MBA Course Work-Economics November 23, 2010

Coursework on the Module, ‘Business Economics’

Course Code: MAN4101M
UB Number: XXXXXXXX

I certify that this assignment is the result of my own work and does not exceed the
word count noted below.

Number of Words: 1750.

(Excluding appendices/references, the title page, table data and graphs, figure captions,
header and footer notes and the question asked)

Signature: Date of submission: 23rd-Nov-2010

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MBA Course Work-Economics November 23, 2010

Introduction:

The Price of a product can be used as an index to measure the profitability of a firm, it is
also a key element to determine whether a firm can sustain in a highly competitive
market. This assignment is divided into two sections; in the first section, we will discuss
the factors that determine the price of a good by understanding the Demand and Supply
curves, Equilibrium price, factors of production, product elasticity and product life cycle.
In the later section, with the example of NEXT, the UK fashion retailer, we will discuss
when it can pass on a price increase to the customers by considering each of the factors
discussed in the first section.

Part 1: The main economic factors that determine the price of a good or service

In economics, Demand and Supply law can be defined as the relationship between the
consumer and the producer. A ‘Demand Curve’ as shown in the figure 1, says customers
demand less goods when priced high and demand more when priced low.

Figure 1-Demand Curve (Source: Griffiths and Wall, 2005)

On the contrast, ‘Supply Curve’ as shown in the figure 2, says that firms supply less
goods at low price and more good at high price to maximize profits.

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MBA Course Work-Economics November 23, 2010

Figure 2-Supply Curve (Source: Griffiths and Wall, 2005)

However, the final determination of the price depends upon the market structure in
which the firm is operating. That means how much control on price does the firm have
on its products or service, in other words, whether the firm is operating in perfect
competition, monopoly, monopolistic competition or oligopoly (Sloman, 2006). To
understand the concept of pricing, let us consider perfect competition and dwell deep
into factors affecting the price of a product or service.

Equilibrium Price:
In a perfect market, the market itself determines the price based on the quantity
demanded and the quantity supplied. The price which is determine by combining
Demand curve and Supply curve is called as Equilibrium Price, which say ‘The price
where the quantity demanded equals the quantity supplied’ (Sloman, 2006, p20).
Whenever there is a fluctuation in either demand or supply, each of it gets adjusted to
reach a new Equilibrium Price. Sloman, in his book Economics has defined this as Price
Mechanism, which by definition is “The system in a market economy whereby changes in
price in response to changes in demand and supply have the effect of making demand
equal to supply” (Sloman, 2006, p20).

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MBA Course Work-Economics November 23, 2010

Figure 3-(Source: www.economicshelp.org)

However, in real world, it is not only the ‘demand and supply’ that determines the price
of a good but also, things such as factors of production, price elasticity and product life
cycle play an important role. Let us examine each of these in detail.

Factors of Production:
The inputs such as labour, land and raw material, and capital, which are used to produce
a good are considered the Factors of Production (Begg & Ward, 2007). A firm,
technically derives the Total Cost (TC) of productions of a good by summing the Total
Fixed Cost (TFC) and Total Variable Cost (TVC). The TFC is the cost that does not varies
with the amount of the output produced, whereas TVC can. A firm could consider land
and equipments as TFC, and raw materials, advertizing cost, R&D, and labour as TVC.

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MBA Course Work-Economics November 23, 2010

Figure 4-Total Cost (Source: Griffiths and Wall, 2005)

Figure 4 clearly illustrates that the Total Cost of production can rise if there is a rise in
the total variable cost. For example, if the cost of raw materials raises then TVC rises
and therefore the TC of production. It is also essential to determine Average Total cost
(ATC = TC/QP where ‘QP‘ is Total Quantity Produced), Average Variable cost (AVC =
TVC/QP), Average fixed cost (AFC = TFC/QP), Marginal Cost (MC, which is the additional
cost incurred by a firm in producing one extra good) and Marginal Revenue (MR, which
is the revenue generated by selling one extra good) (Begg & Ward, 2007). Graphically,
the relation between ATC, AVC, AFC and MC can be shown as in figure 5.

