current level. Each firm faces the same market demand and aims at the maximization of its own profit on the assumption that the price of the rival will remain constant. Now, because the good is homogenous, rational consumers will buy only from the firm selling at a lower price. Hence if two different prices are charged, the entire supply will be made by the firm charging a lower price. This leads to incentive to charge the lowest possible price.
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Each firm will undercut the price charged by its rival and the equilibrium price is likely to be equal to marginal cost, at which point there is zero economic profits. By changing the parameter on which firms compete from quantity to price, we get completely different outcomes. However, that need not be the case when it comes to differentiated products. If products are differentiated, the entire supply need not go to the firm which sells at a lower price. A Bertrand equilibrium, when product differentiation exists, is one at the intersection of the reaction curves of the two firms. Here, reaction curves, or best response curves, represent the relationship between a firms profitmaximizing price and the price it assumes its competitor will fix. Hence at the intersection of these reaction curves, both the firms get their assumptions about the competitors price right. This will be the profit-maximizing point from where firms have no incentive to move out. Bertrand equilibrium with differentiated products is similar to the Cournot equilibrium in the sense that it lies between collusive equilibrium and competitive equilibrium. It should be obvious by now that Bertrand equilibrium is also a Nash equilibrium. The Kinked Demand Curve Model We have seen from the Bertrand model that price competition in oligopolistic competition can wipe out profits. Given that implicit collusions are difficult to maintain, most firms in an oligopolistic market prefer to

have a stable price level among competitors. The concept of kinked demand curve was originally used to explain why, in an oligopolistic market, price would tend to remain rigid. It was economist Paul M. Sweezy who attempted to explain the observed rigidity of price through this. The essence of Sweezy model is that each firm faces a demand curve, which has a kink at the current price level. Each firm assumes that if price is raised above the current price, none of the other firms will react. Hence, the loss of demand for a small upward revision of price will be far more than proportionate. In other words, the demand curve above the current price is highly elastic. What happens if a firm cuts its price? Every other firm follows suit. Hence, the gain in quantity demanded for each of the firms will be relatively small. This implies that, for a price fall, the quantity gained is far less than proportionate and hence, the demand curve below the current price is highly inelastic. As a result of the same demand curve having two distinct parts with significant difference in price elasticity of demand, there is a kink at the current level. This also implies that the firms MR curve is discontinuous at the point where the demand curve is kinked. Hence within that stretch where MR is discontinuous, even if MC rises, the firm will not change its output or price.

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Figure 8.3.1 Kinked Demand Curve

Figure 9.4

The greater the difference between the elastic and inelastic the demand curve, the greater will be the length of the at part the of point P, both the demand curves DD and dd have the same discontinuity in MR curve. The discontinuity between A and B of the MR curve implies that there is a range within which hecosts MRmay will therefore be different because of the differences in the change without affecting the equilibrium price and demand. Only when 8.3.1). the elasticities areand equal at point P, the output of the firm (Figure This level of price output ange also disappears. is compatible with a wide range of costs. Thus the kink can explain why price and output will not change despite changes hat the MC curve of the firm passes through the discontinuous range in cost within the range AB.

difference between the two elasticities of demand, the greater will f the discontinuity. This is so because, we know from the relation rice and the absolute value of demand elasticity (e) that MR = price

e, in this case, we cannot say that MR equals MC at the equilibrium of MR and MC is not possible. All that we can say is that MR han MC. In this situation the price and quantity remain the same at Even if the MC curve shifts but passes through the discontinuous price-quantity combination will remain constant. The price-quantity

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S ECTION 4

Case Study: Lev Leviev vs De Beers

Introduction For about 100 years De Beers, the South African company had been the unchallenged monopoly in the diamonds business. Until a few years back, De Beers could determine who could buy uncut stones, in what quantities and quality and decide which cutting centers would be used. But its share of the rough-diamond market, 80% five years ago, had reduced to 45% by mid-2004 . M e a n w h i l e L e v

Leviev (Leviev), a former De Beers sightholder (one of the few exclusive buyers of De Beers rough diamonds), had emerged as the world's largest cutter and polisher of precious gems. Leviev also provided rough stones to other cutters, polishers and jewelry makers around the globe. Leviev was the diamond industry's first dealer to operate across the value chain from mining and cutting to polishing and retailing.

This case was written by A.V. Vedpuriswar, IBS Center for Management Research. It was compiled from published sources, and is intended to be used as a basis for class discussion rather than to illustrate either effective or ineffective handling of a management situation.

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Frustrated by De Beers high-handed treatment of buyers, who were offered rough diamonds at take-it-or-leave-it prices and risked being permanently cut off if they resisted, Leviev had decided to operate on his own. Leviev had begun dealing directly with diamond-producing governments. This undermined De Beers' all-important relationship with sight holders. Leviev had taken significant business away from De Beers in Russia and Angola--two of the world's largest producers of rough diamonds. Levievs defiance had inspired others like Rio Tinto, owner of Australia's Argyle mine, to bypass De Beers for the first time in 1996 and sell 42 million carats directly to polishers in Antwerp. In the early 1990s, the Russian government also began selling some of its rough supply to others despite its long time exclusive deal with De Beers. A key operator in Russia, Leviev had cultivated good relationships with the political leadership in that country. Realizing that its monopoly was under threat, De Beers was also reorienting its strategy. It was trying to capture more value, undertake branding exercises and establish strong relationships with carefully selected sight holders. It remained to be seen how the battle between De Beers and Leviev would unfold. About De Beers For most of the 20th century, De Beers sold 85% to 90% of the diamonds mined worldwide. With this monopoly, it could artificially keep diamond prices stable by matching its supply to world demand.

The De Beers legacy was more than 100 years old. In 1888, Cecil Rhodes successfully consolidated South Africa's diamond mines, laying the foundation for De Beers. He formed a cartel with the ten largest merchants. Each was guaranteed a certain percentage of the diamonds coming out of De Beers' mines. In return, they provided Rhodes with market data, enabling him to ensure a steady, controlled supply. In the subsequent years, De Beers refined its system for distributing diamonds. Its original partners in the cartel were replaced by 125 of the world's most powerful manufacturers. But the basic principle of De Beers business model remained the same: to match the supply of diamonds with demand. Over time, De Beers began to manage its supply chain in a unique way. Its London-based marketing arm, the Central Selling Organization (CSO), purchased the production of 13 mines owned or co-owned by De Beers in South Africa, Botswana, Namibia and Tanzania. In 1999, this amounted to more than 44% of the world's annual output. In the late 1990s, the CSO also bought diamonds worth $120 million from Canada's Ekati mine and another $1.5 billion from Russia, which together made up an additional 25% of the world's $6.8 billion annual diamond production. De Beers had no interest in polishing the diamonds. It was primarily interested in selling the sorted rough diamonds. De Beers combined rough diamonds, sorted them into 14,000 categories, and divided them into lots. Every five weeks, De Beers held what it called a "sight" and distributed the lots to its 125 partners, known as
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Figure 8.4.1: Mines in Africa

number of these blemishes to the surface, where they could be excised by the spinning blade of the polishing wheel. Once he had made his recommendation, he passed the stone to the cutters and polishers who shaped the pebble-like rough stones into products that could be sold through retail outlets. Only diamond was hard enough to cut diamond. So a diamond cutter used a saw coated with a mixture of oil and diamond dust. In recent years, laser machines had been developed for certain kinds of sawing. The cut diamond was passed to a "girdler," who used one diamond to roughly round out the edges of another. Then it went to the polisher, who placed it repeatedly against a spinning wheel coated with the same diamond dust mixture until the rough outer skin was ground away. This created facets, or flat surfaces, in the stone. When facets and angles were applied according to a specific mathematical formula, the light that entered the top of the diamond was reflected outward with the same intensity. Video 8.4.1:Diamond Cutting at Antwerp De Beers had a sister company called Anglo American, which was one of the world's largest mining companies. Anglo was founded in 1917 by Ernest Oppenheimer.
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Source: http://geology.er.usgs.gov/eespteam/diamondproject/images/diamondh igh.jpg

"sightholders." De Beers set the price in advance and determined the quality and quantity each sightholder received. The sightholders took the rough diamonds back to their factories, cut and polished them and then sold them to their customers throughout the world. De Beers despatched its diamonds to different cutting centers based on the cost of labor. Large, valuable stones were cut in New York City and Antwerp, where the high labor costs could be absorbed in the price of the finished diamond. Mediumsized stones were cut in Johannesburg and Tel Aviv. The smallest and least valuable stones, which constituted the overwhelming majority were cut in Bombay. A marker examined each uncut stone for flaws and then determined which point of entry would bring the greatest

When Ernest took control of De Beers' board in 1929, he initiated a cross-holding arrangement that later became quite complicated. In 2001, De Beers owned 37% of Anglo's stock, while Anglo held 33% of De Beers. The Oppenheimer family controlled a large percentage of each company's shares. The U.S. Department of Justice had been investigating De Beers for years and had an outstanding indictment against the company in a 1994 price-fixing case. As a result, De Beers could not deal directly with customers in its largest market. Its directors did not enter the U.S. for fear of arrest. During the apartheid era, the convoluted structure enabled De Beers and Anglo to deal through their web of subsidiaries with countries that refused to do business with South Africa. Since the 1990s, the threat to De Beers monopoly had increased significantly. In the early 1990s, De Beers suffered a setback in Russia after the collapse of communism. Leviev began to make major inroads into that key market. In 1996, the De Beers cartel was shaken further when Australia's Argyle diamond mine became the first major producer to terminate its contract with De Beers. Argyle produced more diamond by volume,

than any other mine in the world. Although most diamonds were of poor quality, they were important because of the growing popularity of inexpensive jewelry. So Argyle's decision to market its own diamonds hurt the company at the low end of the market. De Beers also faced problems in Canada. The discovery of several rich diamond deposits in the Northwest Territories of Ekati, Diavik, and Winspear in the 1990s eroded De Beers' monopoly. Though the company was able to secure 35% of the production of Ekati, and in August 2000 launched a successful takeover of Winspear, De Beers did not hold the overwhelming position in Canada that it had in the past. Over the years, De Beers had fixed prices by buying surplus diamonds. The policy dated back to 1934, when the Great Depression caused a slump in diamond prices and Ernest Oppenheimer offered to buy all the rough stones in the market. Had prices continued to fall, De Beers might have gone bankrupt. But prices recovered and Oppenheimers gamble laid the foundation for the company's dominance of the diamond industry for the remainder of the century. The buyer of last resort strategy worked brilliantly in times of high inflation when diamond prices were high and the value of the stockpile rose. But in recent times, low inflation and the emergence of new players had made this strategy increasingly unviable. De Beers spent billions of dollars to accumulate a large stockpile of diamonds. At the end of 1999, De Beers' diamond stocks in its London
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vaults were worth around $4bn, nearly as much as the company's annual sales of $5.5bn. Because these assets were not earning an attractive return the share price fell, unnerving several large shareholders, notably in the US. In 2001, Nicky Oppenheimer, Ernests grandson declared that the company was relinquishing its 112-year monopoly over the world's diamond supply. The old De Beers referred to in the industry as "the Syndicate" seemed poised for change. A new generation of leadership, represented by Nicky and managing director Gary Ralfe seemed ready to take over. De Beers announced a new strategy called Supplier of Choice. Instead of trying to control the global supply, De Beers would focus on adding value to the diamonds already under its dominion, through marketing and branding initiatives. "We don't have to go rushing about the world trying to buy every diamond," said Ralfe2. "What is the point of us buying diamonds close to or over our selling prices? It's silly.. I'm perfectly happy to market 60%. What I want to do is differentiate the portion that does come to us and create value on those goods...in order to sell them first, more advantageously, and at better prices. Branding Diamonds A major initiative towards creating value was branding. The diamond industry had failed miserably to generate the earnings growth and profit margins enjoyed by other luxurygoods purveyors. Ralfe3 blamed it on a lack of strong brands, which he said had led to the commoditization of diamonds.

"I don't want diamonds to be discounted I abhor it. What is tantalizing is that at the luxury end--the famous blue box of Tiffany's--there are brands getting the margins and markups enjoyed in the luxury-goods business as a whole. We want to see stores pushing the preciousness of diamonds rather than treating them as a commodity you can discount." De Beers unveiled two branding initiatives. The first, called the Forevermark, was a trademark, guaranteeing the integrity of De Beers' diamonds. The second was the De Beers name itself. The company formed a partnership with French luxury goods conglomerate LVMH to develop a retail strategy for the De Beers brand. The Forevermark replaced the name "De Beers" on the company's famous "A diamond is forever" advertising campaign, leaving the De Beers brand free to be exploited by the partnership with LVMH. In the past, the diamond industrys brand building efforts had seen very little success. The top 15 jewelry brands had less than 15% market share. Yet diamonds could be branded successfully, as an American diamond wholesaler Glenn Rothman had demonstrated over the past few years. In 1997, Rothman introduced his branded diamonds (He bought his raw stones from De Beers sightholders and others) under the name --Hearts on Fire. Rothman spent 8% of gross revenue on public relations and marketing, well above the industry average of 1%. He supported his brand with significant educational initiatives, including a two-day, $500,000 training extravaganza he called Hearts on Fire University. Consequently a brand
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that did not even exist in 1995 generated sales of $40 million in 2000. In 2000, De Beers spent $150 million to advertise cut diamonds. Through its JV with LVMH, De Beers wanted to maintain, and expand (using the Supplier of Choice strategy), its core business of mining and marketing rough diamonds. It also wanted to leverage the powerful consumer brand it had built for diamond jewelry by selling De Beers-branded diamonds and opening De Beers boutiques. This move was likely to put the company in direct competition with its sightholders' retail customers. De Beers had tried to brush aside concerns pointing out that the new company would operate independently and would have to purchase its diamonds like any other retailer--and not directly from De Beers. But sightholders were far from convinced. Through Supplier of Choice, De Beers rewarded sightholders that built strong brands, whether by teaming up with established labels or by creating their own versions of Hearts on Fire. Analysts interpreted this as a sign that De Beers would eventually restrict its sightholders to the most powerful manufacturers with the most successful retail clientele. De Beers also instituted joint initiatives with its sightholders that would reimburse them for a portion of the money they spent on their customers' advertising and marketing efforts. De Beers would place its diamonds with the most profitable, marketing-savvy sightholders, who in turn would sell them to the most profitable, marketing-savvy retailers.

As part of its new strategy, De Beers had also started building closer relationships with sightholders, wholesalers and retailers. "Our relationship with our sightholders has been very arm's-length," admitted Gareth Penny, De Beers' 38-yearold director of sales and marketing4. "We haven't ever really found a need to know what they do with the diamonds we sell them. Now we are trying to make sure that the diamonds we sell are put into the strongest, most effective hands." De Beers asked its sightholders to fill out a questionnaire, which provided the Diamond Trading Co., (the new name for Central Selling Organization) with data--assets, cash flow, and other intimate financial details--about their companies. They also entered into a formal written contract. De Beers amended the criteria for being a sightholder. In the past, De Beers had selected sightholders for their financial strength and manufacturing skills. But in the early 2000s, marketing savvy was also an important factor. For their efforts, sightholders received guaranteed supply, were entitled to use De Beers' Forevermark -- and all the research, marketing savvy, and consumer confidence it represented. De Beers let everyone in the industry benefit from its advertising campaigns, which in 2000 cost the company $150 million. In addition, De Beers maintained a consumer-marketing department--at an annual cost of $5 million--that tracked everything from buying habits and patterns to the number of engagements worldwide.
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Meanwhile, De Beers was aggressively pursuing diamond properties around the globe. In July 2000, De Beers launched two hostile takeover bids. The first, a $205 million offer for Winspear, a mine in Canada's Northwest Territories, was approved in August 2000. The second, a $389 million bid for Australia's Ashton Mining--and its Argyle mine--was held up by the European Union's antitrust commission. So Ashton accepted a lower offer from a competitor. De Beers realized it would not dominate the supply of rough diamonds as it once did. But some analysts opined its plan to transform itself might well give it even greater leverage over the strongest manufacturers, wholesalers, and retailers, the ones the company needed as it sought higher margins for diamonds. Whether this new De Beers would be acceptable to antitrust regulators was an open question. On July 13th, 2004 in an Ohio court, De Beers pleaded guilty to charges of price fixing of industrial diamonds and agreed to pay a $10 million fine, thereby ending a 60 year-long impasse. This implied that De Beers executives were at last free to visit America, a country they had avoided for fear of being arrested. About Leviev Leviev, De Beers challenger had grown up in the Uzbek capital of Tashkent. Despite the prevailing communist rule, his family was committed to Jewish religion and values. Leviev's father was a successful textile merchant and a collector of rare Persian carpets. The family immigrated to Israel in 1971, having converted their wealth into rough diamonds worth $1

million. But when they tried to sell them in Israel, they were told the diamonds were of inferior quality, worth only $200,000. Despite his father's objections, Leviev, only 15 years at that time, decided to give up the familys religious tradition to take up diamond cutting. Leviev opened his own cutting factory in 1977, when speculation in the burgeoning Israeli diamond market was rampant. Most cutters held inventory, thinking prices would keep rising. When the market collapsed three years later, banks stopped extending credit and many cutters went bankrupt. But Leviev had not borrowed against his inventory. So he was in good shape to expand his operations. To procure rough diamonds, he flew frequently to London, Antwerp, Johannesburg and Siberia. He also adapted laser technology and used computer software to create more value. His cutters began to produce digital 3-D models of various diamond cuts, taking into account imperfections, size, weight and shape before touching the stone. In 1987, De Beers invited Leviev to become a sightholder, one of the chosen 150 people who held that status. By then he was one of Israel's largest manufacturers of polished stones. In the next 15 years, Leviev went from strength to strength, as he built connections across the world. In 2003, Leviev owned 100% of his diamond business, Lev Leviev Group, and held a controlling stake in Africa Israel Investments, an Israel-based conglomerate whose holdings included: commercial real estate in Prague and
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London; Gottex, a swimwear company; 1,700 Fina gas stations in the Southwest U.S.; 173 7-Elevens in New Mexico and Texas; a 33% stake in Cross Israel Highway, that nation's first toll road; and an 85% share of Vash Telecanal, Israel's Russian-language TV channel. Leviev also owned a gold mine in Kazakhstan, parts of two diamond mines in Angola and mining licenses in the Urals and Namibia. Going by press reports, Leviev was a controversial figure. When Leviev was preparing a bid for 40% of Australia's Argyle diamond mine, the banks supporting him pulled out at the last moment. According to insiders, the reason for this pullout was a lack of transparency in Leviev's business. In Russia, Leviev had drawn criticism for seeing to it that a Lubavitch rabbi, born in Italy and educated in America, was granted citizenship and installed as the country's chief rabbi, though the nation already had one. Leviev had developed strong political connections across the world. He was close to Russian President Vladimir Putin. Leviev had also become something of a mediator between Israel and central Asian countries, enlisting the support of secular regimes of Islamic states in the fight against fundamentalist groups. Leviev, who lived in Israel, was close to Israeli Prime Minister Ariel Sharon, the presidents of Kazakhstan and Uzbekistan,President Jos Eduardo Dos Santos of Angola and Sam Nujoma of Namibia. Russia Leviev's friendship with Putin dated back to 1992, when the president, then a deputy mayor in St. Petersburg, authorized

the opening of the first new Jewish school in the city (financed by Leviev) in half a century after the mayor hesitated to do it. Leviev had nurtured the relationship with Putin, brokering meetings for the first time between the new Russian president and prominent Israeli politicians. But he avoided being identified with the "Family," a group of business tycoons who tried to convert their economic influence into political power. In hindsight, this was a smart move. When Putin became president, he marginalized some Family members, like Boris Berezovsky. But there were some who felt Leviev was still taking a big risk, by aligning himself so closely with Putin. The Russian president was a maverick. Should he consider Leviev's Jewish activities as violating the promise Putin had extracted from Russia's oligarchs to stay out of politics, Leviev might land in serious trouble. Video 8.4.2 on Siberia Diamond Deposits Russia was an important battleground for both Leviev and De Beers. In 1958, the Soviets discovered rich deposits in Siberia. They built Aikhal, a city encased in translucent plastic, to recover the diamonds from a landscape where temperatures sometimes dropped to minus 80 degrees. When news of the discovery reached the West, De Beers'
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shares plummeted 30%. Recognizing the precariousness of its position, De Beers persuaded the anti apartheid, anti capitalist Soviet regime to sell its entire production to the CSO. But the disintegration of communism made it difficult for De Beers to protect this agreement. An increasing percentage of Russian diamonds began to be sold outside the CSO. In the late 1980s, Russia's state-run diamond mining and selling group, later called Alrosa, asked Leviev to help it set up its own cutting factories. This led to the formation of a joint venture called Ruis5. This was the first time rough diamonds were finished in the country of their origin. Leviev cultivated a cozy relationship with Valery Rudakov, who under Soviet leader Mikhail Gorbachev ran Alrosa. The partnership opened the doors of the Kremlin for Leviev. Leviev insisted that stones for the factories be supplied directly from Russian mines instead of being diverted through De Beers central system. When the factories were privatized, Leviev used his clout to emerge as the exclusive owner. Anticipating De Beers retaliation, Leviev secured supply of rough diamonds from Gokhran, Russia's repository of gems, gold, art and antiques, run by a Boris Yeltsin associate, Yevgeni Bychkov. The Russian government had decided to unload some of the rough and polished stones it had been accumulating for a long time, probably since 1955. The stock was valued at $12 billion in the early 1990s. Leviev became the main player in liquidating the stock, which contained some of the most precious stones in the world, 100 carats and larger.

In 2003, Leviev owned 100% of Ruis, which cut $140 million worth of diamonds a year, and other polishing operations. Angola The world's third-largest producer of rough diamonds, Angola had emerged as a strategic market for Leviev, who had taken advantage of De Beers problems there. Angola mined diamonds worth $600 - $800 million each year, making it the fourth-largest producer (in value terms), in the world. One-fifth of the production came from the country's only mine, Catoca. The rest was scattered in alluvial (surface) deposits. Rebel forces opposed to President Dos Santos, overran Angola The rebels took control of the diamond territories and flooded the market with diamonds worth up to $1.2 billion in a year. The old De Beers prospected for underground deposits in Angola. And in its effort to control the world's diamond supply, it also bought plenty of diamonds--both from the Angolan government and from areas controlled by rebels. De Beers was accused of indirectly funding UNITA, the rebel army in Angola. By 1998, De Beers' operations in Angola threatened to become a public relations nightmare. The nongovernmental organization, Global Witness publicized the atrocities that rebel forces in Angola and other African countries were committing to gain access to diamonds. The phrase "conflict diamonds" became commonly used. The United Nations passed resolutions calling for a boycott. U.S. Congressman Tony Hall sponsored a bill
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that called for an embargo against diamonds not certified by the governments of Sierra Leone and Angola. Blood diamonds soon became a problem for De Beers. In 1998, the United Nations imposed sanctions on the purchase of Angolan diamonds from the rebels. De Beers was singled out for "operating with an extraordinary lack of accountability.6" Under pressure, the Syndicate closed its buying offices in Angola and the Democratic Republic of Congo, while continuing to explore in Angola. Leviev had already made a mark in Angola in 1996 when he made a $60 million investment, in exchange for 16% of Angola's largest diamond mine, after the government took it back from the rebels. Leviev offered to generate more revenues for the state and cut down illegal exports. To create a win-win situation, he gave the Angolan government a 51% share of Angola Selling Corp., or Ascorp, the exclusive buyer of Angolan rough diamonds. Leviev kept the promise he made to Dos Santos. The government's reported tax collections from diamond sales jumped to $62 million in 2002 from $10 million in 1998. De Beers did not seem very comfortable giving up control over such an important source of diamond. It maintained a low-key presence in Angola. De Beers representatives continued to negotiate with the government. De Beers set up a 12-storey sorting house in

Luanda, and was spending millions of dollars every year prospecting in the Angolan jungles. In the meantime, De Beers continued its public relation efforts that projected it as a "conflict-free" supplier. Diamonds that carried its new Forevermark logo were guaranteed to be conflict-free. The company announced that any sightholder caught handling conflict diamonds would be blacklisted. De Beers and other industry leaders joined hands and formed the World Diamond Council, which mandated the eradication of conflict diamonds from the rest of the world's supply. De Beers lost heavily in Angola. By the time the government won the war in the country in 2002, and got control of the countrys diamond mines, the contracts it had struck with Leviev were worth $850 million a year, even larger than the amount De Beers lost in Russia. Meanwhile, Leviev also suffered a setback. In 2003, the government abruptly cancelled three quarters of the deal. Namibia Namibia was another country rich in diamond reserves. De Beers had been mining there since Ernest Oppenheimer bought concessions after World War I. But like Russia, Namibia wanted to process its own stones. In 2000, it forced producers to sell a regular supply of rough diamonds to domestic cutters. De Beers resisted, but later relented and built a cutting factory in Namibiawhich it supplied with rough diamonds from its London offices.

