Wednesday, January 7, 2009

What Happens To Firms If There Is An Increase In Prices Of Raw Materials?

I noticed one of the most popular questions being asked in Part B of Unit 1 (legacy) is “What is the impact onto the consumers of the commodity when there is an increase in price?”

I generally put commodity here since it can be anything: oil, copper, aluminium, steel, palladium, uranium etc

When the question mentions about consumers of the commodity it meant the producers because they are the one who use it in their manufacturing process. Some students confused with the word ‘consumers’ & thought that it is referring to a typical consumers on the street & thus easily lose 6m for this type of question. Consumers like us are called end consumers

So what happen to firms?

(1) Passing on the costs. Since commodities are part of the production cost, therefore any increase will normally be passed on to end consumers. Also one could argue that they may not pass on the cost. This is true especially if their products have many substitutes. Any price increase will cause consumers to switch away to rival goods. Another is depending on the cost of commodity as a % of total costs. If it’s insignificant, firms may not consider passing on the cost

(2) Firms will make losses. Due to stiff competition firms may not be able to pass on much of the cost to consumers. As such they may have to absorb part of the losses. Depending on severe & how long will this last, the firms may go bankrupt in the long run. Those firms that still survive may not have much incentive to conduct R&D

(3) Produce substitute goods. There was one question on the production of tequila using blue agave in 2005. Since blue agave, the main ingredient in tequila manufacturing have gone up in price, producers decide to switch over to other form of alcoholic drinks such as wine etc

(4) Cut costs elsewhere. Firms may start to look elsewhere to cut costs. They may start to shrink employment, use lesser quantity & lower quality of raw materials which are normally substitutes, relocate, combine production under one roof etc. It has lots of implications. Cut employment may lead to problems like structural unemployment. Lesser quantity of raw materials may affect the quality of end products e.g. taste of tequila drinks, safety of the cars etc

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