It was around 2008 that I was first introduced to the English man-band Take That. My dad loved the band – back when he was a boy and Take That was a boy-band, their music was already making waves around the world. For a while, I would refuse to listen to any other songs but theirs, but as my taste in music evolved, and the digital age of music began to offer more choices and greater access than ever before, I found myself listening to Take That less and less. Today, we understand the music industry to be over-saturated and hypercompetitive, with multiple large record labels and an even wider variety of artists who are spending on anything but music, from branding, to apparel and other merchandise. The Take That brand, once a band with an enormously large following, has now waned in popularity, and has “downsized” in a sense, with 2 out of 5 of the original band leaving to pursue individual careers.
As more and more bands and artists come to the fray, as individuals have increasing power over trends in music and how or what they listen to, what does it mean for us as consumers of music, and for the music industry? How do bands like Take That try to hold onto their fan-base and spread their influence? How do new artists find ways to create brand loyalty?
“competitive strategy is about being different. It means deliberately choosing a different set of activities to deliver a unique mix of value” – Michael E. Porter
Besides consumers, firms are another key economic agent, and their strategies and decisions have a profound impact on efficiency and welfare, which could lead to the narrowing or widening of various societal inequalities. Bands, streaming apps, record labels and etcetera in the music industry are all individual players that can make decisions leading to profound impacts on the welfare of consumers and society. The question is, are firm strategies, as per Take That’s song, always an “affirmation” of societal welfare and efficiency, or do they ever serve to exacerbate economic inequality? As Take That loses its position in the music industry and new bands take their place in my heart, this question looms on my mind.
The Dimensions of Efficiency
Efficiency is a relative term, never absolute, and always relative to some criterion. This criterion is generally some kind of value, and a decision that increases value would be decision that increases efficiency. Economists are interested in economic efficiency for two reasons, one positive and the other normative. The positive reason has to do with people’s search for value – the search for value is the driving force of market (and perhaps most non-market) economies, and is commonly discussed when understanding the concepts of utility maximisation and profit maximisation. If there is unexploited value, economists need to explain why someone does not find a way to capture this value. This leads to the normative reason for understanding economic efficiency, which is that economists have a desire to make policy recommendations. In tying to compare certain policies or decisions, policymakers have to compare and contrast the relative subjective benefits or costs of a decision. Thus, we seek to understand the various dimensions of efficiency so as to understand how a firm’s decisions can impact consumers and society.
1. Pareto Efficiency
Pareto Efficiency is also known as exchange efficiency, named after Vilfredo Pareto, an Italian economist. It describes the idea that given a set of alternative allocations of, say, goods or income for a set of individuals, if moving from the current allocation to the alternative allocation cannot make anyone better off without making someone else worse off, then Pareto Efficiency is achieved. However, if moving to the alternative allocation can make at least one individual better off without making someone else worse off, this is called a Pareto improvement (or actual growth). Pareto efficiency and pareto improvements are best illustrated on the Production Possibility Curve. Any point on the PPC is pareto efficient, and moving from a point within the PPC to a point nearer to or on the frontier is a pareto improvement. However, not all points that are Pareto Efficient are necessarily fair.
2. Allocative Efficiency
The idea of equity or fairness is best illustrated by allocative efficiency. It is a market condition whereby resources are allocated in a way that maximises net benefit, and refers to a situation in which resources are allocated according to the wishes of consumers. However, it must be noted that moving towards AE does not necessarily mean that everyone gains, as an increase in total welfare means that winners could gain more than losers. All pareto improvements increase allocative efficiency, but not all allocatively efficient strategies could be pareto improvements, as some people may lose out.
3. Productive Efficiency
This occurs when the economy is operating at the production possibility frontier. This takes place when production of one good is at the highest output and is achieved at the lowest cost possible, given the production of other goods. In the long-run, this is when average cost lies on any point of the average cost curve.
4. X-Efficiency
Proposed by Harvey Leibenstein in a 1966 paper, X-efficiency is the effectiveness with which a given set of inputs are used to produce outputs. If a firm minimises average cost for any level of output, it can be considered X-efficient, as it is producing the maximum output it can, given the resources it employs and the best technology available. It differs from productive efficiency in that where PE depends on processes and the state of technology, X-efficiency depends on management incentives.
