Firm’s Decisions and Strategies

Firms operate in competitive markets where they must make strategic decisions to maximize profits and ensure long-term survival. This chapter explores key business strategies, including third-degree price discrimination, mergers, and other pricing and growth strategies. These strategies help firms increase revenue, lower costs, and remain competitive in their industries. Real-world examples will be used to illustrate these concepts, making them easier to understand for students studying A Level Economics tuition.

1. Third-Degree Price Discrimination

1.1 What is Third-Degree Price Discrimination?

Third-degree price discrimination happens when a company charges different prices to different groups of customers based on observable characteristics, such as age, location, or purchasing behavior.

For this strategy to work, three conditions must be met:

1. Market Segmentation – The firm must be able to divide consumers into groups with different price sensitivities.

2. Market Power – The firm must have some control over pricing (i.e., it should not be in a perfectly competitive market).

3. No Arbitrage – Consumers who pay the lower price should not be able to resell the product to those who would otherwise pay the higher price.

1.2 Why Do Firms Use Third-Degree Price Discrimination?

• Maximize Profits: By charging different prices, firms extract more consumer surplus.

• Increase Market Reach: Lower-income groups can still afford the product at a reduced price.

• Utilize Market Power: Firms with little competition can charge different prices without losing customers.

1.3 Real-World Examples of Third-Degree Price Discrimination

• Movie Theaters charge different prices for students, seniors, and adults because students and seniors are more price-sensitive than working adults.

• Airlines charge business travelers more because they often book tickets last minute and have less flexibility in choosing flight times.

• Uber and Public Transport have peak and off-peak pricing, where commuters pay more during rush hour and less at non-peak times.

• Theme Parks often offer discounted tickets to local residents while charging higher prices to tourists, who are more willing to pay.

This pricing strategy allows firms to maximize profits by charging higher prices to customers who are less sensitive to price changes and lower prices to those who are more sensitive.

2. Merger and Acquisition

2.1 What is a Merger?

A merger happens when two companies combine to form a single entity. Firms merge for many reasons, including to increase market share, reduce costs, or improve efficiency.

There are three main types of mergers:

• Horizontal Merger: Two firms in the same industry combine (e.g., Disney acquiring Pixar).

• Vertical Merger: A firm acquires a supplier or distributor (e.g., Starbucks acquiring coffee bean suppliers).

• Conglomerate Merger: Two firms from different industries merge (e.g., Amazon acquiring Whole Foods).

2.1.1 Benefits of Mergers

• Lower Costs (Economies of Scale): Large firms can produce at a lower cost per unit, reducing prices for consumers (e.g., airlines merging to cut operational costs).

• Increased Market Power: Larger firms can dominate markets, allowing them to set higher prices and boost profits (e.g., Facebook acquiring Instagram and WhatsApp).

• Access to New Markets: Mergers can help firms enter new markets and expand globally (e.g., Tata Motors acquiring Jaguar Land Rover to enter the luxury car market).

2.1.2 Drawbacks of Mergers

• Reduced Competition: If a few large firms control an industry, prices may rise due to lack of competition (e.g., Microsoft facing regulatory scrutiny for acquiring Activision Blizzard).

• Diseconomies of Scale: A very large firm may face inefficiencies such as bureaucracy and slow decision-making (e.g., the failed AOL and Time Warner merger).

• Job Losses: When two firms merge, redundant positions may be eliminated, leading to layoffs.

Mergers can bring significant benefits but also pose risks, which is why governments often regulate them to ensure they do not harm consumers.

2.2 Acquisition

2.2.1 Definition:

A firm acquisition occurs when one company buys another company, either by purchasing a majority of its shares or by buying its assets. After the acquisition, the acquiring firm gains control over the acquired firm, which may continue operating under its original brand or merge with the acquiring company.

2.2.2 Types of Acquisitions

1. Horizontal Acquisition

   • A company buys a competitor in the same industry.

