MGT 1115 REVIEW PROBLEM SETS – CHAPTERS 10 – 17

Instructions: The following are chapter end questions that applies learned concepts to real life
business situations. Your role is to review how each problem was solved. Beside each problem
title, indicate the concepts used to solve it.

10-1 High Rivalry

For each category, indicate which condition is associated with higher rivalry among competitors.

Number of Firms High Low

Fixed Costs High Low
Level of Product Differentiation High Low
Industry Growth High Low
Buyer Switching Costs High Low

The following are associated with higher rivalry:

Number of firms High Low
Fixed costs High Low
Level of product differentiation High Low
Industry growth High Low
Buyer switching costs High Low

10-2 Increasing Customer Value

To increase a company’s performance, a manager suggests that the company needs to increase the value
of its product to customers. Describe three ways in which this advice might be incorrect (Hint: Think
about what else might or might not change that affects profit.)

1. Value increases but price does not; consumer surplus increases but not profit
2. Value increases, price increases and cost increases all by the same amount– no change to profit
3. Value increases, price increases but cost increase is greater than price increase; profit is reduced.

10-3 Five Forces and the Airline Industry

Examine the U.S. passenger airline industry using the Five Forces. Is this an attractive industry? Why or
why not?

Supplier power
Labor unions: labor is a significant portion of cost, and unionization increases power. This is a
significant concern
Aircraft manufacturers: potentially high power given the relatively few number of suppliers but there is
fierce competition among them so power is less significant.
Fuel: fuel is a commodity and its suppliers have little power
Airports: can have significant power given limited supply of gates and landing rights, especially
international expansion.

Buyer power
Buyer power is moderately high; the product / service offered by the different airlines is relatively
undifferentiated and switching costs are low.
Substitutes
Alternate travel (car or train): can be a significant threat, especially for regional airlines.
Information technology alternative (e.g. videoconferencing): more threat for long distance, slows down
industry growth

Rivalry
Rivalry is high; there are many similarly situated airlines that tend to compete aggressively on price.
Fixed costs are high and industry growth is relatively low

Entry
While there are some significant entry costs, these can be overcome (e.g., via leasing rather than
purchasing jets)

Overall, this industry is not particularly attractive

10-4 Smartphone Market

The smartphone market has been dominated by Apple, but recently the Droid has been able to leverage
Google’s information services into market gains while Blackberry, known for its secure business-oriented
network, has attempted to become more attractive with a “friendlier” interface. At the same time, a
number of less capable fringe firms are emerging. How do these features fit into an industrial organization
(IO) view of the market versus a resource-based view (RBV)?

The IO view - The market had been a near Apple monopoly. The profits from this monopoly attracted
entry by Droid- and Blackberry-based phones that tended to increase rivalry between firms. The
emergence of smaller fringe firms suggests that entry barriers have fallen substantially so that
competition has or will soon become fiercer.

The RBV view - Each firm brings its own distinct capabilities to its product design, which appeals to
different segments of the market. Apple is known for aesthetics of their products, Google is known for its
ability to manage information effectively, and Blackberry is known for its more secure data network.
Each of these distinct capabilities is likely to be sustainable for some time and will be the sources of
competitive advantage for each. The fringe firms do not appear to be able to replicate these capabilities
and thus are more homogeneous and are more likely to compete on price.

Chapter 11

11-1 The Carry Trade

In 2014, the euro was trading at $1.35 on the foreign exchange market. By 2015, the rate had fallen to
$1.10, due to falling European interest rates. Explain the fall in the price of a euro using supply and
demand curves, and in words.

A decline in European interest rates reduces the cost of borrowing in the EU. This increases the “carry
trade” where US consumers or businesses borrow euros from EU banks, sell euros to buy dollars, and
spend or invest the dollars in the US. This increases demand for dollars which increases the price of a
dollar. The dollar appreciates against the euro.
You can do the equivalent analysis in euros and say that this increases the supply of euros, which
decreases the price of a euro. The euro depreciates against the dollar.

11-2 Brexit Fears

When Great Britain voted to leave the Eurozone, the pound depreciated 17% against the dollar. It also
raised fears that the Eurozone would fall apart. Explain how this fear would affect the dollar/euro
exchange rate.

The fear of uncertainty causes a flight to safety, so Europeans sell euros to buy dollars. This increases
demand for dollars which increases the price of a dollar. The dollar appreciates against the euro.

You can do the equivalent analysis in euros and say that this increases the supply of euros, which
decreases the price of a euro. The euro depreciates against the dollar.