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Leviev took advantage of the situation. He paid $30 million to acquire 37% of Namibian Minerals Corp. (Namco), an offshore diamond-mining outfit. As part of the deal, he agreed to open a polishing factory on the Namibian coast. Later, when Namco's mining equipment broke down, Leviev faced a dispute with his partners who refused to spend more money on repairs. Leviev forced the company into bankruptcy, and bought all its mining concessions for a meager $3 million. In June 2004, Sam Nujoma visited Levievs factory in Windhoek. Workers used chrome machines and flat screen computers in what Leviev described as Africas largest diamond factory. Namibia might well set a precedent for other African countries to polish and cut their own stones. De Beers executives heard with apprehension Nujomas remarks7 while inaugurating the factory: To our brothers and sisters of neighbouring states, Angola, Botswana, South Africa, I hope this gives you inspiration to try to imitate what we have here. Levievs partnerships in Russia, Angola and Namibia represented part of his bid to gain direct ownership of rough supplies--geopolitically diversified. He had recently bought a piece of Camafuca (a diamond mine) in northeast Angola and a diamond exploration license in Russia's Ural Mountains. Meanwhile, De Beers had been cultivating a strong relationship with Botswana where it had a joint venture, Debswana. Leviev was trying to challenge De Beers by opening a factory in that country. The timing was good as De Beers was renegotiating an important mining lease in

southern Botswana. The mine was estimated to be worth $1.3 billion a year. The Road Ahead In 2004, Leviev claimed to be the only vertically integrated diamond dealer in the world. But De Beers had been moving vertically, too. Its joint venture with the French luxury goods company LVMH in 2000, (each partner putting up $200 million) had been set up to create an up market brand that would fetch a premium over unbranded diamonds. In July 2003, De Beers dropped 35 of its 120 longtime sightholders (adding 10 new ones), fuelling speculation that it was keeping its best supplies for its retail operation. De Beers denied these rumours and said it dropped the sightholders following its objective review process. In any case, the partnership with LVMH had not made the expected progress. In mid-2003, there was just one stand-alone store on London's Bond Street. A planned Madison Avenue store had been delayed indefinitely. Meanwhile, branding in the diamond industry had gathered momentum. Belgian sightholder Pluczenik Group teamed up with fashion house Escada to create the 12-sided "Escada cut" for its signature jewelry line. Leo Schachter Diamonds, a Tel Aviv-based sightholder, spent at least $5 million to advertise its 66-faceted Leo diamond in magazines like People and Vanity Fair. While Tiffany patented the Lucida diamond, a 50-facet square cut, New York's William Goldberg produced the antiquelooking Ashoka variety.
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Leviev had launched his own high-end jewellery line, dubbed the Vivid Collection, reserving his best stones for pieces priced from $50,000 to a few million dollars. Leviev had also stuck a deal with Bulgari, an Italian jewellery maker to market his branded stones. The Israeli businessman was also moving beyond diamonds presumably to diversify risk. He was investing $1 billion in real estate development in Russia over

between Putin and American Jewish leaders to discuss U.S.-Russian relations. Meanwhile, De Beers was far from a spent force. In 2003, the South African Mining giant earned healthy profits of $676 million on sales of $5.5 billion. Freed from its earlier role as the sole distributor of diamonds, it was likely to focus on more profitable activities. As 2004 drew to a close, the battle between De Beers and Leviev seemed interestingly poised. Exhibit: I Appendix The "4 Cs" The quality of a diamond is determined by four factors commonly known as the "4 Cs" -- Carat weight, Clarity, Color, and Cut. The first 3 Cs are very straightforward and will be explained here. However, beware of "cut"!! The difference between a "great" cut, a "good" cut, and a "bad" cut can be subtle to the untrained eye, but will make a huge difference in terms of the value and beauty of the stone. An unscrupulous jeweler will sell you a heavy stone with superb clarity and color for an unbelievably low price and still make a substantial profit, if the 4th "C" -- the cut -- is inferior! Carat Weight "Carat Weight" is simply the weight of the diamond.
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Keynote 8.4.1 Stones and Diamonds

Source: Department of Minerals and Energy, South Africa

the next four years, including three office buildings in central Moscow. Leviev expected to put up a similar amount for office and residential complexes in New York City, Dallas, Texas, and San Antonio, Texas. Leviev continued to nurture his political contacts. In June, he brokered a meeting in Moscow

By definition, 1 carat is exactly 200 milligrams. Since most diamonds sold in the jewelry industry weigh less than 1 carat, the carat is usually subdivided into "points." There are 100 points in 1 carat, so that a diamond weighing 3/4 carat would be a "75 point diamond." In summary: 1 carat = 200 milligrams = 100 points Don't confuse the weight of a stone and its size. This argument is similar to that of cereal boxes or potato chips, where "contents are sold by weight, not volume." Also, don't confuse the carats of a diamond with the carats of a different stone. Because different minerals have different densities, a 1-carat diamond will have a different volume (a.k.a. size) than, say, a 1-carat ruby. Another common source of confusion: The karats used to measure the purity of gold have nothing to do with the carats used to measure the weight of a diamond. Notice the difference in spelling. Clarity Clarity is a measure of the number and extent of the flaws in the diamond. Generally speaking, the fewer the flaws, the more valuable the diamond. Completely flawless diamonds are extremely rare -- only a few hundred "FL" diamonds are produced per year worldwide. There are several grading systems used to describe clarity. By far, the most popular is the Gemological Institute of America's (G.I.A.) scale, which ranks diamonds as Flawless (FL), Internally Flawless (IF), very very slightly included (VVS), very slightly included (VS), slightly imperfect (SI), and imperfect (I):

Although seemingly subjective, the G.I.A. scale has specific criteria that are used to differentiate between the different grades (what's the difference between "very very" slight and "very" slight anyway!): FL: Completely flawless IF: Internally flawless; only external flaws are present, which can be removed by further polishing the stone VVS1 - VVS2: Only an expert can detect flaws with a 10X microscope. By definition, if an expert can see a flaw from the top of the diamond, it is a VVS2. Otherwise, if an expert can only detect flaws when viewing the bottom of the stone, then it is a VVS1 VS1 - VS2: You can see flaws with a 10X microscope, but it takes a long time (more than about 10 seconds) SI1 - SI2: You can see flaws with a 10X microscope I1 - I3: You can see flaws with the naked eye. Consider avoiding I2-I3 diamonds. There are many different types of flaws. The best way to become acquainted with them is to look at lots of diamonds. The more common ones are as follows: Pinpoint: A very small white dot on the surface of the stone. By far, the most common flaw Carbons: A very small black dot on the surface of the stone. Less common than pinpoints

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Feathers:Small cracks within the stone, similar in look to broken glass. Small internal feathers are harmless (other than lowering the clarity rating of the diamond), but large feathers can become a problem because the crack can grow as the diamond ages Clouds:Hazy areas within the diamond, actually made up of many small crystals that are impossible to see individually Crystal Growth:A small crystalline growth within the diamond. Looks like a small diamond within the big diamond Color The "color" of a diamond refers to its degree of "yellowness." The ideal diamond is completely colorless, and therefore it will be the most expensive. The Gemological Institute of America (G.I.A.) grades color alphabetically from D (totally colorless) to Z (yellow):

set" of stones. A jeweler will compare the stone in question with a set of stones of known color (the set is typically made of cubic zirconium!), and make a qualitative determination as to the color grading of the stone in question. The second, more precise method, is to use a colorimeter, which is nothing more than an electrical device that will measure the optical characteristics of the stone and report the color to within 1/3 of a grade. Be aware that most jewelers routinely "round up" the results of a color test. Therefore, a stone that is only slightly better than an F grade automatically becomes an E (and hence becomes more expensive for the consumer to purchase). Cut Cut is by far the most confusing of the 4 Cs, since it can refer to the cutting style, the shape of the stone (round, square, heart-shaped, etc.), its proportions, or the workmanship of the actual diamond-cutting process. Each of these four characteristics are important while evaluating a stone, so we will discuss each separately. 1. Cutting Style

For a diamond to be considered "colorless," the G.I.A. requires that it be a D, E, or F. However, the D-Z scale is continuous, so the difference between an F and G is very small. The average color for engagement diamonds in the United States is G to H. Jewelers have two tools at their disposal to judge the color of a given diamond. The first is what's known as a "reference

Diamonds, as crafted by nature, consist of translucent crystalline carbon. If the outer rough could be peeled away, the resulting stone would be as smooth as glass; unfortunately, it would be no more aesthetically pleasing than a piece of glass crystal. The art of the diamondcutter is to transform that chunk of crystallized carbon into a beautiful piece of jewelry.
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The diamond-cutter has two basic types of cuts in his arsenal: The step cut and the brilliant cut. You may also hear of hybrids of the two basic cuts, such as the emerald cut, or you may also encounter some of the older-style cuts, such as the rose cut, the old European cut, or the old mine cut. If you are planning to purchase a diamond for a modern engagement ring, you only need to concern yourself with the two basic cuts. The step cut has parallel facets that usually span the length or width of the stone. Refer to the picture shown here, and notice the "steps" that lead from the outer edges to the top of the diamond. If a step-cut diamond has rounded-off facets in the corners, this is a variant of the step-cut called the emerald cut. The brilliant cut has triangular facets that surround the stone and usually culminate on a flat top called a table. Again, refer to the picture shown here and notice how the triangles fit into each other. The modern and popular brilliant-cut round engagement diamond has 58 of these triangular facets -- 33 above the middle of the stone (or the girdle), and 25 below. The choice between a brilliant-cut or step-cut stone is simple: If you want the shiniest diamond possible, select a brilliant cut. If you prefer a more glassy, elegant stone, the step cut is for you. One point of clarification is that you cannot just go to the jewelry store and purchase a generic step-cut or brilliant-cut diamond -- you must select a stone with a given shape, that will in turn be created using step-cuts, brilliant-cuts, or a mix

of the two. Continue with the tutorial to learn more about diamond shapes. 2. Shape As the name suggests, shape is nothing more than the intrinsic shape of the diamond. As viewed from the top, the most common shapes are: With the exception of the emerald cut, today's most popular shapes are brilliant cuts or hybrid cuts (as opposed to strict step cuts). In terms of cost, the round brilliant tops the list, while the square cuts typically cost about 10% less for a diamond of the same weight and quality. Unless you're purchasing a diamond as an investment (in which case you should strongly consider a round brilliant), you should choose the shape which pleases you most. Saul Spero, a New York diamond appraiser, spent 25 years interviewing over 50,000 people to determine if there was any correlation between personality and preference of diamond shapes. In his book Diamonds, Love, and Compatibility, he states that if a woman has a strong preference for any of these shapes, she can be characterized as follows: Unless you're buying a diamond as an investment, choose a shape that you like, regardless of its relative value or the correlation between the bride-to-be's personality and Spero's study. Other than personal preference, the only characteristic that you should trade off if you choose one diamond shape over another is in
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Exhibit : Diamond shapes and cuts brilliance and fire. Continue with the tutorial to learn more. 3. Proportions In an ideally-proportioned diamond, all of the light entering the diamond from the top will bounce within the diamond and be reflected back through the top, giving the stone maximum brilliance and fire. If the stone is too shallow or too deep, some light will escape through the bottom part of the diamond, giving the appearance of shadows when viewed from the top. It's easy to see that the deep-cut diamond shown above will have a higher carat weight, but is clearly the less desirable stone! Many jewelers will not discuss cut proportions unless the customer specifically asks; a stone rich in carat weight but poorly proportioned can be deeply "discounted," giving the buyer a false impression of a great deal. Source: www.diamondreview.com

Round shaped 1 of 12

Shape Round Oval Heart

Spero's Personality Traits Family-centered, dependable, unaggressive. Individualistic, creative, wellorganized, willing to take chances. Sentimental, feminine, sensitive, trusting.

Rectangle/Square Disciplined, conservative, efficient, honest. Pear Marquise Conforming, considerate, adaptable. Extroverted, aggressive, innovative, career-centered.

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Footnotes 1. The cartel isnt for ever, The Economist, 17th July 2004, Vol. 372, Issue 8384, pp. 61-63. 2. Stein, Nicholas. A New Cut On An Old Monopoly, Fortune, 19th February 2001, Vol. 143, Issue 4, pp. 88-103. 3. Stein, Nicholas. A New Cut On An Old Monopoly, Fortune, 19th February 2001, Vol. 143, Issue 4, pp. 88-103. 4. Stein, Nicholas. A New Cut On An Old Monopoly, Fortune, 19th February 2001, Vol. 143, Issue 4, pp. 88-103. 5. For decades, De Beers had been channeling all rough diamonds through its Diamond Trading Co. in London before reselling them to sightholders at a markup; a diamond mined in, say, Africa traveled halfway around the world before it was resold to a sightholder in Africa. 6. Berman, Phyllis; Goldman, Lea. The Billionaire Who Cracked De Beers, Forbes Global, 15th September 2003, Vol. 6, Issue 17, pp. 47-58. 7. The cartel isnt for ever, The Economist, 17th July 2004, Vol. 372, Issue 8384, pp. 61-63.

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Bibliography 1. Francesco, Guerrera and Andrew, Parker. The changing face of the diamond industry, Financial Times, 11th July 2000. 2. Stein, Nicholas. A New Cut On An Old Monopoly, Fortune, 19th February 2001, Vol. 143, Issue 4, pp. 88-103. 3. Berman, Phyllis; Goldman, Lea. The Billionaire Who Cracked De Beers, Forbes Global, 15th September 2003, Vol. 6, Issue 17, pp. 47-58. 4. The cartel isnt for ever, The Economist, 17th July 2004, Vol. 372, Issue 8384, pp. 61-63. 5. 6. De Beers Annual Reports. www.fjc.ru

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S ECTION 5

Collusive Oligopoly

When firms come to an understanding and tactically cooperate with each other to prevent or minimize competition, it is referred to as collusive oligopoly. Collusive Oligopoly can be further classified as Price Leadership and Cartel.

Source:http://www.tutor2u.net/

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Price Leadership Price leadership is a form of collusion in an oligopoly market. In this form, one firm sets the price and the other firms follow it because it is advantageous to them or because they prefer to avoid uncertainty. If the product is homogeneous and if there are no transport costs the same price will be charged by all firms. However, if the product is differentiated, prices will differ but the direction of their change will be the same and the same price differential will be more or less maintained. There are various forms of price leadership. The most common types of price leadership are: a. b. c. Price leadership by a low-cost firm, Price leadership by a large (dominant) firm, & Barometric price leadership.

ferent costs. Let us also assume that the two sellers have equal markets. Price leadership by dominant firm: In this situation it is assumed that there is a large dominant firm which enjoys a considerable share of the market and some smaller firms, each of Keynote 8.5.1: Price Leadership them having a small market share. The market demand is assumed to be known by the dominant firm. It is also assumed that the dominant firm knows the supply curves of the smaller firms so that by the horizontal summation of these supply curves the dominant firm can calculate the total supply forthcoming from the smaller firms. Given the market demand curve and the aggregate supply curve of the smaller firms, the dominant firm can calculate its own demand curve. The dominant firm will supply the difference between the total demand and the total supply of the smaller firms. When the demand curve of the dominant firm is known it will set its price by equating MR and MC and this price will be followed by the smaller firms. The dominant firm maximizes its profit by equating MR and MC but the smaller firms, who are price282

The price leader is assumed to set his price by applying marginalistic rules, that is, by equating MR and the MC. As a result the price leader can maximize profit. The other firms are price-takers who take the price set by the leader. At this price the followers may not maximize their profits. If they do, it will be by accident rather by their own independent decisions. Price leadership by low-cost firm: Let us suppose that we are considering a duopoly market having two sellers. It is assumed that they produce a homogeneous product at dif-

takers, may or may not maximize their profits, depending on their cost-structure (Keynote 8.5.1). Barometric price leadership: In order to have the power to impose his price the leader must be both a lowcost and a large firm. However, in many cases where there are several firms of similar costs and similar size, it may be difficult to agree who will be the leader. Under such circumstances, the leader may be decided by common consent, and be neither a low-cost nor a large firm in the industry. We may then have a case of barometric price leadership, the leader being a firm whose price changes are followed by others for convenience. In the barometric price leadership model, it is formally or informally agreed that all firms will follow the changes of the price of a firm which is considered to have a good knowledge of the prevailing conditions in the market. In other words, the firm chosen as the leader is considered as the barometer, reflecting the changes in economic environment. Usually the barometric firm is one which has established the reputation of being a good forecaster of economic changes. It is not always necessary that the barometric firm should belong to the same industry. Instead, the barometric firm may also belong to another industry. For example, a firm in the steel industry may be agreed as a barometric leader for price changes in the engineering industry.

Cartels Cartels imply direct agreement among competing oligopolists with the aim of reducing uncertainty. It is a case of explicit collusion and is prohibited by antitrust laws in many countries. However, cartels do exist, mostly in the international arena though. The aim of a cartel is to prevent competition between members and as much as possible, jointly maximize the monopoly power. Cartels may try to maximize joint profits. Or, they might merely share the market as per agreement. In the former case, the firms appoint a central agency to which the authority to fix total output, price and production quotas among the producers is delegated to. To do this effectively and to distribute profits among the members, the central agency must have full information about the cost functions of the members. It is assumed that all members produce identical products. In the latter case, the agreement might simply be about the common price the members will all charge (loose cartel) or about the common price as well as the production quotas for each member. In some cases, market-sharing could even be territorial, wherein different regions are assigned to different members. It is to be remembered that not all producers in an industry need to be part of the cartel, for it to succeed. In fact, whether it is OPEC or any other successful cartel, most cartels involve only a subset of the sellers in the
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market. However, what matters most is the potential to exercise monopoly power. If forming a cartel helps in making the demand curves facing the firms significantly less elastic, then the likelihood of a cartel succeeding is high. Another factor that increases the probability of success of a cartel is the similarity of cost functions among members. If the costs vary significantly, a common price may not be equally attractive and the benefit of staying in the cartel may not be the same for all, leading to the prospect of some member cheating or quitting the arrangement. How can a central agency fix the profit-maximizing output, price and sub-quotas in a cartel? If the central agency has access to the cost figures of the individual firms, then with some knowledge about the market demand curve and the corresponding MR curve, it can certainly fix the profitmaximizing output and price. First, a horizontal summation of the MC curves of the individual firms will give the market MC curve. Then, the central agency will set the price defined by the intersection of the industry MR and the MC curves. How will the agency decide on production quotas for the members? How should it divide the profit-maximizing output between the firms? For simplicity, let us assume that there are only two firms in the cartel. Their cost structure is shown in the figures below. From the horizontal summation of the MC curves we obtain the market MC curve (Figure 8.5.1). With the formation of a Cartel, the situation is similar to the multi-plant monopolist. Allocation of this output between firms A and B is determined

by equating the common MR determined with MC1 and MC2. Therefore, the equilibrium condition prevails when MR = MC1 = MC2. Hence firm A will produce Q1 and firm B will produce Q2. Fig 8.5.1 Cartels Aiming at Joint Profit Maximization

It should be obvious that the firm with the lower costs produce a larger amount of output. The total industry profit is the sum of the profits from the output of the two firms, denoted by the shaded areas in the figures below. The distribution of the profits is decided by the central agency of the cartel.

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REVIEW 8.5.1 Question 1 of 3

The central agency in a Cartel decides upon:

A. Quantity and price of the product to be produced B. Allocation of production among the members C. Distribution of profits among the members D. All of the above

Check Answer

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S ECTION 6

Case Study: The Indian Aviation Industry: Price Wars and More

There are no riders and no undercutting involved. Its all very transparent. We are targeting an entirely new passenger segment through this novel scheme. - Uttam Kumar Bose, CEO, Air Sahara, Commenting on the Steal a Seat campaign, in August 2002 EVERYONE CAN FLY THROUGH STEAL A SEAT The months of July and August 2002 witnessed unprecedented

development in the commercial aviation industry in India. For the first time in the history of the industry, efforts were made to make air-travel affordable for a larger section of the population. With air-travel fares being much higher than rail and road travel fares, the average Indian traveler rarely traveled by air. However, in these two months, the companies offering air-travel changed the market dynamics completely.

This case was written by D. Sirisha, under the direction of A. Mukund, IBS Center for Management Research. It was compiled from published sources, and is intended to be used as a basis for class discussion rather than to illustrate either effective or ineffective handling of a management situation
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The reason for the above was not very difficult to understand. Though there were only three major players in the Indian aviation market, namely Jet Airways (JA), Air Sahara (Sahara) and the state-owned Indian Airlines (IA), competition was getting fiercer by the day. Thus, when JA launched its promotional campaign Everyone Can Fly that offered special fares on select routes, industry observers commented that such a move was long overdue. Immediately, IA responded by launching its U Can Fly scheme with similar conditions as that of Everyone Can Fly. Thousands of seats were to be offered by both JA and IA between August 1 and October 31 at rates, which were comparable with rail fares. The special fares could be availed of booking at least three weeks in advance. Though JA claimed that its campaign was a move to commemorate the first flight of Wright Brothers in 1902, there were few takers for this. In August 2002, Sahara surprised its competitors and customers alike, by announcing the Steal a Seat campaign. Beginning August 26, 2002, customers could bid for 10% of Saharas unsold seats for as low as Re 1. However, customers would have to plan their journey 25 days in advance. They could bid for their destination online at a leading portal, www.indiatimes.com, or through phone, fax or e-mail. The Steal

Vide 8.6.1:on First Flight of Wright Brothers

a Seat scheme followed the already popular Sixer, Bid n Win marketing campaigns of the carrier.

As a result of these aggressive marketing strategies, fares continued to decline on a daily basis as compared to the 10% increase per annum in the past and sales increased. Airline companies semed to be happy, as it was much better to earn lesser revenues than fly planes with empty seats. However, some industry observers felt that companies took this decision out of desperation to increase the stagnating airtravert-term gimmicks as the companies would not be able to financially sustain these for long. Moreover, it would be irrational to expect travelers (especially those from the business class) to plan their travel 21 days in advance. BACKGROUND: THE INDIAN AVIATION INDUSTRY The history of Indian aviation industry dates back to the early 1930s, when one of the leading Indian business houses, the Tatas set up the Tata Airlines. There was limited activity in the field over the next two decades despite eight more private companies entering the fray. In 1953, the Air Corporations Act 1953 came into force and all the assets of the then existing nine airline companies were transferred to two corporations Indian Airlines Corp. (IA) and Air India International (Air India). While
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Air India offered international air services, IA offered domestic services. The Air Corporations Act 1953 prohibited any person or company to operate any scheduled air transport services from, to or across India. Therefore, two corporations enjoyed a monopoly status in the scheduled air transport services market. In 1962, Air India International was renamed Air India Ltd. In 1986, private airlines were allowed to operate chartered and non-scheduled services under an Air Taxi scheme. The scheme was introduced to boost tourism and augment domestic air services. The carriers were however, not allowed to publish time schedules or issue tickets to passengers. The governments aviation policy was progressively liberalized in the early-1990s. In 1993, the Air Corporations Act 1953 was abolished, which put an end to the monopoly in the scheduled air transport services market. After the abolition of the Cororations Act in 1953, there was a considerable change in the governments aviation policy. From March 1994, the market was opened to any company that fulfilled the statutory requirements of the scheduled services. The government approved eight private carriers to start domestic operations; Some of them were JA, Sahara, Indian International, Archana, East West, NEPC, Modiluft, and Damania. While Indian International was the first licensee after the open skies policy in 1994, East West was the first scheduled airline to take off the ground. In 1995, the Airports Authority of India (AAI) was formed through the AAI Act merged the National Airports Authority (NAA) and International Airport Authority of India (IAAI), the

GALLERY 8.6.1:Domestic Airlines in 1994

Source: http://gyaniz.wordpress.com/tag/ vif-airways/

separate national and international airport authorities. The AAI offered infrastructural facilities to all airlines. At this point of time, there were 449 airports. There were five international airports including Delhi, Mumbai, Kolkata, Chennai and Thiruvanantapuram, for scheduled international operations by Indian

and foreign carriers. However, by late 2000, most of the players disappeared some with short-time successes and some suffering losses from the very beginning. The reasons were aplenty lack of experience in the business, lack of proper planning and poor promoter support. According to analysts, none of the private carriers had the staying power or the professional expertise required in the aviation industry. Rasheed Jung, an aviation consultant, said, All of them, bar none, were riff-raff. All of them were financially extremely weak and almost all of them had extremely poor management. Damania, established by a poultry-farm owner Parvez Damania from Pune (Maharashtra) was one of the first private airline carriers to close down. The airline was sold to NEPC in September 1995. Since NEPC was
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already doing well in South India, by acquiring Damania, which was operating in the North India, it could expand its operations throughout the country. However, NEPC ran into problems after the acquisition when the Securities and Exchange Board of India (SEBI) revealed that the deal was an unfair trade practice. Eventually, NEPC landed in serious financial problems and the company defaulted on payments. East West Airlines was very successful initially with smart looking air hostesses, and courteous and accommodating ground staff, until rumors about East West being funded by the underworld don Dawood Ibrahim surfaced. The company fought back with an extensive advertisement campaign denying the rumors. The government enquiry also could prove nothing against it. However, the problems were far from over. The company owed $3 million to PLM Equipment as lease rentals. In addition, there was a change in the government regulations and it became mandatory for all airlines operating on Category I routes (the most profitable) to operate on Category II and III routes as well (Refer Exhibit I) which were not as profitable. East West was eventually closed down in August 1996. Similarly, ModiLuft, a joint venture of the Modi group with Lufthansa of Germany, the worlds most expensive airline, was into problems right from the start. Though ModiLuft showed book profits, it defaulted on payments to Lufthansa. And though Lufthansa agreed to invest 40% equity in ModiLuft initially, it did not actually do so1. The Modis also complained that Lufthansa did not allow ModiLuft to enter into financial agreements with others and the rates at which it offered its services was quite high. For instance, while a Lufthansa pilot cost $32,000 a

month, a Malaysian Airlines pilot cost $6,000. S.K.Modi said, Our mistake was that we hired the most expensive airline in the world to give us aircraft and services. In May 1996, Lufthansa announced that the agreement was unilaterally terminated by them. THE SURVIVORS Analysts felt that most of the private carriers ran into problems because of the government regulations and high costs of operation. All the carriers hired planes at international prices and their maintenance was also undertaken by global companies at international rates. The only Indian advantage was the availability cheap labor. However, the Indian fares were much lower compared to the global fares. For instance, European fares were almost five times higher than in India. Thus, despite the intense marketing efforts of various companies, by mid-2001, only JA and Sahara managed to stay afloat (along with IA) in the Indian market Sahara started its operations in December 1993 providing services on the Delhi-Mumbai sector. By 2001, it operated in 12 sectors with a fleet strength of 9, all of which were Boeing Aircrafts. The carrier was successful despite a small fleet and won many awards including Pacific Area Travelers Association Award (1997 & 2001), World Travel Market Global Award (1997), Diamond Award (1999) and International Food Services Association Award (1998). Sahara reported a turnover of Rs 3.5 billion in the fiscal year 2001. JA was set up in April 1992, as a 100% subsidiary of TailWinds Ltd., a company registered in Cayman Islands (situated in the
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Table 1: Market Share ( 2000-01) Airlines IA JA Sahara Airlines Market Share (%) 51 42 7 Aircrafts Owned 57 33 9

undergo several more hours of in-flight and classroom training thereafter. Because of the above reasons, the company emerged as a major competitor for IA, while Sahara remained the distant third rank player. ALLS FAIR IN THE FARE WAR As the government owned both AI and IA, the Indian commercial aviation air transport services market was monopolistic in nature. Not surprisingly, the concept of marketing was virtually absent in the aviation industry. The only advertising campaign ever run was AI that of which featured its mascot Maharaja, an elegant, plump little man, with a stylish turban and an impressive handlebar moustache. Advertising and marketing activities started only after the Indian skies were opened for private players. Initially, advertisements by the new players were limited to the print and electronic media. However, with the entry of new players in the 1990s, competition began to intensify. IA also expanded its domestic network and started foraying into international market. All the private airline companies undertook various marketing initiatives and launched aggressive and attractive advertising
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Source: IBS centre for Management research Northwest Caribbean Sea). Kuwait Airways and Gulf Air had 40% stake in TailWinds Ltd2. In May 1993, JA started its operations in India with four Boeing 737-300s and based its operations in Mumbai. In 1997, the companys promoter, Naresh Goyal, bought the stake of Kuwait Airways and Gulf Air in TailWinds for an undisclosed sum, and became the sole owner of JA. By 2001, JA had a fleet of 33 Boeing Aircrafts. JAs success could be mainly attributed to its excellent service. JA always ensured that its service surpassed customer expectations. If a flight was delayed, travelers were phoned and informed in advance. JA primary focus was on the business traveler. To attract and retain business travelers, it offered superior services. On all its flights of more than 20 minutes duration, light refreshments were served and on longer flights passengers were served non-alcoholic drinks, cold towels and a three-course meal. Every new flight attendant was at least put through three months of training in the first year and had to

campaigns. All the advertisements tried to highlight value-added services and offered attractive schemes like festive season off, frequent flyer discounts and free tickets on completion of specified miles of travel. Despite the aggressive marketing efforts by the companies, none of them was able to garner larger volumes. Companies therefore adopted various innovative marketing strategies like offering discounts, free tickets, and gifts like electronic equipment or kitchen appliances. Though these strategies were beneficial for customers, there was no significant growth in volumes. The downturn in the Indian economy during the late 1990s also affected the travel and tourism industry adversely. In April 1999, to cope with the situation, and take advantage of the potential of the peak summer passenger traffic, Sahara announced discounts of Rs 600 to Rs 1000 on all major routes. It offered Rs 1000 off on the Mumbai-Delhi route and Rs 700 on the New Delhi-Bangalore route. This triggered a price war and IA introduced a 50% off for government employees for its evening flights and also started hourly shuttle services between Mumbai and Delhi without any discounts. Though the flight timings and the far-off airport terminals were uncomfortable in Mumbai and Delhi, IAs volume increased. Analysts felt that Sahara could not exploit its discount offer completely as it had a small fleet size of four Aircrafts, which was much lesser than that of its rivals. IA on the other hand, introduced hourly shuttles on the Mumbai-Delhi route and thus, offered more seats. As JA had become known and trusted for its superior service, it chose not to offer any discounts. Instead, it

formulated a new strategy and intensified the marketing war initiated by Sahara. In August 1999, JA entered into agreement with leading hotels and announced discounts between 20-50% on room rates for its passengers flying by the economy or business class. It also offered package tours to Goa. The list of hotels included the Taj Group of hotels all over India, the Welcome Group of Hotels in Bangalore, Ooty, Chennai and Hyderabad, Hotel Hindustan International at Kolkata, Le Meridien in New Delhi and Hotel Pride in Pune. Apart from discounts on rooms, passengers were also entitled for a lucky dip, which would give them a free return ticket and a two-nights free stay at the hotel offering the discount. However, analysts felt that such schemes would not last too long as the hotels were already offering huge discounts due to their low occupancy rates. By September 1999, JA had to eventually reduce its rates. As IA was making some profits due to its lower fares, it decided to continue the discounts. Sahara and JA also seemed determined to carry on with price cuts. As a result of these price wars, fares fell down by 30%. For instance, for the MumbaiDelhi route, fares fell from Rs 5,110 to Rs 3,800 (JA and IA) and Rs 3,555 (Sahara). The price war continued till October 1999 when the fares were brought back to their original levels in the peak season. In December 1999, JA re-launched its frequent flier program called Jet Privilege (JP, initially launched in 1994) wherein passengers could earn miles by taking a JP flight. Customers were not required to pay membership fees to become members and did not have to produce boarding cards or other proof of
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travel. The new program offered three different levels of privileges: JP Blue, JP Silver and JP Gold, depending on the number of miles accrued or the number of flights flown. JP Silver and Gold members could earn bonus miles on all JA flights and enjoyed lounge access, tele check-in benefits. JA also tied up with international carriers like KLM Royal Dutch Airlines and Northwest Airlines, as a result of which, JP members could earn miles on these airline networks as well. They could redeem their miles when they had earned at least 10,000 miles or had flown 10 flights. JA also tied up with Oberoi Hotels and Resorts, and Radisson Worldwide, which enabled its members to earn miles on their stay at any of these hotels. The price reduction story was repeated in June 2001 with IA announcing price cuts on the Mumbai-Chennai, Goa-Mumbai, Mumbai-Kolkatta, Mumbai-Bangalore and AhmedabadBangalore routes. It also reduced the day return fare on the Mumbai-Delhi route and relaxed the rules by permitting passengers to take any return flight on the same day. IA also introduced Specific Flight Fares on the Delhi-Chennai-Delhi route apart from the existing Delhi-Mumbai-Delhi and MumbaiBangalore-Mumbai sectors. It also reduced the Round Trip Executive class fare on the Mumbai-Bangalore-Mumbai route from Rs 10,635 to Rs 9,165. JA followed suit and reduced one-way business class fares in four sectors including Delhi-Mumbai, Mumbai-Bangalore, Mumbai-Chennai and Mumbai-Kolkatta (Refer Table II). It also reduced the economy class fares in five sectors including Delhi-Mumbai-Delhi (Rs 10,280), Mumbai-Bangalore-Mumbai (Rs 8,160), Mumbai-Chennai-Mumbai (Rs 9,000), Mumbai-

Indore-Mumbai (Rs 5,480) and Mumbai-Kolkatta-Mumbai (Rs 12,900). Unlike 1999, when the competitors reduced prices in the same sector, in 2001, the reduction was in different sectors, which benefited customers most. However, industry watchers were doubtful whether the price reduction and promotional fares could help the companies in any way. The fare war in 2002 was the most aggressive ever with innovative offers most of which had been adopted from the global aviation market. It started in June 2002, when IA announced a 3-15% cut in fares for all classes for the western sector and the Delhi-Srinagar, Delhi-Jammu, and DelhiKhajuraho routes. The next day, JA reduced its prices by Rs 635 for the economy class on the Mumbai-Nagpur route and the Mumbai-Goa route. One of the most innovative offers (following the global aviation industrys footsteps) was the Advanced Purchase Excursion (APEX) Fares scheme, under which the passengers had to book their tickets at least three weeks in advance and they would get huge discount on the fares. IA introduced the APEX fares under its U Can Fly scheme and JA under the Everyone Can Fly scheme. (Refer Table III and Exhibit II for APEX fares). Despite the fact that planning air-travel three weeks in advance was not very convenient, the APEX scheme was very successful for both IA and JA. Anil Goyal, Commercial Director, IA, said, We have 1,600 passengers flying everyday under the Apex scheme, says Anil Goyal, commercial director of Indian Airlines, the largest player in the domestic market. This means an addition of about 10 per cent to the number of passengers
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TABLE II: JA ONE-WAY BUSINESS CLASS FARES DURING JULY 2001

Table III
Apex Fares of IA and JA for Ex-Delhi (August 2002) Ex Delhi IA Fares JA Fares New Apex Fares (IA & Jet) Mumbai Kolkatta Bangalore Chennai 5,405 6,875 8,710 8,960 6,095 6,925 8,710 8,960 3,920 2,860 5,053 3,292 4,280 4,370 6,485 6,085 2,485 2,550 3,550 3,415 3,373 3,583 4,353 Rajdhani Express (I AC) Rajdhani Other trains Express (IIAC)

Route Delhi-Mumbai, Mumbai-Bangalore Mumbai-Chennai Mumbai-Kolkatta

Old Price 8,710 6,880 8,210 11,695

New Price (July 2001) 7,680 5,375 6,650 9,585

Source: Business Line, July 9, 2001

carried during the lean season. Revenue generation and passenger load factor have also increased, he adds. We have 1,600 passengers flying everyday under the APEX scheme. This means an addition of about 10% to the number of passengers carried during the lean season. Revenue generation and passenger load factor have also increased. The APEX scheme had another inherent disadvantage which of high cancellation charges. Passengers had to lose 50% of the ticket price if the ticket was cancelled less than 21 days before the travel date.

