Managerial Economics Assignment
1.0 Introduction
The purpose of this paper is to present the economic case for the launch of a new product, designated a ‘Gluten Free’ (GF) Bread.
2.0 Domestic economic landscape
“Almost every economy in the modern world falls somewhere along a continuum running from pure market to fully planned” (Investopedia, 2016).
As a developed capitalist nation, the UK’s economic system is technically a mixed economy; a blend of free market with some government interference via regulation of business and industry. That said, the UK is often determined as having a market economy “because we allow market forces to drive the vast majority of activities, typically engaging in government intervention only to the extent it is needed to provide stability” (Investopedia, 2016).
3.0 Market Analysis
“There are several market structures within which firms can operate. The type of structure influences the firm’s behaviour, whether it is efficient, and the level of profits it can generate” (Economics Online, 2016.a).
Market structure refers to the number of firms in the market, their market share, extent of product differentiation, and other features which affect the level of competition, which, as can be seen below, is the main distinguishing factor in market classification.
Picture 1. Market Structures. Source: www.economicsonline.co.uk
Worthington et al (2005) define a market as “an exchange mechanism which brings together buyers and sellers; in essence it is any situation in which someone wishing to buy and someone wishing to sell come together to effect an exchange (demand and supply)”. The domestic Gluten Free (GF) market falls within ‘monopolistic competition’, which is categorised as many firms selling products that are similar but not identical, with firms competing on other factors besides price. The below picture lists the six characteristics of monopolistic competition:
Picture 2. Market Structures. Source: www.simplilearn.com
Monopolistic competition cannot exist unless there is at least a perceived difference among the products, with product differentiation, such as branding, packaging or quality (Spaulding, 2016) acting as the major tool of competition and thus the defining characteristic. That said, differentiation is not so great as to eliminate other goods as substitutes which although close, are classed as ‘imperfect substitutes’.
This availability of close substitute products means that demand is deemed to be ‘elastic’, such that when one firm increases its price beyond a level consumers are willing to pay for it, consumers switch to a competitor with the lowest or lower price and so are said to be sensitive to changes in prices. However, the greater the level of differentiation, the more inelastic demand becomes. This cross-price elasticity (XED) is thus a measure of the responsiveness of demand for good X following a change in the price of a related good Y, and in this instance XED is deemed to be positive. Although bread is a necessity and therefore should be inelastic, “the greater and closer the number of substitutes, the higher the elasticity” (Worthington, 2005) and GF breads falls into this category given its premium pricing and the number of suppliers in the market.
The demand curve in a monopolistic competitive market slopes downward, so as price decreases, the quantity demanded for that good increases, ceteris paribus, creating important implications for firms in this market. The downward slope signifies that these firms have market power allowing them to increase prices without losing all of their customers, by focusing on product differentiation such as branding or advertising (Boundless, 2016).
Picture 3: Monopolistic Competition Demand Curve. Source: yourarticlelibrary.com (2017)
4.0 Gluten Free Market Insight
Demand
According to research by the University of Nottingham, there has been a fourfold increase in the rate of diagnosed cases of coeliac disease over the past two decades, with an estimated three-quarters of people with the disease still undiagnosed (Thorne, 2014). The only treatment for coeliac disease, an autoimmune disease, is a strict lifelong GF diet, eliminating all products containing wheat, barley and rye (The Gluten-Free Agency, 2012).
“New data on the UK GF market shows that market growth is being driven by a number of factors including greater awareness and diagnosis of food allergies, the desire for a healthy lifestyle and increased availability of gluten free foods, brands and solutions” (Donohoe, 2016).
Research from Mintel (2016) reveals that sales of GF foods in 2016 were forecasted to grow 13% reaching £531million, up from an estimated £470m in 2015, with the market reaching estimated sales of £673m by 2020. 33% of Brits had bought or eaten a GF product in the preceding six months.
This impressive double digit market growth (Robinson, 2014) is said to be because of the rise in product innovation giving customers more product choice, with research claiming that 12% of new food products launched in the UK (2015) carried the GF claim, up from 7% in 2011 (Mintel, 2016). Accordingly, demand is forecasted to increase amongst existing consumers with growing availability at mainstream supermarkets a key factor.
