You’re the resident economic expert of Medaline. The CEO, Jeff, is asking you to complete a project that
another person, Shawn, had started working on before he retired. The project is time‐sensitive. Jeff
explains that Medaline has a manufacturing plant that produces a prescription topical cream called
DermaPlus™, which is used for treating certain skin conditions. Hospitals and pharmacies are the main
buyers of DermaPlus™.
The market for this cream is extremely competitive. A number of other firms produce creams that are
almost identical to DermaPlus™. In fact, Medaline’s current share of the market for this type of topical
cream is so small that it has no ability to influence the market price. On the other hand, because
Medaline is relatively small compared to the size of the market, it can sell as much of the cream as it
likes at the prevailing market price.
The plant producing DermaPlus™ has been operating for a little over three years with the same
manufacturing equipment. Currently there are no plans for upgrading or adding to this equipment. Over
the last three years, the price of DermaPlus™ and related creams has been quite volatile and Medaline
has tried to react to the changing price by varying its output level to constantly maximize its monthly
profit. To date, Medaline has been able to vary monthly production quite easily by taking advantage of a
flexible, non‐union workforce with a large number of part‐time workers. However, the workforce at the
DermaPlus™ plant is just about to be unionized. Once that happens, it will become much more difficult
to vary the amount of labour used in the short run and therefore much more difficult to vary the
monthly production of DermaPlus™.
Before he left, Shawn had been asked to estimate the short‐run cost functions for the DermaPlus™
manufacturing plant. The goal was to use this information to determine the profit‐maximizing output
level and use that information to estimate the optimal size for the new unionized workforce. Jeff tells
you that DermaPlus™ and related products are just about to come under the umbrella of a new
reference‐based pricing scheme. Under the new scheme, the government will set the price of
DermaPlus™ and competing creams, and review that price every two years. Once the price has been set
Medaline and other manufacturers simply have to decide how much of the cream, if any, they want to
produce and sell.
Unfortunately, although the workforce will be unionized in just over a week, the referenced‐based price
for DermaPlus™ will not be announced for another two months. Consequently, Medaline has to choose
the size of its workforce (and therefore its production capacity) before it knows the price it will get for its
product. To reduce the uncertainty about this decision, Jeff recently hired a consultant with expertise in
the pharmaceutical industry and reference‐based pricing to estimate the price that will be announced
for DermaPlus™. The consultant estimates that there is a 6% chance that the price will be $50 per unit, a
19% 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 the
government about the issue. After giving you this background information, Jeff asks you to complete the
1. Determine the profit‐maximizing average monthly production capacity for DermaPlus™ for each of the
possible reference‐based prices identified by the consultant. Estimate the expected monthly profit in
2. Recommend an average monthly production capacity for the next 12 months given the uncertainty
about the price of DermaPlus™. Your recommendation will be used to set the size of the manufacturing
plant’s unionized workforce. (Note: You simply have to determine the best monthly production capacity
for 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 and
recommendations in a brief report. When Jeff makes his recommendations about the structure and
format of the report you realize that they are much the same for Assignment 1 that you completed at
Finally, Jeff gives you a copy of one of Shawn’s spreadsheets. This one contains data that Shawn
collected on the variables he thought would be needed to estimate the short‐run cost functions for
DermaPlus™ and the firm’s profit‐maximizing output level.
Jeff makes it clear that he has complete confidence in Shawn’s technical abilities and professional
judgment and tells you to take the information in Shawn’s spreadsheet at face value and to use it as a
starting point for your analysis.