Download Wylee DSL, INC

Wylee DSL, INC1
US consumers purchase Internet access from a communications company (e.g.,
telephone, cable or satellite company) that provides a physical connection from a
computer at the consumer's home to the company's network. The "bandwidth" or
transmission capacity of those physical connections falls into two major categories -"narrowband" or "broadband." Dial-up Internet using telephone modems provides a
narrowband connection with limited transmission capacity and therefore slow speeds.
Cable modem service, digital subscriber line technology (DSL) and satellite broadcasts
provide much greater transmission capacity and therefore faster speeds. Broadband
connections allow consumers improved access to video and audio content on the
Internet.
By the end of May in 2006, 42% of Americans had some sort of broadband
connection (50% DSL, 41% cable and the remainder from a variety of other
technologies including satellite).2 The market share of broadband has been growing in
recent years and is expected to grow further in the future.
DSL technology was developed in the late 1980's but was commercially
unavailable until the mid 1990's. The slow deployment of DSL was largely attributed to
lack of competition in the market for Internet connectivity. The regulatory changes
under the 1996 Telecommunications Act sought to encourage the rapid deployment of
DSL technology by forcing existing local telephone companies to allow independent
communications companies access to their phone lines. In 2004, the Federal
Communications Commission (FCC) allowed the local phone companies to substantially
increase the speed of their connections by re-wiring their lines with fiber optic lines.
Wylee DSL, Inc. is an independent DSL provider that rents the local telephone
company's lines in order to provide Internet access to customer's homes. Getting an
Internet connection requires the lines in order to provide Internet access to customer's
homes. Getting an Internet connection requires the installation of equipment at both
ends of the phone line to support broadband transmissions. At the customer's home, a
splitter must be installed to separate the voice and data signals over a regular phone
line. The other pieces of equipment required to complete the connection are a DSL
modem and a network card. The modem converts audio signals into digital signals and
the network card completes the connection to the customer's computer.
The other end of the connection requires connecting the existing phone line from
a customer's home to Wylee's network equipment co-located at the local telephone
company's central office (CO). Wylee rents this local phone line and connects it to their
1
This write-up is based on a case written originally by Dr. Shahid Ansari and Dr. Leah Marcal. The revision was
done by Dr. Kenneth S. Chapman, July 2006.
2
This information comes from the Pew Internet Project. The exact numbers are somewhat disputed. The
Leichtman Research Group Incorporated claims that cable has 52% of broadband and DSL has 46%. Read
"Broadband access is on the rise, study says" in the Austin American-Statesman May 29, 2006 for more
information.
Internet equipment that consists of an elaborate network of servers, routers, and
communications software to connect and route traffic to the Internet.
Among the Large Internet Service Providers (ISPs) are AOL, Comcast, TimeWarner Cable's Roadrunner, and SBC-Yahoo, Covad and Wylee. Some of these firms
began life as narrow band ISPs (AOL and MSN), some were cable television firms
(Time-Warner and Comcast), some were phone companies (SBC), while others began
as independent DSL providers (Covad and Wylee). As consumers have moved to
broadband some ISPs have bundled Internet connectivity with their other services. AOL
bundles its software and non-technical, family-friendly version of the Internet. Cable
and Satellite television companies bundle their service with their products, while local
phone companies do the same with DSL. Companies like Covad and Wylee are distinct
from these others in that they sell more generic Internet access.
Last year the broadband divisions of DSL providers did quite well earning an
average of 10% return on sales (Net income / Sales revenue). Wylee DSL, Inc.,
however, is below the industry average and earned only 6.26%. The company's
management is concerned and has hired your firm to advise them about strategies for
improving their company's profitability in both the short and long term.
Last year the firm had an average of 204,050 customers that paid $44.44 per
month. Exhibit 1 shows demand information put together by the Wylee marketing
department.
Required:
Prepare a report that develops a strategy for increasing Wylee's profitability in the
short and long term. Your report must address the following issues:
1.
Consider, for the moment, the near term planning horizon and develop a
crude analysis of costs based on the information produced by the Wylee
accounting office in Exhibit 2.
a. Separate the costs into variable costs and fixed costs. Calculate the total
amount of each type of cost.
b. Calculate the Average Variable Cost (AVC) of serving one more user for a
month. Calculate the Average Fixed Cost (AFC) of serving 204,050
customers. How would this number change if we sold to 300,000
customers.
c. Assume that Average Variable Costs stay the same as we sell to more
customers. As we lower price, the number of customers increases. This
reduces average cost. How low can price go and still earn at least zero
accounting profit?
2.
Calculate the annual revenue of Wylee, and then prepare a pie-chart that
divides the companies revenues into the following categories listed below. Be
sure to identify the connection between the cost information in Exhibit 2 and
the broader categories listed below.
a. Installing equipment
b. Providing subscribers with an on-going connection to the Internet
c. Marketing services
d. General administrative support
e. Profit
3.
