MB0042 Managerial Economics Assignment - Semester 1

Fall 2011, MBA-1 Semester
AUGUST 2011 Master of Business Administration (MBA) Semester 1 MB0042 Managerial Economics - 4 Credits (Book ID: B0908) Assignment - Set- 1
MB0042: Managerial Economics
Roll No. : 541110058
Page 1
Master of Business Administration - MBA Semester I MB0042 Managerial Economics - 4 Credits (Book ID: B0908) Assignment Set- 1 ( 60 Marks)
Note: Each question carries 10 Marks. Answer all the questions.
Q.1 Price elasticity of demand depends on various factors. Explain each factor with the help of an example. Q.2 A company is selling a particular brand of tea and wishes to introduce a new flavor. How will the company forecast demand for it ? Q.3 The supply of a product depends on the price. What are the other factors that will affect the supply of a product. Q.4 Show how producers equilibrium is achieved with isoquants and isocost curves. Q.5 Discuss the full cost pricing and marginal cost pricing method. Explain how the two methods differ from each other. Q.6 Discuss the price output determination using profit maximization under perfect competition in the short run.
Roll No. : 541110058
Page 2
Q.1 Price elasticity of demand depends on various factors. Explain each factor with the help of an example.
Ans:-
In the words of Prof. Stonier and Hague, price elasticity of demand is a technical term used by economists to explain the degree of responsiveness of the demand for a product to a change in its price. Where Ep is price elasticity . It implies that at the present level with every change in price, there will be a change in demand four times inversely. Generally the co-efficient of price elasticity of demand always holds a negative sign because there is an inverse relation between the price and quantity demanded. Symbolically Ep = Original demand = 20 units original price = 6 00 New demand = 60 units New price = 4 00 In the above example, price elasticity is 6. The rate of change in demand may not always be proportionate to the change in price. A small change in price may lead to very great change in demand or a big change in price may not lead to a great change in demand. Based on numerical values of the co-efficient of elasticity, we can have the following five degrees of price elasticity of demand.
Determinants of Price Elasticity of Demand : The elasticity of demand depends on several factors of which the following are some of the important ones. 1. Nature of the Commodity MB0042: Managerial Economics Roll No. : 541110058 Page 3
Commodities coming under the category of necessaries and essentials tend to be inelastic because people buy them whatever may be the price. For example, rice, wheat, sugar, milk, vegetables etc. on the other hand, for comforts and luxuries, demand tends to be elastic e.g., TV sets, refrigerators etc.
2. Existence of Substitutes Substitute goods are those that are considered to be economically interchangeable by buyers. If a commodity has no substitutes in the market, demand tends to be inelastic because people have to pay higher price for such articles. For example. Salt, onions, garlic, ginger etc. In case of commodities having different substitutes, demand tends to be elastic. For example, blades, tooth pastes, soaps etc.
3. Number of uses for the commodity Single-use goods are those items which can be used for only one purpose and multiple-use goods can be used for a variety of purposes. If a commodity has only one use (singe use product) then demand tends to be inelastic because people have to pay more prices if they have to use that product for only one use. For example, all kinds of. eatables, seeds, fertilizers, pesticides etc. On the contrary, commodities having several uses, [multiple-use-products] demand tends to be elastic. For example, coal, electricity, steel etc.
4. Durability and reparability of a commodity Durable goods are those which can be used for a long period of time. Demand tends to be elastic in case of durable and repairable goods because people do not buy them frequently. For example, table, chair, vessels etc. On the other hand, for perishable and non-repairable goods, demand tends to be inelastic e.g., milk, vegetables, electronic watches etc. 5. Possibility of postponing the use of a commodity In case there is no possibility to postpone the use of a commodity to future, the demand tends to be inelastic because people have to buy them irrespective of their prices. For example, medicines. If there is possibility to postpone the use of a commodity, demand tends to be elastic e.g., buying a TV set, motor cycle, washing machine or a car etc. 6. Level of Income of the people Generally speaking, demand will be relatively inelastic in case of rich people because any change in market price will not alter and affect their purchase plans. On the contrary, demand tends to be elastic in case of poor. MB0042: Managerial Economics Roll No. : 541110058 Page 4
7. Range of Prices There are certain goods or products like imported cars, computers, refrigerators, TV etc, which are costly in nature. Similarly, a few other goods like nails; needles etc. are low priced goods. In all these cases, a small fall or rise in prices will have insignificant effect on their demand. Hence, demand for them is inelastic in nature. However, commodities having normal prices are elastic in nature. 8. Proportion of the expenditure on a commodity When the amount of money spent on buying a product is either too small or too big, in that case demand tends to be inelastic. For example, salt, newspaper or a site or house. On the other hand, the amount of money spent is moderate; demand in that case tends to be elastic. For example, vegetables and fruits, cloths, provision items etc. 9. Habits When people are habituated for the use of a commodity, they do not care for price changes over a certain range. For example, in case of smoking, drinking, use of tobacco etc. In that case, demand tends to be inelastic. If people are not habituated for the use of any products, then demand generally tends to be elastic. 10. Period of time Price elasticity of demand varies with the length of the time period. Generally speaking, in the short period, demand is inelastic because consumption habits of the people, customs and traditions etc. do not change. On the contrary, demand tends to be elastic in the long period where there is possibility of all kinds of changes. 11. Level of Knowledge Demand in case of enlightened customer would be elastic and in case of ignorant customers, it would be inelastic. 12. Existence of complementary goods Goods or services whose demands are interrelated so that an increase in the price of one of the products results in a fall in the demand for the other. Goods which are jointly demanded are inelastic in nature. For example, pen and ink, vehicles and petrol, shoes and socks etc have inelastic demand for this reason. If a product does not have complements, in that case demand tends to be elastic. For example, biscuits, chocolates, ice creams etc. In this case the use of a product is not linked to any other products. 13. Purchase frequency of a product If the frequency of purchase is very high, the demand tends to be inelastic. For e.g., coffee, tea, milk, match box etc. on the other hand, if people buy a product occasionally, demand tends to be elastic. For example, durable goods like radio, tape recorders, refrigerators etc. Thus, the demand for a product is elastic or inelastic will depend on a number of factors.
