MANAGERIAL ECONOMICS - FEBRUARY 2009

Part- A

Q1 Define ‘Managerial Economics

Ans: Managerial Economics - Definition

3. Managerial economics is best defined as

a. the study of economics by managers.

b. the study of the aggregate economic activity.

c. the study of how managers make decisions about the use of

scarce resources.

d. all of the above are good definitions.

Managerial economics is the science of directing scarce resources to

manage cost effectively. It consists of three branches: competitive
markets, market power, and imperfect markets. A market consists of
buyers and sellers that communicate with each other for voluntary
exchange. Whether a market is local or global, the same managerial
economics apply.

A seller with market power will have freedom to choose suppliers, set
prices, and use advertising to influence demand. A market is imperfect
when one party directly conveys a benefit or cost to others, or when
one party has better information than others.

Definition. Managerial economics is the science of directing scarce

resources to manage cost effectively.

Scope.

(a) Microeconomics – the study of individual economic behavior where

resources are costly, e.g., how consumers respond to changes in
prices and income, how businesses decide on employment and
sales, voters’ behavior and setting of tax policy.

(b) Managerial economies – the application of microeconomics to

managerial issues (a scope more limited than microeconomics).
 (c) Macroeconomics – the study of aggregate economic variables
directly (as opposed to the aggregation of individual consumers
and businesses), e.g., issues relating to interest and exchange
rates, inflation, unemployment, import and export policies.

Competitive markets.

(a) Markets.

i. a market consists of buyers and sellers that communicate

with one another for voluntary exchange. It is not limited
by physical structure.

ii. in markets for consumer products, the buyers are

households and sellers are businesses.

iii. in markets for industrial products, both buyers and

sellers are businesses.

iv. in markets for human resources, buyers are businesses

and sellers are households.

v. Note: an industry is made up of businesses engaged in

the production or delivery of the same or similar items.

(b) Competitive markets.

i. markets with many buyers and many sellers, where

buyers provide the demand and sellers provide the supply,
e.g., the silver market.

ii. the demand-supply model - basic starting point of

managerial economics, the model describes the
systematic effect of changes in prices and other economic
variables on buyers and sellers, and the interaction of
these choices.

(c) Non-competitive markets – a market in which market power exists.

8. Market power.

(a) Market power - the ability of a buyer or seller to influence market

conditions. A seller with market power will have the freedom to
choose suppliers, set prices and influence demand.

(b) Businesses with market power, whether buyers or sellers, still need
to understand and manage their costs.
 (c) In addition to managing costs, sellers with market power need to
manage their demand through price, advertising, and policy
toward competitors.

9. Imperfect Market.

(a) Imperfect market - where one party directly conveys a benefit or

cost to others, or where one party has better information than
others.

(b) The challenge is to resolve the imperfection and be cost-effective.

(c) Imperfections can also arise within an organization, and hence,

another issue in managerial economics is how to structure
incentives and organizations.

Q2 ‘Cross Elasticity’ – Explain

Ans: In economics, the cross elasticity of demand and cross price elasticity
of demand measures the responsiveness of the demand of a good to a
change in the price of another good.

It is measured as the percentage change in demand for the first good that
occurs in response to a percentage change in price of the second good. For
example, if, in response to a 10% increase in the price of fuel, the demand of
new cars that are fuel inefficient decreased by 20%, the cross elasticity of
demand would be −20%/10% = −2.

The formula used to calculate the coefficient cross elasticity of demand is

In the example above, the two goods, fuel and cars(consists of fuel
consumption), are complements; that is, one is used with the other. In these
cases the cross elasticity of demand will be negative, as shown by the
decrease in demand for cars when the price of fuel increased. In the case of
perfect complements, the cross elasticity of demand is negative infinity.

Q3 What is ‘Economies of Scale’ in production?

Ans: Economies of scale refers to the decreased per unit cost as output
increases. More clearly, the initial investment of capital is diffused (spread)
over an increasing number of units of output, and therefore, the marginal
cost of producing a good or service is less than the average total cost per unit
(note that this is only in an industry that is experiencing economies of scale).

An example will clarify. AFC is average fixed cost.

The advantage is that "buying bulk is cheaper on a per-unit basis." Hence,

there is economy (in the sense of "efficiency") to be gained on a larger scale.

Examples

Economies of scale — As a firm doubles output, the total cost of inputs less than doubles
Diseconomies of scale — As a firm doubles its output, the total cost of inputs more than
doubles.

In addition to specialization and the division of labor, within any

company there are various inputs that may result in the production of
a good and/or service.

• Lower input costs: When a company buys inputs in bulk - for

example, potatoes used to make French fries at a fast food
chain - it can take advantage of volume discounts. (In turn, the
farmer who sold the potatoes could also be achieving ES if the
farm has lowered its average input costs through, for example,
buying fertilizer in bulk at a volume discount.)

• Costly inputs: Some inputs, such as research and

development, advertising, managerial expertise and skilled
labor are expensive, but because of the possibility of increased
efficiency with such inputs, they can lead to a decrease in the
average cost of production and selling. If a company is able to
spread the cost of such inputs over an increase in its production
units, ES can be realized. Thus, if the fast food chain chooses
to spend more money on technology to eventually increase
efficiency by lowering the average cost of hamburger assembly,
it would also have to increase the number of hamburgers it
 produces a year in order to cover the increased technology
expenditure.
• Specialized inputs: As the scale of production of a company
increases, a company can employ the use of specialized labor
and machinery resulting in greater efficiency. This is because
workers would be better qualified for a specific job - for
example, someone who only makes French fries - and would
no longer be spending extra time learning to do work not within
their specialization (making hamburgers or taking a customer's
order). Machinery, such as a dedicated French fry maker, would
also have a longer life as it would not have to be over and/or
improperly used.

• Techniques and Organizational inputs: With a larger scale of

production, a company may also apply better organizational
skills to its resources, such as a clear-cut chain of command,
while improving its techniques for production and distribution.
Thus, behind the counter employees at the fast food chain may
be organized according to those taking in-house orders and
those dedicated to drive-thru customers.

