FdA Business and Management

Bournemouth University
Partner Colleges
University Centre Yeovil

Beverley Cox

Business Environment
The Application of Business
Environment Principles

Unit Leader: Julian Wignall

53060948.doc8 March 2011

 Contents

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Introduction
This report covers a number of key concepts that may be useful to clients
who need advice for their own business plans by way of real examples.

Demand/Supply in the Pricing Process

(2000 words)

Supply and demand is an economic model of price determination in a market. Demand is

the amount that will be bought at a given price. The demand for products and
services is determined by a number of factors. The most important of
these are the tastes, customs, and preferences of the target market, the
consumer's income level, the quality of the goods or services being
offered, and the availability of competitors' goods or services. All of the
above elements are vital in determining the price that a business can
request for its products or services, whether the business in question is a
hair and beauty salon, a petroleum supplier or a potato grower.

The supply of goods and services in the marketplace is also determined

by several factors including how much capacity there is for the production
or the product/service, production costs which include wages, interest
charges, and raw material costs, and market competition. Some factors
that are pertinent in determining supply in one area may not be so in
another. Weather, for example, is an important factor in determining the
supplies of potatoes, but weather rarely (unless extreme) impacts upon
the operations of businesses such as hair and beauty salons or petroleum
suppliers (Referenceforbusiness.com, 2010).

When consumers buy more then demand rises which in turn leads to price
increase. Heilbroner and Thurow (1998) found that the demand supply
mechanism also works in reverse - if incomes fall then so does demand
and price. Supply can also fall as a result of other micro environment
factors such as a rise in production costs for the producer or even changes
in legal regulations or tax policies.

BP is one of the world's largest energy companies, providing its customers

with fuel for transportation, energy for heat and light, retail services and
petrochemical products for everyday items (BP.com, 2010). Oil is a large
cog within the working of BP. The government or other agencies sometimes attempt to control
prices in certain markets such as oil. OPEC’s members own two thirds of the worlds oil
reserves providing it with the ability to decide the cost of oil. OPEC’s aim
is to pursue ways and means of ensuring that prices in international oil
markets are stabilised to avoid harmful and unnecessary fluctuations.
They also oversee the interests of the producing nations giving regard to
securing a steady income for the producing countries together with an
efficient and regular supply of petroleum to consuming nations. They also
seek to ensure a fair return on capital to investors (OPEC.org, 2010). This
said, if OPEC r

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A free market is where individuals are free to make
their own economic buying and selling decisions.
Individuals are free to decide what to buy with their
incomes (demand) and free to choose what to sell
and what production methods to us (supply). These
decisions are transmitted through their effect on
prices. Prices respond by rising if there is a
shortage in goods/services and falling if there are
surplus.

Price elasticity predicts the effect of changing a

product price. Price elasticity of supply (PES) is the responsiveness of the
supply of a given good to a change in the price of that good and Price elasticity of demand
(PED) is the responsiveness of the quantity demanded of a good or service to a change in its
price (Sullivan & Sheffrin 2003). Petrol has a low price elasticity due to the high demand
irrespective of price together with lack of substitute making petrol price inelastic.

There are two key areas of theory related to this case. Elasticity and market power.Price elasticity of
demand is the responsiveness of demand to changes in price. We know that demand is negatively
related to price - when price rises demand falls and vice versa. Elasticity gives us some measure about
the strength of the relationship between price and demand. To measure elasticity we use a formula;

% Change in Quantity Demanded

Price Elasticity of Demand (Ped) =
% Change in Price
The figure we get has no units - it is not centimetres, litres or anything else, just a number but what
that number is tells us a great deal. Part of the problem here is in getting used to the terminology used.
There are certain things to remember:

1. Ped always has a minus sign in front of it - this is not a minus sign in the mathematical sense
but it is there to remind you that there is a negative relationship between price and demand - as
one goes up the other goes down and vice versa.

2. The nearer the number is to 0 the more inelastic the relationship is. A good with an elasticity of
-0.6 is classed as inelastic but one that has a measure of - 0.8 is more ELASTIC than the other
even though it is still classed as inelastic!

3. If the measure is between 0 and -1 (e.g. -0.35, -0.82 etc) the good is said to be 'inelastic'.

4. If the measure is -1 the percentage change in demand is the same as the percentage change in
price. The good is said to have 'unit elasticity' (unit meaning 1!)

5. If the good has elasticity over 1 (e.g. - 1.36, - 2.87, - 5.1 etc) it is said to be 'elastic'.

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 6. The degree of elasticity is important in assessing the impact of price changes on the level of
demand and in particular estimating the effect on the total revenue of the good or service in
question. The impact on total revenue can also have an effect on the tax paid to the government
and as such is important when looking at the so-called 'incidence of tax'.

Businesses regularly have to think about the price that they charge for a product or service. The decision
they make can have far reaching effects. Let us take a scenario to highlight the issue. A fast food outlet
business charges £2.00 for its burger. Sales are at 5,000 per week. If it wants to increase its profits
what should it do? If it drops its price then it would need to consider how much the price fall should be -
5%, 10%, 20% or more? Or, should it raise the price? Again, if so, how much by? It will know that if it
drops its price demand would be likely to rise, but again how much by? If the price is dropped by 10%
but demand only rises by 4% then it will actually see its revenue fall. But if the fall in price of 10% leads
to a rise in demand of 15% then its revenue would rise. Equally, if it raised the price by 15% but
demand only fell by 11% then its revenue would rise. Prices may need to change because of cost
pressures. Assume that the price of beef rises, should the business pass on the rise in costs to the
consumer as a higher price? If it does what will happen to demand and therefore revenue. It might
actually be more appropriate to leave price as it is and absorb the rise in costs through lower margins. If
the increase in cost is 5% and the business decides to increase prices by 5% but as a result demand
falls by 12% then the strategy will lead to revenues falling. The decisions therefore can be more
informed if the business knows the price elasticity of demand for its product.

