The Effect of Changes In Relative Costs We have established that a change in relative prices affects value. If values are significantly affected, then we may reasonably expect decisions to change as a result. We begin by looking at a very simple example of a relative cost change in example 2. Example 2 Montonia Ltd has the capacity to produce one of the following products: The numbers of each item that Montonia could produce are about the same. All prices it is estimated will be subject to 10 per cent inflation, except for the cost of product B, which is constant. Which product is at present preferable? Would the decision change in future years? Since the volumes produced are similar, Product A yields the higher contribution per unit and is therefore preferable. After the first year, the contribution of Product A will have risen by 10 per cent to £2.2: After two years, Product B produces a relatively greater profit and would be preferable. This change in profitability is wholly accounted for by the relative reduction in the cost of Product B. If the cost had kept pace with inflation, it would have been 8 (1.1)?= 9.68 at the end of year 2, and profits of B would have been 1.21 i.e. half of Product A's contribution - the same ratio as in the original figures. Relative price changes, therefore, affect profitability and decisions, unlike general increases. In practice, it is unlikely that we would be able to predict future prices in the manner of example 2. Prices, as a rule, do not follow simple predictable trend lines over time, though we may yet be able to make useful statements about their future levels. In example 2, for instance, if the two products used identical resources, then an increase in the cost of Product A would always be accompanied by a similar increase in the cost of Product B. If this were the case, given the other details in the example, we would be able to say that Product A would always be preferable whatever the level of future prices. In the following sections we examine how specific price movements affect two types of decisions: the make or buy decision and the competitive supply problem.

The Effect of Changes In Relative Costs

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