• Learning inputs: Similar to improved organization and

technique, with time, the learning processes related to
production, selling and distribution can result in improved
efficiency - practice makes perfect!
External economies of scale can also be realized from the above-
mentioned inputs as a result of the company's geographical location.
Thus all fast food chains located in the same area of a certain city
could benefit from lower transportation costs and a skilled labor force.
Moreover, support industries may then begin to develop, such as
dedicated fast food potato and/or cattle breeding farms.

External economies of scale can also be reaped if the industry

lessens the burdens of costly inputs, by sharing technology or
managerial expertise, for example. This spillover effect can lead to
the creation of standards within an industry.

What Does Economies Of Scale Mean?

The increase in efficiency of production as the number of goods being
produced increases. Typically, a company that achieves economies
of scale lowers the average cost per unit through increased
production since fixed costs are shared over an increased number of
goods.

There are two types of economies of scale:

-External economies - the cost per unit depends on the size of the
industry, not the firm.
-Internal economies - the cost per unit depends on size of the
individual firm.
Investopedia explains Economies Of Scale
Economies of scale gives big companies access to a larger market by
allowing them to operate with greater geographical reach. For the
more traditional (small to medium) companies, however, size does
have its limits. After a point, an increase in size (output) actually
causes an increase in production costs. This is called "diseconomies
of scale".

Q4 Write short note on ‘Opportunity Cost’.

Ans: Opportunity cost is the value of the next-best choice available to
someone who has picked between several mutually exclusive choices.[1] It is
a key concept in economics. It is a calculating factor used in mixed markets
which favour social change in favour of purely individualistic economics. It
has been described as expressing "the basic relationship between scarcity
and choice.

What Does Opportunity Cost Mean?

1. The cost of an alternative that must be forgone in order to pursue a
certain action. Put another way, the benefits you could have received
by taking an alternative action.

2. The difference in return between a chosen investment and one that

is necessarily passed up.
What are Opportunity Costs?
Answer: Unlike most costs discussed in economics, an
opportunity cost is not always a number. The opportunity cost of
any action is simply the next best alternative to that action - or
put more simply, "What you would have done if you didn't make
the choice that you did".

I have a number of alternatives of how to spend my Friday night:

I can go to the movies, I can stay home and watch the baseball
game on TV, or go out for coffee with friends. If I choose to go to
the movies, my opportunity cost of that action is what I would
have chose if I had not gone to the movies - either watching the
baseball game or going out for coffee with friends. Note that an
opportunity cost only considers the next best alternative to an
action, not the entire set of alternatives.

Q5 Explain ‘Monopolistic Competition’.

Ans: Monopolistic competition is the market situation where many sellers
provide similar yet not perfectly substitutable products, thereby giving each
seller some monopoly power. Thus, in monopolistic competition production
does not take place at the lowest possible cost. Examples of monopolistic
competition include restaurants, books, clothing.

Monopolies are unfair, big bullies on the playground of business. Say we

both were in the same industry, but I had more money than you did. I wanted
to get your customers away from you so that I could make even more
money. One way I might do that is to drop my prices so low that you can't
afford to lower your prices to equal mine. All of your customers come to me
to save money. You go out of business. I raise my prices back to normal--or
even higher now because you're not there as my competition anymore. I
keep doing this to everyone in our industry until I'm the only choice around,
and everyone has to pay whatever I want to charge.

Monopolies were a huge problem in the late 19th century in the U.S., and
many would argue certain companies around today have too much of a
monopoly on an industry.
Monopolistic competition is a common market structure where
many competing producers sell products that are differentiated
from one another (that is, the products are substitutes, but are not
exactly alike, similar to brand loyalty). Many markets are
monopolistically competitive; common examples include the
markets for restaurants, cereal, clothing, shoes, and service
industries in large cities. The "founding father" of the theory of
monopolistic competition was Edward Hastings Chamberlin in his
pioneering book on the subject Theory of Monopolistic
Competition (1933)

Monopolistically competitive markets have the following

characteristics:

• There are many producers and many consumers in a given

market, and no business has total control over the market
price.
• Consumers perceive that there are non-price differences
among the competitors' products.
• There are few barriers to entry and exit
• Producers have a degree of control over price.

The characteristics of a monopolistically competitive market are almost the

same as in perfect competition, with the exception of monopolistic
competition having heterogeneous products, and that monopolistic
competition involves a great deal of non-price competition (based on subtle
product differentiation). A firm making profits in the short run will break
even in the long run because demand will decrease and average total cost
will increase. This means in the long run, a monopolistically competitive
firm will make zero economic profit. This gives the amount of influence
over the market; because of brand loyalty, it can raise its prices without
losing all of its customers. This means that an individual firm's demand
curve is downward sloping, in contrast to perfect competition, which has a
perfectly elastic demand schedule.

Long-run equilibrium of the firm under monopolistic competition

Major characteristics

There are six characteristics of monopolistic competition (MC):

• product differentiation
• many firms
• free entry and exit in long run
• Independent decision making
• Market Power
• Buyers and Sellers have perfect information

What Does Monopolistic Competition Mean?

A type of competition within an industry where:

1. All firms produce similar yet not perfectly substitutable products.

2. All firms are able to enter the industry if the profits are attractive.
3. All firms are profit maximizers.

4. All firms have some market power, which means none are price
takers.

Monopolistic competition refers to a market structure that is a cross between

the two extremes of perfect competition and monopoly. The model allows
for the presence of increasing returns to scale in production and for
differentiated (rather than homogeneous or identical) products. However the
model retains many features of perfect competition, such as the presence of
many many firms in the industry and the likelihood that free entry and exit
of firms in response to profit would eliminate economic profit among the
firms. As a result, the model offers a somewhat more realistic depiction of
many common economic markets. The model best describes markets in
which numerous firms supply products which are each slightly different
from that supplied by its competitors. Examples include automobiles,
toothpaste, furnaces, restaurant meals, motion pictures, romance novels,
wine, beer, cheese, shaving cream and many more.

