Question

Starbucks has $1 billion to invest. It can either purchase a rival coffee shop chain or build additional Starbucks shops. If Starbucks chooses to purchase the rival chain, what does that say about the relative profitability of purchasing and owning the rival's existing shops versus building additional Starbucks shops? Explain.

Short answer

The relative profitability will be higher. The projected difference between the marginal benefit and marginal cost would be higher for purchasing a rival chain than setting up a new outlet.

Step-by-step solution

Meaning of relative profitability

Profitability is the difference between the marginal benefit and marginal cost of a project. Starbucks will study both projects and compare the marginal benefit and marginal cost associated with each project to determine the profitability it can gain from both.

The reason behind the choice of Starbucks

On comparing the profitability associated with both projects, the company will compare them to identify which project yields higher profitability. Starbucks will choose the project whose profitability will be higher than the other project.

In other words, the project whose relative profitability would be higher will be chosen by Starbucks over the other one. Thus, the decision of Starbucks to purchase the rival chain instead of setting up a new outlet shows that the relative profitability is higher for the former than the latter.