Anas Alam Faizli, Doctor of Business Administration, Assignment Advanced Managerial Economics, BPME7103

SEPTEMBER SEMESTER 2011 BPME7103 – ADVANCED MANAGERIAL ECONOMICS ASSIGNMENT (50%)

LECTURER PROF. DR. MOHD GHAZALI MOHAYIDIN

STUDENT ANAS BIN ALAM FAIZLI

Cure for all ilnesses

September Semester 2011 Student Name: Anas Alam Faizli Centre of Graduate Studies

BPME7103 – Advanced Managerial Economics Prof. Dr. Mohd Ghazali Mohayidin Student ID No.: CGS00621129 DBA Intake: September 2011

___________________________________________________________________________ Read the following case and answer the questions given at the end of the case. THE GLOBAL FOODS SDN BHD (GFSB) ___________________________________________________________________________ The Situation The last of the color slides was barely off the screen when Bakar, the CEO of Global Foods Sdn Bhd, turned to his board of directors to raise the question that he had been waiting all week to ask. “Well, ladies and gentlemen, are you with me in this new venture? Is it a ‘go’? Shall we get into the soft drink business?” “It’s not that easy, Bakar. We need some time to think it over. You’re asking us to endorse a very major decision, one that will have a long-term impact on the direction of the company.” “I appreciate your wish to deliberate further, Dr. Salleh,” Bakar responded, “but I would like to reach a decision today. As the president of a major university, you have been especially valuable in advising this company in matters relating to social and governmental policies. But we must diversify our business very soon in order to maintain the steady growth in profits that we have achieved in recent years. As my presentation showed, the manufacturing and marketing of our own brand of soft drink is one of the best ways to do this. It represents a significant diversification, yet it is very closely related to our core business: food. “The economics of the soft drink market tell us that we would be foolish to pass up the kind of investment return that the market offers to those newcomers willing to take the risk. The food business is generally a mature one. On the other hand, our forecast indicates that there is still a lot of room for growth in the soft drink market. To be sure, there is a tremendous amount of competition from the ‘red team’ and the ‘blue team.’ But we already have expertise in the food business, and it should carry over into the beverage market.” “That’s just it, Bakar,” interjected another board member, “Are we prepared to take this risk? You yourself acknowledged that the market power wielded by the two dominant companies in this business is not to be taken lightly. Others have tried to take market share from them and have failed miserably. Moreover, the projections that you have shown for a growing soft drink market are based on the assumption that the growth rate will remain the same as it has been in the past ten years or so. As we all know, the soft drink market has been growing, but is has also been very fickle. Only recently, Malaysians were on the health kick, and fruit juices and bottled water along with health foods were in fashion. Now it seems that soft drinks are back in style again. Who knows what people will want in the future? Maybe we’ll all go back to drinking five cups of coffee a day. And, what about all the money that we’re going to have to spend up front to differentiate our product? As you well know, in the processed-food business, establishing brand recognition - not to mention brand loyalty – can be extremely difficult and costly.” “Well, ladies and gentlemen, all our concerns are certainly legitimate ones, and believe me; I have given much thought to these draw-backs. This is one of the biggest decisions that I will have made since becoming CEO. My staff has spent hundreds of hours analyzing all available data to arrive at a judgment. Our findings indicate a strong probability of earning an above-average return on an investment in the soft drink business, a return commensurate with 1

September Semester 2011 Student Name: Anas Alam Faizli Centre of Graduate Studies

BPME7103 – Advanced Managerial Economics Prof. Dr. Mohd Ghazali Mohayidin Student ID No.: CGS00621129 DBA Intake: September 2011

the kind of risk we know exists in that market. But if we could make all our decisions with 100 percent certainty simply by feeding numbers into a computer, we’d all be out of a job. To be sure, details on production, cost, pricing, distribution, advertising, financing, and organizational structure remain to be ironed out. However, if we wait until all these details are worked out, we may be missing a window of opportunity that might not appear again in this market for a long time. I say that we should go ahead with this project soon as possible. And unanimity among the board members will give me greater confidence in this endeavor”. The Questions For all the questions below, a. Deliberate on the situation; b. Ask yourself the key question; c. Identify related theories and concepts; d. Determine data, facts, and information needed; and e. Answer the key questions.

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September Semester 2011 Student Name: Anas Alam Faizli Centre of Graduate Studies

BPME7103 – Advanced Managerial Economics Prof. Dr. Mohd Ghazali Mohayidin Student ID No.: CGS00621129 DBA Intake: September 2011

1. INTRODUCTION: a. The Firm and Its Goals. What should be the goals of GFSB? b. The Value of the Firm How GFSB can improve the value of the company, especially when analysts are judging a company primarily on its ability to grow its revenue and profit? This report is written succinctly to elaborate Global Foods Sdn Bhd (GFSB) decision making process, methodologies and strategies executed prior to investment into a new market of carbonated soft drink. It will address the goal and value of the firm, demand analysis, production and cost of production, the market structure, the pricing strategy and the reasoning behind the decision made after considering all these factors. The Encyclopaedia of Global Industries (EGI) (2007) stated that the term soft drink was coined to distinguish flavoured drinks from hard liquor. However, for this report, the product will only be considering on carbonated soft drinks only and not the entire range of soft drink beverages. This report is an important instrument as it forms the basis and the decision support for GFSB to enter the carbonated soft drink market with its new honey cola taste carbonated soft drink. The 1 Malaysia cola drink proposal has been taken out from this as it carries its own economic merit and can be evaluated as a separate project. GFSB primary goals and objective is shareholder wealth-maximization which can be achieved through profit earning. Shareholder wealth is the measure of the value of a firm, which is measured by the present value of all future cash returns expected to be generated by the firm for the benefit of its owners (McGuigan et al., 2011). Hence, it is imperative and is most beneficial to GFSB to ensure shareholder wealth is maximized and eventually results in maximizing the value of the firm. This will emulate Berkshire experience where its book value has growth from $19.46 to $91,845.00 per share in 41 years period. This is achieved by among many others, maximizing shareholder’s wealth where Berkshire’s managers and directors own over 47% of the firm’s stock. Shareholder wealth maximization implies that a firm needs to be forward looking, dynamic with a long term outlook, anticipate and manage changes, and also acquire strategic investment opportunities (McGuigan et al., 2011). This will contribute and continue growing GFSB’s business and support the diversification initiatives. The new venture into the soft 3

