Industrial organization: How is the U.S. American fast food industry structured?

Table of Contents:

1. Introduction....2 2. Background industrial organization........2 3. The model of perfect competition 3.1 Perfect competition in theory....4 3.2 Perfect competition applied to the fast food industry and alternative structures.4 4. Conclusion..6 References...8

1. Introduction

Fast food, as its name implies, is recognized as food that can be made and served quickly. Nowadays one commonly associates fast food as meals or snacks that can be consumed quickly in particular restaurants, also known as Quick Service Restaurants, or as take-away (Jakle, 1999). First forms of fast food restaurants already existed in the ancient world as well as in the middle ages (Stambaugh, 1988; Carlin, 2003). However, the term fast food as we know it today arose in the United States only in the 1920s (National Public Radio, 2002). During the second half of the 20th century fast food came to Europe and is today spread and known all over the world. It has become a synonym for unhealthy fatty food and the fast food industry has to oppose hard criticism from consumer groups and health authorities. Nevertheless the global fast food market grows enormously and reached a value of about 102.4 billion US dollar in 2006 (National Restaurant Association). Due to its significance for many Americans and to the fact that many different companies compete in it, the following purpose statement concerning market structure has to be investigated: Does the model of perfect competition apply to the fast food industry on the basis of the industrial organization approach?

Firstly, this paper gives general information about the approach of industrial organization. Secondly, it the economic model of perfect competition and applies it to the fast food industry. Thirdly alternative structures to a perfect competitive market are discussed with regard to the fast food industry and the theory of games is briefly mentioned. Finally the paper concludes whether the initial idea of the fast food industry being a perfect competitive market has proved right.

2. Background industrial organization

Industrial organization is an economic approach concerned with the mechanisms that affect markets, their structure and how this influences individual firms. In 1958 the U.S. American economist Joe Bain released an analytical framework which developed to the most commonly used method of analysis of industries, the structure- conduct- performance

paradigm. According to Bains approach the structure of an industry influences the strategic behavior (conduct) of all members of this industry and therefore their economic success (performance). The structure- conduct- performance paradigm has been revised several times but is still dominant in economics (Andreosso& Jacobson, 2005).

The different market structures are influenced by the number of firms within the market and the level of difficulty concerning the entry and exit to the respective market. A market without barriers of entry and therefore many potential sellers is defined to be of competition. Since firms in such a competitive market have a very small market share, they have to accept or take the price given by the market. They are called price takers. By contrast, if there is only one firm selling to most of the buyers of the market and the barriers of entry are high for other firms, the firm is a monopoly. Due to their market power and thus ability to set prices they are called price setter. Only if the industry is either an oligopoly or a monopolistic competition more than one seller may have influence on the price. In an oligopoly there are only a few sellers and the barriers of market entries for potential competitors are relatively high. Differently to an oligopoly, a market with absence of any barriers of entry where each firm has some control over the price is called monopolistic competition (Carlton& Perloff, 2000; McDowell, Thom, Frank & Bernanke, 2009).

As mentioned above structure influences conduct according to Bain. Conduct includes strategies such as pricing strategies, differentiation, information strategies and advertising. Price discrimination is a commonly used example of pricing strategies of firms with market power (Carlton& Perloff, 2000). It is a method of charging different customers different prices for the same product of firms in order to gain more profit or more customers. (McDowell et al. 2009). Firms might also use information or advertisement in order to strategically influence customers and therefore gain advantages such as higher profits. Consequently, the less information remains unknown the weaker the individual firms market power. This is since laws forcing companies to give important information and forbid lying in advertisements give customers the opportunity to reconsider buying products (Carlton& Perloff, 2000).

3. The model of perfect competition

3.1 Perfect competition in theory The model of perfect competition claims that a market is perfectly competitive if the members acting in this market cannot influence the price at which they sell their products. Since they are to accept the price given by the market they are defined as price takers.

There are four underlying conditions determining a perfectly competitive market. Firstly, in order to be identified as a competitive market, all firms competing within that market sell the same or at least very similar product. Consequently, this means that the products have very close substitutes and consumers are mostly indifferent between those products. Therefore they may quickly change to a competitors product if it appears to be more economical for them. Secondly, the market has to consist of producers and consumers. Each company sells only a small proportion of the whole quantity sold within that market. As a consequence no individual firm has enough market control to influence the market price or quantity sold. Thirdly, the resources to produce are freely available in a perfect competitive market. This means that there are no barriers to entering or leaving the market such as government regulations or limited raw materials. Finally, the last condition of a perfect competitive market is awareness. This implies that buyers and sellers are well informed. Each buyer is able to get information about all prices at which the products are offered, implying that no producer would be able to sell his or her product at a higher prices than the others. Just as well are all sellers aware of the prices other firms offer so that they can adapt their prices accordingly (McDowell et al. 2009).