The market research team at Wylee estimates their firm's inverse demand
function for DSL to be P = 67.06 - Q/(9020.78). Information summarizing this
relationship between Wylee's price (P) and the number of DSL subscribers
purchasing from Wylee (Q) is described in Exhibit 1.
a. If we assume that Average Variable Costs are constant as we increase
the number of subscribers, then MC = AVC. Using your estimates of AVC
from 1.B as a crude estimate of MC, find the profit maximizing price for
Wylee to charge. What is the associated amount sold?
b. What is the arc elasticity of demand Wylee's current price ($44.44) to a
price of $43.33? What will happen to short run revenues if we cut prices?
4.
Wylee and other DSL providers will face many changes in their business
environment in the coming years. For each of the situations listed below
discuss the effect of the event on Wylee's profit maximizing price as well as
its level of profitability with respect to a carefully drawn diagram.
a. In 2004 the FCC decided that it would allow electric companies to sell high
speed Internet Access over their lines. Since nearly every household in
the United States has a high-bandwidth electric line going into the house,
while many lack cable lines or DSL-capable phone lines many experts
expect the entry of the electric companies to affect the market for high
speed Internet access substantially.
b. Some pundits expect the FCC to begin taxing DSL providers several cents
per customer in the near future.
5.
Broadly discuss anything that Wylee DSL can do to increase its profitability in
over the next few years. Are any of the strategies you discuss likely to be
especially profitable over a long period of time? Are any of these strategies
likely to be especially risky?
Exhibit 1
Number of DSL Subscribers at
Wylee
114,050
124,050
134,050
144,050
154,050
164,050
174,050
184,050
194,050
204,050
214,050
224,050
234,050
244,050
254,050
264,050
274,050
284,050
294,050
304,050
314,050
Price / month
54.42
53.31
52.20
51.09
49.98
48.87
47.77
46.66
45.55
44.44
43.33
42.22
41.11
40.01
38.90
37.79
36.68
35.57
34.46
33.35
32.25
Marginal Revenue
41.77
39.56
37.34
35.12
32.91
30.69
28.47
26.25
24.04
21.82
19.60
17.39
15.17
12.95
10.73
8.52
6.30
4.08
1.87
-0.35
-2.57
Exhibit 2
Wylee DSL -- List of costs incurred during the first year
Cost Incurred
Amortization of intangible costs (leasehold improvements on office building)
TV and mail advertising
Depreciation on network equipment
Rent on building housing the network equipment
Utilities and insurance on network equipment
Office salaries
Utilities and insurance for the office
Salaries of network maintenance staff
Office rent
Network administration salaries
Office equipment and supplies
Signal splitter, modem, and other parts used
Trouble shooting and repair costs at customer sites
Line charges paid to the local phone company ($15 / installation / month)
Customer support help line costs
Total costs
Amount
5,407,155
1,828,680
15,434,678
15,520,000
154,000
2,960,547
25,356
5,576,179
65,000
1,144,022
459,067
10,491,912
5,238,757
36,729,000
973,854
$102,008,207
A Beginners Guide to Strategy
in Markets with Differentiated Products3
I.
Introduction
Many introductory economics students find the economist's emphasis on
competitive markets perplexing. This concern arises from the students' tendency to
focus on matters at the firm level rather than the market. A competitive firm produces a
product identical to every other firm in the market and cannot, as a consequence, select
its product's price. This may be an accurate description of the situation faced by
farmers, but it doesn't describe well the situation faced by most firms.
P
P*
Demand
Marginal
Cost
Marginal
Revenue
Q*
Q
Figure 1
We can correct this "problem" by focusing on a market model where firms each
produce slightly different products, but are constantly under the threat of entry from
other firms. Economists call this "monopolistic competition." A firm in this kind of
industry must set its own price the way a monopoly would, but the firm must also worry
about other firms copying anything they do that proves profitable over an extended
period of time.
3
Excerpted from: Puffedup, I. M., "A Beginners Guide to Strategy in Markets with Differentiated Products,"
Journal of Misunderstood Markets, volume 1 number 2, spring 2006.
We will begin by considering a short run situation where some costs are fixed
and the number of firms and the nature of their products cannot change. In this
situation, the firm will select its profit maximizing amount to sell and price in the same
way as a monopoly. In figure 1, the firm sells every unit for which the marginal revenue
exceeds the marginal cost, and then stops. The firm chooses the highest price they can
charge and still sell that many units. In figure 1 the profit maximizing price is P* and the
amount sold is Q*.
II.
Strategic Issues
Figure 1 provides a simple description of price determination for a
monopolistically competitive firm in the short run. However, broader notions of strategy
for firms require that we consider all relevant issues that may affect the firm's long term
profitability. Should the firm change its product slightly? Will today's pricing decisions
affect the future? Should we expect other firms to begin copying our firm's strategy?