The model is especially useful in explaining the motivation for intra-industry

trade, i.e. trade between countries that occurs within an industry rather than
across industries. In other words the model can explain why some countries
export and import automobiles simultaneously. This type of trade, although
frequently measured is not readily explained in the context of the Ricardian
or Heckscher-Ohlin models of trade. In those models a country might export
wine and import cheese, but it would never export and import wine at the
same time.

Q6 Define ‘Capital Budgeting

Ans: The process of determining which potential long-term

projects are worth undertaking, by comparing their expected
discounted cash flows with their internal rates of return.
Capital budgeting is the process by which the financial manager
decides whether to invest in specific capital projects or assets. In some
situations, the process may entail in acquiring assets that are
completely new to the firm. In other situations, it may mean replacing
an existing obsolete asset to maintain efficiency.

Q7 Explain ‘Peak-Load Pricing’.

Ans:Peak-load pricing is a policy of raising prices when the
demand for a service is at its highest. The most recent analysis
of this pricing policy stems from American research in the
1960s and 1970s.
Peak-load pricing is often used by electricity and telephone
utilities as a means of reflecting the investment they have
made to meet peak demand for their services.

Peak Load Pricing

A system of price descrimination whereby peak time users pay higher

prices to reflect the higher marginal cost of supplying them

Over the last couple of months, the topic of user fees has come up on our
EWOT blog a few different times (see here and here, for example). In
putting together my MBA Micro exams, I got wondering why user fees and
peak-load pricing aren't used a lot more often. Here are three cases in point:

(1) Food consumption probably peaks with dinner. Putting the drunks and
others with munchies aside, it must be lowest between midnight and 5 am.
Why don't restaurants use more "smart" pricing during these off-peak
hours? If it can be done in the heavily regulated electricity market, why not
in the food market?

(2) An extremely ugly side of people comes out when it comes to overhead
bins on full flights. Those with briefcases are asked to cram their feet for the
sake of those who want to take large carry-on bags on board. This problem
has gotten much worse since the introduction of fees for checked bags. Why
aren't airlines being entrepreneurial and also charging for bin space?

(3) Why don't rental car companies pro-rate the first and last days of
rentals? If you go over by even an hour on your final day, you're usually
charged for a full day. Wouldn't a profit-maximizing company have a strong
incentive to cut prices substantially on the final day, attract more customers,
and still the car around right away?

Q8 Distinguish between GDP and GNP.

Ans: Generally the students do not keep the difference between

gross national product (GNP) and gross domestic product
(GDP) in view which can culminate into the various conceptual
errors. There are various production sectors in every country
and each sector produces a particular quantity of
goods. Different raw materials are used in producing the
goods. For instance, cotton is used for producing cloth, for
which the farmer uses the seeds, fertilizers, insecticides,
pesticides, etc. The production, in this manner, is divided into
different parts. It should be noted that on every next stage of
production, the value is added in the production. For example,
the value of the yarn as compared to raw cotton, cloth as
compared to yarn and garments as compared to cloth is
always higher. In other words, the total value of finished
goods is nothing but the aggregate of the stage wise
additions. The total quantity of product, in this way, is called
'Gross Domestic Product'.

These goods are produced in the country but are exported to

other countries, are deduced from the Gross Domestic Product
and what ever is earned by the local people from other
countries is added. In this way, what ever is achieved finally is
called 'Gross National Product'

GDP is the market value of everything

produced within a country; GNP is the value
of what's produced by a country's residents,
no matter where they live.
The difference between GDP and GNP comes down to two factors: ownership
and location.
 • GDP measures economic output based on location. If economic output
occurs in the United States, then it is included in the GDP.

• GNP measures economic output based on ownership. If the resources

that produce the economic output are owned by an American entity, they
are included in the GNP.

Gross Domestic Product (GDP)

The Gross Domestic Product measures the value of economic activity

within a country. Strictly defined, GDP is the sum of the market
values, or prices, of all final goods and services produced in an
economy during a period of time. There are, however, three important
distinctions within this seemingly simple definition:

1. GDP is a number that expresses the worth of the output of a

country in local currency.
2. GDP tries to capture all final goods and services as long as
they are produced within the country, thereby assuring that the
final monetary value of everything that is created in a country is
represented in the GDP.
3. GDP is calculated for a specific period of time, usually a year or
a quarter of a year.

Taken together, these three aspects of GNP calculation provide a

standard basis for the comparison of GDP across both time and
distinct national economies.

The important distinction between GDP and GNP rests on differences

in counting production by foreigners in a country and by nationals
outside of a country.

The distinction between GDP and GNP is theoretically important, but

not often practically consequential. Since the majority of production
within a country is by nationals within that country, GDP and GNP are
usually very close together. In general, macroeconomists rely on
GDP as the measure of a country's total output.
GDP (Gross Domestic Product) is a commonly used calculator of national
income and measures the economic activity in a country. Essentially, the
GDP is a figure which measures the value of the goods and services
produced in a country in a given time period (usually one year).

GNP (Gross National Product) is also a calculator of economic activity.

However, GNP also encompasses the value of net income made abroad.
Moreover, when calculating GNP, the value of what foreign countries earn
in the given country is subtracted from the value.

Gross domestic product (GDP) is defined as the "value of all final goods
and services produced in a country in 1 year"

Gross National Product (GNP) is defined as the market value of all goods
and services produced in one year by labour and property supplied by the
residents of a country

Part-B

Q9 a) ‘Managerial Economics is economics applied in decision making’ – Justify

Ans: Managerial Economics

Managerial economics, meaning the application of economic methods
in the managerial decision-making process, is a fundamental part of
any business or management course. This textbook covers all the main
aspects of managerial economics: the theory of the firm; demand
theory and estimation; production and cost theory and estimation;
market structure and pricing; game theory; investment analysis and
government policy. It includes numerous and extensive case studies,
as well as review questions and problem-solving sections at the end of
each chapter. Nick Wilkinson adopts a user-friendly problem-solving
approach which takes the reader in gradual steps from simple
problems through increasingly difficult material to complex case
studies, providing an understanding of how the relevant principles can
be applied to real-life situations involving managerial decision-making.
This book will be invaluable to business and economics students at
both undergraduate and graduate levels who have a basic training in
calculus and quantitative methods

The Business Economics and Managerial Decision Making analyses the growth
and development of privately owned firms and also the decisions made by firms
operating in both private and public sector enterprises. Coverage is clear and
concise, and avoids specialist techniques such as linear programming, which in a
European context tend to belong in courses dealing with operations research.
The book also avoids straying into areas of industrial economics, instead
retaining a sharp focus on relevant issues such as the theory of the firm and the
varying objectives that may be adopted in practice. Key sections are supported
by case studies of real firms and actual decisions made.