5. Dynamic Efficiency
This considers whether monopolists are more likely to develop more efficient techniques over time than perfectly competitive firms. Where AE and PE are static concepts, in that they relate to welfare at a point in time, DE refers to the outcomes from the sequence of future decision-making relating to the allocation of resources, production technologies of firms, and investment in new knowledge or R&D.
Understanding the 5 dimensions of efficiency allows us to better understand how the welfare of consumers and society is affected by the decisions of firms, given that they are metrics by which we can measure the impact of a firm’s decision-making.
The Strategies of Firms
In general, there are three broad categories of strategies that occur in an imperfectly competitive industry:
- Entry-Limiting Strategies
- Collusive Behaviour – The Strategy of Games
- Developing Competitive Advantage
Strategies can either be competitive (accommodating of new entrants and rivals through price and non-price competition) or anti-competitive (edging put existing rivals and deterring entry of new competitors). We will discuss entry-limiting behaviour, generally seen to be an anti-competitive strategy.
Entry-Limiting Behaviour
This is behaviour in which incumbent firms create strategic/endogenous barriers to entry (BTE) to discourage potential entrants. BTE are obstacles that make it difficult to enter a given market. Since BTE protects incumbent firms and restricts competition, it contributes to distortionary prices. Weighing the costs of production, George Stigler defines an entry barrier as “a cost of producing which must be borne by a firm which seeks to enter an industry but is not borne by firms already in the industry”. However, in looking more broadly at the impacts of raising BTE on society, Franklin M. Fisher defines entry barriers as “anything that prevents entry when entry is socially beneficial”. We will examine various types of entry-limiting behaviour to see if Fisher’s definition holds true.
1. Advertising
Advertising is mass paid communication that imparts information to consumers, and it develops attitudes and induces actions that are beneficial to the advertiser. As described by Robert Dorfman, advertising is an expenditure that influences the slope or position of the firm’s demand curve, as it creates a consumer-perceived difference in its brand from other brands to the degree that consumers see its brand as a slightly different product, reducing its substitutability and making its demand more price inelastic. New entrants are doubly disadvantaged, as posited by Comanor and Wilson, since they not only do not enjoy cost savings from advertising economies, but also, have to advertise more than incumbents to be able to gain consumer acceptance, and “shout louder to be heard so that the effectiveness of each advertising message declines as the aggregate volume of industry advertising increases”, to drown out the “noise” in the market generated by existing firms.
Advertising plays two roles:
- Constructive Role: in providing information to consumers, wants are satisfied at a lower cost. By lowering search costs in a world of imperfect information, allocative efficiency is better achieved as consumers can now make more rational decisions. This has a effect that is counter to entry deterrence (promotes competition) as it increases PED, by facilitating entry as new firms can make consumers more aware of their existence and the number of substitutes increases, and consumers are better able to respond to price differences.
- Socially Wasteful Combative Role: this is achieved through aggressive, persuasive advertising, in which little information is provided, and it only serves to redistribute consumers from one firm to another. This is entry deterring, as it lowers PED by building brand loyalty and goodwill
Persuasive advertising capitalises on an incumbents’ first mover advantage to restrict pay-offs for potential entrants, by distorting consumer preferences in the advertisers’ favour. This is highly wasteful especially in saturated markets, as consumers are merely redistributed while the total quantity of goods remains the same. By increasing the market power of firms, consumers pay higher prices and receive a lower consumer surplus. Furthermore, given that advertising is expensive, requiring long-run supernormal profits to finance it that could ha ve been used to increase dynamic efficiency across time, this strategy is extremely inefficient and not socially desirable.
Advertising is widely seen in the music industry. There is both constructive advertising that informs users about the benefits of a particular streaming service so that they can easily compare services. At the same time, there is socially combative wasteful advertising that encourages users to switch from one service to another.
2. Product Differentiation
Product Differentiation is the process of distinguishing a product or service of a firm from its rivals to make it more attractive to a target market. This affects the performance of firms by reducing direct competition, as the product draws fewer comparisons with its competitors. Similar to advertising, product differentiation is the process of highlighting and broadcasting the unique aspects of a product, such as differences in quality or differences in functional features or designs, thereby creating a sense of value. Product differentiation is the basis for a strategy known as Blue Ocean Strategy. Where Red Oceans are industries in which boundaries are defined and accepted, and the market space becomes overcrowded, reducing the prospect for profits and growth, Blue Oceans can be accessed through product differentiation, as by highlighting unique aspects of one’s product, one creates a niche in the industry that is not in existence today. Hence, demand is created rather than fought over, and there is ample opportunity for growth that is profitable and rapid (think Apple when it introduced the lightning jack – something that became an industry standard as USB-C followed suit by competitors). Though, as with advertising, similar consequences of duplication, imitation, and wastefulness occur, and the total quantity of goods remains the same, this actually incentivises dynamic efficiency as firms work to create actual marketable differences in their product.
