a) Suppose you are hired to manage a small manufacturing facility which produces Widgets.
a. You know from data collected on the Widget Market that market demand has recently increased and market supply has recently decreased. As manager of the facility what decisions should you make regarding production levels and pricing for you Widget facility?
In this case, the manager would increase the supply and price; but is should increase both in a controlled environment so that the total revenue profits does not drop (for example, raising price beyond a certain price might decrease the demand thus reducing overall profit)
Also, the supply should be increased so that Marginal Cost< Marginal Revenue. Because supply has increased along with demand it isn't clear what decision should be made. The manager should gather information as far as how much greater the increase in demand has become. It may indicate the need to increase production. On the other hand, the entrance of new competitors could indicate the need for greater advertising to increase brand recognition, or the introduction of new products. Greater demand means that prices can be increased, as long as the demand isn't matched by the increase in supply.
b) Now, suppose that following the supply and demand changes, in (a). a substitute good goes up in price, and your costs of production decrease. What new decisions will you make regarding production levels and pricing for your Widget facility?
Increase the production levels more than increasing the price as now you can generate incremental net profit at same pricing. If the price of a substitute good increases, the demand for your product should increase . The increase in the cost of production, however, will cause your revenue to fall if you keep your price the same. The increase in demand should enable you to increase price, selling perhaps the same number as before but at a higher price. This will keep revenue from falling.