September Semester 2011 Student Name: Anas Alam Faizli Centre of Graduate Studies

BPME7103 – Advanced Managerial Economics Prof. Dr. Mohd Ghazali Mohayidin Student ID No.: CGS00621129 DBA Intake: September 2011

drink market business and the economics that it offers is substantial and will be a strategic investment opportunity. The return of investment is higher than the cost of capital which will definitely support the decision. Thus, such decision will directly support the overall firm objective in maximizing shareholder wealth and the end result will without no doubt increase the value of the firm. It also promotes long term growth and firm survival, having taken into account the interest of the shareholders. This will also ensure shareholders loyalty to the firm. The value of the firm is measured by the present value of expected future profits or cash flows. It takes into account discounted rate at the shareholder’s required rate of return before tax. Let us take a look at The Coca-Cola Company (TCCC) which is the world’s number one leading soft drink brand. TCCC owns four of the top five soft-drink brands (Coca-Cola, Diet Coke, Fanta, and Sprite). Its other brands include Minute Maid, Powerade, and Dasani water. In North America it sells Groupe Danone's Evian; it also sells brands from rival Dr Pepper Snapple Group (Crush, Dr Pepper, and Schweppes) outside Australia, Europe, and North America. (The Coca-Cola, 2011) Key numbers for fiscal year ending December, 2010 for TCCC: Sales: $35,119.0M One year growth: 13.3% Net income: $11,809.0M Income growth: 73.1% These numbers are a good Key Performance Indicators to show TCCC values of the firm. The formula use to calculate the form is shown below: V=

  t /(1  k t 1

e

)t

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where, V = present value of future profits



= expected future profits or cash flow

k e = discount rate or required rate of return t = time (number of years)

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September Semester 2011 Student Name: Anas Alam Faizli Centre of Graduate Studies

BPME7103 – Advanced Managerial Economics Prof. Dr. Mohd Ghazali Mohayidin Student ID No.: CGS00621129 DBA Intake: September 2011

Based on this formula it can be seen that if firm reduce the perceived risk of a firm, which will result in a reduced in the required rate of return, k e this will increase the value of the firm. In conclusion, there are two ways which will eventually increase the value of the firm, one is to grow its revenue and profit as economic analysts like to point out, secondly is by reducing the risk of a firm and the required rate of return. This investment decision can support to achieve this objective. Investments can always be sorted in the list of highest risk and the highest return. These two factors can be considered prior to making any investment decision. How GFSB will make decisions to invest in a new market? Boundaries and limitation to the decision will be problems related to the three (3) key focus areas namely to incomplete markets, asymmetric information, and unknown re-contracting costs. These complications will be addressed in this report and will be among the many decision support instrument to allow GFSB make an informed decision for this new venture and allow the maximization of the present value to equity owners through the new strategic investment opportunity.

Figure 1.1 - The Decision Making Process (McGuigan et. al., 2011) 5

September Semester 2011 Student Name: Anas Alam Faizli Centre of Graduate Studies

BPME7103 – Advanced Managerial Economics Prof. Dr. Mohd Ghazali Mohayidin Student ID No.: CGS00621129 DBA Intake: September 2011

GFSB adheres to ensuring that decision making in the firm are made through a structured six step decision making managerial economics process as illustrated in Figure 1.1.

Each

decision seeks to support the firm’s primary objective. All managerial decision will be made after carefully going through alternatives and opportunity costs and will select the best decision that support the objective in the most efficient manner and taking into account all risks and constraints. This investment decision will also help establish GFSB brand name in the soft drink industry and assist to continue growing the firm value. As a result of this expansion, capital investment will be made, new manufacturing plant would be opened, more employees would need to be employed and the opportunity will be made available to further grow the firm value. This can be considered as a catalyst for improving the firm value by expansion and diversification to soft drink industry which would lead to new business opportunities and potentials.

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September Semester 2011 Student Name: Anas Alam Faizli Centre of Graduate Studies

BPME7103 – Advanced Managerial Economics Prof. Dr. Mohd Ghazali Mohayidin Student ID No.: CGS00621129 DBA Intake: September 2011

2. DEMAND ANALYSIS: a. State the relevant managerial objectives. b. How do you use demand analysis to serve the managerial objectives? Demand analysis plays important role in delivering three key relevant managerial objectives as follows: i) Provides insight and information necessary for GFSB to manipulate, control and benefits from demand. ii) Helps GFSB forecast and guess estimate an accurate potential sales and revenue. iii) Projects revenue stream portion of a firm’s cash flow stream for financial planning. Prior to committing to a new strategic investment opportunity these three managerial objectives and functions are required to effectively conclude the economics of any market, new or old. The same goes to the soft drink industry. Prior to commitment to the business, a demand analysis is required which will provide the required information for supporting the decision.

