Microeconomic Analysis Pauls Bakery Company for a Business - Case Study Example

Microeconomic Analysis for a Business Name: Student Number: Lecturer: Date: 1. INRODUCTION This is an economic analysis for Paul’s Bakery Company which specializes in the baking of bread. The report largely demonstrates the economic analysis techniques for the firm. It also provides the CEO of the firm with a business strategy, which seeks to maximise profits for shareholders. This has been justified using microeconomic analysis techniques. The main aim of every corporation is to maximise on profits for its shareholders therefore creating value for its shares so that it can maintaining the interest of investors since shareholders and investors tend go for profitable firms. The main aim of this report is analyze Paul’s Bakery and give advice on how to maximise profits. It should improve earnings per share the next and subsequent financial years, (Segal, 2007). It should try to demonstrate a pattern of positive earnings per share growth in the next and subsequent years. A product can simply be defined as any results of a process, labour or effort which has value and can satisfy a need. The firm is an entity, which produces any economic good has one management and aim at maximizing its profits. The market on the other is a point of interaction between the seller and the buyer to exchange goods or services. It can also be used to mean extent of the sale for a commodity like bread for our case. Some also use it to mean trade especially in the business world, (Segal, 2007). ECONOMIC ANALYSIS Paul’s Bakery is a producer in an oligopoly setting where there are few but large firms. In a bread making industry however, each firm determine the prices for its products in the market. The industry also has some close substitutes like cakes and dough. Non-price competition exists especially in differences in quality of the products. Supernormal profits are earned both in the short run and long run. However there is freedom of entry and exit into the industry, new firms are bound to come to the market and disturb the price stability existing in the current market, (Segal, 2007). The customers in the industry however would rather buy a cheaper substitute and therefore if Paul’s Bakery lowers its prices then it will win a large proportion of customers from other firms. (Segal, 2007) thinks that other firms are likely to retaliate by lowering price either to the same extent or a large extent. The first firm will retaliate by lowering the price even further. As the firms will always expect a counter-strategy from rival firms, each price and output decision the firms comes up with is a tactical move within the framework of a broader strategy. This will lead to a price war. If it goes on there will come a time when the prices are so low that if one firm lowers price, the consumers will see no point in changing from their traditional suppliers. Thus, the demand for the product of the individual firm will start by being elastic and it will end by being inelastic, (Dunne, et al, 2009). The demand curve for the product of the individual firm thus consists of two parts, the elastic part and the inelastic part. It is said to be kinked demand curve as shown below. If the firm is on the inelastic part and it raises price, the others will not follow suit. But on this part prices are so low that is likely to retain most of its customers. If it raises price beyond the kink, it will lose most of its customers to rivals. Hence the price P will lose most of its customers to rivals. Hence the price p will be the stable price because above it prices are unstable in that rising price means substantial loss of customers and lowering price may lead to price war. Below P prices are considered to be too low, (Dunne, et al, 2009). DEMAND Otherwise the law demand which states that demand will fall if the price of goods rise and will increase when prices are lowered. However this is based on the fact that all other factors are kept constant. We can therefore conclude that the inverse proportionality between price and demand is due to level of income of consumers; (World Bank, 2003) says that customers feel richer and buy expensive goods when their income is high and the reverse is also true. Demand will increase in the market if the income of buyers is increased. This is demonstrated in figure 2. Demand shifts from D1, D1 to D2, D2 as a result of increasing the consumers income. It will also shift from D2, D2 to D1, D1 when the incomes of the customers are reduced. This demonstrates the income elasticity of demand. Availability of substitution of a product can as well decrease demand for the product in the market. For instance if a cheaper perfect substitute is introduced into the market; demand of bread will go down since many buyers will go for the cheaper substitute, (Arrow and Hahn, 1991). However the elasticity of this kind of change in demand will largely depend on the ability of the new substitute to satisfy the consumers as well as its prices in the market. If the price of the substitute like a cake in the market is increased then the demand of the bread will increase since more cake customers will now shift from buying and opt for bread. If the price of the same substitute is decreased then demand for bread will decrease since more bread users