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MANAGERIAL ECONOMICS
PHARMAGROUP
Managerial Economics Final Exam – 72 hours group project
Troels Tvergaard | CPR: XXXXXX - XXXX
Kåre Toft-Jensen | CPR: XXXXXX - XXXX
Olmo Rauba | CPR: XXXXXX - XXXX
International Business and Politics
Copenhagen Business School
8th April 2014
Word-count: 6.686
STU-count: 41.297
Page 1 of 27
1. By making use of your own assumptions and research make an external analysis of
the market that PharmaGroup is operating in.
PharmaGroup is operating in the pharmaceutical industry of medicine for movement disorders, an
industry characterized by high entry and exit barriers, economies of scale and few actors only. On
the basis of this notion we can conclude that PharmaGroup operates in a differentiated oligopoly.
Research and development of pharmaceutical products require a high front up investment because
they require a high degree of testing. There are high standards of regulations for the approval of
medicine in the different regions, e.g. the EU and North America. Due to the intensive research and
development phases, the released products will be differentiated products, but can to some degree
be substituted by a competitor’s product, all depending on consumer preferences. We choose to
look at the total market for movement disorder medicine, and not just single products.
We utilize the PEST-analysis tool to make an external analysis of the market PharmaGroup is
operating in. The PEST analysis looks at four factors, namely political, economic, socio-cultural
and technological, and determines the importance of these different factors in regards to the firm.
Political:
High standard of regulations for the medicine market, particularly in the mature markets.
Patent laws and regulations will be subject to change in the coming years in the EU.
Economic:
The pharmaceutical industry’s demand is not very sensitive to economic fluctuations, as
people will need medicine regardless of the economic situation.
In pharmaceutical growth markets, like India and China, the industry will to a higher degree
depend on the economic situation in the country.
Socio-cultural:
Consumption of prescription drugs has increased in recent year in the EU and North
America.1
An overall ageing population in Western countries leads to an increase in movement
disorders. 2
1 National Center for Health Statistics: http://www.cdc.gov/nchs/data/databriefs/db42.htm, retrieved 07-04-2014
Page 2 of 27
Technological:
Research and development of new drugs benefit greatly from innovations in technology
PharmaGroup’s most important markets are located in Europe and USA, with both exhibiting high
standards of regulation. The Pharmaceutical industry is not that sensitive to economic fluctuations
because patients require medical attention no matter the state of the economy. Likewise, the demand
for medication in mature markets is stable which upholds stable business planning. The
consumption of prescription drugs is increasing which grows the market in which PharmaGroup
operates. Furthermore, the mature markets’ population is ageing, which increases the demand for
medication, as movement disorders are especially prevalent with the elderly. Finally, overall
technological improvement and innovation improves research and development of new drugs for
PharmaGroup.
Porters Five Forces:
In order to further examine PharmaGroup’s external market we will employ a Porters Five Forces
analysis.
Forces Description Importance
Threat of
new entrants:
PharmaGroup operates in the pharmaceutical industry that, as previously
mentioned, exhibits a high degree of entry and exit barriers. These barriers
are embodied by severe capital requirements in the shape of R&D and
marketing, creating a steep learning curve and economies of scale. New
entrants face large requirements of financial resources. The difficulty of
approval through the three phases of testing of new medicinal products
creates another entry barrier. This dampens the incentive for new
competitors to enter the industry.
****
2Cleveland Clinic Journal of Medicin: http://www.ccjm.org/content/72/Suppl_3/S38.abstract, retrieved 07-04-2014
Page 3 of 27
Bargaining
power of
suppliers:
PharmaGroup’s suppliers include producers of raw material, local co-
marketing and the labour force.3 The bargaining power of labour can be
opposed by negotiating NDA with key employees. The threat of forward
integration from suppliers is small due to the substantial R&D costs.
*
Bargaining
power of
buyers:
The primary bargaining power of buyers resides within hospitals and
doctors, as they possess the essential knowledge and authority over all
prescription drugs. A typical exercise of bargaining power would be by
demanding quantity discounts with big enquiries. The bargaining power
located at the end consumer, the patient, is usually low due to limited
knowledge of the product and the prescription being issued by a doctor.
Additionally, many patients do not carry the costs themselves, because it is
carried by insurances or welfare programs. Thus, the end customer does not
have full information and therefore cannot develop a cost consciousness.