11-3 Effects of the Pound Devaluation on Tourism and Bank Profits

Explain the effects of the pound devaluation on:
(1) imports and tourism to Great Britain; and
(2) profits of US banks with European trading subsidiaries in London (which earn profit in
pounds).

1) A currency devaluation hurts foreign suppliers because it makes foreign goods (exports from foreign
countries imported to Great Britain) more expensive to domestic consumers. The quantity of exports
falls. This hurts domestic consumers and foreign suppliers but helps domestic suppliers and foreign
consumers.

Tourism can be thought of as an “export” in that tourists are foreign consumers, who have a demand
for a domestic product (goods and services produced in Great Britain). A currency devaluation helps
foreign consumers and domestic suppliers.

2) Profits for US banks with trading operations in London earn profit in pounds and then sell pounds to
buy dollars to pay shareholders in the US. A pound devaluation would reduce the dollar profit of the
Bank’s London trading operation.

11-4 Effect of Expectations on the Exchange Rate

If market participants expect the krona to appreciate relative to the dollar, what will happen?

They will accelerate purchases of the krona (an increase in demand for krona), and delay purchases of
dollars (a decrease in demand for dollars). Both of these factors cause the price of a krona to increase, a
kind of self-fulfilling expectation.

Chapter 12

12-1 Parking Lot Optimization

Suppose your elasticity of demand for your parking lot spaces is –2, and price is $8 per day. If your MC is
zero, and your lot is 80% full at 9 A.M. over the last month, are you optimizing?

Because demand is elastic, a decrease in price will likely increase revenues and (since marginal cost is
zero) will increase profit. Therefore, it is unlikely that the lot is optimizing. However, one should
investigate how variable is demand. If the lot is 80% full each day, then decreasing price will be optimal.
On the other hand, if the 80% capacity figure is because the lot is at capacity on weekdays but nearly
empty on weekends, then prices might actually be too low. A price reduction would not increase the
number of customers on weekdays, and a price increase may nevertheless keep the lot at capacity.

12-2 Product Store Locations

Some high-end retailers place their most expensive products right in the entryway of the store, where
consumers will see them first, and place their more popular, better-selling items further back. Why?

They are likely trying to take advantage of psychological pricing. Since managing price expectations is as
important as managing price, focusing consumers on higher prices initially allows consumers to perceive
a discount, or a “win,” when they later encounter the less expensive items. By setting the reference price
higher, they are making consumers more likely to buy the items in the back when they do confront their
prices.

12-3 Macintosh Versus iPhone

When the Macintosh computer was introduced in 1982, Apple made it difficult for third party software
developers to develop software for the platform. In contrast, Apple makes it relatively easy for third-party
developers to make applications that run on the iPhone. Compare and contrast these two strategies.

When Apple made it difficult for third-party developers, it produced both hardware and software and
profited both from the sale of the computers and from the sale of software for those computers. Since the
hardware and software are complements, Apple priced each below its stand-alone profit-maximizing
price.

With the iPhone, Apple encourages third party developers. As the software apps produced by these
developers are complements to the iPhone, they make the iPhone more valuable, allowing Apple to raise
its price.

The relative value of the two strategies depends on how complementary software is to the hardware and
the relative ability of third-party developers relative to Apple.

Chapter (13)-14

14-1 Barbie Dolls and Accessories

Why might Mattel set a much lower margin on its Barbie dolls than on the accessories for the dolls?

This is a form of metering or “giving away the razor to sell the blades.” Consumers differ in their
willingness to pay for “the Barbie experience.” Those who value it a lot are probably going to purchase
more accessories than those who value it less. Purchases of accessories ‘meter’ consumers’ willingness-
to-pay for the experience. A higher margin for the accessories allows Mattel to extract more of the
surplus from the high types without losing the low types.
14-2 German Brothels
German brothels recently began offering a monthly subscription service for multiple purchasers If you
wished to reduce the incidence of prostitution, would you consider this pricing plan to be a desirable
change?

This is a bundling mechanism. Traditionally, prices include a profit margin and price exceeds marginal
cost. This means that there are unconsummated transactions that represent a value-creating opportunity.
By pricing each visit at marginal cost, you increase usage and, therefore, consumer surplus. The monthly
subscription charge is meant to capture some of this additional consumer surplus.

The result of such a pricing scheme is that the patronage of prostitutes increases, so those wishing to
minimize incidence of prostitution would not consider this desirable.

