Managerial Economics II Exam Case 2015 - IBP Union · PDF fileCopenhagen Business School...

Copenhagen Business School Managerial Economics II April 2015 B.Sc. Intl. Business and Politics 3-day Exam Case

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Managerial Economics II Exam Case 2015 1. Provide an external analysis of the European market that EuroAero is operating in by doing your own research and stating your assumptions and sources EuroAero is an airline company that operates primarily within Europe but it also has intercon-tinental routes. We define the industry as the industry for European aircraft transportation. EuroAero is characterized as a low cost company and thus it competes in the market of cost-minimizing airlines. It has achieved high growth rates of 15-20 % for the last years. When making a strategic analysis of the external situation at the European market that Eu-roAero is operating in, we will look at the general environment as well as the competitive environment. In order to do this, we have chosen two models; a PEST analysis and Porter’s five forces. The general environment refers to the macro-environment, which EuroAero as an individual company can’t or only to a very limited degree can affect. Changes in the general environment affect organizations and industries, and therefore it is important to scan the gen-eral environment. In order to do so, we use the PEST analysis. It provides a link between the general environment and the competitive environment since we can identify weak signals and use them to improve the competitive environment. PEST analysis The PEST analysis examines at the significance of political, economic, social, and technolog-ical factors. Political factors have a big influence on the industry that we look at. New laws and regulations on air transport will determine to which degree the industry is restricted. This can arise from special political constellations that prioritize air security differently. Policies about taxes, minimum salaries, working conditions, and consumer-protection also highly af-fect the industry since it is very price sensitive. These changes can occur in single European countries, but can also be in the form of common standards set in the EU. Recently, we have seen how such political factors have affected airlines. Some current examples are; strikes for improvement of social and employment standards in big low-cost airlines like Norwegian and Ryanair. Additionally, in the aftermath of the recent attacks in respectively Paris and Copen-hagen, the European Union has started negotiating about new security restrictions for the air-lines. Similarly, the recent crash of a Germanwings plane in Seyne-les-Alpes, France has giv-en rise to a political discussion about introducing restrictions that impose the airlines to have two pilots in the cockpit at all times during flights (CNN, 2015). Such political decisions are likely to encumber/burden the industry significantly with higher costs. Economic factors are also very important since, as previously mentioned, the industry is very price sensitive. Furthermore, demand is also very sensitive to changes in income. Therefore, the demand for air transport could be affected by a financial crisis, a lowering in disposable income and/or price changes in alternative industries such as train- or car transportation. For low cost carriers even a small change in prices can have significant consequences. Often such changes in costs will be related to political factors. Elaborating on the case of employment standards in airlines such as Norwegian, Ryanair, and SAS, an achievement of higher stand-ards would lead to higher labor costs and thus incurring higher costs on the entire industry. Social factors may influence the industry since different social trends can affect the European demand for flights. In this regard, the cultural, economic, and political globalization has re-sulted in a vast increase in the demand for air travels in the past few decades. The world has


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become much more interrelated and this is partly a result of a changing economic capacity, but also of lifestyle choices and social trends. Technological factors are significant for the industry. The industry is very technology-heavy, and there are big barriers to entry because it is very costly to acquire the necessary technology and equipment. The introduction of new technologies stemming from investments in research and development can lower costs and thus prices within the industry. The degree to which technology is transferred between airlines is essential for the way the industry develops in the future. The PEST analysis could furthermore be extended to include legal and environmental factors. As previously mentioned, changes in legal factors can stem from political decisions. Envi-ronmental factors may also influence political decisions about air transport or the social atti-tude towards it. This is because air transport is very bad for the environment. In conclusion, the PEST analysis has been used as a framework to scan the general environ-ment and point out weak signals that might occur from different changes in the general envi-ronment. The factors are interconnected, and EuroAero must be aware of the development of these factors in the future. We must bear in mind that certain weaknesses are associated with the chosen model. In our analysis some factors that affect the general environment have been left out. If some of these factors had been included, their contribution could have affected the analysis. Furthermore, the change of the PEST factors and increasing unpredictability limits the PEST analysis. Porter’s five forces The competitive environment is composed of the industry and the market, and it can be af-fected by changes in the general environment. The competitive environment affects the organ-izations more directly than macro-environmental changes. We have chosen to analyze the competitive environment by using Porter’s five forces to make an assessment of the industry attractiveness, in other words, the potential to generate profits in that industry. Thus, we can assess EuroAero’s position in relation to their industry. The analysis is made at the level of the strategic business unit and the five forces are; the threat of new entrants, bargaining power of customers, bargaining power of suppliers, threat of substitutes, and the industry competi-tion as measured by the rivalry among existing firms. We have chosen to rate the strength of each force on a scale from 1-5, where 5 is the strong-est. Within the model it is possible to obtain up to 25 points, which would indicate that all forces are very strong. Thus it is hard to generate profits and the industry is not attractive. Forces Analysis Strength of

the force Threat of new en-trants

There are big barriers to entry in the industry. The capital requirements associated with starting an airline company are very high, giving existing firms a big cost ad-vantage. There are economies of scale in the industry, as the high capital costs need to be covered over a high volume of out-put. The industry requires plane- and flying experience and it takes time for an entrant to obtain a license.

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In addition to this, existing firms will exploit their high capital to keep away potential entrants by e.g. lowering costs or even taking on a loss. Some firms may benefit from early entry giving them first-mover advantages and making it difficult for new entrants to imitate their success. We therefore assess that the threat of new entrants is low.

Bargaining power of customers

The industry is very dependent on the customers and their will-ingness to pay. Customers’ demand for flights appears to be very price-sensitive, and they are very likely to switch to anoth-er airline or transportation firm since switching costs are low. There can be some loyalty to specific airline companies, but it is rarely enough to compensate for big price differences. Products are relatively undifferentiated and standardized among low-cost airlines, which gives consumers the confidence that they can find alternatives. Therefore, the bargaining power of customers is relatively strong. Customers can easily get access to information about prices etc., which increases their bargaining power.

4

Bargaining power of suppliers

The major suppliers are the airline manufactures. They supply technology-heavy equipment that is hard to imitate and their products are based on a lot of R&D work. Thus there are only few substitutes to the suppliers. The suppliers’ inputs are very important to the airlines, as the quality of the inputs is crucial and they use specialized compo-nents. Most airlines have long-term contracts with their suppliers be-cause they deal with high capital products, for which it is possi-bly best to make long-term loan agreements and have favorable credit terms. Therefore, the airlines cannot easily switch suppli-er. If the supplier changes the credit terms only a little, it can result in significant costs for the airlines. Thus, the suppliers have built up high switching costs. Because of the high capital requirements there are only few suppliers in the industry, which makes the bargaining power of suppliers relatively strong. Namely, there are two dominating airline manufacturers, which are Airbus and Boeing. Their in-puts are very standardized since planes are very similar and dif-ferentiation is low. On the other hand, the airline companies are the suppliers’ only customers which makes the suppliers very dependent of the air-line companies, giving a lower bargaining power of suppliers.

