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## Economies of scale and scope in Automobile Industry

Either

1.1 Select an industry and explain the relationship between economies of scale and scope, market structure and long-run equilibrium in that industry. Industries you may be familiar with include airlines, automobiles, entertainment, food delivery, AREITs, supermarkets, property developers, textbook publishers, professional software and social media.

Or

1.2 There are three basic strategies. Using a well-known company as a current example, discuss the strategy that company is following in the context of the relevant industry and market.

Either

2.1 A decision on market entry with a new product has to be made.

Sales Level Market A Market B Market C

Probability Units Probability Units Probability Units

Good 0.3 1,200,000 0.3 1,000,000 0.7 700,000

Poor 0.3 600,000 0.5 320,000 0.2 400,000

Fail 0.4 0 0.2 0 0.1 0

The entrant can only enter one of these three markets. Show how to determine which one to enter based on expected unit sales.

The cost of entering is \$250,000. If the product sells for \$10 and has unit costs of \$5, what is the expected profit?

The entrant is uncertain about the price after entry, because profitability will depend on the reaction of the incumbent firm. If there is a 40% probability of the incumbent pricing low and a 60% chance of earning \$5, what are the expected earnings from entry?

Draw the matrix form of this game and use the Prisoners’ Dilemma to show why the incumbent will decide to price low and earn \$0 rather than price high and earn \$5.

Or

2.2 An auction has two bidders, each with a value of either \$30 or \$80, with both values equally probable. What reserve price should the auctioneer set, and what is the expected revenue from auctioning the item with and without a reserve price? Clearly show how this outcome is reached.

If each bidder has a value of either \$60 or \$80, what reserve price should the auctioneer set, and what is the expected revenue from auctioning the item with and without a reserve price?

Compare the outcome of an auction with 2 bidders with the same auction with three bidders. Each bidder has a value of either \$16 or \$20 for the item, and you attach probabilities to each value of 50%. What is the expected price? If two of the three bidders collude, what is the price?

Either

3.1 Explain how the difference in outcomes between simultaneous and sequential games comes about. What effect does moving first have in a sequential game? Why?

Or

3.2 What are hidden actions and hidden information? Why are they important and what might be some solutions? Give examples.

Either

4.1 Incentive conflicts are found in many situations. Give two examples and explain how the conflicts can be managed.

Or

4.2 Explain how cost and extent decisions affect the allocation of assets to higher value uses.

Economies of scale and scope in Automobile Industry

(1.1) Economies of scale is the production condition of a firm under which the firm has the opportunity to increase its production because with every unit increase in production the average cost of the firm will decline (Baumers et al. 2016). Theoretically economies of scale occurs when a firm operates at the downwards sloping portion of long run average cost (LAC) curve.

Economies of scope is the process or strategy by which a firm operating in an industry creates efficiency in business by producing diversified products (Sakhartov 2017). With diversified products a firm can cater to different types of customers in different market and thus can expand its business vertically in the market.

The industry considered in this cases is automobile industry. In automobile industry the firms are of large size and invest huge amount of capital in the production facility. Thus, producing less number of vehicles would surge the average cost of the firm thus producing more number of vehicles would cut the average cost of the firm (Wu et al. 2019). Thus economies of scale is effective in cost structure of the industry. On the other hand, a firm in the industry producing only one product suppose it is car. The firm thus would only cater to the car market and thus the market would be smaller, but as the firm in automobile industry are large, they can produce other products such as bikes like Honda. Producing more than one and diversified product allow firms to cater larger market and more customer and thereby they can more profit (Benur and Bramwell 2015). This business expansion strategy can only be achieved under economies of scope.

In automobile industry there are few firms that compete in a market and the number of buyers are numerous. The products of the industry are hugely expensive and cost of production is also very high. Production of automobiles require expensive production facility and raw materials. The firms operating in the industry have significant market power and can influence the price of products. Thus, there is significant amount of restrictions to exit and entry in the industry (Aga and Francis 2017). The firms in the industry faces down sloping demand curve can earn profit over zero economic profit level. The firms also have the opportunity to collude and charge high prices much above free market equilibrium prices. Thus, the firms after collusion in the market earns super normal profit. By looking at the market characteristics of automobile industry it can be said that the market structure of the industry is of oligopoly structure (Ara and Zhang 2019). However, in the short run there are fixed cost in the industry and no technological innovation. Thus, in short run the new firms will face entry restrictions and the existing firms keep on dominating the industry and earns super normal profit. However, in the long run fixed cost is absent since every cost is variable and there will be technological innovation in the industry that would allow more firms to enter. Thus, number of firms in the industry will grow and the competitiveness of the industry will rise and the firms in the industry will earn zero economic profit in the long run (McAuliffe 2015). Therefore, it can be inferred that in eth long run the industry will become a competitive market.