   • Example: Grab acquiring Uber’s Southeast Asian operations.

   • Purpose: Reduce competition, increase market share.

2. Vertical Acquisition

   • A company buys another firm in its supply chain.

   • Example: A ride-hailing company acquiring a payment platform to streamline transactions.

   • Purpose: Reduce costs, improve efficiency, and control supply chain.

3. Conglomerate Acquisition

   • A company buys a firm in an unrelated industry.

   • Example: Grab expanding into food delivery by acquiring smaller food-tech firms.

   • Purpose: Diversification to reduce risk.

2.2.3 Why Do Firms Acquire Other Companies?

1. Expand Market Share – Acquiring a competitor can help a firm dominate an industry.

2. Increase Efficiency – By acquiring a supplier or distributor, a firm can reduce costs.

3. Diversification – Buying a company in a different sector reduces reliance on one industry.

4. Gain New Technology or Expertise – Acquiring startups or tech firms provides access to new innovations.

5. Eliminate Competition – A firm can acquire rivals to reduce market competition.Real-World Example: Grab Acquiring Uber’s Southeast Asian Operations (2018) and Its Monopoly-Like Behavior

2.2.4 What Happened?

• In 2018, Grab acquired Uber’s ride-hailing business in Southeast Asia.

• Uber exited the region in exchange for a 27.5% stake in Grab.

• This effectively made Grab the dominant player in Southeast Asia’s ride-hailing market.

2.2.5 How Grab's Acquisition of Uber Led to Monopoly-Like Behavior

1. Reduced Competition → Higher Prices

   • Before the acquisition, Uber and Grab competed aggressively, offering discounts and promotions to attract riders.

   • After Uber’s exit, Grab faced little competition, allowing it to increase fares and reduce discounts.

2. Market Dominance

   • With Uber gone, Grab became the only major ride-hailing platform in many Southeast Asian countries.

   • Consumers had fewer alternatives, making Grab a near-monopoly in the region.

3. Regulatory Concerns

   • The acquisition led to concerns over anti-competitive behavior.

   • In 2018, the Competition and Consumer Commission of Singapore (CCCS) fined Grab and Uber SGD 13 million for reducing competition.

   • Governments in other countries also raised concerns about Grab’s pricing power and lack of competition.

4. Exploitation of Market Power

   • Without strong competitors, Grab could set higher fares without fear of losing riders to other platforms.

   • Drivers also faced lower earnings because they had fewer ride-hailing platforms to work for.

2.2.6 Is Grab a Monopoly?

✅ Near-Monopoly in Ride-Hailing: While not a pure monopoly, Grab dominates the Southeast Asian market.
✅ Limited Competition: Other competitors (e.g., Gojek, in some markets) exist but are much smaller.
❌ Not a Full Monopoly: Some alternative transport options (such as taxis and public transport) still exist.

2.2.7 Conclusion

Grab’s acquisition of Uber helped it become the dominant ride-hailing company in Southeast Asia. However, its monopoly-like behavior—such as increasing prices and reducing driver earnings—has led to concerns about lack of competition and consumer welfare. Regulatory bodies have taken action, but Grab’s market power remains strong, making it behave similarly to a monopoly in many ways.

3. How Firms Make Strategic Decisions

3.1 Growth, Diversification, and Shutdown Decisions

Firms must decide when to expand, diversify, or shut down operations based on market conditions and profitability.

Growth

Business growth is the process of improving some measure of an enterprise's success. It can be achieved in a variety of ways, such as increasing the firm's total sales or revenue, hiring more employees, or opening new stores or branches.

Why do firms pursue growth?

Firms seek growth to reap the benefits of economies of scale and to increase their market share.

Economies of Scale: Definition and Explanation

Economies of scale occur when a firm's average costs decrease as its production output increases. This concept is critical to a firm's growth strategy. For instance, Amazon has successfully achieved economies of scale. As the company expanded, it invested in logistics infrastructure, lowering its average cost per item delivered. This allowed Amazon to offer competitive prices while maintaining high profit margins.

