Business and Managerial Economics - Mars Confectionary - Essay Example

LSC London London School of Commerce MODULE Business and Managerial Economics SEMESTER: Semester leading BA SEMESTER : June 2010 – September 2010 SUBMITTED BY: My Name Section Topic page 1 Describe what happens to the rent and to the quantity of housing available if an earthquake suddenly and unexpectedly reduces the supply of housing. Trace the evolution of the rent and the quantity traded over time (in the long-run) 3 2a Explain why may a restaurant charge very high prices for wine and bottled water and yet quite reasonable prices for food? 3 2b Explain price elasticity of demand and discuss the main factors that affect it. 4 3a Draw a diagram illustrating the case of a perfectly competitive firm that is earning an economic profit. In the diagram, show the amount of the economic profit. 5 3b In a diagram, show the case of a perfectly competitive firm in break-even situation. 6 3c Draw a diagram to illustrate the case of a perfectly competitive firm that is incurring an economic loss but is continuing to operate. Be sure to include the AVC curve. Show the amount of the economic loss 6 3d Explain why will economic profits be zero at long-run equilibrium in a perfectly competitive industry? Be sure to mention the roles played by economic profits and losses. 7 4a Explain what is meant by inflation and deflation, clearly distinguish between them. 7 4b Explain the problems associated with inflation. 8 5a Impact on Mars bar market: There is a worldwide shortage of sugar due to unfavourable weather conditions in the major growing regions 8 5b Impact on Mars bar market: The Manufacturer Workers Union successfully negotiate an across the board wage rise for workers based at all Mars Confectionery plants 9 5c Impact on Mars bar market: General economic conditions are favourable with average household incomes increasing by 5% in the past year 9 5d Impact on Mars bar market: Rowntree Headley, manufacturer of Violet Crumbles, have undertaken an aggressive marketing campaign, dropping the price of the bar line by 10%. 10 5e Impact on Mars bar market: Researchers at Mars have developed an improved system for manufacturing the bar, which will increase output per hour by 20%. 10 1. Describe what happens to the rent and to the quantity of housing available if an earthquake suddenly and unexpectedly reduces the supply of housing. Trace the evolution of the rent and the quantity traded over time (in the long-run) (20 marks) An earthquake will affect not only the supply side but also the demand side of the housing market. On the supply side, the earthquake will reduce the supply of housing and, assuming that demand remained unchanged, the earthquake will lead to increases in rentals. However, demand does not remained unchanged in a major earthquake that caused significant damage to housing. Aftershocks take place and these sent jitters to consumers. City services like transport, electricity, and water are affected as well. Schools and workplaces may not be able to operate for some time. Thus, a major earthquake can send consumers to an exodus to locations safer from earthquakes and their aftershocks. In short, demand is affected as well. For this reason, it can happen house rent can remain unchanged or landowners may offer discounts to consumers. If demand is significantly reduced, house rent can even decrease and this seems to be the short-term effect in a strong earthquake everywhere. In the medium term as a location recovers from the earthquake, city and other services are restored and school/workplace operations normalize. But because supply is unable to respond quickly, housing supply may be fixed as demand is restored back to normal. Therefore, in the medium term, rentals may be higher than the immediate pre-earthquake levels. In this case, economic profit can be higher than normal and investors are encouraged to go into the housing sector. More housing units are built and the prices of house rentals decrease. The trend continues until the situation is normalized. This means that either house rentals are restored back to the pre-earthquake levels or the prices of rentals are back into the situation where economic profit is zero or “normal”. This discussion is similar to Varian (2005, p. 9). 2. a) Explain why may a restaurant charge very high prices for wine and bottled water and yet quite reasonable prices for food? (10 marks) Restaurants that charge reasonable prices for food but very high prices for wine and bottled are differentiating markets. On one hand, competition forces them to offer “reasonable” market prices for food. “Reasonable” can mean prices close to prevailing prices in the market plus possible premiums for factors like proximity, quality, ambience, and social status and prestige that may be associated with the restaurant. However, when a consumer patronizes the food in a restaurant, he or she becomes a captured market for the wines and bottled water. The consumer will have a very large transaction cost going to another restaurant just to buy drinks to go with the food. This being the case, the restaurant becomes a monopoly in the wines and bottled water market. As a monopolist, the restaurant can charge a monopoly price for the wines and bottled water. b) Explain price elasticity of demand and discuss the main factors that affect