It is pivotal that the management of GFSB is made aware of the potential

forecasted unit sales the new business will be able to generate and hence the revenue which will be critical for financial planning both capital and operational expenditures of the new business. Demand analysis also confirms the price elasticity of demand, which is required to accurately measure a range of responsiveness of any change in the quantity demanded. Simply said, price elasticity of demand gives the percentage change in quantity demanded when there is a percentage change in price and vice versa. This remains true where all other determinants constant of demand remain unchanged.

Figure 2.1 Law of Demand showing price in relation to Quantity demanded in Litre 7

September Semester 2011 Student Name: Anas Alam Faizli Centre of Graduate Studies

BPME7103 – Advanced Managerial Economics Prof. Dr. Mohd Ghazali Mohayidin Student ID No.: CGS00621129 DBA Intake: September 2011

The law of demand is governing to all products without exceptions and carbonated soft drinks also are unable to shy away from this law. The higher the price, the lower the quantity of demanded for the soft drink would be and vice versa, as reflected in Figure 2.1. The carbonated soft drink market has grown tremendously over the past 100 years. The EGI (2007) stated that the global soft drink industry is exclusively a marketing phenomenon. The product is only a simple blend of water, sweeteners, flavors and other additives, yet however the EGI (2007) complimented that the industry’s genius lies in getting billions of consumers to drink soft drink instead of plain water or other beverages. Furthermore, from 1960 to 1990 the growth of soft drink outpaced the population growth for the period and per capita consumption of soft drinks increased 2.5 times (Muris et al., 1993). According to Euromonitor (Euromonitor International, 2011), F&N Coca-Cola hold the biggest soft drinks share in Malaysia at 72% of the total market. This is contributed directly by the Coca-Cola brand. There is strong determination from consumer to live better and choose healthier drinks which is expected to give halt to the growing consumer base for soft drinks. However, it is projected that the growth for soft drinks will continue to soar contributed by two factors, the increasing number of working Malaysians which is expected to reach thirteen millions by the year 2013 and the global economic downturn which leads to professionals going for fast foods and soft drinks (Just the facts, 2011). Being a product of modest price, the cost of soft drinks will remain non criterion for consumer to continue consuming the product. Furthermore, in Malaysia, it is reported that 1000 cans of soft drink is being drink every minute (Bernama, 2007). GFSB adheres to the demand estimating using marketing research techniques, i.e consumer surveys, consumer focus groups and market experiments.

Surveys have been done to

understand consumer’s needs better and assist in gauging demand on soft drinks.

A

consumer focus group and market experiments with the intention to experiment and test market demand condition has also been executed. Soft drinks with GFSB logo that imitates Coca-Cola red and white colour has been tested at various stores and indicates positive results.

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September Semester 2011 Student Name: Anas Alam Faizli Centre of Graduate Studies

BPME7103 – Advanced Managerial Economics Prof. Dr. Mohd Ghazali Mohayidin Student ID No.: CGS00621129 DBA Intake: September 2011

Consumer surveys and statistics from statistic department has been collected. These data will then be analyzed through marketing analysis technique, to name a few, i.e deterministic time series analysis, barometric technique, econometrics models, forecasting output with input, and polling techniques.

Table 2.1 Soft Drinks quantity demanded in litres for 2000-2010 and its growth, Adapted from United Nations Report on Soft Drink for Malaysia

Table 2.2 Soft Drinks forecasted quantity demanded in litres using two techniques

Table 2.1 and 2.2 shows where statistical data can be used for forecasting. Table 2.2 shows where the first forecast using technique a, called time series model is used to quantify the quantity demanded for the next five years. 9

BPME7103 – Advanced Managerial Economics Prof. Dr. Mohd Ghazali Mohayidin Student ID No.: CGS00621129 DBA Intake: September 2011

September Semester 2011 Student Name: Anas Alam Faizli Centre of Graduate Studies

The formula used is as follows: Xt+1 = Xt + (Xt – Xt-1) Technique b however used the average growth of the data for 10 years which is 6.44% and assumes the same for the next five years. Demand analysis can be used to serve the three key managerial objectives as mentioned earlier. These will assists in sales forecasting, making financial decisions, setting the price, making marketing decision and deciding the quantity of the production. The soft drinks market consists of retail sale of bottled water, carbonates, functional drinks, juices, RTD tea and coffee, and smoothies. The Malaysian soft drinks market generated total revenues of $1.3 billion in 2010, representing a compound annual growth rate of 4.5% for the period spanning 2006-2010. Carbonates sales proved the most lucrative for the Malaysian soft drinks market in 2010, generating total revenues of $407.5 million, equivalent to 30.9% of the total soft drink market's overall value. (Soft Drinks, 2011). These figures presented shows promising space and room for more players and firms to engage and enter the carbonated soft drinks market. The market demand function for a product can be expressed as:

Product X = Qx =

f

(Price of X, Prices of Raw Materials, Price Changes Expectation,

Consumer Incomes, Population, Taste and Preferences, Advertising Expenses, etc) The demand function illustrated above shows variables which are commonly used to run regression to see the inter-relations between each variable. In the case of carbonated soft drink industry the demand function can be as below:

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September Semester 2011 Student Name: Anas Alam Faizli Centre of Graduate Studies

BPME7103 – Advanced Managerial Economics Prof. Dr. Mohd Ghazali Mohayidin Student ID No.: CGS00621129 DBA Intake: September 2011

