Problems and Discussion 1. With the help of diagrams and arguments, explain how the firm identifies the optimal level of production and the optimal price level under the following scenarios: a. The firm is trying to maximise profit. b. The firm is trying to maximise revenues without a profit constraint. The firm is trying to maximise revenues with a profit constraint. d. Suppose there is a decrease in corporate taxation. Using diagrams and arguc. ments compare the reactions of a profit-maximising firm and a revenue-(with profit constraint)-maximising firm with respect to the optimal level of production. 2. Flash Plc competes against Novaphone in the market for mobile phones. The quality-price trade-off for customers of mobiles is described by the equation below: Consumer's Perceived Benefit = Quality -1.3 x Price a. Novaphone sets its quality for mobile phones equal to £400 and its price equal to £300. If Flash sets its quality equal to £300, how much does it need to set its price in order to generate more perceived benefit to customers than Novaphone? Is this always feasible? b. Suppose that the cost for Novaphone from producing a mobile of quality £400 is equal to £320. Flash sets its price equal to £230 and its quality equal to £300. Find the maximum cost per mobile that Flash must have in order to have cost advantage over Novaphone. 3. Firm B competes against Firm A in the market for product X. The positioning of Firm A and the possible positioning for Firm B appear in the graph below: If firm B has the option to choose between positioning B1 and B2, which one should it pick? Does it have cost advantage in the market? a. Suppose now that the customers indifference curves are given by the graph below: Which position should Firm B pick now? Is your answer different from part (a) above and why? 4. By using Porter's 5 Forces analysis, briefly explain what are the main sources of profit erosion and their relation to the five forces. 5. Netscape has designed a new battery for portable devices that can last twice as long as the next best available from competitors. Once it is out in the market, the new battery is estimated to sell 200 million pieces at a price of £100 per battery, yielding £20 billion of revenues in net present value. However, the battery requires a unique material, “zortium”，which is sold by 5N mining, the only supplier of the material. a. Suppose that 5N asks a price of £25 per battery sold for supplying zortium to Netscape. Suppose that all other costs of producing and marketing the new battery are estimated to be at £45 per battery, and that if Netscape directs all these resources to other of its own projects, they will yield £3 billion in profit. Should Netscape go ahead and sign the contract with 5N for the supply of zortium? b. Suppose that after Netscape has signed the contract with 5N, and has sunk all the resources for the development of the new battery, 5N claims that the costs of producing zortium have gone up and that it can only supply it after they renegotiate the original price. At this point, if Netscape liquidates the whole project it will get pounds 1 billion in net present value. What is the maximum price that 5N can ask of Netscape so that it accepts to continue the project? c. After taking into consideration the answer to part b. above, should Netscape still develop the new battery? 6. Briefly explain the implications of hypercompetition to the life-cycle of competitive advantage. How is it related to the concept of creative destruction? 7. Two newly founded firms, MARS2050 and Frontier X, compete in the market for space tourism. They both seek to innovate in a new type of rocket shielding that will make re- entry to the atmosphere possible with minimal generation of friction and heat. Both firms have access to two distinct approaches to succeed in this innovation. The first approach is deterministic and it will take 5 years to develop. The second approach is probabilistic, and it has a probability of 30% to complete in 3 years time and a probability of 70% to complete in 6 years. If both firms select the second approach, then the outcome for each company is independent of the outcome for the other. Moreover, if one firm achieves the innovation before the other then it will enjoy the advantage of being a monopoly for some period of time and it will generate additional expected profit of £500m. The other firm gets nothing in this case. However, if the two firms complete the innovation at the same time, then they will have to share the market and, due to price competition, each one will generate expected profit of £100m for the same time period. Find a stable set of choices of innovation approach and the additional expected profit for each one of the two firms in this scenario. 8. The board of directors of Durant Chemicals, a manufacturer of chemical products, is considering of merging with Novopharm, a pharmaceutical company. They have come up with the following list for the expected benefits and costs of the merger. 1. 2. 3. 4. 5. 6. 7. 8. Economies of scale Economies of scope Legal costs Avoidance of future hold-ups Reduction in agency efficiency Increase in technical efficiency Increase in administration overheads Avoidance of market transaction costs £150 m £200 m £50 m £75 m £300 m £25 m £120 m £30 m On the basis of the above table, should the board of directors approve the merger or not? 9. Metalysis is a small consultancy firm fully owned by its founded and director, Mrs Johnson. The value of the firm is given by the equation in million of pounds, where V is the firm value and F is the value of perks that the director of the firm enjoys. Mrs Johnson utility function is given by , where M is the monetary value of her holding in the firm and is the share of ownership that Mrs Johnson has in Metalysis. a. Suppose that Mrs Johnson retains full ownership and control of her firm. What is the optimal amount of perks that she will choose to enjoy and what will be the firm’s ultimate value? b. Suppose now that Mrs Johnson decides to sell 50% of the firm to an external partner in order to raise finance for future investment while retaining the position of the director. How much money will Mrs Johnson decide to spend in perks after the sale of this equity stake? What is the firm’s new value and how much money will Mrs Johnson raise for investment?
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