4 ½

Threat of substitutes

There are different substitutes to the airplane transportation in Europe such as fast-track trains, cars, buses, and ferries. These alternatives may be more or less costly, but one of their main costs is the cost of time, which we assess will lower the threat of substitutes. This is because air transportation has a significant time advantage. Another determinant is the convenience coming from e.g. the space available and the service. We assess the

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threat of substitutes to be slightly above medium. However, the train industry is improving rapidly with installment of more rails and replacement with faster trains.

Industry competition

The rivalry among existing firms is very intense in the European airline industry. There are several reasons for this; The number of firms in the industry stays rather constant since the industry is neither under- or over capacitated. Any excess capacity would usually result in a price war. The fixed costs are very high, which provides a high barrier to exit and creates pressure to increase the capacity to gain econo-mies of scale. Switching costs are low and the products are undifferentiated, and therefore none of the firms will hold a very large percentage of the market.

5

Added together the strength of the five forces sums up to 17.5 points. Given that the strength of the forces is 17.5 points, it can be concluded that the industry at-tractiveness is low. The analysis tells us that the rivalry among existing firms and the bargain-ing powers of suppliers are the two strongest forces in the industry. The threat of substitutes is medium-high and it might be increasing due to the development of especially fast-track trains. On the other hand, the threat of entrants is low. We can use the analysis to formulate a strategy that defends EuroAero’s position in relation to the five forces and to achieve a sustainable competitive advantage. In the light of this, Eu-roAero’s main priority should be to deal with the competition among the existing firms in the industry. We would advice EuroAero to pursue an overall cost leadership strategy in order to gain a such competitive advantage. Thus they should compete on the low-cost European air-line market. We must bear in mind that there are certain weaknesses associated with the use of this model. A significant lack of the model is the role of complements. In this industry an example of a complement could be the demand for resorts, as we could assume that the demand for resorts is positively related to the demand of flights. Furthermore, the resource-based view on strate-gy could be considered as an opposing model to Porter’s five forces, which instead considers that an organization’s competitive advantage derives from the organization’s resources and capabilities. 2. Describe how the value chain model can be applied and used in the context of Eu-roAero. Value chain analysis can help EuroAero to assess its resources and determine its strengths and weaknesses by looking at each of its activities and how much value they add. The analysis is conducted at the level of the strategic business unit. Thus it can be helpful for EuroAero when developing its internal strategy. The value chain analysis can be divided into primary and supportive activities, where primary activities are the ones that are directly involved in the creation and sale of a product or ser-


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vice. Supportive activities are the activities that ensure that the primary activities are carried out as efficiently as possible. EuroAero’s goal is to optimize the margin, which can be done by enhancing the value added in its own value chain, but also by enhancements in the interaction with value chains in other organizations. When the interaction is with the supplier’s value chain, we refer to upstream value, whereas the interaction with the customer’s value chain is referred to as downstream value. When managing the linkages optimally, all parties in the supply chain system will ben-efit and the organization will achieve a sustainable competitive advantage. For EuroAero, primary activities include inbound logistics, operations, outbound logistics, marketing and sales, and service. Support activities include procurement, technology development, human resource management, and firm infrastructure. EuroAero pursues a low-cost strategy, which implies that it must try to cut away any unneces-sary costs in the supply chain. In order to do so, it makes a detailed analysis of the costs of all inputs and the linkages among them. EuroAero might try to optimize upstream value by pressing the suppliers to cut the prices they ask of the retailer. It is also important that the Eu-roAero outsources any activities that another firm can perform cheaper. EuroAero can follow a lean strategy, which implies eliminating all waste by (Roos, Womack, & Jones, 1991). Value is only what the consumer will be willing to pay for so EuroAero must go into each stage and make sure that they are producing the right value for the right custom-er. We advice EuroAero to keep marketing costs low and minimize customer service because we assess that customers prefer low-price to high service. Having the position as clear cost leader provides sufficient marketing for the airline. For example there are several price com-parison websites, which work in favor of low-cost airlines. EuroAero can also use a just-in-time production method. This implies no stop in production, reducing lead times, and cutting inventory costs. Better coordination of the activities in an organization’s value chain can re-duce costs. 3. Provide your own assessment of the business risk for this investment Business risk is influenced by a number of factors. It is determined by the company’s industry and its cost structure. The following will examine the different factors affecting business risk. It can be evaluated through a PEST analysis, as done in Question 1, which found that espe-cially political and economic factors might make the future more uncertain for EuroAero. Another factor influencing business risk is demand uncertainty. It includes the risk that de-mand might change over time. From the investment begins till it starts generating profits, a long time passes and demand may have changed. Either way, demand is generally growing, which means that demand is likely to have increased from the time when the investment was initiated. Growth drivers are in favor of EuroAero, which has grown with 15-20 % the last years. They indicate a lower business risk in the company’s industry. Nevertheless, by pursuing a cost leader strategy EuroAero is very price sensitive and any change in prices from its suppliers or competitors will have a great impact on the business risk. This can be derived from our previous analysis of Porter’s five forces, which concluded that the competitive rivalry is very intense and this increases business risk. EuroAero is posi-tioned close to its competitors since they also operate at minimum costs. However, we must


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consider that EuroAero is a well-positioned and established company in the market. This low-ers the firm’s business risk compared to smaller and more recent airlines. We can use the firm’s Degree of Operating Leverage (DOL) as a measure for the business risk. DOL measures the ratio of the firm’s fixed costs to its variable costs. By looking at DOL, we include the risk stemming from the company’s cost structure. In the airline industry there is a big proportion of fixed costs associated with the production, which implies that Eu-roAero is highly leveraged. A high DOL entails a high business risk and it makes the compa-ny more sensitive to changes in sales numbers. We calculate the DOL for each of the two investments by using the following formula:

𝐷𝑂𝐿 = %∆𝜋%∆𝑄 = 1−

𝑓𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠𝑝𝑟𝑜𝑓𝑖𝑡𝑠

When calculating profits for respectively Boeing 373 and Airbus A420, we base the calcula-tions on a load factor of 80 %, which implies an annual revenue of € 33.6 million. We base our calculations on a load factor of 80 % because the general trend suggests that this is the average load factor of European airlines (IATA, 2014).

