Reference no: EM132866934

The substantial shortage of surgical masks has created serious concerns in a city, in which there is only one small producer, ER Musk, supplying surgical masks to the market. The cost of producing a mask at ER Musk is HK$ 3, and the market price is HK$ 3.5. The local government plans to procure 10 million marks and freely distributes them to citizens. Several options are available. First, the government can procure masks from producers outside of the city at a unit price of HK$ 4.5. Second, the government can build its own mask factory after incurring a fixed cost of 20 million HK$. The unit cost of a mask will be HK$ 3, the same as ER Musk's. Third, the government can procure the entire 10 million masks from ER Musk at the current market price. To be able to produce more than 10 million masks, ER Musk has to invest 10 million HK$ to expand its production capacity. Although not intending to make profits, the local government wants to minimize its expenditure.

Question 1. Suppose that there are no contractual frictions and no market uncertainties. Assess the cost of each option and advise the local government which option to choose.

Question 2. Now, consider potential contractual frictions and market uncertainties. For instance, the local government may not be able to secure the entire 10 million masks at the promised price even if they are written in the contract (e.g., the market price of masks increases to HK$ 4.5). Or the local government may not honor the procurement contract when better outside options are available (e.g., the market price drops to HK$ 2). From the perspective of the local government, discuss conditions under which the first option is better than the second option. Under what conditions does the second option dominate the first option? Note that there is no correct or wrong answer to this question. As long as your reasoning is logical and your assumptions are reasonable, your answer is acceptable.

Question 3. Focus on the second and third options. Under what contractual arrangement is the third option optimal for both the local government and ER Musk? Explain.

Question 4. In order to induce ER Musk to invest in its capacity expansion, a strategist advises the local government to make a public announcement, inviting a new firm to jointly invest in a new mask factory. The local government and the new firm will bear the fixed-cost investment (HK$ 20 million) evenly and equally share the profit, if any. Will this strategy provide the right incentive for ER Musk to invest in capacity expansion? Explain.

This is a question about Formation of business partnership.