it. (10 marks) The price elasticity of demand is the percentage change in demand for the good or service per percentage change in price (Mas-Colell et al. 1995, p. 27; Nicholson 2001, p. 177). It measures how the quantity demanded measured as a percentage on the original or base quantity demanded changes given a percentage change in prices. According to Hirschey (2009, p. 148), there are three major determinants of the price elasticity of demand: 1. the extent the good or service is a necessity; 2. availability of substitutes; and 3. the proportion of income spent on the product. However, an older book, Eckert and Leftwich (1988, p. 64) identified four major factors influencing the price elasticity of demand and appears to be more precise: 1. availability of GOOD substitutes; 2. number of uses to which the good or services can be used; 3. price relative to the buyer’s purchasing power; and 4. whether the price is established in the upper or lower end of the demand curve. On the latter, Eckert and Leftwich said that demand is likely to be more elastic in the upper end of the demand curve and inelastic towards the lower end. (1988, p. 65) 3. a) Draw a diagram illustrating the case of a perfectly competitive firm that is earning an economic profit. In the diagram, show the amount of the economic profit. (5 marks) With costs computed to include opportunity costs, the economic profit is the difference between price and average cost per unit multiplied by the quantity demanded. The supply curve of a perfectly competitive firm is the marginal cost curve above the variable cost (not shown). The marginal cost curve from its intersection with the variable cost constitutes the supply curve of the competitive firm. The quantity associated with the intersection between the price line and the marginal cost curve is the quantity that the firm is willing to supply at that price. In perfect competition, the firm is a price taker. The quantity associated with the intersection of the firm supply curve and the price line is associated with an average cost. The price minus the average cost associated with quantity is the profit per unit. Total profit is the profit per unit multiplied by the quantity demanded. Total economic profit (costs cover opportunity costs) is the shaded area in the figure. b) In a diagram, show the case of a perfectly competitive firm in break-even situation. (5 marks) When price is equal to the marginal cost and equal to the average cost, then we have a break-even situation. In the figure, the price line is unable to touch the marginal cost curve and average cost curve because of Word precision problems. However, it is essential that P=MC=AC in the breakeven point. Here P=price, MC= marginal cost, and AC=average cost. c) Draw a diagram to illustrate the case of a perfectly competitive firm that is incurring an economic loss but is continuing to operate. Be sure to include the AVC curve. Show the amount of the economic loss. (5 marks) In the preceding figure, the firm continues to operate even when the price is below the average cost provided the price line intersects the marginal cost curve and is above the average variable cost. The firm continues to operate because it has spent the fixed cost anyway (not shown) and it is able to cover the average variable cost. However, the price is below the average cost associated with the intersection between the price line and the average variable cost and, thus, the firm operates at a loss. The loss is equal to the thin rectangle in the preceding figure. The rectangle equivalent to the loss is equal to price minus the average cost multiplied by the quantity associated with the intersection between the price line and the marginal cost. The intersection between the marginal cost curve and the average variable cost is the shutdown point (Samuelson and Nordhaus 1992, p. 144). d) Explain why will economic profits be zero at long-run equilibrium in a perfectly competitive industry? Be sure to mention the roles played by economic profits and losses. (5 marks) Long-run economics profits will be zero in the long-run equilibrium in a perfectly competitive firm because economic profits (costs cover opportunity costs) implies that firms will be entering the industry in which the firm belongs and losses imply that firms will have to leave the industry. The exit and entry of firms into losing and economically profiting industry will lead to a long-run situation in which economic loss will be zero. 4. a) Explain what is meant by inflation and deflation, clearly distinguish between them. (10 marks) In an inflationary situation, prices are increasing fast while prices are decreasing in a deflationary situation. Inflation is usually attributed to too much money in circulation relative to goods (Dornbusch et al. 2008, p. 13; Mankiw 2003, p. 13). Thus, much money is chasing relatively fewer goods and inflation results. In a deflation or deflationary situation, the opposite is the case: there are too many goods relative to money and prices are decreasing. This can happen when output suddenly decreases as in the great depression of the 1930s. b) Explain the problems associated with inflation. (10 marks) There are costs associated with inflation because economic agents may not be able to correctly anticipate inflation (Baumol and Blinder 2009, pp. 121-122). With inflation, economic agents may be unable to get the correct market signals and, therefore, resources are not allocated efficiently based on the market signals provided by prices. Investors can also have the problems related to capital as the required working capital for business operations can suddenly increase and economic agents may have problems in capital access. For Hall and Lieberman (2005, p. 518), inflation is costly for society. It will mean a decrease in the purchasing power of society’s members (Hall and Lieberman 2005, p. 518). 