## Market Structure and Long-run Equilibrium in Automobile Industry

(2.1)

 A B C Probability Units Probability Units Probability Units Good 0.3 1200000 0.3 1000000 0.7 700000 Fair 0.3 600000 0.5 320000 0.2 400000 Poor 0.4 0 0.2 0 0.1 0 Expected unit sales 540000 460000 570000 Cost of entry(\$) 250000 250000 250000 Expected Profit for entrant(\$) 2450000 2050000 2600000

Table 1

The entrant has the option of entering any of the three market named as A, B and C. The entrant has the probability of making sales as per the probability given in Table 1. The probabilities of unit sales has been categorized as good, fair and poor (Cramton and Ockenfels 2016). Thus, by calculating for the unit sales corresponding to the three markets it is found that market B has the lowest amount of expected unit sales and highest amount of expect unit sales is found to be in market C, which is given by 570000. Thus, as per expected unit sales the entrant will make an entry to market C.

It is further given that to enter any of the market, the entrant has to bear cost of \$250000. The price of per unit of product is \$10 and cost is \$5. Thus, profit per unit of product is \$5. The profit the entrant can earn from three different markets thus can be calculated by multiplying per unit profit with total amount sales per market and then the cost of entry will be subtracted from the total revenue. Therefore, the expected profit from market C has been found to be \$2600000.

However, the entry of the entrant depends on the decision of incumbent as there is a probability of 40% that the incumbent charges low price where profit per unit will be \$0 and probability of 60% charging price high such that profit per unit will be \$5 (Aumann 2019). Therefore, the expected earnings for the entrant from entry under the two pricing strategies of incumbent is given in table 2 below.

 Expected profit when 40% probability of earning \$0 Expected profit when 60% probability of earning \$5 A -2500000 1,470,000 B -2500000 1,230,000 C -2500000 1,560,000

Table 2

The matrix form of the above game is given in the table 3 below.

 Entrant Incumbent A B C Low price (0, -250000) (0, -250000) (0, -250000) High price (2700000, 1470000 ) (2300000, 1230000) (2850000, 1560000)

Table 3

The incumbent is not aware of the potential of the entrant and thus suffers from prisoner’s dilemma that if it charges high price then the entrant might charge a low price and appropriate the whole market (Powers 2019). Then the incumbent might have to make an exit from the market. However, it can be observed that charging high price is the best option for the incumbent because entrant has no other option but to charge high price in order to make an entry. Conversely, incumbent is unaware of the fact and thus set price and low such that the entrant cannot make an entry to the market and incumbent can maintains its position in the market.

## Market Entry Decision and Auction Reserve Price

(3.2) Hidden action and hidden information are the phenomena that exist in the society. These are two phenomena that are present in the principal and agent system in an economy. The principal and agent system is found in insurance sector, health sector, legal sector, property sector and job sector. In most of the cases principal faces the difficulty due to the presence of hidden information and hidden action. The paragraphs below discusses about hidden information and hidden action and their importance in and economy.

Hidden action is the phenomenon that occurs between principal and agent and it happens after completion of purchase, negotiation and agreement of given terms and conditions (Hoppe and Schmitz 2018). Agents make actions for benefit of their own interest and in many cases such actions compromise the interest of the principal and imposes harmful effect.

Similarly, the hidden information is such a phenomenon that an agent conducts to meet the eligibility or full the requirement of any purchase of insurance, property and any personal product. Information in this case in most of the times would negatively affect the principal (Belleflamme, Omrani and Peitz 2015). Agents hide information to increase their portion of benefit but in the process the principal faces the negative consequences of not knowing the information about that has significant importance in the business that the principal made with the agent.

The harmful effects that occurs due to hidden action and hidden information are known as moral hazard. Moral hazard is the cost generated by risky action taken by someone and the same is borne by some other (Kostovetsky 2015). Both hidden action and hidden information is widely found in insurance sector. In insurance sector, the seller of insurance faces adverse consequences and make losses due these phenomena. Buyer of insurance hides information in many cases to get extra benefit. Suppose and buyer wants to buy a health insurance and has a chronic health issue and hides this information to earn more benefit because if the full information is furnished then insurance seller would reduce the amount of benefit that the buyer can get. Thus, this hiding if information creates moral hazard. Similarly, hidden action is conducted when person buys insurance of car from an insurance company. In this case, any cost of damage to the car will be borne by the insurance provider or the principal. Thus, the insurance buyer or the agent gets the incentive for not maintaining the car properly and that might increase the probability of car to get easily damaged and thereby increases the cost of principal. Thus, in this case moral hazard occurs at the cost of principal.

