Question

In a hypothetical island that is 5,000 miles away from humanity and includes no frictions in the market other than human nature, there are many shipping companies going back and forth that carry goods produced in the island to the world outside the island. There is also a dock to load these goods to the ships. The shipping industry is perfectly competitive.

In the island, there is a cement factory. The price per unit of cement at the door of the factory is $200 and the world price of same cement per unit is $350. But cement should be carried to the dock to be loaded in the ships. There are two means for transporting cement to the dock: i) a pipeline that pumps the cement to the dock (Company P) and ii) truck companies. There are many truck companies in the island and this industry is also perfectly competitive. Both the pipeline and the truck companies have identical services both in terms of price, speed, and amount carried each time. Truck companies can carry any item produced in the island, but the pipeline can only carry cement.

10 years ago, Company C and Company P signed a contract that set the price per unit of cement carried through the pipeline as $25 (10 years from that date, which is today, the price per unit of cement carried is also $25 for truck companies). This contact will expire tomorrow at 8 am and the companies met to negotiate the new terms of the contract.

1. What should be the new price for this new contract, if the two companies can agree on it? Why? Explain your rationale behind this prediction.

2. What can Company P do to maximize its benefits or survive? (Hint: since this is a hypothetical world, the capital markets are efficient)

Will rate for correct answers! :)

Answer 1

1. Price can remain same i.e. $25. Company P which is owner of pipeline would like to increase the price, and company C will try to negotiate it downwards, citing that trucking company is providing them favourable deal. So ideally if company P is able to maintain price of $25 it may be winwin for both companies.

2.  Profit Maximization Case: Company P can reduce the price by say $1 to $24. This will bring them additional volume of work, although not full volume as company C will not like to be dependent on one vendor. Trucking company has other alternative goods for transport. If they are giving them better margin, they may not decrease the price unless business loss is significant. If this happens, company P can achieve higher turnover and may maximize its profit.  

Survival Case: If Trucking company reduces the prices to say $22, company P must match them. If they do not match the reduced price of the trucking company, their pipeline transport business will slowly reduce and over a period of time may extinct. Trucking company has other alternatives, so in case they have some high margin business in other goods, it can used to compensate temporary loss of cement transport, which may help them to eliminate competitor company P if they are not able to match reduced prices. For P, it may mean pressure on margins, but they may be able to survive if they match the price of trucking company.