Advanced Corporate Strategy

ST104x

Increasing and sustaining market power

A second major motive for diversification is to increase and sustain a firm’s market power by
its presence in multiple product markets. By market power, we mean a firm’s ability to
manipulate prices by controlling supply, demand or both.

Market power provides several benefits to a firm.

• A firm with market power will have high bargaining power over its customers and thereby
it can raise its prices well over its marginal costs.
• A firm with market power can make it difficult for other companies to enter the market
by creating excess capacity or making it difficult for customers to switch.
• Or it can force existing companies to exit the market by predatory pricing i.e., offering
very low prices. Once competitors exit, the firm can then potentially raise its prices and
gain large profits.
While there are potentially many such benefits, the benefits tend to be limited in practice
though.

So how does diversification create market power?

Let us take the example of P&G, the consumer products company that has a presence in
multiple markets such as
• beauty products,
• baby & family care,
• fabric & home care and
• health & grooming.

Now, because of its presence in multiple consumer products that go through the same
channel, it has a much larger scale and so it gains bargaining power over its immediate
customers. Similarly, to the extent that its products use the same inputs, it buys these inputs
on a larger scale and this also lead to bargaining power over its suppliers. It can also bundle

© All Rights Reserved, Indian Institute of Management Bangalore

 Advanced Corporate Strategy

ST104x

its products which can provide it some limited advantages over a company that sells
unbundled products.

Such bundling of products is more effective when the firm has a large market share in one of
the products. For example, Microsoft has a near monopoly in operating systems. Microsoft
often bundles its operating system with other software such as a media player and a web
browser. So, a company that has only a web browser such as Netscape may be at a
disadvantage compared to Microsoft.

To summarize the arguments on market power, a firm that is diversified into multiple product
markets can increase prices or lower competition and thereby become more profitable.
However, the empirical evidence shows that market power gained through product
diversification can be limited. While there have been some prominent cases where a firm has
been able to exerciser its market power, such cases are typically rare. There tends to be
enough competition in multiple markets such that a firm is unable to exercise its market
power.

Similarly, the evidence for predatory pricing, wherein a firm drives out competition through
its low prices has also been weak. Also, it is very important to keep in mind that predatory
pricing is considered illegal in many countries. Also using market leadership in one product to
keep competitors out in another market may also be considered as an unfair use of
competitive power and may attract antitrust actions from the government.

What happens when a firm’s competitors are also present in multiple product markets?

This often drives the firm also to engage in similar diversification. One very good example of
such diversification is the entry of Dell into printers and services. Dell competes primarily
against Hewlett-Packard or HP in the computers market. Now HP also has a presence in the
printers business and the IT services business. Now, HP could potentially use its strong
presence in the printers or services business to get an advantage over Dell in the computers

© All Rights Reserved, Indian Institute of Management Bangalore

 Advanced Corporate Strategy

ST104x

market. So, it makes sense for Dell to enter these two markets. Why did HP get into the
services business? Because it’s main rival IBM entered into services in a big way!

What is the effect of firms competing against each other in multiple markets? Such
competition is called multi-point competition or multi-market contact. Does multi-market
contact lead to more competition or less competition? It typically would result in less
competition because when a firm reduces its prices in one market, its rival can retaliate in
multiple markets. Thus, firms will have a lower tendency to compete against each other
strongly in all the markets that they meet.

The airlines industry is a good example of how multi-market contact can lead to higher prices.
When airlines meet each other in multiple markets – note that these are geographic markets
and not product markets, but the basic idea of multi-market contact is the same across
product and geographic markets.

So, when airlines meet each other in multiple markets they tend to maintain higher prices
than when they meet each other in a few markets. Again, the broad empirical evidence for
how multi-point competition leads to lower competition and higher performance has been
weak.

© All Rights Reserved, Indian Institute of Management Bangalore