FIN FPX 5710 Assessment 4 Pricing Analysis

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Capella University

FIN-FPX5710 Economic Foundations for Financial Decision Making

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Introduction

This report aims to advise our client as they prepare to launch a new ultra-light notebook computer. The analysis will examine how market conditions may influence their pricing and marketing decisions, focusing on the effects of supply, demand, equilibrium, and elasticity on both individual firms and market dynamics. I will apply producer theory principles regarding pricing, assess how competition impacts markets, and explore how economic conditions shape organizational decisions on buying, selling, pricing, and supplying goods. Additionally, I will examine how regulations may influence their business strategy.

Demand, Supply, and Equilibrium

Most of the world’s economies use a market system, also referred to as capitalism or a mixed economy. In this system, individuals and businesses work towards achieving their economic goals by making decisions regarding work, consumption, or production. This system operates through private ownership of capital and uses prices to communicate and coordinate economic activity through markets (McConnell, 2021, p. 27). A market brings together sellers (suppliers) and buyers (demanders). The model of supply and demand is considered one of the most significant contributions of economics, explaining how markets operate, which are essential for the goods and services we rely on (McConnell, 2021, p. 46). Demand refers to a schedule that displays the quantities of a product consumers are willing and able to purchase at various prices over a specific time frame (McConnell, 2021, p. 47).

For meaningful analysis, the quantity of a good being demanded must be measured within a certain time frame and under the assumption that if the price of one item in an industry rises, all similar products will follow. The law of demand shows an inverse relationship between price and quantity demanded. Three factors explain this inverse relationship. First, the law of demand aligns with common sense, as price acts as an obstacle for consumers. Higher prices generally lead to reduced purchases, while lower prices lead to increased consumption. Second, each buyer derives less satisfaction or utility from each additional unit of a product, so they will only purchase more if the price decreases. Lastly, the income and substitution effects provide further explanation.

The income effect shows that a lower price increases a buyer’s purchasing power, allowing them to buy more, while the substitution effect encourages consumers to choose the cheaper of two similar products (McConnell, 2021, p. 48). Five key determinants of demand are: (1) consumer preferences, (2) the number of buyers, (3) consumer incomes, (4) prices of related goods, and (5) consumer expectations (McConnell, 2021, p. 50). Any changes in these determinants can cause a shift in overall demand at the market level, impacting individual firms. For instance, if demand for pickles decreases, the market may not sustain all producers, forcing some out of business while the market itself shrinks.

FIN FPX 5710 Assessment 4 Pricing Analysis

Supply refers to a schedule that shows the quantities of a product producers are willing and able to sell at different prices over a specific period (McConnell, 2021, p. 52). The law of supply indicates a positive relationship between price and quantity supplied. Higher prices encourage firms to produce and sell more, while lower prices have the opposite effect (McConnell, 2021, p. 53). Whereas price is a hurdle for consumers, it represents revenue for producers, motivating them to increase production at higher prices. The six main determinants of supply include: (1) resource prices, (2) technology, (3) taxes and subsidies, (4) prices of other goods, (5) producer expectations, and (6) the number of sellers (McConnell, 2021, p. 52). A change in any of these determinants can lead to an increase or decrease in supply. For example, a rise in resource prices increases production costs, reducing profit margins and ultimately lowering the supply of a product.

Equilibrium price is the price where the intentions of buyers and sellers align, meaning the quantity demanded equals the quantity supplied. At this point, there is no surplus or shortage because market forces have driven the price to equilibrium, which remains stable until affected by changes in supply or demand determinants (McConnell, 2021, p. 56). Adam Smith described this phenomenon as the “invisible hand” guiding economic interactions toward socially beneficial outcomes. Economists now term this an “emergent property,” where the behavior of the entire system is more than the sum of its individual parts (McConnell, 2021, p. 57). For example, if 100 spatulas are priced $1 above equilibrium, there will be a surplus, pushing prices down as producers lower prices to clear excess inventory. Alternatively, if spatulas are priced below equilibrium, competition among buyers will drive the price back up.

Elasticity / Inelasticity

The supply and demand model shows that consumers and producers react to changes in prices and incomes. Elasticity measures how sensitive supply and demand are to these changes (McConnell, 2021, p. 118). Price elasticity of demand gauges how responsive consumers are to price changes, calculated as the percentage change in quantity demanded divided by the percentage change in price (McConnell, 2021, p. 118). When demand is elastic, a decrease in price leads to a proportionally greater increase in demand, resulting in a value greater than 1. This indicates that quantity demanded is highly responsive to price changes (McConnell, 2021, p. 119).

In contrast, inelastic demand results from a price change causing a smaller change in quantity demanded, resulting in a value less than 1, meaning consumers are less sensitive to price changes (McConnell, 2021, p. 119). Total revenue is closely linked to price elasticity; if revenue moves in the opposite direction of price, demand is elastic, and if it moves in the same direction, demand is inelastic. For example, lowering prices may increase total revenue by increasing sales volume, whereas raising prices may decrease revenue if demand is elastic.

Elasticity also applies to supply. If producers are highly responsive to price changes, supply is elastic; if not, supply is inelastic. Supply elasticity is measured similarly to demand elasticity: the percentage change in quantity supplied divided by the percentage change in price (McConnell, 2021, p. 127). Supply is inelastic if the value is less than 1 and elastic if greater than 1. The speed and ease with which producers can shift resources between uses influence supply elasticity (McConnell, 2021, p. 126).