***
Threat from
substitute
products:
Generic products with low prices represent a threat for PharmaGroup.
However, the pharmaceutical industry is characterised by high standards in
PharmaGroup’s primary markets, USA and Europe. Additionally, the
pharmaceutical industry exhibits some degree of patenting, which may delay
or hinder the progress of competitive products. Based on this notion, the
primary threat from substituting products comes from established
pharmaceutical competitors.
**
Intensity of
rivalry
among
competitors:
The pharmaceutical industry is characterized by high fixed costs which
pressures organizations to achieve economies of scale. As mentioned earlier,
the high exit barriers may hinder organizations from leaving an unprofitable
industry because the highly specialized knowledge obtained through R&D is
difficult to utilize in other industries. To be able to differentiate in the
pharmaceutical industry actors must invest into R&D, which in turn leads to
even higher fixed costs.
****
To sum up, PharmaGroup operates in a differentiated oligopoly with a handful of strong
competitors. The industry has high entry and exit barriers mainly due too large capital requirements,
which leads to economies of scale. R&D and is a key investment to ensure future innovation and
3 Gassmann, et. al., Leading Pharmaceutical Innovation, Springer, 2
nd Edition, March 2008
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maintain market position in the primary markets of USA and Europe. Both the increase in
consumption of prescriptive drugs and the ageing population of the primary markets leads to an
increase in future demand for PharmaGroup’s products.
2. Describe the internal and the external view on strategy development and provide
suggestions as to how you see PharmaGroup should develop their business strategy.
To describe the internal view of strategy development we will present the value based and the
resource based approach.
PharmaGroup can examine internal strategy development through a value creating analysis. A value
chain analysis enables a company to ascertain the costs and value that emanate from each of its
value activities. A value chain analysis contains an examination of the primary and the support
activities. The primary activities are activities that are directly involved in the creation of products
or services. In the case of PharmaGroup, this could be the actual production of medicaments. The
support activities are activities that enable the primary activities to be carried out effectively. R&D
could be an example of a support activity that is crucial for value creation in PharmaGroup. An
important notion of the value chain analysis is the linkages between different activities where
economies of scope might ensue.
Another method to optimize internal strategy development for PharmaGroup is to utilize a resource-
based strategy. A resource-based approach is applicable to scrutinize internal capabilities of the
organization to formulate a strategy to gain a competitive advantage. A key aspect of the resource
based approach is to optimize tangible and intangible resources and the utilization of these
resources. Tangible resources are physical assets that an organization possesses, such as production
plants and machinery, capital assets and human capital. Intangible resources include intellectual and
technological capacities and a company’s ability to innovate. These resources are often imbedded in
workflows, rather than being directly measureable. Finally, core competencies are cluster abilities
that an organization possesses which give them a competitive advantage, because this combination
of certain abilities is difficult to imitate.
We suggest that PharmaGroup adopts the value-based approach for their internal strategy
development. PharmaGroup could hereby unlock economies of scope in the linkages between
technology development and operations activities.
Page 5 of 27
To analyse the external view of strategy development we present and formulate growth and generic
competitive strategies. Additionally, we will draw from the Porters Five Forces analysis from
question 1, in which we mapped external industry characteristics.
One approach to look at external strategy development is by applying Porter’s Generic Competitive
Strategies. This model firstly places a firm within a competitive scope, which can be industrywide
or in a particular segment, and then looks at whether the firm will try to gain their competitive
advantage through differentiation or lowering costs.
We assume that PharmaGroup operates within the industry of medicine for movement disorders.
We can hereby place PharmaGroup as industrywide within in the competitive scope, as they
provide medication for multiple movement disorders. PharmaGroup attempts to gain a competitive
advantage through differentiation. This is achieved through extensive R&D which helps
PharmaGroup to launch innovative medicaments. It is important to note that even though a
company employs a differentiation strategy, said company clearly still has a focus on keeping costs
low. Still, PharmaGroup does not attain its competitive advantage through low costs but by
differentiation.
