Theme 6 II B: Firms and Decisions

Explain the cognitive bias firms use in advertising

1. Salience bias 

• Used to retain / increase customer base

  • Eg. TV manufacturer decide to advertise their TVs as “highest resolution TV in the market”

  • Some consumers may be enticed by the salient eye-catching slogan on its high resolution and purchase the TV even if other aspects of the TV like sound quality, power consumption, user interface and connectivity are inferior to the other brands

• To generate interest and desire among consumers in its product, firms advertise frequently and use prominent brand cues (Eg. Just do it [Nike]) -> brand stays at the top-of-mind of consumers  -> increasing the likelihood of purchase

2. Loss aversion 

• Eg. A skincare firm might feature one person looking haggard over time, compared to another because the former did not use the skin lotion while the latter did

Explain how advertising can lead to increase in TR

• Alter or appeal to the tastes and preferences -> increasing the willingness of consumers to purchase it -> increase D + TR 

• Create brand loyalty as taste and preference changes -> consumers may perceive rivals’ products as less-close substitutes -> demand less price elastic and curve is steeper -> firms gain market power and price setting ability -> charge a higher price and earn higher profits

• Whether profit increases depends on whether the increased total revenue > rise in total costs from advertising

• Increased spending on advertising causes average cost to rise from AC to AC’

• MC does not change since advertising is assumed to be a fixed (sunk) cost

• Assuming the firm was initially earning normal profits, the rise in TR (area P’ x Q’ – area P x Q) > rise TC (area AC’ x Q’ – area P x Q) -> rise in profits of area (P’- AC’) x Q’

Describe limitation of advertising (cost)

• Firm may also incur the opportunity cost in terms of the potential increase in profits if the funds were to be used for other strategies such as R&D or mergers and acquisitions instead

• Eg. Shopee, a Singapore-based e-commerce platform, signed famous Footballer Cristiano Ronaldo as an ambassador to promote its annual 9.9 Super Shopping Day. The cost of using his image as an ambassador is extremely expensive and may be even greater than the additional revenue earned from using his image

Describe limitation of advertising (oligopoly)

In an oligopoly with high rival consciousness, the competitor may respond by engaging in advertising as well -> negative impact on demand for the first firm -> firm need to consider the potential response of its competitor(s) 

Describe limitation of advertising (probability of success)

• Failed marketing and advertising efforts may even backfire on the company if not executed well

• Marketing campaigns might lead to public backlash, such as Pepsi's Kendall Jenner advertisement

• This will lead to severe damage to not only the sales but also the reputation of the firm

• Consumers might change their taste and preferences away from the firm's goods -> fall in demand 

• Evaluation: Depends on the country the firm operates in. For Asian countries that tend to be more culturally sensitive or superstitious, the firm may risk a greater chance of their campaign backfiring

Describe impact of advertising on other firms

• Competitor firms fall in demand for their products -> TR falls 

• Greater artificial BOE 

• Large firm -> higher output of Q2 -> lower C2 = P2

• P = AC 

• Other firms cannot compete with incumbent firms with higher cost disadvantage -> unable to reap internal EOS due to smaller scale production

Describe impact of advertising on consumers

• Informative advertising -> more information available make more informed decisions to maximise consumers’ welfare + signals to consumers the quality of product (address imperfect information)

• Persuasive advertising may distort choices because consumers are led by the advertisement to buy a product for its brand instead of basing their decisions on the actual tangible characteristics of the good

• Firms may take advantage of the cognitive biases to influence their buying decision -> skew the weighting of benefits and costs

Describe impact of advertising on government

• Informative advertising -> more informed decisions -> perceived MPB closer to true MPB  -> improve AE

• Persuasive advertising (misleading)  distorts consumer choices where perceived MPB > true MPB -> worsen AE (consumer ignorance) 

• When advertising is successful -> rise in demand and a rise in the firm’s market power -> rise in allocative inefficiency

Describe loyalty programmes and loyalty cards

1. Loyalty programmes 

• A firm may try to get its customers to sign up and pay to become a member of its loyalty programme