In the music industry, this could be visualised in terms of breaking out into new types, forms or genres of music, and marketing a particular sound or style that is unique from other bands.
3. Patents and Innovation
Patents give inventors exclusive rights to their inventions for a limited period of time, and gives a firm the legal right to stop other firms producing the product, restricting entry. Patents are intended to encourage invention and technological progress by guaranteeing proceeds as an incentive. This thus leads to an amount of entry-deterrence, as potential entrants would require access to as equally efficient production technology as the combatant monopolist in order to freely enter the market, and thus, by denying access to competitive technology at a cost negligible relative to the R&D costs and potential profits from a good innovation n the first place, patents can suppress competition.
However, it would not be able to do so indefinitely. This is because other firms can learn and innovate around the patent, and it is highly difficult to guarantee appropriability especially where process innovation is concerned. More often than not, patents do not entry deter, and are in fact necessary for promoting dynamic efficiency through investment in research and development. According to Edwin Mansfield, 65% of pharmaceutical innovations would not have occurred without patent protection, implying that patents are necessary to ensure dynamic efficiency, and in fact, allocative efficiency as innovation allows for the creation of new products to satisfy the wants of consumers. From a societal view, Patents and Innovation are beneficial, as they improve the quality and variety of products available to consumers. In this case, Fisher’s definition may not hold true, as allowing free entry results in the erosion of incumbent supernormal profits that actually hampers the ability of incumbents to research and develop.
4. Limit Pricing
Limit pricing is pricing below the monopoly price to make entry unprofitable. In response to potential entrants, the incumbent monopolist supplies at the limit output (which corresponds to the limit price), which refers to the minimum output required to make the profits of a potential entrant non-positive. Limit pricing is a strategy that works based on the Sylos Postulate, which is that a behavioural assumption made by potential entrants that incumbents will not change their pricing and output combination, and a behavioural assumption made by incumbents is that potential entrants will leave if price falls below their Long Run Average Cost.
Limit pricing could be allocatively efficient in the short run given that it encourages the incumbent to increase its level of production. However, it is a measure that is difficult to carry out, since incumbents will need to have perfect and precise knowledge of the price-output strategies of existing competitors, like their likely AC curves, for instance. Furthermore, Friedman and Dixit both questioned the validity of the Sylos Postulate, pointing out that the pre-entry price and quantity choices should be irrelevant for the entry decision of the potential entrant, since the only thing that should matter are the post-entry market conditions, as prices are likely to change and a new game begins. Where Limit Pricing is a measure that fights the entry of potential entrants, in doing so, this could hurt the incumbent profits more than it helps it, which, though equitable, may reduce the provision of services in the long-run. Thus, it may be wiser to accommodate potential entrants, otherwise, limit pricing may not be a credible threat since it is not in the firm’s self-interest to do so.
5. Excess Capacity
Investing in spare/excess capacity beforehand, would be a pre-commitment made to irreversibly alter the incumbent’s pay-offs in advance, such that it will be in the firm’s self-interest to carry out the threatened action (limit pricing) when the time comes. More aggressive behaviour in the form of visible pre-commitments and credible threats by incumbents will induce less aggressive behavior by the potential entrants; faced with aggressive behavior, the other firm will back off. By investing in extensive spare capacity even before entry occurs, at low output levels (and high price), capacity is unused and profits will be reduced. But at high output levels (and as price lowers), spare capacity is made full use of, in that costs are “reaped back”, and the increase in revenue is high enough to cover costs and give rise to the same payout as originally even before the threat of potential entry. In essence, it allows the incumbent to increase output in the future and engage in competitive warfare should entry occur. By making a visible, “tough” commitment – that is, a commitment to be more aggressive – the firm pushes its competitor into a more passive posture. This, according to Fudenberg and Tirole, is called the “top dog” strategy. It would thus now be in the interest of the incumbent to fight rather than accomodate, as fighting is now a credible threat, while accommodation will lead to reduced profits if capacity is unused.
