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Master of Business Administration MBA Semester 1 MB0042 Managerial Economics

Assignment Set 1 (60 marks)

Answer 1: Price discrimination: Price discrimination or price differentiation exists when sales of identical goods or services are transacted at different prices from the same provider. In a theoretical market with perfect information, perfect substitutes, and no transaction costs or prohibition on secondary exchange (or re-selling) to prevent arbitrage, price discrimination can only be a feature of monopolistic and oligopolistic markets, where market power can be exercised. Otherwise, the moment the seller tries to sell the same good at different prices, the buyer at the lower price can arbitrage by selling to the consumer buying at the higher price but with a tiny discount. However, product heterogeneity, market frictions or high fixed costs (which make marginal-cost pricing unsustainable in the long run) can allow for some degree of differential pricing to different consumers, even in fully competitive retail or industrial markets. Price discrimination also occurs when the same price is charged to customers which have different supply costs. The effects of price discrimination on social efficiency are unclear; typically such behavior leads to lower prices for some consumers and higher prices for others. Output can be expanded when price discrimination is very efficient, but output can also decline when discrimination is more effective at extracting surplus from high-valued users than expanding sales to low valued users. Even if output remains constant, price discrimination can reduce efficiency by misallocating output among consumers. Price discrimination requires market segmentation and some means to discourage discount customers from becoming resellers and, by extension, competitors. This usually entails using one or more means of preventing any resale, keeping the different price groups separate, making price comparisons difficult, or restricting pricing information. The boundary set up by the

marketer to keep segments separate is referred to as a rate fence. Price discrimination is thus very common in services, where resale is not possible; an example is student discounts at museums. Price discrimination in intellectual property is also enforced by law and by technology. In the market for DVDs, DVD players are designed - by law - with chips to prevent use of an inexpensive copy of the DVD (for example legally purchased in India) from being used in a higher price market. The Digital Millennium Copyright Act has provisions to outlaw circumventing of such devices to protect the enhanced monopoly profits that copyright holders can obtain from price discrimination against higher price market segments. Price discrimination can also be seen where the requirement that goods be identical is relaxed. For example, so-called "premium products" (including relatively simple products, such as cappuccino compared to regular coffee) have a price differential that is not explained by the cost of production. Some economists have argued that this is a form of price discrimination exercised by providing a means for consumers to reveal their willingness to pay.

The bases of price discrimination: The monopoly seller has the advantage of price discrimination, as he is the only producer in the market. Price discrimination is charging different price to different buyer for the same product. DEGREES OF PRICE DISCRIMINATION First degree price discrimination It is also called perfect price discrimination, as it involves maximum exploitation of the consumer in the interest of the seller. It happens when the seller is able to sell each unit separately and at a different price. Each buyer is made to pay the amount he is willing to pay rather going without it. The seller will make different bargain with each buyer. Such type of price discrimination enjoyed by the seller is called first degree price discrimination.

Second degree price discrimination It happens when the monopoly seller will charge separate price in such a way that the buyer is divided into different groups according to the price elasticity of demand for his product. Third degree price discriminationWhen the seller will be divided into sub-market and charge different price depending on the output sold in the market and the demand condition of that sub- market. The seller practicing price discrimination between the domestic market and international market, the seller will charge higher price in the domestic market, where he enjoys monopoly and charge low price in the international market, where he has to face more competition.

Answer 2:

Price Determination under Monopoly Monopoly is that market form in which a single producer controls the whole supply of a single commodity which has no close substitute. From this definition there are two points that must be noted: Single Producer: There must be only one producer who may be an individual, a partnership firm or a joint stock company. Thus single firm constitutes the industry. The distinction between firm and industry disappears under conditions of monopoly. No Close Substitute: The commodity produced by the producer must have no closely competing substitutes, if he is to be called a monopolist. This ensures that there is no rival of the monopolist. Therefore, the cross elasticity of demand between the product of the monopolist and the product of any other producer must be very low. PRICE-OUTPUT DETERMINATION UNDER MONOPOLY: A firm under monopoly faces a downward sloping demand curve or average revenue curve. Further, in monopoly, since average revenue falls as more units of output are sold, the marginal revenue is less than the average revenue. The Equilibrium level in monopoly is that level of output in which marginal revenue equals marginal cost. The producer will continue producer as long as marginal revenue exceeds the marginal cost. At the point where MR is equal to MC the profit will be maximum and beyond this point the producer will stop producing.

