N2U5 Economics : Neoclassical and Behavioural Economic
Critically evaluate, through the use of both neoclassical and behavioural economic theories covered on the module, Nestle and its market decision making outlined in the case study.
Answer:
Introduction:
Neoclassical economics represents an approach that deals with demand for and supply of a product in market considering rationality of an individual and firm. The chief focus of the firm is to maximise utility while for an individual the chief focus is utility maximisation. To analyse these economic concepts, neoclassical economists intend to use mathematical equations (Foss and Klein 2015). On the contrary, behavioural economics deals with psychological aspects of a firm and producer regarding their decision-making processes (Pete 2014). In addition to this, the behavioural economics focuses to maximise expected utility of a consumer. With the help of these two economic approaches, a firm takes its business decisions regarding production of output and charging appropriate price. This paper conducts this analysis on Nestle chocolates through considering its market decision-making process.
Nestle is a Switzerland based multinational company that produces drinks and foods. Since 2014, it has remained the largest food producing company across the world in terms of revenue. The company chiefly produces medical food, baby food, breakfast cereals and other energy drinks like coffee and tea. Some well-known brands of this company are Nescafe, Nespresso, Maggie and Kit Kat. In addition to this, Nestle is one of the largest shareholders of L’Oreal, which is the largest cosmetic company of the world. The company has large market share across the world though it competes with other large-scale chocolate producing products. The entire market of Nestle depends heavily on cocoa market. The report will focus on demand and supply of chocolate, demand elasticity, market structure and profit maximisation condition of this firm. In addition to this, the report will discuss about appropriate behavioural economics related to company’s activity.
Neoclassical analysis of Nestle:
Demand and Supply:
Demand and supply are the main tools that help a company to take proper decisions regarding amount of output that it needs to produce and setting price appropriately. Based on demand law, the firm cannot charge higher prices for its product, as it can adversely affect demand in market. On the contrary, the company can supply more amounts of outputs when prices of company’s products increase in market (Canto, Joines and Laffer 2014). The demand and supply curves help the company to obtain market equilibrium amount of output and equilibrium price. According to the given case study, Nestle industry decides to reduce the size of chocolates bars or increase the prices of it for maintaining a balance between supply and demand for cocoa in market. An imbalance between demand and supply of cocoa can influence price of Nestle chocolates in market accordingly (Zoutman, Gavrilova and Hopland 2018). For instance, excess demand of cocoa can lead its price to increase further in market. Furthermore, this will force the price of chocolates to increase in market. The price of chocolates will increase, as input cost of the product increases in market. The opposite situation can also occur if price of cocoa reduces in market due to excess supply. According to case study, cocoa prices increase rapidly in 2017 due to lack of production. The price of this ingredient increases by 2 percent and this in turn increases cost of chocolate production more than 10 percent. This further reduces supply of this product in marker through reducing the size of chocolate bar. At the same time, demand for the product remains same as before. The following diagram can represent this situation accurately.
Figure 1: demand and supply of Nestle chocolates
Source: (created by author)
In above figure, D represents demand for Nestle chocolates in market. The initial supply of this product was S0. After cocoa price increase, supplier reduces the size of chocolate bar and consequently the new supply curve becomes S1. This happens because price of chocolate increases from P0 to P1 (Pirgmaier 2017). Moreover, equilibrium amount of chocolate reduces from Q0 to Q1.
Elasticity:
Through measuring elasticity, Nestle can understand that how much quantity demanded for a product can be changed when price of the product or income of consumer changes accordingly. In general, own price elasticity states the percentage change of demand when price of it changes by 1 percent (Jawad, Lee, Glantz and Millett 2018). In the same way, income elasticity measures change in quantity demanded for a product when income of consumer changes by 1 percent. According to the case study, the chocolate market is price sensitive (Hummels and Lee 2018). In many countries, this product is considered as luxury one. Therefore, a small increase in price of chocolate can reduce its demand by large extend. This can be explained with the help of following diagram:
Behavioural economics of Nestle:
Figure 1: Elastic demand curve of chocolate
Source: (created by author)
The above diagram represents elastic demand curve of chocolate. In this figure, price increases from P0 to P1 and consequently quantity demanded for this product reduces from Q0 to Q1. Based on the given case study, the value of price elasticity of demand for Kit Kat is -2.43 in present European markets. However, negative impact on European market can change this elasticity to -5.87. The absolute value is more than 1, which indicates that a small decrease in price can increase the demand for this good by large extend. The negative impact of European GDP will lead people to reduce chocolate consumption by large quantity when price of it increases by smaller amount.