That said, the report also suggests that price is the key area holding back further growth with 39% of Brits citing price as a barrier to wider adoption (Axtell, 2016) as free from products are considerably more expensive than standard products, e.g. UK’s leading GF Bakery Brand Genius has a RRP of £2.99 for its bread loaves. This point is important because “the ‘health-halo’ of free from foods is a key driver of uptake and has resulted in a much larger group of users than the limited number of actual or suspected allergy sufferers” (The Gluten-Free Agency, 2012).
Demand in the GF market has thus been bolstered by non-coeliac consumers looking to GF products to either lose weight (24%) or improve their energy levels (28%) (Gibbons, 2014). Indeed, in 2014, the Kantar Worldpanel estimated that 55% of the UK population was buying a free-from product with half of those said to be non-sufferers (Incredible Bakery Company, 2016).
Demand is influenced by a range of independent variables such as price, consumer income, consumer preferences, advertising etc. The impact of Brexit on consumer confidence is essential to consider and a new report on household finances from Lloyds bank says that “the pound’s steep fall since the Brexit vote is raising import costs for the UK and trickling through to higher prices for consumers” (Allen, 2016). However, that said, the report also found that household spending on essentials such as food rose at the fastest pace for almost three years, despite a slowing economy (Blanchflower and Sentence, 2016). Looking ahead it is essential to consider that if inflation continues to rise, it will eat into consumers spending power and subdue consumer confidence, however for the GF market, given the makeup of consumers and the variety of product price points (discussed below and in Picture 4), it is likely that demand will be sufficient to justify new products.
The above data supports the case for increasing demand for GF foods in the short and long term, across an unrestricted consumer base. With a 20% annual growth rate of the GF bakery market this is an enticing prospect pursuant to the proposed new product (Donohoe, 2016).
4.1 Supply
“Pricing is one of the biggest opportunities and one of the greatest challenges a company faces” (Schofield, 2016) and “in the same way that price has a significant effect on the quantity of goods demanded by consumers; it also has a significant effect on the quantity of goods supplied by producers” (UK Essays, 2017).
The goal of the law of supply is to produce the right amount of product to meet consumer demand, while charging the highest price that consumers are willing to pay (Schofield, 2016).
If we look at the market prices of supermarket own brand GF bread below (Picture 4), it is evident that there is a range of pricing from £1.50 to £2.29. However, according to Kantar, branded products account for 70% of spend in the GF category (Donohoe, 2016) with Genius, the number one GF brand in UK holding 27.9% market share, growing at higher than market rate of 25.7% versus 16.1% year-on-year for the market. With Genius bread costing consumers £2.99 a loaf, this signals a willingness by consumers to pay premium prices for the right brand, signifying that with a concerted effort on brand differentiation, a company entering the GF market can in the long run set high prices in the face of cheaper substitutes and still maintain market share.
Picture 4 Prices for GF Products. Source: Coeliac UK.
As with demand, there are numerous factors influencing supply apart from price; that is the costs of production or supplying the products. Such resources include:
- fixed factors which do not change as output is increased or decreased: premises, factories and capital equipment, and
- variable factors that do change with output: typically labour, energy, and raw materials directly used in production.
The current economic climate is turning quite hostile for manufacturers. With the pound’s steep fall since Brexit, UK companies will continue to face rising import costs on food and fuel as inflation climbs further in 2017 (Allen, 2016.a). According to the Office for National Statistics (2017), “prices for materials and fuels paid by UK manufacturers for processing (input prices) rose 15.8% on the year to December 2016 and 1.8% on the month…largely as a result of sterling depreciation and a recovery in global crude oil prices”.
The two main relevant imported commodities for GF bread are rice (for rice flour) and oil. The Food and Agriculture Organisation (FAO) of the United Nations Cereal price index predicts that “subdued global trade in rice on account of lower demand from Far Eastern buyers” in combination with “world rice production forecast now at an all-time high of 499 million tonnes” will suppress rice prices (FAO, 2017).
Picture 5: International Rice Prices. Source: AMIS 2017
However, the FAO Vegetable Oil Price Index shows that low global inventory levels and protracted supply tightness continue to bolster palm oil prices and as such this variable has a key bearing on future costs and therefore the price to consumers.