Another approach is by applying Ansoff’s model of Growth Strategies. This model looks at whether
a company wants to stay in the present market or enter new markets, and if it wants to do this with
existing or with new products. The different combinations are called as follows:
Market penetration: present market, present product
Market development: new market, present product
Product development: present market, new product
Diversification: new market, new product
PharmaGroup has a strong base in the US and Europe which make up 83% of their total sales. We
suggest that PharmaGroup’s primary growth strategy should focus on these market. PharmaGroup
utilizes the market penetration strategy through an on-going marketing effort on the present
markets. Additionally, PharmaGroup invests significant capital into R&D in the pursuit to develop
Page 6 of 27
new products. Thus, the overall growth strategy should be a mix of market penetration and product
development.
In the long-run, we suggest that PharmaGroup has an increased focus on the Asian markets in China
and India. The consistent high growth rate of an average of 12% over the last 8 years indicates that
market development will yield future growth.
One thing for PharmaGroup to keep in mind is to focus on sound financial resolutions, because of
the large fixed costs and investments in R&D, which are essential to operate successfully in the
pharmaceutical industry.
3. How can the Boston Consulting Group Matrix be particularly helpful for companies
like PharmaGroup?
The BCG Matrix is a classic portfolio analysis that with the help of a logarithm illustrates market
share and growth rate to assess current performance. The model is used to visualize the success of
single business units or products. The BCG matrix is particularly helpful for PharmaGroup because
they employ a portfolio with many different products, which is continuously developed and revised.
The matrix helps to monitor which products performs better, giving valuable information on where
to intensify marketing, sales and innovation efforts. Furthermore, PharmaGroup can use BCG
Matrix to see the lifecycle of their products through the trends of growth and market shares.
Each product can be classified as either
Star: high growth, high market share
Question mark: High growth, low market share
Cash cow: Low growth, high market share
Dog: low growth, low market share.
For PharmaGroup, we assume that a question mark is a newly developed product, which has passed
the three patent phases, but have not achieved a high market share yet. Through a BSG matrix
PharmaGroup can analyse how markets react to newly developed products.
Page 7 of 27
4. Provide your own assessment of the business risk for this investment
There is several business risks associated with this investment. First of all, there is a high fixed cost
which gives PharmaGroup a high degree of operating leverage. A high degree of operating leverage
entails a higher business risk and makes PharmaGroup’s business more sensitive towards changes
in sales. Secondly, assuming Xiquinon is not going to be approved in the three phases of clinical
approval, the product can’t be launched and will not generate any revenue. Thirdly, there is a degree
of demand uncertainty. From the investment is made until it starts to generate revenue it takes 3
years, the demand for Xiquinon could change within this timeframe. Having clarified that, we
assess the business risk for this investment to be fairly high.
5. How could PharmaGroup try and reduce the business risk as much as possible?
PharmaGroup could reduce the degree of operating leverage and thereby the ratio between total
fixed cost and total variable cost. If they choose to do so, they will be less sensitive towards changes
in sales. The degree of operating leverage can be calculated by the following equation:
Another way to reduce their business risk is by getting external investors to be a part of the
investment. They pay a share of the fixed cost involved with this investment and in return they get
shares of the company or shares of the future revenue. Furthermore, they could cooperate with
another company within the industry and thereby share the risk of the investment. However, it is
difficult to do a low risk investment in the pharmaceutical industry. A new drug requires a costly
research and development, which includes the three phases of approval. A way to counteract the
high business risk could be to choose a financing structure with a low financial risk by having a low
degree of financial gearing.
6. Make a proposal for the discount rate you think should be applied for the investment
and provide arguments.
The discount rate can be estimated by using WACC, Weighted Average Cost of Capital.
PharmaGroup needs a total investment of € 144 million during the first two years. We assume the
investment to be financed by both debt and equity. It will be financed by 65 % debt and 35 %
Equity. We assume the annual nominal interest rate of the loan to be 10 %. PharmaGroup is among
% ( )
% ( )
Q P AVCDOL
Q Q P AVC TFC
Page 8 of 27
the largest companies within the pharmaceutical industry for treatment of movement disorder, we
assume they have a proven track-record and are an established company. A nominal interest rate of
10 % seems reasonable in that light. Had PharmaGroup been a start-up company, the interest rate of
their loan would be higher and it would in many cases be impossible to be financed by a bank loan,
because they have not reached the point where they are able to secure a bank loan. In such a case
venture capital would be an option, where the investor earns equity in the company and in return
provides capital.