Price Determination under Oligopoly: The price and output behavior of the firms operating in oligopolistic or duopolistic market condition can be studied under two main heads: Price and Output Determination under Duopoly: If an industry is composed of two giant firms each selling identical or homogenous products and having half of the total market, the price and output policy of each is likely to affect the other appreciably, therefore there is every likelihood of collusion between the two firms. The firms may agree on a price, or divide the total market, or assign quota, or merge themselves into one unit and form a monopoly or try to differentiate their products or accept the price fixed by the leader firm, etc. In case of perfect substitutes the two firms may be engaged in price competition. The firm having lower costs, better goodwill and clientele will drive the rival firm out of the market and then establish a monopoly. If the products of the duopolies are differentiated, each firm will have a close watch on the actions of its rival firms. The firm good quality product with lesser cost will earn abnormal profits. Each firm will fix the price of the commodity and expand output in accordance with the demand of the commodity in the market.

Price and Output Determination under Oligopoly: If an industry is composed of few firms each selling identical or homogenous products and having powerful influence on the total market, the price and output policy of each is likely to affect the other appreciably, therefore they will try to promote collusion. In case there is product differentiation, an oligopolies can raise or lower his price without any fear of losing customers or of immediate reactions from his rivals. However, keen rivalry among them may create condition of monopolistic competition. There is no single theory which satisfactorily explains the oligopoly behavior regarding price and output in the market. There are set of theories like Cournot Duopoly Model, Bertrand Duopoly Model, the Chamberlin Model, the Kinked Demand Curve Model, the Centralized Cartel Model, Price Leadership Model, etc., which have been developed on particular set of assumptions about the reaction of other firms to the action of the firm under study. Collusive Oligopoly: The degree of imperfect competition in a market is influenced not just by the number and size of firms but by how they behave. When only a few firms operate in a market, they see what their rivals are doing and react. Strategic interaction is a term that describes how each firms business strategy depends upon its rivals business behavior. When there are only a small number of firms in a market, they have a choice between cooperative and non-cooperative behavior. Firms act non-cooperatively when they act on their own without any explicit or implicit agreement with other firms. Thats what produces price wars. Firms operate in a cooperative mode when they try to minimize competition between them. When firms in an oligopoly actively cooperate with each other, they engage in collusion. Collusion is an oligopolistic situation in which two or more firms jointly set their prices or outputs, divide the market among them, or make other business decisions jointly.

Answer 3: Total Revenue and Marginal revenue Total Revenue: The amount received from the sale of a good or service. It equals the price of the good or service multiplied by the quantity. It is the total sales receipts earned from the sale of its total output produced over a given period of time. The total revenue as a function of the total quantity sold at a given price is as below: TR = f (q) It implies that higher the sales, lager would be the TR. Thus the TR =P x Q. Y TR Price X 0 Sales

Marginal revenue: Marginal revenue (MR) is the extra revenue that an additional unit of product will bring. It is the additional income from selling one more unit of a good; sometimes equal to price. It can also be described as the change in total revenue divided by the change in the number of units sold. Suppose a firm is selling 4 units of the output at the price of Rs. 14 per unit, and if it wants to sell 5 units instead of 4 units and thereby the price of the product falls to Rs. 12 per unit. Then the marginal revenue will not be equal to Rs 12 at which the 5th unit is sold. 4 units, which were sold at price of Rs. 14 before will all have to be sold at the reduced price of Rs. 12 and that will mean the loss of rupees 2 on each of the previous 4 units. The total loss on the previous units will be equal to Rs. 8. Therefore this loss of Rs. 8 should be deducted from the price of Rs. 12 of the 5th Unit while calculating the marginal revenue. Therefore the marginal revenue will be Rs12 - Rs.8 = Rs.4 and not Rs. 12 which is an average value.