JA also reported an increase in the number of passengers flying, after the introduction of APEX fares. Saroj Dutta, Executive Director, JA said, The average number of passengers flying on out advance purchase tickets is around 1,500 per day. That means we are selling most of the 1,8502,000 seats offered every day under the concessional window. The response is every encouraging for a new scheme which has been introduced only recently. However, Sahara seemed to have adopted an intelligent marketing strategy by offering innovative schemes rather than offering APEX fares. U K Bose, CEO, Sahara said, While the two rivals fish for railway passengers, lets tap their customer base. Therefore, Air Sahara has advance purchase offers on the Net with high discounts while going all out through the marketing network with its Sixer and Super Sixer schemes which are free of the riders that dog advance purchase fares. For a fixed sum, both schemes offer travel on six sectors, with
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no need for advance booking or photo- identity which is necessary for APEX concessions. In March 2002, Sahara launched a unique Wings & Wheels scheme in the metros Delhi, Mumbai, Kolkatta and Chennai. The scheme offered complementary air-conditioned coach services to pick up passengers at designated points in the cities and drop them at the airport. The coaches also dropped passengers from the airport to certain locations within the city. The coach also had attendants and offered add-ons like magazines, newspapers, mineral water, soft drinks, and other refreshments. During July-August, it launched the Sixer offer, a limited offer scheme for all passengers, which enabled the passengers to buy a six-flight coupon ticket and fly any six sectors on the carriers network for Rs 25,000. The validity of the ticket was till December 2002. U.K. Bose reported that tickets under the Sixer offer sold like hot-cakes and explained, When it comes to the crunch, passengers will realize that unrestricted travel is more useful even if the tariffs are a bit higher. Analysts felt that the scheme was successful because of the flexibility it offered. If one planned properly, the tickets would work out less than the APEX fares offered by IA and JA. On July 21, 2002, Sahara also rolled out a new scheme Crickcitement, with an investment of Rs 250 million. The captain of the Indian Cricket team, Sourav Ganguly was chosen as the brand ambassador for the campaign. The campaign planned to use cricket as a tool to connect people and encourage them to travel by the airline. The campaign was also expected to promote destinations connected by the airline.

Under the campaign, a flyer (any class) had the opportunity to win a wide range of gifts (including a luxury car) everyday. U.K.Bose explained, Realizing the craze for cricket among Indians, we thought it would be appropriate to induce them to travel and get maximum benefits. The Crickcitement is an initiative to promote not only cricket but also tourism coupled with prize-winning schemes, which are simple, as there is no question or slogan to be answered. Hence, passengers can win one million prizes including a Rs 250 million Timber Chalet at Sahara Lake city, Amby valley Lonavala (Mumbai), an E-class Mercedes, Plasma TVs, Pentium 4 computers, fully expense paid tours to watch India play at Sri Lanka, New Zealand and South Africa. In early August 2002, Sahara launched the Bid n Win scheme, which aimed at making the journey more exciting, interactive and enjoyable. The money generated from the scheme was transferred to the Sahara Welfare Foundation, a fund dedicated to social causes. Passengers on board could bid a wide range of gifts categorized as A and B. The base price for category A and category B items was Rs 150 and Rs 50 respectively (Refer Exhibit III). However, what shocked industry observers most was Saharas Steal a Seat online bid scheme in August 2002. Under the scheme, the base price for the tickets was kept at Re 1, and the scheme was open for passengers flying 25 days later. For unsuccessful bidders, there was another scheme called Steal Buys scheme under which they could bid 24-15 days in advance at a reserve price, which could work out much cheaper than the APEX fares offered by IA and JA. Sahara also offered the Delhi-Mumbai ticket for Rs
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4,000 if it was bought between 15-19 days in advance, whereas IA and JA charged at Rs 5,535 and Rs 5,405 respectively for the same time period. On August 15, 2002, IA launched the scheme Wings of Freedom, valid from August 15 to March 31, 2003. This scheme offered unlimited travel on the domestic network for seven days for Rs 15,000 (economy class) and Rs 20,000 (business class). The airline also planned to increase the commission of its agents and offer incentives for the most productive agents. At the same time, it also launched the Bharat Darshan (India tour) which allowed unlimited travel for passengers who bought tickets worth more than Rs 80,000 was also launched. Moreover, while IA and JA were expected to revert to the original prices at the end of the lean season, i.e., October, many of Saharas schemes would stretch till the year-end. THE WAR CONTINUES Industry observers remarked that the most interesting feature of the price war in 2002 was that Sahara, the smallest of the Big Three, was the most aggressive. Apart from launching the novel bid schemes, it also offered the highest agent commissions to increase volumes of the tickets sold, while maintaining the lowest fares. Analysts felt that this was because it had the smallest capacity among the three. However, Sahara increased its capacity in late 2001 and planned to lease about 6 additional Boeing 737s towards the end of 2002.

With increasing competition, the government owned IA also decentralized its fare revision policy, i.e., it allowed its regional heads to take their own decisions regarding the fares. Though IA claimed that the number of passengers had increased in 2002, analysts expected that the number would reduce. In 1996-97, the total number of airline passengers was 11.4 million, which fell to 10.5 million in 1998-99. In addition, it seemed doubtful whether the airlines would be able to attract railway passengers for long as the railway fares had come down in 2002. Though the fare war was not expected to end very soon, analysts remarked that it would affect the financial stability of the private carriers in the long run. While IA owned the Aircrafts and was funded by the government, both the private carriers survived on leased Aircrafts. This lowered their margins and made it difficult for them to sustain these costs in the long run. Some analysts felt that it was too early to predict the impact of the price war. Though the number of passengers had increased in 2002 as compared to 2001, it was mainly attributed to school holidays and increase in the number of business travelers. JA reported that its load factors remained at a sluggish 65%. A senior official of JA explained, The decision to lower fares was taken in view of companies cutting back on travel expenses and even CEOs travelling at the back of aircraft. The official added, It was too early to draw a comparison on how the downward revision had impacted the airline as the revised fares had come into effect from July 1. Meanwhile, IA for a change, seemed to be focusing more on its in-flight customer service initiatives rather than price-cuts to
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sustain the intensifying competition were taken. In August 2002, the state-owned carrier decided to use superfine bone china crockery to replace the melamine ware for the economy-class passengers and replace the crockery used for the upper class with a new elegant design. Company sources claimed that this was done to improve IAs image amongst its customers. However, since JA had always used bone-china crockery in both economy and upper classes, how far would this move give IA an edge in the air-wars, still remained to be seen. QUESTIONS FOR DISCUSSION: 1. Describe and analyze the evolution and structure of Indian aviation industry over the decades. Also, provide reasons for the failure of several companies in the initial phase of deregulation? What are the factors that have contributed to the industry rivalry? 2. Enumerate the customer service initiatives adopted by JA and Sahara to gain significant market share against a formidable competitor, IA? What strategies should IA adopt to retain its position in the market? 3. Examine the innovative schemes initiated by the three airlines in 2002. Do you think that the promotional programs undertaken by airlines are likely to increase the customer base and contribute to corporate viability? Is the intense rivalry exhibited through price-cutting (by industry participants) undermining their viability in the long run? 4. What strategies would you suggest for an airline company in the Indian aviation industry to enhance

market share and increase user base? Which airline, according to you, is better positioned to extend its competitive advantage and enlarge its market share in the near future?

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Footnotes 1. The airline was in financial problems with 12 Boeing air crafts lying idle at that point of time. 2. In 1997, Goyal bought the 40% stake for an undisclosed sum and became the sole owner of JA.

Additional Readings & References: 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. Summer Specials Sahara Triggers Fare War, Financial Express, April 15, 1999. Jet Airways Fires Another Salvo in Air War, www.domain-b.com , August 10, 1999. Indian Airlines to Continue With Discounts, www.domain-b.com , August 13, 1999. Indian Airlines Cheaper, Business Line, July 1, 2001. Phadnis Ashwini, Will Airlines Soar on Slashed Fares?, The Hindu BusinessLine, July 9, 2001. Subramaniam G Ganapathy, Airline Discounts Make Customer the King, Economic Times, August 11, 2002. Subramaniam G Ganapathy, Fasten Your Seatbelts for Some Fare Deals, Economic Times, August 16, 2002. Saxena Neeraj, Fare war: Air Travel to be a Steal Quite Literally, Economic Times, August 18, 2002 www.indiainfoline.com www.jetairways.com www.airsahara.com www.civilaviation.com

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S ECTION 7

Case Study: Yes Bank Competitive Strategy of a Late Entrant

One of the strengths and differentiating features of Yes Bank is its knowledge banking approach. Our approach is service-oriented; we offer what is missing in the marketplace. We offer choice and convenience to customers (to enhance their banking experience).1

Rana Kapoor, Founder, Managing Director and CEO, YES BANK. [Rana Kapoors] aim is to break the stereotype image of banks and bankers. There is, of course, all the seriousness that goes with managing other peoples m o n e y. P r u d e n t

This case was written by Adapa Srinivasa Rao, under the direction of Debapratim Purkayastha, IBS Center for Management Research. It was compiled from published sources, and is intended to be used as a basis for class discussion rather than to illustrate either effective or ineffective handling of a management situation.
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management, new technology, skilled people. Good corporate governance, top quality service. Plenty of social involvement. But there is also an emphasis on conveying the message that banking is not merely a set of cold hi-tech assemblages and serious-looking bankers.2 The Week 3, May 22, 2005. SAYING YES TO DIFFERENTIATION In December 2006, YES BANK (Yes Bank) was rated the third best bank in India by Business World in its annual survey of listed public and private sector banks in the country. It was also ranked second among the new private sector banks in the Financial Express-Ernst & Young survey of Indias best banks for the year 2006 published on March 28, 2007. Yes Bank had experienced unprecedented growth in the Indian banking sector since it started operations in late 2004. This was a significant achievement for a bank which had started late when compared to other new age private sector banks. When Yes Bank announced its decision to enter the Indian banking space in the mid-2000s, industry watchers were skeptical about the move as they felt that the market was already overcrowded. But soon after starting operations, the bank caught the attention of analysts as well as its competitors with its highly differentiated strategy. The bank differentiated itself from other players in the industry through its unique knowledge banking approach, emphasis on technology, and human resources. The knowledge banking approach was its main pillar of differentiation and using this it provided specialized services to various sunrise industries

through domain experts. It also used the latest technology available in the industry to provide highly innovative solutions. Its strategy of outsourcing information technology (IT) infrastructure to proven experts in the field not only helped it to provide superior service to its customers but also to reduce costs and focus on its core business activities. Recognizing that human resources were a source of sustainable competitive advantage, it strove to differentiate itself from its competitors by adopting some winning HR practices. Several new initiatives like giving the employees the freedom to work in the field of his/her own specialized interest and the independence to take initiatives with regard to his/her ideas were especially noteworthy. Analysts attributed the banks fast ascendance, despite its late entry into the market, to its innovative strategies. Unrelenting efforts to provide world class services coupled with a steadfast maintenance of operational standards were the prime reasons for the banks phenomenal growth. The growth was even more impressive considering that it came at a time when the banking sector was on the verge of a consolidation phase and a big question mark hung over the future of the smaller players in the sector. The bank had been able to carve out a niche for itself in the increasingly commoditized sector through its differentiation strategy, they said. Yes Banks founder, MD and CEO, Rana Kapoor (Kapoor), said that the bank had grand plans for the future. Our mission is to build the finest quality brand in banking. We dont want to be a production factory. We want to be good distributors,3 he said. Though the bank had made an impressive entry into the market, analysts felt that it still had a lot to prove. The success
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achieved by the bank in the short term had to be replicated in the long term for it to be viewed seriously, they said. Yes Bank had to achieve this in the face of intense competition from more established public sector banks and private sector banks. Foreign multinational banks were also waiting eagerly for the sector to open up further in 2009 to make a major foray into India. BACKGROUND NOTE Reforms in Indian Banking Sector As part of the economic reforms it started in the early 1990s, the Government of India (GoI) embarked upon reforming the financial sector of the country. A sound financial sector was the key to the growth of the economy and banking was considered the lynchpin of the financial sector in any economy. The country was then dominated by the public sector banks which had nearly 83 percent of the banking business in their hands.7 The reforms in the financial sector were based upon the recommendations of the Narasimham Committee. Many important reforms were undertaken in the banking sector which included better disclosure norms for the banks, deregulation of interest rates, more functional autonomy to the boards of public sector banks, avoiding of pre-emption in the form of high reserves, availability of credit to targeted sectors, and setting up of debt recovery tribunals. As part of the reforms in the banking sector, several new private sector banks were set up in the country to introduce more competition and improve efficiency in the sector.

Some of the important private sector banks set up in the wake of the banking reforms were ICICI Bank, HDFC Bank, and UTI Bank (now Axis Bank). They started operations in 1994. All these new banks were given relatively easy approval to enter the sector. Another significant feature was the reverse mergers of the private banks with their promoters, mostly Development Financial Institutions (DFIs). The motive behind these reverse mergers was to achieve benefits of scale and to move toward Universal Banking where the banks would become financial super markets providing all the financial services like insurance services, investment advice, etc. Another important aim of the reforms in the banking sector was to increase the penetration of the banking services and to make them available to a larger percentage of people. The results of the reforms in the banking sector were impressive. The new generation private banks revolutionized the sector. Several technological advancements like the Automated Teller Machine (ATMs) were introduced; there was also an improvement in the financials of the banking sector. The capital adequacy of the Indian banks came on a par with international standards. The share of the Non Performing Assets (NPAs) as a share of gross advancements went down significantly, increasing the profitability of the banking sector. The other significant outcomes were the increasing recognition of the employees as strategic assets and the increase in the operational efficiency of the banks. After the successful implementation of the first phase of the financial reforms, the GoI constituted the second Narasimham Committee in 1997 to recommend further reforms in the banking sector. The Narasimham committee submitted its draft
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report in April 1998. The committee recommended further improvements in the banking sector. Some of the recommendations were: reducing the governments stake in the Public Sector Banks to less than 51 percent to further improve their efficiency, improving credit facilities to rural areas, reducing NPAs to 3 percent, increasing the capital adequacy norms to 10 percent, reducing the higher rates of interest, giving more importance to priority sector lending, etc. The second phase of the banking reforms was in the implementation stage as of 2007. In addition to the various public and private sector banks, there were also a number of cooperative and rural banks in India. Foreign multinational banks had also brought in service aspects that had forced the other Indian banks to tighten up. The foreign banks were, however, handicapped by the fact that there was a limit on their expansion as the sector had not been opened up fully. However, Video 8.7.1:Yes Bank the Reserve Bank of Indias (RBI) new rules in 2005 gave the foreign banks a glimmer of hope as it pledged to open its banking market further after 2009.13

Yes Bank
Yes Bank was incorporated in November 2003 and started its financial operations in September 2004 in Mumbai as a registered private sector bank in India.5 The founders arrived at the name Yes Bank through marketing research. We spoke to three advertising agencies and shortlisted five names. We also had professionally neutral names like My Bank and Octra. In a qualitative survey, we were surprised that Yes as a financial brand name clicked.... We wish to develop a service culture that should have the ability to say yes. The occasional no has to be done in a prudent manner,6 said Kapoor. The bank was promoted by Kapoor and his brother-in-law Ashok Kapur (Kapur) with financial assistance from Rabobank . Kapur and Kapoor together owned 52.5 percent of the initial promoters equity of Rs 20 million. Kapoor had a banking experience of nearly 25 years and had worked as the CEO and MD of Rabo India Finance Private Ltd., a subsidiary of Rabobank. He had had previous experience with Bank of America and was well known in the Indian banking sector. Kapur too brought in a wealth of experience in banking. Among others, he was ABN Amro Banks first Indian and Asian Country head. Yes Bank was also co- promoted by global private equity institutional investors such as CVC Citigroup, AIF Capital, and ChrysCapital. While the Indian promoters had a 39 percent stake in the bank, Rabobank had a 20 percent stake, and the foreign institutional investors held 18 percent. Kapoor was instrumental in having a good top management team in place. In May 2004, the bank obtained
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the only Greenfield license issued by the RBI since the mid-1990s, and this was largely because of the promoters professional track record.7 The bank went public in June 2005. Through this initial public offering (IPO), the bank raised Rs. 31.5 million. The IPO was so successful that it was over-subscribed by about 30 times.8 Being a relatively late entrant into the Indian banking arena, Yes Bank sought to differentiate itself by offering a new value proposition. According to Kapoor, Yes Bank was a knowledgedriven bank that sought to differentiate itself with its service orientation, technology, and human resources. I think we are a differentiator for emerging India, the small and medium enterprises, where there is a terrific development taking place.9 Rather than expanding very quickly, the bank focused on niche segments of customers. Its aim was to establish itself as a knowledge-based and technology-driven bank that would cater to the needs of the emerging Indian economy. Unlike many of the private sector banks whose focus was mainly on retail banking, Yes Bank focused on corporate banking by offering specialized services to corporate clients. This was in part due to the fact that the retail banking space had already been well covered by some other new generation private banks, which had started a decade earlier. The bank carved a niche market for itself in specialized corporate services like mergers and acquisitions, financial restructuring, currency risk management, etc. It also focused providing wealth management solutions to affluent customers. It was much later that it forayed into retail banking (Refer to Exhibit I for Yes Banks business segments).

Despite being a late entrant, Yes Bank established itself as one of the most efficient banks in the country by adopting international standards for the quality of service provided to customers and through its operational efficiency. As of October 2007, it had 60 branches spread across India and its balance sheet had swelled to Rs. 1,300 million within a span of just three years.10 (Refer to Exhibit II for audited financial results of Yes Bank) DIFFERENTIATING ITSELF IN AN OVERCROWDED MARKET According to industry experts, Yes Bank was entering an overcrowded market dominated by public sector banks such as the State Bank of India (SBI) and private banks such as ICICI Bank and HDFC Bank. In addition, there were many cooperative banks and foreign multinational banks. Moreover, many of the product lines of these banks had become commoditized. Some experts questioned the rationale of Yes Banks promoters decision of entering the Indian banking arena so late, particularly when the market had so many established players.11 The founders were, however, unperturbed by these criticisms. Yes Banks chairman, Ashok Kapur, said, The market is overcrowded if all you can think of is Nariman Point. As for the commoditization point, the fact is that you do not run a new business with old ideas. In that case you are finished even before you start out. It is time we had new ideas on the service side, credit side, and the hedging side.12 Yes Banks promoters contended that being a late entrant had its advantages. Kapoor pointed out that entering about ten years after the other private sector banks had given it the
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benefit of coming into the market with a technology advantage. With this advantage, the bank would be able to provide better service to its clients. Kapoor said that despite the fact that there were a number of banks in India, there were significant gaps in the market in terms of service and the new entrant intended to bridge these gaps. The promoters believed that they had timed their entry into the market well. This is possibly the best period for growth, with loan books showing a 30-40 per cent growth and deposits growing at 18-20 per cent,13 said Kapoor. The bank believed that it had an edge over other players in what it called the knowledge driven approach. This involved experienced professionals providing specific solutions to clients in their area of specialization. The bank also believed in differentiating itself by harnessing the power of IT, by using it as a key tool to provide solutions to meet customers needs. Also, it laid stress on skilled human resources. Some experts felt that focusing on a niche market would help Yes Bank differentiate itself in the crowded marketplace. Vishwavir Ahuja, Managing Director and CEO, Bank of America, said, As far as Yes Bank goes, if they can combine domain expertise with delivery and are ready to go tap emerging companies, the sunrise and agrirelated sectors, and can top all of this with good risk management systems, then yes, they do stand a chance.14 Knowledge Banking Yes Bank decided to follow an innovative approach to break into the heavily cluttered Indian commercial banking space. The bank followed a first of its type approach called knowledge banking - a unique method of acquiring customers and

retaining them. The bank provided specialized services to the emerging sectors of the economy through a better understanding of its clients businesses and industries. The bank focused on providing the customers with specialized banking services depending upon their requirements. It identified some sectors of the economy which had good growth prospects. These sectors were: Food & Agribusiness, Life Sciences, Telecom, IT, Infrastructure and Media & Entertainment (Refer to Box I for parameters used by Yes Bank in choosing the focus sectors). The bank aimed to provide niche banking solutions to these emerging sectors through industry specialists. This it achieved by employing people who had experience in these key sectors. The banks branches were staffed with employees who had an educational background in engineering and management. People who were employed as knowledge bankers were generally past employees from the middle and senior levels in various industry segments with a good amount of experience. Yes Bank realized that this would help it to understand the commercial activities of the client better, to understand their needs, and to ensure that it spoke the language of the clients.

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Some of the areas in which the bank offered specialized services through the constitution of specific banking groups were: Food and Agribusiness: India being an agrarian economy, a major section of its population still depended on agriculture. The food and agri business held much promise due to the emergence of organized retail. Food items and groceries had a major share in organized retail. Specialized knowledge and advisory resources were needed for entrants into this hitherto virgin sector. The food and agribusiness strategic advisory and research team formulated by the bank worked in coordination with the GoI as well as industry clientele. The activities of this group included publishing knowledge reports on specific areas, assignments with the GoI and the corporate sector in project implementations, industry associations and partnerships, etc. Infrastructure Development: With the explosive growth of the economy, infrastructure would be the key force in augmenting the growth of the economy. The private partnership was growing in the sector, which had been dominated by the GoI until then. Build-Operate- Transfer schemes and public private partnerships of both the government and private organizations were the norm. Y es Bank provided various fi nancial services to the organizations in infrastructure development projects. The experienced team at Yes Bank specializing in the infrastructure sector provided advice right from project conceptualization, providing syndication and joint venture agreements with global as well as domestic financial intermediaries. The advisory services continued into the project

implementation phase with advice being given on risk mitigation and project control. Life Sciences and Biotechnology: Life Sciences and Biotechnology was considered one of the highly knowledgeintensive sectors. The main target segments in this sector included pharmaceuticals, health care, medical equipment, nutrition and natural products, and biotechnology. By providing specialized services to this sector, the bank hoped to become its preferred financial partner. One of the major requirements in this sector was networking with international organizations through tie-ups and collaborations. For instance, Yes Bank was appointed as the exclusive strategic and financial advisor to the GoI for a Biotech and Life sciences park project in India.15 Telecommunications: Telecom was one of the greatest success stories of the economic reforms in India. The industry was growing at breakneck speed after several changes in government policy and consolidation in the sector. Yes Banks employees with specialized knowledge in the telecom sector helped in providing specialized services to companies in this sector. Information Technology: The IT sector had been the fastest growing sector in the recent past in India. The sector, with three-fourth of the revenues in the form of foreign currency, and its globe-trotting professionals needed a specialized and non-traditional form of banking services. Yes Bank focused mainly on some of the segments of the IT industry like IT services, IT products, IT and Telecom Hardware, and ITenabled services like business process outsourcing (BPO) and knowledge process outsourcing (KPO).
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Media and Entertainment: The media and entertainment industry was one which needed specialized banking services. Yes Bank provided specialized services to the media and entertainment sector in the fields of content production, content distribution, and infrastructure. The media and entertainment group provided services in the fields of strategic advisory services, fund raising, direct financing, and wealth management services to the organizations as well as to individuals in the sector. Real Estate: The real estate industry sector was growing by leaps and bounds with the increase in the demand for commercial space as well as the easy availability of consumer loans in the real estate sector for individuals. The realty group in Yes Bank provided specialized services in the field of advisory services and financing for real estate projects. As part of its strategy, Yes Bank wanted to take charge of the full supply chain of the industries it had short-listed. Kapoor felt that these industries were the emerging India and said that the bank intended to grow with these industries. Kapoor explained, We plan to build strongly on our knowledge banking strategy, which will be critical in the days ahead when our country will be strengthening its knowledge-based economy. Our strategy is to create complete quality in the bloodstream of the bank.16 Technology Yes Bank was founded with the aim of providing world-class customer services to customers using the latest technology available to the industry. The bank considered technology as a strategic tool to realize this aim and to differentiate itself from its competitors. Srikrishnan H (Srikrishnan), executive director of the bank, said, We have made a calibrated decision to invest in the

best IT systems and practices in order to make its technology platform a strategic business tool for building a competitive advantage.17 Yes Bank had the latest technology using the modern IT solutions available in the banking sector. It provided multiple technologyenabled channels in order to provide customers with convenient access to the bank. The latest such technology enabled channels provided by it included Corporate Internet banking, ATMs, Mobile Banking, and Phone banking to help customers manage their businesses efficiently. Yes Bank had partnerships with many reputed technology service provides to provide multi product solutions customized to the customers needs. An example of the specialized services was providing customized check books to customers to meet specific orders and requirements. Yes Bank also entered into strategic partnerships with Gartner Inc. to formulate and implement the banks IT policy, and with PriceWaterhouseCoopers to facilitate the conformation of policies and processes with ISO and Six Sigma norms. Another strategic partnership was with i-flex solutions ltd. It used FLEXCUBE, a universal banking solution software, as its core banking system for retail as well as corporate banking. Yes Bank used FLEXCUBE to provide key banking solutions to its customers. The bank believed in outsourcing activities which were not part of its core competency and to focus on core tasks to achieve its objectives. Being a late entrant we are converting the delay into an opportunity. Now that we have capable service providers who provide time-tested mature technology and processes, we aim to provide an integrated solution approach to the IT needs of the bank... We also looked at outsourcing to contain costs, mitigate risks by allowing a specialist to do the job, and insulate ourselves
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from the HR challenges of building a complete IT organization,18 said Srikrishnan. Yes Bank entered into a total outsourcing deal with Wipro InfoTech in December 2004, under which Wipro InfoTech would own, install, and operate all the IT assets of the bank. Yes Bank outsourced the entire technology requirements to Wipro InfoTech by entering into a seven-year contract with it.19 As per the deal, the total installation and Strategy maintenance of the YES Bank: Competitive of a Late Entrant firms technological requirements would be handled by Wipro technology and As processes, aim to provide an integrated solution approach to the IT needs of the InfoTech. justwe mentioned, the main reason for the complete bank We also looked at outsourcing to contain costs, mitigate risks by allowing a specialist to do outsourcing of the IT activities was for the bank to focus on its the job, and insulate ourselves from the HR challenges of building a complete IT organization,39 core business of providing financial services to customers. Yes said Srikrishnan. 40 Bank six critical areas related to technology Yes Bankfocused entered into a on total outsourcing deal with Wipro InfoTech in December 2004, under to which Wipro InfoTech would install, and operate all the ITBox assets II of the bank. Yes Bank establish and run aown, new bank (Refer to for critical areas outsourced the on entire technology requirements to Wipro by entering into a seven-year identified the technology front byInfoTech Yes Bank). 41
contract with it. As per the deal, the total installation and maintenance of the firms technological requirements would be handled by Wipro InfoTech. As just the main reason the The bank was determined to make amentioned, difference to thefor already complete outsourcing of the IT activities was for the bank focus onItits core businessto of use cluttered commercial banking space intoIndia. intended providing financial services to customers. Yes Bank focused on six critical areas related to cutting technology to make its II branches and offices technology edge to establish and run a new bank (Refer to Box for critical areas identified on the wire technology front by Yes Bank). Box II

free. The bank used some of the latest wireless advances WiFi in its branches to achieve better connectivity. WiFi offered both excellent speed as well as freedom from wires. On the technology front, another important aspect the bank focused on was providing proper security to the transactions performed by the customers on the banks network. Some of the other companies with which the company entered into a strategic partnership regarding technology were Cash Tech and Murex to provide tailored services to specific chosen sectors of the economy. Yes Bank, which considered itself a pioneer in total IT outsourcing in the Indian Banking Financial Services & Insurance (BFSI) segment, felt that it had been successful in its objective of delivering a complete banking platform comprising Core Banking, Integrated Treasury & Risk Management Solution, Internet Banking for Retail and Corporate, ATMs & Switch, etc., in a very short time-frame.20 The bank also received major awards on the technology front. For instance, in 2006, it received the National Association of Software and Services Companies (NASSCOM) award for IT Innovation in Emerging India. It also won the award for Technology Innovation from AC Nielsen.

