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ECON1194 - PRICES AND MARKETS

Term A/2022

Title of Assignment Assignment 2 - Profit Maximisation Analysis

Name and Student ID

Class group SGS-03

Lecturer Dr. Tam Le Vi An

Word count (excluding 1523 words


cover page, references,
appendices, tables,
figures,...)

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I. Business-context

This paper will develop the analysis of profit maximisation for a new-established coffee shop located in
District 7, HCMC, with Vietnamese-signature-coffee-drink as the-core-product. The shop originated towards
the ‘takeaway-orders’ idea; hence it is quite small-sized and can only hold-up to 15 seating-capacity at a time.

II. Profit-Maximisation-Analysis Question-1:


1.1a Survey-design-for-data-collection

1.1b Demand-curve-based-on-surveyed-price-and-quantity-demanded-axes

The table below sums up the quantity demanded (Qd) at different surveyed price levels. The data evidently
illustrate the law of demand and the functional relationship between the price and Qd: when price increases,
demand decreases (Beveridge 2013). Due to an inverse relationship between price and Qd, the demand curve
is always downward sloping.
1.2 Elasticity-of-demand-calculation-at-different-points-of-price

Coffee-drinks are classified as luxury good as the consumption can easily be given up when economic pressure
or necessity exist (Gallo 2015). Theoretically, a high price segment for non-essential goods is expected-tohave
the-elasticity-level |Ep| > 1, demonstrating elastic demand (Gans, King, Byford-&-Mankiw 2014). Theresults
from the calculation reveals Qd of coffee drinks decrease at a slower rate than price at 20,000VND,
25,000VND and 30,000VND-levels, and-decrease-at a higher-rate than-price starting-from-the point-of
35,000VND, demonstrating-the-hypothetical-theory: lower-price-segment, inelastic-demand; higher
pricesegment, elastic-demand.

At-20,000VND, 25,000VND-and-30,000VND, |Ep| < 1, indicating inelastic demand where 1% changes in


price relatively cause 0.44%, 0.62% and 0.88% changes in Qd alternatively, illustrating-slower
responsiveness-or even unresponsiveness from customers. The inelastic demand portrays consumers' low
price-sensitivity-level as at the increasing points of prices, they are still willing to buy a product (Kenton2020).
Differentially, from-35,000VND-up-to 55,000VND, the market experiences elastic demand as 1% price
change-causes-significant-Qd-change. From-35,000VND to 45,000VND, the elasticity may demonstrate
slight reduction in demand, and start-experiencing-a-bigger-change from 50,000VND with 4.28% decrease in
Qd, then reach the tipping-point of extremely elastic at 55,000VND with nearly 9% demand reduction for only
1% price change. The higher the absolute value, the more sensitive customers are to price changes
(Gallo2015), hence the price changes at 35,000VND to 55,000VND significantly heightened the level of
customers’ price-sensitivity-and-responsiveness.
1.3 Product price levels’ decision-making

As-surveyed, The-coffee-house, Katinat and Phuc Long are most voted by the respondents as their go-to coffee
places, thus they are taken for observation, noting that these-are-prices of traditional-coffee at similar-sizes:

Situation-1: Price-decreases-from-40,000VND-to-35,000VND
At price ranging from 35,000 to 40,000VND, the coffee demand is elastic (|Ep| = 1.26 > 1), Qd will decrease
faster than price with 1% price rise causing 1.26% decrease in Qd. Contextually, with 14.3% price reduction
from 40,000VND to 35,000VND, up to 18% Qd increase. Accordingly, customers’ price sensitivity level will
decrease as price decreases to 35,000VND (Gallo 2015).
Since elastic demand implies the negative correlation between price and organisational revenue (Gans, King,
Byford & Mankiw 2014), price decrease will positively impact the company's total revenue (TR). Given the
customers’ low price sensitivity level, price reduction is proportionately smaller than the rise in Qd (P↓ < Qd
↑). Applying the law of demand, price decrease will stimulate customers to demand more for the goods
(Beveridge-2013), and this-rising-preference will be reimbursed by an-upward-increase-in-revenue. With TR
= P × Q, when price decreases from 40,000VND to 35,000VND, the Qd rises from 4.35 to 5.52 cups,
accordingly-TR-increases-from 174,000-to-193,200VND. TR-will increase if-the-market-price-decreases-
to35,000VND.

Situation-2: Price-increases-from-40,000VND-to-45,000VND

When increasing from the hypothetical MarP to 45,000VND, the result of |Ep| = 1.78 > 1 reveals Qd will
decrease at a speedier rate than price. Accordingly, as 1% increase in price leads to a 1.78% decrease in Qd,
customers’ demand for coffee will reduce by 22.25% when price rises from 40,000VND to 45,000VND. Thus,
the business demand is elastic, and customers’ responsiveness to price change and their price sensitivity level
is vastly significant (Gallo 2015).