Q9b) Define Demand Forecasting. Discuss critically any four important methods
of demand forecasting.

Ans: Demand Forecasting

• the activity of estimating the quantity of a product or service that

consumers will purchase. Demand forecasting involves techniques
including both informal methods, such as educated guesses, and
quantitative methods, such as the use of historical sales data or current
data from test markets. Demand forecasting may be used in making
pricing decisions, in assessing future capacity requirements, or in
making decisions on whether to enter a new market.

The better a company can assess future demand, the better it can plan its
resources. Each company is exposed to three types of factors influencing
demand: company, competitive and macroeconomic factors.

Company factors include market share trends, changes in strategy and

implementation, changes in brand value. Competitive factors include
competitor advertising, competitor product offerings, market share.
Macroeconomic changes include income, economic growth and shocks.

There are several methods to assess and forecast demand. None yields
demand numbers that are a 100% guaranteed. However, using more than one
method improves accuracy and confidence levels. Most companies use
Simple Sales Analysis and Forecasting. Most companies also use Market
Size and Market Share Research. One of the most accurate method used
today is the combination of Market Size Research and Mind Share
Research.

Demand forecasting is the activity of estimating the quantity of a product

or service that consumers will purchase. Demand forecasting involves
techniques including both informal methods, such as educated guesses, and
quantitative methods, such as the use of historical sales data or current data
from test markets. Demand forecasting may be used in making pricing
decisions, in assessing future capacity requirements, or in making decisions
on whether to enter a new market.

Microeconomic, Macroeconomic and Competitive Methods

Market Size & Mind Share Research

Market Size Research combined with Mind Share Research is a good way to
forecast corporate demand. It combines macroeconomic trends with
microeconomic and competitive performance. It is based on the fact that
customers will only buy your product if they

1. need your product or service - macroeconomic trends

2. are able to pay for your product or service -
macroeconomic trends
3. are aware of your product or service offerings -
microeconomic performance
4. perceive your company's offerings to have the best
value - microeconomic plus competitive performance

Market Size Research quantifies the first two issues while Mind Share
Research quantifies the last two. Together they quantify or forecast future
corporate demand as well as future market share.

Market Size & Market Share Research

Market Size Research combined with Market Share Research is often used
to forecast corporate demand. It combines macroeconomic trends with
competitive performance. It is based on the fact that customers will only buy
your product if they need your product or service and are able to pay for it
(macroeconomic trends). It also assumes that your company's market share
will not change in the future.

The advantage of this method is that this information is often well known
and publicized. Several companies offer syndicated reports on these issues.
Customized studies can be performed whenever the information of your
market segment is not published. The disadvantage lies in the assumption
that your market share stays stable.
Microeconomic methods

Simple Sales Analysis and Forecasting

Past sales can be used to forecast future demand. Past sales are broken into:

 trend analysis: used for long-term forecasting; obtained by curve-

fitting past sales with either linear or non-linear regression.
 cycle analysis: used for intermediate range forecasting; up and down
swings in sales.
 seasonality analysis: used for short-term forecasting; hourly, weekly,
monthly, quarterly, etc sales patterns.

While this method is easy to use, it is based on past behavior and does not
include new company, competitor or macroeconomic developments.

Microeconomic Statistical Time-Series Analysis

Sales numbers from several time periods are correlated to one or several
factors such as price, advertising, market share, competitor price
demographics, product life stage, etc. Regression analysis and curve fitting
is then used to predict future demand.

The advantage of this method is that it includes relevant strategy as well as

competitor and macroeconomic trends. The disadvantage is that the outcome
may be biased because of important variables being left out, variables not
being completely independent, new competitive actions not being included.

Macroeconomic methods

Delphi Method or Expert Opinions

This method gathers information from industry experts until a consensus is

reached about where the market is headed. The advantage of this method is
that the information comes from the sources most involved with the market
and thus represents the most accurate information available. The
disadvantage of the Delphi method is the risk of competitive bias and a
tendency toward known information.
Macroeconomic Statistical Time-Series Analysis

This method is a macroeconomic statistical time-series analysis and purely

quantitative in nature. It fits linear and nonlinear curves into time series and
then extrapolating future values. Time series may be correlated to identify
leading and lagging indicators. The advantage of this method is that
recurring trends can be captured and extrapolated easily.

Econometric Modeling

Economists define sets of equations that describe underlying economic

behavior and laws. The coefficients are then fitted statistically. This method
contains fundamental insight and yields qualitative superior forecasts than
pure mathematical models.

Q10A) What is Product Function? Clearly explain Cobb-Douglas Production

Function.

Ans: a production function is a function that specifies the output of a firm,

an industry, or an entire economy for all combinations of inputs

The production function relates the output of a firm to the

amount of inputs, typically capital and labor.

Cobb-Douglas Production Function

If you have not already done so, look at how the parameters of a Cobb-Douglas
production function can be estimated: Estimating a Cobb-Douglas production
function.

The three factor Cobb-Douglas production function is:

q = A * (L^alpha) * (K^beta) * (M^gamma) = f(L,K,M).

where L = labour, K = capital, M = materials and supplies, and q = product. The

symbol "^" means "raise to the power," i.e. L^alpha means "raise the value of L to
the power of the value of alpha."

Production functions need to have certain properties, to ensure that we can solve
the least-cost problem: Check any of the many textbooks. If for given values of
L,K, and M, the Hessian of the production function f is negative definite, then its
isoquants at that point are concave to the origin.
David Hillary thinks we can use a Cobb-Douglas production function to
estimate the effects of income taxes (incidentally, Fred Foldvary's succinct
post today is devastating). He says:

This post examines the effect of Income Tax on rent using the Cobb-
Douglas production and Solow Growth Model.