Roll No. : 541110058
Page 5
Q.2 A company is selling a particular brand of tea and wishes to introduce a new flavor. How will the company forecast demand for it?
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 price decisions, in assessing future capacity requirements, or in making decisions to enter new market. To deliver the right products to the right customers portably requires a fundamental shift in retail decision making from art to science; and from one that is based on human intuition to one that is driven by customer data. Demand Forecasting for a New Product Demand forecasting for new products is quite different from that for established products. Here the firms will not have any past experience or past data for this purpose. An intensive study of the economic and competitive characteristics of the product should be made to make efficient forecasts. Professor Joel Dean, however, has suggested a few guidelines to make forecasting of demand for new products. a) Evolutionary approach The demand for the new product may be considered as an outgrowth of an existing product. For e.g., Demand for new Tata Indica, which is a modified version of Old Indica can most effectively be projected based on the sales of the old Indica, the demand for new Pulsar can be forecasted based on the a sales of the old Pulsor. Thus when a new product is evolved from the old product, the demand conditions of the old product can be taken as a basis for forecasting the demand for the new product. b) Substitute approach If the new product developed serves as substitute for the existing product, the demand for the new product may be worked out on the basis of a market share. The growths of demand for all the products have to be worked out on the basis of intelligent forecasts for independent MB0042: Managerial Economics Roll No. : 541110058 Page 6
variables that influence the demand for the substitutes. After that, a portion of the market can be sliced out for the new product. For e.g., A moped as a substitute for a scooter, a cell phone as a substitute for a land line. In some cases price plays an important role in shaping future demand for the product. c) Opinion Poll approach Under this approach the potential buyers are directly contacted, or through the use of samples of the new product and their responses are found out. These are finally blown up to forecast the demand for the new product. d) Sales experience approach Offer the new product for sale in a sample market; say supermarkets or big bazaars in big cities, which are also big marketing centers. The product may be offered for sale through one super market and the estimate of sales obtained may be blown up to arrive at estimated demand for the product. e) Growth Curve approach According to this, the rate of growth and the ultimate level of demand for the new product are estimated on the basis of the pattern of growth of established products. For e.g., An Automobile Co., while introducing a new version of a car will study the level of demand for the existing car. f) Vicarious approach A firm will survey consumers reactions to a new product indirectly through getting in touch with some specialized and informed dealers who have good knowledge about the Tea market, about the different varieties of the product already available in the market, the consumers preferences etc. This helps in making a more efficient estimation of future demand for the tea . These methods are not mutually exclusive. The management can use a combination of several of them, supplement and cross check each other.
Roll No. : 541110058
Page 7
Q.3 The supply of a product depends on the price. What are the other factors that will affect the supply of a product. Ans:- Factors Determining Elasticity of Supply (Determinants) 1. Time period: Time has a greater influence on elasticity of supply than on demand. Generally supply tends to be inelastic in the short run because time available to organize and adjust supply to demand is insufficient. Supply would be more elastic in the long run. 2. Availability and mobility of factors of production : When factors of production are available in plenty and freely mobile from one occupation to another, supply tends to be elastic and vice versa. 3. Technological improvements: Modern methods of production expand output and hence supply tends to be elastic. Old methods reduce output and supply tends to be inelastic. 4. Cost of production: If cost of production rises rapidly as output expands, then there will not be much incentive to increase output as the extra benefit will be choked off by the increase in cost. Hence supply tends to be inelastic and vice-versa. 5. Kinds and nature of markets: If the seller is selling his product in different markets, supply tends to be elastic in any one of the market because, a fall in the price in one market will induce him to sell in another market. Again, if he is producing several types of goods and can switch over easily from one to another, then each of his products will be elastic in supply. 6. Political conditions: Political conditions may disrupt production of a product. In that case, supply tends to become inelastic. 7. Number of sellers : Supply tends to become more elastic if there are more sellers freely selling their products and vice-versa. 8. Prices of related goods : A firm can charge a higher price for its products, if prices of other products are higher and vice-versa. 9. Goals of the firm : If the seller is happy with small output, supply tends to be inelastic and vice-versa. Thus, several factors influence the elasticity of supply. Practical Importance 1. The concept of elasticity of supply is of great importance to the finance minister while formulating the taxation policy of the country. If the supply is inelastic, the imposition of tax may not bring about any change in the supply. If supply is elastic, reasonable taxes are to be levied. 2. The price of a commodity depends upon the degree of elasticity of demand and supply. 3. It is used in the theory of incidence of taxation. The money burden of taxation is shared by the tax payers and the sellers in the ratio of elasticity of supply and demand
Roll No. : 541110058
Page 8
