Managerial Economics Midterm Test Suggested answers

1
Managerial Economics Mid-term TestSuggested
answers

• MBS, Term 2, 2004
• Paul Kerin

2
1a) Entry-deterring price
(P 160)4010M 500K
Y
Gidget wont enter when pay-off from entering (vs
not) is negative so equate payoffs and solve
for P P 160.125
Gidget
Enter?
N
0
Common mistake ignoring the 500K entry cost
this is not sunk when Gidget is considering the
entry decision
3
1b) Cut price or hire Madonna?
50
EV (590M, 79.5M)
Madonna works?
Y
(710M, -0.5M)
Gidget
Y
HireMadonna
N
(470M, 159.5M)
Enter?
50
Widgets
Cut price orHireMadonna(orNeither?)
Conclusion While hiring Madonna is better than
doing nothing, we should cut price
(601.25590480)
N
Cut price
(1.49B, 0)
(601.25M, 0)
(480M, 159.5M)
Gidget
Y
Enter?
Neither
(1.5B, 0)
N
4
1b) (continued) The pay-offs in the decision
tree were calculated as follows
Wigdets Gidget

• 710M (200-110)8010M 10M
• 470M (200-120)6010M 10M
• 590M 50710M 50470M
• 1.49B (250-100)10M 10M
• 601.25M (160.125-100)10M
• 480M (200-120)6010M
• 1.5B (250-100)10M

• -0.5M (200-200)2010M 500K
• 159.5 (200-160)4010M 500K
• 0 as Gidget chooses not to enter or P160.125
  deters Gidgets entry

• Note I left it to your judgement to make
  assumptions about unit variable cost under the
  20 share loss case this did not affect your
  mark (unless it was truly outrageous). For
  example, assuming that unit costs under a 20
  loss were the same as the 40 loss case was
  acceptable (though unlikely) my assumptions in
  this solution for the 20 loss case are as
  follows
• Widget unit cost 110 (midpoint between 100
  and 120)
• Gidget unit cost 200. As scale is important
  and Widgets unit cost at 60 share is 120 and
  Gidgets at 40 is 160, a 20 scale loss raises
  unit cost by 40 assuming another 40 increase
  in moving from 40 to 20 is probably conservative

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1b) (continued) Most common mistakes

• Not drawing the tree in the right order again,
  this illustrates the importance of reading the
  question very carefully before you draw the tree
• Omitting one or more decision/choice nodes or
  branches from the tree, either forgetfully or
  without checking whether this affects the answer.
  For example, omitting the Gidget entry decision
  in the cut price option is OK (as weve already
  worked out that Gidget wont enter at P
  160.125 or less), but it is risky under options
  that you havent solved yet when you draw the
  tree. If you do decide not to have a Gidget
  entry decision node under the Madonna option,
  it would help to demonstrate why this is OK (that
  Gidget would always enter if Madonna is hired)

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1c) Hire Brittany?
90
EV (691M, 15.5M)
Y
Brittany works?
(715M, -0.5M)
Gidget
Y
HireBrittany
N
(475M, 159.5M)
Enter?
10
Widgets
HireBrittanyorCut price?(next best option)
Conclusion We should hire Brittany Her added
value is94.75M( 691 - 601.25 5)
N
(1.495B, 0)
(601.25M, 0)
Cut price
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1c) (continued) How were the pay-offs in the
decision tree calculated?
Widgets Gidget

• 715M (200-110)8010M 5M
• 475M (200-120)6010M 5M
• 691M 90715M 10475M
• 1.495B (250-100)10M 5M
• 601.25M (160.125-100)10M

• -0.5M (200-200)2010M 500K
• 159.5M (200-160)4010M 500K
• 0 as Gidget chooses not to enter or P160.125
  deters Gigets entry
• 94.75M 691M 601.25M 5M

• Common mistakes
• Not putting Gidgets entry decision in the tree
  or at least not demonstrating that Gidget
  would always enter if Brittany is hired (as in
  1b)
• Not being clear on Brittainys opportunity cost
  in calculating her added value. If her
  opportunity cost is 0 (as she is available),
  we need to include her 5M as part of the value
  created (total value created 691M 601.25
  5 94.75M). If her 5M does reflect her
  opportunity cost, then her added value is
  89.75M either answer is OK, provided your
  assumption about Brittanys opportunity cost is
  clear and consistent with it