Q = x1P + x2RM + x3CI + x4Pop + x5TP + x6AE The equation above is a linear function that will try to evaluate the inter-relationship between each variable, where a change in one variable will affect the outcome of the quantity demanded to the soft drink. The variables representation is shown below: x1 = Price x2 = Price of Raw Materials x3 = Consumer Average Income x4 = Population x5 = Taste and Preference x6 = Advertising Expenses A 10 years historical data from the customer survey and statistics will be used to run the regression analysis; as a result the previously unknown inter-relationship has been identified as follow: Q = -1000P + 100RM + 500CI + 50,000Pop + 20TP + 500A The equation can be read as the quantity demanded for soft drink (litres) will fall by 1000 for each RM 1 increase; rises by 100 with each change in raw materials (RM), increase by 500 for each RM 1 increase in average income (CI), and the quantity demanded increase by 50,000 with each additional 1 million persons in the population (Pop), and it increase by 20 upon enhancement of taste and preferences (TP) and increase by 500 with each RM 1 million spent on advertising (A).

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September Semester 2011 Student Name: Anas Alam Faizli Centre of Graduate Studies

BPME7103 – Advanced Managerial Economics Prof. Dr. Mohd Ghazali Mohayidin Student ID No.: CGS00621129 DBA Intake: September 2011

3. PRODUCTION AND COST OF PRODUCTION: a. Managers are required to make resource allocation decisions. Identify the relevant production theory for the above case. b. Discuss the analysis that you would carry out to assist in the decision making. Production and cost production remains one of the most important steps, in making a managerial economic decision for a strategic investment opportunity. This is more important if the decision revolves in entering a new market. A good historical data and market survey is thus required to ensure that production can be done in the most efficient or the least cost manner. There are many tools which will be deliberated further where these tools will assist in recognizing how to produce at the most least cost. A production function will relate the highest output which can be produced from a given input, namely the variables. These outputs can assist in measuring the average and marginal product of each input. Some inputs are fixed while some follows the Law of Diminishing Marginal Returns. Another important factor to cost in is the time frame. A production function give different results and is required to be calculated differently depending on the time frame which can either be a short-run or a long-run production function.

Figure 3.1 – Data and Graph for Production Function 12

September Semester 2011 Student Name: Anas Alam Faizli Centre of Graduate Studies

BPME7103 – Advanced Managerial Economics Prof. Dr. Mohd Ghazali Mohayidin Student ID No.: CGS00621129 DBA Intake: September 2011

The input to a production function will be cost and labour. Output can be increase by either increasing cost or labour or both. If both inputs can be changed to increase the production that means the production function is in the long-run period. However, if one input is keep at constant and while the other input is changed to increase production that means that the production function is in the short-run period. Figure 3.1 reflects in theory the most standard linkage showing total product (TP), marginal product (MP) and an average product (AP) and also proven the law of diminishing marginal returns. It is like a bell curve, it may vary from a production function graph to another, but in essence it will always follow the same essential rules. The relationship in the graph is summarised as follows (Mohayidin, 2011): 

If MP is positive then TP is increasing.



If MP is negative then TP is decreasing.



If MP > AP then AP is rising.



If MP < AP then AP is falling.



MP=AP when AP is maximised.

L1, L2 and L3 are identified as three stages of production. Stage 1 indicates AP rising from zero to maximum AP and this also equates elasticity as one. Stage 2 is when the AP is declining while the MP remains positive. It starts from where AP is in its maximum until MP is zero. Elasticity in this stage is between zero and one. Stage 3 is where the MP will become negative and the TP starts to decline and the elasticity becomes less than zero. This concludes that for a production cost in short run, it should only best to be operating in Stage 2. There are then other production functions in the long run, and with more than one variable input and etc. However, the most common used form of function used in empirical studies to affectively understand GFSB resource allocation strategy and identify the labour and capital required would be the two-input model used by Cobb and Douglas as per the following formula: Q = αLbKc Where, Q = total production (can be presented as the monetary value of goods produced, RM) L = labour input 13

September Semester 2011 Student Name: Anas Alam Faizli Centre of Graduate Studies

BPME7103 – Advanced Managerial Economics Prof. Dr. Mohd Ghazali Mohayidin Student ID No.: CGS00621129 DBA Intake: September 2011

K = capital input a = total factor productivity b and c = output elasticities of labour and capital respectively. Output elasticity will measure the effect for an output to a change of either labour or capital used in production, ceteris paribus. For example, if b = 0.8, a 1% increase in labour would lead to a 0.8% increase in output. To get value of b and c, see following equation: Q = αLbKc Log Q = Log ( α LbKc) Log Q = Log α + Log Lb + Log Kc Log Q= Log α + b Log L + c Log K A regression run will derives the value of b and c. In supporting GFSB firm’s objective and part of the shareholder wealth maximizing efforts, an efficient pricing and output strategy is important as it will in return maximize the present value of the future profit stream to the firm. There are many factors which will determine the best strategy to maximizing wealth. It depends on the production capacity, cost levels, demand characteristics and the potential for long term competition and anything immediate. The most important step prior to being able to do this is first to understand the market structure. This is the most important information to support all the other managerial decision related to economics.

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BPME7103 – Advanced Managerial Economics Prof. Dr. Mohd Ghazali Mohayidin Student ID No.: CGS00621129 DBA Intake: September 2011

September Semester 2011 Student Name: Anas Alam Faizli Centre of Graduate Studies

4. MARKET STRUCTURE: a. Determine the market structure this particular firm is in. b. Support your answers. c. How would you determine the optimal quantity and price under this market structure? Porter noted in his book in 1980 titled Competitive Strategy and followed by another, called Competitive Advantage in 1985 offered Porter’s model of competitive analysis which concluded that a business strategy in pricing or output should be based on the market structure in which firms operate. Understanding the market structure supports in identifying target markets, in this case the soft drink industry. The strategic investment opportunity can only be successfully implemented if a proper market understanding is gained and recognizing the changes it will make to the firm’s resources, capabilities and core competencies, which in this case is the foods industry.

