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This week I looked at the workings of competitive markets: first in basics, before turning more specifically to my research question around how the Web has changed competition between businesses from an economic viewpoint. I continue to refer to the Sloman, Hinde and Garratt book, ‘Economics for Business’ (5th ed).

As outlined in my posts on management studies from previous weeks, firms are greatly affected by market environments (particularly when it comes to pricing strategies). The more competitive the market, the greater the domination of the market over firms (e.g. resulting in ‘price takers’ nearer the model of the ‘perfectly competitive’ market when price is entirely outside a firm’s control, rather than ‘price setters’ nearer the model of the monopolistic, ‘imperfect’ market).

Although price is often at the heart of competitive strategy, the significance of non-price factors of competition should also not be underestimated. By differentiating one firm’s products from another’s, such as through design and marketing/advertising, firms seek to influence demand. Of course, the most dramatic growth in advertising expenditure over the last decade or so is on the internet (which increased from virtually nothing in 1998 to nearly 20% of all UK total advertising expenditure in 2008 based on data in the Advertising Strategic Yearbook 2009).

The better a firm’s knowledge of a market, the better it will be able to plan its output to meet demand. In particular, knowledge related to the size and shape of current and future demand choices by consumers is critical to the investment decisions that businesses make (Philip Collins, OFT Chairman, Speech 2009). Such predictions include the strength of demand for a firm’s products followed by responsiveness to any changes in consumer tastes (particularly when the economic environment is uncertain). Collecting data on consumer behavior is therefore highly valued by businesses, assuming it can be analyzed properly so it can be used to estimate price elasticity and forecast market trends and changes in demand. Price elasticity as a concept is the measure of the responsiveness of quantity demanded to a change in price. Methods for measurement include market observations, market surveys and market experiments.

Conversely, consumers face a similar problem when they have imperfect information about, in particular complex, products/services. In finding ways for consumers to trust information provided by sellers, establishing a reputation and third parties helping firms to signal high quality can assist. For example, Sloman, Hinde and Garratt refer to the online auction site eBay providing a feedback system for buyers and sellers so they can register their happiness or otherwise with sales.

The supply side of the market is just as important as the demand side. Businesses can increase their profitability by increasing their revenue or by reducing their costs of production. Both these concepts are subject to economic theorizing to discover the particular output at which profits are maximized. The answer in any one case is heavily dependent on the amount of competition in the market which is measured, in turn, by concentration levels.

E-commerce is a force at work undermining concentration (dominance by large consumers) and bringing more competition to markets. Its effects include:

• Bringing larger numbers of new, small firms to the market (‘business to consumer’/B2C and ‘business to business’/B2B e-commerce models), which can take advantage of lower start-up and marketing costs.

• Opening up competition to global products and prices, resulting in firms’ demand curves becoming more price elastic particularly when transport costs are low.

• Adding to consumer knowledge, through greater price transparency (e.g. through price comparison websites) and online shopping agents giving greater information on product availability and quality.

• Encouraging innovation, which improves product quality and range.

On the other hand, e-commerce disadvantages still include – for example – issues around delivery (such as timing) and payment security. Furthermore, larger producers may still be able to undercut small firms based on low cost savings from economies of scale.

Sloman, Hinde and Garratt provide an interesting case study of the challenges to Microsoft by the antitrust authorities in the EU and the US – something which I am very familiar with as a former competition lawyer. This example is illustrative of the balancing exercise required when assessing the virtues of allowing very large firms to be unfettered in terms of their potential exclusionary practices, versus allowing smaller firms a more even playing field to challenge such large firms which could dampen the latter’s investment in innovation over the long-term.

Of course, new internet-only firms (such as Facebook and Google) have very different business models from that of Microsoft, including the provision of numerous free products as part of a desire to create large networks of users and heavy dependence on tailored advertising revenues.

Next week, I will look at business strategy this time from an economic (rather than management) perspective.

This week I turn to my second discipline, economics, as a basis for considering a different slant on my research question (how the Web changes competition between businesses). While having some degree of economics knowledge in my background, I have approached the subject area afresh in a systematic fashion with guidance from a book looking at economics for businesses (Sloman, Hinde and Garratt 2010).