will shift to using cake which is cheaper, (Segal, 2007). Population of the country largely affect changes in demand in the market of bread. An increase in population will cause and increase in demand of the bread because bread is stable food for many people. Increased population will mean and increased market for bread hence increasing demand, (Irwin, et al, 2008). Reduction of population will also mean reduction of the consumers of bread in the market and therefore demand of the bread will go down. The shift in demand curve is normally caused by determinants of demand. However the movement along the curve is normally caused by changes in prices of bread only. This is normally referred to as changes in quantity demand and refers to the amount of a good that a consumer is willing to buy and able to pay for at a given price over a given period of time. In predicting effects of changes in demand in responses to prices changes, firms can use demand curve as a tool. This will be done as shown in the figure 3 P If Paul’s Bakery can increase the price of bread from say 2 units as shown in the diagram which has a current demand of 200 loafs in the market to 4.5 units, the demand in the market will reduce by 100 and new demand will be only 100 loafs. The reverse is also true. (Irwin, et al, (2008) argued that the changes in demand along the demand curve are cause by changes in prices of goods and the determinants of demand cause shift in the demand curve. These determinants of demand include buyer income changes, changes in prices of substitutes, new firms entering the industry, population, growth and changes in taste and preferences among others. SUPPLY The supply schedule below shows relationships between the changes in prices and its effects on supply in the market. Price per loaf in dollars ($) Quantities offered for sale per month in ‘000 2 10 2.5 20 3 30 3.5 40 4 50 4.5 60 5 70 Table 1 Paul’s Bakery Supply Schedule Movements along the supply curve are brought about by changes in the price of the commodity. Figure 4; Price elasticity of supply P represent price, while q is quantity When price increases from P1 to P2, quantity supplied increases from Q1 to Q2 and movement along the supply curve is from A to B. Conversely when price falls from P2 to P1, quantity supplied falls from q2 to q1 and movement along the supply curve is from B to A. Shifts in the supply curve are brought about by changes in factors other than the price of the commodity. A shift in supply is indicated by an entire movement (shift) of the supply curve to the right (downwards) or to the left (upwards) of the original curve. When supply increases, the supply curve shifts to the right from S1S1 to S2S2. At price P1, supply increases from q1 to q’1 and at price P2 supply increases from q2 to q’2. Conversely, a fall in supply is indicated by a shift to the left or upwards of the supply curve and less is supplied at all prices. Thus, when supply falls, the supply curve shifts to the left from position S2S2 to position S1S1. At price p1, supply falls from q’1 to q1 and at price p2, supply falls from q’2 to q2, (Dunne, T., et al, 2009). The determinants of supply are those factors which cause a shift in demand curve, they include; output price, input price, price of substitutes in production, expected prices, number of firms and technology. If the cost of inputs for the firm go up it will cause a shift in demand curve down wards meaning that the firm will be able to take less quantity of loafs of bread to the market than it used to before the cost was increases. This can be attributed to the fact that if the cost of production moves up, the firm will use the available resource to produce but fewer amounts of goods than before. This means therefore that input price has an elastic impact on the market supply. The opposite is also true that if the cost of output rise, the there will be an upward shift in demand curve meaning the firm can now supply more goods to the market since profitability ratio will increase and motivate more production. This has elastic effects on the supply curve as well. The prices of substitutes in the market will also impact on the firm supply to the market. An increase in the cost of production for a competitor will result in reduced supply to the market causing a shortage of supply in the market. The shortage of supply will cause high demand in the same market for substitute goods and will call for more production from close substitutes as well as cause price changes for substitutes in production. The prices will rise for the substitute goods. Another factor which causes a change in supply is technology used in production. An efficient technology will have the effect of reducing the cost of production and therefore the effects will be the same as those of reduced input costs. An equally bad technology will cause an increase in the input and hence the effects will be the same as those of the increased input cost. If draw on the same grid, supply curve will meet the demand curve at a point, the point of intersection is what will determine the bread in the market at both optimum supply and demand. This point of intersection will determine price of the product in the market. This is illustrated in figure 6. Figure 6: the intersection between supply and demand Paul’s bakery is guided by Profit-maximization