𝐷𝑂𝐿!"#$%& !"! = 1−4.3

(33.6− 11.5+ 4.3 ) =4.317.8 ≈ 0.24

𝐷𝑂𝐿!"#$%& !!"# = 1−4.6

(33.6− (11.92+ 4.6) =4.617.08 ≈ 0.27

Thus, we see that Airbus A420 has a higher DOL implying a higher business risk than Boeing 373. DOL is one of the largest contributors to business risk that management has the power to control. In conclusion, we assess the business risk to be at a fairly high level. 4. Propose the discount rate you think should be applied for the investment analysis and provide solid arguments. Discounting is a financial tool, which is used to compare cash flows generated at different times. The discount rate can be defined as the cost of using money for the opportunity at hand and is therefore also referred to as the cost of capital. The discount rate is a reflection of posi-tive time preference, risk, inflation, and taxes. There are two elements in the cost of capital; the cost of debt and the cost of equity. The cost of debt is the interest rate a financial institu-tion typically demands from lending money to a company. The cost of equity reflects the fact that a company’s shareholders miss the possibility of gains on alternative investments with the same risk profile if they choose to invest in the project at hand. In order to estimate a discount rate, we use the weighted average cost of capital, WACC. We assume no taxes. EuroAero will need to invest either $94.7 million if they choose to invest in the Boeing 373 aircraft or €81.1 million if they choose to invest in the Airbus A420 aircraft. We assume that the investment is partly financed with debt and that EuroAero has a capital structure where debt constitutes 45 % over the firms overall value and that equity constitutes 55 % of the firms overall value. This is a realistic capital structure for EuroAero because a company’s optimal debt-to-equity ratio will be one that offers balance between debt and equi-


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ty and the lowest cost of capital. A high financial gearing where a company holds a large amount of debt to equity will in theory provide a low cost of capital. However, as debt ratios increase the company’s risk will also increase, and shareholders will demand a higher return to be compensated for the higher risk. Furthermore, more profitable firms have lower debt ratios. We assume the annual nominal interest rate is 4.1 %, which seems reasonable since EuroAero is not a startup company, but has proven to be creditworthy and a reliable borrower. EuroAero can also provide their inventories as a security for the loan and this may make the bank willing to lend EuroAero the money at a lower interest rate. To estimate the cost of equity for EuroAero we use the Capital Asset Pricing Model (CAPM), which is a model that calculates the expected rate of return on the firm’s common stock based on its beta and the market risk premium. The expected rate of return on the firm’s common stock is also the company’s cost of equity. By looking at market betas for the air transport industry in Europe (Damodaran, 2015), we see that the general trend is a market beta of 1.5. Therefore we use 1.5 as a market beta for EuroAero. This also seems a reasonable market beta since cyclical firms – meaning firms whose revenues depend strongly on the state of the busi-ness cycle – tend to have high betas. Shareholders will demand a higher return from invest-ments whose performance is strongly tied to the performance of the economy, which will be reflected in a higher cost of equity. The risk-free rate in the market is considered the same as long-term government bonds, which are considered to be risk free because of the low chance that the government will default on its loans. The interest rate on a thirty-year UK government bond is currently 2.32% (Bloomberg, United Kingdom Government Bonds, 2015) so we use this as our risk-free interest rate. The market risk premium is chosen from a current global weighted average of 6.88 (Damodaran, 2015). With these numbers we can calculate our cost of equity.

𝑟! = 𝑟! + 𝛽 𝑟! − 𝑟! 𝑟! = 2.32+ 1.5 ∗ 6.88 = 12.6 %

Looking at a comparable European based airline company as Norwegian, this cost of equity also seems reasonable considering that Norwegian at the end of 2014 had a 11.14 % return on equity (Bloomberg, Norwegian Cruise Line Holdin, 2015). With the cost of equity and the cost of debt estimated, we can now calculate the weighted average cost of capital.

WACC = rE E/V + rD D/V WACC = 12.6 * 0.55 + 4.1 * 0.45 = 8.8

Discount rate = 8.8 % We use a discount rate of 8.8% for EuroAero projects. This discount rate seems realistic for airline companies where the general trend from 1993 to 2013 has been a discount rate be-tween 7 % and 9 % for airline companies worldwide (Aviation, 2013). 5. Based on the information at hand, do your own financial evaluation of the investment and in the confirmative of undertaking the investment, which aircraft type you suggest purchased. State all your assumptions. There are several methods to employ when making a financial evaluation of investments. The most common method to measure profitability is to estimate net present value, which express-


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es an investment’s degree of value creation. Net present value considers all cash flows of an investment and discounts them back to time 0 where the cash flows are added together. If net present value is positive, the investment creates value for shareholders whereas a negative net present value reflects a value reduction. When we make a choice between two mutually ex-clusive investments we choose the investment with the highest net present value since this is the investment that will be most profitable and create the most value for the company. Investments can also be evaluated using the internal rate of return method, which calculates the rate of return on an investment where net present value equals 0. However, different prob-lems arise when using the internal rate of return method to evaluate two alternative invest-ments, which involve the relative investment size of the projects. If one of the projects has a larger amount invested, the internal rate of return can be misleading. This is because IRR only looks at the return and does not consider the difference in the initial amounts invested. There-fore we will not use the internal rate of return to evaluate the two projects. A third method that is commonly used is the annuity value method. When the net present val-ue of the investment project is found, it can be converted into equal annual cash flows spread out over the fixed number of time periods. With the annuity value method we are given an average yield of the investment over its life span. For two alternative investments the project with the highest annual yield should be chosen. If the net present value and annuity value of the two investments are both negative, EuroAero should pursue neither of them. We will use the annuity value method and the net present value method to choose between the two in-vestment projects. Then we will reflect on the internal rate of return and the significance of the difference between the internal rate of return and the discount rate for the two projects. The initial investment for the Boeing 373 is $94.7 million and the initial investment for the Airbus A420 is €81.1 million. In order to compare the two investment projects, we will con-vert the investment of $94.7 million into euro. The current exchange rate between dollars and euro is 0.91830; therefore the $94.7 million investment is $94,700,000 * 0.91830 = 86,962,900 (OANDA, 2015). We will use our discount rate of 8.8 % to discount for time and risk. When calculating WACC we have assumed no taxes. We will also base our calculations of cash flows on the assumptions of no taxes. In order to calculate the annuity value of the projects, we use an annuity factor of !

!− !

! !!! ! = !!.!""

− !!.!""∗ !!!.!"" !" = 9,9839037.

The internal rate of return is calculated by using the Excel function IRR. Load factor 50 Boeing 373 Airbus A420 NPV -€ 32,211,949.20 -€ 33,430,249.44 Annuity -€ 3,226,388.21 -€ 3,348,414.65 Discount rate 8.8 % 8.8 % IRR 3.37% 2.65% For a load factor of 50 associated with revenues of €21 million, neither investments have a positive NPV or annuity. Furthermore, the internal rate of return is lower than the discount rate for both projects so EuroAero should not invest if they estimate their load factor to be 50. Load factor 60 Load factor 70

Boeing 373 Airbus A420 Boeing 373 Airbus A420 NPV € 6,328,855.55 € 5,110,555.31 € 47,622,574.93 € 46,404,274.68


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Annuity € 633,905.91 € 511,879.47 € 4,769,935.32