The Cobb-Douglas Production function is normally said to be

Y=t*K^a*L^(1-a) but I will use the Y=t*K^a*L^b*N^(1-a-b) form where N
is land (K is capital and L is labour). We will use a=0.227, b=0.523 and
N=65967.

Here he introduces N (land) as a factor of production whose contribution to

output is said (in his version) to be proportional to its share of national
income (assumed here to be 1-a-b = 0.25).

The fundamental fallacy in this approach is to assume that what factors are
paid is a measure of what they contribute to income (Y). It is particularly
dubious in the case of land. The supply of land is fixed. Thus it cannot
explain any of the increase (or decrease) in Y. It is labour, capital and,
especially, entrepreneurship and innovating activities, that explain growth.
Land is entirely passive, but is needed, and hence gets a "reward" (income)
in the form of rent-as-surplus.
Q11 B)
Distinguish between Balance of Trade and Balance of Payments. Explain
the policy measures to correct disequilibrium in BOP.
Ans: Balance of trade is actually the legally imports and exports
of the country is in equilibrium states.means the total export
done by nation and total import coming from another nation is
equal or equilibrium.while the balance of payment is slightly
different form balance of payment,balance of payment is
actually based on current account,capital account and official
settelments acount,balance of payment is,doing payment to
abroad and the payment which comes from the abroad is
balanced.balance of trade is the part of balance oy payment.
Balance of Payments is the difference between the money coming into a
country and the money leaving the same country. In economics, the balance
of payments, (or BOP) measures the payments that flow between any
individual country and all other countries. It is used to summarize all
international economic transactions for that country during a specific time
period, usually a year. The BOP is determined by the country's exports and
imports of goods, services, and financial capital, as well as financial
transfers. It reflects all payments and liabilities to foreigners (debits) and all
payments and obligations received from foreigners (credits). Balance of
payments is one of the major indicators of a country's status in international
trade, with net capital outflow.

Balance of trade represents the net of imports and exports, while balance pf
payments includes trade as well as capital flows.

The balance of payments accounts of a country record the payments and

receipts of the residents of the country in their transactions with
residents of other countries. If all transactions are included, the
payments and receipts of each country are, and must be, equal. Any
apparent inequality simply leaves one country acquiring assets in the
others. For example, if Americans buy automobiles from Japan, and
have no other transactions with Japan, the Japanese must end up
holding dollars, which they may hold in the form of bank deposits in
the United States or in some other U.S. investment. The payments of
Americans to Japan for automobiles are balanced by the payments of
Japanese to U.S. individuals and institutions, including banks, for the
acquisition of dollar assets. Put another way, Japan sold the United
States automobiles, and the United States sold Japan dollars or dollar-
denominated assets such as Treasury bills and New York office
buildings....

BALANCE OF TRADE: The difference between the value of goods and

services exported out of a country and the value of goods and services
imported into the country. The balance of trade is the official term for
net exports that makes up the balance of payments. The balance of
trade can be a "favorable" surplus (exports exceed imports) or an
"unfavorable" deficit (imports exceed exports). The official balance of
trade is separated into the balance of merchandise trade for tangible
goods and the balance of services....
A balance of trade surplus is most favorable to domestic producers
responsible for the exports. However, this is also likely to be
unfavorable to domestic consumers of the exports who pay higher
prices.

Alternatively, a balance of trade deficit is most unfavorable to

domestic producers in competition with the imports, but it can also be
favorable to domestic consumers of the exports who pay lower
prices....

An open economy is an economy which interacts with other nations to

exchange goods, services, and investments. Trade between open economies
can be strengthened by economic integration.
To protect domestic industries from competition, government imposes
barriers. The barriers can be both tariff and non-tariff. Tariff barriers include
advalorem duties, specific duties and compound duties. Non-tariff barriers
include quotas, subsidies, licensing, administered protection, and health and
safety standards.

The world is becoming an integrated market place and trade equations are
changing rapidly. Realizing the importance of private capital inflow for the
development of a country, many countries are taking numerous measures to
attract foreign investors.
Balance of Payment (BoP) can be defined as a systematic record of all
economic transactions between the residents of the reporting country and the
residents of the rest of the world.

Disequilibrium in the BoP can be corrected with the help of both monetary
and non-monetary measures. Monetary measures include deflation,
exchange rate depreciation, devaluation and exchange control. Non-
monetary measures include tariffs (import duties), import quotas and export
promotion polices and programmes. Exchange rate means the price of one
currency in terms of another. Exchange rates are either fixed by
governments or determined by the market forces. The two basic exchange
rate regimes are the fixed exchange rate and the floating/flexible exchange
systems.

Q12A) Briefly explain the different methods of measuring national

income. Explain the relevance of national income statistics in
business decisions.
Ans; The names of all of the measures discussed here consist of one of the
words "Gross" or "Net", followed by one of the words "National" or
"Domestic", followed by one of the words "Product", "Income", or
"Expenditure". All of these terms can be explained separately.

"Gross" means total product, regardless of the use to which it is

subsequently put.
"Net" means "Gross" minus the amont that must be used to offset
depreciation – ie., wear-and-tear or obsolescence of the nation's fixed
capital assets. "Net" gives an indication of how much product is
actually available for consumption or new investment.
"Domestic" means the boundary is geographical: we are counting all
goods and services produced within the country's borders, regardless
of by whom.
"National" means the boundary is defined by citizenship (nationality).
We count all goods and services produced by the nationals of the
country (or businesses owned by them) regardless of where that
production physically takes place.
The output of a French-owned cotton factory in Senegal counts as part
of the Domestic figures for Senegal, but the National figures of
France.
"Product", "Income", and "Expenditure" refer to the three counting
methodologies explained earlier: the product, income, and expenditure
approaches. However the terms are used loosely.
"Product" is the general term, often used when any of the three
appraoches was actually used. Sometimes the word "Product" is used
and then some additional symbol or phrase to indicate the
methodology; so, for instance, we get "Gross Domestic Product by
income", "GDP (income)", "GDP(I)", and similar constructions.
"Income" specifically means that the income approach was used.
"Expenditure" specifically means that the expenditure approach was
used.

