Question

Two Rival Companies having a Price War – Assume Companies “A” & “B” are in construction business. They both are bidding to get part of a big construction job – let’s say building a long highway. The government who is giving out the contracts wants to work with at least 2 separate companies. This is the government’s condition to the 2 companies who are independently bidding on this job.

• If there is any collusion between the two companies on setting and fixing the price, the CEOs of both companies will go to jail for 5 years

• The government budget is, based on their internal estimate, is not to exceed $2M per mile

• If both companies come up with the same dollar amount as the cost of building per mile, then it will be divided 50 - 50. This means each company will do 50% of the job.

• If they both estimate it to be higher than they government’s budget, then the government will disregard both of these companies and seek other alternative, or cancel the project. If a company estimates it to be higher it will be kicked out of the system --- so they can’t go higher than $2M per mile.

• If one of these companies is lower than the 2nd one, that company will get 75% of the job and the more expensive company gets 25% of the job.

So let’s assume the choices are to estimate the cost to be either $2M per mile or $1.5M per mile (lower than $1.5M is not possible, you might lose money --- and higher than $2M is not acceptable). If both companies estimate the cost to be either $2M or $1.5M, then each company gets 50% of the work. If one of them is lower than the other, it gets only 25% of the work. Of course each company wants to maximize its profit and charge the higher price. If you are the CEO of either company what price will you go with? What do you think the other company will do?

Answer 1

Answer: As a CEO of one of the company to earn the tender would fix the cost at the lower end i.e $1.5 M so as to ensure normal profits. Making sure that the company gets 50% of the project. (which will ensure normal profits)

TC = TR (Total cost = total revenue) - Normal profit condition.

Here it should be noted that in TC we are considering the reward for all 4 factors of production ( i,.e land labour capital and entrepreur)

In total cost i.e TC normal profits are inclusive as it  is a reward given to the entrepreur for his risk taking capacity.

Whereas if we fix the price below $1.5M it would lead to subnormal profits or losses.

TC > TR (Total cost > Total revenue) - sunbnormal profits - wherein the cost price is less than $1.5M

Viceversa if we fix the price $2 M the competitor may get 75% of the tender and our company will get only 25% of the project value which again would be a loss to the company.