Increased Market Share: Definition and Explanation

Market share refers to the portion of a market controlled by a particular company or product. A higher market share usually equates to greater sales dominance. Coca-Cola, for instance, has aggressively grown its market share by expanding its product line and entering new markets. This has not only increased its dominance in the soft drink industry but also led to significant economies of scale.

Strategies to Pursue Growth

To achieve growth, firms can expand their product or service offerings, enter new markets, or acquire or merge with other firms.

Expanding product or service offerings with examples

One strategy for growth is to broaden the range of products or services a firm offers. Apple, for example, has successfully transitioned from selling personal computers to offering a diverse range of products, such as smartphones, tablets, and wearable devices.

Entering new markets with examples

Firms can also grow by entering new markets, either geographically or by targeting new customer segments. Starbucks, for instance, has successfully entered new markets worldwide by adapting to local preferences, attracting new customers, and increasing its global market share.

Acquisition or merger with examples

Insert handshake icon indicating partnershipAnother growth strategy involves acquiring or merging with other companies. Facebook's acquisitions of Instagram and WhatsApp expanded its product offerings, increased its user base, and kept it competitive in the social media landscape.

Risks of Aggressive Growth

However, aggressive growth also carries risks such as over-expansion, which could strain resources and dilute focus. Firms must, therefore, balance growth objectives with sustainable practices to ensure long-term success.

Critical Thinking Exercises

1. Can you think of a company that has experienced growth? What strategies did it use, and what were the results?

2. Discuss the potential advantages and disadvantages of a firm growing too quickly.

3. How might a firm's growth strategy differ depending on its industry or market?

Growth is a critical aspect of a firm's strategy, and it can be achieved through economies of scale, increased market share, product expansion, market entry, and acquisitions or mergers. However, firms should be cautious of the potential risks associated with aggressive growth.

Diversification

Diversification is a strategic approach involving the broadening of a firm's range of products or services, or its entry into new markets. This strategy reduces risk, protects firms from market volatility, uncovers new revenue streams, and expands their customer base.

Why do firms diversify?

Firms diversify to hedge against risks associated with dependence on a single product or market. They may also seek out new business opportunities or strive for economies of scale by leveraging their core competencies.

How do firms carry out diversification?

Firms diversify by developing related products or services, acquiring or merging with other firms, or creating joint ventures or collaborations.

Developing related products or services with examples

One approach to diversification is to develop new products or services related to the firm's existing portfolio. This approach allows the firm to utilise its existing knowledge and capabilities while reaching new markets.

For instance, Amazon began as an online bookseller but has since diversified into a plethora of products and services. The company leveraged its existing e-commerce platform and customer base to offer items ranging from electronics to clothing, and later further diversified into digital services like streaming media and cloud computing. Amazon even ventured into healthcare, offering online pharmacy services.

Acquisitions or mergers with examples

Another approach to diversification involves acquiring or merging with other firms. This strategy allows firms to access new technologies, markets, or products, while maintaining their core competencies.

Take Alphabet Inc., the parent company of Google, for example. Alphabet has pursued diversification through a series of acquisitions, including Nest, a smart home device company, and Waymo, a self-driving car company. These acquisitions have expanded Alphabet's product offerings, allowing it to explore new business opportunities beyond its core internet services.

Joint ventures or collaborations with examples

A third approach to diversification involves creating joint ventures or collaborations. This strategy allows firms to share resources and knowledge with other companies while maintaining independence.

Consider Toyota and Mazda's joint venture to build a factory in the United States. This partnership allowed Toyota to utilise its existing manufacturing capabilities while expanding into new markets and industries. By sharing resources, both firms could mitigate the investment risk associated with building a new manufacturing facility.

