Question

Suresh Freemantle has owned and operated a trailer company for a number of years. He uses the standard mark-up of 200 per cent used in this industry, to determining the selling price of the trailers. Lately, sales have faltered as the country faces a recession. Suresh heard that you have learned about a pricing formula based on the price elasticity of demand, which may be useful to determine the selling price for the trailers.

Required: (1) Provide a plausible explanation as to why Suresh would currently use cost-based pricing to determine the selling price of the trailers.

(2) Explain elasticity to Suresh in simple terms, giving one example of a high elasticity product and one of an inelastic product.

(3) Discuss two possible reasons why a product’s price elasticity of demand would change.

(4) Explain how changes in the economy affect prices. Give two examples from the current business environment in Nz in your explanation.

Answer 1

1) Plausible explanation as to why Suresh should use cost based pricing to determine the selling price of the trailers is that as demand is low, consumers are only willing to buy if they are able to afford the trailers. The cost based pricing will include direct and indirect costs of production plus the markup in order to generate a reasonable amount of profit. Using this mechanism Suresh will be able to give the break up of the costs he is charging and will also be able to justify the price in times of recession, so that more number of consumers will end up purchasing the trailers because of this transparency and lower price. This will lead to higher sales and profitability.

2) A product is defined as highly elastic whenever because of increase in price, its demand reduces, whenever the elasticity is more than one, it implies demand reduces more than the price increase, for example market for luxury goods, or vacations. If the tour cost reduces drastically, demand will increase more than the change in price.

In the case of an inelastic product on the other hand, if the price increases, the demand doesn't reduce drastically, people continue to buy products even at a higher price, for example essential commodities such as medicines, milk and eatables.

3) Two possible reasons that a product's price elasticity of demand would change could be because of availability of substitutes and number of uses. For example if only tea is available in a country, then even if the price increases, people will continue to consume tea, but if coffee emerges as an alternative, then people will start to replace tea with coffee, leading to fall in demand for tea.

Number of uses also plays an important role, If a person uses a telephone, then even if the price increases, the consumer will continue to buy a telephone because there is no other alternative and a telephone is required to serve business needs. But on the other hand, if a mobile phone emerges with several advantages, then price elasticity of demand for telephone will change as people will replace telephone with a mobile phone.

4) Changes in the economy in terms of demand and competition, leads to reduction in the price level, if the demand is low and there is high unemployment. Thus because of decline in demand the oil prices reduced drastically and it reduced the import bill of New Zealand. House prices have also fallen in New Zealand, because of lower demand, consumer confidence and people saving and hoarding more money.