Figure 5-(Source: Griffiths and Wall, 2005)

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MBA Course Work-Economics November 23, 2010

“Economists have discovered that, a firm maximizes profit or makes the most amount of
profit when MC = MR” (Begg & Ward, 2007, p103).

Figure 6: (Source: Griffiths and Wall, 2005) C = cost, R = revenue TP = Total Profit.

Price Elasticity:
Mathematically, Elasticity (ε) is defined as the ration of Percentage change in Quantity
demanded to Percentage change in price (Begg & Ward, 2007).

Elasticity Value Description

ε = % ΔQuantity ε=0 Perfectly inelastic
% ΔPrice ε<1 Inelastic demand
ε=1 Unit elasticity
ε>1 Elastic demand
ε=∞ Perfectly elastic

A firm while deciding the price of a product should consider the nature of the product’s
elasticity. If it is inelastic, then a change in price will result in little change in quantity
demanded. In case of an elastic product, a change in price can result in big change in
quantity demanded.

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MBA Course Work-Economics November 23, 2010

Figure 8-Elastic Demand Curve (Source:

Figure 7- Inelasticity Demand curve (Source: Griffiths and Wall, 2005)
Griffiths and Wall, 2005)

We will discuss more about the application of elasticity in the later section.

Product Life cycle:

Product cycle gives the phase of a product of a firm. When a product is in the
Introduction phase, it is priced higher to capture the initial high demand. The demand
will be inelastic during this phase. In the Growth phase, competition is introduced and
firms are forced to cut prices to gain market share and thereby makes it elastic.
Following in the Maturity phase, the ferocity of the competition is at acme, so does the
demand and the elasticity. The firm is forced either to cut price to retain market share
or participate in ruthless price competition. Finally, in the Decline phase, as firms tends
to leave the market, competition along with market share declines. The sensitivity of the
elasticity, in this phase, tends to be more inelasticity. (Begg & Ward, 2007)

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Figure 9-Product Life Cycle (Source: Griffiths and Wall, 2005)

Part 2: Circumstances that will enable a company to pass on the price increase to the
customers

NEXT, the UK retailer launched in February 1982, trading in more than 500 stores in the
U.K and over 180 in more then 30 countries, has been seeing an increase in the
operating profit for the past two years. By this, we can say that NEXT is operating in the
maturity phase of the product life cycle and is pricing its products at the most
competitive prices. However, it is now anticipating to increase the cost on clothing and
apparel, due to an increase in the cotton price.

UK imports major amount of cotton from US, China, India and Pakistan (Figure 9 and
Table 2) but the imports from each of these countries have tremendously reduced due
to various reasons.

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MBA Course Work-Economics November 23, 2010

Cotton

United States
Quantity

China
India
Pakistan

1000
2000 2001 2002 2003 2004 2005 2006
Year

Figure 10 (ESDS, IMF Direction of Trade Statistics 1980-2010)

Table 2: Quantity in kilograms (ESDS, IMF Direction of Trade Statistics 1980-2010)

This resulted in the decrease in the cotton supply to the clothing industries in the UK,
nevertheless the demand remained the same. As we discussed earlier, if there is a
fluctuation in demand or supply, the market tries to attain a new equilibrium price,
which (in this case) could be higher than the previous equilibrium price. The rise in
cotton price, which is the raw material for NEXT, will directly effect on their Total
Variable Cost (TVC), by raising it to a new level that will in turn change the MC curve.

