Question

7. Consider a Mexican firm that knits sweaters for sale to a U.S. department store. The firm incurs total costs of 16 pesos/sweater and sells the sweaters to the department store for $5 per sweater. The exchange rate is 4 pesos/$.

a) What is the firm’s markup per sweater as a percentage of revenues?

b) If the peso is devalued 20%, what is the new value of the peso?

c) If the firm keeps dollar prices constant and peso costs constant, what is the markup per sweater as a percentage of revenue after the devaluation?

d) If the firm decides to keep the gross margin per sweater constant (at 20%), would sales expand or decline? Why? What would the new dollar price be after devaluation?

Answer 1

a) Markup per sweater as a percentage of revenues is calculated below:

• CP =16 pesos/sweater
• The exchange rate is 4 pesos/$.
• So the CP in $ = 16/4 = $4 per sweater
• SP = $5 per sweater.
• 
• 
• 

b) If the peso is devalued 20%, the new value of the peso is calculated below:

• The exchange rate is 4 pesos/$.
• Devaluation of 20% would mean that now 20% more peso would be required to buy $1
  • therefore the new exchange rate would be 4 x 1.2 = 4.8 peso/$

c) Keeping dollar prices constant and peso costs constant, the markup per sweater as a percentage of revenue after the devaluation is calculated below

• CP =16 pesos/sweater
• The exchange rate is 4.8 pesos/$.
• So the CP in $ = 16/4.8 = $3.33 per sweater
• SP = $5 per sweater.
• 
• 
• 

d) If the firm has to keep the gross margin per sweater constant (at 20%), and the cost is now $3.33, the SP would be as calculated below:

• 
• 
• 
• 
• So the price will be reduced from $5 and therefore the sales will increase as demand rises when price falls keeping all other things constant