assumption in its production process. In all its decisions and action it is focused on increasing profits. Profit-maximization is coupled with production of utility-maximization for the behaviour of the consumer According to microeconomic theory, the best profit output is produced when the Marginal revenue (MR) and marginal costs (MC) are equal. It can also be approached from the side of input where varying the inputs to come up with an increase usage of all factors of production. This will be realized when the Marginal Revenue Product (MRP) is also equal to MC. MRP is actually the variable in input excluding labour, (Atkinson, 1990). When MR= MC the marginal profit or profit function slopes at zero. Figure 1.3 where the company will be most profitable at ON. According to the economic theory, the company management who make decisions should identify and go for this unique output level of production which maximises on profit. Figure 7 Fig 7; Net profit function; y-axis represent price, x-axis is output The economic real world has a shortage of resources which give rise to a lot of complexities and therefore makes it impossible to attain the maximum output level (ON). Practically the maximum output level can be attained as a result of limiting of resources, (OM). Now the problem is getting the real output which will represent the profits beyond OM and to the left, however this theory will not help ON is irrelevant to the side of resource limitation. Figure 8 Y-axis rep. Price (P), X-axis is Output(Q) Otherwise marginal profits (Mπ) equal marginal revenue (MR) less marginal cost (MC). But since MR is greater than MC, Mπ is a positive value, but when MR is less than MC, then Mπ is a negative value. In a situation where MR = MC then Mπ = 0. Profits will increase when Mπ is a positive value but decrease when Mπ is a negative value. However, profits will be at its maximum when Mπ = 0 or in a where MC = MR, (Ariel, 2005). The business strategy for profit maximization for Paul’s Bakery will be changing cost by reducing the total cost and trying to increase the marginal revenue. The important factor here is effect on the company profit when marginal cost is changed. If the price of wheat is increased; noting that wheat flour is a critical input in the process on making bread, this will definitely increase the cost and hence the supply curve will shift upwards. Figure 9; marginal cost and marginal revenue Y-axis rep Price (P), X-axis rep Output (Q) BUSINESS STRATEGY A business strategy that Paul’s bakery will employ is the prudent management of its costs. This enables the business to maximize profit. Profit is the actually revenue obtained from selling the organization output less the total cost of production of the output. Paul’s Bakery will therefore have to generate the greatest difference between total revenue (TR) and total cost (TC). For instance considering Paul’s Bakery profit maximization, when it generates $100,000 of profit by producing 1,000 Bread; its profits will be the difference between $10,000 of revenue and $9,000 of cost, (Ariel, 2005). The shift in the MC curve generated will make a new meeting point MR an MC at a value of $0.75 maintaining the number of breads at 1,000. This intersection remains on the vertical segment of the MR curve. Paul’s Bakery maximizes profit by producing 10,000 breads sold for $1 each. This is equal to profit-maximizing price and quantity combination that Paul’s Bakery had prior to alteration of the MC If profit falls from this $100,000 level when The Paul’s Bakery produces more (100,001) or fewer (99,999) Bread, then it is maximizing profit at 100,000. Alternatively, if profit can be increased by producing more or less, then The Paul’s Bakery is not maximizing profit. Suppose, for example, that producing 100,001 Bread adds an extra $11 to revenue but only $9 to cost. In this case, profit can be increased by $2, reaching $100,002; by producing two more breads then 100,000 is not the profit maximizing level of production, (Varian, 1992). In contrast, suppose that producing 99,999 Bread reduces cost by $11 but only reduces revenue by only $9. In this case, profit can also be increased by $2, reaching $100,002, by producing 1 bread less the former quantity. As such, 100,000 is not the profit maximizing level of production. Now that wages paid to the Paul’s Bakery workers decline, resulting in a decrease in production cost. In this case, marginal cost decreases and the marginal cost curve shifts downward, (Eaton Et al, 2002). The shift of the marginal cost curve generates a new intersection between marginal revenue and marginal cost at a value of $0.50 and a quantity of 10,000 crates. This intersection is also on the vertical segment of the marginal revenue curve. Paul’s Bakery maximizes profit by producing 10,000 crates sold for $1 each. This is also the same profit-maximizing price and quantity combination that Paul’s Bakery had before the change in marginal cost, (Willstatter, 1999). Paul’s Bakery also can enjoy a decrease in cost without changing the profit-maximizing price and quantity combination from its initial level. This generates the key conclusion from the kinked-demand curve analysis, (Eaton Et al, 2002). An oligopolistic firm facing a kinked-demand curve produces the same quantity at the same price for significant increases and decreases in