• Consumers more inclined to buy from firms as they are compelled to spread out sunk cost of membership fee (sunk cost fallacy) instead of considering MB or MC 

2. Loyalty cards 

• Shoppers may already feel they have made a significant start on their card and will want to complete the card by buying more products from the firms to get the free coffee, instead of focusing on the cost and benefits of buying the firms’ products in their buying decision

Describe contract signing

• Eg. Telecommunications providers often require their customers to sign contracts whereby early termination results in losses due to the payment of termination fee

• Enables firms to better retain their customers as they may not want to break their current contracts and incur any losses even though they may gain more by switching over to other providers which offer cheaper rates (loss aversion) 

Describe free trials

• Chance of getting consumers to buy the full package of the service is higher if the consumers were given a free trial

• When the free trial period comes to an end, users feel like they’re about to lose out on something they have been using which makes it harder to give up -> drives them to buy the product

• Consumers who have never used the product can focus only on potential gains valued less than losses

• Salience bias -> having tried the product, the experience of using the products themselves becomes more salient to consumers in their decision making than looking at their functions on printed brochures or having a conversation with the salesperson

Describe attractive packaging

• Potential consumers would focus more on the attractive packaging in his buying decision over other qualities like the ingredients that were used to make the chocolate (usually printed in fine print) (salience bias) 

Define and describe product innovation

• (Def.): Developing new products or improving the quality of existing goods / services, through R&D

• If a firm is successful in product innovation, demand increases + less price elastic (DD’) as the product is better and more differentiated from its substitutes (real production differentiation)

• Firm gains market power and price setting ability -> able to charge a higher price of P’ -> total revenue and profits rise, assuming TR rises by a greater extent than TC

• AC is higher as it includes the R&D costs (fixed cost)

• Cost of R&D + patent creates artificial BOE (same as advertising) 

Define and describe process innovation

• (Def.): Improving the method of production leading to more efficient production process and reduces MCOP (streamline production process) 

• If fall in AC (variable cost) > fall in price -> profit per unit rises 

• Firm having a cost advantage over its competitors -> ability to reduce its price -> assuming fall in cost of production larger than cost of process innovation -> firm will earn higher profits

• Eg. In China, dark factories replace all labour with machines -> machines do not need electricity or light to work -> so no electrical costs -> increase productivity of FOP  

Describe limitations of innovation (costly, copied by competitors, competitors R&D too)

1. Costly + no guarantee 

• Evaluation: Costs dependent on past accumulated supernormal profits -> oligopolies with high BOE will have sufficient profits to fund R&D efforts 

2. New product or method can be copied by competitors -> firm not willing to undertake innovation unless they obtain a patent 

3. Competing firms may be doing R&D simultaneously -> result lies in first-mover advantage (first firm that successfully innovates will gain an advantage over others) -> returns on R&D for the remaining firms may be less than expected

Describe limitations of product innovation: Probability of success

• Difficult to accurately predict the consumers' future tastes and preferences -> despite many firms' best efforts, the R&D might not yield a product that will be in demand -> strategy ineffective 

• Evaluation: In industries where consumer trends are more stable and predictable such as electronic gadgets, it is likely that the firm will be able to better predict consumer's future tastes and preferences. However, in industries where consumer trends are prone to volatility such as the fashion industry, it is less likely that the firm will be able to predict consumer's future tastes and preferences

Describe limitations of process innovation: Probability of success

• High initial costs of R&D may outweigh potential cost savings from process innovation -> ineffective strategy 

• Evaluation: Depends on the nature of the production process. If the production process is currently very labour-intensive, it is likely that the firm will be able to cut down on labour inefficiencies via process innovation

Describe impact of innovation on other firms, consumers and government

Other firms	Competitors experience fall in D + TR  Eval: Extent depends on degree of substitutability of products OR whether competitors also innovate and are successful New tech can deter entry of potential entrants -> lower contestability of market
Consumers	Product innovation -> new, larger variety and better-quality products -> greater customer choice -> increase consumer welfare Process innovation -> lower prices -> increase CS
Government objectives	Firm adapts and improve its products or productivity over time to remain competitive in response to changing markets, technologies and consumer preferences -> dynamic efficiency  Using machines instead of humans would displace workers, leading to structural unemployment as they may lack skills to take on other available jobs in other sectors

