Tropical Delights, Inc., is considering introducing a new fruit juice to the mainland market. This juice, to be called Tropic Morning, is a mixture of various tropical fruits, but TDI plans to keep the exact formulation secret. Consumer clinics conducted in Waikiki using tourists from mainland states indicate that the product will face a market demand curve in the first year of the venture specified by P = 33.535 - 0.2828Q, where Q represents thousands of cases, and P is the price per case of twelve bottles. Market demand is expected to increase by 20 percent per year for the next five years. TDI’s cost of production is expected to be TC = 300,000 + 6.25Q + 0.025Q2. The coefficients in this expression that determine the marginal cost are expected to decline by about 15 percent per year, because of learning effects in the production process.

Other firms are expected to enter the market with competing tropical fruit juices if TDI’s product proves to be a success in the first year (that is, if the demand estimates prove to be accurate). TDI will have no cost advantages over these potential entrants, and in fact will proba¬ bly have higher costs than a large rival that currently specializes in pineapple fruit and juice production. TDI’s cost disadvantage would be about 20 percent, it estimates. On the demand side, however, TDI expects to establish a strong brand name identity which will make rivals’ products only imperfect substitutes for Tropic Morning, such that it will retain about half the market after the expected entry of three or four rival firms, when prices are roughly equal.

The management of TDI is deliberating whether to set a skimming price or a penetration price initially. Their time horizon is three years, and their opportunity discount rate is 10 per¬ cent. You are asked to advise them on the pricing strategy they should employ.

(a) What are the arguments that might be used in favor of the skimming price? What skim¬ ming price level would you recommend?

(b) What arguments militate in favor of the penetration price? What penetration price level would you recommend?

(c) What is likely to happen to TDI’s price and output level in the second and subsequent years, (1) if a skimming price is set initially, and (2) if a penetration price is set initially?

(d) Advise TDI’s management as to the strategy you feel they should pursue, with supporting arguments and qualifications.