Measuring national income

To measure how much output, spending and income has been

generated in a given time period we use national income accounts.
These accounts measure three things:
1. Output: i.e. the total value of the output of goods and services
produced in the UK.

2. Spending: i.e. the total amount of expenditure taking place in

the economy.

3. Incomes: i.e. the total income generated through production of

goods and services.

What is National Income?

National income measures the money value of the flow of output

of goods and services produced within an economy over a period of
time. Measuring the level and rate of growth of national income (Y)
is important to economists when they are considering:

measuring national income

To measure how much output, spending and income has been

generated we use national income accounts. These accounts
measure the:

1. Total value of the output of goods and services produced in the

UK
2. Total amount of expenditure taking place in the economy
3. Total amount of income generated through production of goods
and services

National Income is a term used to measure the monetary value of

the flow of output of goods and services produced within the
economy over a period of time. Measuring the level and rate of
growth of national income (Y) is important to economists when they
are considering:

The rate of economic growth and where the economy is in the

business cycle

Changes to overall living standards of the population

Looking at the distribution of national income (i.e. measuring

income and wealth inequalities)
Gross Domestic Product (GDP)

GDP measures the value of output produced within the domestic

boundaries of the UK. It includes the output of the many foreign
owned firms that are located in the UK following the high levels of
foreign direct investment in the UK economy in the 1980s and
1990s. Read this article on 100 years of UK GDP

There are three ways of calculating GDP - all of which should sum to
the same amount since by identity:

National Output = National Expenditure (Aggregate Demand) =

National Income

Under the new definitions introduced in 1998, GDP is now known as

Gross Valued Added.

i) The Expenditure Method (Aggregate Demand)

This is the sum of the final expenditure on UK produced goods and

services measured at current market prices. The full equation for
GDP using this approach is

GDP = C + I + G + (X-M)

C: Household spending (consumption)

I: Capital Investment spending
G: General Government spending
X: Exports of Goods and Services
M: Imports of Goods and Services

ii) The Income Method (Sum of Factor Incomes)

Here GDP is the sum of the final incomes earned through the
production of goods and services.

Main Factor Incomes

Income from employment and self-employment
Added to Profits of companies
Added to Rent income
= Gross Domestic product (by factor income)
Only factor incomes generated through the production of output are
included in the calculation of GDP by the income approach.
Therefore, we exclude from the accounts the following items:

Transfer payments (e.g. the state pension, income support and the
Jobseekers' Allowance)

Private Transfers of money from one individual to another

Income that is not registered with the Inland Revenue (note here
the effects of the Black or shadow economy where goods and
services are exchanged but the value of these transactions is hidden
from the authorities and therefore does not show up in the official
statistics!)

iii) The Output Method

This measures the value of output produced by each of the
productive sectors in the economy using the concept of value
added. Value added is the increase in the value of a product at each
successive stage of the production process. We use this approach to
avoid the problems of double-counting the value of intermediate
inputs. The main sectors of the economy are the service industries,
manufacturing and construction, and extractive industries such as
mining, oil together with agriculture

The Difference between GDP and GNP

Gross National Product (GNP) measures the final value of output or
expenditure by UK owned factors of production whether they are
located in the UK or overseas. GDP is only concerned with incomes
generated within the geographical boundaries of the country. So
output produced by Nissan in the UK counts towards our GDP but
some of the profits made by Nissan here are sent back to Japan -
adding to their GNP.

GNP = GDP + Net property income from abroad (NPIA)

NPIA is the net balance of interest, profits and dividends (IPD)

coming into the UK from UK assets owned overseas matched against
the flow of profits and other income from foreign owned assets
located within the UK.
Q12 b) Explain the significance and importance of Capital Budgeting decisions

Ans: The key function of the financial management is the

selection of the most profitable assortment of capital investment
and it is the most important area of decision-making of the
financial manger because any action taken by the manger in this
area affects the working and the profitability of the firm for many
years to come.

1. Meaning
o The process through which different projects are evaluated is
known as capital budgeting
o Capital budgeting is defined “as the firm’s formal process for the
acquisition and investment of capital. It involves firm’s decisions to invest its
current funds for addition, disposition, modification and replacement of fixed
assets”.
o Capital budgeting consists in planning development of available
capital for the purpose of maximising the long term profitability of the concern”
– Lynch
o The main features of capital budgeting are
o a. potentially large anticipated benefits
o b. a relatively high degree of risk
o c. relatively long time period between the initial outlay and the
anticipated return.
o
o Significance of capital budgeting
o The success and failure of business mainly depends on how the
available resources are being utilised.
o Main tool of financial management
o All types of capital budgeting decisions are exposed to risk and
uncertainty.
o They are irreversible in nature.
o Capital rationing gives sufficient scope for the financial manager
to evaluate different proposals and only viable project must be taken up for
investments.
o Capital budgeting offers effective control on cost of capital
expenditure projects.
o It helps the management to avoid over investment and under
investments.
o
o Capital budgeting process involves the following
o 1. Project generation : Generating the proposals for investment is
the first step.
o The investment proposal may fall into one of the following
categories:
o Proposals to add new product to the product line,
o proposals to expand production capacity in existing lines
o proposals to reduce the costs of the output of the existing
products without altering the scale of operation.

o Factors influencing capital budgeting

o Availability of funds
o Structure of capital
o Taxation policy
o Government policy
o Lending policies of financial institutions
o Immediate need of the project
o Earnings
o Capital return
o Economical value of the project
o Working capital
o Accounting practice
o Trend of earnings
o
o Methods of capital budgeting
o Traditional methods
o Payback period
o Accounting rate of return method
o Discounted cash flow methods
o Net present value method
o Profitability index method
o Internal rate of return
o
o Pay back period method
o It refers to the period in which the project will generate
the necessary cash to recover the initial investment.
o It does not take the effect of time value of money.
o It emphasizes more on annual cash inflows, economic
life of the project and original investment.
o The selection of the project is based on the earning
capacity of a project.
o It involves simple calcuation, selection or rejection of
the project can be made easily, results obtained is more reliable,
best method for evaluating high risk projects.
2.
o Internal Rate of Return
o It is that rate at which the sum of discounted
cash inflows equals the sum of discounted cash outflows. It
is the rate at which the net present value of the investment
is zero.
o It is the rate of discount which reduces the NPV
of an investment to zero. It is called internal rate because it
depends mainly on the outlay and proceeds associated
with the project and not on any rate determined outside the
investment.
o Merits of IRR method
o It consider the time value of money
o Calculation of casot of capital is not a prerequisite for
adopting IRR
o IRR attempts to find the maximum rate of interest at
which funds invested in the project could be repaid out of the cash
inflows arising from the project.
o It is not in conflict with the concept of maximising the
welfare of the equity shareholders.
o It considers cash inflows throughout the life of the
project.