14-3 Microwave Ovens

A manufacturer of microwaves has discovered that male shoppers, on average, have lower values for
microwave ovens than female shoppers. Additionally, male shoppers attribute almost no extra value to an
auto-defrost feature, while female shoppers, on average, value the auto-defrost feature. There is little
additional cost to incorporating an auto-defrost feature. The manufacturer is considering introducing two
different models. The manufacturer has determined that men value a simple microwave at $70 and one
with auto-defrost at $80, while women value a simple microwave at $80 and one with auto-defrost at
$150. If there is an equal number of men and women, what pricing strategy will yield the greatest
revenue? What if women comprise the bulk of microwave shoppers?

There are three possibilities. First, we can market a single microwave (with auto-defrost) to both men
and women at $80. Second, we can market a single microwave (with auto-defrost) only to women at $150.
Third, we can version by selling a simple microwave targeted to men for $70 and an auto-defrost version
targeted to women for $140 ($70 + $150 - $80). The existence of a simple microwave constrains our
pricing on the auto-defrost one. Women value the auto-defrost feature at $70 ($150-$80), and therefore
its price cannot exceed that of the simple one by more than $70.

If there is an equal number of men and women (say 1 of each), the revenue from each of our three
strategies, respectively, is $80x2=$160, $150x1=$150, and $70x1+$140x1=$210. Therefore, offering the
two versions is best.

On the other hand, if almost all shoppers are women, the best strategy will be to sell only microwaves
with auto-defrost feature at $150.

14-4 Music Pricing

The pricing model for iTunes has been to price songs individually. Instead, Spotify opted to offer
unlimited song playing for a monthly fee. Would Spotify’s pricing model likely yield more profit than
pricing songs individually?

The per-song pricing policy of iTunes does not capture the consumer surplus from people willing to pay
more—sometimes much more—for some songs. It also does not capture the consumer surplus for songs
that people value less than the price but more than marginal cost. Thus, this policy "leaves money on the
table." It will leave more money on the table if the value that people attach to songs varies greatly across
songs and people.
The monthly subscription fee pricing policy of Spotify is an example of bundling and has the potential to
capture this "money left on the table." Spotify prices each song at $0, which is very close to the marginal
cost. This means that subscribers listen to more songs than they would if it charged per song this
generates more potential consumer surplus. Spotify can capture this surplus by charging a subscription
fee of just under the sum of the surplus for all songs listened to. Of course, not all music lovers have the
same demand curve for songs. What matters is if the value of the bundle is more homogeneous across
consumers than the values of the individual songs. This is likely to be true in this case.

14-5 Bundling
At a student café, there are equal numbers of two types of customers with the following values. The café
owner cannot distinguish between the two types of students because many students without early classes
arrive early anyway (i.e., she cannot price discriminate).

Students with Early Classes Students without Early Classes

Coffee $0.70 $0.60
Banana $0.50 $1.00

The marginal cost of coffee is $0.10. The marginal cost of a banana is $0.40. Is bundling more profitable
than selling separately? If so, what price should be charged for the bundle?

Mixed bundling is more profitable than only selling separately:

Mixed bundle: Price bundle at 160, earn 160-50=110; price coffee at 70, earn 70-10=60. Total Profit is
170.
Price separately only: price coffee at 60, earn 120-20=100; price bananas at 100, earn 100-40=60 Total
profit is 160.
Bundle only: coffee + banana at 120, earn 240 – 100 = 140; Total profit is 140.

Chapter 15

15-1 To Vote or Not to Vote

Mr. and Mrs. Ward typically vote oppositely in elections and so their votes “cancel each other out.” They
each gain two units of utility from a vote for their positions (and lose two units of utility from a vote
against their positions). However, the bother of actually voting costs each one unit of utility. Diagram a
game in which they choose whether to vote or not to vote.

Mrs. Ward
Vote Don't Vote
Vote
Mr. Ward
Don't Vote
ANSWER:
Mrs. Ward
Vote Don't Vote
Vote -1, -1 1, -2
Mr. Ward
Don't Vote -2, 1 0, 0

15-2 To Vote or Not to Vote Part II

Suppose Mr. and Mrs. Ward agreed not to vote in tomorrow’s election. Would such an agreement
improve utility? Would such an agreement be an equilibrium?

The Nash equilibrium of this game is for both to vote. This is the worst of all possibilities as total payoffs
are minimized here (this game is a prisoners’ dilemma). In fact, the outcome with the highest total payoffs
is for the couple not to vote. Therefore, an agreement not to vote would improve utility. However, because
cheating on the agreement is so hard to detect, it is easy to cheat and thus difficult to maintain the
agreement.

