Question

Caterpillar Tractor, one of the largest producers of farm machinery in the world, has hired you to advise it on pricing policy. One of the things the company would like to know is how much a 5-percent increase in price is likely to reduce sales. What would you need to know to help the company with this problem? Explain why these facts are important.

Short answer

You would need to know the elasticity of the market demand, the presence of substitutes, competitor reactions, sector profitability, and the need for the commodity.

Step-by-step solution

Step 1. Factors that are required to identify change

As Caterpillar Tractor is one of the world’s largest producers of farm machinery, it should consider the impact on the market demand while adjusting its pricing policy.

To determine the impact of a 5-percent increase in price on sales requires the knowledge:

1. The elasticity of the market demand: The essential factor that you should know is the elasticity of the market demand curve. Suppose the elasticity of demand for the commodities produced by Caterpillar Tractor is high. In that case, a five percent increase in price will have an enormous adverse impact on sales than a low elasticity.

2. Presence of substitutes: If the farm products produced by Caterpillar Tractor have close substitutes, the elasticity of the market demand will increase. Thus, people will opt for close substitutes when the price rises, leading to a drastic reduction in sales.

3. The reaction of competitors: It is mentioned that Caterpillar Tractor is one of the largest producers, indicating that there are other producers of farm products in the market. The impact of a price rise on Caterpillar Tractor sales also depends on how the competitors adjust their prices in response. If the competitors do not change their prices, its sales will decrease by a large percentage, losing a significant market share.

4. Agricultural sector profitability: If the farming sector is not profitable and the farmers do not have a significant income, the price increase will lead to a large drop in sales. This fall is because of the low affordability by the farmers owing to their low incomes. However, if the farmers have a comparatively high income, the price rise will not affect Caterpillar Tractor sales by a significant amount.

5. Need for the commodity: The impact on sales also depends upon how urgently the farmers need the commodities produced by Caterpillar Tractors. For example, if the farmers have recently purchased farm products with good durability, they would not need to repurchase them soon. In this situation, a five percent price rise will reduce the sales by a higher percentage because of the low demand.

However, if a majority of the farmers have old products that need to be renewed by new purchases, a rise in the price will not affect sales by a large percentage because of the urgency of the purchase.

Thus, essential factors affecting the market demand and its elasticity needs to be known by you before commenting on the pricing policy of Caterpillar Tractors.