Q.4 Show how producers equilibrium is achieved with isoquants and isocost curves. Ans:- ISO-Quants and ISO-Costs The prime concern of a firm is to work out the cheapest factor combinations to produce a given quantity of output. There are a large number of alternative combinations of factor inputs which can produce a given quantity of output for a given amount of investment. Hence, a producer has to select the most economical combination out of them. Iso-product curve is a technique developed in recent years to show the equilibrium of a producer with two variable factor inputs. It is a parallel concept to the indifference curve in the theory of consumption. Meaning and Definitions The term Iso Quant has been derived from Iso meaning equal and Quant meaning quantity. Hence, Iso Quant is also called Equal Product Curve or Product Indifference Curve or Constant Product Curve. An Iso product curve represents all the possible combinations of two factor inputs which are capable of producing the same level of output. It may be defined as a curve which shows the different combinations of the two inputs producing the same level of output . Each Iso Quant curve represents only one particular level of output. If there are different Iso Quant curves, they represent different levels of output. Any point on an Iso Quant curve represents same level of output. Since each point indicates equal level of output, the producer becomes indifferent with respect to any one of the combinations. PRODUCERS EQUILIBRIUM (Optimum factor combination or least cost combination). The optimal combination of factor inputs may help in either minimizing cost for a given level of output or maximizing output with a given amount of investment expenditure. In order to explain producers equilibrium, we have to integrate Iso-quant curve with that of Iso-cost line. Isoproduct curve represent different alternative possible combinations of two factor inputs with the help of which a given level of output can be produced. On the other hand, Iso-cost line shows the total outlay of the producer and the prices of factors of production. The intention of the producer is to maximize his profits. Profits can be maximized when he is producing maximum output with minimum production cost. Hence, the producer selects the least cost combination of the factor inputs. Maximum output with minimum cost is possible only when he reaches the position of equilibrium. The position of equilibrium is indicated at the point where Iso-Quant curve is tangential to Iso-Cost line. The following diagram explains how the producer reaches the position of equilibrium. It is quite clear from the diagram that the producer will reach the position of equilibrium at the point E where the Iso-quant curve IQ and Iso-cost line AB is tangent to each other. With a given total out lay of Rs. 5,000 the producer will be producing the highest output, i.e. 500 units by employing 25 units of factors X and 50 units of factor Y. (assuming Rs. 2,500 each is spent on X MB0042: Managerial Economics Roll No. : 541110058 Page 9
Fall 2011, MBA-1 Semester and Y) The price of one unit of factor X is Rs.100-00 and that of Y is Rs. 50-00.. Rs.100 x 25 units of 2500 - 00 and Rs. 50 x 50 units of Y = 2500 - 00. He will not reach the position of equilibrium either at the point E1 and E2 because they are on a higher Iso-cost line. Similarly, he cannot move to the left side of E, because they are on a lower Iso-Cost line and he will not be able to produce 500 units of output by any combinations which lie to the left of E. Thus, the point at which the Iso-Quant is tangent to the Iso-Cost line represents the minimum cost or optimum factor combination for producing a given level of output. At this point, MRTS between the two points is equal to the ratio between the prices of the inputs.
Q.5 Discuss the full cost pricing and marginal cost pricing method. Explain how the two methods differ from each other . Pricing - full cost plus pricing Full cost plus pricing seeks to set a price that takes into account all relevant costs of production. This could be calculated as follows: Total budgeted factory cost + selling / distribution costs + other overheads + MARK UP ON COST Budgeted sales volumes An illustration of applying this method is set out below: Consider a business with the following costs and volumes for a single product: Fixed costs: Factory production costs 750,000 Research and development 250,000 Fixed selling costs 550,000 Administration and other overheads 325,000 Total fixed costs 1,625,000 Variable costs Variable cost per unit 8.00
Roll No. : 541110058
Page 10
Mark-Up Mark-up % required 35%
Budgeted sale volumes (units) 500,000 What should the selling price be on a full cost plus basis? The total costs of production can be calculated as follows: Total fixed costs 1,625,000 Total variable costs (8.00 x 500,000 units) 4,000,000 Total costs 5,625,000 Mark up required on cost (5,625,000 x 35%) 1,968,750 Total costs (including mark up) 7,593,750 Divided by budgeted production (500,000 units) = Selling price per unit 15.19 The advantages of using cost plus pricing are: Easy to calculate - Price increases can be justified when costs rise - Price stability may arise if competitors take the same approach (and if they have similar costs) - Pricing decisions can be made at a relatively junior level in a business based on formulas The main disadvantages of cost plus pricing are often considered to be: This method ignores the concept of price elasticity of demand - it may be possible for the business to charge a higher (or lower) price to maximise profits depending on the responsiveness of customers to a change in price The business has less incentive to cut or control costs - if costs increase, then selling prices increase. However, this might be making an "inefficient" business uncompetitive relative to competitor pricing; It requires an estimate and apportionment of business overheads. For example, total factory overheads need to be calculated and then allocated in some way against individual products. This allocation is always arbitrary. MB0042: Managerial Economics Roll No. : 541110058 Page 11
Fall 2011, MBA-1 Semester If applied strictly, a full cost plus pricing method may leave a business in a vicious circle. For example, if budgeted costs are over-estimated, selling prices may be set too high. This in turn may lead to lower demand (if the price is set above the level that customers will accept), higher costs (e.g. surplus stock) and lower profits. When the pricing decision is made for the next year, the problem may be exacerbated and repeated. Amongst the factors that influence the choice of the mark-up percentage are as follows: Nature of the market - a mark-up should reflect the degree of competition in the market (what do the close competitors do?) - Bulk discounts - should volume orders attract a lower mark-up than a single order? Pricing strategy - e.g. skimming, penetration (see more on pricing strategies further below) - Stage of the product in its life cycle; products at the earlier stages of the life cycle may need a lower mark-up percentage to help establish demand. pricing - variable or marginal cost pricing With variable (or marginal cost) pricing, a price is set in relation to the variable costs of production (i.e. ignoring fixed costs and overheads). The objective is to achieve a desired contribution towards fixed costs and profit. Contribution per unit can be defined as: SELLING PRICE less VARIABLE COSTS Total contribution can be calculated as follows: Contribution per unit v Sales Volume The resulting profit in a business is, therefore: Total Contribution less Total Fixed Costs The break even level of sales can be calculated using this information as follows: Break even volume = Total Fixed Costs / Contribution per Unit Consider a business with the following costs and volumes for a single product: Fixed costs: Factory production costs 750,000 Research and development 250,000 Fixed selling costs 550,000 Administration and other overheads 325,000 Total fixed costs 1,625,000 MB0042: Managerial Economics Roll No. : 541110058 Page 12