With reference to Figure 10, the total profit generated by NEXT is the area enclosed in
ΔR0V0C0 (refer Δ as triangle) (where MC0 = MR0). The rise in the raw material will shift
the MC0 to a new level MC1. In this situation, for NEXT, to make as much profit as it has

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MBA Course Work-Economics November 23, 2010

been making earlier with the same level of output production, has to proportionately
increase the MR0 to MR1.
TP
C
o R1 MC1
s
t
/ MC0
R R0
e V1
v
e
n
u V0
e
/ C1 MR1
P
r
o
f C0 MR0
i
t

Quantity Q0
Figure 11

This can be achieved by raising the price of the product by as much amount as there is a
raise in the Average Total Cost of production. The new profit obtained by doing this is
the area enclosed in ΔR1V1C1 (where MC1 = MR1)

Area ΔR0V0C0 = Area ΔR1V1C1

But, it is not certain that at an increased price of the product will attract same number
of customers. If we consider the product to be inelastic, the demand response will make
a merge shift. Consider Figure 11, when a product is priced at P, the total number of
quantity sold is Q; the revenue generated at this price is the area of rectangle PVQO.
When the price is increased to P1, the quantity sold is Q1. The revenue generated at this
price is the area of the rectangle P1V1Q1O.

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MBA Course Work-Economics November 23, 2010

V1

Figure 12 (Source: Griffiths and Wall, 2005)

If the area PVQO is equal to the area P1V1Q1O, then MC1 (with reference to Figure 10)
will be equal to MR1 and NEXT will earn maximum profit. If the area of PVQO is less than
area of P1V1Q1O, then MR1 will be greater than MC1. NEXT in this case will not be making
maximum profit and should therefore, increase the output produce to maximize profit.
Finally, if the area of PVQO is greater then area P1V1Q1O, then MC1 will be greater than
MR1 and NEXT must reduce producing output to maximize profit. Similar logic applies
when a product is elastic, where a small change in price will result in large change in
quantity sold.

But, the elastic nature of the product, in spite increasing the product price, will make
NEXT difficult to generate maximum revenue in such stringent conditions. In such
situation, it can think about outsourcing its work to countries where the price of cotton
as well as labour is cheap. Consider the example of GAP, which outsources it work to the
Asian countries. Alternatively, NEXT could improve on the production process or use
substitutes of cotton so that, it can reduce on the Total Cost of Production and keep
good profit margin on each unit of output.

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Conclusion:
If there is an increase in the Total cost of Production, then it is necessary for NEXT to
pass on a price increase to the customers, proportionately, to maintain there profit
margin to a maximum of what it has achieved. As the increase in the cotton price will
affect the entire fashion industry in the UK, NEXT need not worry about loosing its
market share unless other retailers choose an alternative means to reduce their Total
Cost of Production and price their final goods relatively cheaper.

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References:
• Begg, D., & Ward, D., (2007). Economics for Business, 2nd Edition, McGraw-Hill
Publications, pp 22-107
• Economics and Social Data Service, IMF Direction of Trade Statistics 1980-2010,
http://esds80.mcc.ac.uk/wds_oecd/TableViewer/tableView.aspx, [Accessed on
20th-Nov-2010]
• Economics: Helping to Simplify Economic (2008), Definition of Consumer Surplus,
http://www.economicshelp.org/blog/concepts/definition-of-consumer-surplus/
[Accessed on 18th-Nov-2010]
• Felsted, A., and O’Doherty, John., (2010), Next warns of inflation in clothing
prices,http://www.ft.com/cms/s/0/e2299c1a-c091-11df-94f9-
00144feab49a.html#axzz1630lWTxI [Accessed on 18th-Nov-2010]
• Griffiths, A., and Wall, S., (2005), Economics for Business and Management,
Pearson Education Limited, pp 3-115
• Meyer, G., (2010), Cotton surges on Asian crop fears,
http://www.ft.com/cms/s/0/e2299c1a-c091-11df-94f9-
00144feab49a.html#axzz1630lWTxI [Accessed on 18th-Nov-2010]
• NEXT (ND). Business Overview.
http://www.nextplc.co.uk/nextplc/aboutnext/businessoverview/
[Accessed on 21st-Nov-2010]
• Sloman, J. (2006), Economics, 6th Edition, Financial Times Prentice Hall: Pearson
Education, pp 33-65, 92-152
Bibliography:
• Briscoe, L., (1971), The Textile and Clothing Industry of the United Kingdom,
Manchester University Press, pp 61-76

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