## Sequential Games and Hidden Actions/Information

These causes of moral hazard can be mitigated or solved by the solving the issues of hidden information and hidden action. In case of health insurance the company should penalize the buyer with fine if it is found that it has concealed any information that is relevant to the insurance policy. In addition to that, in case of hidden action the insurance company should provide a maximum insurance of 90% such that the agent also faces some cost if it takes any hidden adverse action.

(4.1) Incentive conflict is a condition that creates inefficiency due to difference in interest among the players of existing in an economy. Incentive conflict is found mostly in the cases of company managers and shareholders and group or team members (Liu et al. 2019). The interest of the shareholders is to make more dividends whereas the interest of the managers to earn more recognition in the organization and gain control in the business. Managers also aim to increase the incentive for themselves and their co-workers. On the other hand, the shareholders has no control over the business and also cannot monitor the managers to ensure their incentive. The managers and shareholders thus does not share any common grounds for generation of mutual incentive. Therefore, there exist conflict in their incentive causing adversities in the business structure. Further, incentive conflict is more severe in the case of team members (Glover and Levine 2017). Team members handling a project in a company shares different kind of incentive such as every member wishes to receive most credit for their work. Hence, if no common incentive opportunity is absent in a project then the team members would act as per their own interest irrespective of others. In many cases actions are taken such that to satisfy self-interest members harms interest of others.

The conflict occurs due to non-existence of common incentive among the shareholders and manager and team members. Suppose in the case of shareholders and managers if the incentive structure is made in such a way that more is the dividend for shareholders more is the incentive for managers then the they will work in such a way that to gain incentive for themselves they will generate dividend for shareholders too. Thus, it is important to provide common grounds and between the managers and shareholders in order to mitigate the problem of incentive conflict. The problem of incentive conflict among the team members is closely similar to the problem of shareholders and managers thus the solution should be similar for them as well. The team members should incentivized according to the performance of the entire group but not individually. Under this policy problem of free riding might generate. Thus to deal with such problem and preventing that from happening close monitoring of each member of the teams is required and there should be penalty for any kind of misconduct or under performance by any of the members of the team (Howard, Turban and Hurley 2016). Apart from that, a slight impact of penalty should be imposed on the other members such that team members motivate each other to work efficiently. Therefore, the policies discussed above could solve the problem of incentive conflict.

References

Aga, G. and Francis, D., 2017. As the market churns: productivity and firm exit in developing countries. Small Business Economics, 49(2), pp.379-403.

Ara, T. and Zhang, H., 2019. Tariffs, Vertical Oligopoly and Market Structure: Empirical Investigation. Research Institute of Economy, Trade and Industry (RIETI).

Aumann, R.J., 2019. Lectures on game theory. CRC Press.

Baumers, M., Dickens, P., Tuck, C. and Hague, R., 2016. The cost of additive manufacturing: machine productivity, economies of scale and technology-push. Technological forecasting and social change, 102, pp.193-201.

Belleflamme, P., Omrani, N. and Peitz, M., 2015. The economics of crowdfunding platforms. Information Economics and Policy, 33, pp.11-28.

Benur, A.M. and Bramwell, B., 2015. Tourism product development and product diversification in destinations. Tourism Management, 50, pp.213-224.

Cramton, P. and Ockenfels, A., 2016. Economics and design of capacity markets for the power sector. In Interdisziplinäre Aspekte der Energiewirtschaft (pp. 191-212). Springer Vieweg, Wiesbaden.

Glover, B. and Levine, O., 2017. Idiosyncratic risk and the manager. Journal of Financial Economics, 126(2), pp.320-341.

Hoppe, E.I. and Schmitz, P.W., 2018. Hidden action and outcome contractibility: An experimental test of moral hazard theory. Games and Economic Behavior, 109, pp.544-564.

Howard, L.W., Turban, D.B. and Hurley, S.K., 2016. Cooperating teams and competing reward strategies: Incentives for team performance and firm productivity. Journal of Behavioral and Applied Management, 3(3), p.1054.

Kostovetsky, L., 2015. Political capital and moral hazard. Journal of Financial Economics, 116(1), pp.144-159.

Liu, Y., Du, J.L., Yang, J.B., Qian, W.Y. and Forrest, J.Y.L., 2019. An incentive mechanism for general purpose technologies R&D based on the concept of super-conflict equilibrium: Empirical evidence from nano industrial technology in China. Technological Forecasting and Social Change, 147, pp.185-197.

McAuliffe, R.E., 2015. Economic Profit. Wiley Encyclopedia of Management, pp.1-2.

Powers, R., 2019. Prisoner's dilemma. Atlantic Books.

Sakhartov, A.V., 2017. Economies of scope, resource relatedness, and the dynamics of corporate diversification. Strategic Management Journal, 38(11), pp.2168-2188.

Wu, Y., Sun, X.M., Zhao, X. and Shen, T., 2019. Optimal control of Boolean control networks with average cost: A policy iteration approach. Automatica, 100, pp.378-387.

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