Question

1. Assume that the structure of the airline industry is characterized as an oligopoly. Airline D observes that if it raises its price, the other airlines do not follow the change, but if it lowers its price, the other airlines always follow the change. Describe the shape of Airline D's demand curve.

2. Explain why the present value of the cash flow expected to be created by the acquisition of a business will decline as the risk of that acquisition rises?

3. Explain why an investment today depends on comparing the costs of the investment to the returns on the investment in present value term.

4. Describe profit maximization in terms of marginal revenue and marginal cost.

Answer 1

1) In the given scenario, if a firm increases its price, then other firs with lower price will capture all the market demand. However, if it lowers its price, it will get caught in a competition where every firm will be undercutting each other. Thus, an equilibrium is reached when price set by all the firms are equal. This is called the kinked demand curve. For price above the demand curve, a unit change in price leads to more than unit reduction in quantity sold. Below the equilibrium price, a unit reduction in price leads to a less than unit increase in output, because all other firms are competiting in price cutting. So, demand curve forms a kinked shape.

2) An increase in risk of acquisition increase the discount rate of the investment. An increase in discount rate lowers the present value of cash flow. This is because an increase in risk lowers the average returns from investment.

3) For comparing investments, the cost is compared with net present value of cash flows. If the value of NPV is more than the cost, then it is worth incurring the investment. If it is equal to the cost, the investor is expected to get zero benefit from the investment. But if cost exceeds NPV, then the investor expects a loss.

4) profit maximizing decisions are made at the margin. If margina revenue is more than marginal cost, then its worthwhile to produce more, thus incurring extra cost. But if marginal cost is more than marginal revenue, then it is profitable to reduce output so as to reduce cost. So, profit maximizing output is where marginal cost=marginal revenue.