€ 4,647,908.88

Discount rate 8.8 % 8.8 % 8.8 % 8.8 % IRR 9.75% 9.63% 15.55%

15.84 %

Load factor 80 Load factor 90

Boeing 373 Airbus A420 Boeing 373 Airbus A420 NPV € 83,410,465.05

€ 82,192,164.80

€ 121,951,269.80

€ 120,732,969.55

Annuity € 8,354,949.14

€ 8,232,467.70

€ 12,214,788.26

€ 12,092,761.82

Discount rate 8.8 % 8.8 % 8.8 % 8.8 % IRR 20.27%

20.88%

25.21%

26.16%

From these key numbers we see that if EuroAero estimates a load factor of 60 or above both investment projects become profitable and EuroAero should invest. For all load factors of 60 or above, Boeing 373 have the highest net present value and the highest annuity. We also see that at a load factor of 60 the internal rate of return is slightly higher than the discount rate meaning that the project is profitable. As the load factor and the associated revenues increase the internal rate of return also increases for both projects. At a load factor of 90, the internal rates of return for Boeing 373 and Airbus A240 are respectively 25.21 % and 26.16 %, which is well above the discount rate of 8.8 %. Here we also see clearly why the internal rate of re-turn cannot be used to choose between the two different investment projects. If the investment project were chosen on the basis of the internal rate of return, this would suggest that Eu-roAero should invest in Airbus A420. However, Boeing 373 has a higher net present value and EuroAero should invest in Boeing if they expect a load rate of 60 or above. If they expect a load rate of 50, they should not invest in either of the projects. 6. Analyze and provide calculations with regards to the investment uncertainty stating your own assumptions When making investments, we must make some predictions about the future, which impli-cates some uncertainty. The longer the time horizon of the investment, the higher the uncer-tainty will be as there will be more possible outcomes to consider and the probabilities of the outcomes will become more uncertain. There are different methods for evaluating uncertainty and sensitivity of an investment such as break-even analysis, scenario analysis and real op-tions analysis. We will look at the uncertainty related to investing in Boeing 373 because we previously concluded that this investment was preferred to Airbus A420. Break-even analysis When using break-even analysis, we set up some critical values for how much an input factor can change before the investment becomes unattractive. We consider the investment as unat-tractive when NPV is negative. The minimum acceptable NPV = 0, which is where PV in-flows equal PV outflows. We use sales revenue as the critical value upon which the invest-ment attractiveness depends. The below formula can be used to calculate the critical values.


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𝑁𝑃𝑉(0) = 𝑓 𝐶𝐹, 𝑐𝑟𝑖𝑡𝑖𝑐𝑎𝑙 𝑓𝑎𝑐𝑡𝑜𝑟 𝑡 ∗ (1+ 𝑟)!!!!

Another way of calculating the critical value can be done by using an excel spreadsheet and the function “goal seek cell”, which gives us a critical value of € 24,510,310.37. We conclude that the critical value is relatively low. We can conclude that EuroAero should not fly if the sales revenues are less than € 24,510,310.37. If sales revenues are lower than this, EuroAero would suffer a loss since NPV would become negative. We must bear in mind that this method holds all other input factors than sales revenue con-stant. This is a simplification and therefore we might have underestimated the sensitivity. Scenario analysis When undertaking a scenario analysis, we set up different possible future scenarios that the investments might lead to. The scenarios will capture the interaction between relevant varia-bles. This can be done by setting up extreme cases of the worst and best-case scenario based on the base case. One can also choose to set up more scenarios. The worst case scenario is when all factors influencing the investment become negative at the same time whereas the best case scenario is when all factors influencing the investment become positive at the same time. In the table below, we have set up three scenarios for EuroAero’s investments. We predict what happens to NPV at different load factors, which EuroAero may face. We set our base case at a load factor of 80 and we assume that the probability of the worst case scenario is 30 %, the probability of the base case is 50 %, and the probability of the best case is 20 %. Worst case Base case Best case Load factor 50

(Annual revenue of € 21 million)

Nothing changes Load factor of 80 (Annual revenue of € 33.6 million)

90 (Annual revenue of € 37.8 million)

NPV € - 32,211,949.20 € 83,410,465.05 € 121,951,269.80 Probability of scenario

30 % 50 % 20 %

We use the values of the scenarios and their respective probabilities to calculate the total ex-pected NPV, which is the weighted-average investment model:

NPV0 = 0.30 * - 32,211,949.20 + 0.50 * 83,410,465.05 + 0.20 * 121,951,269.80 NPV0 = 56,431,901.73

Based on these calculations, we conclude that EuroAero should still pursue the investment in Boeing 373 because the expected NPV is positive. The three scenarios are simplifications since we could also have included changes in other factors that would have affected NPV.


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7. Explain the rationale behind having options on purchase of more aircrafts in the fu-ture The delivery time of aircrafts takes several years because of the complex manufacturing and assembly process. As previously mentioned, the issue for airlines is that the future demand does not necessarily reflect the present demand. An order of newly manufactured aircrafts may be highly needed now, but maybe not in the future where the aircrafts are delivered. Conversely, the situation could instead be that demand has increased by the time of delivery. This is why real options are worth investigating further upon. When choosing whether or not to purchase the aircrafts EuroAero has the first option, which is to commit now. They agree with the manufacturer and the deliverer, Boeing, where they lock the price and delivery date. This is done if their forecasts for the future give them a bul-letproof sign of increasing demand and profits, which is why the new aircrafts are needed. EuroAero is planning on using this option to place the order of 15 aircrafts for delivery in 2016. However, due to the uncertainty of the future they have not yet determined what option to use regarding the 20 extra aircrafts in 2017. Thus, EuroAero has to decide whether to use this option or one of the following two options. The second option EuroAero has is to buy an option from the manufacturer where they ac-quire the right to decide later whether to buy the aircrafts or not. Purchase options are – like the above choice – set with a fixed price and delivery date. However, the main difference is that the airline has acquired a right, but not an obligation to exercise the option to buy the 20 aircrafts. The third option is to wait and decide later. This option is chosen if EuroAero is uncertain of the future prospects for their company. The disadvantage of choosing this option is that Eu-roAero may have missed a favourable price by not buying the above option. When choosing the option to wait and decide later EuroAero has to agree on a new price when they want to buy. This future price might be a lot higher than the present price. If EuroAero places the order of 15 aircrafts for delivery in 2016, they are secured 15 aircrafts. Due to the uncertainty of the market it would be risky to use option one and place a further order of 20 additional aircrafts. As seen in the market analysis above in Question 1, there are many external factors affecting the demand for EuroAero’s services. Regarding the two next options the pay-offs from option three can never be better than the gains from option two. Even though there’s a cost connected to acquiring a purchase option (option two), it allows EuroAero to be more flexible to changing market conditions. We advice EuroAero to choose a combination of option one and two. 8. What happens to the expected return on stock? Provide explanations. The expected return on stock is the income that stockholders expect to receive for every €1 invested in the company. Initially, equity holders require an 18 % return on their shares while debt holders only demand a 12 % return on debt. By increasing our common stock with €100 million, common stock will increase from €250 million to €350 million while debt will de-crease from €400 million to €300 million. The overall firm value does not change and remains at €650 million. To examine how the expected return on equity changes, we will first deter-


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mine the cost of capital before the change in common stock. We will use the formula for the weighted average cost of capital since it takes into account the risk of both equity and debt.

WACC = rD D/V + rE E/V

WACC = 0.12 * (400/650) + 0.18 * (250/650)

WACC = r = 14.31 % We will use this discount rate (r) to calculate the expected rate of return on equity if new common stock is issued. The change in capital structure affects the composition of WACC, but WACC remains constant.