The opportunity cost of equity is estimated to 21 %. As elaborated in question 4 we consider the
business risk of the investment to be characterized by fairly high risk. Currently, thirty years US
Treasury bonds offer a return rate of 3.58 %4. Investing in the state bonds market is generally
considered as a low risk investment. The return for our high risk investment should be remarkably
higher. By looking at several pharmaceutical companies at the S&P 500 index, the general trend is a
21 % return on equity. We consider it reasonable to apply the same opportunity cost of equity to
this investment. Novo Nordisk, a large Danish operator within the pharmaceutical industry, has the
past three years had a return on equity above 40 %.5 However, we consider this to be a too
optimistic estimation of PharmaGroup’s return on equity.
We is the proportion of equity in the capital structure. Ke is the opportunity cost of equity. Wd is the
proportion of debt in the capital structure and Kd is the cost of debt which is normally expressed by
the interest rate.
Discount rate = 13.85 %
7. Based on the information at hand, do your own financial evaluation of whether the
investment is worthwhile pursuing and state all your assumptions.
Common methods of evaluating an investment are the following three, net present value (NPV),
internal rate of return (IRR) and annuity. Based on the cost of capital, NPV discounts all future cash
flows of the investment back to present time. If the NPV is positive, the investment adds value to
4 National bank of Denmark’s Statistics bank: http://nationalbanken.statistikbank.dk
5 Novo Nordisk’s annual report 2013: http://www.novonordisk.com/images/annual_report/2013/Novo-Nordisk-
Annual-Report-2013-UK.pdf
Page 9 of 27
the firm. If NPV on the other hand is negative the investment reduces the value of the firm and is
not worthwhile pursing.
The IRR calculates the percentage rate of return of an investment, when the NPV have a net present
value of precisely 0. If the IRR is greater than the discount rate the investment is profitable. The
annuity calculates the average annual cash flows of the investment. If the investment has an average
positive cash flow the investment should be done, if it is negative it is not worthwhile pursuing. All
three methods have to be looked at in comparison before making a final evaluation of the
investment.
Please see appendix 1 for the investment’s cash flow and calculation. One could have chosen a
longer time horizon of cash flows than 10 years, and this would result in a higher NPV, IRR and
Annuity due to the fact that our cash flows have a positive value of € 61.504.625 from year 7 and
onwards. We have, however, decided to limit the time horizon to 10 years, because we think the
uncertainty would get too high.
The key figures are illustrated in the table below:
NPV € 11.718.483
IRR 15%
Annuity € 2.233.445
The net present value is calculated to be € 11.718.483, which means that the investment is
profitable and is worthwhile pursuing. The Internal Rate of Return is at 15 %. This is slightly higher
than our discount rate. The annuity is calculated to be € 2.233.445, which means that the investment
has a positive average return of 2.224.445 in each time period.
Because the NPV is positive and the IRR exceeds our discount rate of 13,85 %, we conclude that
the investment is worthwhile pursuing. However, the IRR is only 1,15 percentage point higher than
our discount rate. If we had chosen a higher cost of debt or the investors had required a higher rate
of return on equity, we would have estimated a discount rate above 15 %, and the investment would
not be pursuable. The discount rate could be lower with a higher financial gearing of
PharmaGroup’s financing structure associated with this investment. However, they need to be
aware the risk involved in a high financial gearing and particularly if they combine high financial
gearing with a high degree of operating leverage.
Page 10 of 27
8. Analyse and provide calculations with regards to the investment uncertainty
All types of investment carry some sort of uncertainty and this is also the case with PharmaGroup’s
investment in the new drug Xiquinon. Our financial evaluation in question 7 was built upon
estimates. The risk of the investment can be reduced by a proper analysis of the uncertainty of the
investment. First we do a break-even analysis and see how much the estimated units sold can
decrease before the investment turns unprofitable and unattractive. We find the critical values to
determine the break-even point, which we set at a minimum accepted NPV of 0. Our critical factor
is units sold. To calculate how much our units sold could change until NPV is equal to 0, we used
Excel and the goal seek tool.
Break-even analysis Xiquinon
Sales in units 4,90 %
If the total sales drop by more than 4.90 %, the investment will turn unprofitable. This is the stage
where we reach a NPV of 0.
Another way to analyse the investment uncertainty is by doing a scenario analysis. We have made
three different scenarios for the outcome of the investment; Best case scenario, base case scenario
and a worst case scenario. Please see appendix 2 for the different scenario’s cash flow.