Income elasticity also plays significant role to determine and understand demand for a commodity when income of a consumer changes accordingly. For chocolate, the value of income elasticity is positive, which means people will consume more chocolates when their income will increase (Hummels and Lee 2018). In this situation, own price of chocolate as well as price of other related goods of chocolate will be at the same position. This situation of income elasticity can be explained with the help of following diagram.
Figure 2: Income elasticity of Nestle Chocolates
Source: (created by author)
According to figure 2, when income of a consumer increases from I0 to I1, quantity demanded for this product also increases from Q0 to Q1. The income elasticity of demand for chocolate is given as 2.6. As the value is more than 1, it indicates that the product is a luxury one (Coglianese, Davis, Kilian and Stock 2017). This implies that if income of a consumer increases by small proportion, demand for this product will increase by large amount.
The cross price elasticity also has significant impact on quantity demanded for a commodity. Other companies like Mars, Ferrero, Hershey and other chocolate making companies are the biggest competitors of Nestle. Products of these companies are substitute of Nestle (Akimaya and Dahl 2018). Therefore, increase in price of one of these companies’ product can increase the demand for Nestle chocolates effectively. The other situation can be occurred as well. The following diagram of cross price elasticity can represent this condition more accurately.
Figure 3: Cross-price elasticity of Nestle Chocolates
Source: (created by author)
The above diagram clearly represents the situation of cross-price elasticity of Nestle. According to the diagram, when price of Ferraro chocolates increases from P0 to P1, the amount of quantity demanded for Nestle chocolates also increase from Q0 to Q1 (Farnham 2014).
Cost pattern of Nestle:
To maximise company’s profit, it is essential for any company to understand and analyse cost structure accurately. An efficient firm can successfully minimise this cost structure through producing efficiently. This is also true for Nestle. The value of total cost (TC) has two parts, which are, variable costs (TVC) and fixed costs (TFC) (Sloman, Garratt, Guest and Jones 2016). Through dividing each type of cost with total amount of quantity produced, the firm can obtain its average total cost (ATC), average variable cost (AVC) and average fixed cost (AFC). Due to the law of variable proportions, both ATC and AVC curve have “U” shaped (Cheung et al. 2015). However, the shape of AFC is rectangular hyperbola. AVC curve influences ATC curve compare to AFC curve. On the other side, the marginal cost (MC) curve also looks like “U” shaped (Shepherd 2015). The chief characteristic of this type of cost is that, it remains high during small production of output while it stars to fall when output production increases. The value of present estimated MC for Kit Kat is €0.75. However, the new production process will increase cost to €0.80. The following diagram can successfully describe different forms of cost curves.
Figure 4: Cost curves of Nestle
Source: (created by author)
Market structure of Nestle:
According to the case study, Nestle operates in a monopolistically competitive market. Nestle has some strong competitors across the world and consequently enjoys also equal market share with all (Haaland and Venables 2016). The other strong competitors of Nestle are Mars, Mondele, Ferrero, Hershey and Lindt & Sprungli. From the given case study, the following statistical diagram can be obtained from where market share of each company can be understood accurately.
Figure 5: Market share of different chocolate making companies all over the world
Source: (Gallo, Antolin-Lopez and Montiel 2018)
These companies produce and sell similar products though these are not identical. Hence, these products are close substitutes of each other with some minor differences. Hence, each firm enjoys monopoly power through selling their unique products in market (Boateng et al. 2018). The number of chocolate making firms is large while the number of consumers is also very large. Moreover, other chocolate producing firms can easily enter into the market and can exit from the market without any restriction. Therefore, the demand curve or average revenue (AR) curve of each firm will be downward slopping (Connelly et al. 2018). The marginal revenue (MR) curve will also have negative slope and will remain below the AR curve.
Profit maximisation of Nestle:
The difference between total revenue and total cost represents the amount of profit that a firm can obtain. In a monopolistically competitive market, the firm can earn excess profit or normal profit during short-run. The firm can also incur loss during this period. However, in long-run, the firm experiences normal profit only (Nikaido 2015). The market obtains its equilibrium amount of output and price through equating marginal cost and marginal revenue. The simple demand equation of Kit Kat is:
P = -0.1250Q+1.59
Therefore, total revenue is:
TR= P*Q= -0.1250Q2 +1.59Q
Thus, marginal revenue is:
MR= -0.25Q + 1.59 the estimated marginal cost of this product is €0.75. Thus, the following diagram represents the long-run condition of Nestle where it can earn normal profit only.
