Mind Your Business - 18 November 2008

1. Using break-even analysis, explain the reasoning behind the Chief Executive's claim that if Groupe Eurotunnel were able to have more control over their pricing they would be in a position to reduce their losses (8 marks)

If GE had more control over its pricing it can be assumed that they could either increase or decrease their prices. The article suggests that the Chief Executive wants to be able to reduce prices and suggests that if he was able to do so that then volumes would increase. It can be assumed therefore that GE would want to reduce the price they charge. The total revenue received by a business is given by the price multiplied by the amount sold. In break-even analysis, the slope of the TR curve will be determined by the price charged – the lower the price the more shallow the curve (assuming a constant scale). If the price was reduced, we would expect the TR curve to pivot from TR1 on the diagram below to TR2. This would, in turn, mean that the break-even point would now be reached only after a greater number of sales (Q3 rather than Q1). The article suggests volumes would rise by between 2.5 million and 10 million tonnes – a rise of around 300%. If this turns out to be the case, and assuming the debt has been restructured, then it is possible that despite a greater number of sales being needed to break-even the company could generate sufficient sales from the price reduction to make the strategy successful.

2. Using the graph, calculate the price elasticity of demand for freight services and comment on the degree to which the company's claims in respect of the price reductions on freight services are likely to be successful (12 marks)

Price elasticity of demand measures the responsiveness of demand to changes in price. The formula is given by:

Price elasticity of demand = Percentage change in quantity demanded % Percentage change in price

The article suggests that the reduction in price that the company would like to implement is between 50 and 60% - let us assume the top end of that range, 60%. The increase in demand it anticipates is said to be likely to rise from 2.5 – 10 million tonnes. This represents a percentage increase of 300% (7.5/2.5 x 100).

Substituting these figures into the formula we get:

Price elasticity of demand = 300 % -60

PED = -5

This tells us that the reduction in price would increase demand by 5 times the reduction in price. Such a figure tells us that demand is relatively elastic and thus highly sensitive to changes in price.

If we assume that the suggested price changes and volume increases that the company are proposing are based on accurate market research then the relatively high price elasticity of demand would suggest that such a strategy would be successful. The result would be higher total revenue and this would help to offset the costs of production. Given that the article also suggests that the variable costs of running the tunnel are relatively small in comparison to the initial cost of construction, such a rise in revenue would help to improve the operational profitability of the company.

However, this analysis is based on the assumption that the data given is accurate. In practice the accuracy of the data will depend on the quality of the market research carried out. In addition, it will also depend on the response of the competition to the price cuts made by GE. The tunnel faces competition from ferry and air transport. A key factor in favour of the tunnel is the time saving that businesses can make by sending freight through the tunnel. Air transport can be expensive while ferries can be time-consuming. The decisions by firms about whether the tunnel represents the most efficient and cost effective method of distributing its products in relation to the competition will be crucial in the success of the move by GE. GE might need to have some idea of the flexibility of its competitors in meeting its more competitive pricing structure. If GE really does have the sort of price elasticity suggested in our calculation then it would seem to be that the evidence supports such a move.

3. Consider the market structure in which Groupe Eurotunnel are operating and assess, in the light of this, assess the likely success of their proposed strategy (20 marks)

Market structure refers to the extent of the competition and the resulting behaviour of firms in the market. Market structure can range from highly competitive to ones where individual firms have a considerable degree of monopoly power. In the case of GE, the market is one for carrying passengers from the UK to Europe. Other competitors in the market will, therefore, include ferry companies and airlines. Within the air transport market itself there are also a number of different competitors, ranging from the established national airlines, such as British Airways, through to the budget airlines like easyJet and the dedicated air freight companies. Ferry companies will include such firms as P&O, Stena Line, Brittany Ferries and Condor Ferries. Not all these companies operate from the same ports but businesses may prefer to have a greater degree of flexibility in where they might need to operate from.

The success that GE will have in attracting business will be partly dependent on the number and closeness of substitutes for its service. In addition, it will also be affected by the prices that these rivals charge and the speed and efficiency with which they are able to carry out the job of getting people and goods from A to B. The relatively small number of firms in the industry would tend to suggest that this market is relatively oligopolistic (competition amongst the few) but at the same time is likely to be highly competitive between these relatively small numbers of firms.

In order to compete effectively, GE is suggesting that price is key to their strategy. We might assume that firms making decisions on which mode of transport to use will be heavily influenced by price. By reducing price, and given the relatively elastic nature of demand - as emphasised in the last question - GE's strategy might be heavily dependent on using price as their main source of competitive advantage.

Competitive advantage has to be both distinctive and defensible, however, and if other businesses in the industry could match the sort of price reductions that GE are proposing then GE's potential competitive advantage might be eroded. One factor in GE's favour is the fact that their variable costs are relatively low and as a result it might be much harder for an airline, for example, to cut its process to the extent that GE are proposing.

Price is not the only reason why freight companies will make decisions on the mode of transport used, however - quality of service might also be important. GE has control over the tunnel itself, but what happens before and after freight enters and leaves the tunnel might also be a consideration. Plans to build a high-speed rail link and to improve road networks in the UK might help improve the quality of the experience for freight companies, but there are still concerns that the experience on the other side of the Channel is far better and more efficient than on the UK side.

Ferry companies might be disadvantaged by comparison because of the speed with which it takes ships to get people and goods across the Channel, but this might be offset by the price charged and the fact that freight drivers need to have some period of rest (which can be incorporated into a ferry journey). EU regulations on driver times at the wheel might ultimately mean that despite a quicker actual journey time across the Channel using the tunnel, if you include rest then the overall journey time from A to B is not that much different. In such a case, GE might not have the advantage it thinks and might also be matched in terms of price by the ferry companies. It will depend, therefore, on how competitive the ferry companies can be in meeting the price levels set by GE.

It would appear that the strategy that GE are proposing has a high chance of success given the nature of the competition and the market structure that the firm operates in. Much of the success might, however, be dependent on the extent to which the market for freight changes in the next 5–10 years. GE will have to look at extended time scales in their planning not just the next few months or years. The longer the time period the greater the chance that competitors will be able to adjust their tactics in response to that of GE and this, in turn, affects the price elasticity of demand upon which the tactic GE wish to use is based.