Changes in Price Levels

Changes in Price Levels Problem Outline Comparative static analysis in micro-economics, that is analysis of the firm using demand curves, marginal cost and total cost curves, etc., advocates that a change in price of inputs should be accompanied by alterations to the selling price (where the market permits) and to output levels, in order to maximize profits. Although such analysis provides useful insights into what is a very complex picture, it should not necessarily be taken as a direct prescription for practice. Any manager who has organized a change in selling price or output will know that production, sales and marketing managers as well as financial managers and the directors of the company have to be consulted in order to determine the extent of any such changes. Discussions can be long and difficult, for no production manager wants to decrease output, and no sales manager wants to raise prices. Extensive calculations have to be made, sales literature has to be altered, salesmen informed, production plans must be changed, bonus schemes adjusted and future estimates of both output and revenue revised. Special exercises may be required, such as a reduction or increase in labour force, the discontinuing of a product and a discount sale. The general exercise is expensive and risky; an error in a price increase can lose valuable customers, an ill-timed price decrease can also seriously damage a company's performance. On the cost side, where there is an increase in cost and a cheaper alternative supplier, the advice of conventional analysis is to use the cheaper alternative. Again, in practice the picture is rarely so simple. A supplier will often be producing to the firm's own specification. A just-in-time default free supply policy may have been developed (Kaplan and Atkinson, 1989), and changing to an unknown supplier will require increased inspection and extensive discussions. If there are 'teething problems', the knock-on effects can be very costly. In addition, the alternative supplier may not be cheaper for very long, but may be pursuing a pricing policy to attract customers. It would be wrong to infer from this description of the practical problems of changes in price levels that a firm should never change its prices or alter its buying policy. Of course, there will be circumstances where to do nothing would be suboptimal; but equally there will be many circumstances where a change is too costly. It is the understanding of these circumstances and their effect on decisions that is the focus of this chapter. In discussing price changes, we shall divide our consideration between general and specific change. A general price change is a uniform uplift or decrease in prices due to general economic conditions. Firms will periodically review their prices with a view to adjusting for this effect. The intention of such changes is to maintain the real value of returns. As regards decision making, the prospect of a general change in prices should not affect decisions, as general inflation is a measurement rather than a valuation problem. For instance, if all prices and incomes were to double no item would be cheaper or more expensive and hence no decision need alter. A specific price-level change occurs when a cost or a selling price moves independently of other prices. In this case an item may become relatively cheaper or more expensive than a comparable alternative. By contrast there-fore, the prospect of specific price-level changes will affect our decisions. General price-level changes Real and monetary rates Decisions are potentially distorted by comparing costs and revenues at different times without adjusting for general inflation. For instance, if a firm is offered an agreement to purchase Product A at 15 each for the next 5 years and the current selling price is £4.80, which is expected to keep pace with inflation, the offer is not necessarily unprofitable. The cost of £5 is the actual money amount that will be paid and is known as the monetary rate. The revenue of £4.80 is the current selling price, and general inflation of, say, 8 per cent per annum, would mean that at the end of 4 years we could expect to be selling product A for £6.53 (i.e. 4.8 x 1.084) whereas our cost of £5 would not have altered. In fact, after only the first year there would be a small trading profit. The value of the revenue in terms of purchasing power would not have changed (this is normally expressed as the real value of sales); however, the monetary rate of sales would have changed. As regards cost the £5, the position is reversed: the real value over time declines as inflation continues but the price does not change - in other words, the monetary rate is constant. Clearly, in planning and decision making we must not mix monetary and real rates: either our figures are expressed in monetary terms - the actual cash amounts paid and received - or in real terms, i.e. today's prices. These two methods are illustrated in Table, using the example given above. It is assumed that inflation during the year is 8 per cent per annum and that one item is bought and sold at the end of each year. The profits are identical, except that the real rates are given in today's money and the monetary rates are stated at estimated actual amounts paid and received. For example, the real and monetary profits in the fourth year are related by the inflation rate, thus : Monetary profit 1.53 = real profit x inflation = (1.12) x ( 1.08)^4 What if we wanted to calculate the net present value of the figures in Table? To do this, we assume that the example represents cash flows. Our only problem therefore is to decide the appropriate discount rate. In general, the discount rate (i) is made up of three elements: time preference (tp), inflation (f) and risk (r). The relation is multiplicative - hence: (1 +1)=(1 -tp) × (1+f) × (1 xr). Both monetary and real rates include time preference and risk, and the monetary rate also includes inflation. If we take the bank rate (currently at 12 per cent) as an indication of time preference and expected intlation, and individual risk is estimated to be an extra 2 per cent, then the total monetary discount rate will be (1.12) × (1.02) = 1.1424 or 14.24 per cent. When applied to the monetary cash flows in the conventional way, the net present value expressed in pounds sterling at year 0 will be: