Because rival firms are likely to retaliate against price cuts, oligopolists often emphasize nonprice competition to boost demand. To illustrate, assume that a firm demand function is given by Equation 11.2:
where QA is the quantity of output demanded from firm A, PA is A's price, PX is the average price charged by other firms in the industry, Ad is advertising expenditures, SQ denotes an index of styling and quality, I represents income, and Pop is population. The firm can control three variables in Equation 11.2: PA, AdA, and SQA. If it reduces PA in an effort to stimulate demand, it will probably cause a reduction in PX, offsetting the hoped-for effects of the initial price cut. Rather than boosting sales, firm A may have simply started a price war.
Now consider the effects of changing AdA and SQA. Effective advertising shifts the firm's demand curve to the right, thus enabling the firm to increase sales at a given price or to sell the same quantity at a higher price. Any improvement in styling or quality would have a comparable effect, as would easier credit terms, better service, and more convenient retail locations. Although competitors react to nonprice competition, their reaction is often slower and less direct than that for price changes. Nonprice changes are generally less obvious to rivals, and the design of an effective response is often time-consuming and difficult. Advertising campaigns have to be designed; media time and space must be purchased. Styling and quality changes frequently require long lead times, as do fundamental improvements in customer service. Furthermore, nonprice competition can alter customer buying habits, and regaining lost customers can prove to be difficult. Although it may take longer to establish a reputation through nonprice competition, its advantageous effects are likely to be more persistent than the fleeting benefits of a price cut.
The optimal level of nonprice competition is defined by resulting marginal benefits and marginal costs. Any form of nonprice competition should be pursued as long as marginal benefits exceed marginal costs. For example, suppose that a product has a market price of $10 per unit and a variable cost per unit of $8. If sales can be increased at an additional cost of less than $2 per unit, these additional expenditures will increase profits and should be made.
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