Variable costs Variable cost per unit Mark-Up Mark-up % required 35% Budgeted sale volumes (units) 500,000 Prices are set using variable costing by determining a target contribution per unit. This reflects: Variable costs per unit Total fixed costs The desired level of target profit (i.e. contribution less fixed costs) The variable/marginal costing method can be illustrated using the same data used further above: Assume that the selling price per unit is 12 Variable costs per unit are 8 The contribution per unit is, therefore, 4 (12 less 8) What is the break even volume for the business? Total fixed costs are 1,625,000 To achieve break-even, therefore, the business needs to sell at least 406,250 units (each of which produces a contribution of 4) Looked at another way, what would be the required sales volume to generate a profit of 250,000? Total contribution required = total fixed costs + required profit Total contribution = 1,625,000 + 250,000 = 1,875,000 Contribution per unit = 4 Sales volume required therefore = 468,750 (1,875,000 / 4) The advantages of using a variable/marginal costing method for pricing include the following: Good for short-term decision-making; Avoids having to make an arbitrary allocation of fixed costs and overheads; Focuses the business on what is required to achieve break-even However, there are some potential disadvantages of using this method: MB0042: Managerial Economics Roll No. : 541110058 Page 13 8.00
Fall 2011, MBA-1 Semester There is a risk that the price set will not recover total fixed costs in the long term. Ultimately businesses must price their products that reflects the total costs of the business; It may be difficult to raise prices if the contribution per unit is set too low
Marginal Cost Pricing Marginal cost pricing is the practice of setting the price of a product at or slightly above the variable cost to produce it. This situation usually arises in one of two circumstances: A company has a small amount of remaining unused production capacity available that it wishes to use; or A company is unable to sell at a higher price The first scenario is one in which a company is more likely to be financially healthy - it simply wishes to maximize its profitability with a few more unit sales. The second scenario is one of desperation, where a company can achieve sales by no other means. In either case, the sales are intended to be on an incremental basis; they are not intended to be a long-term pricing strategy. The variable cost of a product is usually only the direct materials required to build it. Direct labor is rarely completely variable, since a minimum number of people are required to crew a production line, irrespective of the number of units produced. The Marginal Cost Calculation ABC International has designed a product that contains $5.00 of variable expenses and $3.50 of allocated overhead expenses. ABC has sold all possible units at its normal price point of $10.00, and still has residual production capacity available. A customer offers to buy 6,000 units at the company's best price. To obtain the sale, the sales manager sets the price of $6.00, which will generate an incremental profit of $1.00 on each unit sold, or $6,000 in total. The sales manager ignores the allocated overhead of $3.50 per unit, since it is not a variable cost. Advantages of Marginal Cost Pricing The following are advantages to using the marginal cost pricing method: Adds profits. There will be customers who are extremely sensitive to prices. This group might not otherwise buy from a company unless it were willing to engage in marginal cost MB0042: Managerial Economics Roll No. : 541110058 Page 14
pricing. If so, a company can earn some incremental profits from these customers. Market entrance. If a company is willing to forego profits in the short term, it can use marginal cost pricing to gain entry into a market. However, it is more likely to acquire the more price-sensitive customers by doing so. Accessory sales. If customers are willing to buy product accessories or services at a robust margin, it may make sense to use marginal cost pricing to sell a product on an ongoing basis, and then earn profits from these later sales. Disadvantages of Marginal Cost Pricing The following are disadvantages of using the marginal cost pricing method: Long-term pricing. The method is completely unacceptable for long-term price setting, since it will result in prices that do not capture a company's fixed expenses. Ignores market prices. Marginal cost pricing sets prices at their absolute minimum. Any company routinely using this methodology to determine its prices may be giving away an enormous amount of margin that it could have earned if it had instead set prices at or near the market rate. Customer loss. If a company routinely engages in marginal cost pricing and then attempts to raise its prices, it may find that it was selling to customers who are extremely sensitive to price changes, and who will abandon it at once. Evaluation of Marginal Cost Pricing This method is useful only in a specific situation where a company can earn additional profits from using up excess production capacity. It is not a method to be used for normal pricing activities, since it sets a minimum price from which a company will earn only minimal (if any) profits. It is generally better to set prices based on market prices.
Q.6 Discuss the price output determination using profit maximization under perfect competition in the short run.
Cost data: Assumption - a pure monopolist hires resources competitively and has the same MB0042: Managerial Economics Roll No. : 541110058 Page 15
technology as a purely competitive firm. MR=MC rule: A monopolist seeking to maximize total profit will employ the same rationale as a profit-seeking firm in a competitive industry; they will produce at the point where MR = MC. Profit maximizing price: Find MC= MR and draw a vertical line up to the demand curve. Draw a horizontal line. This is the price they set.
How to determine the profit-maximizing output, profit-maximizing price, & economic profit (or minimized loss) in PM industries: 1. Find the profit-maximizing output at the point where MR = MC. 2. Draw a vertical line upward from Qpm to the demand curve. 3. Determine the economic profit using one of two methods: Method I: Find profit/unit by subtracting ATC of Qpm from Ppm. Then multiply the difference by Qpm to determined economic profit. (In other words, Economic Profit = (P - ATC) x Qpm ) Method II: Find TC by multiplying ATC of Qpm by Qpm. Find TR by multiplying Qpm by Ppm. Then subtract TC from TR to determine economic profit. (In other words, Economic Profit = TR-TC )
No monopoly supply curve: No unique relationship between price and quantity supplied for a monopolist no supply curve o Because the monopolist does not equate marginal cost to price, it is possible for different demand conditions to bring about different prices for the same output
Misconceptions concerning monopoly pricing: Not Highest Price: o Misconception: Monopolists will charge highest price possible because they can manipulate output & price o Monopolies still face consumer demand. If the price is too high, consumers won't buy their products, and profits are decreased. o Although there are many prices above Pm, monopolists don't charge at those prices MB0042: Managerial Economics Roll No. : 541110058 Page 16