Worst case
scenario
The competitor develops a superior substituting product:
Sales drop by 35 %
The probability for this to occur is 10 %
Key figures:
NPV = € -71.942.427
IRR = 1 %
Annuity = € -13.711.690
Base case scenario The example provided in the case:
Sales stays as elaborated in the exam case
The probability for this to occur is 80 %
Key figures:
Page 11 of 27
NPV = € 11.718.483
IRR = 15 %
Annuity = € 2.233.455
Best case scenario Government subsidy for Xiquinon which impact demand positively:
Sales increase by 18 %
The probability 10 %
Key figures:
NPV = € 54.744.093
IRR = 21 %
Annuity = € 10.433.816
With the three scenarios we calculated the expected NPV;
( )
( )
By applying the critical value tool and the scenario analysis we can conclude that it is a fairly
uncertain and risky investment. If the estimated future units sold is reduced by 5 %, the investment
will turn unprofitable. The total expected NPV is € 7.654.953 which can be considered to be rather
low compared to the investment of € 144 million before PharmaGroup can launch the product.
9. How does the above information impact your above analysis of the investment? State
and make your own assumptions in order to build up a presentable business case
A third way to analyse the uncertainty of an investment is by doing a real options analysis with a
decision tree. This splits up the investment decisions as desired by the board of PharmaGroup. The
€ 34.000.000 already invested is a sunk cost and should not be taken into consideration when
evaluating the investment before phase-II and phase-III approval. The management will at each
stage have the opportunity to decide whether to invest or not. The real options decision tree is
illustrated below:
Page 12 of 27
For simplicity we assume that Xiquinon will go directly through Phase II approval as long as they
invest €23 million, without any risk of a pure rejection or an investigation of future options. With
the good outcome we use the same scenarios as elaborated in question 8. With the mediocre
outcome we have use the same scenarios, but agreed to share 20 % of our total revenue with the
other player in the industry.
The different expected NPV outcomes of the investment are illustrated in the table below:
Good outcome – phase 2 Mediocre – phase 2
Best case: € 98.572.169 * 10 % = € 9.857.217 Best case: € 34.840.436 * 10 % = € 3.484.044
Base case: € 49.963.220 * 80 % = € 39.970.576
Base case: € -4.046.723 * 80 % = € -3.237.378
Worst case: € -44.554.180 * 10 % =
€ -4.455.418
Worst case: € -79.660.644 * 10 % =
€ -7.966.064
Expected NPV: € 45.372.375 Expected NPV: € - 7.719.399
Inve
st
Good 70%
Best
Base
Worst
Mediocre 20%
Best
Base
Worst Rejection 10%
Page 13 of 27
Rejection - phase 2
Expected NPV: € -87.000.000
We have estimated the three outcomes of Phase II with the following probabilities:
Good: 70 %
Mediocre: 20 %
Rejection: 10%
The total expected NPV of the three outcomes is €21.516.783, so we advise PharmaGroup
undertake the initial investment of € 87.000.000.
We then evaluate the investment of € 23.000.000 for Phase III. Our advice for PharmaGroup is as
follows:
Outcome of Phase II = good:
PharmaGroup should undertake the investment, because the expected NPV is positive at €
45.372.375.
Outcome of Phase II = mediocre:
PharmaGroup should not undertake the investment, because the expected NPV is negative at € -
7.719.399.
Outcome of Phase II = rejection:
PharmaGroup should not invest anything, as it would require a substantial investment to redo Phase
II testing.
10. Illustrate the loan’s cash flow
Please see the loan’s cash flow in “appendix 3 – question 10”. A serial loan is characterized by
equal instalments in each time period. The amount of interest decreases as the principal goes down
and the total payment decreases over time. The advantage of a serial loan is that the initial time
periods reduce the principal as much as the last time periods. Furthermore the debt is paid down by
Page 14 of 27
the same amount in each time period, which is also an advantage. The last advantage is that the
payment is reduced and becomes smaller over time. The disadvantage is that the payments are high
in the initial periods and if the investment has not generated positive cash flows in the introduction
phase, the high payment can be problematic to cover. However, the serial loan PharmaGroup has
been offered includes a three year instalment free period and thus begins the high payment when the
investment starts to generate revenue. The illustration below shows the ratio between the interest
and instalments for the serial loan:
In the first 12 time periods there is only interest, illustrated by the blue colour. From time period 13
and onwards PharmaGroup starts to pay instalments and as the loan is amortized the ratio between
interest and instalment goes down.
