QuestionQuestion

(1) MATHEW MANUFACTURING INC.

Mathew Manufacturing Inc. (MMI) manufactures a part called Jighil that is used in production of refrigerators. The company currently charges $50 per Jighil and sells 4,000 to a market comprised of a large number of small customers. MMI’s fixed costs are $10,000 per month and marginal costs of producing Jighil units are $30 for production up to 10,000 units per month. The company cannot increase its production above 10,000 units per month. Frugal Corp, a manufacturer of a substitute units of Jighil has approached MMI and has offered a one-time $35,000 contract for 1,000 Jighils to be delivered this month. This is a onetime event and will not be repeated and has no effect on MMI’s demand curve in the future months.

QUESTIONS:
1) Before deciding on the contract you want to analyze your current market. What is the optimal price for units of Jighil if the price elasticity of demand is estimated to be -2 for prices between $45 and $65 per Jighil?
2) Would you recommend setting your price to that determined in part (1)? Explain why or why not.
3) Would you recommend accepting the offered contract? Explain why or why not.
4) Does your answer to (3) change if your fixed costs are $12,000 per month? Explain why or why not.



(2) PASCAL USED CAR DEALERSHIP

Pascal LLC, is a used car dealership serving Boston Metropolitan area. The company has experienced a rather sharp decline in used car prices in recent years. A casual observation of the secondary car market by the management reveals that this is an industry wide national trend and it is not specific to the Pascal LLC or Boston area market. At the same time, the management has noticed that for several years, major manufacturers of automobiles in the United States have offered flexible payments, easy credit, rebates, and zero percent financing deals to buyers of new cars. Consequently, an increase in demand for new car has been evident. Further investigation suggests two reasons for the observed decline in the price of used cars. The first is the increase in the supply of used cars provided by those customers who buy the new cars. As more individuals trade in their cars to buy new ones, there will be more used cars on the market. The second reason is the decrease in demand for used cars resulting from increase in demand for a substitute product, that is, the new cars. Moreover, management thinks that the deals offered by car manufacturers accelerate the rate cars lose their value as they age. The explanation is that buying a car, say for $30,000 when a $3,000 rebate is offered, renders the actual cost of a new car to be $27,000. This rebate, in turn, instantly lowers the new car's value by the same amount and simultaneously reduces the trade-in price of the previous year's model. The effect then cascades through all older models and affects their value by substantial amounts.

QUESTIONS:
1) Use supply and demand to analyze the effect of a $3000 new-car rebate on the price and quantity of used cars. Explain in words the effects of the rebate on supply and/or demand and its effects on quantity and price.
2) Suppose the owner of a one-year old GM minivan is going to purchase a new minivan. Is the GM minivan owner better off if he/she goes to purchase the Toyota minivan after GM Corporation introduces a rebate on the purchase of a new minivan? Why?



(3) Passing Along Costs

In 2010, the costs of powdered milk, cocoa, coffee, and wheat rose at double-digit rates. Wildfires in Russia had caused wheat and other crop prices to shoot up. Cocoa prices reached a 33 year high in July, helped along by speculative activities, including the London-based commodity trading house Armajaro Holdings Ltd.’s move to store 240,000 metric tons of cocoa, worth roughly $1 billion. Tea prices went up significantly on account of higher fuel costs and poor harvests in India.
Big consumer-goods companies often find ways to offset the commodity price increases, sometimes through cost-cutting and sometimes by passing along higher prices to retailors and consumers. J.M. Smucker Co. raised prices about 9 percent on products in its coffee line up, which includes Folgers, Dunkin’ Donuts, and Millstone brands. In response to rising milk prices, Danone, which makes yogurt products, increased prices in markets including Mexico and Poland. Unilever’s chief financial officer noted that tea costs have gone up, and Unilever has already sent that higher costs down the chain on its consumer tea products.