15-3 Compatibility
Microsoft and a smaller rival often have to select from one of two competing technologies. The rival
always prefers to select the same technology as Microsoft (because compatibility is important), while
Microsoft always wants to select a different technology from its rival. Describe the equilibrium of this
game.

This is a two-player, two-strategy, simultaneous move game. The actual payoffs could differ for different
students but the game should look something like this one:
Microsoft
A B
Technology A 1,-1 -1, 1
Rival
Technology B -1, 1 1, -1

There is no equilibrium in pure strategies. Therefore we expect that both the Microsoft and the rival will
randomize.

15-4 Salary Negotiation

The below figure represents the potential outcomes of your first salary negotiation after graduation:
 Employer

Low Salary Offer High Salary Offer

Employee Walks Employee Accepts Employee Walks Employee Accepts

Employer gets 0 Employer gets 100 Employer gets 0 Employee gets 100
Employee gets 0 Employee gets 75 Employee gets 0 Employer gets 75

Assuming that this is a sequential-move game with the employer moving first, indicate the most likely
outcome. Does the ability to move first give the employer an advantage? If so, how? As the employee, is
there anything you could do to realize a higher payoff?

Outcome = Low salary offer and employee accepts

Employer has a first mover advantage; can force movement down low salary offer side.
Employee strategy: communicate a clear, credible commitment to walking if salary offer is low.

Chapter 16

16-1 Newspaper Bargaining

Two equal-sized newspapers have overlap circulation of 10% (10% of the subscribers subscribe to both
newspapers). Advertisers are willing to pay $10 to advertise in one newspaper but only $19 to advertise in
both, because they’re unwilling to pay twice to reach the same subscriber. What’s the likely bargaining
negotiation outcome if the advertisers bargain by telling each newspaper that they’re going to reach
agreement with the other newspaper, so the gains to reaching agreement are only $9? Suppose the two
newspapers merge. What is the likely post-merger bargaining outcome?

The Nash bargaining outcome tells us that parties split the gains from agreement. Pre-merger, each
newspaper splits the gains to agreement, which are $9. So each newspaper receives $4.50. After the
merger, the newspapers bargain together and split $19. So the merged newspaper gets $9.50, an
increase of $0.50.

16-2 Airline Merger

American Airlines and British Airways are proposing to merge. If British pilots and American pilots are
represented by different unions, how would this merger affect airline costs?

After the merger, the airline could staff some flights with pilots from either union. That means that the
disagreement value for management negotiating with any one union is higher. As a consequence, each
union is in a worse negotiating position and we would expect salaries to fall thus reducing airline costs.
16-3 House Closing
You’ve entered into a contract to purchase a new house, and the closing is scheduled for next week. It’s
typical for some last-minute bargaining to occur at the closing table, where sellers often try to tack on
extra fees. You have three options for the closing: (1) attend yourself, (2) send an attorney authorized to
close only per the previously negotiated terms, or (3) pre-sign all the closing documents per the current
terms and not attend the closing. Which of these would be most advantageous from a bargaining position?

Attending the closing yourself would probably be the least attractive option. The sellers would know that
you have the authority to bargain over terms of the deal. Sending the attorney would be a better option
serving as your commitment that you would walk away from the deal unless it is closed per the current
terms. Pre-signing the papers would likely be the best option, as it is the most credible commitment to
your unwillingness to negotiate the terms (the sellers might believe that the attorney would have some
bargaining authority; pre-signed papers with no personal representative leaves little ambiguity regarding
your commitment).

16-4 A City and Its Unions

Robert G. Flanders Jr., the state-appointed receiver for Central Falls, RI, said his city’s declaration of
bankruptcy had proved invaluable in helping it cut costs. Before the city declared bankruptcy, he said, he
had found it impossible to wring meaningful concessions out of the city’s unions and retirees who were
being asked to give up roughly half of the pensions they had earned as the city ran out of cash. Why does
bankruptcy give the city bargaining power against its unions?

Remember that the alternatives to agreement determine the terms of agreement. Bankruptcy gives cities a
much better alternative—they can abrogate pension obligations in bankruptcy—and this alternative
allows them to gain a more favorable split of the proverbial pie, by extracting concessions from Unions.
Cities without this outside option have a more difficult time extracting concessions from Unions. [link].