Critical Areas Identified on the Technology Front by Yes Bank

Achieving a high level of efficiency through the automation of operations Maintaining centralized databases and centralized processing for speedy retrieval of data Connectivity with customers and external agencies to provide a consistent experience at various touch-points Using the best systems for seamless integration of front, middle, and back offices Adopting the best surveillance and security systems to provide a better comfort zone for users of the banks systems Using real time environment for good disaster recovery process and back-up systems
Source: www.yesbank.in.

Human Resources
Yes Bank believed in using the human resources of the organization as a strategic asset. It believed that the only way the bank could achieve a long-term competitive advantage over its competitors was through highly efficient human capital. The bank recruited and nurtured talent for the long- term success of
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The bank was determined to make a difference to the already cluttered commercial banking space in India. It intended to use cutting edge technology to make its branches and offices wire free. The bank used some of the latest wireless advances WiFi42 in its branches to achieve better

the organization. The main objectives of its HR policy were to emerge as one of the best employers in the country and as the most preferred recruiter in the banking sector. Retaining talented employees in the organization was also one of its main focuses because of the huge scarcity of talented employees in the financial services sector. Initially, when the founders were putting together a top management team they leveraged on their professional stature in the industry. Yes Bank commissioned senior-level recruiting to Kom Ferry, but Kapoor involved himself in the process from a very early stage to explain his vision to potential recruits.21 The pedigree of the top-level team developed by the founders helped the company earn the confidence of the market. After that, Yes Bank took several initiatives in HR strategy to improve the performance of the organization. It followed a performance management process that aligned the goals of the individual with those of the organization and enabled them to work in perfect synergy. The aims of these innovative performance management practices were to encourage the employees to think innovatively and to inculcate professional entrepreneurship in them to make the shareholders and themselves prosperous. The bank had a 5 percent executive ownership clause, which was the first such in the banking sector. The logic behind this initiative was that employee ownership would lead to the success of the bank. Yes Bank paid its employees more than the industry average in order to hire highly talented people. Some of the key initiatives that the bank took in the area of Human Resources Management were:

Yes Entrepreneur in Action: This program helped the employees of the bank to take a break from regular work and to focus on a project of his/her interest. This resulted in the employee focusing on a specific project to deliver specific results to the organization. This helped in the employee achieving his/her goals in the organization for the year. Yes-Professional Entrepreneurship Program (YPEP): YPEP was the talent management initiative of the bank. This program focused on developing the talents of the people working in the organization. The aim of the project was to ensure that the bank had the best managers in the middle and upper levels of the management to implement its various strategic initiatives. Yes-Retail Entrepreneurship programme (YREP): YREP was yet another talent management program initiated by Yes Bank. This program aimed to inculcate cutting edge skills in the employees in the latest developments of the sector to meet the banks future requirements. Yes Bank expected this to give it a big competitive advantage over its competitors. Yes Mentor: Yes Mentor was another important initiative in the banks Human Resources program. Yes Mentor involved assigning a senior and dynamic employee as a mentor to a new employee. This helped the new employee to understand the organizational environment and the goals of the organization. Yes School of Banking (YSB): The Yes School of Banking was modelled on the lines of some of the centers of learning promoted by the corporate sector. YSB was incorporated to create a center of excellence for providing training in banking and other related financial services in the country. The institute
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was modelled on the values of Yes Bank to recruit and nurture the best talent in the banking sector. Some experts termed it as the best talent management initiative undertaken yet in the banking sector in India. Yes University and School Relations: With recruiting meritorious students directly from university campuses becoming the norm, the banks University and School Relations program focused on maintaining good relations with the university/schools to recruit students for the bank. This partnership went to the extent of preparing specialized courses for the sector to meet the banks specific requirements. The program also focused on reverse contribution to the academia by giving access to the universities through internships to the students. The internships gave these budding professionals corporate exposure. Yes Bank contended that its innovative HR strategy would help it differentiate itself as its employees would provide superior service to its customers. The banks HR strategies won major awards including the Continuous Innovation in HR Strategy award at TheIndiatimes Mindscape Employer Branding Awards 2007 held in January 2007 in Mumbai.22 It also received the Most Innovative Recruiting and Staffing Program award at the Recruitment & Staffing Best in Class (RASBIC) Awards 2006, and the Organization with Most Innovative HR Practices award at the Global HR Excellence Awards, as part of the Asia Pacific HRM Congress 2007 held in February, 2007 in Mumbai.23 According to Kapoor, the banks focus on developing its human capital had paid off handsomely. He said people from more established banks were joining the bank not due to the pay hike but because of the opportunity to work with a Greenfield bank

which would become a case study on professional entrepreneurship banking.

Promotion
Yes Bank also differentiated itself in the way it promoted itself. It did not bank too much on advertising and went in for a management led client acquisition for corporate and wealth management clients. It also strove to provide a delightful banking experience to the customers through the layout of the branches and other service aspects. Kapoor explained, As you enter there is a technology bay with a human texture, done through a lot of wall effects and flooring. We are probably the first bank to have a chief marketing officer. A roving ambassador ensures that anybody walking in gets immediate personal attention... We are putting investment officers, insurance officers, and mutual funds salesmen in the branches so that there is complete service. Then there is the private banking lounge24. In its introductory TV ads, the bank showed the growth stages of the money plant, Scindapsus Aureus. According to the bank, the plant derived its name from the Roman word Aureus (gold coin). The plant, believed to bring wealth and happiness, was used by the bank as a metaphor for ideas getting realized.25 A perennial climber, it symbolized the banks commitment to growth. The print ad too had this theme, unlike the ads of other banks which showed the smiling faces of customers, and had an uncluttered e f f e c t . T h e a g e n c y b e h i n d t h e c a m p a i g n , Tr i t o n Communications, said, The money plant as a symbol adequately met our needs. There was no need for a human face. It also differentiates the commercial from the
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competition.26 As part of the campaign, 8,000 potted money plants were gifted to the banks clients. The bank continued this activity and instead of sending diaries, calendars, or sweets to its clients on various occasions, it gifted them with a potted money plant. Yes Bank planned to launch radio, outdoor, and online ad campaigns in the future. The bank also had plans to focus on educating the customers on risk issues. It planned to organize open house forums to achieve this. THE GROWTH STORY The bank had grown at a tremendous pace since its inception. In the first two quarters since it began operations in (2004-2005) its balance sheet was standing at Rs.1,300 million, which made it one of the most successful ventures in India. The bank started its operations with just 250 employees and two branches. As of October 2007, it was operating with 60 branches and 3,263 em ployees.27 The banks business size was Rs. 800 million in December 2006. This was significantly higher than the growth reported by other private sector banks with the same background (Refer to Table I for Yes Bank: the growth story). Initially, almost the entire emphasis of the bank was on lending to corporate clients, the next focus area being wealth management.28 The bank focused mainly on Business Banking and Small and Medium enterprises (SMEs) for its growth. Later it forayed into retail banking and by April 2007, it had a base of 25,000 customers. Corporate and institutional banking still contributed 70 percent of its total business.

In December 2006, Yes Bank was rated the third best bank in India in Business Worlds annual survey of listed public and private sector banks in the country and the second best among the new private sector banks in the Financial Express-Ernst & Young survey of Indias best banks for the year 2006 (Refer to Table II for top ten banks in India: 2006, and Table III for top five new private sector banks in India: 2006).

e In addition to this, the bank achieved many awards and recognitions in this relatively short timeframe (Refer to Exhibit III for a list of awards and recognition received by Yes Bank). The market cap of the bank had grown from Rs.164.2 million in July 2005 to Rs.424.3 million in February 2007.29 This was indeed a great achievement for a bank that had entered the Indian banking scenario so late. Kapoor said, We have been able to achieve this growth through four instruments: a focused business strategy and entrepreneurial leadership, highly rated employees, best-in-class processes, and evolutionary technology.30

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Table II Entrepreneurial LeadershipTop Ten Banks in India

Top Ten Banks in India Rank 1 2 3 4 5 6 7 8 9 10 HDFC Bank ICICI Bank Yes Bank Indian Overseas Bank Kotak Mahindra Bank Punjab National Bank Andhra bank Corporation Bank Allahabad Bank UTI Bank (Axis Bank) Top 10

A SUCCESSFUL MARKET ENTRY According to the analysts, the banks competence in terms of using high-end technology, its knowledge banking approach, and emphasis on highly qualified human resources helped it to differentiate itself from other private banks in an increasingly commoditized market. In particular, its knowledge banking initiative drew a lot of interest. The fact that the bank catered to a niche segment of the market with a differentiated strategy meant that it did not have to compete with other banks on price. Moreover, it had the opportunity to cross-sell a number of its financial products and services to this niche.31 Analysts felt that Yes Bank had timed its entry into the market very well. The first few private sector banks that began their operations in the mid-1990s had to suffer in the high interest regime that had been necessary to contain inflationary pressures in April 1995. At that time, the new private sector banks had liquidity problems as borrowers paid more than 25 percent interest on loans, and call money rates had crossed the 100311

Yes Bank rank on various parameters Profitability-6 Efficiency-1 Safety-1 Size-32 Valuation-3 Growth-1

Adopted from Businessworld, December 4, 2006

percent mark. Though the demand for credit was high, these banks had to be very careful in giving out loans as default rates were high. The situation had changed a lot since then, and by the time Yes Bank started its operations, the retail boom had also started in India. Industry watchers were impressed by Yes Banks business model. It was somewhat similar to that of the foreign multinational banks which relied on a steady flow of fee income, and as such, it competed primarily with such banks. Kapoor had himself openly said in the past that Yes Bank benchmarked itself against UBS AG32 This was an advantage for the bank in the initial years as the foreign banks in India were somewhat handicapped by the limit placed on their growth till 2009. However, some analysts were concerned that the bank was growing too fast. This was a concern as bad loans too increased with the demand for credit increasing. Many banks had suffered due to this. S S Tarapore, a renowned economist, said, The banking system is going berserk in giving credit... The bad loans will come once the music stops.33 But others such as Ernst & Youngs Director, Viren H Mehta, felt that this was not a cause for concern as long as the company increased its share of current and savings accounts (CASA) and expanded its branches in line with its projections. According to him, business confidence in India was at an unprecedented high and the trend was expected to continue for another 15-20 years. OUTLOOK The high growth rates of the Indian economy provided tremendous opportunities for the Indian banking sector. The

future also posed several challenges as the banking sector was set to open up to the foreign players by 2009. The banks were gearing up to face the competition. In tune with the developments, Yes Bank wanted to grow into a major bank in India with a presence all over the country. The bank expected to expand mostly in the small and medium towns, where it saw good growth prospects. The opening up of the economy saw many small towns becoming prosperous, but most of these towns had still not been tapped by the private sector banks. Having made an impressive entry into the Indian banking sector, Yes Bank wanted to establish itself in this sector before the sector was opened up to foreign players. As of 2007, Yes Bank was still in its infancy stage and had not launched all the products in banking. It was yet to introduce some of the most lucrative products in banking like credit cards. As the bank had not expanded its reach to many parts of the country, it was missing out on cheap funds in the form of small deposits from the public. The bank expected to reach the 100-branch mark by March 2008 and add another 150 branches by 2010. Kapoor was confident that Yes Bank would grow at a rate of 70-90 percent through 2010. The bank aimed to reach a balance sheet size of Rs.1,500 million by 2009. Though the contribution of the retail banking segment was very small as of 2007, it would be the key value driver in the long term. It planned to roll out more products such as personal loans, credit cards, etc, sequentially as its customer base increased. The bank, which had already entered into retail broking and microfinance, also wanted to open a KPO unit by 2010 to leverage on its knowledge base.
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Kapoor said that the bank would grow organically in the domestic market but was interested in opening representative branches in Singapore to cater to South East Asia, and in Dubai to cater to West Asia, to serve the strong non-resident Indian (NRI) market.34 The bank would focus on other international markets only when its domestic business model was in full bloom. The bank wanted to make its fundamentals very strong before it expanded aggressively in the market. This idea was to not lose its competitive advantage of providing excellent customer service to the customers. According to Edelweiss Capital, Yes Bank would be the perfect acquisition target for a foreign player by 2010.35 Kapoor contended that Yes Bank was capable of growing on its own but he was open to such a possibility in the future. In the life of the bank, there will be a stage when we will need to globalize. At that stage, we could look at offering a stake to a foreign bank, which can help us tap the global market and we could help them tap the domestic Indian market.36 Analysts felt that despite its impressive entry into the banking arena and strong growth, Yes Bank was a relatively new bank and its ability to consistently perform on certain key parameters was yet to be established. The banks future valuation would depend upon its ability to increase business volumes and on whether it would be able to stick to its branch rollout plans.37 It also remained to be seen if the much-acclaimed management team at Yes Bank would be able to effectively handle the bank as it got bigger, they said. Moreover, the young bank had to contend with stiff competition from more established players such as SBI, ICICI Bank, and HDFC Bank, which could adversely affect its profitability.
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Footnotes
1. 2. 3. Wireless Banking Gets the Nod, www.intel.com/business/casestudies/yes_bank.pdf.

11. Banking the Emerging India, Gulf Business (Retrieved from www.yesbank.com) 12. Raghu Mohan, A Dream Comes True, Business India, February 14-27, 2005. 13. T.R.Gopalakrishnan, Knowledge is Key, The Week, May 22, 2005. 14. Raghu Mohan, A Dream Comes True, Business India, February 14-27, 2005. 15. www.yesbank.in/lifesciences.htm. 16. Sunita Jyoti, Banking on Knowledge, (Retrieved from www.yesbank.com). 17. Raghu Mohan, A Dream Comes True, Business India, February 14-27, 2005.

T.R.Gopaalakrishn, Knowledge is Key, The Week, May 22, 2005. Anita Bhoir, We Have a Subprime Problem Brew i n g i n P L s , w w w. b u s i n e s s - s t a n d a r d . c o m , October 12, 2007. Abhijit V. Banerjee, Shawn Cole, and Esther Duflo, Banking Reform in India, www.mit.edu, June 2004. Banking the Emerging India, Gulf Business (Retrieved from www.yesbank.com) T.R.Gopaalakrishn, Knowledge is Key, The Week, May 22, 2005. L a l i t B a t r a , M a r k e t Vo l a t i l i t y M a y C o n t i n u e , www.tribuneindia.com, August 28, 2006. Richard Nevins, Gathering Pace, Business India, December 31, 2006. T.R.Gopalakrishnan, Knowledge is Key, The Week, May 22, 2005.

4. 5. 6. 7. 8. 9.

18. Soutiman Das Gupta, A Matter of Strategy, Network Magazine, March 2005. 19. S o u t i m a n D a s G u p t a , A M a t t e r o f S t r a t e g y, www.networkmagazineindia.com, March 2005. 20. Banking on IT, Literally, Network Magazine, Novem ber 2006. 21. Vikas Kumar, Call of the Wild, The Economic Times, August 20, 2004. 22. YES BANK Recognized for HR Strategy at the Employer Branding Awards 2007, www.yesbank.in, January 16, 2007
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10. Anita Bhoir, We Have a Subprime Problem Brewing in PLs,www.business-standard.com, October 12, 2007.

23. YES BANK Wins Two Awards for Innovative Recruitment and HR Practices at the Asia Pacific HRM Congress February 1-3, 2007, www.yesbank.in, February 6, 2007. 24. T.R.Gopalakrishnan, Knowledge is Key, The Week, May 22, 2005. 25. yan Rodriguez, The Yes Approach, Business India, April 8, 2007 26. Y e s B a n k i n g o n K n o w l e d g e A p p r o a c h , www.thehindubusinessline.com, February 4, 2005. 27. Anita Bhoir, We Have a Subprime Problem Brewing in PLs, www.business-standard.com, October 12, 2007. 28. 29. Ryan Rodriguez, The Yes Approach, Business India, April 8, 2007. Ryan Rodriguez, The Yes Approach, Business India, April 8, 2007.

34. N B R a o , S a y i n g Y e s t o I n n o v a t i o n , www.ibef.org/download/banking_story_06.pdf. 35. Resounding Yes for Yes Bank, AsiaMoney, June 2006. 36. Anita Bhoir, We Have a Subprime Problem Brewing in PLs, www.business-standard.com, October 12, 2007. 37. Sunita Jyoti, Banking on Knowledge, (Retrieved from www.yesbank.com).

References & Suggested Readings:

1. Abhijit V. Banerjee, Shawn Cole, and Esther Duflo, Banking Reform in India, www.mit.edu, June 2004. Vikas Kumar, Call of the Wild, The Economic Times, August 20, 2004. Ye s B a n k i n g o n K n o w l e d g e A p p r o a c h , www.thehindubusinessline.com, February 4, 2005. Raghu Mohan, A Dream Comes True, Business India, February 14-27, 2005. S o u t i m a n D a s G u p t a , A M a t t e r o f S t r a t e g y, www.networkmagazineindia.com, March 2005. T.R.Gopaalakrishn, Knowledge is Key, The Week, May 22, 2005.

2. 3. 4. 5. 6.

30. Raghu Mohan, Say Yes to Growth, Businessworld, February 26, 2007. 31. Quantum Information Services Private Limited Independent I n v e s t m e n t R e s e a r c h , Ye s B a n k L i m i t e d , www.equitymaster.com, September 20, 2006. 32. Resounding Yes for Yes Bank, AsiaMoney, June 2006. 33. Raghu Mohan, Say Yes to Growth, Businessworld, February 26, 2007.

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7. 8. 9.

Next Phase of Banking Reforms Under Way, www.hindu.com, June 5, 2005. Post- IPO, Rabobank to Keep 20 pc Stake in Yes Bank, www.thehindubusinessline. com, June 10, 2005. Deepika Sriraman, Positive Banking, www.chennaionline.com, June 30, 2005.

18. Raghu Mohan, Say Yes to Growth, Business World, February 26, 2007. 19. Ryan Rodriguez, The Yes Approach, Business India, April 8, 2007. 20. Anita Bhoir, We Have a Subprime Problem Brewing in PLs, www.business- standard.com, October 12, 2007. 21. Banking the Emerging India, Gulf Business (Retrieved from www.yesbank.com) 22. N B R a o , S a y i n g Y e s t o I n n o v a t i o n , www.ibef.org/download/banking_story_06.pdf. 23. Sunita Jyoti, Banking on Knowledge, (Retrieved from www.yesbank.com). 24. W i r e l e s s B a n k i n g G e t s t h e N o d , www.intel.com/business/casestudies/yes_bank.pdf. 25. www.en.wikipedia.org. 26. www.yesbank.in.

10. Resounding Yes for Yes Bank, AsiaMoney, June 2006. 11. L a l i t B a t r a , M a r k e t Vo l a t i l i t y M a y C o n t i n u e , www.tribuneindia.com, August 28, 2006. 12. Quantum Information Services Private Limited Independent Investment Research, Yes Bank Limited, www.equitymaster.com, September 20, 2006. 13. Priya Kansara, Our NIM will be 3.5 per cent by 2010, www.business-standard.com, November 6, 2006. 14. Banking on IT, Literally, Network Magazine, November 2006. 15. Richard Nevins, Gathering Pace, Business India, December 31, 2006. 16. YES BANK Recognized for HR Strategy at the Employer Branding Awards 2007, www.yesbank.in, January 16, 2007. 17. YES BANK Wins Two Awards for Innovative Recruitment and HR Practices at the Asia Pacific HRM Congress February 1-3, 2007, www.yesbank.in, February 6, 2007.

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S ECTION 8

Case Study: Wal-Marts Cost Leadership Strategy

Theres nothing like Wal-Mart. Theyre so much bigger than any retailer has ever been that its not possible to compare.1 - Ira Kalish, Global Director of Deloitte Research

INTRODUCTION For the financial year ending January 31, 2003, retailing giant Wal-Mart reported revenues of $244.5 billion, making it the worlds largest company. The company topped Fortunes list of the worlds largest companies for the second year in succession (Refer Exhibit I). Considering the modest beginning of this company f o u r d e c a d e s a g o , n o b o d y, including the company officials

This case was written by K. Prashanth, under the direction of Vivek Gupta, IBS Center for Management Research. It was compiled from published sources, and is intended to be used as a basis for class discussion rather than to illustrate either effective or ineffective handling of a management situation

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expected Wal-Mart to emerge such a dominant player in the retailing industry (Refer Exhibit II). Wal-Marts success story is a classic example of a company, Video 8.8.1:Wal-Marts which became successful by Success Story rigorously pursuing its core philosophy of cost leadership, right from the day it began operations in 1962. Wal-Mart was founded by an ambitious entrepreneur, Sam Walton (Walton), who figured out early that retailing was a volumeSoderquist former COO, ex- d r i v e n b u s i n e s s , a n d h i s plains the keys to Wal-Marts c o m p a n y c o u l d a c h i e v e Success success by offering consumers better value for their money. Wal-Marts growth during the first two decades was propelled primarily by following the strategy of establishing discount stores in smaller towns and capturing significant market share. The company was able to foster its growth in the 1980s by making heavy investments in information technology (IT) to manage its supply chain and by expanding business in bigger metropolitan cities. In the late 1980s, when Wal-Mart felt that the discount stores business was maturing, it ventured into food retailing by introducing Supercenters. In the late 1990s, Wal-Mart launched exclusive groceries/drug stores known as neighborhood markets in the US (Refer Exhibit III for the various types of Wal-Mart stores).

GALLERY 8.8.1: Cost Leadership

With Cost Leadership strategy, the objective is to become the lowest-cost producer in the industry. Many market segments in the industry are supplied with the emphasis placed minimizing costs. If the achieved selling price can at least equal (or near) the average for the market, then the lowest-cost producer will (in theory) enjoy the best prots. This strategy is usually associated with large-scale businesses offering "standard" products with relatively little differentiation that are perfectly acceptable to the majority of customers. Occasionally, a low-cost leader will also discount its product to maximize sales, particularly if it has a signicant cost advantage over the competition and, in doing so, it can further increase its market share.

Though Wal-Mart had achieved huge success over the decades, the company drew severe criticism from industry analysts for its strategies that aimed at killing competition. At the speed at which Wal-Mart was growing, analysts feared that the company would soon face an anti-trust suit for its monopolistic practices. Christopher

Video 8.8.2Neighborhood Markets

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Hoyt, president of Scottsdale, an Arizona-based supermarket store, Hoyt & Company, said, The only thing that could stop Wal-Mart is if the government gets involved, just as it did with Microsoft.3 WAL-MARTS AGGRESSIVE PRICING On July 2, 1962, Samuel Moore Walton (Walton), a merchant with over 15 years of experience in retailing, set up his first discount store in Rogers, a small town in the state of Arkansas, US. The store offered a wide variety of branded merchandise at a competitive price. During the initial years, Walton focused on establishing new stores in small towns, with an average population of 5,000. These towns were largely neglected by leading retailers like Sears Roebuck & Company, K-Mart and Woolco, which concentrated more on larger towns and big cities. In his efforts to attract people from the rural areas to his stores, Walton introduced the concept of every day low prices (EDLP). EDLP promised Wal-Marts customers a wide variety of high quality, branded and unbranded products at the lowest possible price, offering better value for their money. Wal-Marts advertisement describing EDLP said, Because you work hard for every dollar, you deserve the lowest price we can offer every time you make a purchase. You deserve our Every Day

Low Price. Its not a sale; its a great price you can count on every day to make your dollar go further at Wal-Mart.3 From the very beginning, Walton made efforts to procure products at the lowest prices possible from manufacturers. He always shared these savings with customers by charging them lower prices, thus giving them the maximum value for their money. Wal-Marts products were usually priced 20% lower than those of its competitors. Waltons pricing strategy led to increased loyalty from price-conscious rural customers. It helped the company to generate more profits due to larger volumes. Explaining his pricing strategy, Walton said, By cutting your price, you can boost your sales to a point where you earn far more at the cheaper retail price than you would have by selling the item at the higher price. In retailer language, you can lower your markup but earn more because of the increased volume.4 EDLP was extremely attractive to rural customers and emerged as the key contributor to Wal-Marts growth over the years. The strategy of setting up large discount stores in small towns worked wonders for Wal-Mart. The stores attracted a sizeable customer base. The customers had a wide variety of branded merchandize to choose from, that were priced attractively. Wal-Mart stores were located at convenient places in big warehouse-type buildings and catered to those customers who bought merchandise in bulk. The strategy discouraged competitors since it was impractical for them to compete with Wal-Mart in small towns by setting up stores of such size, owing to the lack of volumes. As Wal-Mart continued to build on its store count, it ensured that it recruited
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and retained service-oriented individuals who were prepared to go the extra mile to serve customers better. This pricing strategy worked extremely well for Wal-Mart. By 1967, Wal-Mart had 24 stores, generating total revenues of $12.6 million. In October 1969, Wal-Mart was formally incorporated, with its headquarters at Bentonville, Arkansas. By the financial year ending January 1970, the companys revenues had crossed $31 million and its store count was 32. ACHIEVING COST LEADERSHIP Offering products at EDLP, especially during its early years, when Wal-Mart was not an established retail player, was quite difficult. The company aggressively followed a cost leadership strategy that involved developing economies of scale and making consistent efforts to reduce costs. The surplus generated was reinvested in building facilities of an efficient scale, purchasing modern business-related equipment and employing the latest technology. The reinvestments made by the company helped it to maintain its cost leadership position From the start, Wal-Mart imposed a strict control on its overhead costs. The stores were set up in large buildings, while ensuring that the rent paid was minimal. The company imposed an upper limit for its rent payment at $1.00 per square foot during the late 1960s. Not much emphasis was laid on the interiors of the stores. The company did not invest on standardized ordering programs and on basic facilities to sort and replenish the stock. There was not enough staff to support the back-office operations; store managers handled the stores and even did the accounting for the store. The company didnt

even have a standard distribution system in place. Though the organizing across stores was not really standardized at this point, the key elements of strict cost controls and constant supervision were maintained everywhere. The manually written-up accounting was periodically reviewed to keep stock of the situation at the stores. The focus was on effective management of the day-to-day operations and expansion into new territories. As Wal-Mart grew, the company kept investing in infrastructural facilities. In order to access more funds for its aggressive expansion plan, Wal-Mart decided to go public. In October 1970, Wal-Mart became a publicly-held company. Equipped with funds, Wal-Mart started reorganizing its business activities. The foremost challenge was to put in place a standard distribution and inter-store communication system. This was needed since the stores in the rural areas had to regularly replenish their stocks, and also had to interact with each other frequently. To overcome the problems involved in this, a massive 60,000-sq. feet distribution center was built in Bentonville in the early 1970s. This made Wal-Mart one of the first retailing companies in the world to centralize its distribution system, pioneering the retail hub and spoke system. Under the system, goods were centrally ordered, assembled at the distribution center (hub), from where they were dispatched to the individual stores (spokes) as per the orders received from the stores. The hub and spoke system enabled Wal-Mart to achieve significant cost advantages by centralized purchase of goods in huge quantities and distribution of them through its own fast and responsive logistics infrastructure to the retail stores spread across the US. The dedicated, company-owned
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truck fleets allowed Wal-Mart to ship goods from the distribution centers to the stores within two days and replenish the store shelves twice a week. In 1978, Wal-Mart became the first company to establish a fullyautomated distribution center. The company employed an advanced automated conveyor system in which the conveyor belts moved goods at a speed of 200 feet per minute. This helped Wal-Mart to keep its inventory handling costs at the bare minimum. At these centers, Wal-Mart made use of a logistics technique called cross docking to quickly receive goods and dispatch them to individual stores. Wal-Mart always emphasized the need to reduce its purchasing costs and offer the best price to its customers. The company procured goods directly from manufacturers, bypassing all intermediaries. Wal-Mart was a tough negotiator on prices and finalized a purchase deal only when it was fully confident that the products being bought were not available elsewhere at a lower price. According to Claude Harris, one of Wal-Marts earliest employees, Every buyer has to be tough. That is the job. I always told the buyers, You are negotiating for your customer. And your customer deserves the best prices that you can get. Dont ever feel sorry for a vendor. He always knows what he can sell, and we want his bottom price. We would tell the vendors Dont leave in any room for a kickback because we dont do it here. And we dont want your advertising program or delivery program. Our truck will pick it up at your warehouse. Now what is your best price? 5 Wal-Mart spent a significant amount of time meeting vendors and understanding their cost structure. By making the process

transparent, the retailer could be certain that the manufacturers were doing their best to cut down costs. Once satisfied, WalMart believed in establishing a long-term relationship with the vendor. In its attempt to drive hard bargains, Wal-Mart did not even spare big manufacturers like Procter & Gamble (P&G). However, the company, generally, preferred local and regional vendors and suppliers. ECONOMIES OF SCALE In the 1970s, Wal-Mart embarked on a massive expansion strategy. The strategy was to build stores around the distribution center (within a 300-mile radius), which could be effectively served by the center and controlled by the district managers and top management at Bentonville. The stores needed to be a maximum of a days drive away from the center. Using the distribution center as a base, Wal-Mart started off by setting up a store at the maximum permissible ditance of 300 miles. The company then worked backwards, establishing stores in each district and town until the entire area around the center was fully covered. By implementing this strategy, Wal-Mart was able to accelerate its revenue growth and reap significant economies of scale. As the number of stores increased, the popularity of the company increased. Since the company generated tremendous word-ofmouth publicity, it was able to minimize spending on advertising and promotion activities. Wal-Mart had established stores serving population ranging between 5,000 and 25,000 with five different store sizes (floor areas) within the range of 30,000 to 80,000 sq. feet. The average store size was 50,000 sq. feet.
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In the 1970s, Wal-Mart continued to grow rapidly due to the huge customer demand in small towns. From fiscal year 1970 to 1980, Wal-Marts sales increased from $31 million to $1.2 billion, while its store count increased from 32 to 276, served by four strategically located distribution centers. Commenting on the growth of Wal-Mart, Walton said: When we arrived in these small towns offering low prices every day, customer satisfaction guaranteed, and hours that were realistic for the way people wanted to shop, we passed right by that old variety store competition, with its 45 percent mark ups, limited selection and limited hours.7 Analysts attributed Wal-Marts phenomenal growth in the 1970s to EDLP. The company was able to get loyal customers by persisting with its EDLP strategy, even though it could have easily cashed in on its popularity by raising prices of the merchandise. Describing the essence of EDLP, Tim Crane, regional buyer for Wal-Mart said, EDLP has always been the philosophy of Wal-Mart. We offer value every day. Customers dont have to wait for sales. We distribute 13 circulars a year, two during the Christmas period, one a month otherwise, and it is a rare day that we do any off-price advertising. We are not interested in co-op monies, exchanging terms, guaranteed sales, or any other deals, which we feel add to the cost of the merchandise. We simply want the lowest net cost we call that net down pricing. For EDLP to be successful, you must drive all the unnecessary costs out of the equation. When vendors work with the appropriate Wal-Mart buyers, they will, I assure you, work to achieve that.6