Page 15 of 27
11. Calculate the effective annual interest rate.
The effective cost of debt is the actual interest rate paid, it is important to take the effective cost of
debt into consideration and not only look at the nominal interest rate. The effective cost of debt and
thereby the quarterly effective interest rate can be found by the IRR formula in Excel.
This gives us a quarterly effective interest rate of 2,11 %. To get the annual effective interest rate,
we use an equation which takes the compound interest into consideration:
( )
( )
If we compare the nominal interest rate of 8 % with the annual effective interest rate we can
conclude that PharmaGroup is effectively paying 0,71 percentage points more than the nominal
interest rate.
12. Apart from the loan’s effective annual interest rate what other issues would you
consider?
Apart from the effective annual interest rate, PharmaGroup should consider if the loan type suits the
investment. The serial loan offered has high payments from the initial phase and at that point the
cash flow of the investment has not started to generate a high return. A way to avoid a liquidity
problem in the initial phase of the loan is to have a longer grace (instalment free) period. Another
solution is to get an annuity loan, where the payments are equal in each time period. Furthermore,
PharmaGroup should consider which currency they obtain the loan in and exchanges rates with
regards to this. Assuming that the US market is PharmaGroup’s main market and their finance
structure is denominated in Euros, they are vulnerable to exchanges rate fluctuations and in worst
case unable to pay back their loan. We advise PharmaGroup to get the finance structure
denominated according to their sales in Europe and US, to avoid this currency risk.
Page 16 of 27
It is also of great importance to consider the rating and stability of the bank where the loan is
obtained, because this will impact the interest rate and the general agreement with regards to the
loan, i.e. security, termination and change of repaying schedule.
If the investment shows to have a higher return than expected and the risk profile changes due to a
greater stability we would advise PharmaGroup to look at the possibility of refinancing for a loan
with lower interest rate. However, it should carefully be looked upon if this is desirable.
Refinancing is often associated with a front and administration fee which can be an expensive
business.
13. Explain and provide calculations assuming that competition plays out based on
volumes.
If the competition plays out on volumes, PharmaGroup finds itself in a Cournot duopoly. In this
market structure, two firms are facing each other, and each firm decides which quantity to produce
based on the other firms decision on quantity. They take for granted the quantity provided by the
other firm, and thus the demand they face is equal to the market demand minus the quantity
provided by the other firm. Each firm will optimise production by setting MR = MC. The firms will
continue to react on each other’s decisions, until equilibrium is reached. Both firms have the same
cost, in this case MC = 3.000. Assuming that both firms produce products that are perfect
substitutes, equilibrium can be derived with the following method:
Page 17 of 27
We know that:
Thus:
Equilibrium at:
Isolate Q to get the reaction functions:
Solve for Q by substituting Q2 into the reaction function of Q1:
Page 18 of 27
(
)
And by symmetry
Substitute both Q into the demand function to find P:
As we have no information on fixed cost, we assume total fixed cost to be equal to 0.
Furthermore, we assume MC to be constant at 3.000.
Total revenue for each firm:
Total variable cost for each firm:
∫
Profits for each firm:
.000
Page 19 of 27
Both firms operate at the same quantity and price, so by symmetry, they both have the same profits.
PharmaGroup and its competitor will end up setting quantity at 9.000 at a price of 12.000, which
yields a profit for each firm of 81.000.000. This is the Nash equilibrium (9.000, 12.000) at which
both firms will arrive.
14. Explain and provide calculations assuming that competition plays out based on
prices
If the competition plays out on prices, PharmaGroup finds itself in a Bertrand duopoly. In this
market structure, two firms are facing each other, and each firm decides which price to set based on
the other firms decision on price. They each take for granted the price set by the other firm.
If PharmaGroup knows the price that its competitor sets, it will set a slightly lower price to capture
all the market demand. The competitor knows this though, and will try to undercut PharmaGroup’s
price. When both firms set the same price, they each get half of the market demand. Should a firm
set their price below the marginal cost, they would make losses, so they will avoid that. This leads
to a Nash equilibrium, where both firms set their price equal to marginal cost. This means that
neither PharmaGroup nor its competitor will make any profits. As in the Cournot duopoly, we
assume that both firm’s products are perfect substitutes.