Number of firm Product type

Price control

Entry obstacles Price competition

Pure Pure Monopoly Competition Very large One firm number of firms

Monopolistic Competition

Oligopoly

Many firms

Few firms

Standardised or differentiated products Control over Some control price No control over Much control over price in a circumscribed price over price by mutual narrow range interdependence No obstacles to Relatively easy Many obstacles Entry is blocked to entry entry entry Much nonNo non-price Public relations Much non-price price competition advertising competition competition Standardised products

Unique product

Differentiated products

Table 4.1 Market Structure Types and Comparison between Pure Competition, Pure Monopoly, Monopolistic Competition and Oligopoly Table 4.1 exhibits the attributes and characteristics between the four market structures category namely pure competition, pure monopoly, monopolistic competition and oligopoly. Going through the four characteristic of soft drink market will inevitably identify the market 15

September Semester 2011 Student Name: Anas Alam Faizli Centre of Graduate Studies

BPME7103 – Advanced Managerial Economics Prof. Dr. Mohd Ghazali Mohayidin Student ID No.: CGS00621129 DBA Intake: September 2011

structure of the soft drink industry. The soft drink market share in Malaysia is in short divided between few major firms, F&N, Coca-Cola Company and PepsiCo, Inc. with the latter having a smaller share of the market (Datamonitor, 2011).

Globally, the soft drink

industry is dominated by give big companies, Coca-Cola, Cott, Cadbury, National Beverage and Pepsi which in total accounted for 95% of soft drink sales worldwide (John and Carl, 2010). Soft drink industry market structure is a monopolistic competition. Comparison and further deliberations will be made further to prove this point to show why a soft drink market is not an oligopoly. An oligopoly is the domination of the market by a few firms.

Some might

argue that a soft drink market structure is a duopoly where only two firms dominate a market which is not the case for the soft drink industry as there are more than two players but not as many dominant more than the big five. Furthermore, there is no standardised product in a soft drink market, hence a monopolistic competition. Where an oligopoly exists, a few large suppliers will be dominating the market and industry leading to a high degree of market concentration. This means the market share is taken by a few leading firms as in the case of the soft drink industry. An oligopoly market offers high barriers to entry. It will be difficult to make an entrance into the market. Consumer loyalty and brand recognition has already been embedded in the market and will make it difficult for new players to enter the business, and which is not the case for the soft drink industry as shown in Table 4.2 where 36% consumers surveyed opt to try on new beverage.

Table 4.2 Surveys of Reasons for Trying New Beverage, Oct 2011

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September Semester 2011 Student Name: Anas Alam Faizli Centre of Graduate Studies

BPME7103 – Advanced Managerial Economics Prof. Dr. Mohd Ghazali Mohayidin Student ID No.: CGS00621129 DBA Intake: September 2011

This often leads to a lack of price competition as the big players in the industry would be very sensitive to play with the price. Any changes in price can lead to an informal collusion as firms try to match their price and can lead to a price war. As an oligopoly market structure involves few firms, any action by another firm will be noticed by the other competitor and the competition will be more towards advertisement and marketing rather than through price. If a firm cut the price, the other firms has to follow, this is an unhealthy practice in the business. However, if a firm increase the price, other firms might not follow which can leads to losing the market share and profits as per the law of demand and supply. The soft drink carbonated industry is unquestionably the best example of monopolistic competition structure. It is either a Coke or a Pepsi and perhaps a Sprite or 7-Up. It is a much branded industry where every brand is recognized by the consumer. Any moves by any of these firms are also likely to evoke a countermove by its rivalling competitors. The famous Cola Wars is a classic example of this rivalling competition where each firm try to outdo each other via advertisement and marketing (“Cola Wars,” 2011). In conclusion the soft drink industry is in a monopolistic competition market structure due to the reason that there are many firms, relatively easy entry, differentiated product, there is some control over price in a narrow range and much non price competition. Table 4.3 to 4.5 is a comparison of price summary statistics which is carried across the board for various carbonated soft drink products. Uri (1986) has undertaken a study to calculate beverage price elasticity where the result shows all own-price elasticity were negative and significant at 1% level and demand for whole milk -0.69, juice -0.52, soft drinks -0.80, coffee and tea -0.89 was inelastic.

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September Semester 2011 Student Name: Anas Alam Faizli Centre of Graduate Studies

BPME7103 – Advanced Managerial Economics Prof. Dr. Mohd Ghazali Mohayidin Student ID No.: CGS00621129 DBA Intake: September 2011

Table 4.3 Price Summary Statistics for Carbonated Soft Drinks, 1 RM for each 2 litres

Table 4.4 Own Price Elasticity Results and Share Equation Summary Statistics for Carbonated Soft Drink New Product Introductions, 1 RM for each 2 litres

Table 4.5 Own Price Elasticity Results and Share Equation Summary Statistics for Carbonated Soft Drink Sector Leaders, 1 RM for each 2 litres

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BPME7103 – Advanced Managerial Economics Prof. Dr. Mohd Ghazali Mohayidin Student ID No.: CGS00621129 DBA Intake: September 2011

September Semester 2011 Student Name: Anas Alam Faizli Centre of Graduate Studies

It is important that an optimal pricing strategy is adopted for the new product in dynamic monopolistic competition market. The two major factors which will influence GFSB’s new product pricing would be diffusion effects on the demand side and the cost experience effects. The demand side and diffusion effects refer to increase or cause the likelihood to buy to increase.