Since the demand is elastic, P↑ < Qd↓ meaning the rise in price of coffee drink will adversely impact TR.
Following the law of demand, price increase might discourage customers to demand less for the goods, making
the TR gained from the higher price tag cannot compensate for substantial loss in Qd (Beveridge 2013).
Applying the formula TR = P × Q, when price increases from 40,000VND to 45,000VND, the Qd reduces
from 4.35 to 3.18 cups, so TR decreases from 174,000VND to 143,100VND. TR will decrease if the market
price increases to 45,000VND.
Overall, decreasing price to 35,000VND compared to the current market rate is the most preferential choice
for profit maximisation since an increase to 45,000VND results in lower quantity demanded and revenue.

Question-2:

2.1.2.3 Importance-of-the-law-of-diminishing-marginal-returns-in-the-production

In the short-run, the-law-of declining marginal returns (LDMR) stated that an expanded production input
reduces output. After a certain level of capacity utilisation, adopting more of a production element will lead
to reduced marginal returns (Hinojosa 2021). Referring to the given situation, when additional baristas
(variable input) are employed with fixed capitals, LDMR can help business decision-makers identify the
correct balance in operation, thus identifying optimum amount of labour for the most efficient production
process.
To-experiment the LDMR in the short-run, we assume:
1. Inputs, including machinery and equipment that will be used to produce coffee, along with the rental,
are fixed.
2. In short run production, labour will be setted as a variable input. All employees get paid
19,500VND/hour, working 40 hours/week.
With limited seating capacity, the amount of capital required will be three since most coffee shop owners
suggest keeping three-to-four equipment on average for successful management of output production. On the
minimum average, a coffee shop with three baristas can produce up to 200 cups/day and 1400 cups/week
(Nguyen-2022). The-numerical-example-is-hypothesised-as-below:
A typical behavioural pattern of marginal products of labour (MPL) can be observed via Table-5: increases,
peaks, decreases, and-then-becomes zero, proving the existence of the LDMR. This happens as two conflicting
effects, specialisation-and-congestion, occur when additional baristas are hired (Borland-2012).

Initially, as labour increases from 0 to 4, the MPL also increases sharply from 0 to 817 cups per week due-to
the-specialisation-effect (Beveridge 2013). When-extra-workers-are-added, it becomes possible to divide
tasks hence their speed of operation can be increased, causing a rise in MPL. At the-peak-point-of-fourbaristas,
the coffee shop is at the most efficient use of capital-capacity, and easier to-meet customers-demand at the-
busiest-times.

As continual labour employment with fixed constraints, MPL dramatically drops yet positive at the fifth
workers, implying a beginning of marginal productivity reduction because newcomers lessen space for
movements. From-the-sixth-to-seventh-baristas, MPL becomes zero to negative, as this is when the congestion
outweighs the specialisation (Beveridge 2013). With limited capitals and overcrowded barista stations,
individual competence discontent, which simultaneously decreases productivity. Once-MPL-reaches the
optimal point, allocating extra workers results in the LDMR: employing more variable input (labour) to the
same amount of a fixed-input (capital) will decline marginal productivity (Hinojosa 2021).
2.4 LDMR-is-related-to-the-marginal-cost-of-the-firm

In-Table 5, marginal-cost (MC) is calculated by change in barista salaries (TVC) over change in outputs
(MPL), and-MC-tends-to-decrease when MPL increases as greater quantities are produced at the similar wage
rate. Therefore, MC and MPL possess an inverse relationship, meaning-MC-follows-an-opposite-pattern-with
LDMR as the-law is-represented-by-MPL (Figure-4,5). Beveridge (2013) stated-that-MC-decreases-with-
thedominance of specialisation effect while increasing with the congestion effect. Indeed, as the specialisation
effect occurs at the fourth labour, MPL is maximised and MC is minimised, reaching the optimal point of
production. Conversely, when the-congestion-effect hits-at the-fifth-to-seventh-baristas, the decline to
negative in MPL results in faster rising in MC, warning that the overcrowded-employment-has-
adverselyimpacted-the-production, the business owners-should-consider-investing-on-capitals-instead. To-
maximiseefficiency, the ideal strategy is to choose the-point-of-labour-where MPL-reaches its-peak and MC-
at-itstrough.
Question-3:

3.1 Perfectly-competitive-firms-in-the-short-run

In a perfectly competitive market, with a high number of sellers competing for homogenous products, firms
will-have-minimal-impact on the price (Borland-2012). The pressure of competitiveness forces buyers and
sellers having to accept the market price; thus they are defined as price takers. When Covid-19 pushes up price
levels, all businesses in this market theoretically increase their prices to match with the market's new
equilibrium. For firms that are price takers, the demand curve is perfectly elastic, P = D = MR = AR, henceMR-
will-increase-as-P-surges (1).