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1d) Widgets WTP

• The additional value captured by Widgets with
  Brittany is 89.75M ( 691M 601.25M)
• However, this is after paying Brittany 5M
• Therefore, Widgets WTP 89.75M 5M
  94.75M
• Common mistake forgetting to add back the 5M
  (in calculating Widgets WTP, this is essential,
  regardless of what Brittainys opportunity cost
  is thats irrelevant to Widgets WTP)

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1e) Brittanys fee range specific prediction
Fee range 6M -94.75M Specific predictionP
50.375M Common mistake assuming Brittany would
make a TIOLI offer. To do so, she has to have a
credible threat for Widgets to believe her.
Settling for a 6M BATNA is not credible when
there is so much more money on the table via
negotiation
94.75M
Widgets WTP
P 50.375M(50/50 split, as 2-player
negotiation, Brittany knows Widgets WTP, Widgets
knows Brittanys WTS)
6M
Brittanys WTS(BATNA)
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2a) Value created? Yes

• Foodies profit on extra sales 3.75M(
  1B57.5)
• Petrolheads profit on extra sales
  -1.5 M ( (10M/2)30(0.03 - 0.04)
• Total value created 2.25M
• Common mistakes
• Forgetting to deduct the cost of the price
  discount in Petrolheads profit calculation
• Calculating the sales impact, rather than
  the profit impact

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2b) Voluntarily enter?

• Foodies Yes, as makes 3.75M incremental profit
• Petrolheads No, as makes 1.5M loss
  Foodies will have to pay Petrolheads to play

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2c) Payment per litre?

• Split equal bargaining power implies 50/50 split
  of the value created (2.25M, from a))
  each gets 2.25M/2 1.125M
• Total payment as Petrolheads loses 1.5M from
  the deal if there is no payment, Foodies must pay
  Petrolheads a total of 2.625M ( 1.125M 1.5M)
  to achieve this outcome
• Cents/litre - Litres sold (10M/2)30 150M-
  Payment per litre 2.625M/150M 1.75
  cents/litre
• Alternatively, you could have used our four box
  approach, which gives the same answer

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2c) (continued) Common mistakes

• Splitting something other than the value created
  (eg, splitting the 4c/litre 50/50)
• Determining the payment as half the surplus, but
  ignoring the direct impacts on profit eg, if
  Petrolheads makes a 1.5M loss if no payment, why
  would a payment of half the surplus (1.125M)
  induce it to co-operate?
• Not being clear on who is paying whom
• Not calculating the cents per litre payment

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2d) Which deal to accept?
11.5M p.a.
Petrolheads should accept Worthwools offer
better off by 375K p.a. (or 3.75M in present
value)
Worthwools
Petrolheads
Which deal?
10M current profit 1.125M share of
surplus or 10M 2.625M - 1.5M
Foodies
Common mistake Forgetting to add in Foodies
current profit
11.125M p.a.
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2e) Counter-offer? feasibility specific offer

• Offer required? From d), Foodies needs to
  increase its offer to Petrolheads by at least
  375K to lure Petrolheads away from Worthwools.
  This is equal to 0.25 cents/litre ( 375K/150M)
  increase offer from 1.75 cents/litre to 2.0
  cents/litre
• Feasible? Yes if Foodies makes this offer, it
  will still be better off (new surplus is 1.125M
  - 375K 750K)
• Common mistakes- Answering half the question -
  eg, yes to feasibility, but no specific offer-
  Forgetting about Petrolheads current 10M profit

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General tips

• Dont forget to do sanity checks on your
  calculations/conclusions eg- if in 1a) you
  calculate that the entry-deterring price is less
  than Gidgets 160 unit variable cost, this is
  a good signal that something is amiss- if in
  1c) you calculate that Madonna is better than
  Brittany, check whether this makes sense. Of
  course, in real life it doesnt and it
  doesnt here either, as Brittany has 2 advantages
  over Madonna (cheaper and higher probability of
  success) and no disadvantages- if in 2a) your
  calculations show Petrolheads making a profit,
  ask whether this makes sense, given that its
  profit margin before discounts is 3 and it
  would bear the cost of the discounts (4 of
  sales)
• Read the question very carefully and make sure
  that you answer each part of it
• Always attempt every question an attempt is
  worth some marks, which is better than the value
  of the next best alternative (0)

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Other

• Rest assured that students were not penalised in
  subsequent parts of a question if they got an
  earlier part wrong (eg, if in 1b) you concluded
  that Madonna was better than cutting price and
  then used her as the next best option to
  Brittany, you were not disadvantaged in 1c)
• Thank you to the many students who pointed out
  the correct spelling of Ms. Spears first name!