Shut-down Decision

The shut-down condition refers to the point at which a firm chooses to cease production due to economic conditions. This decision typically occurs when a firm's average revenue (AR) is less than its average variable cost (AVC), meaning it can no longer cover its operational expenses.

Understanding Key Terminologies: Total Cost, Variable Cost, and Fixed Cost

Total Cost (TC) is the sum of a firm's Variable Cost (VC) and Fixed Cost (FC). VC refers to the costs that change directly with the level of output, such as raw materials and labour. FC are costs that remain constant regardless of the output level, like rental and interest expenses.

When do firms decide to shut down?

Firms typically decide to shut down production in the short term when their AR falls below AVC, implying they can't even recover the costs of production.

When Average Revenue (AR) < Average Variable Cost (AVC) with examples

Imagine a local bakery in Singapore experiencing a decline in sales due to a low-carb diet trend. Despite reducing production, its AR falls below AVC. The bakery is incurring losses as it cannot cover its variable costs, such as the cost of flour, sugar, and labour. In this case, the bakery might decide to shut down temporarily until the diet trend passes or permanently if it deems the trend long-lasting.

When Average Revenue (AR) > Average Variable Cost (AVC) with examples

On the flip side, imagine a tech start-up offering an online service. Its VC includes server costs, which vary with the number of users. As long as the subscription fee (AR) it charges users exceeds these server costs (AVC), it will continue operations, even if it's not covering all its FC, such as office rent or salaried staff, expecting that growth will eventually cover these.

Implications of the Shut-Down Decision: Discuss the long-term impacts of the shut-down on the firm and the economy.

A firm's shut-down decision can have various long-term impacts. For the firm, it may lead to a loss of market share or reputational damage. It might also affect employees, suppliers, and customers, leading to job losses, reduced sales for suppliers, and less choice for consumers.

For the economy, if many firms in an industry shut down, this could lead to increased unemployment and lower economic output. However, it could also encourage resources to shift to more profitable industries, promoting economic restructuring.

3.2 Price Competition Strategies

Firms can compete by lowering prices or differentiating their products.

• Price Wars: Companies aggressively cut prices to gain market share (e.g., Grab vs. Gojek in the ride-hailing industry).

• Penetration Pricing: Firms set low initial prices to attract customers (e.g., Netflix offering cheap subscriptions in new markets).

• Predatory Pricing: Firms lower prices to drive competitors out of business, though this is often illegal (e.g., Amazon has been accused of using this strategy in e-commerce).

Price competition benefits consumers by lowering prices but can harm small firms that cannot afford to compete.

3.3 Innovation, Research, and Development (R&D)

Firms invest in R&D to improve efficiency and create new products.

• Product Innovation: Creating new products to stay ahead (e.g., Apple launching the iPhone).

• Process Innovation: Improving production efficiency (e.g., Tesla’s Gigafactories reducing electric vehicle costs).

• Artificial Intelligence: Companies like Google and Amazon use AI to personalize customer experiences.

Investing in R&D helps firms stay competitive and maintain long-term profitability.

3.4 Marketing & Branding Strategies

Marketing and branding help firms attract and retain customers.

• Advertising: Coca-Cola spends billions on advertising to maintain its global presence.

• Sponsorships & Endorsements: Nike signs top athletes to promote its brand.

• Loyalty Programs: Airlines and hotels use rewards programs to encourage repeat customers.

Effective marketing allows firms to differentiate their products and charge premium prices.

Conclusion

Firms use various strategies to maximize revenue, reduce costs, and stay competitive. Pricing strategies like third-degree price discrimination, mergers, and innovation play key roles in firm decision-making. Real-world examples show how these strategies work in practice, making them essential for students studying A Level Economics tuition.

Discussion Questions

1. Can you think of a company that uses third-degree price discrimination? How does it segment its customers?

2. What are the main risks and benefits of mergers? Provide an example.

3. Why do some firms compete by cutting prices while others focus on branding and product differentiation?

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