Covid-19 crisis has weakened the financial situation of many small firms with only 15% of them having
enough coverage for 3- opening. In response, the firms are forced to reduce wage-schemes-and-
month restructure- 40% upward in labour-termination
personnel to prevent large-scale losses, thus there is a
(Engidaw-2022). In this context, the LDMR can be argued to have happened before Covid but owing to the
heavy impact of the pandemic this has just been recognized and corrected now (Francis-Devine-2022).
Reduction in both wages and the amount of labour decreases AVC, making ATC drops accordingly.
Equationally, ATC and MC move in the same direction, thus MC declines as well (2). From (1); (2), we have:
MR↑ while MC↓, therefore-MR > MC, suggesting the firms to increase and maximise its profits by producing
more outputs. Similarly, the comparison between P↑ and ATC↓ (P > ATC) also concludes that the-
firmexperiences-economic-profit in the-short-run, so it will be ideal to produce-more-output for
greatercompetition (Gans, King, Byford-&-Mankiw-2014).

3.2 Perfectly-competitive-firms-in-the-long-run

Due to ‘low barriers to entry’ characteristic of perfect competition, number of rivals producing identical
products is expected to increase, making existing perfectly competitive firms down their production price to
‘breakeven’ level that only make sufficient revenue to cover its TC (minimum ATC) and remain competitive
in an industry (Hall 2021). Hence, firms eventually only make normal or zero economic profit in the long-run,
where-P = ATC = MR = MC.
III. Appendices

Appendix 1: Questionnaires (Link to the form: https://forms.gle/y5u5uWStDZn5pVG68)

Appendix 2: 20 customers’ chosen price preferences for their coffee drinks


Appendix 3: Respondents’ quantity demanded of coffee drinks at price level they have stated above

Appendix 4: Respondents’ choices of favourite coffee brands (Support Question 1.3 discussion)

II. References
Beveridge, T 2013, A Primer on Microeconomics, 1st edn, Business Expert Press, New York, United States
of America.

Borland, J 2012, Microeconomics : Case studies and applications, 2nd edn, CENGAGE Learning, Melbourne,
Australia.

Engidaw, AE 2022, ‘Small businesses and their challenges during COVID-19 pandemic in developing
countries: in the case of Ethiopia’, Journal of Innovation and Entrepreneurship, vol. 11, no. 1, p. 1.
Francis-Devine, B 2022, ‘What happened to wages in the coronavirus pandemic?’, UK Parliament, 8 March,
viewed 15 April 2022, <https://commonslibrary.parliament.uk/what-happened-to-wages-in-the-
coronaviruspandemic/>.

Gallo, A 2015, ‘A Refresher on Price Elasticity’, Harvard Business Review, 21 August, viewed 15 April
2022, <https://hbr.org/2015/08/a-refresher-on-price-elasticity>.

Gans, J, King, S, Byford, M & Mankiw, NG 2014, ‘Principles of Microeconomics’, 1st edn, CENGAGE
Learning, Melbourne, Australia.

Hall, M 2021, ‘Why Are There No Profits in a Perfectly Competitive Market?’, Investopedia, 23 August,
viewed 15 April 2022, <https://www.investopedia.com/ask/answers/031815/why-are-there-no-
profitsperfectly-competitive-market.asp>.

Hinojosa, A 2021, ‘The Law of Diminishing Marginal Returns Definition’, Indeed, 31 March, viewed 15
April 2022, <https://www.indeed.com/career-advice/career-development/law-of-diminishing-
marginalreturns#:~:text=The%20law%20of%20diminishing%20marginal%20returns%20is%20one%20of%
20the,dir ect%20impact%20on%20its%20efficiency>.

Kenton, W 2020, ‘Inelastic’, Investopedia, 29 September, viewed 15 April 2022,


<https://www.investopedia.com/terms/e/inelastic.asp>.

Nguyen, T 2022, ‘How Much Coffee Is Sold Per Day?’, Trung Nguyen Online, 24 March, viewed 15 April
2022, <https://www.trung-nguyen-online.com/how-much-coffee-is-sold-per-day/>.

Qian, Z n.d, ‘FACTORS AFFECTING THE PURCHASING BEHAVIOUR OF COFFEE SHOPS’


CUSTOMERS IN CHENGDU’, College of Innovative Business & Accountancy, viewed 15 April 2022,
<https://grad.dpu.ac.th/upload/content/files/year9-1/9-12.pdf>.

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