This includes words of mouth, improved reputation of the products via

advertisement and other factors. As more units of the new products are sold, the remaining untapped market potential decreases.

On the cost experience effects, it implies on the

learning curve effects.

The unit production costs will decrease as cumulative output

increases, ie experience.

Optimal price determination as discussed previously is in reality

more difficult, complex and complicated from the one presented in the literatures. The two most important characteristics of real world markets are dynamics and competition. These two characteristics have continuously shaped the pricing strategy required for new products which however has always been neglected or treated inadequately in the pricing strategy. Kalish (1983) pointed out that the main direction for future research in the area of dynamic pricing is the incorporation of competition and competitive interdependencies. Thus, in order to derive pricing for a new product, a marketing survey, a customer preference regressions engulfed with the demand side and cost experience effects can determine the most optimal pricing of the product. An optimal pricing technique can be made by following several steps where GFSB would be required to develop the market strategy, marketing decisions, estimate the demand curve, calculate the cost for the product, understand the competitor, the pricing requirement and objectives (revenue and profits) and finally with all the steps would be able to finalize the best price for this new product. Pricing methods that can be used includes cost-plus pricing, target return pricing, value-based pricing and psychological pricing. Cost plus is where the production cost plus an agreed profit margin would be the set price. Target return price is where the price would be the price which allows return on investment. Value based pricing would where the price is based to customer relative to other brands. Psychological pricing is based from consumer perspectives where the consumer feels that the set price is fair.

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September Semester 2011 Student Name: Anas Alam Faizli Centre of Graduate Studies

BPME7103 – Advanced Managerial Economics Prof. Dr. Mohd Ghazali Mohayidin Student ID No.: CGS00621129 DBA Intake: September 2011

5. PRICING STRATEGY: a. In reality, price determination is more complicated than the one discussed in Question 4. Why? b. Would you consider a more complex pricing technique for your product? The demand curve in an oligopoly market structure will look like a peculiar demand curve often called kinked demand curve. The curve is a downward sloping demand curve and the price elasticity might depend on the reaction of rivals to changes in price and output. This also suggests that demand curve is not straight. An increase or reduction in price will be very sensitive and will take into consideration what other competitors might react. A price cut will only if the potential that other firms will not follow. A price increase will however be done if there are the potentials that other firms will follow to ensure prospects of losing market share does not occur. In conclusion, an oligopoly market structure has little incentive to change price. Oligopoly market structure however has a different approach when it comes to pricing and output determination as it needs to compare with its competitors. It is not as straight forward as a monopoly market where the monopolist will need not to worry about pricing strategy by its competitor as it has no rivals. The same goes in a pure competition market where pricing by a firm is independent decision and does not affect other firm as there is no single firm that is influential enough to bring effect to the market price.

In order to maximize shareholder

wealth, it is important that in an oligopoly market structure, all rival responses remain an important factor in decision making and especially in the pricing and output strategy. The demand curve for a monopolistic competition will however looks differently. It slopes downward due to product differentiation. The demand curve slopes downward from the left to the right. In the short run, the demand curve for firms in the monopolistic competition might vary.

The profits can be categorized as super profits, normal profits or subnormal

profits as illustrated in Figure 5.1 to 5.3.

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September Semester 2011 Student Name: Anas Alam Faizli Centre of Graduate Studies

BPME7103 – Advanced Managerial Economics Prof. Dr. Mohd Ghazali Mohayidin Student ID No.: CGS00621129 DBA Intake: September 2011

Figure 5.1 – Monopolistic Competition Firm’s Super Normal Profit

A,B,R,F,C = Intersection Points MC = Marginal Cost MR = Marginal Return ATC = Average Total Cost AR = Average Revenue Qe – Optimum Qty at the Point Pe – Price at Point

Figure 5.2 – Monopolistic Competition Firm’s Normal Profit

Figure 5.3 – Monopolistic Competition Firm’s Sub-Normal Profit In the long run however, a firm in the monopolistic competition would only earn normal profit. This is due to normalization. Whenever a firm in a monopolistic competition indulges 21

September Semester 2011 Student Name: Anas Alam Faizli Centre of Graduate Studies

BPME7103 – Advanced Managerial Economics Prof. Dr. Mohd Ghazali Mohayidin Student ID No.: CGS00621129 DBA Intake: September 2011

in super profit scenario, this will indefinitely attracts a number of new firms to make entrance to market. This would normalize the super profit firms to normal profits. In the event of sub normal profit, some firm would leave the industry and again normalizing the other firms to normal profits. Notice that the change from Figure 5.1 to 5.3 is only on the ATC which is shift either upward or below which result in different intersection of the ATC with MR at Qe. In a monopolistic competition market, the price determination can be more complicated as there are many numbers of firms and due to the condition of easy entry and exit attribute. Product differentiation also plays a major role which contributes to a difficult price determination. Further factors which lead to difficulties in price determination are as follows: 1. Excess capacity. 2. Average cost equal to price (long run). 3. Product advertising (lead to non price competition). As a result of all this factors, it is difficult to identify Marginal Return (MR) and Marginal Cost (MC), and also the price point where MR = MC. Furthermore, the profit will be only maximized at short-run profits. Thus, a more complex pricing technique is required to further enhance the profits. Suggested techniques include product bundling and the loyalty program. Price can means differently under different context, it can be rent, tuition, fee, fare, interest, assessment, retainer fees, salary, wages, and income taxes (Schwartz, 1981). It is also defined as the quantity or amount of thing exchanged in sale or barter for another at the cost at which the object is obtained. The pricing strategy is dependent on the very nature of the product, and in this case a new product introduction of a different taste. A honey taste carbonated cola drink. In the case of honey soft drink, market skimming and market penetration can be the pricing strategy that should be employed for this product as it is innovative and new. This product will need to be positioned in the marketplace in order to acquire profit.

