Impact of direct sales model on perfectly competitive market (Research Paper Sample)

Table of Contents Introduction 2 Dell Computers and its competitors 3 The DSM vs. Traditional Indirect Distribution Model 3 Cost advantages of direct sales model 5 Short run analysis 7 Firms in perfectly competitive markets 7 DSM and profit maximization 8 The impact of DSM on the computer market 8 Long run analysis 10 Impact of DSM on profit maximizing behaviors: 10 Computer market and 10 Individual computer manufactures 11 Beneficiaries of direct sales model 13 Beneficiaries in the short run 13 Beneficiaries in the long run 16 Conclusion 17 References 18 1. Introduction With the economic success of the direct sales model (DSM) pioneered by Dell Computers in the early 1990’s, many competing firms have attempted to adopt a similar model with the ultimate aim of replicating Dell’s financial achievements (Kraemer et al. 2000). However, many questions arise as to how such a process functions from an economic perspective. Using the theoretical model of competitive markets, this paper intends to analyse the impact of Dell’s DSM on both the individual firm and computer market as a whole, both in the short and long run. Although this paper’s central argument revolves around this theoretical model, real world scenarios rarely follow such ideologies, as such, inferences drawn from this analysis must be taken with a grain of salt when applying such theories in commercial practice. Relevant assumptions will be stipulated throughout the document. 2. Dell Computers and its competitors 2.a The DSM vs. Traditional Indirect Distribution Model The DSM as used by Dell Computers is a model based upon supply chain efficiency by eliminating third party distributors and resellers, thereby allowing direct sales from manufacturer to customer (Tyson 1998). Although not a new model, the ability of Dell’s founder, Michael Dell, to effectively integrate this process in the computer market was founded upon the realization of the importance of time and efficient use of information technology (IT) (Kraemer et al. 2000). Such was the success of this model, Dell became the largest supplier of personal computers (PCs) in the United States (Head 2000). By the 1990’s, computer manufacturers were no longer able to differentiate themselves through innovations in design, rather, the driving force for sales became efficiency through structure and distribution (Kraemer et al. 2000). This formed the basis of DSM. Through the effective use of telecommunications and IT, Dell was able to connect to customers directly, facilitating their involvement from the beginning customization and selection of computer components through to the reception of the product. Fig. 1 diagrammatically illustrates Dell’s DSM.  A simplified comparison of Dell’s DSM against the traditional indirect distribution model adopted by many of its competitors including Lenovo/IBM (Roberts, 2005) and Compaq (Stafford, 1999) reveals a clear distinction, the elimination of the need for distributors and retailers/resellers/integrators.
Fig. 2 - Dell’s direct distribution model (Kraemer et al. 2000)
Fig. 3 – Traditional indirect distribution model of the computer industry (Kraemer et al. 2000) 2.b Cost advantages of Direct Sales Model With the coupling of DSM and Build to Order (BTO) model, also implemented and refined by Dell, it was able to overcome significant sources of high production costs plaguing a progressively more accessible computer market. Direct customer interaction enabled inventory to be assembled only when ordered and eliminated the need to pre-empt market trends (Kraemer et al. 2000). Relative to competitors, DSM enabled a heavy reduction in inventory stockpiling through all channels of the supply chain, greatly increasing inventory turnover (refer Fig. 4) as well as freeing up physical warehouse space for more capital efficient use (Tyson 1998). Inventory Turnover, 1998 DellGatewayCompaqPC IndustryInventory turnover55.527.912.923.6Days cost of goods sold in inventory6132815Fig. 4 – Inventory Turnover (Kraemer et al. 2000) DSM reduced fixed costs by eliminating the need for specialized Dell Computer retailers, thus, a reduction in capital outlay to purchase premise (Kraemer et al. 2000). Computers were sold direct to consumers at market prices, as opposed to diluting profits through selling stock to retailers/distributors at cost. The removal of two key logistical steps from supplier to customer (as depicted in Figure 2) reduced overall distribution costs. Transportation and logistics costs were reduced due the formation of close relations with a limited number of suppliers located within close proximity to Dell assembly plants. Suppliers bore the burden of stockpiling inventory, reducing Dell’s inventory costs. (Tyson 1998, Kraemer et al. 2000)3. Short Run Analysis 3.a Firms in perfectly