Waltham Wallpaper Company has developed a new type of wallpaper that is easier to apply. WWC calls their product Magicpaper. It does not need glue, nor does it need to be immersed in water before application. Instead it is more like a contact paper that sticks by itself, but Magicpaper may be removed and readjusted very easily because the “glue” does not set permanently until 24 hours after exposure to air. Because of this ease of application WWC intends to supply Magicpaper in 40-inch widths, which is expected to be a major selling feature as well. Finally, the new type of backing used on Magicpaper allows all kinds of fabric and other materials to be bonded to the front side for a far superior finish, rendering all formerly available textured wall¬ papers inferior by comparison.

WWC’s average variable cost of producing Magicpaper is expected to be $25.00 per lin¬ ear yard (40 inches wide) the first month, and this cost is expected to fall by about 20 percent each time cumulative output doubles. The output rate is fixed at 2,000 yards per month. WWC’s usual markup on wallpaper of 100 percent over AVC allows its prices to be quite com¬ petitive. With Magicpaper, however, it is considering setting the initial price using a 200 per¬ cent markup, since it expects demand to support this price given the limit on output per month. Also, it expects to be the only supplier for at least a year, and it would like to recoup its rather substantial developmental costs quickly. At this price, all five of the firm’s rivals are likely to respond with similar versions of this new product by the second year, at which time prices will be forced downward until markups are more competitive, probably around the 100 percent level, since this is the conventional level in the wallpaper market. Eventually, market shares tend to come out equal in any particular product line, as well.

Alternatively, WWC could employ a strategy to limit entry to the only two other firms that could afford to incur the developmental costs. This strategy would involve using a markup of 150 percent initially and then reducing markups back toward 100 percent after the firms enter. At that price, demand is expected to be 2,500 yards per month, and WWC could produce this amount using a “weekend shift.” About half of the regular workers and several “weekenders” would work as long as it takes on Saturday to produce the extra 500 yards of Magicpaper. This Saturday session would initially have an incremental cost to WWC of $20,000, labor and mate¬ rials included. Learning effects are expected to allow this figure to decline at the same rate as weekday production, however.

(a) Advise WWC what their EPV of contribution is likely to be if they follow the skimming- price strategy. (Assume an opportunity discount rate of 12 percent and make any other assumptions you need to, but consider the sensitivity of your answer to these assumptions.)

(b) Alternatively, what is the EPV of profits if WWC follows the moderate pricing strategy that will limit entry to just its two largest rivals?

(c) Should WWC simply start with a 100 percent markup and limit the entry of all rivals? Consider the issues involved.

(d) Summarize your recommendation to WWC.