According to the “In the News” below, In the News: Joe Camel Acquires Newport In

Question

According to the “In the News” below,

In the News: Joe Camel Acquires Newport

In a widely anticipated move, Reynolds American, producer of best-selling brand Camel, announced yesterday that it has agreed to buy Lorillard, maker of Newport, the number 1 menthol cigarette. The $25 billion deal will combine the number 2 and number 3 cigarette manufacturers. The new company, retaining the Reynolds American name, will have 35 percent of the U.S. market, running second to Altria’s 47 percent share. As part of the deal, Imperial Tobacco will purchase several of Lorillard’s brands, including Blu, its popular e-cigarette, and end up with 10 percent of the market. Liggett Vector will keep 4 percent of the market. Prior to merging, Reynolds had 25 percent of the market and Lorillard had 12 percent, with Imperial at 8 percent. Reynolds expects to cut annual costs by $800 million through eliminating overlap in sales, production, and overhead costs. Consumers worry that reduced competition will raise cigarette prices and further limit choices. The deal must win antitrust approval before it is finalized.

(a) How many years will it take Reynolds to recoup its purchase price through cost savings?

______years

(b) If Reynolds increases cigarette prices by 10 percent and the price elasticity of demand is 0.4, by how much money will its annual revenue of $11 billion increase?

$ ______ billion

Explanation / Answer

(a) Number of years to recover = Deal value / Annual cost cut = $25 billion / $800 million = $25 billion / $0.8 billion

= 31.25 years

(b) Price elasticity of demand = % Change in quantity demanded / % change in price

0.4 = % Change in quantity demanded / 10%

% Change in quantity demanded= 0.4 x 10% = 4%

So, quantity will decrease by 4% (Since price elasticity is negative).

Initial revenue = P x Q = $11 billion

Now, Price = P x 1.1 = 1.1P

Quantity = Q x 0.96 = 0.96P

New total revenue = 1.1P x 0.96Q = 1.056 x P x Q = 1.056 x $11 billion = $11.616 billion

Increase in total revenue = $(11.616 billion - 11 billion) = $0.616 billion

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