Question

1. Explain the process by which price changes may be initiated by a general change in costs.

2. How can a default risk premium change over time?

Answer 1

Answer for the 1st Question

The general change in cost can cost the price to rise or fall both. Costs can either be decreased or increased by the company, let's analyze both of them separately.

In case of cost increase this may be the outcome on price change:

a) Increase in the price: Having increased costs, the price increase is a general scenario, because to maintain a constant level of profit as it was previous if the price won't be increased then the profit margin will take a hit.

b) The decrease in the price: This is an unlikely scenario, though can happen if the market is in the contraction phase.

In case of cost decrease this may be the outcome on price change:

a) Increase in the price: This is rather an unlikely ratio, though can happen if the demand of our product is higher than the supply, or if the company is a monopoly, or if even if it's a competitive market but the prices of all the competitors are increasing, so we can also increase our price to get even more profits.

b) The decrease in the price: The company can reduce it's price in this scenario, as it would be targeting to cover a wider market segment keeping the profits per product constant, as the cost is being reduced, so reducing the price by the interconnected rate won't affect the profit margin.