There are many implications to investing in excess capacity – unused excess capacity is socially wasteful as the money spent could have been used for other socially beneficial purposes. However, since demand for the product is now below what the business could potentially supply to the market, a company can use excess capacity to offer customers lowered prices and generate more sales.
6. Mergers and Acquisition
Mergers and Acquisitions could be either vertical or horizontal. Vertical Integration refers to a firm’s coverage of more than one level of production, while pursuing practices which favour its own operations at each level. This creates barriers to entry as it requires competitors to be able to produce at different steps so as to enter the market all at once. This is made more difficult due to supplier agreements or the complete acquisition of firms in the supply chain, as other manufacturers now no longer have any access to these suppliers.
Horizontal Integration, in addition to the purchase and acquisition of firms in related markets, allows incumbents to reap internal economies of scale as it increases output at that level of the production process, and also results in network effects that can be reaped from merging these markets. Network effects are reaped when an establish company broadens and captures a significant user base, such as how Facebook has spread its dominance in multiple markets through its acquisition of WhatsApp and Oculus Rift. This makes it difficult for competing players to enter the market as the value of the goods and services owned by Facebook is high given the large number of existing customers.
Mergers and acquisitions allow incumbents to consolidate their market power and prevent entry. In the music industry, there are tie-ups between services such as Spotify and social media like Facebook, and on top of that, certain artists have their music streamed exclusively on Spotify, or the streaming service offers special deals on a particular artist’s music. All these are strategies that can be employed once there are tie-ups and integration between different players within and outside of the supply chain, that help to consolidate the dominance of streaming services like Spotify, and boost the popularity of particular artists that benefit from the dominance of this service. For consumers, this of course limits consumer choice, and for those who cannot afford particular services, there exists an inequality as the range of music one is able to listen to is now limited.
7. Branding
Branding is different from advertising, in that, rather than spreading information (or misinformation), the goal of branding is to achieve brand loyalty from consumers. This is usually done through advertising with a consistent theme, look or feel, with iconic colours, catch phrases and celebrities used to promote a product. Over time, these messages of branding are ingrained into consumers, creating brand loyalty that allows a companies demand curve to be highly price inelastic in the long run. Branding can also be done by offering a particular brand of friendly sales service, building brand loyalty over time.
Branding is generally more effective than advertising, since spending on advertising does not incentivise firms to maintain a high standard of quality. Advertisements are unlikely to sustain brand loyalty in the Long Run especially of consumers find the product quality to be lower than what was promised in advertisements. On the other hand, to upkeep their reputation, branding encourages firms to ensure a high standard of quality, thus, better, more efficient services are offered to consumers.
We see branding being an important part of the music industry. Many artists and bands build up a reputation for themselves, and create a particular image of what their listeners could be if they listened to their music (such as rock bands creating music videos about parties and rocking out at arenas and stadiums). Consumers identify with these images, and if a band can consistently offer a high quality of music, then brand loyalty is built up.
“Haven’t got the strength to fight anymore / Don’t even know what I’m fighting you for” – Affirmation, by Take That
The music industry is cutthroat, as new bands and services appeal directly and build loyalty with particular consumers. Bands like Take That are slowly phased out, unable to fight with the competition. Entry Deterrence strategies are just one of many strategies firms employ to ensure their market dominance, but are generally seen to be strategies that are the least beneficial for consumer welfare. X-Inefficiency occurs and Productive Efficiency is reduced as, across the board, these strategies are generally revenue-side rather than cost-side strategies (with the exception of vertical integration, which could actual improve X-efficiency and PE as cost is lowered when suppliers are absorbed into the company.) Strategies such as Limit Pricing and creating Excess Capacity, though allocatively efficient in that firms increase output to meet the wants of consumers, reduces Dynamic Efficiency as supernormal profits are reduced in the short run. Thus, I would make the argument that only Branding, Mergers and Acquisition, as well as Patents and Innovation, are all entry deterrence strategies that have positive effects for both competing firms as well as consumers, and can actually reduce social inequality as better services are offered for cheaper as incumbents can reap cost advantages through internal economies of scale. Thus, these strategies do not fit Fischer’s definition of a barrier to entry.
Perfect competition never exists, so in an imperfect world in which firms employ anti-competitive strategies to survive, entry deterrence strategies that have fewer socially undesirable consequences should be the way to go.
And as for the way to go for Take That from here, my only hope is that they continue to find ways to innovate and make new music to appeal to new generations of listeners, else they become even smaller fish in an ever-growing pond.
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