5. Examine the impact of the following events on the Mars bar market (20 marks): a) There is a worldwide shortage of sugar due to unfavourable weather conditions in the major growing regions. A worldwide shortage of sugar will have several effects. One possible effect is that production costs will increase in industries that are dependent on sugar. Candies or confectionaries, chocolate bars, ice cream, cakes, and bakery products are among the industries that are deeply dependent on sugar and production costs of these products can increase. In turn, the quantity demanded for products that are dependent on sugar may decrease thereby affecting both investors and labour. The combination of increased costs and dwindling demand for their products will be a concern among manufacturers that are dependent on sugar or whose demand for sugar is inelastic. At the same time, there may be industries who may be able to shift to artificial sweeteners. Thus, demand for sugar substitutes may increases. It is likely however that health concerns will prevent a large shift to use sugar substitutes and the more likely impact will be increases in the prices of products dependent on sugar. This also means that investors and labour both in the sugar industries as well as in industries that are dependent on sugar will most likely experience difficulties. In the case of Mars, management will likely explore ways for using substitutes for sugar. Otherwise, the increased in cost figures will likely lead to decreases in sales if the Mars bar market is elastic. b) The Manufacturer Workers Union successfully negotiate an across the board wage rise for workers based at all Mars Confectionery plants. A wage increase for workers in the Mars Confectionary plants will imply an increase in operational costs and will most likely result into a price increase of Mars confectionary products, especially if demand for the Mars products are relatively inelastic. Demand for substitutes of Mars confectionary products will likely increase. Thus, management may not be able to pass on the increase in operational or labour costs to consumers. The increase in wages will most likely influence the company to institute labour-saving policies and to favour mechanisation or automation. Management will most likely institute changes favouring the use of capital rather than labour-intensive technologies. The current labour force may or may not be affected but, most likely, the search for non-labour production or manufacture will be favoured in the coming years. c) General economic conditions are favourable with average household incomes increasing by 5% in the past year. Demand for all products will generally increase. Of course, essentially, this can be a case-to-case situation because whether demand for each product would increase would depend on the income elasticity of demand of each product. This means that products whose demand are highly elastic with respect to income will likely increase and demand for products that are relatively inelastic with respect to income will be unaffected. The increase in income will also imply that people are holding much money relative to goods and inflation will most likely result. Demand for Mars bar is most likely highly income elastic and, most likely, the Mars bar company will be looking forward to better sales. Of course, if demand for Mars bar is not income elastic (which is not likely), the effect of an increase in average household income may be nil. Further, an average income increase may not mean that all members of the population have experienced an increase in income. Demand for Mars bar will likely increase among sectors whose income have increased. d) Rowntree Headley, manufacturer of Violet Crumbles, have undertaken an aggressive marketing campaign, dropping the price of the bar line by 10%. Demand for Mars bars would likely decrease because Violet Crumbles can be a substitute for Mars bars. However, whether the demand would actually decrease is an empirical question and research can provide evidence whether demand for Mars bar are inelastic or elastic with regard to price movements for its close substitutes. e) Researchers at Mars have developed an improved system for manufacturing the bar, which will increase output per hour by 20%. An improved system for manufacturing the bar will probably lead to lower prices of Mars bar and will boost the demand for Mars bars. However, whether or not the improvement in the manufacturing process would actually lead to lower prices of Mars bars and boost the demand for Mars bars is essentially an empirical question. In short, we will have to check on the monetary costs of the improved production methods. The production methods may have shortened production time but it may have also increased production costs. 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