The Importance Of Capital Budgeting

Capital budgeting (or investment appraisal) is the planning process used to
determine a firm’s expenditures on assets whose cash flows are expected to
extend beyond one year such as new machinery, equipments, etc. It is also
the process of identifying, analyzing and selecting investment projects
whose cash flows are expected to extend beyond one year such as research
and development project.

Capital expenditures can be very large and have a significant impact

 on the firm’s financial performance. Besides, the investments take time to
mature and capital assets are long-term, therefore, if a mistake were done in
the capital budgeting process, it will affect the firm for a long period of time.
Basically, the importance of capital budgeting are as follow:

1) Avoid forecast error

The future success of a business largely depends on the investment

decisions that corporate managers make today. Investment decisions may
result in a major departure from what the company has been doing in the
past. Through making capital investments, firm acquires the long-lived fixed
assets that generate the firm’s future cash flows and determine its level of
profitability. Thus, this decision greatly influences a firm’s ability to achieve
its financial objectives.

For example, if the firm invests too much it will cause higher
depreciation and expenses. On the other hand, if the firm does not invest
enough, the firm will face a problem of inadequate capacity and thus, lose its
market share to its competitors.

2) Helps firm to plan its financing

Proper capital budgeting analysis is critical to a firm’s successful

performance because capital investment decisions can improve cash flows
and lead to higher stock prices. Yet, poor decisions can lead to financial
distress and even to bankruptcy. Although a tactical investment decision
generally involves a relatively small amount of funds, strategic investment
decisions may require large...

Importance of Capital Budgeting:

• Proper decision on capital budget will increase a firm’s value as well

as shareholders’ wealth
• Capital budgeting is critical to a firm as it helps the firm to stay
competitive as it is expanding its business like proposing to purchase equipments
to produce additional or new products, renting or owning premises for opening
new branches, etc
MANAGERIAL ECONOMICS --- JUNE 2009
Part-A

Q2 What is profit function

Ans: In our cost-minimization exercise, we were able to derive a cost

function C(w, y) and a compensated factor demand function x = x(w, y).
There are analogues in the profit-maximization case. The first is the profit
function, which is defined as :

π (p, w) = maxx p�(x) - wx

where the terms follow their traditional definitions (w and x are vector of
factor prices and factor demands respectively). Notice that output price (p)
and factor prices (w) the only parameters entering into profit-function.

Q3 Define the law of supply.

Ans: Supply by definition: those quantities of goods and services that are
produced to meet consumer's "demand" at a given price and at a given point
in time;
the "law" of supply simply states that supply shows the relationship between
quantities supplied and and the quantity a firm is willing to supply!

What Does Law of Supply Mean?

A microeconomic law that states that all things being equal, as the price of a
good or service increases, the quantity of that good or service offered by
suppliers increases and vice versa.

Q4 What is elasticity?
Ans: Elasticity is the amount of stretch that an object contains. It is property
by virtue of which matter keeps its shape from deforming into another.
When an external force is applied to an object the size and shape of the
object may change, for example, an appropriate force is applied to a spring
can elongate it. If the force ceases to act the object may restore to its original
size and shape. An object is said to be elastic if it restores its original size
and shape. This property of an object is known as elasticity.

In economics, elasticity is the ratio of the percent change in one variable to

the percent change in another variable. It is a tool for measuring the
responsiveness of a function to changes in parameters in a relative way.
Commonly analyzed are elasticity of substitution, price and wealth.
Elasticity is a popular tool among empiricists because it is independent of
units and thus simplifies data analysis.

An "elastic" good is one whose price elasticity of demand has a magnitude

greater than one. Similarly, "unit elastic" and "inelastic" describe goods with
price elasticity having a magnitude of one and less than one respectively.

Q5 What is business cartel

Ans: Business cartel

A group of companies or countries acting together to control the

supply and price of certain goods or services. Cartels are formed to
produce higher profits than would ordinarily be earned.

formal organization set up by a group of firms that produce and sell

the same product for the purpose of exacting and sharing
monopolistic rents.

Q6 What is cost of capital

Ans: The rate of return an enterprise has to offer to induce investors to provide it
with capital. The cost of loan capital is the rate of interest that has to be paid. The
cost of equity capital is the expected yield needed to induce investors to buy
shares.

The cost of capital is the cost of a company's funds (both debt and equity),
or, from an investor's point of view "the expected return on a portfolio of all
the company's existing securities."[1] It is used to evaluate new projects of a
company as it is the minimum return that investors expect for providing
capital to the company, thus setting a benchmark that a new project has to
meet.
What Does Cost Of Capital Mean?
The required return necessary to make a capital budgeting project,
such as building a new factory, worthwhile. Cost of capital includes
the cost of debt and the cost of equity.

Q7 What is GNP
Ans: Definition
Gross National Product. GNP is the total value of all final goods
and services produced within a nation in a particular year, plus
income earned by its citizens (including income of those located
abroad), minus income of non-residents located in that country.
Basically, GNP measures the value of goods and services that the
country's citizens produced regardless of their location. GNP is
one measure of the economic condition of a country, under the
assumption that a higher GNP leads to a higher quality of living,
all other things being equal.

Q8 Define inflation.

Ans: Inflation: Inflation is an upward movement in the average level of

prices. The boundary between inflation and deflation is price stability.