Return on equity (ROE) = r + (r – rD) D/E

Return on equity (ROE) = 0.1431 + (0.1431 – 0.12) (300/350)

Return on equity (ROE) = 16.29 %

WACC with new capital structure = 0.12 * (300/650) + 0.1629 * (350/650) = 14.31 %

Increasing common stock and thereby buying off debt will decrease financial gearing. This will cause financial risk to decrease due to a lower debt-equity ratio. The expected return on equity will decrease from 18 % to 16.29 %. The decreased financial risk causes shareholders to demand a lower rate of return on their stocks. 9. Explain what is a corporate bond and how it differs from ordinary borrowing. When companies invest in different projects they will have to decide how to finance these projects and as very few firms can finance an entire project with equity, the company will have to issue debt. Ordinary borrowing is one possibility when considering debt. We consider ordinary borrowing as a loan for a specific amount from a bank that is to be repaid following a schedule and has a floating interest rate. However, there are also many other different kinds of debt a company can issue. One of them is corporate bonds, which EuroAero is considering. Corporate bonds are a debt security, which are issued by a company and sold to investors. Investors are then entitled to a fixed set of cash payoffs. The company chooses a date where the bonds will mature and every year until the bond matures, investors receive regular interest payments. Corporate bonds are a key source of capital for many corporations along with equi-ty and bank loans. The more consistent the earnings of the company are and the higher the perceived credit quality of a company, the easier it becomes for the company to issue debt at low interest rates. However, even the companies with the highest perceived credit quality still have higher interest rates than government bonds. This is because corporate bonds are consid-ered more risky due to the fact that a government default is fairly unlikely. One of the main differences between ordinary borrowing and corporate bonds is that a corporate bond is high-ly tradable whereas a bank loan is not. Ordinary borrowing is a loan-relation between the bank and EuroAero. On the other hand, corporate bonds create a loan-relation between Eu-roAero and different investors.


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10. Provide a calculation and explanation for a WACC WACC is the weighted average cost of capital and it calculates the cost of capital for a given capital structure composed of equity and debt. The cost of equity and the cost of debt are pro-portionately weighted. WACC is used to determine the expected return on a portfolio of all the company’s existing securities. It is the opportunity cost of capital for existing projects and is used as a discount rate for the firm’s average risk projects. The lower the WACC, the less risky the portfolio of the company. WACC is calculated by the following equation:

WACC = (1 - TC) rD * D/V + rE * E/V This formula includes the corporate tax rate. By including taxes, the cost of debt decreases since it is multiplied by a number between 0 and 1. However, we have assumed that there are no taxes, and thus the formula is:

WACC = rD * D/V + rE * E/V In order to calculate WACC, we have to find the market value of both equity and debt. In the following we calculate this. Market value of equity = Market shares * price per share = 20,000,000 * €14 = €280,000,000

Market value of debt = Book value * percentage of book value = 300,000,000 * 0.9 =

€270,000,000 We are given the cost of debt (maturity) and the cost of equity and we are thereby able to cal-culate WACC:

WACC = 0.11 * 270/550 + 0.18 * 280/550

WACC = 14.56 % This WACC is quite low and shows that the firm is relatively low risk. A start-up firm will have a significantly higher risk while mature companies have a discount rate between 10-25 %. 11. Explain and provide calculations assuming that competitions plays out based on vol-umes When competition only has to be played out on volumes, the Cournot model can be applied. EuroAero competes under an oligopoly, which means that there are only a few dominating firms in the market. In the given situation EuroAero only has one main competitor and thus the situation is like a duopoly. The Cournot model assumes that each firm simultaneously and independently decides to produce a given quantity. Both firms seek to maximize profits based on the quantity produced by the other firm. Each firm finds its optimal price and quantity by equating marginal cost with marginal revenue.


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From the information at hand, we know that:

MC = 70 P = 1000 – 0.01Q

The total demand function depends on the quantity produced by both firms.

Q = QEuro + QComp P = 1000 – 0.01 (QEuro + QComp)

In order to estimate the optimal price and quantity, we will set MC = MR.

TR = P * QEuro TR = (1000 – 0.01 (QEuro + QComp))*QEuro

TR = 1000QEuro – 0.01QEuro2 – 0.01QComp*QEuro

We calculate MR by differentiating the TR function with respect to QEuro.

MR = TR’ MR = 1000 – 0.02QEuro – 0.01QComp

MC = 70

MR = MC

1000 – 0.02QEuro – 0.01QComp = 70 0.02QEuro = 930 – 0.01QComp QEuro = 46,500 – 0.5QComp

Since we have two different quantities, we compute two different reaction functions.

QEuro = 46,500 – 0.5QComp QComp = 46,500 – 0.5QEuro

Next, we solve for the optimal quantity by substituting QComp into QEuro.

QEuro = 46,500 – 0.5 (46,500 – 0.5QEuro) QEuro = 46,500 – 23,250 + 0.25QEuro

0.75QEuro = 23,250 QEuro = 31,000

The two airlines have identical reaction functions and thus they produce the same quantity. Total quantity is found by:

Q = QEuro + QComp Q = 31,000 + 31,000

Q = 62,000 In order to calculate the optimal price, we will insert this quantity into the price function.

P = 1000 – 0.01*62,000


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P = 380 The duopolist airlines each have an optimal price of €380 where they produce a quantity of 31,000 tickets between Lisbon and Zurich. They have identical optimal price and quantity because they share the same MC function and total market demand. Now we will turn to cal-culating the profit for each firm, which will be identical given the assumptions just stated. Profit is calculated as the difference between total revenue and total costs. We are not given any fixed costs and thus we will assume they equal 0.

MC = 70 TC = 𝑀𝐶 = 70Q TC = 70 * 31,000 TC = 2,170,000

TR = P * Q

TR = 380 * 31,000 TR = 11,780,000

Profit = TR – TC

Profit = 11,780,000 – 2,170,000 Profit = 9,610,000

Due to the fact that the firms have identical cost functions and optimal price and quantity, they generate the same profit. EuroAero and its airline competitor set a price of €380 per tick-et and produce a quantity of 31,000 tickets. This yields a profit of 9,610,000 for each airline. 12. Explain and provide calculations assuming that competition plays out based on pric-es When competition is played out on prices, the Bertrand model can be applied. As in the pre-vious question, EuroAero competes under an oligopoly. The airline has only one main com-petitor under the given situation and thus both firms operate under a duopoly. The Bertrand model assumes that each airline sets prices rather than quantities and there is a focus on price reactions. EuroAero will set a price that is just below the price of the competitor in order to attract passengers and capture the entire market. However, the competitor will follow this strategy and set an even lower price. This price war continues until the price charged by each airline equals the marginal cost of production. If EuroAero sets a price below MC, they will suffer a loss. Therefore it is not optimal. The price of EuroAero will equal the price of the competitor due to identical marginal costs. Neither airline will make any profit. The Bertrand model states the following.

P = MC MC = 70

P = MC = 70 We will set the price/MC equal to the demand function in order calculate quantity.

70 = 1000 – 0.01Q


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0.01Q = 930 Q = 93,000

As stated in the previous question, the total demand function depends on the quantity pro-duced by both firms. We assume that each firm produces the same amount. Thus we split the quantity of 93,000 tickets to calculate the optimal quantity produced by each firm.

