With summer approaching in the southern hemisphere and the days getting brighter you will be looking to don sunglasses on a more regular basis. Sunglasses come in various styles and brands, eg. Rayban, Oakley, Gucci, Prada, Versace to name but a few, but can be quite expensive when you consider the so-called competition that is in the market which in theory should driving down the price. Sunglasses these days are reasonably homogeneous in that the frames and materials are very similar and it surprised me that 80% of the major sunglass brands are controlled by Luxottica, in a market that is worth US$28 billion.
Luxottica produced the following brands of sunglasses under their name:
Prada, Chanel, Dolce & Gabbana, Versace, Burberry, Ralph Lauren, Tiffany, Bulgari, Vogue, Persol, Coach, DKNY, Rayban, Oakley, Sunglasses Hut, LensCrafters, Oliver Peoples, Pearle Vision, Target Optical and Sears Optical.
This list of brands is fairly comprehensive and by controlling 80% of the market you have a monopoly and dictate the price consumers have to pay for each specific brand since the industry isn’t competitive. Therefore they are Price Makers. But Luxottica also dictate what goes in the shops as they own Sunglass hut, Oliver peoples and Pearle Vision where consumers shop for sunglasses. This makes it very difficult for a brand outside one that is produced by Luxottica to compete as you can’t get your product into those shops. So not only do they have a monopoly in the production but they also control the distribution of sunglasses. See monopoly graph below.
In the clip below from ’60 Minutes’ they mention Oakley’s dilemma when their sunglasses became more popular than those produced by Luxottica. When this happen Luxottica proceeded to hold fewer Oakely sunglasses in their Sunglass Hut shops causing Oakley’s stock to plunge. Then in 2007 Oakley was left with no choice but to merge with Luxottica.
We discussed Contestable Markets in my A2 class today and I used this clip from Commanding Heights to show how regulated the US airline industry was during the 1970’s. Regulations meant that major carriers like Pan Am never had to compete with newcomers. However an Englishman named Freddie Laker was determined to break this tradition and set-up Laker airways to compete on trans-atlantic flights. He offered flights at less than half the price of what Pan Am charged. Alfred Kahn was given the task by the then President Jimmy Carter to breakup the Civil Aeronautics Board (the regulatory body) and he wanted a leaner regulatory environment in which the market was free to dictate price. There is a piece in the clip that shows how ludicrous some of the regulations were:
When I got to the Civil Aeronauts Board, the biggest division under me was the division of enforcement – in effect, FBI agents who would go around and seek out secret discounts and then impose fines. We would discipline them. It was illegal to compete in price. That means it was illegal to compete in the discounts you offer travel agents. So we regulated travel agents’ discounts. Internationally, since they couldn’t cut rates, they competed by having more and more sumptuous meals. We actually regulated the size of sandwiches. Alfred Kahn
When the CAB was closed down competition was the rule and the industry had vastly underestimated the demand for air travel at lower prices – a very elastic demand curve – see graph below.
In the A2 course contestable markets is a popular essay question and is usually combined with another market structure.
What is a contestable market?
• One in which there is one firm (or a small number of firms)
• Because of freedom of entry and exit, the firm faces competition and might operate in a way similar to a perfectly competitive firm
• The threat of “hit and run entry” from new firms may be sufficient to keep the industry operating at a competitive price and output
• The key requirement for a contestable market is the absence of sunk costs – i.e. costs that cannot be recovered if a business decides to leave a market
• When sunk costs are high, a market is more likely to produce an price and output similar to monopoly (with the risk of allocative inefficiency and loss of economic welfare)
• A perfectly contestable market occurs only when entry and exit into and out of a market is perfectly costless
• Contestable markets are different from perfect competitive markets
• It is possible for one incumbent firm to dominate the industry
• Each existing firm in the market produces a differentiated product (i.e. goods and services are not perfect substitutes for each other)
There are 3 conditions for market contestability:
• Perfect information and the ability and or legal right to use the best available technology
• Freedom to market / advertise and enter a market
• The absence of sunk costs
• Liberalisation of the US Airline Industry in the 1970’s and the European Airline Market in late 1990s
• Traditional “flag-flying” airlines faced new competition
• Barriers to entry in the industry were lowered (including greater use of leased aircraft)
• New Entrants – easyJet- Ryanair
Not to be outdone by my previous post, colleague Warren Baas had his A2 class use M&M’s to construct Imperfect Competition graphs. See the selection below – subnormal profit and normal profit.
