MBA 505: Problem Set 3 Problem 1: The cargo shipping industry is in the business of shipping freight between ports all over the world. It is a fragmented industry consisting of a large number of independent ship owners. For all intents and purposes, firms act as price takers and the industry is perfectly competitive. The figure below shows the path of real prices (i.e., adjusted for the effects of inflation) in the cargo shipping industry between 1991 and 2001. PRICE per VOYAGE (S million) 0 1991 1992 1993 1994 1005 1996 1997 1998 1099 2000 2001 YEAR You are a member of a consulting team that is conducting a study the cargo shipping industry, and you and your colleagues want to try to make sense of price movements in this market since 1990. After a day or so of quick fact-finding, you learn the following. 1. Cargo shipping takes place in large ocean-going vessels. These ships are manufactured in a handful of shipyards in Northern Europe and North America. 2. Depending on a shipper's type and geographic location, the best available substitutes for shipment by cargo ship are to ship by rail or by air freight. For example, a customer shipping large bulk freight items from Los Angeles to New Orleans could either ship over land by rail or over sea (via the Panama Canal) by cargo ship. 3. The world's fleet of cargo ships have approximately the same cost structures. Throughout most of the early 1990s, the variable and fixed costs of cargo ships remained virtually unchanged. 4. Cargo ships are very specialized assets and have extremely limited redeployment value (e.g., they cannot easily be converted to, say, oil tankers). Cargo ships have a useful life of about 10 years. 5. Depending on the flow of orders to shipyards, it can take anywhere between 12 to 18 months to build a new ship. 6. Real prices of key variable inputs --- most notably fuel, crew, and supplies --- in the operation of cargo ships remained remarkably stable from year to year throughout the 1990s. 7. Capacity in the ship building industry adjusts very slowly and the size of that capacity at the end of the 1990s was essentially what it was at the beginning of the 1990s. 8. An economist at lllinois Tech estimated a market demand curve for the bulk cargo shipping for the years 1993 and again for the year 1999. The estimated demand curves took the form, Q =a bP, where P is price per voyage (inflation adjusted), and Q is the number of voyages. The study found that the while the estimate of the \"b\" parameter was virtually the same in both years, the estimate of the \"a\" parameter in 1993 was smaller than the estimate of \"a\" in 1999. 9. In late 1994, a new deepwater port was opened in New Orleans. One article on this was titled \"Customers' Prayers are Finally Answered,\" alluding to the significant reduction in unloading and handling costs (usually born by the customer whose freight is being unloaded) that was expected to come because of the new port facilities. 10. When you asked a senior manager of a cargo shipping company what discount rate firms use to evaluate new investments, the response was, \"Every firm in this industry has historically used a discount rate of 12 percent to evaluate new projects.\" 11. There were limited attempts to consolidate this industry in the early 1980s. Those attempts were widely considered to be a failure. Your job is to develop a hypothesis that explains the pattern on prices that we see in the cargo shipping industry. While there are, in principle, many hypotheses that you might formulate, your engagement manager is looking for a hypothesis that is based on sound economic theory and tightly linked to the fact-base above. Tasks: 1. What is the most likely explanation for why the market price rose in 1995? 2. What is the most likely explanation for why the market price fell in 1998-1999? 3. How does the size of the cargo fleet in 2001 compare to the size of the fleet in 1993: would you expect that the fleet in 2001 was larger, the same as, or smaller than the size of the fleet in 1993? 4. What is the most likely explanation for why the market price in the 1999-2001 period is higher than the price that prevailed prior to 1995