MAINTAINING LOW COSTS THROUGH REINVESTMENTS After being highly successful in the rural markets of the US, Wal-Mart focused on expanding into bigger metropolitan cities and diversifying into other areas of retailing. In 1983, Wal-Mart ventured into the membership club business, by establishing Sams Clubs. Sams Clubs were wholesale clubs, which offered goods in bulk at wholesale prices, exclusively to its members, who comprised mainly small business resellers who paid a nominal membership fee. The company also continuously upgraded its existing stores. Wal-Mart made heavy investments in technology in its efforts to further reduce costs (Refer Exhibit IV). In 1983, Wal-Mart installed the point of sale (POS) scanning system in its 25 major stores. The system required Wal-Marts key suppliers to place bar codes on each and every item and case shipped to the company. Scanners were installed which could read the bar codes of the products being sold at the stores. Wal-Marts store associates were equipped with handheld terminals to scan the shelf labels, through which product information regarding the quantity ordered previously and its cost per product was displayed. This helped the store associates in easy re-ordering of goods. In 1987, Wal-Mart installed a satellite communication system (SCS), the largest established by a private company in the US, at an estimated cost of $700 million. The system helped in establishing virtual communication links between all Wal-Mart stores and distribution centers with its headquarters, through two-way voice and data and one-way video communication. It also helped Wal-Mart in linking its own systems with those of its
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suppliers leading to a significant improvement in its supply chain efficiency. In December 1987, Wal-Mart opened its first hyper-mart in the US, a food and general merchandize retailing center. The innovative concept of offering a wide variety of fresh groceries and other general items under one roof was in its initial stages of evolution in the US. Wal-Mart became one of the first movers to enter into the food retailing business. These stores were later called Supercenters. In Wal-Marts Annual Report 1987, Walton wrote, The Supercenters are a result of our continuing interest in the experimentation with and the understanding of what we believe to be significant new retailing vehicles. By 1990, Wal-Mart had emerged as the #1 retailing company in the US with sales of $32.1 billion, surpassing leading retailers such as Sears, Roebuck & Company, K-Mart and Target. Between 1980 and 1990, Wal-Marts revenues grew at a compounded annual growth rate (CAGR) of 36%. As Wal-Mart became a leader in the retailing industry, leading product manufacturers competed with each other to offer the best prices to the company. Moreover, Wal-Marts distribution costs comprised 3% of its total sales against 4.5-5% of its major competitors. This difference resulted in savings of $750 million per year. WAL-MART IN THE 1990s In the early 1990s, Wal-Mart started focusing on its Supercenters and Sams Clubs to fuel growth. Wal-Mart expanded its operations into the Northeast and West of the US by placing a lot of emphasis on the groceries business through its Supercenters. The modus operandi was to first establish

discount stores, after which the best performing stores were to be converted into Supercenters. By 1991, Wal-Marts mammoth retail network comprised of 1,355 discount stores, 120 Sams Clubs and three Supercenters being served by 16 distribution centers. However, at this time, Wal-Mart had yet to enter as many as 23 states in the US. In the early 1990s, it was estimated that the size of the groceries business in the US was three times that of the discount store business. So, Wal-Mart decided to focus on Supercenters to propel its growth. Following Waltons death in 1992, David Glass (Glass) succeeded him as the CEO of Wal-Mart. Glass viewed food retailing as a key driver to increase revenue growth in the 1990s. He aimed at capturing a major share in the food retailing market in the US through Supercenters. Between 1992 and 1996, the numbers of Supercenters were increased from 6 to 219 (Refer Table I for the number of stores of Wal-Mart during 1991-2003). The company also built fully-automated food distribution centers, which were located close to the Supercenters to provide a rapid supply of fresh foodstuffs. Apart from Supercenters, Wal-Marts other retail division, Sams Clubs, also witnessed a significant growth during the period. In 1994, Wal-Mart bought 99 Pace Membership Warehouses from rival Kmart in its efforts to focus on business customers and reduce costs further. However, this move was considered to be a risky proposition by industry analysts since the wholesale club business was already showing signs of maturity. In spite of Wal-Marts efforts towards improving its growth, the company faced declining profit margins in the mid-1990s. In the quarter ending January 1996, Wal-Mart reported its first-ever
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decline in earnings in its 24-year history. The companys quarterly earnings fell by 10% from $1 billion in 1995 to $900 million. The companys earnings growth dipped from an increase of 24% in the fiscal 1992 to no growth in the fiscal 1995. To add to the problems, Wal-Marts international operations in countries like Canada, Mexico, Brazil, Argentina and China were not performing well in spite of the heavy investments made they accounted for a meager 4% of its total revenues.

Analysts started expressing concern over the companys prospects. They were skeptical about Wal-Marts strategy of focusing on the maturing wholesale clubs business and its continued reliance on the discount stores business (which accounted for over 50% of the companys sales). Describing some of the other operational problems, Michael Gade, head of retail practice at The Associates, a financial services firm, said, Wal-Mart has the critical mass and great technology to win, but things are happening at the store level that I havent seen before. I see problems with out-of-stock merchandise. Im amazed to see greeters at the front door talking to other employees instead of customers, and floors that arent beautifully waxed and clean as they were just a year ago.7 Concerns were also expressed over the sagging morale of employees and over the top managements ability to run a large corporation like Wal-Mart, after Waltons death. In attempts to overcome these problems, Glass initiated a series of planned and well-executed measures. The company imposed strict cost controls, employed improved inventory management practices and upgraded its IT systems. Using IT, the store managers were intimated about the goods that were selling in their respective areas, and the goods to be stocked on their store shelves. Further, the size of the packages in several product categories was reduced, providing more storage space. IT helped in tracking the movement of each and every product, and generated automatic alerts at the distribution centers about when to replenish the inventory. All these efforts led to the reduction in the amount of inventory by an estimated $2 billion, generating savings of $150 million on interest costs. Wal-Mart also continuously renovated its stores,
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making the product displays more attractive, and worked towards reducing the checkout time, to enable more convenient shopping for customers. Apart from contributing towards improved profitability, these initiatives reduced the burden on store managers and associates, who started concentrating on improving their efficiency and providing better customer service. By 1998, Wal-Mart had over 40 distribution centers at different locations in the US. Over 80,000 items were stocked in these centers. Wal-Marts own warehouses directly supplied 85 percent of the inventory, compared to 50-65 percent for competitors. According to rough estimates, Wal-Mart was able to provide replenishments within two days (on an average) against at least five days for competitors. Shipping costs for Wal-Mart worked out to be roughly 3 percent as against 5 percent for competitors. Having overcome these problems, Wal-Mart continued its expansion spree in the late 1990s. Banking on the success of the food retailing business, the company started testing the concept of building exclusive groceries stores. In October 1998, Wal-Mart opened the 40,000 square feet neighborhood market, its first exclusive grocery store. Analysts felt that WalMart wanted to do away with the weaknesses of its Supercenters and attract supermarket shoppers. The company realized that the large size (averaging over 180,000 square feet) of the Supercenters was unattractive to supermarket shoppers. Further, most supermarkets offered a wider variety of merchandize than the Supercenters.

In order to capture a sizeable market share of the retailing business, Wal-Mart decided to use an intelligent combination of Supercenters and neighborhood market stores. While persisting with its expansion strategy through its Supercenters, it used neighborhood markets for capturing the consumer segments that were not catered to by the Supercenters. In few cases, the company established a neighborhood market between two Supercenters. Thus, Wal-Mart was able to capture more market share in the food retailing business, retaining not only its traditional customer base, but also attracting new customers. In what industry experts called a remarkable revival, Wal-Mart was back on the growth path by the late 1990s. Between fiscal year 1996 and 1999, Wal-Marts overall revenues grew from $93.6 billion to $137.6 billion (Refer Exhibit V for the financial performance of Wal-Mart). By the late 1990s, Wal-Marts international operations had also expanded rapidly. Between 1995 and 1998, Wal-Marts international sales grew five-fold, from $1.5 billion to $7.5 billion. THE GROWTH CONTINUES By the beginning of the new millennium, Wal-Mart was one of the worlds largest companies, with revenues of $165 billion in fiscal 2000. Wal-Marts rapid growth continued in the initial years of the new millennium. While continuing its aggressive expansion in the food business, the company started launching innovative programs to further penetrate the US markets. For instance, in 2001, Wal-Mart launched a program, called Store of the community. Under the program, Wal-Mart began remodeling its discount stores and Supercenters in the US to
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fulfill the needs of customers they served, in line with what the customers wanted. Explaining the program, Tom Coughlin, President and CEO of Wal-Mart Stores Division, said, The one-size-fits-all concept simply doesnt work anymore in the retail industry. Customers tell us what they want and it is our responsibility to meet those needs. Our store associates live and work in each stores community and interact with over 100 million customers each week. If we utilize information from all available resources including customers, associates and suppliers, our store will reflect the interests of its community. We will sell merchandise the customers want to buy, not merchandise we want to sell. By accomplishing this goal, we create happy, satisfied customers because they can now complete all of their shopping in one location - our store.8 The program benefited Wal-Mart by increasing its sales to existing customers and attracting new customers. By stocking all the products likely to be purchased by customers at one time and one place, WalMart also reaped the benefits of cross selling. In an attempt to reduce the purchasing costs further, Wal-Mart embarked upon a global sourcing strategy in 2002. The company employed a standard methodology for global sourcing. It identified a few products which were commonly used by people across the world, following which it would explore how it could reduce costs by purchasing it in bulk from a global supplier. Wal-Mart not only passed on the cost benefits reaped through global sourcing to its customers but also worked closely with the suppliers to enhance the quality of the products supplied by them.

As a part of its global sourcing strategy, Wal-Mart sourced $10 billion worth of goods in 2001 and $12 billion in 2002 from Chinese suppliers. Commenting on the importance of this strategy in the future, Lee Scott (Scott), the new CEO (since January 2000) of Wal-Mart said, I believe the benefits of global sourcing will be one of the most important factors in earnings growth in the next five years.9 Wal-Marts continued focus on its cost leadership strategy over the past 40 years has led the company to emerge as the worlds largest retailing company with its fiscal 2002-03 revenues reaching $244.5 billion (Refer Exhibit VI). Wal-Marts dominance in the US retailing industry is reflected in the fact that it emerged as the largest retailer in several product categories. For several top product manufacturers, Wal-Mart was their largest retailer. While continuing to foster its domestic growth, Wal-Mart also expanded its international operations with a presence in 11 countries in 2003. PLANS AND CHALLENGES Wal-Mart has chalked out an aggressive expansion plan to accelerate its growth in the near future. By the fiscal year ending 2007-08, Wal-Mart aims at achieving a revenue target of $500 billion. The company plans to achieve this by expanding aggressively in international markets. In the US, Wal-Mart plans to increase its store count and to introduce new product categories. The company plans to increase the total number of stores in the US from 3,400 to 5,000 in the next five years. By 2008, Wal-Mart plans to open 1,000 Supercenters in the US.
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Analysts and media reports are expressing doubts as to whether Wal-Mart will be able to achieve its ambitious $500 billion revenue target. Given the size of its operations, some analysts felt that Wal-Mart may also face the danger of antitrust suits. However, not all analysts agree on this issue, as Wal-Mart enjoys significant customer support, and the customers are the ultimate beneficiaries of low prices. According to Harry First, a Law professor at the New York University, When Wal-Mart comes in and people desert downtown because they like the selection and the low prices, its hard for people in the antitrust community to say we should not let them do that. 10 Wal-Marts dominance over its suppliers and the impact of its cost leadership strategy on its competitors has become a matter of great debate among industry experts. The companys consistent efforts at reducing costs has affected the profit margins of its suppliers significantly Even leading consumer goods suppliers have little bargaining power against Wal-Mart as they generate a significant portion of their sales through Wal-Mart stores (Refer Table II). They have to adhere to the strict price and quality controls imposed by Wal-Marts merchandizing personnel. However, the advantage for these vendors is the increasing sales volumes. Recent studies in the US indicate that the amount of business transacted at Wal-Mart in three months equals to the amount transacted by its nearest competitor, Home Deport in one whole year. Wal-Marts revenues surpassed the combined revenues of the top retailers in the US including Target, Sears, Kmart, J.C. Penney, Safeway, and Kroger.

The impact of Wal-Mart has been felt most by small town supermarkets, which have been forced to close down because of Wal-Mart. According to a recent BusinessWeek report, 30 supermarkets were shut down in the Oklahoma City, Oklahoma, after Wal-Mart entered the city. By establishing stores wherever possible in the US, without any let-up, Wal-Mart poses a severe threat to the survival of small supermarkets, and even of larger retail chains.

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According to a study in Retail Forward, on an average, for every Supercenter opened by Wal-Mart, two supermarkets might be forced to close down. Gary E. Hawkins, CEO of Green Hills, a supermarket in New York said, It will be a sad day in this country if we wake up one morning and all we find is a Wal-Mart on every corner. QUESTIONS FOR DISCUSSION: 1. One of the major reasons for the success of Wal-Mart over the decades has been its focus on achieving cost leadership. Comment critically on the key elements of Michael Porters cost leadership strategy as followed by WalMart. 2. According to Porter, the low-cost position of a company leads to above-average returns in an industry in spite of the presence of strong competitive forces. Critically analyze this statement in the case of Wal-Mart, and explain how the companys low cost position acted as a defense for each of the five competitive forces.

Exhibit I :Wal_Marts Awards and Recognitions Year Awards #1 most respected retailer in North America 1999 Retailer of the century 5th most admired company in America 2000 Ranked No 5* on Fortunes Global Most Admired Company List - up from No.7 in 1999 3rd most admired company in America 2001 Awarder FinancialTimes and Pricewaterhouse Coopers Discount Store News and Mass Market Retailers Fortune Fortune

Fortune

Ranked as 8th most admired FinancialTimes and company in the world Pricewaterhouse Coopers Awarded the Ron Brown Award President of US for Corporate Leadership # 1 on the Fortune 500 list of wolrds largest companies (2001) Fortune

2002

3. Analysts are divided on whether Wal-Mart will be able to achieve its $500 billion revenue target by the end of fiscal 2007-08. Conduct a SWOT analysis of Wal-Mart, on the basis of its status in 2003. What measures must the company take to accelerate its revenue growth in the future?

2003

The most admired company in Fortune America #1 in the Fortune 500 list of worlds largest companies (2002)

Source: www.walmartstores.com NB* Rankings was based on parameters like leadership, people-centric values and teamwork.

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Exhibit III Wal-Mart Types of Retail Stores

Discount Stores A discount store is a place where a wide variety of branded and un-branded products are offered at a discounted price. In the 1970s, the products offered at the stores were categorized into 36 merchandizing departments. The size of the stores range between 30, 000 sq. feet to 1,00,000 sq. feet with an average size of 50,000 sq. feet. Over the years, with the growth of WalMart, the size of the discount stores also increased. Sams Clubs A wholesale membership club designed to operate at a very low margin. Goods are sold in bulk to small and medium size businesses, who become its members. The no-frills facilities comprise shelving and racks designed to handle large quantities of displayed items. A select 3,500 branded quick selling items are sold at the Sams Clubs. Apart from the price discounts, the members are also provided with other benefits such as discounts on traveling, hotels, rented cars, long distance telephone service and so on. Wal-Mart also introduced its private label products under the brand name, Great value in Sams Clubs. The size of the Sams Clubs is approximately 1,00,000 square feet. The clubs are primarily targeted at larger metropolitan markets. Over the years, with the growth of Wal-Mart, the size of the Sams Clubs also increased.
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Supercenters A combination of a general merchandize store and a full-line grocery store. The mammoth stores facilitate a single point shopping experience where fresh food products are sold along side the general merchandize and complementary convenience stores such as portrait studios, dry cleaners, optical shops and hair salons. The centers are open round the clock. The size of the Supercenter ranges between 1,60,000 sq. feet to 1,80,000 sq. feet. Neighborhood Markets Medium sized (approximately 40, 000 sq. feet) food and pharmacy stores. The stores provide facilities like selfcheckout, coffee and pastries, pharmacies and mini-photo studios which processes camera rolls within half an hour.
Source: Compiled from Wal-Marts AnnualReports.

Interchange (EDI) that linked the computers at the stores, its distribution centers and even key suppliers like P&G. In order to make its distribution system more efficient and to establish stronger links with all its suppliers, Wal-Mart installed the satellite communication system in 1987 at an estimated cost of $700 million. The system connected all the operating units of company and the General Office with 2-way voice, data and one-way video communication. Wal-Mart could keep a constant track of the movement of inventory from the manufacturers to the distribution centers and finally, to the stores. Its thousands of suppliers could obtain daily sales reports. The system also helped Wal-Mart to automate the inventory replenishment process. Wal-Mart also used IT to improve its supply chain efficiency in the 1990s. In 1990, Wal-Mart installed the Retail Link system that connected Wal-Marts EDI networks to an extranet accessed and used by Wal-Marts business customers and its thousands of suppliers to obtain data relating to sales and stock levels at every Wal-Mart store. The data enabled WalMarts suppliers to analyze market trends, undertake the necessary stock replenishment and plan out their production schedules to cater to Wal-Marts needs. Apart from investing in building advanced IT systems, Wal-Mart simultaneously built massive databases of point of sales data at each of its stores. Using data mining, Wal-Mart was able to determine the needs and preferences of its customers up to an individual store level and customize its merchandize accordingly.
Source: IBS Center for Management Research.
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Exhibit IV Wal-Mart Using IT A major reason for Wal-Marts success over the years was its constant emphasis on installing the most modern IT systems, which helped it to achieve better economies of scale, remarkably improve its distribution efficiency and pass on the benefits of the same to the customers. By offering low prices to the customers, Wal-Mart was able to generate more sales and minimize the promotional expenditure of the company. By using IT, Wal-Mart was able to establish proper communication links with its suppliers, distribution centers and individual stores. Wal-Mart employed Electronic Data

Exhibit V Financial Performance of Wal-Mart (1972-2003)

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Footnotes 1. As quoted in the article, Is Wal-Mart Too Powerful?, by Anthony Blanco and Wendy Zellner, in Business Week, dated October 6, 2003. 2. As quoted in the article, Inside the Battle to Beat the Market, by Alice Z. Cuneo, posted on www.adage.com, dated October 6, 2003. 3. As quoted in the article, Pricing Philosophy, posted on www.walmart.com. 4. As quoted in the article, Pricing Philosophy, posted on www.walmart.com. 5. As quoted in the book, Sam Walton: Made in America, My Story, by Sam Walton and John Huey, Bantam books, 1992. 6. As quoted in the article, Wal-Marts Top Ten by Loretta Roach, in Discount Merchandiser, dated August 1993. 7. As quoted in the article, Can Wal-Mart get back the magic? by Patricia Sellers and Suzanne Barlyn, in Fortune, dated April 29, 1996. 8. As quoted in the article, This store is your store, in WalMart Annual Report 2001. 9. As quoted in the article, Worldwide sourcing will produce gold, by Andrea Lillo, in Home Textiles Today, dated February 24, 2003. 10. As quoted in the article, Is Wal-Mart Too Powerful, by Anthony Bianco and Vendy Zellner, in Business Week, October 6, 2003.

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Additional Readings & References: 1. 2. Weiner. S, Retailing, Forbes, January 8, 1990. Chakravarthy, S.N, A Tale Of Two Companies, Can the Stock of Any Giant Company be Worth 29 Times, Forbes, May 27, 1991. Sawaya, Z, In Retailing, The Rich Are Getting Richer, And Many Of The Poor Will Fall By The Wayside, Forbes, January 6, 1992. Stalk Jr., G, Evans-Clark, P, Competing On Capabilities: The New Rules of Corporate Strategy, Harvard Business Review, March / April 1992. Charan, Ram, Capabilities-Based Competition, Harvard Business Review, May /June1992. Moreau, Dan, Goldwasser, Joan, How Wal-Mart Intends to Refuel its Spectacular Growth, Kiplinger's Personal Finance Magazine, August 1992. Moore, James F, The Evolution of Wal-Mart: Savvy Expansion and Leadership, Harvard Business Review, May /June 1993. Moore, James F, Predators and Prey: A New Ecology of Competition, Harvard Business Review, May/June 1993. Button, Graham, Watch Out, Safeway, Forbes, August 16, 1993.

11. Gilliam, Margaret, Wal-Mart's Era of Greatness, Discount Merchandiser, August 1993. 12. Johnson, Jay L, Wal-Mart's Secret Weapon, Discount Merchandiser, August 1993. 13. Brown, Thomas L, It's Often the Little Things that Count, Industry Week/IW, October 18, 1993. 14. JLJ, How A Consultant Views Wal-Mart, Discount Merchandiser, August 1994. 15. Speer, Tibeett, Where Will Wal-Mart Strike Next?, American Demographics, August 1994. 16. Tigert, Douglas J, The Profit Wedge: Key to Successful Retailing, Chain Store Age Executive with Shopping Center Age, January 1995. 17. Stores of Value, Economist, March 4, 1995. 18. Longo, Don, Wal-Mart Defines its Three-Pronged Future, Discount Store News, June 19, 1995. 19. Pellet, Jennifer, Wal-Mart: Yesterday and today, Discount Merchandiser, September 1995. 20. Kumar, Nirmalya, The Power of Trust in ManufacturerRetailer Relationships, Harvard Business Review, November /December 1995. 21. Moukheiber, Zina, The Great Wal-Mart Massacre, Part II, Forbes, January 22, 1996. 22. Saporito, Bill, A Humbled Wal-Mart Vows to Get Tough, Fortune, February 19, 1996. 23. Sellers, Patricia, Barlyn, Suzanne, Can Wal-Mart Get Back the Magic? Fortune, April 29, 1996.

3.

4.

5. 6.

7.

8.

9.

10. Roach, Loretta, Wal-Mart's Top Ten, Discount Merchandiser, August 1993.

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24. Dvorak, Robert E van Paasschen, Frits, Retail Logistics: One Size Doesn't Fit All, McKinsey Quarterly, 1996 Issue 2. 25. Zellner, Wendy, A Grand Reopening for Wal-Mart, BusinessWeek, February 9, 1998. 26. Schwartz, Nelson D, Why Wall Street's Buying Wal-Mart again, Fortune, February 16, 1998. 27. Zellner, Wendy, Look Out, Supermarkets--Wal-Mart is Hungry, BusinessWeek, September 14, 1998. 28. Shopping All Over the World, Economist, June 19, 1999. 29. Chimera, Economist, January 29, 2000. 30. Sam would be Proud, Fortune, April 18, 2000. 31. Janoff, Barry, High-tech Knowledge, Progressive Grocer, December 2000. 32. Longo, Don, Wal-Mart, Retail Merchandiser, January 2001. 33. Longo, Don, Supercenter Key to Wal-Mart Future, Retail Merchandiser, July 2001. 34. Zellner, Wendy, Schmidt, Katharine A, Ihlwan, Moon, D a w l e y, H e i d i , H o w W e l l D o e s Wal-Mart Travel? BusinessWeek, September 3, 2001. 35. Barron, Kelly, Spamouflage and Cajun Crawtators, Forbes, October 29, 2001. 36. AMR Research: IT Contributes to Wal-Mart's Record Third Quarter, www.softwarestrategies.com, November 20, 2001. 37. Wal-Mart around the World. Economist, December 8, 2001.

38. Schrage, Michael, Wal-Mart Trumps Moore's Law, www.cosn.org, March 2002. 39. Retail: the Wal-Mart effect. By: Johnson, Bradford C, McKinsey Quarterly, 2002 Issue 1. 40. O'Keefe, Brian, The High Price of Being No. 1, Fortune, April 15, 2002. 41. Berner, Robert, Forest, Stephanie Anderson, Wal-Mart Is Eating Everybody's Lunch, BusinessWeek, April 15, 2002. 42. O'Keefe, Brian, Meet Your New Neighborhood Grocer, Fortune, May 13, 2002. 43. Koretz, Gene, Wal-Mart vs. Inflation BusinessWeek, May 13, 2002. 44. Tsao, Amy, That Famous Wal-Mart Value, BusinessWeekOnline, August 8, 2002. 45. Sourcing Synergies Facilitate Cost-Effective Expansion, Chain Store Age, August 2002. 46. Tsao, Amy, Will Wal-Mart Take Over the World? BusinessWeeKOnline, November 27, 2002. 47. OHiggins, Eleanor R E, Weigel, John R, Has Sams Magic Passed its Sellby Date? Business Strategy Review, Autumn 2002. 48. Saporito, Bill, Boston, William, Gough, Neil, Healy, Rita, Can Wal-Mart Get Any Bigger? Time South Pacific, January 13, 2003. 49. Useem, Jerry, Schlosser, Julie, Kim, Helen, One Nation Under Wal-Mart, Fortune, March 3, 2003.