My starting position is to look at the essence of economics: how to get the best outcome from limited resources. In other words, economics tackles the problem of scarcity which is a central problem faced by all individuals and societies. Demand and supply and the relationship between them are central to this analysis. Also key is the concept of choice (known as “opportunity cost”): the sacrifice of alternatives in the production or consumption of products or services.

Economics is traditionally divided into two main branches: macroeconomics and microeconomics. Macroeconomics examines the economy as a whole at a national or indeed international level (i.e. aggregate demand and supply), whereas microeconomics examines the individual parts of the economy. The latter includes all the economic factors that are specific to a particular firm operating in its own particular market. As microeconomics explores issues surrounding competition between firms, and due to limits in time, I will not be looking at macroeconomics in any detail (other than indirectly via a general awareness of the factors that affect economies as a whole, which in turn affect individual firms as an important determinant of their profitability).

From a microeconomics perspective, the choices made by firms are studied alongside their results. Such choices include how much to produce, what price to charge, how many inputs to use, what types of inputs to use and in what combinations, how much to invest etc. Making such choices involve rationality in weighing up the marginal benefits versus the marginal costs of each activity to best meet the objectives of the firm.

It is worth pausing at that point to make a comparison between the relevance of economics to business decision-making and the contents of my previous blog posts on management study’s approach to business activities and competition between firms. Both use similar terminology and look to the structure of industry and its importance in determining firms’ behavior. They also both look at ranges of factors that affect business decisions and consider the wider environment in which firms operate (including conditions of competition in relevant markets) in helping to devise appropriate business strategies. For example, Sloman, Hinde and Garratt also refer to how the pace of technological change has had a huge impact on how firms produce products and organize their businesses, together with a ‘PEST’ – political, economic, social and technological – analysis (compare my previous blog entry ‘Management 102’).

Where economics (more specifically, we can call it ‘business economics’) differs from management is its focus on how firms can respond to demand and supply issues. In other words, its emphasis is more on internal decisions of firms related to achieving rationally efficient outcomes and the effects of such decision-making on a firm’s rivals, its customers and the wider public.

In keeping with the theme of efficiency, economics has traditionally considered that business performance should be measured against a structure-conduct-performance (structure affecting conduct affecting performance) paradigm measured by several different indicators. Performance is also determined by a wide range of internal factors and external factors other than just market structure, such as business organization, the aims of owners and managers.

In returning to the theme of how economics differs from management/business studies, economists have traditionally paid little attention to the ways in which firms operate and to the different roles they might take. Firms were often seen merely as organizations for producing output and employing inputs in response to market forces. In other words, virtually no attention was paid to how firm organization and how different forms of organization would influence their behavior. This position has changed as economist interest in firms’ roles with respect to resource allocation and production (and how their internal organization affects their decisions) has increased.

Economists have also conventionally assumed that firms will want to maximize profits. The traditional theory of the firm shows how much output firms should produce and at what price, in order to make as much profit as possible. While it may be reasonable to assume that the owners of firms will want to maximize profits, it is the management (as separate from the shareholders) that normally takes decisions about how much to produce and at what price. Management may be assumed to maximize their own interests, which may conflict with profit maximization by the firm. In summary, the divorce of ownership from control implies that the objectives of owners and managers may diverge and hence the goals of firms may be diverse.

In their introductory section on business and economics, Sloman, Hinde and Garratt include an interesting case study on the changing nature of business in those countries where economies are knowledge driven and innovation is therefore central to business success. They include a quote from a European Commission publication (Innovation Management and the Knowledge-Driven Economy, 2004) on this point:

“With this growth in importance, organisations large and small have begun to re-evaluate their products, their services, even their corporate culture in the attempt to maintain their competitiveness in the global markets of today. The more forward-thinking companies have recognised that only through such root and branch reform can they hope to survive in the face of increasing competition.”

Thus, it is suggested that the dynamics of knowledge economies require a fundamental change in the nature of business. This is an interesting comment in considering the impact of the Web on competition from an economical viewpoint. Knowledge is fundamental to economic success in many industries. The result is a market in knowledge, with knowledge diffusing and cutting across industry boundaries. Another result is the increasing outsourcing of various stages of production and collaborations across industries. Furthermore, whereas in the past businesses controlled information, today access to information via sources such as the Web means that power is shifting towards consumers.

Next week I will turn to the concept of markets from an economic viewpoint and how competition is assessed via the theory of the market.