Compare internal and external growth

Internal growth – The firm increases its size by producing more of its existing products or extending its range of products External growth – The firm grows when it joins forces with another firm to form a larger firm -> growth is much faster than internal expansion

Define and describe internal expansion (what it includes, limitations)

• (Def.): refers to expansion of firms by expanding its own operations (new plants or outlets) 

• Increase production capacity through investment in new plants -> reap internal EOS -> lower unit cost of production 
  

Includes: 

1. Growing a customer base through marketing 

2. Development & launch of new products

3. Finding new markets, for example by exporting to other countries

Limitation: 

1. Firms face difficulties in raising funds to finance investments in new plants

2. Expansion might also lead to internal DEOS where the unit cost of production rises with output level -> lower profits

Define external expansion + limitation

• (Def.): refers to expansion through mergers with or acquisitions of other firms

Limitation: 

• Greater likelihood of internal DEOS due to difficulties in communication / coordination among the working staff arising from different corporate cultures

Compar emerger and aquisitions

Merger	Acquisition
(Def.): coming together of two or more firms to create a single new firm Perceived as a cooperative and mutually advantageous arrangement Includes integration of resources, personnel, and operations aimed at becoming a more formidable competitor in the market/industry Eg. Heinz and Kraft, Disney and Pixar	(Def.): one firm buying another firm, with the buyer completely establishing itself as the new owner Acquirer maintains its original name and identity, while the acquired entity may either dissolve or be absorbed into the firm of the acquirer Eg. Google and Android, Facebook and Whatsapp

Describe reason for merger and aquisition (Create artificial BOE)

• Create artificial BOE -> an incumbent firm can put in a takeover bid for any new entrant easily because of the former’s strong financial capability

• Discourage new entrants because their efforts and resources spent in creating a new company would be eliminated upon acquisition

• Eg. In 2019, Disney acquired 21st Century Fox – they were two of the biggest movie and TV producers globally

• By acquiring Fox, Disney gained control of things like the X-Men, Deadpool and Avatar franchises, and the National Geographic network

• The merger increased Disney’s market power and reduced competition in the entertainment industry, including the film production and streaming services markets.

• Authorities only approved the deal after Disney divested certain assets (Fox’s regional sports networks) to preserve some market competition and to avoid excessive market dominance

Describe reason for merger and aquisition (Market share dominance)

• Horizontal merger -> capture larger share of global market as consumer base from both firms are combined -> MR and AR increase 

• Increased brand loyalty -> PED inelastic and less substitutable -> gain market power and price setting ability 

• Lateral/conglomerate integration, where firms merge producing entirely different products -> merged firm will be able to compete in more than one industry -> earn more profits -> decreases their risk of failure if primary market crashes 

• Eg. Kraft merged with Heinz in 2015 to diversify their product offerings (sauce, condiments, snacks)

Describe reason for merger and aquisition (Reap internal EOS)

• Because it now produces on a larger level of output -> reap greater internal EOS -> AC and MC falls

• Eg. Manufacturing firm, building a bigger plant enables it to enjoy a reduction in MC and AC from the use of automated assembly lines which increases factor productivity -> the SRMC and SRAC curves shift downwards (This is the set of MC/AC curves that correspond with the use of a bigger plant size)

• Eg. Kraft and Heinz can gain marketing EOS -> gain more bargaining power to buy in bulk -> negotiate with suppliers for discounts to lower unit cost of production 

• Backward integration -> by integrating with a supplier firm, can gain more control over supply chain -> reduce vulnerability to external supply shocks  

• During industry wide shock which increases cost of all firms, companies will suffer less and gain a cost advantage 

• Eg. Apple bought their chip supplier, a semi-conductor company Dialog Semiconductors in 2018 -> during COVID-19, supply chain disruptions lead to a semiconductor shortage which Apple was not affected by