because they would yield a smaller-than-maximum total profit. (High prices would potentially reduce sales and total revenue too severely to offset any decrease in total cost) o Monopolist seek maximum total profit, NOT the maximum price Total, Not Unit, Profit: o Output level may not be at maximum per-unit profit, but additional sales make up for lower unit profit, which in turn maximizes total profit.
Possibility of losses by monopolist: Pure monopolists likelihood of earning economic profit greater than that of purely competitive firms o PC long-run destined to earn only normal profit o PM has high barriers of entry; therefore, the concept of entry eliminates profits does no apply to PM Pure monopoly does not guarantee profit: o Monopoly is not immune from upward-shifting cost curves caused by escalating resource prices o Monopoly is not immune from changes in tastes that reduce the demand for its product o Both of these factors can lead to losses - initially it will persist in operating at a loss and to stop incurring loss, the firm's owners will reallocate their resources
Establishing price and output in the short run under perfect competition
The previous diagram shows the short run equilibrium for perfect competition. In the short run, the twin forces of market demand and market supply determine the equilibrium marketclearing price for the industry. In the diagram below, a market price P1 is established and output Q1 is produced. This price is taken by each of the firms. The average revenue curve (AR) is their individual demand curve. Since the market price is constant for each unit sold, the AR curve also becomes the Marginal Revenue curve (MR). For the firm, the profit maximising output is at Q2 where MC=MR. This output generates a MB0042: Managerial Economics Roll No. : 541110058 Page 17
total revenue (P1 x Q2). The total cost of producing this output can be calculated by multiplying the average cost of a unit of output (AC1) and the output produced. Since total revenue exceeds total cost, the firm in this example is making abnormal (economic) profits. This is not necessarily the case for all firms. It depends on their short run cost curves. Some firms may be experiencing sub-normal profits if average costs exceed the market price. For these firms, total costs will be greater than total revenue.
Short run losses The adjustment to the long-run equilibrium If most firms are making abnormal (or supernormal) profits, this encourages the entry of new firms into the industry, which if it happens will cause an outward shift in market supply forcing down the ruling market price. The increase in supply will eventually reduce the market price until price = long run average cost. At this point, each firm in the industry is making normal profit. Other things remaining the same, there is no further incentive for movement of firms in and out of the industry and a longrun equilibrium has been established. This is shown in the next diagram.
We are assuming in the diagram above that there has been no shift in market demand, i.e. we are considering an outward shift in market supply brought about by the entry of new competing firms each of whom is supplying a homogeneous product to the market. The effect of increased supply is to force down the market price and cause an expansion along the market demand curve. But for each supplier, the price they take is now lower and it is this that drives down the level of profit made towards the normal profit equilibrium. In an exam you may be asked to trace and analyse what might happen if There was a change in market demand (e.g. arising from changes in the relative prices of substitute products or complements) There was a cost-reducing innovation affecting all firms in the market or an external shock that increases the variable costs of all producers. Effects of a change in market demand We now consider how a competitive market adjusts to a change in market demand in both the MB0042: Managerial Economics Roll No. : 541110058 Page 18
short and the long run. In the short run, businesses are operating with at least one fixed factor. Therefore the elasticity of the supply curve depends on the amount of spare capacity, the level of existing stocks and also the time scale of the production process in other words how fast and at what cost the industry can expand supply when demand changes. In the long run, because of freedom of entry and exit into and out of the industry, we expect the market supply curve to be more elastic in response to a change in demand. The diagram below shows an outward shift of demand with short run market supply deemed to be relatively inelastic (in which case the short run adjustment in the market drives prices higher) but where long run market supply is elastic, putting downward pressure on price as market output increases. Pure competition and economic efficiency Perfect competition can be used as a yardstick to compare with other market structures because it displays high levels of economic efficiency. 1. Allocative efficiency: In both the short and long run in perfect competition we find that price is equal to marginal cost (P=MC) and thus allocative efficiency is achieved. At the ruling market price, consumer and producer surplus are maximised. No one can be made better off without making some other agent at least as worse off i.e. the conditions are in place for a Pareto optimum allocation of resources. 2. Productive efficiency: Productive efficiency occurs when the equilibrium output is produced with average cost at a minimum. This is not achieved in the short run, but is attained in the long run equilibrium for a perfectly competitive market. 3. Dynamic efficiency: We assume that a perfectly competitive market produces homogeneous products in other words, there is little scope for innovation designed purely to make products differentiated from each other and thereby allow a supplier to develop and then exploit a competitive advantage in the market to establish some monopoly power. Some economists claim that perfect competition is not an optimal market structure for high levels of research and development spending and the resulting product and process innovations. Indeed it may be the case that monopolistic or oligopolistic markets are more effective in creating the environment for research and innovation to flourish. A cost-reducing innovation from one producer will, under the assumption of perfect information, be MB0042: Managerial Economics Roll No. : 541110058 Page 19