We know that:
Thus
Total demand:
PharmaGroup and its competitor split the market demand equally, so each firm will produce a
quantity of
Page 20 of 27
As we have no information on fixed cost, we assume total fixed cost to be equal to 0.
Total variable cost for each firm:
∫
Total revenue for each firm:
Profits for each firm:
PharmaGroup and its competitor will end up setting quantity at 13.500 at a price of 3.000, which
yields no profit for both firms. This is the Nash equilibrium (13.500, 3.000) at which both firms will
arrive.
15. What can you say about the pay-off matrix and the most rational decision seen from
PharmaGroup’s perspective?
Page 21 of 27
We assume, as the two firms are competitors, they do not cooperate on price setting. If both firms
set high prices, each of them could get a higher pay-off by setting low prices, provided that the
other firm stays at high prices. Therefore, they will not both set high prices. If PharmaGroup sets
high prices and the competitor chooses to set low prices they will have a negative payoff of 500. If
PharmaGroup on the other hand choses to set low prices, and the competitors set high prices,
PharmaGroup will have a profit of 1000. The competitor faces the same conditions. This leads to a
dominant strategy where the competitor and PharmaGroup both choose low prices, as this is the
choice with the highest pay-off regardless of the other firm’s decision. This is an example of the
classical prisoner’s dilemma, where the dominant strategy of both players, and thus the Nash
equilibrium, yields a lower profit for both players. Would they cooperate, they would each have
profits of 500 rather than 100, but their dominant strategy dictates otherwise. The most rational
decision seen from PharmaGroup’s perspective is to set low prices.
16. Would your above conclusions change if the situation is viewed as a repeated game?
If the game is repeated, there is a possibility that both PharmaGroup and its competitor will be
afraid of retaliation by the other, because they know they will have to face them again. This could
lead to cooperation in the future, where both firms agree on setting high prices. Both firms would
stick to their promises of keeping high prices, knowing that if they cheat by setting low prices, they
will get punished in the future. Over time, PharmaGroup and its competitor could build up trust and
keep up their promises. Should one of the firms set low prices to gain an advantage, the other firm
would react to this by setting low prices in turn, and they would be back at the original prisoner’s
dilemma. In this case, both PharmaGroup and its competitor would end back at setting low prices.
Alternatively, the firm that cheated in the first time will go back to agreeing on high prices. Both
scenarios are possible. This is called a tit-for-tat strategy; do to your competitor as he does to you.
This strategy has shown to be the most profitable one for both parties in the long run.
17. Could and should PharmaGroup do anything to deter/influence the competitor’s
decision?
PharmaGroup could signal credible threats to its competitor. They could threaten to undercut the
equilibrium price to try and get a bigger market share by sacrificing profits. Although a costly
strategy, there is a chance that this would push the competitor out of the market. This threat could
be made credible by written commitments to customers to undercut any lower price by the
competition. Credible threats would increase PharmaGroup’s profits over time. Furthermore,
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PharmaGroup could spread false information on market conditions or the development stage of a
new product, thereby influencing their competitor’s decision to their own favour. All in all these
strategies are difficult and risky to implement, so PharmaGroup should refrain from implementing
any of them.
18. Would you suggest PharmaGroup to consider 2nd degree price differentiation?
There are several preconditions for using price discrimination. First of all PharmaGroup must be
price setters by controlling prices. Secondly, they must have information about the consumers,
typically found by customer analysis and market segmentation. The price discrimination must be
legal. The second degree price discrimination is illustrated in the diagrams below:
With price discrimination PharmaGroup is able to capture some of the consumer surplus and
convert it to producer surplus. With second degree price discrimination PharmaGroup will sell their
products in batches, consisting of a limited number of product units, and charge different prices for
different batches. Second degree price discrimination is also called “block pricing”.
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We would suggest PharmaGroup to consider second degree price discrimination, as long as the cost
of the market segmentation and consumer information analysis does not exceed the additional profit
gained by the price discrimination and if it does not break any legal terms.
