- Potential Entrants
Advantages of existing firms:
The existing companies within the industry have already established their market share over the years from when they first started trading. They have done this by marketing the products they sell and gaining loyal customers who are use to that brand and then only buy that product. These customers are what the company will aim the new marketing strategies at. The market shares of these companies will continue to grow. For example Galllaher manufacturers, who have a number of brand names, have experienced a large market share and continued growth. In 2002 it stood at 37.7%, which then rose to 38.1% in 2003. Another well known manufacturer Imperial, witnessed their market share grow from 42.9% in 2002, to 44% in 2003. Between Gallaher & Imperial they control 80% of the market. This doesn’t leave much for the new firms to gain when they enter the market.
The smokers that have been smoking for years will have their own preferred favourite. If they are loyal customers they will be obliged and want to purchase the same cigarettes they always have. They will not want to try new brands as they are happy with their existing brands. The new tobacco brands will have to try and break down the barriers to entry and try to gain their own market share. New companies that try to enter the market will find it difficult to penetrate the long standing smoker’s tastes. They will have got into a pattern of buying the same brand. This buying curve will be difficult for new firms to break down.
3.4 Substitute Commodities
The precise nature of demand for tobacco:
Demand is the flow of goods and services required by customers over a given period of time. Generally the higher the level of price, the lower the level of demand. The concept of elasticity is important in both microeconomics and macroeconomics. Elasticity of supply is the responsiveness of quantity supplied to a change in price. The main use of cross elasticity is to understand the changes in the prices of substitutes with substitutes goods.
The precise nature of demand for tobacco can by found out by studying the target market for tobacco. The market for which tobacco is targeted at is the people who smoke tobacco either in its natural form of just tobacco or in cigarette form. We can find the demand for cigarettes by using cross elasticity of demand.
Cross elasticity is defined as measuring the responsiveness of demand to a small change in price. It is calculated by dividing the proportional (or %) change in the quantity demanded by the proportional (or %) change in price.
Diagram A: shows how demand is measured.
Source: Bized, 2004 (www.bized.ac.uk)
The effects of health information on tobacco use can be analyzed in an extended version of the standard economic model of consumer behavior. Each consumer is assumed to compare the monetary price of tobacco products to the pleasure received in smoking, taking into account the effects of addiction and smoking-related health problems on future utility. The individual demand curve summarizes consumer behavior by showing that, holding other factors constant, the quantity demanded declines as the price of tobacco products increases. For instance cigarettes as the quantity of cigarettes that are smoked declines the prices of cigarettes will still go up. The impact of changes in consumer information about the addiction and health consequences of tobacco use are examples of what happens when other factors are not held constant. Each individual consumer demand curve will shift down and to the left, meaning that because of the new information for any given price, the quantity demanded is lower. Market demand is the aggregate of individual demand and shifts in the same way in response to new information.
Are there any substitutes for tobacco?
There are no substitutes for tobacco in the market at this present moment in time. More times than most products like low tar cigarettes and nicotine chewing gum are referred to as substitutes. However, this concept is wrong due to the fact that these products are usually used by people who want to give up smoking and are not used as a replacement for smoking. Although it has been studied that in the most uncommon of cases people have been found to still be addicted to the chewing and reduce their craving for nicotine by having a nicotine chewing. The only thing that could be possibly considered as a substitute for tobacco could be marijuana, which is commonly used with the aid of tobacco but can be used in its pure form although it is not legal in a lot of countries around the world.
Innovation within the tobacco industry and health risks.
In recent years there has been innovation seen within the tobacco the biggest change being the warning on the packaging stating the health risks of tobacco. With an estimated half million deaths a year caused by smoking and with 80% of new smokers being under 18 in Europe alone, the idea of EU legislation to combat tobacco consumption appeals to many people. However, the EU has limited powers to legislate on public health, which is mainly the support of the Member States. One way the EU can adopt anti-tobacco measures is through single market legislation, because EU laws designed to remove barriers to trade within the Community must also take account of health issues.
Since 30 September 2003 cigarette packets must also carry large health warnings. Thanks to the persistence of MEPs (medical expenditure panel), these warnings are much bigger and can be more hard-hitting than the Commission originally proposed.