3.2 Perfect competition applied to the fast food industry and alternative structures Comparing the features of a perfectly competitive market to the fast food industry one can observe the following: The first condition of a perfectly competitive market implies that all firms within the particular market are to produce a very similar nearly standardized product. The fast food industry however offers a broad range of snacks and meals consumers can eat on the go, varying from hamburger over pizza to doner kebab. Moreover many companies offer much differentiated menus. Even though a burger selling company might raise their prices it does not mean that they will lose all their customers, as a particular proportion simply

prefers burger over pizza or doner kebab. Therefore the first condition necessary for a market to be identified as a perfectly competitive one does not apply for the fast food industry.

The second condition, that each of the sellers within a perfectly competitive market sells only a small proportion of the whole quantity exchanged in that market does not prove either for that fast food industry. The fact that McDonalds had 43% of the U.S. market share where as opponents Burger King (18,5%) and Wendys & Co (13,2%) had significantly less in 2002 clearly disproves the second condition of an equally shared market between many small sellers (Buchholz, 2002). Due to very limited information no more up-dated data were available but the figures from 2002 are sufficient enough to demonstrate the market structure.

The third condition, mobility of resources, is fulfilled. There is neither any restriction on resources nor governmental regulations that hinder potential producers to enter the market if they can afford the necessary capital. However one should consider other factors apart from resources. Since the market is dominated by a few companies with relatively high market share substantial barriers of entry exist in terms of brand loyalty towards these companies, economies of scale and probably high initial investments. The condition of awareness applies as well to the fast food market. Consumers are able to compare the prices offered from the different companies. This is also the case for the selling companies. As two conditions of a perfectly competitive market do not apply to the fast food industry, it cannot be identified as such. However claiming it was a monopoly would be a too drastic approach since this would imply that there would be only one single firm selling unique products. The model of such a monopoly is rather seldom in real life. Rather and more realistically the fast food industry can be considered as an oligopoly. By definition, an oligopoly is a market with substantial barriers of entry and exit and only a few comparatively large firms that dominate the market (McDowell et al. 2009). Looking at the figures mentioned above the fast food industry can be proved to be an oligopoly with market shares of 43% of McDonalds, 18,2% of Burger King and 13,2% of Wendys in 2002 (Buchholz, 2002).

The main difference between a monopoly and an oligopoly is that firms within an oligopoly

act in terms of strategy according to their awareness of their competition considering their speculations about their competitors actions (Andreosso& Jacobson, 2005). For this reason, only in an oligopoly strategies are of such significance. This observation can be applied to the economic model of game theory. The game theory is an economic approach of explaining the correlation of strategies of two or more players in a game. It claims that the payoff (performance) of one player (individual firm in an oligopoly) depends on the behavior (conduct) of the other player. According to the game theory players chose their strategy after considering all of their competitors different possible strategies since all their possible payoffs result from these. If one players strategy results in a higher payoff independent from what his opponent does, he is following a dominant strategy. The alternative strategy to a dominant strategy is called a dominated strategy. If both players chose their strategy resulting in a situation where no one has an incentive to change his strategy, it is a Nash equilibrium situation (McDowell et al. 2009).

Typical examples of such interaction between two firms in the fast food industry are the marketing strategies of McDonalds and Burger King. When McDonalds started to redesign their brand image by promoting environmentally friendly production processes and more healthy food in 2009 Burger King reacted by implementing a very opposing marketing strategy (Environmental Leader, 2009; Hegmann, 2009). They started to promote a lifestyle of hard American men and provoked with displeasing advertisement to arise attention (Hanebeck, 2009).

4. Conclusion

This paper has proved that the model perfect competition does not apply to the fast food industry on the basis of industrial organization. Having investigated the four major conditions of perfect competitive markets, it is obvious that the assumption about the fast food industry being a perfect competitive one can be rejected. This is on the one hand due to that fact that companies in the fast food industry do not sell similar standardized products but a wide range of snacks and meals. One the other hand the figures of market shares clearly disprove the assumption of a perfect competitive market, with McDonalds dominating the market with 43% market share.

For this reasons one can conclude that rather the model of an oligopoly applies to the fast food industry as it is a market with substantial barriers of entry and exit and only a few comparatively large firms that dominate the market. The theory of games has also been briefly mentioned and further research on the interaction of the competing firms as well as on many other features of oligopolies within the fast food industry can be suggested.

References

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