FIN FPX 5710 Assessment 4 Pricing Analysis

Income elasticity of demand measures how consumers alter their purchases in response to income changes, expressed as a percentage change in quantity demanded divided by the percentage change in income (McConnell, 2021, p. 130). This value can be positive or negative, unlike price elasticity of supply and demand. Typically, income elasticity is positive, with demand rising as income increases. However, for inferior goods, income elasticity is negative, as consumers buy fewer cheap goods when their income rises (McConnell, 2021, p. 130).Understanding elasticity helps businesses set prices. For example, airlines use elasticity to differentiate pricing between business and leisure travelers, with business travelers less sensitive to price changes (McConnell, 2021, p. 132).

The total contribution to gross profits from the 9,000 units sold amounts to $114,000. By subtracting the total fixed costs of $24,000 from the $114,000, the gross profit from these 9,000 units is $90,030. This approach provides a clearer understanding of how changes in production would impact the bottom line, as fixed costs remain constant regardless of whether 9,000 or 12,000 units are produced (based on the facility’s capacity before requiring capital investments for physical changes to increase production). The same method can be used to evaluate potential savings in production costs if any part of the final product is outsourced.

Long-term production costs can be viewed through the concept of economies of scale, which generally states that average costs decrease with mass production (McConnell, 2021). Mass production can lower costs due to factors such as improvements in efficiency from labor and managerial specialization, as well as technological innovation leading to increased output. However, for companies that cannot efficiently coordinate expansion, diseconomies of scale may arise, where output increases are smaller than the rise in production costs. Before considering expansions or additions to production, it is essential to understand the concept of minimum efficient scale, which refers to the lowest level of output at which a firm can minimize long-run average costs (McConnell, p. 190, 2021).

Competition

A firm’s decisions regarding pricing and production are influenced by the level of competition in its industry and market. There are four main market structures: (1) pure competition, (2) pure monopoly, (3) monopolistic competition, and (4) oligopoly (McConnell, pp. 196-197, 2021). Pure competition involves a large number of firms producing standardized products, where firms can easily enter or exit the industry and must accept the market price. Pure monopoly occurs when one firm is the sole seller of a product or service, with blocked entry and exit, giving the firm complete control over pricing. Monopolistic competition features a relatively large number of sellers producing differentiated products, where entry and exit are relatively easy, and firms have some control over selling prices. Oligopoly markets are characterized by a few sellers of standardized or differentiated products, where each firm is affected by its rivals’ decisions and must consider these when determining its own prices and output (McConnell, p. 197, 2021).

Most real-world industries fall somewhere between pure competition and pure monopoly, often in monopolistic competition. Many firms have differentiated products, leading to competition based on price, quality, location, service, and advertising (McConnell, p. 251, 2021). Before launching their new extra-light notebook computer, the firm should assess the competition and determine how to differentiate itself based on factors such as product attributes, post-sale service, target sales locations, packaging, and advertising. This will help inform pricing decisions, considering variable and fixed costs. The Herfindahl index can also assist by measuring the degree of industry concentration—the extent to which the largest firms account for most of the industry’s output and competition (McConnell, p. 253, 2021).

Generally, a lower Herfindahl index indicates a more monopolistically competitive industry. In the short term, firms aim to maximize profit and minimize loss by setting output where marginal revenue equals marginal cost, thus achieving economic profit (McConnell, p. 199, 2021). However, long-term profits in monopolistic competition may decrease, as easy entry into the industry leads to increased substitute products and reduced demand per firm. When firms exit due to losses, this raises demand for the remaining firms, increasing their profitability (McConnell, p. 156, 2021). To remain competitive in the long run, firms should offer a variety of products, make continuous technological improvements to reduce production costs, and invest in strong marketing campaigns.

Economic conditions

The economy is not a static environment in which businesses operate. Economic growth fluctuates, significantly impacting business operations. During periods of growth with low unemployment, consumers tend to spend more freely, increasing demand and allowing producers to expand and raise prices. In times of expansion requiring capital investment, producers are more willing to borrow and invest when interest rates are low, materials are available, and demand is strong enough to ensure profitability. Conversely, during recessions, when consumer demand contracts and unemployment rises, expansion becomes unwarranted. Producers may need to reduce spending and production costs while lowering prices to avoid excess inventory and maintain revenue.

Inflation, even outside of recessions, can also raise production costs, as can disruptions in material availability. In the current economic climate, driven by the COVID-19 pandemic, businesses have experienced material shortages due to global production pauses, followed by stimulus injections and low-interest rates, leading to increased inflation. Inflation reduces purchasing power and often prompts the Federal Reserve to raise interest rates. In this environment, producers should avoid capital investment for expansion, as they would face higher interest rates, material costs, and overall production expenses, which may not be offset by consumer demand.

Regulatory considerations

Regulations affect pricing decisions and must be considered to avoid legal and financial penalties. Competitive monopolies resulting from anti-competitive actions are illegal under antitrust laws, which are enforced by the Federal Trade Commission and the U.S. Department of Justice. This also applies to mergers and vertical or horizontal integration. Price-fixing, where firms collude to maintain a commodity’s price at a certain level, is illegal, as it inhibits competition and restricts market entry. Social regulations also directly impact business operations. For instance, manufacturing processes must comply with Environmental Protection Agency (EPA) regulations to protect the environment. Employment practices are governed by the Equal Employment Opportunity Commission (EEOC), and violations related to discrimination can result in legal and financial consequences. Understanding and adhering to these regulations is crucial for ensuring that business strategies align with legal and financial requirements.

References

Agarwal, P. (2022). Theory of production: Short run analysis. Intelligent Economist. https://www.intelligenteconomist.com/theory-of-production-short-run-analysis/

Marshall, D., McManus, W., & Viele, D. (2020). Accounting: What the numbers mean (12th ed.). McGraw-Hill.