Youre the resident economic expert of Medaline. The CEO, Jeff, is asking you to complete a project thatanother person, Shawn, had started working on before he retired. The project is time?sensitive. Jeffexplains that Medaline has a manufacturing plant that produces a prescription topical cream calledDermaPlus, which is used for treating certain skin conditions. Hospitals and pharmacies are the mainbuyers of DermaPlus.The market for this cream is extremely competitive. A number of other firms produce creams that arealmost identical to DermaPlus. In fact, Medalines current share of the market for this type of topicalcream is so small that it has no ability to influence the market price. On the other hand, becauseMedaline is relatively small compared to the size of the market, it can sell as much of the cream as itlikes at the prevailing market price.The plant producing DermaPlus has been operating for a little over three years with the samemanufacturing equipment. Currently there are no plans for upgrading or adding to this equipment. Overthe last three years, the price of DermaPlus and related creams has been quite volatile and Medalinehas tried to react to the changing price by varying its output level to constantly maximize its monthlyprofit. To date, Medaline has been able to vary monthly production quite easily by taking advantage of aflexible, non?union workforce with a large number of part?time workers. However, the workforce at theDermaPlus plant is just about to be unionized. Once that happens, it will become much more difficultto vary the amount of labour used in the short run and therefore much more difficult to vary themonthly 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 outputlevel and use that information to estimate the optimal size for the new unionized workforce. Jeff tellsyou that DermaPlus and related products are just about to come under the umbrella of a newreference?based pricing scheme. Under the new scheme, the government will set the price ofDermaPlus and competing creams, and review that price every two years. Once the price has been setMedaline and other manufacturers simply have to decide how much of the cream, if any, they want toproduce and sell.Unfortunately, although the workforce will be unionized in just over a week, the referenced?based pricefor DermaPlus will not be announced for another two months. Consequently, Medaline has to choosethe size of its workforce (and therefore its production capacity) before it knows the price it will get for itsproduct. To reduce the uncertainty about this decision, Jeff recently hired a consultant with expertise inthe pharmaceutical industry and reference?based pricing to estimate the price that will be announcedfor DermaPlus. The consultant estimates that there is a 6% chance that the price will be $50 per unit, a19% 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 thegovernment about the issue. After giving you this background information, Jeff asks you to complete thefollowing tasks:1. Determine the profit?maximizing average monthly production capacity for DermaPlus for each of thepossible reference?based prices identified by the consultant. Estimate the expected monthly profit ineach case.2. Recommend an average monthly production capacity for the next 12 months given the uncertaintyabout the price of DermaPlus. Your recommendation will be used to set the size of the manufacturingplants unionized workforce. (Note: You simply have to determine the best monthly production capacityfor 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 andrecommendations in a brief report. When Jeff makes his recommendations about the structure andformat of the report you realize that they are much the same for Assignment 1 that you completed atanother company.Finally, Jeff gives you a copy of one of Shawns spreadsheets. This one contains data that Shawncollected on the variables he thought would be needed to estimate the short?run cost functions forDermaPlus and the firms profit?maximizing output level.Jeff makes it clear that he has complete confidence in Shawns technical abilities and professionaljudgment and tells you to take the information in Shawns spreadsheet at face value and to use it as astarting point for your analysis.
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