Marginal Revenue can also be directly calculated by finding out the difference between the total revenue before and after selling the additional unit of the product. Total revenue when 4 units are sold at the price of Rs. 14 = 4 x 14 = Rs. 56 Total revenue when 5 units are sold at the price of Rs. 12 = 5 x 12 = Rs. 60 Therefore, Marginal revenue or the net revenue earned by the 5th unit = 60-56 = Rs.4 Thus, marginal revenue of the nth unit is equal to the difference in the total revenue in increasing the sale from n 1 ton units. Marginal revenue is equal to the change of in the total revenue over the change in quantity. If one knows the marginal revenue, one can tell what happens to the total revenue if sales change. Implicit and Explicit cost Implicit Cost: An implicit cost results if the person who at first foregoes the satisfaction in the search of an activity and is not rewarded by money or another form of payment. The implicit cost begins and ends with foregoing the benefits and satisfaction. When an organization or owner uses its own equity for company's well-air then that cost is considered as implicit cost. Goodwill is a good example of implicit cost. Explicit Cost: An Explicit cost is a business expense accounted cost that can be easily identified such as wage, rent and materials. Explicit costs gives clear and evident cash outflows from business that decreases its end result profitability. This cost directly affects the revenue. Intangible expenses such as goodwill and amortization are not explicit expense because these expenses don't show clear effects on a business's revenue and expenses.

Answer 4: In the short-run the level of production can be changed by changing the factor proportions. This law examines the production function with on factor variable, keeping the other factors quantities fixed. In other words this law explains the short-run production function. When the quantity of one input is varied, keeping other inputs constant, the proportion between factors changes. When the proportion of variable factors increases, the total output does not always increase in the same proportion, but in varying proportion. This is why the law is named Law of Variable proportions. The law of variable proportion is the new name given to the famous Laws of Diminishing Returns. The law of variable proportion or the law of diminishing returns has been defined by a number of economists. In the words of F. Benham. As the proportion of one factor in a combination of factors is increased, after a point, first the marginal and then the average product of that factor will diminish. This law explains return to a factor. Thus, the law states that if more and more units of a variable factor are applied to a given quantity of fixed factor, the total output may initially increase at an increasing rate but beyond a certain level the total output, the rate of increase in total output eventually diminishes in the use of additional units of the variable factor. The volume of goods produced can be looked at form three different angles viz.: Total Product, Marginal Product Average Product. Total Product (TP): refers to the total volume of goods produced during a specified period of time. Total product can be raised only by increasing the quantity of variable factors employed in production. For instance, more shirts will be produced when more labor and capital are used. Total product, generally goes on increasing with an increase in the quantity of the factor services employed. But there is a limit to which total product can increase with increase in the quantity of variable factors of production. Marginal Product (MP): The rate at which total product increases is known as marginal product. We also define marginal product as the addition to the total product resulting from a unit increase in the quantity of the variable factor. Initially marginal product rises, but ultimately it begins to fall down, it becomes zero and at last becomes negative. It would be seen that the total product is maximum when the marginal product is zero.

Average Product (AP): Average product can be known by dividing total product by the total number of units of the variable factor. AP = Total Product No. of Units It can be easily seen that the average product also show almost the same tendency as does the marginal product. Initially, both the marginal product and the average product rise but ultimately both of these falls. However, marginal product may be zero. The output does not increase at a constant rate as more of any one input is added to the production process. For example: on a small plot of land we can improve the yield by increasing the fertilizer use to some extent. However, excessive use of fertilizer beyond the optimum quantity may lead to reduction in the output instead of any increase as per the law of Diminishing Returns (for instance, single application of fertilizers may increase the output by 50 per cent, a second application by another 30 per cent and the third by 20 per cent. However, if we apply fertilizer five to six times in a year, the output may drop to zero). The principle of diminishing marginal productivity (returns) states that as additional units of a variable inputs are added to other inputs that are fixed in supply, the increment to output eventually decline (for a constant technology). This phenomenon has been widely observed and there is enough empirical evidence to support it. For business managers, managers, marginal productivity of an input plays an important part in determining how much of that input will be employed.