Figure 6: Normal profit of Nestle
Source: (created by author)
The figure 6, represents profit maximising condition of Nestle within a monopolistically competitive market. According to the diagram, the firm needs to produce 0.34 (‘000000) amount of Kit Kat worth €1.55 for each. For one chocolate, the firm will earn € 0.8 amount of profit.
The company also introduces its new brand Cailler. The weight of each bar is 500g and the approximated price is €9. The estimated demand function for this new brand is:
P = -28 Q +12
Thus, total revenue is:
PQ = -28 Q2 + 12 Q
Thus, the value of marginal revenue is:
MR = -56 Q + 12
The, profit maximising condition is:
-56Q + 12 = 9
56Q = 3
Q = 0.05
Hence, the firm needs to produce 0.05 (000,000) amount of Cailler bar.
The corresponding price will be:
P = -28 * 0.05 + 12
P = 13.4
Thus, profit maximising price of Nestle for its new bar is €13.4
Market Power:
Through observing market share of all chocolate producing companies, it can be stated that each firm enjoys almost equal market share all over the world. As the market is monopolistic competitive market, it is not possible for Nestle to charge higher for its product. If the firm does so, then consumers will be shifted to other companies (Shaffer and Spierdijk 2015). To understand the capacity of market power, Nestle needs to calculate Lerner Index, which is, (P-MC)/P. Here, the value of this index for Kit Kat is 0.52 and for Cailler bar is 0.33. Thus, the company can charge comparatively higher price for Kit Kat compare to Cailler.
Behavioural Economics:
Behavioural economics helps a firm to understand consumers’ psychology and their process of decision-making. The neoclassical economics helps Nestle to understand demand for their products in market with the help of numerical figure. However, these concepts do not consider psychological aspects of a consumer. However, it an important factor to analyse further in the context of utility maximisation. According to behavioural economists, consumers always try to take optimal decisions for getting higher level of satisfaction as well as benefits. The rational choice theory states that a consumer has many options that she can select under scarcity. Among these, the concerned person selects a particular option though which she can maximise her utility (Berndt 2015). This is also applicable for Nestle as well. The company produces chocolates with higher amount of sugar. Hence, each chocolate contains large amount of calories and fat. As a result, health conscious people try to avoid chocolates and consume healthy foods. This preference of consumers can reduce the demand for chocolates in future by significant amount. Hence, it is essential for Nestle to understand the choice of customers and their preference (Kao and Velupillai 2015). To solve this problem, the company launches new chocolates that contains comparatively lower amount of sugar. Through consuming these low-calorie chocolates, health conscious consumers can maximise their utility.
This type of economics helps a firm to understand that why consumers take irrational decisions. This understanding is essential because irrational decisions reduce demand for the product in market (Vuong et al. 2018). As a result, the general pricing strategy, in this context, may not be correct and consequently the firm may not achieve its desired amount of revenue or profit. Thus, it is essential to focus on emotional side of consumers. Heuristics is one type of behavioural economics. According to this concept, a person can take immediate decisions and generates cognitive bias (Szymanek and Zielonka 2017). At present, each firm uses this economic concept to increase sales through maximising consumer satisfaction. This also influences Nestle significantly. As a result, the company intends to produce low calorie products with comparatively higher prices.
The behavioural theory of Nestle considers other process of profit maximisation. This is one of the chief objectives of the company. The company sometimes act as profit-seeker instead of profit maximisation. According to this behavioural theory, large-scale organisations like Nestle are complex one and consequently have different types of stakeholders. Different group of stakeholders have different operational objectives (Devine et al. 2018). The dominant group can easily look after its objectives. Thus, instead of profit maximisation, the firm can take other initiatives like maximisation of output and revenue and behaviour satisfaction. Behavioural theories include firm size, human emotion, ethical concerns and profit satisfactions. Thus, owners and managers possess different views compare to traditional one.
Conclusion:
Thus, the entire report discusses about both neoclassical economic theory and behavioural economic theory in the context of Nestle. These two types of theories are essential for increasing consumer satisfaction through utility maximisation. This further can help the company to maximise its revenue as well as profit by selling higher amount of chocolates to consumer. According to the case study, it is seen that cocoa price increases by large amount due to some reasons. Hence, input cost of these firms increase and consequently the firm reduces the supply of chocolates in market through reducing the size of chocolate bars. Chocolate is considered as luxury product in many countries. Therefore, the small increase in price of this product leads the demand for it to decrease by large amount. Nestle operates in a monopolistically competitive market. Hence, it cannot enjoy market power like a monopolist. The report considers the importance of consumer’s psychology for understanding the actual behaviour of them. For maximising utility of consumers, Nestle produces new chocolates with comparatively lower calories and sugar.
References:
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