Having just completed Perfect Competition with my A2 class I used a couple of packets of M&M’s to drum home the concept of marginal analysis MC=MR. It has always been something that students have struggled with but I am hoping this experience of creating graphs with M&M’s might help their understanding and when to use the concept.
Profit is maximised at the rate of output where the positive difference between total revenues and total costs is the greatest. Using marginal analysis, the perfectly competitive firm will produce at a rate of output where marginal revenue equals marginal cost. Marginal revenue, however, is equal to price. Therefore, the perfectly competitive firm produces at an output rate where marginal cost equals the price of output. Remember that the firm will make profits as long as the extra revenue brought in from selling the last unit of output(MR) is greater than the extra cost which is incurred in producing it(MC). Below are some of the graphs they created – perfect competition normal profit, subnormal profit, supernormal profit and the firm and the market for long-run perfect competition.
Here is a quick revision note on monopolistic competition. This is a market structure in which there are a large number of firms selling commodities which are very close substitutes. There are weak barriers to entry and firms may enter the industry with ease. Notice on the diagram that the firm initially makes supernormal profit at Q0 – at MC=MR Price = P0 and Cost = AC0. However with weak barriers to entry these profits are competed away and they now produce at Q1 where at MC=MR and the Price and Cost = AC1
Modern capitalism is characterised by a large number of ‘limited’ monopolies. They are sole suppliers of branded goods, but other firms compete with them by selling similar goods with different brand names. This is the market structure described as monopolistic competition. Thus the commodities produced by any one industry are not homogeneous; the goods are differentiated by branding and the use of trade marks. The individual firm has a monopoly position, but it faces keen competition from firms supplying very similar goods. It has, therefore, only a limited degree of monopoly power – how much depends upon the extent to which firms are free to enter the industry. Product differentiation is emphasised (some would say, created) by the practice of competitive advertising which is, perhaps, the most striking feature of monopolistic competition.
Advertising is employed to heighten in the consumer’s mind the differences between Brand X and Brand Y. It is important to realise that we are concerned with the differentiation of goods in the economic sense and not in the technical sense. Two branded products may be almost identical in their technical features or chemical composition, but if advertising and other selling practices have created different images in the consumer’s mind, then these products are different from our point of view because the consumer will be prepared to pay different prices for them.
Living in a rural area you tend to get a lot of free newspapers with a agricultural bent. Skimming the pages of NZ Farmer (March 28 2016) I came across a very informative article by Keith Woodford about European farmers expanding their value-add dairy production and its impact on New Zealand.
Up to April 2015 European farmers were protected by production quotas and the Common Agricultural Policy (CAP) which provided large production subsidies which led to over-production. At the outset of the EU, one of the main objectives was the system of intervention in agricultural markets and protection of the farming sector.
An intervention price is the price at which the CAP would be ready to come into the market and to buy the surpluses, thus preventing the price from falling below the intervention price. This is illustrated opposite. Here the European supply of lamb drives the price down to the equilibrium 0Pfm – the free market price, where supply and demand curves intersect and quantity demanded and quantity supplied equal 0Qm. However, the intervention price (0Pint) is located above the equilibrium and it has the following effects:
1. It encourages an increase in European production. Consequently, output is raised to 0Qs1.
2. At intervention price, there is a production surplus equal to the horizontal distance AB which is the excess of supply above demand at the intervention price.
