Question

Discussion:

Imagine you are the CEO of Very Big US Auto. In anticipation of the upcoming quarterly disclosure of profits, you prepare your Board of Directors for the challenge that US Tariffs on Chinese Imports is having on profits.

Very Big US Auto - Very Big US Auto is one of the oldest and one of the largest auto manufacturers of autos in the US. Very Big US Auto's supply chain is highly dependent components manufactured in China and assembled in the US. Like the US economy the Chinese continue to have major stoppage in production due to Covid-19. Additionally manufacturing facilities like ours must take extra precaution to keep workers safe. Costs are rising we are experiencing rising costs. Very Big US Auto know that demand is relatively elastic with a price elasticity of demand of 1.2. We also know that the supply of auto is relatively inelastic and all our competitors are facing the same cost increase.

Is the demand curve for your product relatively elastic, inelastic or unitary elastic? Demonstrate for your company's product, by how much the quantity demanded will change if you pass on a 10% increase in cost. In other words, show your calculation of the percentage change in the quantity demanded given a 10% change in your price. You must provide a calculations showing the percentage change in quantity demanded.

Given your company's and price elasticity of demand and the industry supply/competitive environment you face prepare a statement for your board as to the potential impact on profits. Who will pay the larger share of the cost increases, your firm or your customers?

Answer 1

The demand curve for our product is relatively elastic with a stated Price Elasticity of Demand of 1.2 meaning a percentage increase in the price of our product would cause the demand for our product to fall by 1.2 percentage i.e. more than one and therefore the demand curve is relatively elastic.

Formula for Price Elasticity of Demand:

Price Elasticity of Demand = % Change in Quantity Demanded / % Change in Price

Calculations:

Price Elasticity of Demand = % Change in Quantity Demanded / % Change in Price

=> 1.2 = % Change in Quantity Demanded / 10%

=> % Change in Quantity Demanded = 12%

For our company's product, the quantity demanded will decrease by 12% if we pass on a 10% increase in cost.

Statement for Board:

Dear Shareholders,

We are the oldest and one of the largest auto manufacturers of autos in the US. Our supply chain is highly dependent on components manufactured in China and assembled in the US. Like the US economy the Chinese also continue to have major stoppage in production due to Covid-19. Additionally manufacturing facilities there like ours must take extra precaution to keep workers safe. Costs are rising and we are experiencing rising costs. Very Big US Auto know that demand is relatively elastic with a price elasticity of demand of 1.2. We also know that the supply of auto is relatively inelastic and all our competitors are facing the same cost increase.

Being in the industry that we are in, passing on costs to customers will lead to stunted revenue generation and reduced profitability, thereby we as a firm must bear the brunt of increased costs to the largest extent taking the various cost optimization processes by way of laying off employees and the rest must receive pay-cuts proportionally with respect to seniority of designation and yet we will be experiencing reduced profitability from reduced demand and increasing costs that cannot be passed on to customers for the near to medium term as long as the Covid-19 scenario does not stabilize.

-  Very Big US Auto