Answer 5: Elasticity of demand is the economists way of talking about how responsive consumers are to price changes. For some goods, like salt, even a big increase in price will not cause consumers to cut back very much on consumption. For other goods, like vanilla ice cream cones, even a modest price increase will cause consumers to cut back a lot on consumption. Elasticity of demand is an elasticity used to show the responsiveness of the quantity demanded of a good or service to a change in its price. More precisely, it gives the percentage change in demand one might expect after a one percent change in price. Elasticity is almost always negative, although analysts tend to ignore the sign even though this can lead to ambiguity. Only goods which do not conform to the law of demand, such as Veblen and Giffen goods have a positive elasticity demand. Goods with a small elasticity demand (less than one) are said to be inelastic: changes in price do not significantly affect demand e.g. drinking water. Goods with large elasticity demands (greater than one) are said to be elastic: even a slight change in price may cause a dramatic change in demand. Revenue is maximized when price is set so as to create an ED of exactly one; elasticity demands can also be used to predict the incidence of tax. Various research methods are used to calculate price elasticity, including test markets, analysis of historical sales data and conjoint analysis. There is a neat way of classifying values of elasticity. When the numerical value of elasticity is less than one, demand is said to be inelastic. When the numerical value of elasticity is greater than one, demand is elastic. So elastic demand means that people are relatively responsive to price changes (remember the vanilla ice cream cone). Inelastic demand means that people are relatively unresponsive to price changes (remember salt). An important relationship exists between the elasticity of demand for a good and the amount of money consumers want to spend on it at different prices. Spending is price times quantity, p times Q. In general, a decrease in price leads to an increase in quantity, so if price falls spending may either increase or decrease, depending on how much quantity increases. If demand is elastic, then a drop in price will increase spending, because the percent increase in quantity is larger than the percent decrease in price. On the other hand, if demand is inelastic a

drop in price will decrease spending because the percent increase in quantity is smaller than the percent decrease in price. The price elasticity of demand measures how responsive the quantity demanded of a good is to a change in its price. The value illustrates if the good is relatively elastic (PED is greater than 1) or relatively inelastic (PED is less than 1). A good's PED is determined by numerous factors, these include; Number of substitutes: the larger the number of close substitutes for the good then the easier the household can shift to alternative goods if the price increases. Generally, the larger the number of close substitutes, the more elastic the price elasticity of demand. Degree of necessity: If the good is a necessity item then the demand is unlikely to change for a given change in price. This implies that necessity goods have inelastic price elasticitys of demand. Price of the good as a proportion of income: It can be argued that goods that account for a large proportion of disposable income tend to be elastic. This is due to consumers being more aware of small changes in price of expensive goods compared to small changes in the price of inexpensive goods. The following example illustrates how to determine the price elasticity of demand for a good. The price elasticity of demand for supermarket own produced strawberry jam is likely to be elastic. This is because there are a very large number of close substitutes (both in jams and other preserves), and the good is not a necessity item. Therefore, consumers can and will easily respond to a change in price.