QEuro = QComp = Q / 2 QEuro = QComp = 46,500

The two airlines each produce a quantity of 46,500 tickets at a price of €70. The price and quantity are identical for both firms because they have the same cost and demand function. We will now turn to calculating the profit for each firm. The profit will be identical for the two airlines since they produce at the same optimal levels.

Profit = TR – TC We are not given any fixed costs and thus we will assume they equal 0.

MC = 70 TC = 𝑀𝐶 = 70Q TC = 70 * 46,500 TC = 3,255,000

TR = P * Q

TR = 70 * 46,500 TR = 3,255,000

Profit = 3,255,000 – 3,255,000

Profit = 0 EuroAero and the competitor will each set a price of €70 and produce a quantity of 46,500 tickets. This will yield an economic profit of 0. The lack of economic profit is due to the fact that the price war pushes the price down to equaling the marginal cost. 13. Suggest other pricing strategies that EuroAero could pursue As management consultants, we suggest different pricing strategies that EuroAero could pur-sue. Firstly, we would propose using peak-load pricing where the firm charges a price based on demand. For example EuroAero could increase prices during different holidays, i.e. Christmas and summer season. The demand for flight tickets increase in these periods and thus the price sensitivity is more inelastic. Passengers are therefore more willing to pay more for services. Alternatively, we would advise the airline to offer discounts during off-peak sea-sons and to early bookings. In this way, EuroAero attracts more customers during low seasons and hopefully passengers will develop brand loyalty and also use the airline during high sea-sons. Furthermore, offering discounts will increase their load factor and increase revenue. This will offset the initial decrease in prices. Secondly, we advice EuroAero to use price bundling where the purchase of flight tickets is tied to the booking of e.g. hotel rooms. Thus, we would advice the airline to cooperate with


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hotel booking websites e.g. Hotels.com or Booking.com. Furthermore, it would be profitable to cooperate with different traveling agencies. Both factors will increase the load factor on flights and thereby increase revenues. Moreover, more consumers will become aware of the airline and hopefully use it for future travels. Another way of using price bundling is by offer-ing a lower payment if a return ticket is booked as well. Lastly, we advice EuroAero to pursue the pricing strategy of economy pricing. This is a typi-cal method for low-cost airlines where there are no add-ons and the tickets are sold at a low price. Additional services that passengers should pay for when pursuing an “economy” ticket could for example be seat reservation, food onboard, travelling insurance, luggage check-in, priority-boarding etc. If the passengers would like the extra services, they will have to pay an additional amount of money and this enhances EuroAero’s revenues. By following this strate-gy, the airline will attract various customer segments since passengers can choose to go com-pletely low-fare or pay for the luxury of add-ons. Thus EuroAero will only create value that passengers are actually willing to pay for. Both peak-load pricing and economy pricing strategies are pursued by other low-cost airlines like Ryanair and easyJet. Therefore, in order to gain a competitive advantage, EuroAero should especially focus on price bundling. Reaching cooperation with hotel websites and traveling agencies before other low-cost airlines will set them ahead and make them gain a competitive advantage. 14. Explain if there are Nash equilibria Nash equilibrium is the best response given the strategy of the opponent. EuroAero will choose a strategy where they maximize their profits given the strategy of the competitor. At Nash equilibrium no airline can obtain a higher payoff by choosing another strategy. There-fore, no player will have the incentive to deviate from the Nash equilibrium. Competitor Low Price High Price EuroAero Low Price -200 ; -300 9000 ; 6000

High Price 1000 ; 8000 500 ; 500 EuroAero and the competitor compete in a market defined as an oligopoly. Each firm has to consider the pricing strategy of its competitors in order to stay price competitive in the airline market. From the pay-off matrix, we can conclude that there are two different Nash equilibria which have been marked in the above table. One where EuroAero has high price whereas the competitor chooses low price, and another where EuroAero has low price, but the competitor selects a high price. Thus both airlines will maximize profits by choosing a different pricing-strategy than the other. The two bundles consist of profits of (1000 ; 8000) and (9000 ; 6000). The given pay-off matrix does not include any dominant strategy, which is defined as the best result regardless of the action taken by the opponent. In the case of EuroAero and the compet-itor, their profit is completely dependent by the other and consequently there are no dominant strategies.


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15. Reflect on the outcomes in case of maximin strategies from both sides and the out-come in case of cooperation A maximin strategy is also referred to as a secure strategy. The assumption behind this sort of strategic behavior is that it ensures the player the best possible outcome given the worst pos-sible scenario. In order to find the secure strategy, we must determine the strategy that max-imizes the minimum gain that can be achieved (Gugnani, 2008). If EuroAero chooses low-price then the worst possible gain for the airline is if the competitor selects low-price as well. The profit will be 200 for EuroAero. However, if the company chooses a high-price strategy, the minimum profit for EuroAero will be when the competitor sets a high price as well. In this case its profit will be 500. Among these two worst possible pay-offs, the airline would be bet-ter off with the high-high price situation, which is then the maximin strategy. The same can be said about the competitor’s secure strategy. The maximin strategy of the pay-off matrix is for both airlines to choose a high price and gain a profit of 500. Here, both airlines are guaranteed a minimum payment. Players who choose the maximin strategy are risk-averse because they secure the highest possible pay-off no matter what the competitor chooses. Cooperation would ensure that both airlines gain a higher profit than a situation where both firms take on a maximin strategy. The optimal bundle of profits is the one that maximizes joint profits. From the pay-off matrix we can thereby conclude that cooperation would result in EuroAero setting a low price while the competitor chooses a high price. The joint profit will be 15,000 (9,000 + 6,000). The cooperate outcome is significantly higher than the joint profit of a maximin strategy, which is only 1,000 (500 + 500). 16. Calculate the total supply curve for the five fringe airlines. The supply curve of a given firm is the marginal cost curve above average total costs (long run). Therefore, when estimating the total supply curve for the five fringe firms we will do a horizontal addition of their individual marginal cost functions.

MCIndividual = 20 + 5q 5q = MC - 20 q = 0.2MC – 4

Q = 5*q à

Q = 5*(0.2MC – 4)

Q = 1MC – 20 MCFringe = 20 + Q

By doing a horizontal addition, we have calculated the total marginal cost function for the five fringe firms. Thus their total supply curve is MC = 20 + Q. 17. Calculate and illustrate EuroAero’s demand curve. The market in the given situation is characterized by a Stackelberg oligopoly. EuroAero dom-inates the market on the route between Berlin and Paris. As a result, the airline can be consid-ered to be a price leader. Under price leadership, the leader will act like a monopolist and


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therefore set prices. EuroAero will find the optimal quantity by equating marginal cost to marginal revenue and charge the price that the consumers are willing to pay. The five fringe airlines will act as followers and take the price as given. Thus they will act as if under perfect competition and will find the optimal quantity by equating the price with marginal cost. The market demand for the price leader is equal to total market demand minus the total supply of the five fringe firms. Market demand:

Q = 400 – 2P Supply curve of fringe firms:

MCFringe = 20 + Q Q = P – 20

Demand curve for EuroAero:

Q = 400 – 2P – (P – 20) Q = 400 – 3P + 20 QEuro = 420 – 3P

The graph below illustrates the market demand for EuroAero as the price leader of the market.