immediately and without cost transferred to all of the other suppliers. That said, a competitive market (i.e. a contestable market) provides the discipline on firms to keep their costs under control, to seek to minimise wastage of scarce resources and to refrain from exploiting the consumer by setting high prices and enjoying high profit margins. In this sense, a more competitive market can stimulate improvements in both static and dynamic efficiency over time. It is certainly one of the main themes running through the recent toughening-up of UK and European competition policy as this introductory passage to a competition white paper demonstrates: Gains from competition Competitive markets provide the best means of ensuring that the economy's resources are put to their best use by encouraging enterprise and efficiency, and widening choice. Where markets work well, they provide strong incentives for good performance - encouraging firms to improve productivity, to reduce prices and to innovate; whilst rewarding consumers with lower prices, higher quality, and wider choice. By encouraging efficiency, competition in the domestic market - whether between domestic firms alone or between those and overseas firms - also contributes to our international competitiveness. Source: www.dti.gov.uk The long run of perfect competition, therefore, exhibits optimal levels of economic efficiency. But for this to be achieved all of the conditions of perfect competition must hold including in related markets. When the assumptions are dropped, we move into a world of imperfect competition with all of the potential that exists for various forms of market failure. The next diagram shows how when price and output is not at the competitive equilibrium, the result is a deadweight loss of economic welfare. The competitive price and output is P1 and Q1 respectively.
Roll No. : 541110058
Page 20
Master of Business Administration - MBA Semester I MB0042 Managerial Economics - 4 Credits (Book ID: B0908) Assignment Set- 2 (60 Marks)
Note: Each question carries 10 Marks. Answer all the questions.
Q.1 Income elasticity of demand has various applications. Explain each application with the help of an example. Q.2 When is the opinion survey method used and what is the effectiveness of the method. Q.3 Show how price is determined by the forces of demand and supply, by using forces of equilibrium. Q.4 Distinguish between fixed cost and variable cost using an example. Q.5 Discuss Marris Growth Maximization model and show how it is different from the Sales maximization model. Q.6 Explain how fiscal policy is used to achieve economic stability.
Roll No. : 541110058
Page 21
Q.1. Income elasticity of demand has various applications. Explain each application with the help of an example.
Income elasticity of demand may be defined as the ratio or proportionate change in the quantity demanded of a commodity to a given proportion change in the income. In short, it indicates the extent to which demand changes with a variation in consumers income. The following formula helps to measure the income elasticity (Ey). Or Where
Example Original demand=400 units Original income= 4000 units New demand =700 units New
income= 6000 units Change in demand= 700-400= 300 units change in income=60004000=2000 Hence Ey=300/2000*4000/400=1.5 Generally speaking Ey is positive. This is because there is a direct relationship between income and demand, i.e. higher the income; higher would be the demand and vice versa. On the basis of the numerical value of the co-efficient, Ey is classified as greater than one, less than one, equal to one, equal to zero and negative. The concept of Ey helps us in classifying commodities in to different categories.
Roll No. : 541110058
Page 22
Fall 2011, MBA-1 Semester 1. 2. 3. 4. 5. 1. When Ey is positive, the commodity is normal (used in day-to-day life) 2. When Ey is negative, the commodity is inferior. ( for example jowar, beedi etc) 3. When Ey is positive and greater than one, the commodity is luxury. 4. When Ey is positive but less than one, the commodity is essential. 5. When Ey is zero, the commodity is neutral. E.g. salt, match box etc.
Practical application of income elasticity of demand 1. Helps in determining the rate of growth of the firm. If the growth rate of the economy and income growth of the people is reasonable forecasted, in that case it is possible predict expected increase in the sales of a firm and vice versa. 2. Helps in the demand forecasting of a firm. It can be in estimating future demand provided the rate of increase in income and Ey for products are known. Thus, it helps in demand forecasting activities of a firm. 3. Helps in production planning and marketing. The knowledge of Ey is essential for production planning, formulating marketing strategy, deciding advertising expenditures and nature of distribution channel etc in the long run. 4. Helps in ensuring stability in production. Proper estimation of different degrees of income elasticity of demand for different types of product help in avoiding over-production or under-production of a firm. One should know whether rise or fall in income is permanent or temporary. 5. Helps in estimating construction of houses. The rate of growth in incomes of people also helps housing programs in a country. Thus it helps a lot in managerial decisions of a firm.
Roll No. : 541110058
Page 23
Q.2 When is the opinion survey method used and what is the effectiveness of the method.
Survey of buyers intention or preference is one of the important methods of demand forecasting. It is also called Opinion Survey Method . Under this method, consumer buyers are requested to indicate their preference and willingness about a particular product. They are about to reveal their future purchase plans with respect to specific items. They are expected to give answer to question like what items they intends to buy, in what quantity, why, where, what quality they expect, how much they are planning to spend etc. Generally, the field surveys are conducted by the marketing research departments of the company or hiring the services of outside research organization consisting of learned and highly qualified professionals. The heart of the survey is questionnaire. It is a comprehensive one covering almost all questions either directly or indirectly in a most intelligent manner. It is prepared by an expert body who are specialist in the field or marketing. The questionnaire is distributed among the consumer either through mail or in person by the company. Consumers are requested to furnish all relevant and correct information. The next step is to collect the questionnaire from the consumers for the purpose of evaluation. The materials collected will be classified, edited and analyzed. If any bias prejudices, exaggerations, artificial or excess demand creation are found at the time of answering they would be eliminated. The information so collected will now be consolidated and reviewed by the top executives with lot of experiences. It will be examined thoroughly. Inferences are drawn and conclusions are arrived at. Finally a report is prepared and submitted to the management for taking final decisions.
Roll No. : 541110058
Page 24
The success of the survey method depends on many factors: 1. 2. 3. 4. 5. 6. 7. 8. 1. The nature of the question asked. 2. The ability of the surveyed. 3. The representative of the sample 4. Nature of the product 5. Characteristics of the market 6. Consumer behavior 7. Techniques of analysis 8. Conclusion drawn etc. The management should not entirely depend on the result of survey reports t project future demand. Consumer may not express their honest and real views and as such they may give only the broad trends in the market. In order to arrive, at right conclusion, field surveys should be regularly checked and supervised. This method is simple and useful to the producers who produce goods in bulk. Here the burden of forecasting is put on the customers. However this method is not much useful in estimating the future demand of the household as they run in a large numbers and also do not freely express their future demand requirements. It is expensive and so difficult. Preparation of questionnaire is not an easy task. At best it can be used for short term forecasting.