Answer 6: The Marginal Efficiency of Capital (MEC) is that rate of discount which would equate the price of a fixed capital asset with its present discounted value of expected income. Annual percentage yield earned by the last additional unit of capital. It is also known as marginal productivity of capital, natural interest rate, net capital productivity, and rate of return over cost. The significance of the concept to a business firm is that it represents the market rate of interest at which it begins to pay to undertake a capital investment. If the market rate is 10%, for example, it would not pay to undertake a project that has a return of 9%, but any return over 10% would be acceptable. In a larger economic sense, marginal efficiency of capital influences long-term interest rates. This occurs because of the law of diminishing returns as it applies to the yield on capital. As the highest yielding projects are exhausted, available capital moves into lower yielding projects and interest rates decline. As market rates fall, investors are able to justify projects that were previously uneconomical. This process is called diminishing marginal productivity or declining marginal efficiency of capital. More precisely, the marginal efficiency of capital as being equal to that rate of discount which would make the present value of the series of annuities given by the returns expected from the capital-asset during its life just equal to its supply price. This gives us the marginal efficiencies of particular types of capital-assets. The greatest of these marginal efficiencies can then be regarded as the marginal efficiency of capital in general. The marginal efficiency of capital is here defined in terms of the expectation of yield and of the current supply price of the capital-asset. It depends on the rate of return expected to be obtainable on money if it were invested in a newly produced asset; not on the historical result of what an investment has yielded on its original cost if we look back on its record after its life is over. If there is an increased investment in any given type of capital during any period of time, the marginal efficiency of that type of capital will diminish as the investment in it is increased, partly because the prospective yield will fall as the supply of that type of capital is increased, and partly because, as a rule,

pressure on the facilities for producing that type of capital will cause its supply price to increase; the second of these factors being usually the more important in producing equilibrium in the short run, but the longer the period in view the more does the first factor take its place. Thus for each type of capital we can build up a schedule, showing by how much investment in it will have to increase within the period, in order that its marginal efficiency should fall to any given figure. We can then aggregate these schedules for all the different types of capital, so as to provide a schedule relating the rate of aggregate investment to the corresponding marginal efficiency of capital in general which that rate of investment will establish. We shall call this the investment demand-schedule; or, alternatively, the schedule of the marginal efficiency of capital. FACTORS DETERMINING M.E.C.: Marginal efficiency of capital depends on two sets of factors: 1. Short run factors, and 2. Long run factors Short run factors Short run factors are important in determining marginal efficiency of capital as well as investment. Following are the long run factors affecting marginal efficiency of capital: Marginal propensity of consumption: Increasing level of marginal propensity of consumption increases marginal efficiency of capital. The intensity of consumption encourages marginal efficiency of capital. Income: Higher levels of income yield larger marginal efficiency of capital. Increasing income will also increase conspicuous consumption. Price level: During periods of inflation marginal efficiency of capital will be high. Price levels with more money supply will increase capacity to pay. Interest rate: Higher interest rates discourage marginal efficiency of capital. Higher cost of capital increases cost of production thus reducing chances of increasing marginal efficiency of capital.

Consumption expenditure: Higher consumption expenditure increases the marginal efficiency of capital. Increasing consumption expenditure can be due to reasons like income, price levels, demonstration effect or price illusion.

Government Policy: Government policy of taxation, controls on output will reduce the possibility of increasing marginal efficiency of capital. Business cycles: Business cycles mainly deal with mood in business environment. There can be business optimism or business pessimism. During 17 periods of business optimism the marginal efficiency of capital will be high similarly, during periods of business pessimism, marginal efficiency of capital will be low. Rational expectations: A rational expectation is a post Keynesian concept, concerned with business environment and business. It is regarding the business adapting to changing policy, market, consumer expectation and management of business with rational risk management. Long run factors Long run factors do not fall under the study of Keynes, because, Keynesian economics is short run economics. Yet, these are the factors which are effective in the ling run. Following are the long run factors affecting marginal efficiency of capital: Population: Though population changes even in the short run. The effect of population can be seen only in the ling run, by way of changes in the pattern of demand and labor force. Technology: Technology helps in the ling run in reducing costs and making production function efficient. Alternative sources of raw material and energy: Alternative and cheaper sources of raw material and energy change the production function and help in expanding output and making it economical. Expanding markets: Expanding markets provide purpose for the industry to produce and distribute. In the long run, mass consumption increase.

Note that MP-AP the maximum of average product function. This is always the case if MP>AP, the average will be pushed up by the incremental unit and if MP.