Neither firm could raise prices due to the above- mentioned ‘price-war’. Speeches parent company Assai has issued a mandate for the firm to increase margins to 10% by 201 5 and so Speeches have been forced to raise prices to meet this deadline. CA have followed suit by raising prices, thus, ending the ‘price-war’. In this assignment we briefly explain the background of the Australian soft drink industry decrease in demand and increase in production costs and provide an economic analysis of Speeches decision to raise prices, focusing on he short run and long run costs in a competitive market versus an oligopoly.
Finally predictions on what this will mean for the soft drink market in the future are discussed. Economic Analysis This economic analysis focuses on the Australian soft drink market and its current change in climate due to a decreased demand for caffeinated, sugary beverages. (“Drinks Slump Sees More Than $mom Wiped Off Coke’s Earnings” 2013) To make matters worse, in 2013 Australian Health organizations launched a marketing campaign, labeled “Rethink Sugary Drinks” aimed at reducing Australians institution of soft drinks which will likely result in further decline in demand. “Gussies Warned to Rethink Sugary Drinks” 2013) The health organizations responsible for this campaign, Cancer Council, Diabetes Australia and the National Heart Foundation are also recommending a tax on sugary beverages and restrictions on the sale of soft drink in schools and workplaces. The Australian Beverage Council and Australian Association of Convenience Stores are both against such recommendations and believe that rather than combating obesity this will cause uncial burden on business (Mali 2013).
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The future looks to see consumer’s habits change and as individuals become more health conscious, preferences may move away from soft drinks. Decreased demand is not the only problem the soft drink industry faces. There has also been an increase in the cost of production. The article reports that the cost of goods for CA increased by 1 . 7% last year and CA anticipate this will rise by a further 2. 5%. Speeches similarly experienced an increase in cost of goods in 2013, which they estimated had risen by 3. 4%. (Mitchell 2014).
These non- price changes would have a negative effect on both supply and demand in the Australian soft drink market. The increased cost of production would cause a decrease in supply, while people’s preferences of moving away from sugary drinks would cause a decrease in demand. The negative shift in the supply (S) and demand (D) curves can be seen in Figure 1, where S shifts to SSL and D shifts to ODL respectively. These shifts create a new equilibrium, represented as X in Figure 1. At X the efficient market price is PA however due to the ‘price-war’ between the firms the rice is reduced to PA.
In doing so a consumer surplus is created and is shown at Z,Y,PA in Figure 1. The lower price that has been set as a result of the ‘price-war’ (PA) does not reflect equilibrium. This has resulted in a consumer surplus that is greater than the producer surplus and as such the market is not efficient. Figure 1: Increased Supply Costs and Decreased Demand of soft drink Higher costs for aluminum, plastics, utilities and distribution have increased the cost of production across the Australian soft drink market.
Looking at the short run analysis for Speeches (figure 2) we can see that these increases in the cost of goods cause the Average Total Cost (TACT) and Average Variable Costs (TV) to shift up creating a new equilibrium at point X where MIMIC = ATTIC . By using this short run cost analysis we can understand Speeches’ decision to continue to operate at Pl . Although Pl is below the new average total cost (ATTIC) it is still higher than the new average variable cost (VIC) and as such the firm can continue to operate.
The article points out that this decision by Speeches to continue supplying at the lower price Pl) was influenced by the firms desire to increase market share and volumes while endeavoring to boost sales of a new product. As the cost of goods has increased in both firms, Figure 2 can also be used to reflect Coca’s short run cost analysis. However the article points out that the increase in Coca’s variable cost is slightly less than Speeches due to the ability of CA to purchase the concentrate ingredient used to make the soft drink in Australian Dollars rather than United States Dollars.
Figure 2: Short run cost analysis This scenario changes when we take a look at the long run analysis. In Figure 3 we again see the higher cost of goods increasing the average total costs (TACT) to ATTIC . However in the long run analysis, where all factors are variable, this is not sustainable. The firm cannot continue to operate at price Pl , where the new average total cost (ATTIC) is now higher than the price (Pl) represented at point A. In a perfectly competitive market, when the firm is a ‘price taker’, this would mean ‘Shutdown’ and the firm would be forced to exit the market.
In contrast, Speeches chose to raise prices by 4% to PA demonstrating their status as a ‘price maker’. Figure 3: Long Run Cost Analysis Speeches’ ability to raise prices is due to the market it operates in. The Australian soft drink industry has extremely high barriers to entry. Both Speeches and CA have market power, considerable market share, carry out large amounts of advertising and are mutually interdependent. These are all factors that indicate they are operating in an oligopoly rather than a perfectly competitive market.
However Speeches decision to raise prices by almost 4% and Coca’s reaction to increase their price as much as 6% goes against the usual behaviors of an oligopoly market. The theory says where one firm decreases their price competitors would usually follow, while on the other hand, when one firm increases their price competitors would usually not. To analyses the firm’s costs in an oligopoly market we have chosen to use the Kinked Demand Curve Theory. Figure 4 shows the firms increased cost of production shifting the Margin Cost (MAC) curve up to MIMIC .
Because of the discontinuity in the marginal revenue curve (MR.), proposed by the Kinked Demand Theory, the firm can absorb the increases in marginal costs between point A and point B without raising prices. With the ongoing increase in marginal costs, and in the case of Speeches, the risk of MIMIC eventually surpassing point A, the firm needs to raise its prices in order to maintain the revenue margins required to operate. Speeches chose to increase prices by 4% which is represented as PA in Figure 4.
Due to Coca’s decision to follow and increase prices by 6% the kink in the demand curve would likely change to point X as the higher price (PA) set by both firms would be accepted as market price and the demand curve below point X would change to a more elastic demand. Figure 4: Cost Analysis based on Oligopoly Having analyses the effect of the increasing cost of production and the decreasing consumer demand on the individual firms’, we can now relate this back to the industry market for Australian soft drinks. Figure 5 shows this as a decrease in supply from S to SSL and a decrease in demand from D to ODL .
Speeches and Coca’s decision to end the price war and increase the price per unit from PA to PA will bring the market back to equilibrium (X) where the consumer surplus and the producer surplus are once again equal and the market is operating efficiently. Figure 5: Future supply and demand with increased prices Conclusion As suggested in the article, the price war between Speeches and CA appears to be coming to an end and we predict that the recent increase in prices will bring the soft drink market back to efficiency.