Question

Two Rival Companies having a Price War – Assume Companies “A” & “B” are in construction business. They both are bidding to get part of a big construction job – let’s say building a long highway. The government who is giving out the contracts wants to work with at least 2 separate companies. This is the government’s condition to the 2 companies who are independently bidding on this job.

•   If there is any collusion between the two companies on setting and fixing the price, the CEOs of both companies will go to jail for 5 years
•   The government budget is, based on their internal estimate, is not to exceed $2M per mile
•   If both companies come up with the same dollar amount as the cost of building per mile, then it will be divided 50 - 50. This means each company will do 50% of the job.
•   If they both estimate it to be higher than they government’s budget, then the government will disregard both of these companies and seek other alternative, or cancel the project. If a company estimates it to be higher it will be kicked out of the system --- so they can’t go higher than $2M per mile.
•   If one of these companies is lower than the 2nd one, that company will get 75% of the job and the more expensive company gets 25% of the job.

So let’s assume the choices are to estimate the cost to be either $2M per mile or $1.5M per mile (lower than $1.5M is not possible, you might lose money --- and higher than $2M is not acceptable). If both companies estimate the cost to be either $2M or $1.5M, then each company gets 50% of the work. If one of them is lower than the other, it gets only 25% of the work. Of course each company wants to maximize its profit and charge the higher price. If you are the CEO of either company what price will you go with? What do you think the other company will do?

Answer 1

As the CEO of the company, the cost should be fixed at $1.5M so that the tender can be earned. Fixing the lower cost would ensure that atleast the normal profits are earned by the company. The company will earn normal profits when its cost(TC) equals the revenue(TR).

The total cost computation includes considering the four factors of production that is land, labour, capital and entrepreneur.It includes the normal profit as it is a result of the risk taking capacity of an entrepreneur.

50 percent  value of the project would be earned by the company if the company earns normal profits. They would get 25% value of the project if the prices are fixed at $2M and would earn subnormal profits or losses.

Subnormal profits are made when the cost is less than the $1.5M.