3. In buying the surplus, the intervention agency incurs costs equal to the area ABCD. It will then incur the cost of storing the surplus or of destroying it.
4. There is a contraction in domestic consumption to 0Qd1
Consumers pay a higher price to the extent that the intervention price exceeds the notional free market price.
Production quotas in Europe were eliminated in April 2015 and from April to November European milk production increased by 4% with a 6% increase in December from the previous year. However, as with the reduction in subsidies in New Zealand in 1984, they will be a lot of pain for European farmers as their ‘safety net’ has now been taken away.
The Europeans are producing as much cheese, butter, infant formula and cream as they can, with cheese being more important than liquid milk. The Europeans are also selling increasing quantities of UHT and infant formula to China. With both products, they are out-marketing New Zealand.
Chinese infant formula statistics for 2015 show European countries with 78 per cent market share of imported product, compared to New Zealand at 8 per cent.
#1 – Holland – 34%
#2 – Ireland – 15%
The Europeans would like to decrease their production skim milk powder (SMP), but with butter and cream being profitable, they keep producing the SMP as a by-product. However, the European production of whole milk powder (WMP) has been drifting down in response to low prices.
The European producers have protection from some of the Global Dairy Auction process through their reliance on value-add products. Also, apart from Ireland, all European dairy systems are 12-month-a-year production systems. These 12 month production systems can lead to higher production costs, but they also lead to lower processing costs through better utilisation of processing infrastructure. This then feeds back into higher farm-gate prices.
The Europeans have been putting limited quantities of skim milk powder (SMP) into what are called intervention stocks. At the end of January 2016, there were about 50,000 tonnes of SMP in a public intervention store. The intervention quantities could reach a new limit of 218,000 tonnes over coming months. The main benefit of the SMP intervention is a smoothing of commodity prices. So if the price is too high stocks are released into the market and when they are too low authorities buy stock in order to reduce supply and therefore increase the price to a specific level.
European Farmers and the future
There is a good chance that in the longer term European milk production will further increase, as some farms become bigger and fewer in number. Poland has become one of the largest milk producers in the EU become a major milk producer with its flat terrain, very fertile soil, low feed and labour costs. Furthermore compared to other EU members it doesn’t have the pressure on land for residential use. Since joining the EU in 2004, the informal dairy sector is also still considerable in Poland, but the 2015 quota lift has seen these farms absorbed into the formal sector which in turn are expected to expand quickly without quota impediments.
For this longer term, the Europeans are not going to try and compete with New Zealand with WMP. Europeans regard WMP as an outlet for product with no other immediate use. And they know that, in low-priced volatile commodity markets for long-life products, they lack competitive advantage relative to New Zealand.
What a difference a year makes for Indian low cost airline Spicejet. On the verge of shutting down in December 2014 with $300m of debt with suppliers refusing to refuel planes unless paid upfront and staff not been paid their monthly salaries, the airline has made a remarkable recovery. Today it is filling 93% of available seats and has made a profit in the last 4 quarters.
What has been the cause of the turnaround?
- Aircraft fuel expenses dropped nearly 35 percent
- Demand has increased – compared to the previous year Indian airlines carried 20% more passengers in 2015.
- Negotiated better terms with aircraft-leasing firms
- Cut jobs and managers pay
- Scrapped unprofitable routes
Measures to reduce inefficiencies of Spicejet
- Reducing the time to second-tier cities and thereby making it possible to fit in an extra flight a day.
- Steel brakes on wheels of Boeing 737 were replaced with lighter carbon brakes
- In-flight magazines reduced – less weight
- Meals served in cardboard boxes instead of plastic trays – reducing fuel consumption
- Planes were filled with just enough fuel within safety margin
- Landing gear was deployed 8km from touchdown instead of 14km – reduce drag
- Taxi on the runway using just one engine – more fuel efficient
- Stocks of spares parts are now more readily available so planes spend less time on the ground
Although the airline still has a long way to go to reduce its debt its recent performance has enabled it to think about long-term expansion.