The 'rule' is as follows:

• If demand is price inelastic the increasing price will lead to an increase in total revenue because
the fall in demand will be a smaller percentage than the increase in the price.

• Reducing the price when demand is price inelastic would cause total revenue to fall because
demand would rise by a smaller proportion than the reduction in price.

• If demand is price elastic, reducing the price would lead to a rise in total revenue - the rise in
demand would be a greater percentage than the fall in the price.

• If demand is price elastic then increasing the price would lead to a fall in total revenue; the
percentage change in the quantity demanded would be greater than the percentage change in
price.

The Chancellor of the Exchequer and OPEC have a pretty good understanding of price
elasticity. They know that one of the determinants of elasticity is the number and closeness of
substitutes - and that oil and petrol have very few substitutes in the short term. The
Chancellor knows that taxing petrol will yield tax revenues because the price elasticity of
demand for petrol is relatively low. The rise in duty will be passed on to the consumer but the
number of people finding an alternative to petrol is likely to be very low so demand hardly
changes at all. Some people may of course be persuaded to now use public transport (if it is
available) or decide to walk or cycle to their destination but in most cases the number
changing their behaviour in this way is going to be very small.

This process is explained using a PowerPoint presentation - [74K].

Goods, which have duty on them such as petrol, tobacco and alcohol, are likely to have an
inelastic demand; it would make little sense for a government to place a tax on a good, which
increases its price and leads to a reduction in tax revenue!

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The second issue relates to market power. A business will have market power if it is in a
position to influence the price of a product. It can do this through affecting the supply of the
product on the market or it could simply set price and then look to set its output levels to
meet demand.

OPEC was set up to represent the interests of countries for whom oil is a key product and the
export of which represents a major proportion of their national income. The eleven countries
are:

• Algeria

• Indonesia

• Iran

• Iraq

• Kuwait

• Libya

• Nigeria

• Qatar

• Saudi Arabia

• United Arab Emirates

• Venezuela

Iraq has not taken a full part in the OPEC discussions in recent months for obvious reasons
but is a member. OPEC account for around 40% of total global oil production. What is as
important is that different oil has different qualities and is therefore useful for different
purposes, the oil produced by the OPEC countries are an important part of total world oil
supplies therefore. OPEC acts as a cartel. A cartel is a group of businesses, individuals or
companies who agree to influence the price in a market through controlling supply. OPECs
reasons for acting as a cartel is to protect members interests - they aim to 'stabilise' oil prices
so that both producers and consumers are in a better position to plan ahead and in the case of
producers to know what their revenues are going to be. Each country has a quota, which they
are obliged to adhere to - this highlights the problems that cartels can face - there is always an
incentive for one or more of the group to break the agreement to secure some personal gain.
Despite this, OPEC has been relatively successful in maintaining member relations during its
existence. It was established as a permanent institution in 1960 but there had been discussion
between oil producing states since 1949. OPEC is able to exert influence on the market partly
because it accounts for such a large proportion of oil production but also because it knows
that the price elasticity of demand for oil is low. If it chooses to cut supply therefore, it knows
that the price will be likely to rise but as the price rises, the demand for oil will fall by a very
small amount; this helps to maintain or to boost their revenue. Attempts to maintain price
stability can be difficult because there is no telling what the level of demand is going to be for
oil. This winter, for example, could be a hard one throughout Northern Europe and North
America, if so the demand for oil for heating and so on is likely to be far higher than
expected. See the associated PowerPoint presentation [54K] to see a diagrammatic
explanation of how OPEC might operate to maintain the price of oil at $25 per barrel
following a fall in the demand for oil.

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Merger and Takeover

Economies of Scale

Legal Considerations

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53060948.doc 8 March 2011 8
Bibliography

BP.com, 2010, At A Glance, Available from

http://www.bp.com/sectiongenericarticle.do?
categoryId=3&contentId=2006926 23 November 2010

Referenceforbusiness.com, 2010, Supply and Demand - cost, Factors

Impacting Supply and Demand. Available from:
http://www.referenceforbusiness.com/small/Sm-Z/Supply-and-
Demand.html#ixzz167WQlt9i 23 November 2010

OPEC.org, 2010, OPEC Statute, Available from:

http://www.opec.org/opec_web/en/publications/345.htm 23 November
2010

Heilbroner R L and Thurow L, 1998, Economics Explained: Everything You Need to

Know about How the Economy Works and Where It's Going, 4 th Edition, Touchstone Books,
Florida

Sullivan, Arthur; Steven M. Sheffrin (2003). Economics: Principles in action. Upper Saddle River, New Jersey
07458: Pearson Prentice Hall. pp. 104. ISBN 0-13-063085-3

Bized.co.uk, 2010, Mind Your Business , Oil Petrol Taxes and Elasticity,
Available from: http://www.bized.co.uk/current/mind/2003_4/061003.htm
25 December 2010

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