Thirty per cent of the front of each packet sold in the EU is taken up by a compulsory general warning. Examples are "Smoking kills/Smoking can kill" or "Smoking seriously harms you and others around you". This was agreed by the insistence of the European Parliament, which wanted attention to be drawn to the dangers of passive smoking.
Forty per cent of the back of each packet must be covered by a compulsory additional warning, which Member States can select from the agreed list of 14 messages laid down in the directive. Examples are "Smoking when pregnant harms your baby", "Smoking is highly addictive. Don't start" and "Smoking can cause a slow and painful death".
3.5 Rivalry between existing producers
There is a fairly constant demand for cigarettes due to them being of an addictive nature. The demand for cigarettes is constant throughout the year and has been for many decades. There has been a suggestion of a slight decline in the demand for cigarettes in recent years as the table below indicates.
Source: Mintel, 2004
The results here show a decline of -3.6% between 2001 to 2003 this is a large percentage in a short period of time. However, these figures may not give a true representation of the amount of cigarettes being smoked due to the impact of smuggling into the UK. This is very hard for the authorities to keep track of.
The UK Cigarette market has also had to deal with a ban on advertising, which may be the cause of a reduction of cigarettes being smoked. A ban on the use of printed and outdoor media came into force in February 2003, this was followed by a ban in direct marketing methods later in that year. However, the reduction in the amount of advertising may have resulted in the increase of cigarettes being smoked. This is because some manufacturers have used the money previously spent on advertising to lower the price of cigarettes resulting in more being purchased.
The cigarette and tobacco industry has been operating for decades. Its product life-cycle has reached the maturity stage and shows no indication of altering. However, this may begin to change in the future as the increase in anti-smoking groups and pressure by the government comes into force. The introduction of a ban to smoking in public places may reduce the amount of smokers as smoking becomes more unsociable. This may begin the de-maturity of tobaccos product-life-cycle as demand decreases.
The cigarette and tobacco industry is an example of an oligopoly as the market is dominated by two main manufacturers. Imperial Tobacco holds the largest market share at 53.7%, followed by Gallaher at 36.8%. Rothams hold a small market share at 6%.
Source: Mintel, 2004
Gallaher was the market leader in the UK for many years, but in recent years it has concentrated on international sales. In 1999 Gallaher acquired Austria Tabak and Ligget-Ducatt increasing its international sales. Another major step in the increase of international sales was the signing of a deal with Chinese state tobacco monopoly to market it cigarettes in China. International sales now counted for 87.3% of Gallaher’s sales in 2003, up from 38% in 1998. Gallaher have also been concentrating on their interests in the UK market, in 1999 they horizontally merged RJ Reynols from RJR-Nabisco Corporation and acquired UK distribution rights of Camel and More.
Imperial Tobacco are the leaders in the UK cigarette industry. They have increased their market share by the acquisition of UK distribution rights for Phillip Morris International’s brands. In 2002 their market share rose to 42.9% and climbed further to 44% in 2003. In 1997 they purchased the company Rizla, which produces cigarette papers this shows an example upstream vertical integration. Imperial Tobacco have also been increasing their international sales, by purchasing German tobacco company Reemtsma. In 2003 international sales counted for 54% of Imperials total sales.
The barriers of entry to the tobacco industry are high due to the fact of it being an oligopoly industry. It would be very hard for new companies to enter the industry due to the fact that the three largest tobacco manufacturers have 95.6% of the market share. Another barrier new firms would face is that of the preference of the consumer. Many smokers stick to the same brand of cigarette and are unlikely to change unless there are serious benefits of smoking another brand. This may include a cheaper price which would be very hard for a new company to achieve with the setting up of a new company. Also the majority of the price of cigarettes is due to tax taken by the government.
A new company would also face the disadvantage of not being able to advertise its product because of the ban of advertising in the UK.
The tobacco industry is operating under an oligopoly. Oligopolies are usually characterised by product differentiation and the branding of the product. Tobacco manufacturers are producing technically very similar products but it is the purpose of the marketing department to make consumers believe that their product is perfect and the rival products are not good substitutes. However, with the ban on advertising in the UK the manufacturers are unable to market their product so rely heavily on customer loyalty.
The nature of competition within the tobacco industry shows elements of collusive practices. As the UK tobacco industry is dominated by two main manufacturers there have been suggestions of price-fixing. It is very unlikely that one manufacturer will suddenly slash their prices, due to the fact that demand for tobacco is constant and does not waiver greatly due to price increases or decreases.
