Determine the profit-maximizing average monthly production capacity for DermaPlusfor each of the possible reference-based prices identified by the consultant. Estimate the expected monthly profit in each case.
You’re the resident economic expert of Medaline. The CEO, Jeff, is asking you to complete a project that another person, Shawn, had started working on before he retired. The project is time-sensitive. Jeff explains that Medaline has a manufacturing plant that produces a prescription topical cream called DermaPlus, which is used for treating certain skin conditions. Hospitals and pharmacies are the main buyers of DermaPlus.
The market for this cream is extremely competitive. A number of other firms produce creams that are almost identical to DermaPlus. In fact, Medaline’s current share of the market for this type of topical cream is so small that it has no ability to influence the market price. On the other hand, because Medaline is relatively small compared to the size of the market, it can sell as much of the cream as it likes at the prevailing market price.
The plant producing DermaPlushas been operating for a little over three years with the same manufacturing equipment. Currently there are no plans for upgrading or adding to this equipment. Over the last three years, the price of DermaPlusand related creams has been quite volatile and Medaline has tried to react to the changing price by varying its output level to constantly maximize its monthly profit. To date, Medaline has been able to vary monthly production quite easily by taking advantage of a flexible, non-union workforce with a large number of part-time workers. However, the workforce at the DermaPlusplant is just about to be unionized. Once that happens, it will become much more difficult to vary the amount of labour used in the short run and therefore much more difficult to vary the monthly production of DermaPlus.
Before he left, Shawn had been asked to estimate the short-run cost functions for the DermaPlusmanufacturing plant. The goal was to use this information to determine the profit-maximizing output level and use that information to estimate the optimal size for the new unionized workforce. Jeff tells you that DermaPlusand related products are just about to come under the umbrella of a new reference-based pricing scheme. Under the new scheme, the government will set the price of DermaPlusand competing creams, and review that price every two years. Once the price has been set Medaline and other manufacturers simply have to decide how much of the cream, if any, they want to produce and sell.
Unfortunately, although the workforce will be unionized in just over a week, the referenced-based price for DermaPluswill not be announced for another two months. Consequently, Medaline has to choose the size of its workforce (and therefore its production capacity) before it knows the price it will get for its product. To reduce the uncertainty about this decision, Jeff recently hired a consultant with expertise in the pharmaceutical industry and reference-based pricing to estimate the price that will be announced for DermaPlus. The consultant estimates that there is a 6% chance that the price will be $50 per unit, a 19% chance that the price will be $100 per unit, and a 75% chance that the price will be $150 per unit. This is the best estimate the consultant can provide given the lack of information coming from the government about the issue. After giving you this background information, Jeff asks you to complete the following tasks:
1. Determine the profit-maximizing average monthly production capacity for DermaPlusfor each of the possible reference-based prices identified by the consultant. Estimate the expected monthly profit in each case.
2. Recommend an average monthly production capacity for the next 12 months given the uncertainty about the price of DermaPlus. Your recommendation will be used to set the size of the manufacturing plant’s unionized workforce. (Note: You simply have to determine the best monthly production capacity for the next 12 months, not the number of workers required.)
3. Write a short report summarizing the results of your analysis and any recommendations.
Jeff makes it clear to you that he is a “risk neutral”person.
You only have a week to complete the analysis, interpret the results, and summarize your findings and recommendations in a brief report. When Jeff makes his recommendations about the structure and format of the report you realize that they are much the same for Assignment 1 that you completed at another company.
Finally, Jeff gives you a copy of one of Shawn’s spreadsheets. This one contains data that Shawn collected on the variables he thought would be needed to estimate the short-run cost functions for DermaPlusand the firm’s profit-maximizing output level.
Jeff makes it clear that he has complete confidence in Shawn’s technical abilities and professional judgment and tells you to take the information in Shawn’s spreadsheet at face value and to use it as a starting point for your analysis.
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