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50. Tsao, Amy, How Wal-Mart Keeps Getting It Right, BusinessWeekOnline, April 16, 2003. 51. Landry, John T, The Wal-Mart Decade, Harvard Business Review, June 2003. 52. Kalakota, Ravi, Robinson, Marcia, From e-Business to Services: Why and Why Now?, www.informit.com, August 15, 2003. 53. Shelf Involved, Operations & Fulfillment, August 2003. 54. Bianco, Anthony, Zellner, Wendy, Brady, Diane, France, Mike, Lowry, Tom, Byrnes, Nanette, Zegel, Susan, Arndt, Michael, Berner, Robert, Palmer, Ann Therese, Is WalMart Too Powerful? BusinessWeek, October 6, 2003. 55. Cuneo, Alice Z, Inside the Battle to Best Wal-Mart. How Rivals Maneuver against a Marketing Goliath www.adage.com, October 06, 2003 56. Clarke, Katherine R, Wal-Mart's Global Growth Challenges Explored in New Retail Forward Report, Retail Forward, November 12, 2003. 57. Fishman, Charles, The Wal-Mart You Don't Know, www.fastcompany.com, December 2003. 58. T h i n g s a b o u t W a l - M a r t Y O U S h o u l d K n o w, members.rogers.com. 59. W a l - M a r t A n n u a l R e p o r t s , ( 1 9 7 2 - 2 0 0 3 ) , www.walmartstores.com. Books Referred 1. Walton, Sam, Huey J, Sam Walton: Made in America, Doubleday Publishing, 1992. Related Case Studies: 2. Gujarat Ambuja Redefining Operational Efficiency, Reference No. 602-056-1.
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S ECTION 9

Case Study: OPEC: The Economics of Cartel

Consuming one out of four oil barrels daily, US remains its largest consumer. Americans consume oil, more than double the Britons and Germans; and 13 times as much as the Chinese. With its thirst for oil, the US has dominated the dynamics of global oil industry for a long time (Annexure I). Annexure I also displays the change in the consumption of crude oil and natural gas in major regions of the world. Led by the US, oil-consuming

countries had an upper hand over oil-producing countries. To counter that and to protect the interests of oil-producing countries, many attempts were made to unite the oil producers. One such attempt resulted in formation of OPEC. Organisation of Petroleum Exporting Countries (OPEC) was established in 1960, constituting of five main oil-producing countries. Later on many more countries

This case study was written by Sai Manohar, under the direction of Saradhi Kumar G., IBSCDC. It is intended to be used as the basis for class discussion rather than to illustrate either effective or ineffective handling of a management situation. The case was compiled from published sources.

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joined the group and by end of 2007, OPEC had 13 oilproducing countries as its members. The main function of OPEC was to frame the policies that were mandatory for each member country. There were also many benefits as well as hindrances to these member countries. The Origin and Evolution of OPEC The most important facet in oil is the distinction between resource and reserve. Resource is the total amount of oil on the planet and reserve is the total amount of oil we know and can extract economically.1 The countries that held the worlds maximum reserves joined together to form OPEC. The establishment of the OPEC was announced on September 16th 1960 in Baghdad. Representatives from five different oilproducing countries Iran, Kuwait, Saudi Arabia, Venezuela, and Iraq signed its doctrine. Thus OPEC was established as a permanent intergovernmental organisation. These five founding members were later joined by another nine members: Qatar (1961); Indonesia (1962); Socialist Peoples Libyan Arab Jamahiriya (1962); United Arab Emirates (1967); Algeria (1969); Nigeria (1971); Ecuador (1973); Angola (2007) and Gabon (19751994).2 In the first 5 years of its existence, OPEC had its headquarters in Geneva, Switzerland. Later it moved over to Vienna, Austria on September 1st 1965.

Yom Kippur War Arab Oil Embargo

Video 8.9.1:Arab Oil Embargo

Source: NBC News Nightly Coverage

The Yom Kippur War that started in 1973 between Israel and Arab states, led by Egypt and Syria, initiated a oil price surge.

Crude oil price, which was $3 per barrel in 1972, shot to $12 per barrel by the end of 1974.3 During the war, US and other
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western countries supported Israel. This support negatively effected oil trade between OPEC and the western countries. The Arab nations that exported oil imposed an embargo on those that provided aid to Israel. Further the prices also increased to $13/barrel by 1978 (Exhibit I). From 1972 to 1992, it was estimated that the general demand for petroleum in OPEC countries was income- and price-inelastic.4 Another revolution in Iran and Iraq, in 1979 and 1980 respectively, led to an increase in the price of crude oil. The outcome of these events led to a loss in the production of crude oil in those 2 years. At one point, production almost halted.

Original Structure and Functions of OPEC OPEC comprises countries that depend mainly on oil revenues as national income. It was argued that since the oil exporters were exploited by the western governments and the multinational corporations, OPEC was created. Its main objective was to organise and bring out policies necessary to fend off any exploitatory measures from the importers. Also, to stabilise prices for petroleum producers and, to have an efficient and economic supply for consuming nations.5 All of OPECs functions are carried out by the OPEC Secretariat under the guidance and direction of the board of governors. The Secretariat consists of secretary general and some staff. The secretary generals tenure is for 3 years, running the organisation under the guidance of board of governors. Twice a year, ministers of OPEC member countries meet to discuss the status of oil markets and the actions necessary to improve their position. The board of governors consists of one governor each from a member country who is confirmed for 2 years. Boards main duties include directing OPECs management and executing resolutions.6

Members of OPEC
Shortly in 1980, the production increased to 4 million barrels a day. However, in the 1980s, Iraq invaded Iran and this war brought about a loss in production for both the countries (Exhibit II). This further resulted in an increase in the price of crude oil. Amid all this, OPEC was criticised that it could not control oil prices. There is an unequal division of worlds petroleum geology among 182 nations, of which 42 produce 98% of oil and the next 70, the remaining 2%; and the other 70, effectively nothing (Exhibit III).7 The production peak years for some nations are already established whereas for others, it is forecast. It is noted that 14 of the 42 nations have passed their peaks. Former
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Soviet Union (FSU) and US reached a highest peak of oil production of 4.62 gallon barrels per year (Gb/ year) and 4.12 Gb/year in 1987 and 1970 respectively. In the future, it is expected that Saudi Arabia may exceed the US in oil production and soon grab the second place. The last column (RR, N/ RR, 42N) in the Exhibit III represents the ratio of reserves for the

Arabia is the only country that controls 16.3% of the worlds future oil supply.There are also many advantages for being an OPEC member8 : nations that produce oil in a very less quantity, to the reserves of the top 42 oil-producing countries. It is noted that Saudi Most of the oil produced by OPEC members is exported to other countries. On the other hand, oil produced in non340

OPEC countries is sold in the local markets. Only 38% of the oil is exported from non-OPEC countries. Also in the case of US, a non-OPEC country, its production represents 50% of its consumption. As a result, it imports the remaining 50% from Saudi Arabia, Venezuela and Mexico Cost difference also plays an important role. In the case of OPEC countries, the cost amounted for exploring and developing oil reserves is low compared to non-OPEC countries. The average cost of exploration and development in the Middle East amounted to $2.2 per barrel, compared to $5.1 per barrel in the US As non-OPEC countries produce at their full capacity, the ability to increase the production is unfeasible. On the other hand, OPEC countries have the ability to produce an extra amount, as they have the required additional reserves Even though the refining capacity is focused on industrial countries, the world depends on OPECs oil exports. OPEC nations have had many benefits as its members. An increase in the profit and cash flow were the valuable benefits that they enjoyed. Also the Real Gross Domestic Product of Saudi Arabia, which was $53 billion in 1970, increased to $162 billion in 1980.9 There was also a similar growth in other OPEC member nations. During early 1980s, there was a fall in the prices and demand of oil, for which OPEC made its first attempt to stabilise prices by controlling production. They then set a ceiling for oil production at 18 million barrels a day. OPEC also set optimum limit for each member country. Still the oil price continued to fall below $10

per barrel during mid-1980s, as member countries did not follow their quota and produced beyond the limits. Finally in 1986, OPEC suspended the quota system. From 1985 onwards, the growing demand for oil in the Asian countries helped boost the production of OPEC members. This increase in the demand also shot up prices. This steep rise in demand coincides with recovery of OPECs production (Exhibit IV), increasing the market share from 29% in 1985 to 40% in 1994.10 However, in 1997, OPEC suffered a severe setback. As it expected the Asian countries demand for oil to grow, it increased its production ceiling by 2.5 million barrels a day. Its expectations were however wrong the Asian countries demand instead declined due to the currency crisis in late 1997. This reduced the market price to below $10 a barrel, forcing OPEC to lower its output quota for the next 7 years. The 9/11 attacks made OPEC cut its quotas further to 5.8 million barrels a day, bringing about a decline in its market share to about 37.6%.11 Ultimately OPECs production, which was 32 million barrels a day (Mbbl/d) 25 years ago, declined to 27 Mbbl/d in 2003. During the same period, the oil demand increased by 14 Mbbl/d, resulting in a decline in OPECs market share.12 This collapse of the market share almost shuttered the organisation. Further in 2004, OPEC reduced its quotas to 23.5 Mbbl/d and resolved to cut back its member output, as it was exceeding the quotas (Exhibit V).

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Many of the oil-producing and exporting countries did not join OPEC, mainly Soviet Union and Mexico. China also was an oilexporting country that was not an OPEC member. In order to minimise the increasing costs of oil imports, the Chinese government minimised its imports from the Persian Gulfs oil exporters. Instead it resorted to non-OPEC exporters, mainly Russia, whose exports constitute the bulk of Chinas oil imports.13 Ecuador and Gabon were OPEC members. However, on December 31st 1992, Ecuador withdrew since it was unable to pay the membership fee of $2 million14. It also felt that it could produce more oil than they were under the OPEC quote. Similar concerns prompted Gabon to follow suit in January 1995. OPEC: Monopoly vs Cartel OPEC conducts its business as a group and decides in unison over the oil prices and output quotas and also initiates all necessary market activities to increase revenues for member states.

As displayed in Exhibit I, the crude oil prices of OPEC countries increased to $60 per barrel by 2007. Even though the cost of producing is not very expensive, in the case of Middle Eastern countries, the cost is less than $5 per barrel. The five Persian Gulf countries Saudi Arabia, United Arab Emirates, Iran, Kuwait and Qatar are the biggest OPEC members, with minimum production costs of $5 per barrel. OPEC members, outside the Gulf have some what higher costs of production of $9perbarrel.15 Artificialscarcityis one of the main reasons for high price of crude oil and OPEC is largely criticised for creating that.18 The necessary condition for a Cartel to exercise the power of a monopoly is OPECs large market share.17 Its share in the total world production, compared to non-OPEC countries, was high (Exhibit VI). As displayed in Exhibit IV, during the 1980s, the production of crude oil increased in Rest of the World and stayed constant in the case of OPEC countries. Also the market
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share of OPEC decreased from50%in1974to47%in1979.18 This was due to OPECs operating capacity that was running at lessthan-full capacity and also due to an increase in the production for Rest of the World.

Footnotes 1. T h e I n s t i t u t e o f P e t r o l e u m , http://www.energyinst.org.uk/education/natural/1.htm 2. W h o a r e O P E C M e m b e r C o u n t r i e s ? , http://www.opec.org/library/FAQs/aboutOPEC/q3.htm 3. Oil Price History and Analysis, www.wtrg.com/prices.htm 4. Narayan Paresh Kumar and Smyth Russell, Panel Estimates of the Demand for Oil in the Middle East, http:// www.griffith.edu.au/school/gbs/afe/research/vol_01_0407_ middle_east_oil_demand.pdf 5. Dessai Suraje, An Analysis of the Role of OPEC as a G77 Member at the UNFCCC, http://assets.panda.org/downloads/ opecfullreportpublic.pdf 6. O P E C G e n e r a l I n f o r m a t i o n , http://www.opec.org/library/General%20Information/pdf/geni nfo.pdf 7. Duncan Richard C and Walter Youngquist, The World Petroleum Life-cycle, http://dieoff.org/page133.htm 8. Numerous Relative Advantages Pushing OPEC to Stay as a Major Player in the Market, h t t p : / / w w w. m o o . g o v. k w / m a g a z i n e / en/index.asp?More=yes&NewsID =169&mode=0&day=5&page=3 9. Shaw Robert Russell, The Organisation of Petroleum Exporting Countries and Oil Price Controls as They Have Ef343

fected the Economic Development of Countries Engaging i n P e t r o l e u m Tr a d e S i n c e O P E C s C r e a t i o n , http://www.ccds.charlotte.nc.us/ History/MidEast/04/Rshaw/Rshaw.html#four 10. Saxton Jim, OPEC and the High Price of Oil,http:// www.house.gov/jec/publications/109/11-17-05opec.pdf 11. OPEC and the High Price of Oil, op.cit. 12. Chalabi Fadhil J., What future for OPEC?,http:// www.mees.com/postedarticles/oped/a46n42d01.htm 13. Peimani Hooman, China suffering from high oil priceshttp://www.taipeitimes.com/News/editorials/ archives/2003/02/10/ 194058 . 14. Ecuador Set to Leave OPEChttp:query.nytimes.com/gst/ fullpage.html?res=9E0CE4DF1F3AF93BA2575AC0A9 64958260 15. Saxton Jim, OPECs 902 billion barrel oil reserve, www.house.gov/jec/publications/109/rr109-28.pdf 16. OPEC and the High Price of Oil, op.cit. 17. O P E C , h t t p : / / w p s . a w . c o m / aw_carltonper_modernio_4/0,9313,1424964-content,00.ht ml 18. M a r k e t S h a r e w i t h i n O P E C , http://www.wtrg.com/opecshare.html

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C HAPTER 9

Game Theory

Section 1

Game Theory

In most of the real markets, a number of firms interact strategically to maximize their profit. In oligopoly market, the issue of strategic interaction arise in an industry with a small number of firms. Game theory is one of the theories concerned with general analysis of strategic interaction. It can be new to study parlor games, political negotiation and economic behavior. It helps a firm determining the conditions under which lowering its price would not trigger a ruinous price war, whether firms

should build excess capacity to discourage entry into the industry. Even through it lowers the firms short-run profit and why cheating in a cartel usually leads to its collapse. The importance of game theory has increased tremendously in the present globalized competition even though the concept dates back to 1944 (John Von Neumann and Omist Oskar Morgenstern) This chapter explains the ways in which the game theory can be used to study economic behavior in monopolistic market.

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Different Types of Games In a game the strategic interaction involves many players, many strategies and their pay-offs. The players are the decision makers (firms) whose playing behavior are to be predicted. The strategies are the choices to change price, develop new products, undertake a new advertising campaign, build new capacity and other such actions that effect the sales and profitability of firms and its rivals. The pay-off is the outcome or consequence of the strategy. For each strategy a firms take, there are many strategies available to rival firm. In short, pay-off is the outcome of the each combination of strategies by the two firms. Games can be either zero sum and non zero sum or cooperative and non cooperative. In zero sum game, the gain of one player comes at the loss of other. Hence the sum of total gains in the game is zero. On the other hand, if the gains or losses of one firms do not come at the expense of other, it is called non zero sum game. In this game, the total gain from the game is not equal to zero. Similarly, cooperative games are games in which players negotiate contracts between them which are agreed upon. In this game both the players become better off after the game. For example, the bargaining between seller and buyer in a retail shop. On the other hand, in non cooperative games, possibility of negotiation of contract do not exist. For example, most of the strategic interaction in oligopoly market belongs to non cooperative games. Because the firms in oligopoly market set their prices without any negotiation, but by considering the reaction of the rival firms pricing strategy.

Video 9.1.1:Game Theory

The Pay-off Matrix Anil & Co and Binil & Co are two brick producing firms, competing in the same market. Either of them can start a price war by lowering prices. Let us assume that the initial price is set at the monopoly level. The managers of each firm calculate their firms profits for both, the case in which the competing firm keeps its price fixed and the case in which it matches their firms price cut. The managers of each firm calculate the profits it can earn when it lowers price or keeps price constant. They do this for two contingencies. The first is the case in which the rival firm lowers price. The second is the case in which the rival firm does not lower price. The result is a pay-off matrix that shows the gain or loss from each possible strategy for each possible reaction by the rival player of the game.

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percent, they will gain sales only if Binil & Co do not match the price cut. The first row in the pay-off matrix shows the consequences of Anil & Cos price cut. If Binil & Co also cuts their price by ten percent, Anil & Cos profit will be Rs.45,000 per month. If Binil & Co maintains their price at the current level, Anil & Cos profits will increase to Rs.65,000 per month as a result of a sharp increase in its share of the market. Anil & Cos alternative strategy is to maintain the current price. If it does so, it will earn a monthly profit of Rs.40,000 even if Binil & Co still went ahead and cut their price. On the other hand, Anil & Co will earn a monthly profit of Rs.50,000 if both maintain their respective prices. Now let us look at the pay-off matrix given to examine the options and possible profits of each seller, given the options available to its rival. The matrix shows what will happen if either seller chooses a course of action and how the pay-off to that action will vary with the choices made by the rival seller. Each box in the matrix is called a cell. Each cell indicates the profit that each of the sellers can expect to earn under a combination of strategies that they each choose independently. The cell in the upper left-hand corner shows the monthly profits of each of the two companies if both choose to cut price. The higher number in the cell gives Anil & Cos monthly profit, and the lower number gives Binil & Cos monthly profit if both have cut their prices from the initial price level by, let us say, ten percent. The two options that are open to the companies are they can cut their price by ten percent in an attempt to gain market share from their rival, or they can maintain their current price. Managers at Anil & Co knows that if they cut the price by ten If Anil & Cos managers knew for sure that when they cut price, Binil & Co would maintain their price, then they would know that the price cut would result in a profit of Rs.65,000, which is their best scenario. However, they probably suspect that their rivals may match the price cut, in which case Anil would earn a profit of only Rs.45,000 per month

Dominant Strategies and Nash Equilibrium

The managers of both the firms can pursue various strategies in their attempt to maximize profits. However, is there an equilibrium? In game theory, we search for what is called a dominant strategy, the strategy for which a player is getting the highest possible pay-off, regardless of what the rival players are doing. Let us look at the previous pay-off matrix once again to see if there are dominant strategies.

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Let us first look at Anil & Cos strategies. No matter what Binil & Co does, Anil & Co would be better off by cutting price. How do we know? Look at the numbers. If Binil & Co matches their price cut, Anil & Co would earn Rs.45,000 and if they dont, Anil & Co would earn even higher, i.e. Rs. 65,000. On the other hand, if Anil & Co keeps price unchanged while Binil & Co goes ahead with the price reduction, Anil & Co earns Rs. 40,000, which is Rs. 5,000 less than had they also reduced the price. Similarly, if they keep price unchanged while their rivals also keep their price unchanged, Anil & Co will earn only Rs. 50,000, which is Rs. 15,000 less than what they would have had they reduced their price. Hence, irrespective of what Binil & Co does, Anil & Co stands to gain from a price reduction. Therefore, we can say that price reduction is the dominant strategy for Anil & Co. Interestingly, in this case, price reduction is the dominant strategy for Binil & Co as well. Look at the numbers and you will find that no matter what Anil & Co does, it makes sense for Binil & Co to reduce the price by ten percent. When both players have dominant strategies, the solution to the game is pretty obvious. Both the firms in this case will reduce price. and make a profit each of Rs. 45,000 and Rs. 40,000 respectively. What if only one of the players has a dominant strategy? The solution is easy if the second player can know that the first player has a dominant strategy. Once you know your rivals dominant strategy, you need to opt for that strategy which maximizes your pay-off given your rivals dominant strategy.

Since you are doing the best you can given your rivals strategy, the equilibrium is a Nash equilibrium. The Nash equilibrium is the situation where each player choses his/her optional strategy, given the strategy chosen by the other player. When both the firms have dominant strategy, each firm is able to choose its optimal strategy regardless the strategy adopted by its rivals. But, if only one firm has dominant strategy the other cannot choose its optimal strategy independently of that firm. Hence, only when each player has chosen its optimal strategy of the other player, we will have a Nash equilibrium. In short, a dominant strategy equilibrium is always a Nash equilibrium. But a Nash equilibrium is not a necessarily a dominant strategy equilibrium. Dominated Strategies Many games do not have a dominant strategy for any player. In fact, dominance is the exception rather than the rule. However, it may be possible to simplify a game by eliminating dominated strategies. A dominated strategy is an alternative that yields a lower pay-off than some other strategy, no matter what the other players in the game do. Whenever there is a dominated strategy, the game can be simplified because the dominated strategy should always be avoided. Thus by reducing the number of viable options, it may be easier to identify an equilibrium or use other techniques to analyze the outcome. This makes a difference when pay-off matrix is more complex than the simple two-by-two matrix that we have used for illustration.

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Maximin and Minimax Strategies The analysis of market structures has assumed that managerial decisions focus on maximizing profits. But in highly competitive situations, or when a firm is a fringe player in an oligopolistic market, decision makers might adopt a risk-averse strategy of maximizing the minimum gain that can be earned. This decision rule is referred to as a maximin strategy. Technically, in game theory, a distinction is made between maximin and minimax strategies. In a zero-sum game, where the gain of one player is always equal to the loss of another, one can have a strategy of minimizing the opponents maximum payoff. This is referred to as minimax and in a zero-sum game, this is not different from minimizing one's own maximum loss, or maximizing one's own minimum gain. In other words, in a zerosum game, maximin and minimax should mean the same thing. However, in practice, maximin is a term more commonly used for non-zero-sum games to describe the risk-averse strategy which maximizes one's own minimum payoff. In non-zero-sum games, it should be obvious that this is not the same as minimizing the opponent's maximum gain. The Prisoners Dilemma The oligopolistic firms often face a problem called prisoners dilemma. It refers to the situation in which each firm adopts its dominant strategy but each could do better through cooperation. This section discusses the prisoners dilemma and firm decision-making issues. For example, two men (A and B) are arrested and are in police custody, but the cops do not have enough evidence for a conviction. Hence, the police holds them

separately and offer them both the same deal: If one gives a statement about the incident (confesses), admitting the facts, while and the other remains silent (does not confess), the one who confesses is let off with a warning, but the one who does not receives a full-year sentence. If neither of them confesses, they will be charged for a minor offense, which will get both of them only a month in jail. If both confess, both of them will be sentenced to a three-month sentence. Each prisoner must choose either to confess or remain silent, but the other will not know about the decision taken by his partner in this regard. What should they do? Since A always adopts a strategy of confessing the crime irrespective of what B adopts, it will be his dominant strategy. Similarly, B will confess the crime irrespective of what strategy does A adopt. Hence, both of them will end of in getting 3 month imprisonment by confessing the crime. In an extended form of this game, where it is repeated, the game is played over and over, and consequently, both prisoners continuously have an opportunity to penalize the other for the previous decision. If this repetition is done infinite times, the players may, due to threat of retaliation (known as tit-for-tat strategy), find it rational not to confess. Hence, in repeated games, the outcomes could be different from the first round itself. It must be noted that we are talking about repeated games and not sequential games. Sequential games are games where players take turn to play but not simultaneously. In sequential games, Bs action will depend upon As action in each round. In
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a repeated game, A and B take simultaneous strategic decisions, but the game itself is repeated over and over again. Now what if the number of times the game will be played is known? Well, the result will be similar to that of a stand-alone game. The finite aspect of the game means that in the final round, there is no threat of retaliation subsequently and hence, the dominant strategy should be back in play. But, if that is true in the last round, why should a player hope for an understanding competitor in the second-last round? Thus, if the game is repeated a finite number of times, by backward induction, it can be seen that the two prisoners will betray each other repeatedly. In oligopolistic markets, as desirable as cooperation is, each firm suspects that if it cooperates with its rival, it will lose market shares. This is a case of prisoners dilemma. Of course, in real world, some firms develop reputations over time, which can result in other firms trusting its intend to cooperate. Hence, some oligopolistic cooperation may prevail, as we saw from the section on price leadership.

both could be then making losses, which could force you to alter your quantity now. What does this mean? An established firm can deter the entry of a competitor by threatening to increase volumes further or drive down the prices. However, will the threat be taken seriously? An empty statement, which can be altered later is no threat for a rival. Also, what if the established firm goes ahead and creates the extra capacity to produce the output that was threatened with? Now that is a commitment made involving financial costs and the threat is credible. And the marginal cost of increasing volumes is only variable cost, whereas a potential competitor has to look at both fixed and variable costs. However, by making this commitment, the established firm is incurring higher costs and reducing current profit margins. Although this appears to be strange, it makes rational sense because by making a threat credible, potential entrants are deterred from entering the market. Reputation can also make a threat credible. If a particular firm is known to be ruthless in its retaliation, probably due to its past history, competitors are likely to factor in that when they compete with it, especially on price terms. As we have seen, price leadership can be the result of such a reputation, especially in the case of a barometric firm. Hence developing a reputation can be a very important strategy from a long-run perspective, in the case of repeated games. In fact, a firm might actually find it advantageous to develop a reputation of being irrational in its retaliation, which might allow it to have less competition in the long-run.

Threats, commitment and credibility

From our understanding of Stackelberg model, we know that moving first has its own advantages in a duopoly market, for no matter what your competitor does, your competitor has to factor in your output while taking a call on the quantity to produce. Suppose most of the cost of goodion is variable cost and your competitor has deep pockets to sustain some loss. Should the fact that you are already producing a large quantity deter your competitor from producing large quantity? Not really as you

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To illustrate what we have discussed about credible threats, consider two companies, which know that they are interdependent and their decisions in the coming future will affect each other. Both companies will want the best possible benefit for themselves. If the first firm is going to produce cars (big/small) and the second is going to produce tyres (big/small), it should be obvious that the one who moves first will have an advantage. Let us assume that for the first firm, higher profit is when it produces big cars whereas for the second firm, its profits are when it produces small tyres, assuming the first firm produces small cars. Now, the second firm can threaten to produce only small tyres, but will that force the first firm to produce small cars? That depends upon the credibility of the threat. Suppose, the first firm has already started producing big cars, then this threat is an empty threat as it does not make sense for the second firm to produce tyres for small cars. On the other hand, if it is the second firm, which has already started producing small tyres, the the first firm will have to roll out small cars. Suppose neither have started goodion, but the second firm has decided to go ahead with Video 9.1.2: Threats investment in a plant to produce small tyres, then the first firm has to treat small tyres as done deal and take its strategic decision. Entry deterrence Any action taken by an existing business, which deters a potential

entrant from entering a market is referred to as entry deterrence. Such actions are taken mainly to maintain monopoly power and profits. The existing firm has to convince the new entrant that its entry into this market is going to be unprofitable. Existing businesses deter entries of competition because, the new entrant may eat into its market share, lower market prices, and thus, lower profits. Hence the existing business has to decide whether to accommodate the new entrant or deter its entry. Depending on whether it can afford to make credible threats or not, it will decide its strategy. How deep its pockets are compared to that of its potential rival will also be a key factor. In other words, the ability to bear short-run losses combines with potential economies of scale will determine whether market power gets concentrated or diluted in the long run.

References Game theory

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REVIEW 9.1.1 Question 1 of 6 Game theory is most useful for analyzing:

A. The results of the Super Bowl B. The ways that two or more players choose strategies that jointly affect each participant C. Uncertainty in economic analysis D. Equilibrium in a perfectly competitive market.