The pricing of tobacco is also affected greatly by the amount of tax applied by the government. The pricing of tobacco is not wholly based on the demand of the consumer but is mainly due to forces being put on it by external forces. The government has forced an increase in the price of tobacco above inflation rate; this is to try and lower consumption of cigarettes and to raise more money for spending on anti-smoking campaigns.
The tobacco industry faces increased pressure to spend money on research and development into innovative tobacco products which would be healthier for the consumer. However, there has been a suggestion that due to the tobacco industry being an oligopoly the main tobacco firms have agreed within themselves not to market such products as they fear it would make a comparison with the existing harmful nature of products.
In many of the tobacco firms corporate social responsibility papers it describes the steps they have gone to fund research and development into their healthier products. Many tobacco companies fund research into the effects of cigarette smoke. However, there has discrepancies between the research conducted by companies paid by tobacco companies and that of research conducted externally. Suggestions have been made that the tobacco companies may be influencing the results of research to be in their favour.
The increase in the price of cigarettes has encouraged tobacco firms to invest in product differentiation. Over the recent years the value-for-money sector has continues to show growth. Due to the increased demand for low priced cigarettes Imperial Tobacco introduced their brand Richmond in 1999 and it is now the second largest brand with 12.4% volume share. The table below shows the percentage market share over recent years by cigarette price range.
Source: Ash, 2004
Not all premium brand cigarettes have suffered due to the demand for value for money cigarettes. Imperial Tobaccos Marlbro brand has increased its volume sales from 4% in 2001 to 8.2% in 2003. An explanation of this sharp increase is that the brand is popular with the younger, image-conscious smokers.
Imperial Tobacco the UK’s largest cigarette manufacturer reported pre tax operating profits of £859 million in 2003. The second largest company Gallaher reported operating profits of £457 million in 2003. So even with the effect of tax increases by the government both firms are still making large profits on their products. The tables below show the financial progress of the two firms over the current years
Imperial Tobacco
(*Underlying. All figures adjusted for goodwill)
Gallaher
Source: The Motley Fool, 2004
This information shows how both firms have increased their profit rapidly over the current years.
One of the reasons for this steep increase in profit of the tobacco manufacturers may be due to the reduction of workforce within the industry. This reduction is mainly due to the advancement of technology resulting in productivity improvements. In 1996 only 6000 people were employed in the manufacturer of tobacco and 7100 employed in the wholesale of tobacco products.
4 Generic Strategy
To suggest a relevant strategy for development of an existing tobacco company or the introduction of a new company into the tobacco industry, Michael Porter’s generic strategies have been considered. He suggests three different types of strategies for the development of a firm these include cost leadership strategy, focus strategy and differentiation strategy.
The cost leadership strategy puts emphasis on a company to become a low cost producer of a given level of quality. The producer has to sell its products at a lower price than its competitors but the quality remain of the same standard to increase market share or keep the cost at average industry cost but increase quality to increase profitability. A firm who wishes to adopt this strategy needs access to capital to make investments in production assets. This can create a barrier to entry for some firms who do not have access to this amount of capital. The firm must also invest in efficient manufacturing to lower costs.
This strategy has already been adopted by the two major producers in the tobacco industry. Both Imperial Tobacco and Gallaher have introduced low price cigarettes in the recent years and are competing for market share in the low-cost tobacco market. Due to the fact of the tobacco industry being an oligopoly it would be very hard for a new company to enter the industry, as with the initial cost of setting up a business it would be hard to compete in a price war with the existing firms.
The focus strategy concentrates on a small part of a firm’s production and attempts to achieve either a cost advantage or differentiation. As in the tobacco industry a tobacco producer would concentrate its efforts on a few brands of cigarettes and rely on customer loyalty for sales. A firm that would use this strategy would rely heavily on customer loyalty, and this in turn may discourage other firms from competing directly. In relation to this being used in the UK tobacco industry, the two main tobacco companies have got such a large market share that it would not be beneficial for them to use this strategy to increase sales. Due to the high barriers of entry into the tobacco industry a new company could not take on this strategy as they would not have any existing customer loyalty.
