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Passing costs on to customers

1. A recent input price increase has John worried about his profitability. He would like to pass on the increase to his customers, but he doesnâ??t want to take a hit on his total revenue. Last year, when a similar situation came about, John did pass the increase on with the following results:

Original Price of Product = $2 Original Quantity Demanded = 150
New Price of Product = $4 New Quantity Demanded = 148

John has no reason to believe that the market or any characteristics of his customers changed since last year.

a. Please calculate his elasticity of demand using the midpoint method.

b. State whether the elasticity that you calculated is elastic, inelastic or unitary elastic.

c. Make a recommendation as to whether or not he should pass the price increase on to his customers based on relationship between total revenue and elasticity.

2. Letâ??s consider the perfectly competitive market.

a. Letâ??s assume that the market price is $20 and the Average Total Cost of the firm is $24. The firm is currently producing 100 units.

i. Is the firm making a profit or a loss?

ii. Calculate the total amount of profit or loss.

b. In economics, what is the difference between the short run and the long run?

c. Discuss and / or illustrate the difference between the short-run and long-run supply curves for a purely competitive firm.

3. Chewables Gum Factory produces two types of gum, Spearmint and Wintergreen. Their production procedures illustrate the law of increasing opportunity costs.

a. Use a production possibilities frontier to illustrate their production options. Be sure to label your drawing.

b. Identify a point that is efficient. Label the point â??Aâ?.

c. Identify a point that is inefficient. Label the point â??Bâ?.

d. Identify a point that is unattainable. Label the point â??Câ?.

e. Using your diagram, illustrate the opportunity cost of producing more Wintergreen Gum. Label your new production level â??Dâ?. Explain your findings.

4. Consider the market for bottled water. Illustrate and discuss the impact of the following changes on the market (demand and/or supply). Be sure to discuss the impact on equilibrium price and quantity.

a. A technological breakthrough in the water bottling industry occurs.
b. Consumers expect the price of bottled water to increase in the near future. They believe that it will be a permanent price increase.

c. The average income of the bottled water customers increases.

d. The government imposes a tax on the producers of bottled water.

5. Classify each of the following businesses by their characteristics. For parts a. through d., write Pure Competition, Pure Monopoly, Monopolistic Competition or Oligopoly.

a. Rick owns a Greek restaurant in a small, rural town. There are four other restaurants in town and five other fast food establishments; however, none of the others sell Greek Cuisine.

b. Katie owns her own research firm. Much by accident she stumbled onto a chemical combination that, when inhaled, cures the common cold in a matter of minutes with no adverse side effects. She has a patent on the new drug.

c. Eric and Allen own the only two gas stations in a 40 mile radius. When Eric lowers his price, Allen quickly follows because his sales start to fall off very quickly. Eric experiences the same result when Allen decides to lower his price.

d. Alexandria owns a farm and produces wheat. When she takes her wheat to sell it, she can sell her entire harvest, but she has to accept the going price on the market because there are so many other wheat farmers.

Solution Preview

1. A recent input price increase has John worried about his profitability. He would like to pass on the increase to his customers, but he doesnâ??t want to take a hit on his total revenue. Last year, when a similar situation came about, John did pass the increase on with the following results:

Original Price of Product = $2 Original Quantity Demanded = 150
New Price of Product = $4 New Quantity Demanded = 148

John has no reason to believe that the market or any characteristics of his customers changed since last year.

a. Please calculate his elasticity of demand using the midpoint method.

Elasticity of demand midpoint = average change in Quantity demanded/ average change in price
The change in quantity demanded is 2, and average demand is 198 / 2 = 149
The change in price is $2, and average price is $3.
This gives us:
2/149 / 2/3 = 0.013/ 0.666 = .02

b. State whether the elasticity that you calculated is elastic, inelastic or unitary elastic.

Values less than one are considered inelastic

c. Make a recommendation as to whether or not he should pass the price increase on to his customers based on relationship between total revenue and elasticity.

When demand is inelastic, increases in price have little effect on quantity demanded. So raising prices will result in greater revenue. The greater the elasticity of demand, the more total revenue will decline with price increases.

2. Letâ??s consider the perfectly ...

Solution Summary

Characteristics of different markets; passing costs on to customers; production possibility curves

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