Q.3 Show how price is determined by the forces of demand and supply, by using forces of equilibrium.
The word equilibrium is derived from the Latin word aequilibrium which means equal balance. It means a state of even balance in which opposing forces or tendencies neutralize each other. It is a position of rest characterized by absence of change. It is a state where there is complete agreement of the economic plans of the various market participants so that no one has a tendency to revise or alter his decision. In the words of professor Mehta: Equilibrium denotes in MB0042: Managerial Economics Roll No. : 541110058 Page 25
Fall 2011, MBA-1 Semester economics absence of change in movement. Market Equilibrium There are two approaches to market equilibrium vi z., partial equilibrium approach and the general equilibrium approach. The partial equilibrium approach to pricing explains price determination of a single commodity keeping the prices of other commodities constant. On the other hand, the general equilibrium approach explains the mutual and simultaneous determination of the prices of all goods and factors. Thus it explains a multi market equilibrium position. Earlier to Marshall, there was a dispute among economists on whether the force of demand or the force of supply is more important in determining price. Marshall gave equal importance to both demand and supply in the determination of value or price. He compared supply and demand to a pair of scissors We might as reasonably dispute whether it is the upper or the under blade of a pair of scissors that cuts a piece of paper, as whether value is governed by utility or cost of production . Thus neither the upper blade nor the lower blade taken separately can cut the paper both have their importance in the process of cutting. Likewise neither supply nor demand alone can determine price of a commodity, both are equally important in the determination of price. But relative importance of the two may vary depending upon time under consideration. Thus demand of consumers and supply of all firms together determine price of commodity in the market.
Equilibrium between demand and supply price: Equilibrium between demand and supply price is obtained by the interaction of these two forces. Price is an independent variable. Demand and supply are dependent variables. They depend on price. Demand varies inversely with price, a rise in price causes a fall in demand and a fall in price causes a rise in demand. Thus the demand curve will have a downward slope indicating the expansion of demand with a fall in price and contraction of demand with a rise in price. On the other hand supply varies directly with the changes in price, a
Roll No. : 541110058
Page 26
rise in price causes a rise in supply and a fall in price causes a fall in supply. Thus the supply curve will have an upward slope.At a point where these two curves intersect with each other the equilibrium price is established. At this price quantity demanded is equal to the quantity demanded. This we can explain with the help of a table and a diagram
In the above table at Rs.20 the quantity demanded is equal to the quantity supplied. Since the price is agreeable to both the buyer and sellers, there will be no tendency for it to change; this is called equilibrium price. Suppose the price falls to Rs.5 the buyer will demand 30 units while the seller will supply only 5 units. Excess of demand over supply pushes the price upward until it reaches the equilibrium position supply is equal to the demand. On the other hand if the price rises to Rs.30 the buyer will demand only 5 units while the sellers are ready to supply 25 units. Sellers compete with each other to sell more units of the commodity. Excess of MB0042: Managerial Economics Roll No. : 541110058 Page 27
supply over demand pushes the price downward until it reaches the equilibrium. This process will continue till the equilibrium price of Rs.20 is reached. Thus the interactions of demand and supply forces acting upon each other restore the equilibrium position in the market. In the diagram DD is the demand curve, SS is the supply curve. Demand and supply are in equilibrium at point E where the two curves intersect each other. OQ is the equilibrium output. OP is the equilibrium price. Suppose the price OP2 is higher than the equilibrium price OP. at this point price quantity demanded is P2D2. Thus D2S2 is the excess supply which the seller wants to push into the market, competition among the sellers will bring down the price to the equilibrium level where the supply is equal to the demand. At price OP1, the buyers will demand P1D1 quantity while the sellers are ready to sell P1S1. Demand exceeds supply. Excess demand for goods pushes up the price; this process will go until equilibrium is reached where supply becomes equal to demand.
Q.4 Distinguish between fixed cost and variable cost using an example.
Fixed cost: These costs are incurred on fixed factors like land, building, equipments, plants, superior types of labour, top management etc. fixed costs in the short run remains constant because the firm does not change the size of plant and the amount of the fixed factors employed. Fixed costs do not vary with either expansion or contraction in output. These cost are to be incurred by a firm even output is zero. Even if the firm close down its operation for some time temporarily in the short run, but remains in business, these cost have to be borne by it. Hence, these costs are independent of output and are referred to as unavoidable contractual cost. Prof. Marshall called fixed cost as supplementary costs. They include such items as contractual rent payments, interest on capital borrowed, insurance premium, depreciation and maintenance allowance, administrative expenses like managers salary or salary of the MB0042: Managerial Economics Roll No. : 541110058 Page 28
permanent staff, property and business taxes, license fees, etc. They are called as over-head costs because these costs are to incurred whether there is production or not. These costs are to be distributed on each units of output produced by a firm. Hence, they are called as indirect costs.
Variable Costs: The costs corresponding to variable factors are described as variable costs. These costs are incurred on raw materials, ordinary labour, transport, power, fuel, water etc, which directly vary in the short runs. Variable costs are directly and proportionately increases or decreases with the level of output. If a firm shut down for some times in the short run; then it will not use the variable factors of production and will not therefore incurs any variable costs. Variable costs are incurred only when some amount of output is produced. Total variable cost increases with the level of increase in the level of production and vice-versa. Prof. Marshall called variable costs as prime costs or direct costs because the volume of output produced by a firm depends directly upon them. It is clear from the above description that a production cost consists of both fixed as well as variable costs. The difference between the two is meaningful and relevant only in the short run. In the long run all costs become variable because all factors of production become adjustable and variable in the long run. However, the distinction between the fixed and variable costs is very important in the short because it influences the average costs behavior of the firm. In the short run, even if a firm wants to close down its operation but wants to remain in the business, it will have to incur fixed costs but it must cover at least its variable costs.