18. Find the profit-maximizing quantity and price charged by EuroAero and the quanti-ty and price charged by each of the fringe airlines. The profit maximizing quantity and price charged by the price leader, EuroAero, is estimated like under a monopoly. Following this assumption, the optimal price and quantity is found by equating marginal cost with marginal revenue. Market demand for EuroAero:

QEuro = 420 – 3P 3P = 420 – Q

P = 140 – 1/3Q

0 50 100 150 200 250 300 350 400 450

0 50 100 150

Demand for EuroAero

Demand for EuroAero


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Optimal price and quantity is found by MR = MC. TR = P*Q

TR = 140Q – 1/3Q2

MR = TR’ = 140 – 2/3Q

MC = 20

MR = MC 140 – 2/3Q = 20

2/3Q = 120 Q = 180

We calculate the associated price.

P = 140 – 1/3*180 P = 80

In order to maximize profits, EuroAero should set a price of €80 and produce a quantity of 180 connections per week. The profit of EuroAero is the difference between total revenue and total cost.

Profit = TR – TC

TR = P*Q = 80*180 TR = 14,400

We are not given any fixed costs and thus we will assume they equal 0.

MC = 20 TC = 𝑀𝐶 = 20Q

TC = 20*180 TC = 3,600

Profit = 14,400 – 3,600 = 10,800

The maximum profit for EuroAero is €10,800 given the information available. Now we will estimate the profit for each of the five fringe firms. The profit for each of the fringe firms is determined by treating them as companies operating under perfect competition. Hence they will take the price of €80 as given. The optimal quantity is found by equating the price with marginal cost.

P = 80 MCIndividual = 20 + 5q

P = MC

80 = 20 + 5q 5q = 60 q = 12


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Each individual fringe airline will take the price of €80 as given and under this assumption they will each produce 12 connections per week. Profit is calculated as the difference between total revenue and total cost.

Profit = TR – TC

TR = P*q TR = 80 * 12

TR = 960 We are not given any fixed costs and thus we will assume they equal 0.

MCIndividual = 20 + 5q TC = 𝑀𝐶 = 20q + 5q2

TC = 20*12 + 5*122 TC = 960

Profit = 960 – 960 = 0

Under perfect competition, firms cannot achieve economic profits. The followers act as price takers and therefore price equals marginal cost when optimizing quantity. No profits are available because the price leader utilizes the market and thereby gains all economic profits. As price leader, EuroAero generates a profit of €10,800 leaving the followers with no eco-nomic profits. 19. Suppose there are ten fringe firms instead of five. How does this change the results? The market on the route between Berlin and Paris changes and becomes more competitive since there are now twice as many fringe firms. This will have an impact on the total supply function of the fringe airlines.

MCIndividual = 20 + 5q 5q = MC - 20 q = 0.2MC – 4

Q = 10*q à

Q = 10*(0.2MC – 4)

Q = 2MC – 40 ó Q = 2P – 40 MCFringe = 20 + 0.5Q

When there were only five fringe firms, the total supply function was MC = 20 + Q, but now it is MC = 20 + 0.5Q. Due to the increased competitiveness of the environment, the supply function has become flatter. This entails that the firms have to produce more at a lower price. The demand curve of EuroAero is market demand minus the supply of the fringe firms: Market demand for EuroAero:

Q = 400 – 2P – (2P – 40)


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Q = 440 – 4P

4P = 440 – Q P = 110 – 0.25Q

To find the optimal price and quantity, we set marginal cost equal to marginal revenue.

TR = P*Q = 110Q – 0.25Q2 MR = TR’ = 110 – 0.50Q

MR = MC

110 – 0.50Q = 20 90 = 0.50Q

Q = 180 We calculate the associated price.

P = 110 – 0.25*180 P = 65

Increasing competition in the market has forced EuroAero to reduce their price from €80 to €65 while still producing the same quantity of 180 connections per week. In order to calculate the profit for the airline we will find the difference between total revenue and total cost.

Profit = TR – TC

TR = P*Q = 65 * 180 = 11,700 We are not given any fixed costs and thus we will assume they equal 0.

MC = 20 TC = 𝑀𝐶 = 20Q

TC = 20*180 = 3,600

Profit = 11,700 – 3,600 = 8,100 Now we have calculated the profit of the price leader, €8,100, and we will estimate the profit of the 10 individual fringe airlines. The fringe airlines act as price takers like under perfect competition and therefore they will find the optimal quantity by equating the price, €65, to marginal cost.

P = 65

MCIndividual = 20 + 5q

P = MC 65 = 20 + 5q

45 = 5q q = 9


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In order to calculate the profit for the 10 followers, we will find the difference between total revenue and total cost.

Profit = TR – TC

TR = P*q = 65 * 9 = 585 We are not given any fixed costs and thus we will assume they equal 0.

MC = 20 + 5q TC = 𝑀𝐶 = 20q + 5q2

TC = 20 * 9 + 5 * 92 TC = 585

Profit = TR – TC

Profit = 5,850 – 5,850 = 0 As in the previous question, it is shown how the followers act as if under perfect competition. Thus they will not receive any economic profits. EuroAero acts like a monopoly and gains all economic profits of the market. However, when there were only five fringe airlines, the price leader had a profit of €10,800. After the number of followers has doubled to 10, the profit of EuroAero reduces to €8,100. The decrease in profit is due to the fact that the price set by the airline has decreased from €80 to €65. As more followers have entered the market, competi-tion has increased. The overall market demand remains unchanged, but there are more suppli-ers. This causes the price leader to lower the price in order to maintain its position as the dom-inating firm. Due to the increase in suppliers, the initial firms will not produce as much as before. The fringe firms now produce a quantity of 9 connections per week each whereas be-fore they produced 12 connections per week. 20. Suppose there continue to be five fringe firms but that each manages to reduce its marginal cost to MC = 20 + 2q. How does this change your results? The market for airlines flying between Berlin and Paris is once again characterized by a price leader and five followers. However, now the followers have managed to reduce their marginal cost functions. This cost minimization can stem from for example more efficient use of labor or new technological developments. We will calculate the new total supply curve for the five fringe firms.

MCIndividual = 20 + 2q 2q = MC – 20

q = 0.5MC – 10

Q = 5*q à

Q = 5*(0.5MC – 10) Q = 2.5MC – 50

2.5MC = Q + 50 ó Q = 2.5P – 50 MCFringe = 20 + 0.4Q


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The demand curve of EuroAero is market demand minus the supply of the fringe firms. Market demand for EuroAero:

Q = 400 – 2P – (2.5P – 50) Q = 450 – 4.5P

4.5P = 450 – Q

P = 100 – (1/4.5)Q To find the optimal price and quantity, we set marginal cost equal to marginal revenue.

TR = P*Q = 100Q – (1/4.5)Q2

MR = TR’ = 100 – (2/4.5)Q

MR = MC 100 – (2/4.5)Q = 20

80 = (2/4.5)Q Q = 180

P = 100 – (1/4.5)*180

P = 60 EuroAero produces the same amount of quantity (180) as in Question 18. However, the airline reduces the price from €80 to €60 because the fringe firms have become more competitive by lowering their costs. In order to calculate the profit for EuroAero we will find the difference between total revenue and total cost.