QUESTIONS:
1. Suppose the price of coffee beans increases by $0.20 per pound. What is the effect of this raw material price increase on the demand for roasted coffee? If one pound produces 50 cups of coffee, would the price of a cup of coffee rise by $.01? Explain
2. The article reports that J.M. Smucker Co. plans to increase its coffee prices by 9%.
If Smucker has a lot of rivals but has a brand name that has value, will this 9% increase in retail prices imply that profit will rise by 9%?
3. Is it optimal for a firm to slash prices to retain market share? Is cutting prices during
a recession and then raising them in a recovery a good strategy?

Case 3: Renter’s Insurance
An insurance company would like to offer theft insurance for renters. The policy would pay the
full replacement value of any items that were stolen from the apartment. Some apartments have security alarms installed. Such systems detect a break-in and ring an alarm within the apartment. The insurance company estimates that the probability of a theft in a year is .05 if there is no security system and .01 if there is a security system (there cannot be more than one theft in any year). An apartment with a security system costs the renter an additional $50 per year. Assume that the dollar loss from a theft is $10,000 and that the insurance company is risk neutral and the renter would be willing to pay more than the expected loss to insure against the loss of theft.

a. What is the insurance company's breakeven price for a one year theft insurance policy for an apartment without a security system?
b. Does a renter have incentive to pay for a security system if he does not have insurance? To answer this question you must calculate the expected cost to the renter with and without a security system.
c. For a security system to be effective the renter must turn it on whenever he or she leaves the apartment. Suppose it costs the renter $10 per year in expended effort to turn on the alarm system. What is the insurance company's breakeven price for a one year theft insurance policy for an apartment with a security system? (HINT: Moral Hazard)
d. What deductible amount would provide sufficient incentive for the renter to turn on the alarm system each time he or she leaves the apartment?
e. What is the insurance company's breakeven price for a one year theft insurance policy with that deductible amount for an apartment with a security system?

Case 4: Optimal Pricing and Elasticity
Your company manufactures controllers used in the production of commercial air conditioning units. Your current price is $50 per controller. At that price the total quantity demanded is 4,000 spread over a large number of small customers. Fixed costs are $10,000 per month and marginal costs are $30 for production up to 10,000 units per month. Production cannot be pushed beyond 10,000 units per month. A hurricane has damaged the production facility of a company that produces a low-quality substitute controller. As a result that company has offered you a one-time $35,000 contract for 1,000 controllers to be delivered this month so they can meet the demand of their customers. Within a month the damage to that company's facility will be repaired and they will be back to normal production. Hence this event will not cause your demand curve to shift.

a) Before deciding on the contract you want to analyze your current market. What is the optimal price of your controller if the price elasticity of demand is estimated to be -2 for prices between $45 and $65 per controller?
b) Would you recommend setting your price to that determined in part (a)? Explain why or why not.
c) Would you recommend accepting the offered contract? Explain why or why not.
d) Does your answer to (c) change if your fixed costs are $12,000 per month? Explain why or why not.

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1) Before deciding on the contract you want to analyze your current market. What is the optimal price for units of Jighil if the price elasticity of demand is estimated to be -2 for prices between $45 and $65 per Jighil?

Optimal price can be calculated using the formula:
Optimal price = (1 + Markup) * Marginal cost
Markup is related to price elasticity of demand using the formula
Markup = 1/(-Elasticity of demand – 1)

Given that elasticity is -2, so markup = 1/(-(-2) – 1) = 100%
Since marginal costs are $30 per unit, optimal price per unit = (1 + 100%) * 30 = $60

2) Would you recommend setting your price to that determined in part (1)? Explain why or why not.

In order to make this decision, it is important to assess the change in profits of the company.
The profits have been computed using the formula:

Profits = (Selling price – Marginal cost) * Number of units sold – Fixed costs.

Currently, the total profits are: 4000 * (50 – 30) – 10,000 = $70,000

Raising the price to $60 means percentage increase in price is (60 – 50)/50 = 20%
Given the price elasticity as -2, percentage decline in quantity would be (-2 * 20%) = 40%
This means it can sell (1 – 40%) * 4000 = 2400 units.
Profits at $60 per unit = 2400 * (60 – 30) – 10000 = $62,000....
$101.25 for this solution

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