19. Illustrate the data in a relevant way and comment on the data
The data can be illustrated with a total production function, units sold as function of number of
labour. Furthermore, we calculate the MPL,
, and the APL,
. The different values are illustrated
in the graph and table below:
0
200
400
600
800
1000
1200
1 2 3 4 5 6 7
Un
its
sold
Labour
Total Product of labour
Total productof labour
0
50
100
150
200
250
1 2 3 4 5 6 7
Un
its
sold
Labour
Marginal Product and Average Product of labour
Marginal Product
Average Product
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TP L MP AP
50 1 50 50
140 2 90 70
300 3 160 100
510 4 210 127,5
700 5 190 140
860 6 160 143,3333
1000 7 140 142,8571
The slope of total product is maximised when the MPL curve is at its maximum. The MPL and APL
will intersect at the maximum of the APL curve. At this point, we enter “Stage II of labour”. Until
they intersect each other, we operate in “Stage I of labour”. When MPL reaches 0, we enter “Stage
III of labour”, where adding an additional labour is decreasing the total product of labour. The
reason for the MPL to decrease and eventually become negative is due to the law of diminishing
returns. A firm will normally operate within Stage II of labour, where adding more labour still
yields a positive MPL.
20. Can you say anything about the optimal number of sales people to employ?
If PharmaGroup wants to maximize their total product of labour, they should employ labour until
MPL intersects the horizontal axis. However, this is not necessarily the optimal point because a
production normally includes some sort of labour cost. The optimal point in short-run production
theory is where the marginal resource cost of labour (MRC) equals the marginal revenue of product
(MRP). The MRC is calculated by
, and the MRP is calculated by
( )( ). It is beneficial to hire more labour as long as marginal revenue product of labour is
higher than marginal resource cost of labour. The case does not provide any information on the
marginal cost or marginal revenue, so we cannot determine the optimal number of sales people to
employ. The optimum will typically be in “Stage II of labour”. At L = 7, PharmaGroup have just
entered “Stage II of labour” and we assume that they still can hire some more labour to before they
get to the optimum.
21. What is your analysis of the present production set-up and would you suggest
changes?
To be at the optimal point in the long run, the slope of the isocost line needs to equal the slope of
the isoquant, marginal rate of technical substitution (MRTS). The MRTS is the rate at which one
input can be substituted by the other. The MRTS can be found by the following equation:
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With the information provided, the slope of the isocost line is calculated by:
The MRTS is equal to at Q = 2000 is:
With this calculation we can see that PharmaGroup is not operating at the optimum. We would
advise them to substitute some capital with labour to reduce their costs at the output level of Q =
2000. The total cost of the current production setup can be calculated by the following equation:
22. How can you illustrate this and what does it tell you about economies of scale for
this production?
We can illustrate the increase in production and inputs by drawing both isoquants and an expansion
path. The inputs capital and labour are increased by a factor of 3, output increases by a factor of
9000/2000 = 4,5. Because output increases by a higher factor than the increase in inputs, this
production exhibits economies of scale with increasing returns to scale. Due to high fixed costs and
relatively low variable costs, the long-run average cost is decreasing with an increase in output. The
fixed cost is divided among a greater number of produced units, thus the average cost per unit
decreases, and profits per unit sold increase.
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However, this is only a tendency between Q = 2000 and Q = 9000. We do not assume
PharmaGroup’s LAC curve to decline continuously as they expand their output. If this was the case
PharmaGroup would be in a naturally monopoly. Instead we assume their LAC curve to be L-
shaped, which means that the economies of scale are exhausted at some point and is kept more or
less constant afterwards. The LAC curve could look something like illustrated below:
0
1000
2000
3000
4000
5000
6000
7000
8000
0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34 36 38 40 42
K
L
Expansion path
Q = 2000
Q = 9000
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23. What is “economies of scope” and what could be examples of this for PharmaGroup
according to you?
Economies of scope refers to a reduction of the average cost by producing two or more goods
simultaneously at a lower average cost than if you would produce those goods separately. Utilising
an assembly line to produce several different goods, or selling bundles of goods rather than a single
good, are good examples of economies of scope. In the case of PharmaGroup, economies of scope
could include the research that is undertaken when a new medicine is developed. The knowledge
acquired throughout the research process could partly be applied to research on another product,
thereby reducing the time and resources required to finish the research. Furthermore, the production
of different medicinal products incorporates similar processes, so PharmaGroup could produce
several different drugs on one production plant.