The final strategy Michael Porter suggests is that of differentiation. This strategy relies on the development of a product or service that is unique to the industry and that customers perceive to be better or different from the products of the competition. This uniqueness can allow the company to charge premium prices for its product. A company that adopts this strategy must have access to up-to-date scientific research, a skilled development team, a good marketing strategy and be constantly innovating its product to suit its customers.
Existing tobacco producing companies would find it hard to adopt this strategy as when a new product is introduced it needs to be marketed correctly to obtain sales and market share. However, with the recent ban on tobacco advertising introduced by the government it would be very hard for the tobacco firms to market its new product and convert customers. The tobacco industry is also limited in what it produces with the laws and legislation enforced by the government.
A new company may be able to overcome the high barriers of entry into the tobacco industry by introducing a new product that is innovative and has better health benefits for the consumer. Below are recommendations based on a new company entering the tobacco industry using Michael Porter’s differentiation strategy.
Due to the tobacco industries barriers of entry being very high, a new company would have to introduce a new product that is revolutionary and provide an advantage to the consumer. At the moment there is an intense focus on the health risks due to smoking. The government and anti-smoking groups are doing their best to reduce the amount people smoke and help them give up completely.
The new company could introduce a product that specialises in helping people give up the habit of smoking. This could be achieved by creating a range of cigarettes that increasingly reduces the amount of nicotine in them, allowing the user to gradually lower their nicotine intake and become less addicted and hopefully give up. This would involve creating a new product range of cigarettes. For example three different varieties within the brand, starting with a higher nicotine level cigarette in packaging coloured red, the second, a medium nicotine level cigarette with packaging coloured amber and finally the lowest nicotine level cigarette with green packaging.
The advantage of this strategy is that the government may relax its laws on advertising for the product as it is being used as an aid for the consumer to give up. This would give the company a large advantage over other tobacco producing companies who are unable to market their products. The product may also get the backing from anti-smoking groups and they may recommend it as an aid to quit smoking.
The new company would also not be directly competing with the other tobacco companies, as the product would be used as an aid to stop smoking, rather than competing directly with them. The existing tobacco companies would also not introduce rival brands to the market because it is not in their advantage for people to quit smoking.
The market the new company would be in competition with is that of smoking cessation aids, these include nicotine chewing gum, nicotine tablets, nicotine skin patches, nicotine inhalator and nicotine nasal spray. The new company has an advantage over these companies as it allows the consumer to give up gradually rather than giving up cigarettes completely and relying on nicotine replacement products. This would reduce the negative effects associated with quitting of smoking, including mood swings and the reduction of cravings.
The advantage that the new company has is that it is individual to its market due to the lack of substitutes in the industry. Also due to the individual nature of the product the new company would be able to pass on supplier price increases to its customers.
One of the disadvantages the new company may face is that of self destruction. As the product it is producing is meant for the buyer to eventually give up cigarettes altogether. One option to compensate for this is for the new company to invest in a different industry completely for example sports and leisure. The aim of this strategy is for the customer having given up cigarettes to continue their spending on fitness regime in gyms and other leisure facilities. To encourage this the final lowest nicotine, green packaged cigarettes could include an incentive voucher to collect towards discounts in the sports and leisure facilities owned by the new company. This is an example of conglomerate diversification.
5 Conclusion
To conclude, the analysis of the tobacco and cigarette industry has shown that it is an oligopoly industry with the UK market being dominated by two main firms, Imperial Tobacco and Gallaher. These firms have a large influence over the barriers of entry set in the industry due to price fixing.
The tobacco industry is on the decline due to increased awareness of the health risks associated with it, and also the ban on advertising and marketing in the UK. However, due to the increase in smuggling of cigarettes into the UK it is very hard to record the actual figures of the consumption of cigarettes.
The suppliers to the tobacco industry have very little power over the prices they set due to the tobacco manufacturers being large organisations who can demand the price they pay. The customers to the tobacco industry have some power over the manufacturers by demanding lower price cigarettes; this has allowed a boom in low-cost sector of the tobacco industry.
The barriers to entry into the tobacco industry are very high. A new entrant would find in difficult to break into the market. This is why it has been recommended that a new entrant uses Michael Porter’s differentiation strategy to develop its product. It has been suggested that the new entrant developed a product that allows users to slowly give up smoking. This would hopefully allow for relaxation on advertising restraints and approval from anti-smoking groups.
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