1. In February 2015, broadband and fixed line carrier BT (British Telecom) re-entered the UK mobile market by buying EE. BT will be able to sell bundles of service combining mobile, fixed line, broadband, and television. It will challenge Vodafone, which sells only mobile services. (Source: “BT in £10bn move to reclaim dominant position”, Telegraph, February 12, 2015.).
(a) How would BT’s purchase of EE affect the concentration of the UK mobile services market?
(b) Suppose that the competing mobile carriers set capacity by the Cournot model. If BT’s purchase does not affect the marginal cost of the carrier that it buys, how would BT’s entry affect the equilibrium capacities?
(c) Using a suitable figure, explain how BT’s entry would affect the residual demand for Vodafone and how Vodafone should adjust its prices.
2. In 2010, of a total of 67,000 rooms on the Las Vegas Strip, Caesars Entertainment managed 22,880, while MGM Resorts managed over 12,000. However, owing to the Great Recession and new hotel openings, between 2008 and 2010, MGM’s hotel occupancy decreased from 92% to 89%, while its average daily room rate fell from $148 to $108. Meanwhile, CityCenter, managed by MGM Resorts, and the Cosmopolitan opened with 4,000 and 3,000 rooms respectively, and the 1,720-room Sahara closed. (Sources: Caesars Entertainment Corp., Annual Report 2010; MGM Resorts, Annual Report 2010; “Sahara’s closure on May 16 will mark `the end of an era’,” Las Vegas Sun, March 11, 2011.)
(a) Using a suitable figure, explain how the opening of CityCenter and the Cosmopolitan affects the residual demand for an existing hotel and how it should adjust prices.
(b) If MGM Resorts had not reduced its room rates, what would have been the effect on occupancy?
(c) Use the Cournot model to explain MGM Resorts’ opening a new hotel and Sahara’s closing.
3. Pluto Limited is financed with $2 billion of debt at an interest rate of 10% and $8 billion of equity. If management works as usual, Pluto would earn revenues of $10 billion and incur operating expenses of $9.5 billion, and so, operating income would be $0.5 billion. If management works hard to cut costs, operating expenses would be $9.0 billion.
(a) Construct a game in extensive form with the following nodes. At the first node, a private-equity fund chooses between a leveraged buyout of Pluto and the status quo. At the subsequent node, management chooses between working as usual and cutting costs.
(b) Suppose that the leveraged buyout recapitalizes Pluto to $8 billion of debt at an interest rate of 10% and $2 billion of equity. Calculate Pluto’s profit if management: (i) works as usual, and (ii) cuts costs.
(c) Explain how the leveraged buyout serves as a strategic move to cut costs.