Kotler and

Armstrong (1991) noted that this kind of product can employ some of these options: productline pricing, optional-product pricing, captive-product pricing, by-product pricing and product-bundle pricing. In economics, pricing strategy is objectively understood as a method on how to set price under certain assumptions to maximize profits.

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BPME7103 – Advanced Managerial Economics Prof. Dr. Mohd Ghazali Mohayidin Student ID No.: CGS00621129 DBA Intake: September 2011

September Semester 2011 Student Name: Anas Alam Faizli Centre of Graduate Studies

Product bundling is a business strategy that packages physical product together, prices and sells it as a single entity. This strategy is an effective instrument for price discrimination which also presents opportunities to enhance revenue without increasing the input or raw materials required to produce the end product. This is already a common practice across both service and manufacturing industries.

Bundling satisfy customers who many not be

interested in buying the individual product but might be keen to buy the either one of the product in the bundle. GFSB can use this product-bundle pricing strategy to bundle its food range of products with the new introduced honey drink. Another strategy that can be adopted is loyalty or reward program. Soft drink industry is a market with repeated purchases, it is common for a firm to offer different or special discount to its repeat customers. This will also help entice customers to switch from their existing brand and become GFSB customers.

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BPME7103 – Advanced Managerial Economics Prof. Dr. Mohd Ghazali Mohayidin Student ID No.: CGS00621129 DBA Intake: September 2011

September Semester 2011 Student Name: Anas Alam Faizli Centre of Graduate Studies

6. CONCLUSION: Should Global Foods (GF) enter the soft drink business?

Figure 6.1 GFSB Revenues and Forecast, 2001-2010 Figure 6.1 exhibits the potential revenue generation by diversification into the soft drink market. Data is presented based on the projected sales of the new product at a growth rate of 8% per year. The decision to expand into the soft drink market via honey cola which is illustrated in Figure 6.2 will also enable future potentials and tap into potential new markets. This would also assist in introducing other new products in the future, ie 1 Malaysia Cola. GFSB revenue is forecasted to grow from the current RM 85 Million (2010) to RM 204 Million for year 2020.

Cure for all ilnesses

Figure 6.2 Proposed Honey Cola Can Packaging 24

September Semester 2011 Student Name: Anas Alam Faizli Centre of Graduate Studies

BPME7103 – Advanced Managerial Economics Prof. Dr. Mohd Ghazali Mohayidin Student ID No.: CGS00621129 DBA Intake: September 2011

The capital requirement for soft drink industry necessitates a USD 50 Million initial outlays (McGuigan, 2011).

This would be enough for the plant, bottling, manufacturing and

operations, transportation and distribution. GFSB budget for expansion as approved by board is at USD 200 Million.

Table 6.1 New Carbonated Soft Drinks Products by Flavor, 2005-2010

Table 6.2 New Carbonated Drinks Products by Company Carbonated soft drink industry is distinguished by product differentiation at attribute and ingredient level. Anderson (2008) has noted that the pivotal key for beverage companies for their product is differentiation. This is the most important factor of success for soft drink products. Product differentiation can be driven by brand, flavour, calorie content, taste and others.

Ulrich and Eppinger (2000) noted that it is critical to understand customer

preferences, short product life cycles and fast technology changes for a successful introduction of a new product. Furthermore, if multiple firms are producing similar products pricing decision would become more complicated in such a dynamic environment. Lazim & Hasliza (2011) concluded that in Malaysia there are four major factors in consumer’s preferences over the selection of their soft drinks: branding, validation and prices, packaging and taste, respectively while branding is proven to be the dominant factor in 25

September Semester 2011 Student Name: Anas Alam Faizli Centre of Graduate Studies

BPME7103 – Advanced Managerial Economics Prof. Dr. Mohd Ghazali Mohayidin Student ID No.: CGS00621129 DBA Intake: September 2011

customer preferences. Understanding these factors would be pivotal key decision factors to make entrance to the soft drink market. As mentioned earlier, soft drink growth will continue as working Malaysians reach thirteen millions by the year 2013 and the global economic downturn which leads professionals going for fast foods and soft drinks (Just the facts, 2011). The cost of soft drinks will remain non criterion for consumer to continue consuming the product. The Malaysian soft drinks growth rate is 4.5% for the past five years where carbonated sales are 30.9% of the total soft drink market's overall value. (Soft Drinks, 2011). These figures presented shows promising space and room for more players and firms to engage and enter the carbonated soft drinks market. GFSB acknowledge that a product should be different and thus after concluded the consumer survey and would introduce a honey taste carbonated soft drink which will have cola and also caffeine in the ingredient. The new honey carbonated soft drink proposed to be introduced to the new market by GFSB is unique, appealing and is very different. Plus, it has the health catchphrase which can be used as ‘honey is the cure for all illnesses’. This goes very well with the latest public health trending. Table 6.1 and 6.2 illustrated that such taste (honey) has never been introduced and it also show how the big player in the industry is trying so hard to introduce new product every year to capture the ever growing market, where others have failed, GFSB will succeed. It is identified that the main feature of the soft drink industry is that the product is either bottled or in can and GFSB will package the honey drink in the same method. While economics of scale remain an issue, GFSB will leverage on its existing manufacturing capacity for its food production and will be able to optimize and produce within this constraint for large scale production and reduce the average cost for each amount of litre produced. Access to raw materials would not be an issue to GFSB as it already has existing price agreement contract with supplier of sugar, caffeine, cola, aluminium cans, bottles and plastics.

