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Case Prompt:
A company is considering entering the pick-up truck market and needs to invest $1 billion to build a plant. The market currently sells 750,000 pick-up trucks, and the interviewer wants to know if the company should enter the market.
Exhibit:
Current Price: 30K
Plant Capacity: 200K
Elasticity of Demand: 3
Variable Cost: 20K
Cost of Capital: 10%
Background:
The interviewer provided information about the pick-up truck market, and the company is considering entering the market. The interviewer wants to know if the company should enter the market by investing $1 billion to build a plant.
Analysis:
To determine if the company should enter the market, we need to estimate the impact of the entry on the price. The plant's capacity is 200K, and the market currently sells 750K pick-up trucks, so the percentage change in Q is around 30%.
Using the elasticity of demand, we can calculate that the new price will be 27K (30K less 10%). Therefore, the company can sell 200K pick-up trucks at 27K and generate a contribution margin of 7K per truck.
Thus, the contribution per year is $1.4 billion, and the plant has a life of ten years, so the total contribution will be $14 billion. However, there is a capital charge of 100M dollars per year for a total of $1 billion. The $1 billion investment must be returned at the end, so the total profit is $12 billion.
The interviewer also asked about the Cournot equilibrium and whether it is surprising that Toyota entered the truck market. This is a basic profitability case where new entrants reduce the market price and must carefully assess their profitability given the demand elasticity. Therefore, it is not surprising that Toyota entered the market.
Frequently asked questions
Should a company enter the pick-up truck market with a $1 billion investment?
Yes, if the company can sell 200K units at $27K per unit, it generates a $1.4B annual contribution. After subtracting capital costs, the 10-year profit is $12B, making the investment highly profitable.
How does elasticity affect the pricing strategy in this case?
With an elasticity of 3, a 30% increase in quantity leads to a 10% price drop. This makes the new price $27K from the original $30K, crucial in evaluating profit potential.
What is the Cournot equilibrium in the context of market entry?
In Cournot equilibrium, firms decide output assuming rivals' production is fixed. A new entrant like Toyota reduces prices by increasing supply, but if profit margins remain strong, entry is still viable despite price drops.
What is the contribution margin in this case?
At a selling price of $27K and variable cost of $20K, the contribution margin is $7K per unit. Multiplied by 200K units, this yields an annual contribution of $1.4B.
Is it surprising that Toyota entered the pick-up truck market?
No, given the high profitability despite price drop, Toyota’s entry aligns with strategic decisions in elastic markets. With strong brand value and economies of scale, it’s a calculated and rational move.
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