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*Production costs change frequently due to  changes in the price of labor, machines, fuel, etc.
Cost-plus contracts shift the responsibility and  risk of the price changes to the purchaser of the  product.
* They can reduce the incentives of the supplier  to be efficient and to seek cost reductions. The  supplier is paid a mark-up regardless of cost.
* Presumably Bhagat will be able to avoid part of  the increase in labor costs by changing the input  mix (reducing labor and increasing capital).  Consider the standard isocost line analysis.
* The flexibility to change the input mix is likely  to be less in the short run than the long run.  Thus, the price increase might be more justified in  the short run.
The input mix is flexible to change which could  make it less in the short run than the long run.
Applying this method the price increase would be  justified for short term.
* Presumably Gina’s optimal input mix will  change as well since she is paying more for  machine parts.
1. Why do many firms use cost-plus pricing for  supply contracts?
2. What potential problems do you envision with  cost-plus pricing?
3. Should Gina contest the price increase?  Explain.
4. Is the increase more likely to be justified in  the short run or the long run? Explain According  to our text.
5. How will a $3 increase in the price of machine  parts affect Gina’s own production decisions?

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