16-5 PBMs
Pharmaceutical Benefits Managers or PBMs are intermediaries between upstream drug manufacturers and
downstream insurance companies. They design formularies (list of drugs that insurance will cover) and
negotiate prices with drug companies. PBMs want a wider variety of drugs available to their insured
populations, but at low prices. Suppose that a PBM is negotiating with two nondrowsy allergy drugs,
Claritin and Allegra, for inclusion on the formulary. The “value” or “surplus” created by including one
nondrowsy allergy drug on the formulary is $100, but the value of including a second drug is only $30.
a. What’s the likely bargaining negotiation outcome if the PBM bargains by telling each
drug company that they’re going to reach agreement with the other drug company?
b. Now suppose the two drug companies merge. What is the likely post-merger bargaining
outcome?

a. The payoffs are $100 to the PBM, $15 to one drug company, and $15 to the other.
b. The payoffs are $65 to the PBM, $65 to the merged drug company.

Chapter 17
17-1 Global Expansion
You’re the manager of global opportunities for a U.S. Manufacturer, who is considering expanding sales
into Asia. Your market research has identified the market potential in Malaysia, Philippines, and
Singapore as described next:

Success Level Malaysia Philippines Singapore

Probability Units Probability Units Probability Units
Big 0.3 1,200,000 0.3 1,000,000 0.7 700,000
Mediocre 0.3 600,000 0.5 320,000 0.2 400,000
Failure 0.4 0 0.2 0 0.1 0

The product sells for $10 and has unit costs of $8.

If you can enter only one market, and the cost of entering the market (regardless of which market you
select) is $250,000, should you enter one of these markets? If so, which one? If you enter, what is your
expected profit?

Yes, you should enter. The market you should enter is Singapore. The expected profit is $890,000.

Malaysia: Expected unit sales = 0.3*1,200,000+0.3*600,000+0.4*0 = 540,000

Philippines: Expected unit sales = 0.3*1,000,000+0.5*320,000+0.2*0 = 460,000
Singapore: Expected unit sales = 0.7*700,000+0.2*400,000+01*0 = 570,000

Expected profit of entering Singapore: 570,000*($10-$8) - $250,000 = $890,000

17-2 Game Show Uncertainty

In the final round of a TV game show, contestants have a chance to increase their current winnings of $1
million dollars to $2 million dollars. If they are wrong, their prize is decreased to $500,000. The
contestant thinks his guess will be right 50% of the time. Should he play? What is the lowest probability
of a correct guess that would make playing profitable?

You should play the game.

You have a 50% chance of winning $1 million dollars and a 50% chance of losing $500,000.
($1,000,000*0.5 = 500,000). (0.5*$1,000,000 + 0.5*-$500,000) = $250,000

Alternative way to look at the problem: It costs $1 million to play; if you are right, you win $2 million, if
you are wrong, you win $500,000. Expected value of playing is $1 million (0.5*2000000 + 0.5*500000)
= $1,250,000 which is higher than the cost of playing

The minimum probability of a guess to make playing still profitable is 33.3%.

$1,000,000(x) + (-$500,000)(1-x) = 0
$1,000,000x -$500,000 + $500,000x = 0
$1,500,000x = $500,000
X = ($500,000/$1,500,000)
X = 1/3 = 33.3%
17-3 Ad Agencies
To test the effectiveness of a two Web advertising agencies, you increase your ad purchase with agency A
by 50% without changing your purchase through agency B. The referrals to your website from agency A
increased by only 34% but the referrals from agency B fell by 21%. Why might the difference-in-
difference estimate of the referrals per dollar through agency A be biased?

To construct a "difference-in-difference" estimate of referrals per dollar, you measure the change in
referrals from Agency A (+34%) relative to the control group of Agency B (less -21%), for an estimate
per dollar of ((55%) change in referrals/(50%) change in dollars) or 1.1. However, in this case, there
may be some “leakage” since customers may have seen both ads laced by both agencies. The referral
may be the result of the cumulative views a customer sees from both agencies but the referral comes from
the last ad seen.

17-4 Disposing of Used Assets

Your company has a customer who is shutting down a production line, and it is your responsibility to
dispose of the extrusion machine. The company could keep it in inventory for a possible future product
and estimates that the reservation value is $250,000. Your dealings on the secondhand market lead you to
believe that there is a 0.4 chance a random buyer will pay $300,000, a 0.25 chance the buyer will pay
$350,000, a 0.1 chance the buyer will pay $400,000, and a 0.25 chance it will not sell. If you must
commit to a posted price, what price maximizes profits?

Price Prob. of sale Expected profit

$400,000 10% .1(400-250)=$15,000
$350,000 35% .35(350-250)=$35,000
$300,000 75% .75(300-250)=$37,500

A price of $300,000 yields the highest expected profit