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Economics

Economics

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Published by tonydickpatakesseh

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Published by: tonydickpatakesseh on Nov 23, 2010
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11/23/2010

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 QUESTION
KK Enterprise deals in 3 products namely KK peace, KK praise and KK hallelujah.These products appear to be the drivers of KK enterprise, ensuring that profit marginsare always above normal. In recent times however, there appears to be keencompetition from hither to unknown firms. As a move to ensure that profit margins arestill high the MD decided to slash price by 26%, 46% and 35.2% respectively for peace,praise and hallelujah.(a). Are these percentages significant in achieving the objective of profit maximization?(b) If the records show that the numerical values of elasticity are 0.84, 1.33 and 1respectively for peace, praise and hallelujah,(i) which of the products should experience the price cut strategy.(ii) what pricing strategy should be adopted for the other products.
 
 (a).
Profit
max
i
m
iz
a
tion
 
objective.
 
Profit-maximization implies earning highest possible amount of profits during the giventime. Profit- making is one of the traditional, basic and major objectives of a firm. Profit-motive is the driving force behind all business activities of a company. It is the primarymeasure of success or failure of a firm in the market. To achieve profit maximization in acompetitive environment, a firm needs to look at the various products it offers andwhether they have elastic demand, inelastic demand or demand is unitary. It also has tolook at the substitute products from competitors and the strength of competition. Thethree products may be analyzed based on the price elasticity of demand.The Price Elasticity of Demand measures the rate of response of quantity demandeddue to a price change.It is the ratio of percentage change in quantity demanded inresponse to a percentage change in price. Demand could be elastic, inelastic or unitary.Elasticity varies among products because some products may be more essential to theconsumer. Products that are necessities are more insensitive to price changes becauseconsumers would continue buying these products despite price increases. Conversely,a price increase of a good or service that is considered less of a necessity will deter more consumers because the opportunity cost of buying the product will become toohigh.When change in quantity demanded is greater than the change in price, in percentageterm, demand is said to be relatively elastic. The numerical value of relatively elasticdemand is greater than unity. When percentage change in quantity demanded of acommodity is less than the percentage change in prices demand is said to be relativelyinelastic. The numerical co-efficient relatively inelastic demand is less than one.Whenpercentage change in quantity demanded is in the same proportion as the change inprice, demand is said to be unitary. A change in price in either direction therefore wouldresult in no change in revenue To cope with competition and at the same time maximize profit, KK enterprise shouldhave looked at which of the products faces elastic demand, inelastic demand or unitarydemand. If a firm is operating in the elastic range of a linear demand curve the firm canincrease profits by reducing prices since the percentage decrease in price will be morethan offset by the percentage increase in quantity demanded - Total revenue goes up.
 
S
o the firm can always increase revenue by reducing price. On the other hand if the firmis operating in an inelastic range of a linear demand curve the firm can increaserevenue by upping the price. Increasing the price would cause quantity demanded tofall. However, the percentage decrease in quantity would be less than the percentageincrease in price. Therefore total revenue would increase.
S
o a firm operating in theinelastic range of a linear demand curve can always increase revenue and profits byraising the price. Revenue is maximized where elasticity equals one because whendemand is inelastic revenue can be increased by raising prices and when demand iselastic revenue can be increased by lowering prices.To determine whether the price cut for each of the products is significant or not woulddepend on whether the products are necessities or luxury products and whether their demand is elastic, inelastic or unitary elastic. If all the three products are necessities(inelastic demand), then the percentage decrease in price will result in a smaller percentage increase in quantity demanded hence total revenue will decrease and profitwill decrease. On the other hand if the products are luxuries (elastic demand), thepercentage decrease in price would result in a greater percentage increase in quantitydemanded hence total revenue will increase but profit increase will depend on total cost.If the products face a unitary demand the decrease in price will not have any effect ontotal revenue or profit as the percentage change in price will be the same as thepercentage change in quantity demanded.Therefore whether the percentage price cut is significant or not to achieve the objectiveof profit maximization will depend on the characteristics of the products, that is whether any of the products faces elastic demand which case the price cut is significant if andonly if it can cover total cost and still ensures that the firm achieve its objective of profitmaximization. The percentage price cut will not be necessary if the product(s) facesinelastic demand as the product(s) will still be bought whether the price is reduced or increase. The product is a necessity so a change in price will have a very little impact onquantity demanded. The percentage price cut will also have no effect if the productfaces a unitary demand as the percentage price cut will equally be off-set by percentageincrease in quantity demanded.In summary, to achieve profit maximization objective, the characteristics of the variousproducts (elastic, inelastic or unitary) must be considered before any decision on pricecut is taken.
(
b)
 
i.
 
If the numerical values of elasticity are 0.84 then the product has inelastic demand. Inthis case ³peace´ has inelastic demand and hence a price cut will lead to a fall in profit.To achieve profit maximization, a product with inelastic demand must see an increase inprice as any percentage increase in price will be greater than a percentage decrease inquantity demanded.

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