Profit = TR – TC

TR = P*Q = 60 * 180 = 10,800 We are not given any fixed costs and thus we will assume they equal 0.

MC = 20 TC = 𝑀𝐶 = 20Q

TC = 20*180 = 3,600

Profit = 10,800 – 3,600 = 7,200

Now we have calculated the profit of the price leader and we find the profit of the five indi-vidual fringe airlines. The fringe airlines act as price takers as under perfect competition and therefore they will find the optimal quantity by equating the price, 60, to marginal cost.

P = 60

MC = 20 + 2q

P = MC


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60 = 20 + 2q 40 = 2q q = 20

The followers produce 20 connections per week at the price of €60. In order to calculate the profit for the five fringes firms, we find the difference between total revenue and total cost.

Profit = TR – TC

TR = P*q = 60 * 20 = 1,200 We are not given any fixed costs and thus we will assume they equal 0.

MC = 20 + 2q TC = 𝑀𝐶 = 20q + q2

TC = 20 * 20 + 202 TC = 800

Profit = 1,200 – 800 = 400

Given the new cost structure of the followers, the price has decreased from €80 to €60 while the optimal quantity remains constant at 180 connections per week. This means that the profit of EuroAero decreases from €10,800 to €7,200. The more competitive environment has wors-ened the situation for EuroAero. The opposite can be stated about the five followers. As price takers their price has also decreased from €80 to €60 while their quantity has increased from 12 to 20 connections per week. This results in a profit of €400. Cost minimization of the fol-lowers means that they have gained an economic profit. However, this profit is not sustaina-ble. Like under perfect competition, the prospect of economic profits attracts new entrants into the market. In the long run this will resemble the situation of Question 19 where there are more followers in the market. The increased number of followers drives down the price until the last firm, which enters, makes zero profits. At this point, it will only be EuroAero, the price leader, which yields economic profits. 21. Derive and draw EuroAero’s demand for labor curve when the output sells for €10 in a competitive market. How many staff will EuroAero hire when the wage rate is €30 per day? €60 per day? The demand for labor is the amount of workers that EuroAero needs in delivering their sale of “grab-as-you-board” meals. The optimal use of labor is determined to be at the point where the marginal resource cost of labor (wages) equals the marginal revenue product of labor. The marginal resource cost of labor is the additional cost of hiring one more worker. The marginal revenue product of labor is the amount of revenue that one additional worker will contribute with. The airline will keep on employing more labor when the marginal revenue product of labor is higher than wages. In order to estimate the optimal use of labor given a specific wage, we will have to estimate and draw the demand for labor. This curve illustrates where the marginal revenue product of labor is equal to a given wage. We assume that EuroAero is a profit-maximizing firm, which will optimize its use of labor. The following will illustrate how this point is determined.


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Total product of labor is calculated using the production function and inserting the different numbers of labor. The marginal product of labor is the output produced from hiring one addi-tional worker. After these calculations have been made, we can estimate the marginal revenue product of labor, which is defined as the income that one more worker will generate. It is cal-culated as MPL times the price of each unit, €10. The calculations can be seen in the table below. Using these numbers, we can derive the demand for labor as illustrated in the graph below. L Q = TPL MPL MRPL = W 0 0 0 1 11 11 110 2 20 9 90 3 27 7 70 4 32 5 50 5 35 3 30 6 36 1 10

The optimal use of labor depends on the wage. If the wage is set at €30 per day, the optimal number of workers will be 5. However, if the wage is increased to €60, the optimal use of labor will be between 3 and 4. When the cost of labor increases, EuroAero will not demand as much labor. This is due to the fact that their staff becomes more expensive and hence they will not be able to afford as many. Furthermore, as a result of increasing wages, the price of the “grab-as-you-board” meal will increase and fewer passengers will buy the food. Conse-quently, quantities will decrease and this will also make the need for labor decrease. Making a trend line in Excel, we have found that the demand for labor is: W = -20 * L + 130. Mathematically, we find the optimal point by equating wage with the demand for labor.

30 = -20*L + 130 20L = 100

L = 5

y = -‐20x + 130 R² = 1 0

20

40

60

80

100

120

140

0 1 2 3 4 5 6 7

Demand for Labor

Demand for Labor

Lineær (Demand for Labor)


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60 = -20*L + 130

20L = 70 L = 3.5

It can be seen that EuroAero demands five workers when the wage is €30 and that it demands 3.5 workers when the wage is € 60. It is obvious that EuroAero cannot hire 3.5 workers. They have to decide whether they want to hire three or four workers. If the wage exceeds the mar-ginal product of labor – hiring four workers – it means that EuroAero’s profits will rise if the number of workers decline. If EuroAero only hires three workers marginal product of labor exceeds the wage, which means that the profit will rise if the number of workers are in-creased. Therefore, we suggest that the firm hires three workers and one part-time worker. 22. Do you see it relevant for EuroAero to consider possibilities related to economics of scope? Explain Economies of scope is when firms can decrease their average total costs and thereby gain higher profits by producing goods jointly. EuroAero can minimize their average total costs by computing a “hub and spoke system”. To have such a system means that the airline chooses a central airport, which will function as a stopover between final destinations. Instead of having point-to-point routes, EuroAero can lower their costs by using a central airport where passengers from different destinations can be gathered and afterwards put on the same aircraft to the final destination. This way Eu-roAero will increase their load factor and thereby revenues. Moreover, the “hub and spoke system” makes it possible for EuroAero to optimize their use of labor because the hub allows them to reuse the cabin crew faster, more efficiently, and flexibly on several routes – minimizing layover between flights. This type of economies of scope is frequently used by other airlines such as AirBerlin, which has Berlin as their hub. EuroAero is a European-based firm and thus their hub should be situated in Europe. Since Paris-Berlin is their most popular route and both are centrally located in Europe, we advide EuroAero to choose one of those two cities as their hub. When choosing between them, EuroAero should focus on the most cost-minimizing airport with regards to taxes, tariffs, etc. The figure illustrates the system of hub and spoke (Froeb, McCann, Ward, & Shor, 2013).


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• Froeb, L. M., McCann, B. T., Ward, M. R., & Shor, M. (2013). Managerial Economics - A Problem Solving Approach. Boston: Cengage Learning.

• Gugnani, S. (01. 11 2008). Maximin strategy. Hentede 07. 04 2015 fra Microeconomics: http://economicsmicro.blogspot.dk/2008/11/maximin-strategy.html

• IATA. (06. 02 2014). Passenger Demand Maintains Historic Growth Rates in 2013. Hentede 08. 04 2015 fra International Air Transport Association (IATA): http://www.iata.org/pressroom/pr/Pages/2014-02-06-01.aspx

• OANDA. (08. 04 2015). Currency Converter. Hentede 08. 04 2015 fra OANDA : http://www.oanda.com/currency/converter/)

• Roos, D., Womack, J. P., & Jones, D. T. (1991). The Machine That Changed the World. New York City, USA: Harper Perennial.


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Appendixes


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