Assignment: Passing along Costs

In 2010, the costs of powdered milk, cocoa, coffee, and wheat rose at double-digit rates.

Wildfires in Russia had caused wheat and other crop prices to shoot up. Cocoa prices reached a 33-year high in July, helped along by speculative activities, including the London-based commodity trading house Armajaro Holdings Ltd.'s move to store 240,000 metric tons of cocoa, worth roughly $1 billion. Tea prices went up significantly on account of higher fuel costs and poor harvests in India.

Big consumer-goods companies often find ways to offset the commodity price increases, sometimes through cost-cutting and sometimes by passing along higher prices to retailers and consumers. J.M. Smucker Co. raised prices about 9 percent on products in its coffee lineup, which includes Folgers, Dunkin' Donuts, and Millstone brands. In response to rising milk prices, Danone, which makes yogurt products, increased prices in markets including Mexico and Poland. Unilever's chief financial officer noted that tea costs have gone up, and Unilever has already sent that higher cost down the chain on its consumer tea products.

1. Suppose the price of coffee beans increases by $0.20 per pound. What is the effect of this raw material price increase on the demand for roasted coffee? If one pound produces 50 cups of coffee, would the price of a cup of coffee rise by $0.01? Explain.

2. The article reports that J.M. Smucker Co. plans to increase its coffee prices by 9 percent. If Smucker has a lot of rivals but has a brand name that has value, will this 9 percent increase in retail prices imply that profit will rise by 9 percent?

3. Is it optimal for a firm to slash prices to retain market share? Is cutting prices during a recession and then raising them in a recovery a good strategy?