Because inflation is a rise in the general level of prices, it is intrinsically

linked to money, as Captured by the often heard refrain "Inflation is too
much money chasing too few goods".

inflation is caused by a combination of four factors:

1. The supply of money goes up.

2. The supply of other goods goes down.

3. Demand for money goes down.

4. Demand for other goods goes up.

Causes of inflation: The main cause of inflation is the increase of paper

money in circulation in an economy. When there is an increase in an
economies currency, the value of the currency decreases, which then has a
negative effect on the prices of goods and services.

There are different schools of thought as to what causes inflation. Most can
be divided into two broad areas: quality theories of inflation, and quantity
theories of inflation. Many theories of inflation combine the two. The
quality theory of inflation rests on the expectation of a buyer accepting
currency to be able to exchange that currency at a later time for goods that
are desirable as a buyer. The quantity theory of inflation rests on the
equation of the money supply, its velocity, and exchanges. Adam Smith and
David Hume proposed a quantity theory of inflation for money, and a quality
theory of inflation for production.

The role of inflation in the economy: In the long run, inflation is generally
believed to be a monetary phenomenon, while in the short and medium term,
it is influenced by the relative elasticity of wages, prices and interest rates.
[1] The question of whether the short-term effects last long enough to be
important is the central topic of debate between monetarist and Keynesian
schools. In monetarism, prices and wages adjust quickly enough to make
other factors merely marginal behavior on a general trendline. In the
Keynesian view, prices and wages adjust at different rates, and these
differences have enough effects on real output to be "long term" in the view
of people in an economy.

A great deal of economic literature concerns the question of what causes

inflation and what effect it has. A small amount of inflation is often viewed
as having a positive effect on the economy. One reason for this is that it is
difficult to renegotiate some prices, and particularly wages, downwards, so
that with generally increasing prices it is easier for relative prices to adjust.
Many prices are "sticky downward" and tend to creep upward, so that efforts
to attain a zero inflation rate (a constant price level) punish other sectors
with falling prices, profits, and employment. Efforts to attain complete price
stability can also lead to deflation, which is generally viewed as a negative
outcome because of the significant downward adjustments in wages and
output that are associated with it. Inflation is also viewed as a hidden risk
pressure that provides an incentive for those with savings to invest them,
rather than have the purchasing power of those savings erode through
inflation. In investing, inflation risks often cause investors to take on more
systematic risk, in order to gain returns that will stay ahead of expected
inflation. Inflation is also used as an index for cost of living adjustments and
as a peg for some bonds. In effect, inflation is the rate at which previous
economic transactions are discounted economically.

Inflation also gives central banks room to maneuver, since their primary tool
for controlling the money supply and velocity of money is by setting the
lowest interest rate in an economy - the discount rate at which banks can
borrow from the central bank. Since borrowing at negative interest is
generally ineffective, a positive inflation rate gives central bankers
"ammunition", as it is sometimes called, to stimulate the economy.

However, in general, inflation rates above the nominal amounts required to

give monetary freedom, and investing incentive, are regarded as negative,
particularly because in current economic theory, inflation begets further
inflationary expectations.

• Increasing uncertainty may discourage investment and saving.

• Redistribution
• ** It will redistribute income from those on fixed incomes, such as
pensioners, and shifts it to those who draw a variable income, for
example from wages and profits which may keep pace with inflation.
o Similarly it will redistribute wealth from those who lend a fixed
amount of money to those who borrow. For example, where the
government is a net debtor, as is usually the case, it will reduce
this debt redistributing money towards the government. Thus
inflation is sometimes viewed as similar to a hidden tax.
• International trade: If the rate of inflation is higher than that abroad, a
fixed exchange rate will be undermined through a weakening balance
of trade.
• Shoe leather costs: Because the value of cash is eroded by inflation,
people will tend to hold less cash during times of inflation. This
imposes real costs, for example in more frequent trips to the bank.
(The term is a humorous reference to the cost of replacing shoe leather
worn out when walking to the bank.)
• Menu costs: Firms must change their prices more frequently, which
imposes costs, for example with restaurants having to reprint menus.
• Relative Price Distortions: Firms do not generally synchronize
adjustment in prices. If there is higher inflation, firms that do not
adjust their prices will have much lower prices relative to firms that
do adjust them. This will distort economic decisions, since relative
prices will not be reflecting relative scarcity of different goods.
 • Hyperinflation: if inflation gets totally out of control (in the upward
direction), it can grossly interfere with the normal workings of the
economy, hurting its ability to supply.
• Inflation tax when a government can improve its net financial position
by allowing inflation, then this represents a "stealth" tax on holders of
the currency.
• Bracket Creep is related to the inflation tax. By allowing inflation to
move upwards, certain sticky aspects of the tax code are met by more
and more people. Commonly income tax brackets, where the next
dollar of income is taxed at a higher rate than previous dollars.
Governments that allow inflation to "bump" people over these
thresholds are, in effect, allowing a tax increase because the same real
purchasing power is being taxed at a higher rate.

Some economists see moderate inflation as a benefit; some business

executives see mild inflation as "greasing the wheels of commerce." A very
few economists have advocated reducing inflation to zero as a monetary
policy goal - particularly in the late 1990s at the end of a long disinflationary
period, when the policy seemed within reach.

Part-B
Q9A) State the scope and importance of managerial economics in a business
organization

Ans: Managerial Economics deals with allocating the scarce resources in a

manner that minimizes the cost. As we have already discussed, Managerial
Economics is different from microeconomics and macro-economics. Managerial
Economics has a more narrow scope - it is actually solving managerial issues
using micro-economics. Wherever there are scarce resources, managerial
economics ensures that managers make effective and efficient decisions
concerning customers, suppliers, competitors as well as within an organization.
The fact of scarcity of resources gives rise to three fundamental questions-

a. What to produce?
b. How to produce?
c. For whom to produce?

Scope of Business Economics:

1. Consumer analysis focusing on demand

2. Production analysis
3. Equilibrium analysis focusing cost and revenue

4. Structure of markets and its imperfection

5. Pricing of products and services

6. Capital and profit management.