Picture 6. Food Commodity Price Indices. Source: FAO.org (2017)
5.0 Scale of Output
The fundamental principles of production relate closely to time periods when the firm adjusts its productive capabilities:
1) the ‘short run’: a production process that uses at least one fixed input e.g. capital such as factory, where costs are both fixed and variable;
2) the ‘long-run’: a production process in which all inputs and costs are variable, and capacity can be altered to maximise profits.
“In the short run, a monopolistically competitive firm maximizes profit or minimizes losses by producing that quantity that corresponds to when marginal revenue (MR) equals marginal cost (MC). If average total cost (ATC) is below the market price, then the firm will earn an economic profit” (Spaulding, 2017).
A firm making profits in the short run will nonetheless only break even in the long run, because as new firms enter the market, demand will decrease and average total cost will increase (Wikipedia, 2017).
Picture 7. Monopolistic Competition Short-Run Profit. Source: Spaulding (2017)
As a firm expands its scale of operations, it is said to move into its long run. Businesses that can lower average costs by increasing scale of operation are said to have economies of scale, with cost per unit of output generally decreasing with increasing scale as fixed costs are spread out over more units of output.
“Because the percentage change in output exceeds the percentage change in factor inputs used, then, although total costs rise, the average cost per unit falls as the business expands”.
“This represents an improvement in productive efficiency and can give a business a competitive advantage in a market”. (Riley, 2017)
The consumer is also eligible to benefit if reduced costs are passed on in lower prices (Worthington et al, 2005).
Picture 8 Economies of Scale in the Long Run. Source: Riley (2017)
Provided the long run average total cost curve (LRAC) is declining, then economies of scale are being exploited (Riley, 2017) beyond which is diseconomies of scale. In terms of the GF Bakery market, no data is identified to inform range of outputs for increasing returns to scale.
Economies of scale are a very effective barrier to entry. Incumbent firms operating at a lower cost than a potential new entrant will compromise the newcomer’s ability to compete effectively at a small scale of output, since higher prices will need to be charged to cover costs. This is a key consideration for the GF market as it’s dominated by established big brands, and costs of production are very high due to:
- Importation of vast number of raw materials in small batches
- Quality assurance supervision
- Smaller production plants with less automation
- Higher staffing levels.
Source: Lucinda Bruce-Gardyne, founder of Genius Gluten Free (Foods Matter, 2015).
6.0 Macroeconomic Policy Considerations
“Governments often intervene in their economies in an attempt to maintain economic stability” (Grimsley, 2016).
Governments implement an expansionary fiscal policy to encourage growth through increased spending for goods/services which increases demand thereby increasing production and raising employment. Taxes can also be decreased. On the other hand, if it wants to slow the economy down, the government will engage in contractionary policy by decreasing spending and increasing taxes.
According to PwC (2016), UK economic growth following Brexit is projected to slow which will mean higher public borrowing, but a recession in 2017 is not expected.
“Living standards are also likely to fall meaning declining growth of employment. Furthermore, weak sterling and rising inflation will erode real wages. The Resolution Foundation forecasts growth of real earnings at around, or below, zero in the second half of 2017. High inflation will also aggravate the freeze on the nominal value of welfare benefits”. (FT.com, 2016)
A good sign for new small businesses however, is that the Chancellor pledged £400 million to be injected into venture capital funds via the British Business Bank (a government-owned business development bank for small businesses) which will then be invested into growing UK companies.
“Venture capital investment is vital for small and medium sized businesses who are often unable to access more traditional funding sources” (KWM, 2016).
7.0 Conclusion
The macroeconomic factors described above signal contrasting economic forces acting upon both the consumer and producer in the near future. Consumer spending is forecasted to be depressed with lower disposable incomes coming up against obdurate rising food prices. However, the target market, GF consumers who mainly purchase out of necessity but also out of lifestyle choice across all consumer segments, will likely demonstrate rising demand and a willingness to pay premium prices (Watrous, 2016). As a new business looking to launch a new product, the GF market is yet to mature and product innovation is driving demand. The general economic outlook in light of Brexit is an obvious concern and rising costs of imports is a key consideration however, with the government’s recent commitment to support investment in small firms, the economic case for this venture seems sound.
15.2.2017