We will consider each of these issues in detail.
P
P2
P1
D1
MC
D2
MR2
Q2
Q1
MR1
Q
Figure 2
A. Increased Product Differentiation
"Product differentiation" refers to just how different one firm's product is from
those offered by other firms in the mind of consumers. It describes our firm's product
niche. Consumers in our niche will pay more for our product than other firm's charge for
theirs because it is well suited to their tastes. In effect, increased product differentiation
makes a firms demand less elastic. Figure 2 shows the effect of this. D 1 is the original
demand curve with very little difference between our firm's product and that of other
firms, while D2 show the effect of product differentiation. Notice that differentiation
allows us to raise price and substantially increase our markup of price above marginal
cost.
Product differentiation can raise profitability, but there are a
Focusing on a small niche can reduce the overall level of demand even
less elastic. If the group focused on is tiny enough, profitability can
product differentiation may be costly. If costs rise sufficiently, then even
prices will not offset the cost increases, and profit may fall.
few caveats.
as demand is
fall. Further,
the increased
Product differentiation may also make short run profit last longer if it is more
difficult for other firms to copy what we are doing. Some firms have extended the period
of short term profit successfully by many years by keeping secret the methods used to
produce a comparatively unique product.
B. Dynamic Issues
In some kinds of markets the price and product design choices made today affect
the demand and cost conditions faced by the firm in the future. Consequently, today's
decisions must be modified to take this into account. This suggests that conclusions
drawn from simple diagrams like Figure 1 must be modified somewhat.
i.
Network Effects
A product exhibits a "network effect" if its value to consumers depends on how
many others use the product. High technology products often exhibit this characteristic.
Imagine being only one of three people who had a FAX machine. The device would be
nearly useless. Alternatively, if millions of people have FAX machines they are very
valuable.
Products with network effects must often be priced carefully when they are
introduced. The more people buying the product today, the more people who will want
to buy the product in the future. Products with network effects are often offered at
initially low prices or are given away for free. This maximizes the present value of
expected future profit (even though today's profit could be larger) by increasing
profitability in future periods.
ii.
Switching Costs
Some purchase decisions exhibit "switching costs." This happens when
purchase of the product makes it difficult to switch to another product afterwards. When
people purchase a Windows based computer, for example, they spend money on
software and time on learning how to use it. Switching to a Macintosh for their next
purchase becomes more difficult after one has invested time and money in a Windows
computer.
Switching costs give firms a reason to charge less
customers than they charge to existing customers. Existing
costs to change products, while the new customers do not.
are using a competitor's product, price may have be set low
incur switching costs of their own.
for their products to new
customers incur switching
In fact, if new customers
enough to induce them to
iii. Learning By Doing
Learning-by-doing occurs when a firm develops a new product. Initially the best
methods of producing the product are not obvious. As more units are produced, the
firm gets more familiar with the production process and comes up with methods of
reducing costs.
Firms with new products often set very low initial prices so that they will sell a lot
of products to hasten the learning-by-doing process. This strategy is somewhat risky
because if the hoped for efficiencies in production do not materialize.
iv. Durable Products
Economists call products that last a while "durable products". The more durable
the product is, the longer before consumers purchase it again. This suggests that a
sale today may increase current profitability, but reduce demand and profitability in the
future. As a result, prices of durable products are sometimes higher than for other
products.
An example will clarify the issue. Suppose the product is a light bulb. If we give
away light bulbs today, then people will stockpile them. Next month we will have very
few customers. Hence, today's price of a light bulb must take into account that every
bulb sold today reduces future demand.
C. All Good Things Come to an End
Economists tend to emphasize that any unusually high short run profit earned by
firms will be lost in the long run as new firms copy what the old firms were doing, driving
down prices and profitability. It is certainly true that if we look at the list of unusually
profitable firms across long periods of time, the names at the top of the list change
substantially. This suggests that unusually high profits are difficult to sustain.
Some firms, though, do maintain consistently high profit for fairly long periods -- a
decade or more -- while others find their profit eliminated by competition almost
immediately. The difference seems to lie in how difficult the methods used by a
particular firm are to copy. For example, in the early 1960's Wal-Mart became very
profitable by moving large retail stores into sparsely populated areas of the rural
southeastern United States. They kept costs low by keeping inventory low in local
stores and having large regional super-centers that did deliveries on a just-in-time basis.
Other firms found the cost structure easy to copy, but they couldn't move into the same
rural areas as Wal-Mart because there weren't enough customers to support two firms
the size of Wal-Mart in those areas. Because Wal-Mart's strategy was difficult to copy,
they kept profitability above industry norms for 15 years before they had to alter their
strategy significantly.