Question

The market for pizza pie behaves as follows: Government has set the price at \(\$ 3.00\) a pie and the quantity demanded is assumed to be constant at \(1,000,000\) pies per year. There are five companies in the market, each selling exactly \(20 \%\) of the total quantity. The five companies' products are identical and cost each company \(\$ 2.00\) each to produce. Early this year, company A added a secret ingredient its product which costs \(\$ 0.30\) for each pie. As a result, Company A's share of total pizza sales increased to \(40 \%\), at the expense of the four other companies whose market share dropped to \(15 \%\) apiece. With the industry in an uproar over the shift away from equal shares of the market, Company A's president offered to tell what the secret ingredient was if each company would pay him \(\$ 35,000\), reasoning that each other company could double its sales, just as Company A had, and would therefore be more than willing to pay the \(\$ 35,000\). (a) What is the fallacy here? (b) Should the other companies accept A's offer? What should they propose instead if they wish to return to an evenly divided market with a uniform product?

Short answer

(a) The fallacy in Company A's president's argument is assuming that if each company paid $35,000, they would double their sales, just as Company A had, which is not possible due to the constant total market demand of 1,000,000 pizzas per year. (b) The other companies should not accept Company A's offer of paying $35,000 each. Instead, they should propose a collaborative approach to find an alternative ingredient or strategy that lowers the cost of production or improves the quality of the pizza without increasing the price, ultimately maintaining their market shares and increasing customer satisfaction without increasing costs.

Step-by-step solution

Original Market Situation

To analyze the original market situation, let's identify the profit for each company. Since there are 5 companies each selling 20% of the total quantity and price was set at $3.00 each, we can calculate the profit as follows: Price per pizza: \$3.00 Cost per pizza: \$2.00 Profit per pizza: Price - Cost = \$3.00 - \$2.00 = \$1.00 Quantity of pizzas sold by each company (20% of the market share): 0.20 * 1,000,000 = 200,000 Total profit for each company: Profit per pizza * Quantity = \$1.00 * 200,000 = \$200,000

Impact of Secret Ingredient

After Company A added the secret ingredient, its cost per pizza increased by $0.30, but it increased its market share to 40%. Calculate the new profit for Company A: New Cost per pizza for Company A: \$2.00 + \$0.30 = \$2.30 New Profit per pizza for Company A: Price - New Cost = \$3.00 - \$2.30 = \$0.70 New quantity of pizzas sold by Company A (40% of the market share): 0.40 * 1,000,000 = 400,000 New total profit for Company A: Profit per pizza * Quantity = \$0.70 * 400,000 = \$280,000

Identify the Fallacy

The fallacy in Company A's president's argument is assuming that if each company paid $35,000, they would double their sales, just as Company A had. However, because the total market demand is assumed to be constant at 1,000,000 pizzas per year, it is not possible for every company to double their sales. If every company adopted the secret ingredient, it would simply redistribute the market shares back to an equal 20% per company, not double the quantity for all of them.

Evaluate Accepting the Offer

The other companies should not accept Company A's offer of paying $35,000 each. This is because in the scenario where every company adopts the secret ingredient, the profit for each company would decrease due to the additional cost per pizza, and the market shares would be equal again. Instead, they should propose an alternative that ensures a uniformly distributed market share.

Alternative Solution

The other companies can propose that they collaboratively come up with a new ingredient (if possible) that lowers the cost of production or improves the quality of the pizza without increasing the price, to attract more customers. If they can find such an alternative ingredient or strategy, they can return to the evenly divided market with a uniform product. This cooperative approach would allow them to maintain their market shares and increase customer satisfaction through improved quality without increasing their costs.

Key concepts

Price Elasticity

Price elasticity is a measure of how sensitive the quantity demanded of a product is to changes in its price. In the case of the pizza market from the exercise, the government setting the price at $3.00 results in a constant demand of 1,000,000 pies per year. This indicates that the price elasticity of demand in this scenario is very low, or inelastic. Even if the price were to change slightly, the quantity demanded remains stable.

• **Understanding Price Elasticity:** It is typically calculated as the percentage change in quantity demanded divided by the percentage change in price.
• **Inelastic Demand:** When elasticity is low, consumers' quantity demanded is not very responsive to price changes.
• **Implications:** Knowing elasticity helps businesses decide on pricing strategies. For the pizza companies, maintaining a stable price ensures consistent demand.

Exploring elasticity can provide insights into how much pricing power a company holds, guiding competition strategies to create value without losing customers.

Market Share

Market share represents the portion of a market controlled by a particular company or product. In our scenario, the market for pizza pies was originally evenly divided, with each of the five companies holding a 20% share. However, Company A's innovation led it to gain a larger 40% share.

• **Why Market Share Matters:** It reflects how well a company is performing against its competitors.
• **Gaining Market Share:** Innovative products, like Company A’s secret ingredient, can capture more market share by attracting more customers.
• **Redistributing Share:** If all companies implemented the same strategy, as Company A suggested, the share would likely stabilize back to an equal division since total demand doesn't change.

Market share is a critical performance metric and can indicate the success of competitive strategies and innovation efforts.

Profit Maximization

Profit maximization is the process by which a company seeks to make the highest possible profits. Here, Company A attempts to maximize its profits by adding a secret ingredient, shifting its market share from 20% to 40%. Although its profit per pizza decreased due to a higher production cost, the total profit increased due to higher sales volume.

• **Profit Calculation:** Total profit is determined by multiplying profit per unit by the quantity sold.
• **Strategic Moves for Profit:** Introducing new ingredients or features can initially increase costs but also revenue, if it successfully captures more market share.
• **Balancing Costs and Revenue:** Successful companies analyze whether the increased cost of production is justified by the additional revenue generated.

The goal is to find a sweet spot where profits are highest, which may require trial and error with different strategies, as seen in Company A’s case.

Competition Strategy

Competition strategies are plans developed by companies to gain a competitive edge over others in their market. In our pizza market example, Company A used product differentiation by adding a secret ingredient.

• **Types of Strategies:** These include lowering prices, improving product quality, or differentiating products.
• **Collaboration vs. Competition:** The alternative solution proposed encourages collaboration among the other companies to develop a strategy that benefits all, rather than competing over a zero-sum game.
• **Innovative Solutions:** By focusing on innovation, a company can shift the market dynamic without merely engaging in a price war.

Competition strategies should be aimed at sustaining long-term growth and maintaining positive relationships within the market structure.