competitive markets In discussing firms in perfectly competitive markets, Samuelson (2001) comments that, “Perfect competition is the world of price-takers.” Firms in competitive markets produce homogeneous computer products and sells at the price determined by the market’s supply and demand, thus, are price takers. To maximize profits, companies will always increase its output as long as the price is greater than the marginal cost (MC) of the last unit, until they produce, “at that level where marginal cost equals price” (Samuelson, 2001) Marginal cost = Marginal revenue = price Fig 5(a) illustrates how the market supply and demand determine the equilibrium price and quantity. In a perfect competitive market, every firm faces a horizontal demand curve P which is also its marginal revenue (MR) curve. Fig 5(b) indicates that one single firm maximizes its profit by producing a quantity were MR = P = MC.  (a) Industry (b) Firm      Fig 5 - Firm versus industry short-run equilibrium in a perfectly competitive market 3b. DSM and profit maximization To maximize profits, Dell will increase its output to the level where MC = P and make an economic profit. As the Fig. 6(b) shows, thanks to its lower cost, Dell increases its productivity from Q0 to Q1 as the new profit maximizing output at which the MR just covers the MC. At this output, price exceeds Dell’s ATC. Its total revenue is TR = P0×Q1 and its total cost is TC = P1×Q1. Dell makes an economic profit EP = (P1-P0) × Q1.  EMBED Visio.Drawing.11 
  EMBED Visio.Drawing.11 
 Fig. 6 - The lower cost of direct sales model brings Dell economic profit 3.c The impact of DSM on the computer market In order to analyze the impact of DSM on the computer market, we must firstly assume that Dell is the sole firm integrating DSM and all other competitors are utilizing a homogenous indirect distribution model. As stated previously, DSM presents various cost advantages over the traditional distribution models. The marginal cost (MC) and average total cost (ATC) are reduced relative to other manufacturers at the same given level of output. The total market ATC remains unaffected as the influence of Dell’s lower ATC on the whole computer market is negligible. Market price and quantity remain unchanged. However, based on the model of competitive markets, Parkin (2005) stipulates that, “perfect competition is an industry which… established firms have no advantage over new ones.” If we were to assume that all competing firms have access and ability to implement the same DSM without restrictions and no new firms enter the market in the short run, the price and quantity effect on the computer market would be vastly different.  EMBED Visio.Drawing.11 
 Fig. 7 - The ATC of whole PC industry will decrease and accordingly, supply will increase to maximize profit. As the quantity supplied to the market increases, movement along a constant demand curve indicates prices will decrease. All firms using DSM will now experience economic profit. 4. Long Run Analysis 4.a Impact of DSM on profit maximizing behaviors i. Computer market The long run effect of DSM on the computer market as a whole may be illustrated in Figure 9. The lower costs provided by the technological innovation of DSM creates economic profits in the short term for firms already using DSM (refer Fig. 6). As stated previously, we have assumed that all competing firms have now adopted DSM. Economic profit provides incentive for new firms to enter the market, where profit maximization allows MR > MC. Assuming perfect competition, new firms are able to enter without barriers. An increase in the total number of suppliers causes a downward shift in the market supply curve from S0 to S1. Assuming demand curve remains constant, the resultant increase in quantity supplied from Q0 to Q1 causes movement downward along the demand curve and price to fall from P0 to P1. As new firms enter and price diminishes, the economic profits are competed out of the market in the long run. “The long-run outcome of a perfectly competitive industry, then, is that the price is forced down to the level of the lowest possible average cost.” (Davies and Lam 2001) This process will continue until the point where the market reach equilibrium, where Q1 = P1, as per Fig. 6, where all firms experience zero economic profits, only normal profits. Thus, the long run effect of DSM on the computer market is an overall increase in the quantity supplied and a fall in the market price.  EMBED Visio.Drawing.11 
 Fig. 8 – Long run effect of DSM on individual firms ii. Individual computer manufactures In the long run, economic profits derived from DSM provide incentive for new firms to enter the market. Total quantity supplied increases, however, market price decreases. This decrease in market price directly impacts individual firms. As stated previously, in a perfectly...