Roll No. : 541110058
Page 29
Q.5 Discuss Marris Growth Maximization model ? Profit maximization is traditional objective of a firm. Sales maximization objective is explained by Prof. Boumal. On similar lines, Prof. Marris has developed another alternative growth maximization model in recent years. It is a common factor to observe that each firm aims at maximizing its growth rate as this goal would answer many of the objectives of a firm. Marris points out that a firm has to maximize its balanced growth rate over a period of time. Marris assumes that the ownership and control of the firm is in the hands of two groups of people, i.e. owner and managers. He further points out that both of them have two distinctive goals. Managers have a utility function in which the amount of salary, status, position, power, prestige and security of job etc are the most import variable where as in case of are more concerned about the size of output, volume of profits, market shares and sales maximization. Utility function of the manager and that the owner are expressed in the following manner-Uo= f [size of output, market share, volume of profit, capital, public esteem etc.] Um= f [salaries, power, status, prestige, job security etc.] In view of Marris the realization of these two functions would depend on the size of the firm. Larger the firm, greater would be the realization of these functions and vice-versa. Size of the firm according to Marris depends on the amount of corporate capital which includes total volume of the asset, inventory level, cash reserve etc. He further points out that the managers always aim at maximizing the rate of growth of the firm rather than growth in absolute size of the firms. Generally managers like to stay in a grouping firm. Higher growth rate of the firm satisfy the promotional opportunity of managers and also the share holders as they get more dividends.
Roll No. : 541110058
Page 30
Q.6 Explain how fiscal policy is used to achieve economic stability
In order to achieve a stable economic condition, fiscal policy has to play a positive and constructive role both in developed and developing nations. The specific role to be played by fiscal policy can be discussed as follows: To act as optimum allocator of resources: As most of the resources are scarce in their supply, careful planning is needed in its allocation so as to achieve the set targets. Rational allocation would ensure fulfillment of various objectives. To act as a saver: 1. 1. It should follow a rational consumption policy reduces the MPC and raises MPS. 2. 2. Taxation policy has to be modified to raise the rates of old taxes, introduces new additional taxes, and extends the tax-nets. 3. 3. Profit earning capacity of public sector units are to be raise substantially to mop-up financial resources. 4. 4. The government should borrow more money both in and outside the country. 5. 5. Higher the rate of interest is to be offered for government bonds and security. To act as an investor: Mere mobilization of financial resources is not an end in itself. It should result in the creation of real resources which are more important in accelerating the growth process. Rapid economic growth depends upon the volume of investment. Hence, fiscal policies have to be ensuring higher volume of investment in both private and public sectors. To act as price stabilizer: Price stability is of paramount of importance in an economy. Extreme levels of both inflation and deflation would disrupt and disturb the normal and regular working of an economic system. This would come in the way of stable and persistent growth. Hence all measures are to be taken to check these two dangerous situations so as to create necessary congenial atmosphere to prepare the background for rapid economic growth. To act as an economic stabilizer: Price stability would create the necessary background for over all economics stability. Upswing and downswing in the level of economic activities are to be avoided. If an economy is subject to frequent fluctuation in the form of trade cycle, certainly, it would undermine and disturb the growth process. Instability would come in the way of persistent and consistent growth in a country. Hence all measure to be taken to ensure economic stability. MB0042: Managerial Economics Roll No. : 541110058 Page 31
To act as an employment generator: Fiscal policy should help in mobilizing more financial resources, convert them in to investment and create employment opportunity to absorb huge unemployed man power. To act as balancer: There must be proper balance between aggregate saving & aggregate investment, demand and supply, income and output and expenditure, economic overhead capital and social overhead capital etc. Any sort of imbalance would result in either surpluses or scarcity in different sectors of the economy leading to fast growth in some sectors followed by lagging of some other sectors. To act as growth promoter: The basic objective of any economic policy is to ensure higher economic growth rates. This is possible when there is higher national savings, investment, production, employment and income. Hence, fiscal policy is to be designed in such a manner so as to promote higher growth in an economy. To act as in come redistribute: Fiscal policy has to minimize inequalities and ensure distributive justice in an economy. This is possible when a rational taxation and public expenditure policy is adopted. More money is collected from richer section of the society through various imaginative taxation policies and a larger amount of money is to be spent in favor of poorer sections of the society. Thus, inequality is reduced to the minimum. Thus, fiscal policy has to play a major role in promoting economic growth in a country. To act as stimulator of living standards of people: the final objective is to raise the level of living standards of the people. This is possible when there is higher output, income and employment leading to higher purchasing power in the hands of common man. Hence, fiscal policy should help in creating more wealth in the economy. If there is economic prosperity, then it is possible to have a satisfactory, contended and peaceful life.
Roll No. : 541110058
Page 32

MB0042 Managerial Economics Assignment - Semester 1

Hochgeladen von

Dokumentinformationen

Originaltitel

Copyright

Verfügbare Formate

Dieses Dokument teilen

Dokument teilen oder einbetten

Freigabeoptionen

Stufen Sie dieses Dokument als nützlich ein?

Sind diese Inhalte unangemessen?

Copyright:

Verfügbare Formate

MB0042 Managerial Economics Assignment - Semester 1

Hochgeladen von

Copyright:

Verfügbare Formate

Fall 2011, MBA-1 Semester