marginal cost. In other words, Paul’s Bakery does not automatically pass along higher or lower production cost to the buyers. Interdependent decision-making and other firms in the industry prevent Paul’s Bakery from passing cost changes to buyers, (Mary, Snell, and William, 2007). Paul’s Bakery has to absorb higher production cost with less profit. However, Paul’s Bakery receives a boost in profit should production cost fall. To obtain the profit maximising output quantity therefore, we start by recognizing that profit is equal to total revenue (TR) minus total cost (TC). Where the profit and t is the time period in financial year(s), but TR for period t is the same as price per commodity, (Pt) multiplied by the Quantity of sales (Qt) TC for time t is equal to cost per unit (Vt) multiplied by the Quantity produced in the market added to the fixed cost for the length of time. If the present value of shareholders in Paul’s Bakery is Vo, and π is profit expected at the end of each trading period, then;  A common equation will therefore be; In Equation (3), the term aTR/aQ is the slope of the total revenue curve, which is equal to the marginal revenue (MR). Similarly, the term aTC/aQ is the slope of the total cost curve, which is equal to the marginal cost (MC). Thus, the first-order condition for profit maximization can be stated as: MR=MC, (Tian, 2004) The first-order condition is also called necessary condition, as it is so important that its non-fulfillment results in non-occurrence of the secondary condition and thereby the profit maximization objective is not attained. Pursuing a profit maximization strategy comes with the obvious risk that the company may be so entrenched in the singular strategy meant to maximize its profits that it loses everything if the market takes a sudden turn. Risk Analysis The limitation that Pauls Bakery Company is likely to face in the process of increasing its profit margins include large increases in production cost, this will force Paul’s Bakery to reduce production and charge a higher price for its products which will be a big challenge in the market. In this case the leftward/upward shift of the marginal cost curve is so great that Paul’s Bakery maximizes profit by reducing production to 50 breads and raising the price to $1.10 bread, (Tian, 2004) . Sufficiently large decreases in production cost also induce Paul’s Bakery to increase production and charge a lower price. In this case the rightward/downward shift of the marginal cost curve is so great that Paul’s Bakery maximizes profit by increasing production to 12,000 crates and lowering the price to $0.90 per can. This kinked-demand curve analysis illustrates why oligopolistic firms might keep prices relatively rigid. The explanation rests with interdependent decision-making among oligopolistic firms. Higher prices are not matched by other firms, but lower prices are. However, this analysis only indicates why prices do not change. It does not explain why or how prices are established in the first place. Why, for example, is the initial price of Paul’s Bakery $1? The kinked-demand curve analysis offers no insight, (Eaton Et al, 2002). CONCLUSION To sum it up, this theory is the best approach to maximization of profits for Paul’s Bakery. The reason underlying is that this business is able to utilize functional concepts of revenue and costs applying them mathematically to attain the required approach to attain optimum point where profit will be at its maximum. Derived equation will help guide the management in decision making on financial allocations for the various factors of production to ensure they create the greatest difference between costs incurred in the bread making process revenue obtain by selling bread in the market. REFERENCES 1. Ariel, R. (2005) Lecture Notes in Microeconomics (modelling the economic agent), Princeton University Press 2. Arrow, J. and Hahn, H. (1991) General Competitive Analysis. Edinburgh: Oliver and Boyd 3. Atkinson, A. B. (1990). On the measurement of inequality; Journal of Economic Theory 2, 244.263 4. Dunne, T., et al, (2009). Producer Dynamics: New Evidence from Micro Data. University of Chicago Press. Chicago 5. Eaton, B. Et al, (2002) Microeconomics. Prentice Hall, 5th Edition. 6. Irwin, J.G., Hoffman, J.J. & Geiger, S.C. (2008). The effects of technological adaptation on organizational performance: Organizational size and environmental munificence as moderators. The International Journal of Organizational Analysis, 6(1): 50-64. 7. Mary A.; Snell, and William M. (2007) Macroeconomic and International Policy Terms [intenet], Retrieved from; http://www.ca.uky.edu/agc/pubs/aec/aec75/aec75.pdf. Retrieved on; 2011-09-27. 8. Segal, I. (2007), Lecture Notes in Contract Theory, Stanford University. 9. Tian, G., (2004) The Basic Analytical Framework and Methodologies in Modern Economics. [Internet] Retrieved form; http://econweb.tamu.edu/tian/chinese.htm. Retrieved on: 25th Sept, 2011 10. Varian, H., (1992) Microeconomic Analysis, 3rd ed. W.W. Norton and Company, New York 11. Willstatter, E., (1999) Topics in Microeconomics - Industrial Organization, Auctions, and Incentives, Cambridge Press 12. World Bank (2003), The Impact of Economic Policies on Poverty and Income Distribution: Evaluation Techniques and Tools, edited by L. Pereira da Silva and F. Bourguignon. Read More