Check Answer

Section 2

Case Study: Airbus 350 Vs Boeing 787: Battle for Skies

Airbus 350 vs Boeing 787 Battle for the Skies Aircraft manufacturers Airbus and Boeing have been the main players in the aviation industry for a long period of t i m e . To c o m p e t e w i t h Boeings successful aircraft 787, in 2007, Airbus planned to launch a larger aircraft

the A350 XWB. Airbus is facing difficulties in trying to c o m b a t i t s c o m p e t i t o r, Boeing. Though Boeings 787 gained the maximum number of orders almost from every major airliner, the Paris Air Show held between June 18th and June 21st of 2007, indicated that Airbus A350 XWB is proving to be a

This case was written by Md Sadik Hassan under the direction of Menaka Rao, IBSCDC. It is intended to be used as the basis for class discussion rather than to illustrate either effective or ineffective handling of a management situation. This case was compiled from published sources

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stiff competition to the Dreamliner. Boeing intends to launch its Dreamliner by 2008, with which it aims to be the fastest selling commercial aircraft in the history of aviation. However, the demand for the aircrafts prompted many other airliners to enter this market, who might challenge the existing duopoly of Airbus and Boeing, which they have retained over the decades. With the increasing competition from Russia, China and Japan, analysts observe that t h e dominance of the two seem to be in jeopardy. History of Airbus and Boeing The Civil aviation and aircraft manufacturing industry is mainly concentrated in the United States and Europe. It is dominated by Airbus backed by the European Union (EU) and Boeing by the US government. The trade disputes between EU and US takes precedence in the fight between the two companies. Headquartered in Chicago, Illinois, USA, Boeing was founded by William Edward Boeing in 1916. With no competition, till the 1970s, the US enjoyed a monopoly in the civil aircraft sector. Boeing has been dominating the industry since its inception. However, the formation of Airbus in 1970 challenged its monopoly. Airbus was established to compete with the

American aircraft manufacturing companies like Boeing, McDonnell Douglas and Lockheed. Airbus is the aircraftmanufacturing unit of European Aeronautic Defence and Space Co. (EADS), with its headquarters at Toulouse, France. It has its dominance in European countries and is one of the two big players in the commercial aircraft-manufacturing industry. Airbus has around 57,000 employees in 16 sites in Germany, France, UK and Spain. It outsources its work to US, Japan and China but the final assembly goodion takes place in Toulouse (France) and Hamburg (Germany) . Both Airbus and Boeing are equipped in manufacturing similar aircrafts like the single aisle, long range and wide-body aircrafts. The competition caused concerns for the US, as it did not want its monopoly jeopardised. The main cause of the dispute between Airbus and Boeing has been aircraft subsidies. The issue of subsidy has not only caused disputes, but has also brought in drastic changes in the aircraft industry. On one side, Boeing countered by alleging that Airbus was being paid subsidies by the EU and the EU in turn alleged Boeing of availing subsidies from the US government. To end the tiff between the two, in 1992, both the companies signed a bilateral agreement3 which was over the years ignored and bypassed by both Boeing and Airbus. In 2003, the dispute was further triggered when for the first time Airbus, sold more planes than Boeing [Exhibit I] and the same continued in 2004. Despite Airbus consistent growth over time, Boeing remained the global market leader with 80% of large aircraft in service.
5 4 2 1

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In 2004, Boeing filed a complaint against Airbus with the World Trade Organization (WTO), for violating the 1992 bilateral EUUS agreement, which was subject to regulations for large civil aircraft support from the respective governments. Boeing accused Airbus of receiving unfair subsidies from the European Union (EU). In response, Airbus also filed a complaint against Boeing, stating that it has been receiving unfair tax reductions from the US government and investment subsidies from the Japanese airliners, thus violating the agreement. In January 2005, both the companies decided to find a solution for the dispute without WTOs help. But in June 2005, both Airbus and Boeing again filed complaint against
Keynote 9.2.1: Aircraft Orders for Boeing and Airbus During 2000-2006
6

each other regarding the subsidies received from their respective governments. Airbus and Boeing had been strong contenders in the aircraft industry for many years. The question of aircraft demand in the industry has always depended on the Airbus-Boeing dispute. Airbus has traditionally been in stiff competition with Boeing year after year for aircraft orders, though the competition between them has not always been head-to-head. Each responds to the demand of the market with models either smaller or bigger than the other, in order to gain a competitive edge. It was evident with their previous models A380 was designed a little larger than Boeing 747, and the A320 is larger than Boeings 737-700 but smaller than Boeings 737-800, its direct competitor. Airliners all over the world are the biggest benefactors from the competition between Airbus and Boeing as they could choose aircrafts ranging from 100 seat aircrafts to 500 seat aircrafts, instead of opting for similar models. Though there are 4,463 Airbus aircrafts in service, Boeing outnumbered its competitors 6 times the number which Airbus had still in service. However, Airbus had a greater share of orders in 2003, 2004 and 2005 with 1,111 orders as compared to 1,002 of Boeing [Keynote9.2.1]. Based on this intense size-led competition, both the companies launched 787 Dreamliner and A350 XWB in 2005 and 2007 respectively.
7

Compiled by the author from: 1.Orders and Deliveries: Time Period Reports, http://active.boeing.com/commercialordersindex.cfm 2.Historical Orders and Deliveries,www.airbus.com/storeimm/repository/pdf/ att00009024/media/objective

Boeing 787 vs Airbus 350 Although Boeing introduced the Dreamliner in 2003, it was launched in 2005. Boeings attempt to address the 200-300seat aircraft segment prompted the introduction of the 787 in the market. The Boeing 787 Dreamliner is a long-range, mid356
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sized, wide-body, twin-engine passenger airliner. According to Randy Tinseth, vice president, marketing, for commercial airplanes, I think any time you bring a new model in such as the 787-9, which is a little larger than the 767-300 you get a situation where the market-space occupied by each airplane becomes more defined. But when we were developing 787 family, we were always thinking about the 777s capability, and we were looking at making 787 a complement rather than a competitor. In June 2006, the assembling of the 787aircraft began. According to Boeings spokesperson, Interchangeability is a big economic advantage for commercial jetliner owners and operators. The Dreamliner is designed to carry passengers for at least 30 years. During that period, interior styles will likely change several times. Seats, lavatories, galleys and especially in-flight entertainment systems will be upgraded or replaced several times as well. When an airplane is sold or leased, the new operator will want to redo the cabin in the colors and patterns of the airlines brand identity.
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earlier aircrafts, this model is a lighter aircraft that was built using a composite material. Its fuel efficiency also gave an edge for the models saleability. Keeping in view both the environmental factors and the comfort of the passengers, Boeing designed engines that reduced noise pollution. It also claims that the 787 Dreamliner is the most advanced and efficient airplane in its class, one that will set new standards for environmental leadership and passenger comfort.
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To compete with Boeings Dreamliner, Airbus planned to launch its A350 XWB in 2007. The design of the A350 is an improvised version of the A330. When the launch of 787 was announced, Boeing claimed that the low operating cost of the A330 would pose a threat to its aircraft. And yet, Boeing continued with its goodion and ignored the threat. On the contrary, the sales of A330 were hampered with the introduction of Boeings 787. Due to the hampering of sales, Airbus decided to launch A350, a wide body aircraft derived from the existing design of A330. This strategy backfired, as customers did not favour the design. In 2006, in response to criticisms from its customers ILFC, GECAS and Singapore Airlines, Airbus decided to have a wider fuselage as the earlier one could accommodate only eight passengers in a row as against nine passengers on the 787. Modifications were also done in the aircraft with larger wings, more powerful engines and higher cruise speed. Airbus modified its earlier model and presented the new A350 XWB in 2007. The new designs of A350 has a wider fuselage with a diameter of 31 cms as compared to A330 and Boeings 787, which had a fuselage with a diameter of 18cms-13 cms. The new design enabled Airbus to accommodate wider economy seats than Boeing. It
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According to Marty Bentrott, vice president of sales for Boeing 787, Our strategy has been to design and build an airplane that will take passengers where they want to go, when they want to go, without intermediate stops; do it efficiently while providing the utmost comfort to passengers; and make it simple and cost-effective for airlines to operate. The design team of the Dreamliner worked with the cabin component suppliers and developed standard mounts and interfaces that enable quicker and economical modifications. Boeing planned it in such a way that the aircraft owners could expect higher lease and resale value throughout its lifecycle. As compared to
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also maximised the usable space by having a constant crosssection from door one to door four. The passenger windows in A350 were five cms wider as compared to A330. John Leahy (Leahy), the chief salesperson of Airbus claimed that it is the widest on any airliner . The company sources also affirm that the A350 would be less noisy than A330 and also provides fuel efficiency that is 4% to 5% per seat better than the 787. According to Leahy, The new A350 engines are more advanced than 787 with thrust ranges between 75,000 and 95,000. Expressing his opinion, Chew Choon Seng, CEO of Singapore Airlines, said, It is heartening that Airbus has listened to customer airlines and has come up with a totally new design for the A350.
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By April 2007, the companies in the Asia-Pacific region placed more than 500 orders for Boeing Dreamliner, including an order of five planes by Japan Airlines. According to Kunio Shimizu, vice president of Japan Airlines, It will be our key airplane on international and domestic flights.
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In November 2007, post Dubai Airshow, Airbus won a $31billion contract from Emirates, the biggest Arabian carrier and a $13.5-billion order from a leasing unit of the Dubai Aerospace Enterprise (DAE). Boeing also won a $13.7-billion order from DAE and an order worth $6.1 billion from Qatar Airways. Airbus also claimed to have secured 1,021 contracts by the end of October 2007 as compared to 956 contracts of Boeing. Dubai based Emirates placed an order for 70 A350s apart from 11 double-deck A380s [Exhibit III]. At the same time, Boeing 787 Dreamliner is expected to outreach A350 in China as it has secured 60 orders from the Chinese airlines while Airbus could not secure a single order. According to Michael Bair, vice president and general manager of the 787 Program at Boeing Commercial Airplanes, Its a competitive market but Boeing is expected to take more than half of the market as we have advantage in timing. According to Robert Laird, vice president of Boeing, China sales, China has the worlds fastest growing airline industry and by 2026 will have an annual increase of 9% in passengers and an increase of 15% in cargo. According to him, China needs 2,800 aircraft in the coming 20 years to replace existing airplanes and as airlines expand their fleets, Boeing is confident to take a major share of that. Out of the 60 ordered, 57 orders are from various firms. Air China and China
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Considering the demand for the aircrafts and seeking a wider market share as well, both the companies are targeting the Asia-Pacific region. According to Boeings 2005 Current Market Outlook forecasts, by 2025, a market of about 7,200 new airplanes worth $770 billion in the Asia-Pacific region will be the next largest market outside North America. According to the report, Asia-Pacifics fleet will nearly triple, to about 8,600 airplanes by the end of the forecast period. As per the forecast made by Airbus, between 2004-2023, unit demand for airplanes in the Asia-Pacific region will be of 5,515 new airplanes, with larger airplanes having a bigger portion of total deliveries. Airbus also expected that, by the end of its forecast period the airlines in the Asia-Pacific would operate 33% of the worlds passenger airplanes as compared to 29% of Europe and 26% of North America.
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Eastern Airlines have ordered 15 aircrafts each, Hainan Airlines have ordered 8 aircrafts, Shanghai Airlines have ordered 9 aircrafts, and China Southern Airlines have ordered 10 aircrafts.
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its US competitors. It is not tolerable that one producer should have ready access to billions of dollars in up-front, risk-free financing to develop airplanes. The EU also had similar accusations against the US government for aiding Boeings 787 with $5 billion [Annexure II]. In defence of their aid, EU said that the US case against Airbus ignored relevant international agreements and is supported by incorrect facts. The dispute is at a key stage of the settlement process as both the parties have submitted a written allegation against one another in the WTO, detailing their legal arguments. According to some market analysts this trade dispute might also hamper both the companies future sales as China has announced its proposal to set up a company to build large passenger airplanes to compete with Airbus and Boeing.
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One huge market, which both Airbus and Boeing wished to tap, is the US. Till now only airliners in the Middle East and Asia have orders for the 787, but US legacy carriers are also showing interest in the 787. This helped boost Boeings confidence against the A350, which cost more than 787 and would not be available till 2013. US Airways have plans to order the A350, but Boeing is trying to persuade the airline to switch the order to its 787 instead.
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According to Forecast International, a market research firm, 9,528 commercial aircrafts, worth $986 billion will be produced between 2007 and 2016. It also predicts that Boeing will build 56% of those aircrafts and Airbus will produce 43%, and Russian government backed companies and the Ukrainian will produce the remaining 1%. In 2007, Airbus forecast record orders. According to a spokesperson, orders for Airbus, will surpass 1,111 (2005) and deliveries will exceed 450 making it The Road Ahead In 2007, US government accused Airbus of getting illegal aid for $100 billion from the European Union [Annexure I]. EU denied the claim and asked how finances received by Airbus hampered Boeing. In response, the US government said, Subsidies have enabled Airbus to develop a full family of airliners, targeted at
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the No.1 aircraft manufacturer in the industry for the fifth year. However, a spokesperson from Airbus denied the speculations of further delay of the A350 XWB and the announcement of the launch date of A350 was announced in 2007. However, there are concerns regarding the launch date of A350 as the company will lag behind by six years of Boeing 787 Dreamliners launch. Due to the redesigning of the A350 XWB
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model, the launch of the aircraft was scheduled to be in 2013, which falls behind the scheduled introduction of the Boeing 787. Company sources of Airbus also felt that the delay might make them loose some orders but will make up the delay with the ample time it gets, to improvise on its design. For the next 20 years till 2025, Airbus aims to increase its market share than Boeing. Analysts opine that Airbus might face hurdles for introducing its aircraft. But felt that the success will depend on the design aspects and services of both 787 and A350. On the other side, few analysts predict that soon after its launch, Boeing would have sold more than a thousand 787s37.The issue was further precipitated when a senior aviation analyst from Forbes announced that A350 XWB would be delayed till 2014. The problem with Airbus is that it plans to build most of A350 with aluminium alloy whereas Boeing is planning to build 50% of Boeing 787 with hardened plastics which will make it lot lighter and more fuel efficient. Though Airbus and Boeing battle for supremacy in commercial aircraft goodion, the duopoly is hampered with growing international competition from emerging markets like Brazil, Russia and China. Analysts also observe that Bombardier Aerospace, a division of the Bombardier Group and third largest aircraft company is competing to grab a market share from Airbus and Boeing. The company plans to launch the C-Series aircrafts in the large-sized commercial aircrafts segment in which both Boeing and Airbus operates. The Canadian and UK governments have invested $700 million in Bombardier, for the C-Series aircrafts which is set to provide competition to the big two. The Russian aerospace industry run by the government is
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also planning to combine all its aircraft companies like Irkut, Mikoyan, Sukhoi, Ilyushin, Tupolev and Yakovlev into a single company called Unified Aircraft Building Corporation (UABC), to compete with Airbus and Boeing in a big way. China seems to be by far emerging as the biggest competitor to both Airbus and Boeing, although Airbus and Boeing have outsourced their work to China. And after years of being a supplier, China has gained adequate experience and competence to challenge the duopoly players. China has its own ARJ-21 aircraft which is 60-105 seater and is also planning to manufacture a wide body aircraft along with Russia. Japan is also poised to become a future competitor in the aircraft industry. Mitsubishi Heavy Industries of Japan is all set for the launch of its first ever passenger jet expected to be manufactured in Japan. Annexure I The US Challenge to the EUs support for the Airbus The US now seeks to argue that the benefit of Member-State Financing (MSF) alone amounts to as much as $205 billion. This estimate is completely unrealistic. It is more than 8 times the capitalisation of EADS, $25.8 billion, or roughly 12 times the net assets of EADS, $18.4 billion! The calculation method used is contrary to accepted wisdom, practices and WTO subsidy rules. If the US methodology were to be applied to the massive federal, state and local subsidies benefiting Boeing, the amount challenged by the EU would be not $23 billion, but rather $305 billion.

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The US argues that without MSF, Airbus could not have launched its aircraft programmes. The US conveniently overlooks that a number of Airbus models were launched without any MSF, just as launch has also taken place in situations where Airbus in fact obtained financing on better terms and conditions in the commercial market. This is fatal to the US argument that MSF caused adverse effects to Boeing in fact the EU has shown that all Airbus aircraft launched in the last 15 years could have been launched without MSF. Boeing's stellar financial performance makes any US claim of "injury" highly implausible: the EU shows this by pointing at Boeing's record numbers of order backlogs and profits
Source: WTO dispute settlement,www.ec. europa.eu/trade /issues

For other subsidies such as those granted by Kansas authorities the US makes sweeping statements that Boeing has not benefited - and will not benefit. The US offers no or very limited evidentiary support for these claims. Finally, as regards the massive overpayments in terms of R&D contracts for the Department of Defence and NASA, the US predictably seeks to argue that this constitutes payment for services not covered by the WTO disciplines on subsidies that the US government is not overpaying and follows procurement procedures, and that Boeing receives adequate consideration in return. First, the US does not provide evidentiary support for such claims but simply refers to Department of Defence and NASA Regulations. This ignores, however, that for NASA R&D programs in particular, these are sham transactions whose objective is solely to support the US aeronautics sector/Boeing in very specific areas of research, with the resulting R&D being applied to Boeing's aircraft models. The US is also challenging the amount of R&D subsidies granted to Boeing - an apparent contradiction with its stance on its own challenge of Airbus support where the US grossly inflates the numbers.
Source: WTO Dispute Settlement, http://ec.europa.eu/trade /issues/ respectrules/

Annexure II The EUs Challenge of US subsidies to Boeing The US filed its reply to the EU's challenge on July 6th 2007. The following points will be the focus of the hearing before the WTO panel scheduled for 26-27 September 2007: The US readily acknowledges that FSC and successor schemes were prohibited export subsidies and that Boeing was a main beneficiary thereof. For certain subsidies granted by the State of Washington and the State of Illinois the US puts up a less than vigorous defence and appears to agree with the EU that subsidies have benefited - and will benefit - Boeing.

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Footnotes: 1. 2. Employees from all corners of the world,http:// www.airbus.com/en/corporate/ethics/diversity/index.html Pritchard David and MacPherson Alan, Strategic Destruction of the North American and European Commercial Aircraft Industry: Implications of the System Integration Busin e s s M o d e l , h t t p : / / w w w. c u s t a c . b u f f a l o . e d u /content/documents/OccPaper35.pdf, January 2007. In the late 1980s, the EU and the US started bilateral negotiations for the limitation of government subsidies to the Large Civil Aircraft sector. Negotiations were concluded in 1992 with the signature of the EC-US Agreement on Trade in Large Civil Aircraft which imposes discipline on both governments. The Agreement regulates in detail the forms and limits of government support, prescribes transparency obligations and ensures avoiding the trade disputes between the parties. Economic Brief: Airbus vs. Boeing, http://www.pinr.com/ r e p o r t . p h p ? a c = v i e w _ r e p o r t & r e p o r t _ i d = 3 1 0 & l anguage_id=1, June 7th 2005. Civil Aircraft Sector, http://ec.europa.eu/ trade/issues/sectoral/industry/aircraft/index_en.htm Economic Brief: Airbus vs. Boeing, op.cit. Hardee Jeffery Everette, Airbus and Boeing: A comparis o n , h t t p : / / w w w. p u b l i c . a s u . e d u / ~ j h a r d e e /PUP598_Paper1.doc Butcher David R., King of the Sky: Boeing Dreamliner vs. Airbus A350 XWB, http://news.thomasnet.com /IMT/

archives/2006/10/aircraft_design_ king_of_sky_boeing_dreamliner_versus_ airbus_a350xwb .html?t=recent, October 26th 2006. 9. The Battle of the long-range twin-aisles, http://www.aviation industrygroup.com/downloads /thebattleofthelongr-1018- 1023.pdf, September-October 2005

10. Ibid. 11. Babej Marc E. and Pollak Tim, Boeing versus Airbus, http://www.forbes.com /2006/05/23/unsolicited-adviceadvertising- cx_meb_0524boeing.html, May 24th 2006 12. King of the Sky: Boeing Dreamliner vs. Airbus A350 XWB, op.cit. 13. Holmes Stanley, Airbus Bides Its Time in Boeing Battle, http://www.businessweek.com/bwdaily/dnflash/content/july 2007/db2007076_848468.htm, July 6th 2007. 14. King of the Sky: Boeing Dreamliner vs. Airbus A350 XWB, op.cit. 15. King of the Sky : Boeing Dreamliner vs. Airbus A350 XWB, op.cit.

3.

4.

5. 6. 7.

16. Airbus Bides Its Time in Boeing Battle, op.cit. 17. King of the Sky: Boeing Dreamliner vs. Airbus A350 XWB op.cit. 18. Ibid. 19. Polek Gregory, Asia-Pacific market outlooks highlight Airbus-Boeing divide, http://www.ainonline.com/airshowconvention -news singapore -air-show/single-publication362

8.

story/article/ asia-pacific-market-outlooks-highlight-airbusboeing- divide/?no_cache=1, February 2006. 20. Ibid. 21. Ibid. 22. Boeing 787 sets record its fastest-selling airliner, http://www.sbac.co.uk/community /cms/content/preview /news_item_view.asp?i=16220&t=0, April 12th 2007.

32. US and EU trade charges at WTO over aircraft subsidies, op.cit. 33. Ibid. 34. B o e i n g & A i r b u s t o d o m i n a t e f o r a d e c a d e , http://www.mfgdigital.co.uk /NewsArticle.aspx?aeticle id=1810, August 17th 2007. 35. Ibid. 36. Mideast puts Airbus Ahead of Boeing, op.cit. 37. Airbus Bides Its Time in Boeing Battle, op.cit. 38. King of the Sky: Boeing Dreamliner vs. Airbus A350 XWB, op.cit. 39. Strategic Destruction of the North American and European Commercial Aircraft Industry: Implications of the System Integration Business Model, op.cit.

23. Rothman Andrea and Derhally Massoud A., Mideast puts Airbus Ahead of Boeing, http://seattletimes.nwsource. com /html/businesstechnology/2004010207_airshow13.html, November 13th 2007 24. Boeing 787 set to fly past rival A350 in China, http://www.chinadaily.com.cn/bizchina/2006-10/20/content_7 13052.htm, October 20th 2006 25. Boeing 787 set to fly past rival A350 in China, op.cit. 26. Ibid. 27. Ibid. 28. A350 Redesign Threats Boeing 777; Boeing prepares 787 for Challenge, http://www.leeham.net/filelib/ScottsColumn 060 606.pdf. 29. US and EU trade charges at WTO over aircraft subsidies, http://wwwiht.com/articles/2007/03/21/business/plane.php,M arch 21st 2007. http://wwwiht.com/articles/2007/03/21/business/plane.php,M arch 21st 2007. 30. Ibid. 31. Ibidkj

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C HAPTER 10

Market Failures

All through we have held that the advantages of free market systems are the advantages of competitive markets. But we now know that all markets are not competitive and many markets are not free. Therefore, while competitive markets are indeed economically efficient, and hence, any intervention by the government reduces

e c o n o m i c e ff i c i e n c y a n d causes deadweight loss, not all markets without government intervention are economically efficient. In other words, free markets do fail.

S ECTION 1

Market Failure and the Role of the Government

Market failure occurs when the allocation of goods and services by a free market is not efficient. In other words, there exists at least one other outcome in which an economic agent can be made better-off without another being made worse-off. Market failures could exist because free markets are not competitive or because

competitive markets have problems related to asymmetric information, contracts being unenforceable, property rights not defined well or not protected, principal agent problems, externalities,or public goods. Often, the existence of a market failure is cited as a justification for government intervention in a particular market.

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Understanding the causes of market failure and figuring out possible means of correction are important for policy makers, economists and managers who operate in a regulated environment. This is all the more important because many types of government interventions in the market, whether in the form of taxes or subsidies, wage and price controls, regulations, or even bail-outs, also lead to inefficient allocation of resources. Hence market failures do happen and when it occurs, market outcomes are sub-optimal. But, government failures occur too. Therefore, while there is no doubt that market failures cause e c o n o m i c i n e f f i c i e n c y, n o t everyone is sure about the ability of governments to improve inefficient outcomes. Market Power We now know that competitive markets work in efficiently allocating scarce resources. We also know that there are some conditions for competitive markets to work efficiently and these conditions are not automatically held. In the chapter on imperfect competition, we have seen that when firms exercise monopoly power, economic efficiency is affected. Similarly, if buyers exercise monopsony power too, there is deadweight loss. In other words, any exercise of market power, whether by sellers or buyers result in markets failing to achieve economic efficiency.

It should be kept in mind that this is true not only about the market for goods and services, it is true about factor markets as well. For instance, if due to trade-unionization, if wages are higher than the competitive wage, then economic efficiency is lost in the labor market. In turn, due to higher than competitive input cost, other markets too are affected. By definition, significant exercise of market power either by sellers on buyers in a market, makes the market less c o m p e t i t i v e . H e n c e , t o i m p r o v e e f f i c i e n c y, competitiveness has to be improved. It is in this context that antitrust laws and commissions should be seen. Antitrust laws and monopoly regulations are common in most free market economies. They are intended to ensure that concentration of market power in the hands of a few is prevented. In India, for instance, there is a Competition Commission of India, which has been established to prevent practices having adverse effect on competition, to promote and sustain competition in Indian markets and to ensure freedom of trade in the country. Public goods Some goods are such that once it is provided, no one can be denied their consumption. This feature is called nonexcludability in consumption. When goods are excludable, a seller can insist on the price being paid, failing which consumption can be denied. When goods are nonexcludable, once provided, it is difficult to deny its consumption whether the price is paid or not. In such
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Video 10.1.1:Market Failure

cases, most people may not pay the price and the seller goes out of business soon. Some goods are non-rivalrous in consumption. This means that the fact that one is consuming the good does not affect the availability of the same to other consumers. Music being played in the open is a good example. My listening to it does not reduce your ability to hear it. Goods, which are both non-excludable and non-rivalrous in consumption, are called public goods. It should be obvious that markets will undersupply public goods. Often, therefore, governments themselves start supplying public goods or provide incentives to private sector to produce such goods and services. Of course, questions will still remain unanswered though. For instance, in the absence of well-functioning market for public goods, how much should the government produce? After all, production of public goods involve scarce resources, which can be used to meet other wants. At zero price, the demand for these goods would be significantly higher than what it would have been at a positive price. Externalities What happens if the prevailing price does not reflect some cost or benefit because it affects or benefits someone other than the ones who are buying and selling? It, obviously, affects economic efficiency. Such scenarios are called externalities, because the costs and benefits to others are external to the market arrangements between the buyers and sellers.

Externalities are discussed in greater detail in the subsequent section. However, it is important to recognize that the problem of externalities is often a problem of property-rights. To use a simplistic example, a river is polluted by parties who dont pay the cost for it because the river is usually a common property. Had it been someones well-defined property and had that property-right been enforceable, then any use of river as a resource will only have been at a price, implying that what is an externality now would have been then internalized. Missing markets A missing market is when a competitive market allowing the exchange of a good or service would have been economically efficient, but the market currently does not exist. Missing markets could be because of many factors including externalities. For instance, today, we have what is referred to as emissions trade, which in fact is a market for tradable permits to pollute. But, in most cases, we know that a market to determine optimal pollution is missing. Such a market is unlikely to emerge on its own, till tradable permits are made well-defined and protected propertyrights. Another reason for missing markets is what is referred to as coordination failure. To illustrate, let us assume that a firm may not be supplying a marketable product in a particular area only because it does not have a plant in some location. Now, the plant is not set-up there because
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roads and telecom infrastructure is not set-up yet. However, roads and telecom infrastructure is not set-up because no one has an incentive to set them up in an area where no one has so far set up plants and production facilities. It should be clear that if both infrastructure and the plants can be set up, both would be viable, but this has to be done in a coordinated fashion. Lack of adequate technology or high transaction costs could also be the cause of missing markets. If the required technology is not yet available, a product which might have demand in a market, cannot be supplied. Similarly, if firms think that to operate in a particular market huge, it has to pay high transaction costs (perhaps in the form of bribes), which make the business unviable, then goods and services for which demand exist in the market, may never be produced. Markets can also be missing if there is a failure of trust or information. Prisoners dilemma illustrates scenarios where Video 10.1.2:Milton Friedman on Solutions to Mareconomic agents acting ket Failure independently will result in suboptimal outcomes, when they could have benefited from cooperating, but on their own will not. Asymmetric Information Market systems work best when economic agents are well aware of what they are buying and selling. If there is asymmetric information, implying that the parties involved in a transaction are not aware equally about

the good or service, then market will not operate efficiently. This may result in too high a price or too little a quantity or any other result which is not optimal. Often, the seller knows more about the product than the buyer. This is especially true about used products, the market for which is often referred to as market for lemons. With asymmetric information, low-quality goods can drive good-quality goods out of the market as buyers cant be sure of the quality and sellers cant get a good price for quality products. At its extreme, some markets (eg. market for well-maintained second-hand durable goods) cease to exist because of asymmetric information. One of the most commonly used examples is that of used cars. A used car is one in which ownership is transferred from one person to another, after a period of use by its first owner and its inevitable wear and tear. There are good used cars ("cherries") and defective used cars ("lemons"), normally as a consequence of several not-always-traceable variables such as the owner's driving style, quality and frequency of maintenance and accident history. Because many important elements are hidden from view and most people cant make out the difference between what is good and what isnt inside, the buyer of a car rarely knows beforehand whether it is a cherry or a lemon. So, the buyer's risk-averse guess for a given car is that the car is of average quality; accordingly, the buyer will be willing to pay for it only the price of a car of average quality. This, though, implies that the owner of a carefully maintained, well-taken care off, good used car is unlikely to get a sufficiently high price to make the person sell such a car.
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Therefore, owners of good cars will not bring their vehicle to resale market, and guess what, the withdrawal of good cars reduces further the average quality of cars in the market, causing buyers to decrease their price even more for any given car.

Video 10.1.3:Principal-Agent Problem

because the costs are not borne by the party taking the risk and information asymmetry might prevent it from being detected. For example, a person with insurance against automobile theft may be less careful about guarding their car, because the negative consequences of vehicle theft are now, at least in part, the responsibility of the insurance company. This is the primary reason why insurance coverage is rarely 100% and why companies insist on co-pay in their clauses. Another manifestation of asymmetric information is called a principal-agent problem. This describes problems arising from managers (agents) pursuing their self interest and goals, which are sometimes contrary to the objective of the firms (principals), but which cant often be made out. Moral hazard also manifests itself in a principalagent problem. The agent usually has more information about his or her actions or intentions than the principal does, because the principal usually cannot completely monitor the agent. For instance, the agent may take decisions about how much risk to take, when gains from the risks benefits the agent significantly, while another party bears the loss if things go badly. Since, the party insulated from risk behaves differently from how it would if it were fully exposed to the risk, moral hazard comes into play. Investment firms, which pool the money of others and invest in the markets, often face this issue in a very serious way. Moral hazard arises because an individual or institution does not take the full consequences and responsibilities of its actions, and, therefore, has a tendency to act less carefully than it otherwise would, leaving another party to bear the consequences of those actions.
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Adverse selection is another form of market failure due to asymmetric information. When products of different qualities of the product are sold at the same price, more low-quality products and less high-quality products are likely to be there. This has serious implications in many markets including insurance and credit. Insurance markets work on the basis of pooling of risks and if people who insure themselves are all people with higher than usual risks, then market for insurance fails. In insurance sector, adverse selection is used to describe a situation where an individual's demand for insurance is positively correlated with the individual's risk of loss, but the insurance agency is unable to discriminate on price terms because of not really knowing who is more risky and who is less risky or sometimes because of regulatory reasons. Hence the insurance agency ends up selecting more risky cases than they should, increasing the average cost of pooled risk. What happens when the average cost and average price of insurance then rises? Well, less risky customers are likely to drop out raising the average costs further. Moral hazard is another manifestation of asymmetric information. Moral hazard is a tendency to take undue risks

S ECTION 2

Case Study: Externalities: Justification for Public Goods?