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September Semester 2011 Student Name: Anas Alam Faizli Centre of Graduate Studies

BPME7103 – Advanced Managerial Economics Prof. Dr. Mohd Ghazali Mohayidin Student ID No.: CGS00621129 DBA Intake: September 2011

Table 6.3 Profit Margin of Coca-Cola, PepsiCo and Nestle, 2006-2010 As part of GFSB promise to the shareholder wealth in achieving a minimum of 5% profit margin for new investments, Table 6.3 exhibits that soft drink industry is returning a minimum profit margin of 10% and above illustrated by the three giants in the soft drink industry.

As a conclusion, it is suggested that GFSB enters the carbonated soft drink industry as part of its diversification plan. It is an opportunity lost if GFSB do not venture into the soft drink business as the return of investment offered is higher than the capital cost. The product produces by GFSB would be very different, in fact, even to a global scale. It would be something even new to the whole world; a honey taste carbonated cola soft drink. The proposed 1 Malaysia Cola proposal will be presented in another report after concluding with the studies and report expected to be out in six months time.

Negotiations and

discussion with the government has been initiated and a subsidy formula from the government is expected.

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BPME7103 – Advanced Managerial Economics Prof. Dr. Mohd Ghazali Mohayidin Student ID No.: CGS00621129 DBA Intake: September 2011

September Semester 2011 Student Name: Anas Alam Faizli Centre of Graduate Studies

Anderson, L., (2008). Carbonated Beverages. Hoovers. Bernama, 2007. Rakyat Malaysia Tidak Jaga Makan. http://www.bernama.com/bernama/v3/bm/news.php?id=284195

Retrieved

from

Borenstein, Severin, Colin A. Cameron, and Richard Gilbert (1997), “Do Gasoline Prices Respond Asymmetrically to Crude Oil Price Changes?” Quarterly Journal of Economics, 112 (1), 305–339. Cola

Wars. (n.d.). In Wikipedia. http://en.wikipedia.org/wiki/Cola_Wars

Retrieved

October

14,

2011

from

Datamonitor Research Store – Soft Drinks Market in Malaysia to 2014. (2011). Retrieved from http://www.datamonitor.com/store/Product/soft_drinks_market_in_malaysia_to_2014? productid=DBCM8027 Euromonitor International – Country Report – Carbonates in Malaysia. (2011). Retrieved from http://www.euromonitor.com/carbonates-in-malaysia/report John, C. G., Carl, B. M. Jr., (2010). A Note on the Regional Triad Model and The Soft Drink Industry. Multinational Business Review., 18(1), 89-94. Just the facts – Malaysian soft drink markets. (2011). Retrieved from http://www.justdrinks.com/news/just-the-facts-malaysian-soft-drinks-market_id100281.aspx Kalish, S., (1983). Monopolistic Pricing with Dynamic Demand and Production Cost. Marketing Science, 2, 135-139. Kotler, Philip and Gary Armstrong (1991), Principles of Marketing (5th ed.). Englewood Cliffs, N.J.: Prentice-Hall. Lazim, A., Hasliza, A. (2011). Factor Analysis Evidence in Describing Consumer Preferences for a Soft Drink Product in Malaysia. Journal of Applied Sci., 11(1), 139144. Marcus, A, C., (2009). Carbonated Soft Drink Demand: Are New Product Introduction Strategies a Viable Approach to Industry Longetivity. Michigan State University. McGuigan, J. R., Moyer, R. C. & Harris, F. H. (2011). Economics for managers. (12th ed.). Canada: South-Western, Cengage Learning. Mintzberg, H., Ahlstrand, B., Lampel, J., (2009). Strategy Safari: Your Complete Guide through The Wilds of Strategic Management. (2nd ed.). Harlow, England: FT Prentice Hall. Mohayidin, M. G., (2010). BMME5103 Managerial Economics. Open University Malaysia.

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September Semester 2011 Student Name: Anas Alam Faizli Centre of Graduate Studies

BPME7103 – Advanced Managerial Economics Prof. Dr. Mohd Ghazali Mohayidin Student ID No.: CGS00621129 DBA Intake: September 2011

Muris, Timothy, J., David, T, S., and Pablo, T, S. (1993). Strategy, Structure and Antitrust in the Carbonated Soft Drink Industry. Westport: Quorum Books. Porter, M. E., (1985) Competitive Advantage: Creating and Sustaining Superior Performance. New York: Free Press. Schwartz, David J. (1981), Marketing Today: A Basic Approach (3rd ed.). New York: Hartcourt Brace Jovanovich. Soft

Drinks in Malaysia (2011). Retrieved from http://marketpublishers.com/report/consumers_goods/food_beverage/soft_drinks_in_m alaysia.html

The Coca-Cola Company: Information from Answers.com. (2011). Retrieved from http://www.answers.com/topic/the-coca-cola-company Ulrich, K, T,. and Eppinger, S, D., (2000). Product Design and Development. New York: McGraw-Hill. Uri, N, D., (1986). "The Demand for Beverages and Interbeverage Substitution in the United States." Bulletin of Economic Research 38(1):77-85.

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