Answered: In 2009, Detroit Michigan experienced…

Managerial Economics: A Problem Solving Approach

5th Edition

ISBN:9781337106665

Author:Luke M. Froeb, Brian T. McCann, Michael R. Ward, Mike Shor

Publisher:Luke M. Froeb, Brian T. McCann, Michael R. Ward, Mike Shor

Chapter23: Managing Vertical Relationships

Section: Chapter Questions

Problem 8MC

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Question

Case Study

In 2009, Detroit Michigan experienced an aggressive recession compared to the rest of country. With unemployment rates topping 15%, the city was faced many challenges financially, economically and socially.

In addition to the financial challenges, the city was also experiencing political instability and corruption. The major and various city officials were being investigated for fraud, bribery and other criminal charges.

Spirit Electric, operating as a natural monopoly, was the only company in the area to provide electric serves to the households. Like many other companies, it was experiencing financial difficulties and could no longer continue without some intervention. This was mainly due to high operating costs, foreclosures in the area and the fact that many households were not paying their bills.

As a result, Spirit Electric came to a standstill in the latter part of 2009. Matt Green, Spirit electric CEO gathered the Board of Directors and determined that the company would need to take some sort of course of action in order to remain functioning.

Matt Green outlined 4 proposals and urged each board member to vote accordingly, providing justification to their proposal.

The following are the proposals:

Proposal 1

Ask the government for a bailout of $30 Million dollars to allow Spirit Electric to continue operating. Pay back will be at 15% within 5 years.

Proposal 2

Allow two other additional Electric companies to join the industry and supply electric to the people of Detroit. The companies would be competing against one another and households would have a choice in choosing which company they would like.

Proposal 3

Increase electric rates in the short term for all users. Once the economy regains, electric rates return to normal.

Proposal 4

Create private ‘virtual’ accounts managed by Spirit Electric for all households. These accounts would allow households who fall behind to ‘credit’ their account with a 2% fee after 6 months of not paying.

Required

1. How should you forecast the outcome for Spirit Electric?

2. What are the different types of risk involved in your proposal?

3. What types of costs should be considered in your proposal?

4. Did a principle agent problem occur in this situation? How can it be avoided moving forward?

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