Life without plastic is inconceivable in this modern age. Lightweight yet strong, the invention of plastic has, arguably, touched more lives than any other technological breakthrough. It has epitomised a modern solution to numerous issues on portability and packaging. Embodiment of cutting-edge technologies in so many products such as car, computer, aircraft, telephone, etc., has propelled plastic industry to assume ever-increasing importance since 1950s. In fact, since 1976, plastic has been the most used material in the world and was voted one of the top 100 news events of

the century.1Plastic has indeed seeped into every sphere of human existence. However, its association with large-scale externalities at every stage of its life cycle is a matter of immense concern. Market transactions characterise voluntary exchange of goods and services. However, involuntary exchange of benefits or costs accompanies production of goods and services at times, without the originator of the goods or services being adequately compensated or penalised. Markets do not have any mechanism to circumvent these spillover effects, called externalities. These may

This case study was written by Nitu Gupta under the direction of Akshaya Kumar Jena, IBSCDC. It is intended to be used as the basis for class discussion rather than to illustrate either effective or ineffective handling of a management situation. The case was compiled from published sources.

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be positive or negative depending upon whether benefit or cost impacts others. Almost every stage in production of plastic bags involves creation of some form of negative externality. Toxic chemicals hazardous for human health and environment are used to manufacture plastic bags (Exhibit I). Di EthylHexyl Phthalate (DEHP), a chemical used to stabilise the plastic in plastic bags, acts as a neurotoxin and has been shown to decrease sperm levels. Vinyl chloride, a key ingredient in manufacturing plastic bags is a proven carcinogenic. It may also cause liver, kidney and brain damage. Out of the 47 chemical plants ranked highest in carcinogenic emissions, 35 produce plastics, as per United States Environment Protection Agency.2 Major emissions contain sulphur oxides and nitrous oxides, which contribute to global warming.

$70 billion.3 In India, the per capita consumption of plastic is 6 kgs which is projected to reach 12 kgs by 2011. India is likely to be the third largest consumer market for plastic goods, behind US and China with a consumption of 12.5 million tonnes per annum, by 2012. According to R. A. Lohia, former president of Indian Plastic Federation, the Indian plastic industry is likely to grow by 15% in the next couple of years even with the global slowdown. The Indian plastics market comprising 55,000 operating units is worth about INR 400 billion has a scope for 10,000 more units.4 Plastic takes around 500 to 1,000 years to break down. Being non-biodegradable, it decays only though weathering. Hence, it is almost ubiquitous. Its ubiquity has earned different nicknames in different countries like, witches knickers in Ireland ,white pollution in China and roadside lillies in South Africa. Littered plastic is so widespread in Africa that it has given rise to a cottage industry, which gathers plastic litter to weave hats and bags. Litter is a huge societal burden. Lightweight plastic bags are easily transported by wind and water. They cover streets and clog drains and gutters leading to diseases. In India, there was flood in 2005 in Mumbai during monsoons, which killed more than 1,000 people and resulting 1.5 billion worth damage.5 Official reports pointed out that the situation was aggravated due to choking of drains and gutters by plastic bags.

People tend to overuse plastic bags as they do not pay for their spillover costs. It is estimated that by 2009, global consumption of rigid plastics will be $120 billion and flexible plastics will be

Cleaning and disposal of littered plastic bags entails great costs. In San Francisco, about $8.5 million are spent on this.6 The cost of living in a dirty city is difficult to calculate but it is
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immense. It also decreases tourism, as tourists prefer to visit a clean city rather than a dirty one. The plastic bags that end up in landfills take up valuable landfill space. Plastics in general make up between 14% and 28% by volume of waste in general. Every hour, over 200,000 plastic bags are thrown in landfills around the world.7 Eventually, the landfills will also leak and can cause immense environmental damage. Plastic bags put enormous strain on marine life too. Plastic constitutes 90% of the floating litter in the ocean. There are over 46,000 pieces of plastic in every square mile of ocean as per UN estimates8 . Plastic bags are wrapped around living corals leading to their quick death. Plastic bags contaminate soil and waterways and thereby enter the food web when ingested by animals. The small plastic fragments act like a sponge for toxic chemicals.9 Marine life then eats these pieces and dies. Endangered turtles that confuse these for jellyfish, their primary source of food ingest these are choked to death due to suffocation. It is estimated that over hundreds of thousands of sea turtles, seals, whales and other marine mammals die every year due to this. The problem does not end once the animal dies, its carcass decomposes and the plastic is again free to wander in the ocean and continues its killing spree. Though the market mechanism fails, there is a market-based way of limiting plastic bag consumption as witnessed in Ireland. In March 2002, Ireland became the first country to introduce plastic bag tax or PlasTax. Such a tax resulted in reduced consumption by approximately 90% from 1.2 billion to 230 million plastic bags per year. There is a remarkably reduced litter around Ireland and it saved approximately 18,000,000 litres of oil.10

A non-market based way of limiting plastic bag consumption is to completely ban its usage and production. In US, San Francisco was the first big city to ban plastic bags in 2007. There have been dozens of legislative proposals in states like Connecticut, Maryland, Massachusetts, Texas and Virginia to impose similar ban. A few Indian states also placed ban on plastic bag use and manufacturing. The various negative externalities of plastic have prompted suggestion to switch back to paper. However, a comparison of Plastic vs Paper does not indicate unmixed merits of the former. Production process of paper involves heating wood chips in a chemical solution under pressure. This results in enormous air and water pollution. Paper bag production leads to 70% more air pollution and 50 times more water pollution than plastic bag production11 (Exhibit II). Manufacturing of plastic does not require cutting of trees while increased use of paper bags necessitates more felling of trees, which is a huge resource cost. Production of plastic bags requires 70% less energy than paper bags. Thus, comparatively speaking, plastic bags are quite resource efficient. For every seven trucks required to transport paper bags, only one truck is required for the same number of plastic bags. This results in reduced emissions and energy conservation. While 1,000 plastic bags weigh 15lbs, 1,000 paper bags weigh 190lbs.12 As less weight implies less waste, plastic bags take up a lot less space in a landfill. Moreover, modern landfills are lined with clay and plastic and sealed from water, light, oxygen, etc., to prevent materials from decaying. Therefore, the argument that paper bags are biodegradable loses importance in light of the fact that nothing substantially decays in these landfills.
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drinking or bathing in its waters will lead to salvation. D.S. Bhargava, a retired hydrology professor, based on his exhaustive experiments on the Ganges opines that the available oxygen is usually depleted by the organic material and it starts decomposing in most of the rivers. However, in the Ganges, an unknown substance referred to as a disinfectant by Indians works on organic materials to kill them. This selfpurifying characteristic of the Ganges results in oxygen levels 25 times higher than any other river in the world.14 Approximately 400 million people stay in the river basin of the Ganges15 , earning it the status of the most populous river basin in the world. Agriculture is the mainstay of these people residing in the Gangetic delta. As their need for regular water supply through irrigation is duly taken care of by the Ganges, they grow crops on its fertile floodplains. Jute, tea and rice are among the major crops that are grown here. Fishing is also a significant source of livelihood for the population of the delta. They often treat fish as a major source of food. Sundarbans, a vast tract of mangrove forest and swampland forming the lower part of the Ganges Delta in a chain of 54 islands, is one of the unique ecosystems. It is the ecological habitat of various endangered species like Bengal tiger, clouded leopard, Asian elephant, spotted deer, Indian python and crocodiles. Kingfishers, eagles, swamp partridges and woodpeckers are among the birds inhabiting the delta region. The great Ganges supports a remarkable variety of flora, vital to nutrient and water conservation, and soil erosion control. A large number of these plants have a wide range of therapeutic uses.
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Recycling a pound of plastic takes 91% less energy than it takes to recycle a pound of paper13 . It is claimed that there is nothing in the recycling world that can be recycled more easily than plastic. Therefore, plastic is a greener alternative to paper. While negative externalities assume great importance and are mostly the topic of discussion, positive externalities are economically no less significant. It is indeed more significant since it justifies not merely governments intervention, but often its active participation. If there are huge external benefits, too little of the good or service would be produced by private markets. In such a situation government has to take initiative to set things right as has been seen in case of cleaning the river Ganges. Positive Externalities of the Ganges From the Gangotri glacier of the great Himalayas, originates the Ganges, one of the worlds greatest river. The sacred river is an insignia of Indias rich cultural past and is worshipped for its purifying properties. The Ganges water is said to be endowed with characteristics of Ambrosia. Hindus believe that

As an alternative mode of transport, the river Ganges assumes immense commercial significance. Transport of heavy goods by relatively cheap and cost effective means is facilitated by the Ganges. The river is the basis a large number of industries, for example, the jute industry of West Bengal and leather tanneries of Kanpur. It serves all the water requirements of these industries as well as sustains the workforce of these industries. Cleaning the Ganges The current reality of the Ganges presents a painful paradox. While it is worshipped on one hand, it is being polluted on the other. Today, it is among the five most polluted river systems of the world. Though the positive externalities of river Ganges are being enjoyed by millions of individuals, there is no evidence of private initiative to prevent Ganges from being polluted. The private entities that are responsible for large-scale Ganges water pollution are not accounting for the social costs in their cost benefit analysis (Exhibit III).

dealing with the environmental concerns has continued to be the burden of a few green crusaders. The vast majority of the population has shirked away from the issue in the hope that others would take the lead. This mass apathy has called for the role of government in cleansing the Ganges. The Central Pollution Control Board (CPCB) of India did a comprehensive survey of the situation in 1984, which formed the base for an action plan known as Ganga Action Plan (GAP) by Department of Environment and Forests. GAP was approved by the cabinet as 100% centrally sponsored scheme and thus launched in June 1985 with the formation of Ganga Project Directorate. It was renamed as the National River Conservation Directorate (NRCD) in June 1994. As a part of the Department of Environment, it was formed for the execution of the plan. A Central Ganga Authority (CGA), under the chairmanship of the Prime Minister, was formed by the Government of India to monitor the project, which was later renamed as the National River Conservation Authority (NRCA). GAP was launched with an aim to reduce the quantum of water pollution and improve the quality of Ganges water to acceptable standards. Later, the objective was reviewed to restore the riverwater quality to the bathing class standard (Exhibit IV).

Cleansing of Ganges definitely calls for private initiative and contribution from all corners of the nation. However, the task of
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complete. GAP II was supposed to be completed in 2001 but was extended till December 2008. Assessment by Public Account Committee (PAC) 20032004 reveals the NRCD had discontinued the water quality monitoring of river Ganges, an important function of GAP, since September 1999, allegedly due to funds constraints. In absence of water quality test checks, successful implementation of schemes sounds vague. Findings exposed further worsening of water quality in all its parameters. The coliform levels exceeded in 17 out of 60 stations sampled during 1999.16 GAP has achieved only 39% of its primary target of sewage treatment during the period of 19932000 reviewed by PAC. Creation of assets and facilities under the GAP was also quite short of the target. Effluent Treatment Plants have been installed in only about 45% of the grossly polluting industrial units, out of which more than 18% neither function properly nor are at par with the technical standards. The NRCD having no power to take any punitive action against violators could not enable proper implementation.17 In 2009, the government took a path breaking initiative in recognition of the need for revamping the Ganges cleaning programme. In February 2009, the Government decided to give the Ganges the status of a National River and the setting up of a National Ganges River Basin Authority (NGRBA). The NGRBA will be chaired by the Prime Minister and have as its members, the Chief Ministers of all the states through which the Ganges flows namely., Uttarakhand, Uttar Pradesh, Bihar, Jharkhand and West Bengal. The NGRBA would be responsible for addressing the problem of pollution in the Ganges in a holistic and comprehensive manner. This will
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Municipal sewage accounted for around 75% of the rivers pollution and therefore, a major part of public investment allocated for the plan was diverted towards elimination of it. The non-point sources of pollution were also addressed through creation of facilities like crematoria, improvement of bathing ghats, toilet complexes, etc., in the vicinity of the Ganges. Industrial pollution was prevented and controlled through the existing environmental laws. The cleansing of the great Ganges was designed in two phases. Ganga Action Plan- I was launched in 1985 in the states of Uttar Pradesh, Bihar and West Bengal. Ganga Action Plan-II, launched in 1993, incorporated the tributaries of river Ganges namely, Yamuna, Gomati and Damodar. It was to be implemented by states of Uttaranchal, Haryana, Delhi, Uttar Pradesh, Bihar and West Bengal. The success of GAP can be gauged from its sluggish pace. The GAP-I scheduled to be completed by March 1990 was extended till March 2000, when it was officially declared

include water quality, minimum ecological flows, sustainable access and other issues relevant to river ecology and management. Under the new approach, the river basin will be the unit of planning. The NGRBA would seek to maintain minimum ecological flows in the river Ganges with the aim of ensuring water quality and environmentally sustainable development. The cleaning of the Ganges is a source of immense positive externalities. But the benefits of a cleaned Ganges being nonrivalrous and non-excludable, the individuals intent to free ride is blatant. Though the political frigidity and bureaucratic rigidity have not achieved much success in cleaning the Ganges, the need for Governments role seems to be no less compelling.

Footnotes 1. T h e H i s t o r y o f P l a s t i c , http://www.americanchemistry.com/s_plastics/doc.asp?CID =1102&DID=4665 2. Moorthy V. Krishna, Say No! - to Plastic Bags, http://www.vigyanprasar.gov.in/comcom/plasticbags.htm 3. P l a s t I n d i a 2 0 0 9 , http://www.indiaplasticdirectory.com/plastindia2009/, February 2009 4. P l a s t i c c o n s u m p t i o n t o d o u b l e b y 2 0 1 1 , http://www.business-standard.com/india/news/plastic-consu mption-to-double-by-2011/18/00/345971/, January 13th 2009 5. Clubb G., Plastic Bag Litter Position Paper, http://www.keepwalestidy.org/english/images/plasticbags.pdf 6. C o n s u m p t i o n E x t e r n a l i t i e s , http://www.plasticbageconomics.com/index.php?option=co m_content&task=view&id=16&Itemid=30 7. Ibid. 8. Adventurer to sail plastic boat into oceans plastic dump, http://www.telegraph.co.uk/earth/4285594/Adventurer-to-sai l-plastic- boat-into-oceans-plastic-dump.html, January 18th 2009 9. T h e R e a l C o s t o f F r e e , http://www.reusablebags.com/facts.php?id=2
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10. The PlasTax - About Irelands Plastic Bag Tax, http://www.reusablebags.com/facts.php?id=20 11. P a p e r V S . P l a s t i c , http://www.plasticbageconomics.com/index.php?option=c om_content&task=view&id=30&Itemid=45 12. Kellinger Jeniffer, Info Sheet: Recyclable Plastic Bags, http://www.americanchemistry.com/s_plastics/doc.asp?CI D=1106&DID=7939 13. ibid. 14. Hollick Crandall Julian, Mystery Factor Gives Ganges a Clean Reputation, http://www.npr.org/templates/story/ story.php?storyId=17134270, December 16th 2007 15. B r o o k a n d B h a g a t G a u r a v , C l e a n t h e Ganges,http:www.ecoworld.com/features/2004/12/19/ clean-the-ganges/, December 19th 2004 16. GANGA ACTION PLAN: Sixty Second Report -Public Accounts Committee (2003-2004), http://www.cseindia.org/misc/ganga/ GAP2004.pdf 17. ibid.

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S ECTION 3

Externalities - Market Failure and Government Intervention

Video 10.3.1:Externalities As we have seen earlier, an externality is an action by a seller or a buyer, which benefits or affects a third-party, but the benefit or cost to the third-party does not get accounted for in the price. They are clearly third-party effects arising from the production or consumption of goods and services for which no appropriate compensation is paid. Externalities could be positive or negative. When it results in a benefit for the thirdparty, it is a positive externality and when it results in a loss for the thirdparty, it is a negative externality. In the case of both negative and positive externalities, prices in a competitive market do not reflect the full costs or benefits of producing or consuming a product or service. Also, producers and consumers may neither bear all of the costs nor reap all of the benefits of the

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economic activity, and too much or too little of the goods will be produced or consumed in terms of overall costs and benefits to society. For example, manufacturing that causes air pollution imposes costs on the whole society, while fireproofing a home improves the fire safety of neighbors. Failure to take into consideration the external costs of pollution results in too much of pollution, beyond what is optimal. Failure to take into consideration external benefits, such as social benefits of fire-proofing private houses, results in sub-optimal provision of such goods. Externalities can be in consumption, known as consumption externalities. Similarly, there can be production externalities as well. Both consumption and production externalities can be either positive or negative. And, as we have seen in the section on market failures, externalities will lead to market failure unless the externalities are internalized. In the absence of externalities, private costs are equal to social costs and private benefits are equal to social benefits. Externalities create a wedge between them. When negative externalities exist, social cost of production (or consumption) is greater than private cost by the amount of negative externality caused. Similarly, when positive externalities exist, social benefit of consumption (or production) is greater than the private cost by the amount of positive externality generated. MARKET FAILURE AND EXTERNALITIES The figure below shows how when negative production externalities exist, marginal social cost will be greater than private marginal cost. This is shown in the figure below where

the marginal social cost of production exceeds the private costs faced only by the producer of the product. Pesticides in agricultural sector creates some external costs to the environment both during their production as well as during their consumption.

How do externalities lead to market failure? The objective of a firm is to maximize its profits. Firms, hence, will take into account only the private costs and private benefits of their product. We can see from the
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figure below that the profit-maximizing level of output is at Q1. (By now, you should know from the figure that the firm in question is operating in a perfectly competitive market!) However, to calculate the socially optimum output, external costs need to be considered. This social optimum output level is lower at Q2.

failure to take into account the negative externality effects results in sub-optimal allocation of scarce resources causing efficiency loss and market failure. As we mentioned before, not only producers but consumers can also create externalities. In the case of negative externalities of consumption, the net marginal social benefit of consumption will be less than the net marginal private benefit of consumption. This leads to the good or service being over-consumed relative to the social optimum. Without government intervention the good or service are likely to be under-priced. This results in a loss of economic efficiency and deadweight loss. Public Goods As we have seen before, left to the market, public goods such as street lighting or police services will either be not provided at all or be under-provided. In the case of public goods, it should be clear that the net marginal social benefits far exceed the net marginal private benefits of a private producer. In fact, when it comes to private costs and benefits, it is possible that the costs of providing them may be higher than the benefits, but when it comes to social benefits and costs, benefits are likely to be higher than the costs. Private benefits of providing public goods are lower primarily because of non-excludability and the resulting absence of customers willing to pay the right price for it. On the other hand, social costs are lower because providing the good for an addition consumer has hardly any cost due to non-rivalry in consumption.
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This implies that, when it comes to negative externalities, the private optimum output is greater than the social optimum level of production. The producer causing the externality does not take its effects into calculations. The

Merit Goods Merit Goods are those goods and services that the government feels that people left to themselves will under-consume and which therefore ought to be subsidized or provided free at the point of use or even be compelled to consume. Primary education is often considered an example. It is possible that a poor parent might think that the private benefit of sending a child to school is less than the private cost (including opportunity cost), but the child becoming an educated citizen has benefits for the society as a whole, beyond the immediate family. Another interesting example is the case of helmets and seatbelts being made compulsory. Unlike public goods, both the public and private sector can produce and supply merit goods and services. It is their consumption which is of concern. Consumption of merit goods generate positive externality effects and hence, the social benefits from consumption exceeds their private benefits.

Government intervention may seek to correct for the distortions created by market failure and to improve the efficiency in the way that markets operate. Some examples of government interventions are: Pollution taxes to correct for externalities Regulation of monopoly power and cartel behavior Direct provision of public goods, like street-lighting Price controls and administered pricing mechanism Incentives for externality mitigating systems Environmental Concerns Environmental issues, especially about pollution as well as resource degradation, are primarily economic issues, related to negative externalities. Pollution is an externality because the cots of pollution is substantially borne by third-parties. In fact, if the polluter can be made to pay the cost of pollution, the externality can be internalized. Traditionally, government policy towards the environment has concentrated in two main areas: Intervention in the price mechanism for example through environmental taxes, known as Pigouvian taxes, which increases the private marginal cost, such that it equals the marginal social cost.

Government Intervention
Government intervention often becomes the prescribed solution to market failure. We have seen in the previous section that government failure is common too. Governments justify market intervention by claiming to do so in public interest. Especially in a democratic country, it is important for governments to be seen to be doing something in the presence of market failure.

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Command and control measures for example direct regulation and legislation, which puts a cap on the maximum pollution that is allowed. However, in the recent past, market-based policy instruments have also been put to use. Tradable permits is the best example of such market-based instruments. In the case of tradable permits, a ceiling is kept on the total pollution of a particular kind and this total is partitioned into several packets of rights to pollute within the limit, which can be traded. Since this right now has a price, it is costly to pollute. Even if your firm is polluting within the limit set, it has incentives to reduce pollution further, as lowering pollution further will allow it to sell the excess rights at a price to others who need them to stay in the market. An economic understanding of externalities recognize the duality of the problem of externality. A youngster playing his guitar at mid-night to entertain his partying friends may or may not cause an externality, depending on his neighborhood. In other words, an externality is caused not merely by his playing music, but also by the presence of neighbors who are looking forward to a quiet night. A person who has gone ahead and bought a one-bed room apartment next to a night club cannot possibly blame the night club for the externality its patrons cause to him, because until he arrived at the scene, there was no externality. Market-based policies take into consideration both sides of the problem. By creating a market, these policy instruments attempt to internalize the externalities. The assumption is that once the

right price prevails, it really does not matter which side pays for the good in question, but the right quantity will always prevail. In other words, once a functioning market is created, allocation of scarce resources is taken care and economic efficiency is restored. All in all, government policies, whether market-based or not, are intended to: Achieve a more efficient use of environmental resources Promote substitution between resources Provide incentives for a reduction of pollution emissions Property Rights and externalities Tradable permits is an interesting example of creation of property rights to solve a problem of externality. Often externalities exist because there is some property whose ownership is not clearly defined or is not enforceable. Look at the problem of garbage on the street. Why does it occur? What if the streets are the property of someone specific? While this might have other consequences, one happy consequence will be that dumping of garbage on the street will come down. Property-rights make something tradable in the market place. One cannot sell something which is not ones property. Hence, private property is a fundamental requirement for markets to function. By making the right to smoke a cigarette a tradable permit, one can clearly arrive at a price for smoking. In fact, not only smokers, even non-smokers may bid for the limited
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number of permits in order to ensure that smoking further comes down. For many externalities, designing a market-based solution is still difficult, especially due to political economy concerns. Hence governments often resort to command and control systems, which are relatively less efficient, but often politically more acceptable. In many cases, governments manage to merely pass legislation which prohibits certain things in order to minimize externalities, but this is usually extremely difficult to implement as market usually, at least indirectly, triumphs over non-market solutions and this results in corruption.

REVIEW 10.3.1 Question 1 of 4 Externalities may lead to market failure, if

A. The price mechanism does not take into account the full social costs and social benefits of production and consumption B. The price mechanism takes into account the full social costs and social benefits of production and consumption. C. The price mechanism does not take into account the full social costs and social benefits of production alone. D. The price mechanism does not take into account the full social costs and social benefits of consumption alone.

Check Answer

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This document is authorized for internal use only at IBS campuses- Batch of 2012-2014 - Semester I. No part of this publication may be reproduced, stored in a retrieved system, used in a spreadsheet, or transmitted in any form or by any means - electronic, mechanical, photocopying or otherwise - without prior permission in writing from IBS Hyderabad.

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Kom Ferry
Kom Ferry is a leading executive search rm.

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L N Mittal
In 2005 , Indian-born steel tycoon Lakshmi Mittal became the third richest person in the world, trailing only Microsoft chief Bill Gates and US investment guru Warren Buffett. According to Forbes Magazine, London-based Mittal boosted his fortune after quadrupling his net worth by $18.8 billion to $25 billion. Mittal climbed 59 steps from 2004 to number three in 2005. He was also listed as the richest person in Britain in the Sunday Times Rich list 2005. His success has largely been built on buying up loss-making state-owned mills and quickly turning them around.Mittal has received accolades for his achievements. In 1996, he was awarded the title 'Steel maker of the Year' by New Steel Magazine in the USA, and he received the Eighth Honorary Willy Korf Steel Vision Award, the highest recognition for world wide achievement in the steel industry in June 1998.In 2004, he was awarded the 'European Business man of the year' by Fortune Magazine.

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Macroeconomics
Analysis dealing with the behavior of the economy as a whole with respect to output, income, the price level, foreign trade, unemployment, and other aggregate economic variables.

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Maharaja
Air-India adopted the Maharaja as its mascot in 1946. Though it was rst meant to be a design for memo-pads on board Air-India's ights, it was used all over the place in promoting the airline. Air-India's then commercial director Bobby Kooka, and Umesh Rao, an artist with J. Walter Thompson Ltd, created the Maharajah.

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Microeconomics
Analysis dealing with the behavior of individual elements in an economy such as the determination of the price of a single production or the behavior of a single consumer or business firm.

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Modiluft
ModiLuft was one of Indias rst post-deregulation airline, launched in May 1993 by the Indian industrialist S K Modi, in technical partnership with the German ag carrier. The airline project was started by S K Modi, Ashutosh Dayal Sharma and Kanwar K S Jamwal and on 5 May 1993 took the rst ight from New Delhi to Mumbai. The airline ceased operations in 1996.

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Murex
Murex SAS is a leading software provider of trading, risk management, and processing.

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Narasimham Committee
The Narasimham committee on banking reforms set up by the GoI, was chaired by M. Narasimham

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Nariman Point
Nariman Point is a premier business district in Indias nancial capital, Mumbai.

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NASSCOM
The National Association of Software and Service Companies (NASSCOM) is a consortium that serves as an interface to the Indian IT and BPO industry.

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Policy
As the competition increased, the civil aviation ministry relaxed its control on fares. Unlike the past, IA did not need to seek approval from the ministry every time it adjusted its fares. The airline was allowed to cut fares on one sector while hiking it on another. This supplemented its FlexiFare policy under which, the fare could vary from sector to sector, season to season and even during the day, peak to non-peak time.

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PriceWaterhouseCoopers
PriceWaterhouseCoopers, headquartered in New York, USA, is the worlds largest professional services rm.

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Production possibility curve

A graphical representation of the boundary between possible and unattainable levels of production in a particular economy.

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Property rights
Private property rights is ones right to use their property, engage in lawful transactions related to the sale, purchase and mortgage of that property, and enjoy ones property to the exclusion of others.

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Rabobank
Rabobank is a private cooperative bank based in The Netherlands. It provides services all over the world

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State Bank of India (SBI)

State Bank of India (SBI), headquartered in Mumbai, India, is the largest bank in India. It had revenues of US$ 13.775 billion in 2005.

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Supplier of Choice
The Supplier of Choice strategy was introduced On July 12, 2000. Under this strategy a written contract was formalized between De Beers and its Sightholders. The Supplier of Choice strategy included the creation of powerful new identity, the introduction of a policy statement and a code of professional and ethical standards to insure continued consumer condence through the industrys commitment to the highest professional and ethical standards. Sightholders were forbidden buying diamonds that were smuggled out of war-torn areas of Africa, Sierra Leone and Angola. Any sightholder found purchasing such supply were shut out from the De Beers stock and De Beers stopped steping in to be the buyer of last resort.

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UBS AG
UBS AG, with its headquarters in Basel & Zrich, Switzerland, is a diversified global financial services company.

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Universal Banking
Universal Banking is a combination of commercial banking, investment banking and various other activities including insurance.

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UTI Bank (now Axis Bank

UTI Bank is one of the leading private sector banks in India. As of July 2007, it was the fth largest bank in India with total business of Rs. 10 billion and market capitalization of Rs. 2181.7 million. In July 2007, UTI Bank rebranded itself as Axis Bank.

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WiFi
WiFi is a latest wireless advancement which provides hi-speed Internet access over a limited area as well as provides wireless LAN facility to all the IT devices like laptops over a limited area.

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Wipro InfoTech
Wipro InfoTech, headquartered in Bangalore, India, is a leading manufacturer of computer hardware and provider of systems maintenance and integration services all over the world.

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