How does economic theory contribute to managerial decisions?

Baumol believes that economic theory is helpful to managers for three reasons. Firsts, it
helps in recognizing managerial problems, eliminating minor details which might obstruct
decision-making and in concentrating on the main issue. A manager is able to ascertain the
relevant variables and specify relevant data. Second, it offers them a set of analytical
methods to solve problems. Economic concepts like consumer demand, production function,
economies of scale and marginalism help in analysis of a problem. Third, it helps in clarity
of concepts used in business analysis, which avoids conceptual pitfalls by logical structuring
of big issues. Understanding of interrelationships between economic variables and events
provides consistency in business analysis and decisions. For example, profit margins may be
reduced despite an increase in sales due to an increase in marginal cost greater than the
increase in marginal revenue.

Ragnar Frisch divided economics in two broad categories – macro and micro. Macroeconomics
is the study of economy as a whole. It deals with questions relating to national income,
unemployment, inflation, fiscal policies and monetary policies. Microeconomics is concerned
with the study of individuals like a consumer, a commodity, a market and a producer.
Managerial Economics is micro-economics in nature because it deals with the study of a firm,
which is an individual entity. It analyses the supply and demand in a market, the pricing of
specific input, the cost structure of individual goods and services and the like. The
macroeconomic conditions of the economy definitely influence working of the firm, for
instance, a recession has an unfavourable impact on the sales of companies sensitive to
business cycles, while expansion would be beneficial. But Managerial Economics encompasses
variables, concepts and models that constitute micro-economic theory, as both the manager and
the firm where he works are individual units.

Q2.Explain the law of demand.Briefly discuss the exception to the law of demand.

In economic terminology the term demand conveys a wider and definite meaning than in
the ordinary usage. Ordinarily demand means a desire, whereas in economic sense it is
something more than a mere desire. It is interpreted as a want backed up by the -
purchasing power. Further demand is per unit of time such as per day, per week etc.
moreover it is meaningless to mention demand without reference to price. Considering all
these aspects the term demand can be defined in the following words,

“Demand for anything means the quantity of that commodity, which is bought, at a given
price, per unit of time.”

Law Of Demand - Demand Price Relationship

This law explains the functional relationship between price of a commodity and the
quantity demanded of the same. It is observed that the price and the demand are inversely
related which means that the two move in the opposite direction. An increase in the price
leads to a fall in the demand and vice versa. This relationship can be stated as

“Other things being equal, the demand for a commodity varies inversely as the price”

or

“The demand for a commodity at a given price is more than what it would be at a higher
price and less than what it would be at a lower price”

Exceptions of the 'Law of Demand'

In case of major bulk of the commodities the validity of the law is experienced. However
there are certain situations and commodities which do not follow the law. These are
termed as the exceptions to the law; these can be expressed as follows:

1. Continuous changes in the price lead to the exceptional behavior. If the price
shows a rising trend a buyer is likely to buy more at a high price for protecting
himself against a further rise. As against it when the price starts falling
continuously, a consumer buys less at a low price and awaits a further in price.
2. Giffens’s Paradox describes a peculiar experience in case of inferior goods. When
the price of an inferior commodity declines, the consumer, instead of purchasing
more, buys less of that commodity and switches on to a superior commodity.
Hence the exception.
3. Conspicuous Consumption refers to the consumption of those commodities which
are bought as a matter of prestige. Naturally with a fall in the price of such goods,
there is no distinction in buying the same. As a result the demand declines with a
fall in the price of such prestige goods.
4. Ignorance Effect implies a situation in which a consumer buys more of a
commodity at a higher price only due to ignorance.

In the exceptional situations quoted above, the demand curve becomes an upwards rising
one as shown in the alongside diagram. In the alongside figure, the demand curve is
positively sloping one due to which more is demanded at a high price and less at a low
price.

Q3. Explain the various components in demand function.

A typical demand function would look like this:

D1 = a - b(P1) - c(P2) + d(P3) + e(Y)

Where D1 is the demand for the good in question, good 1

P1 is the price of the good in question, good 1
 P2 is the price of a complementary good, good 2
P3 is the price of a substitute good, good 3
Y is consumer income

a is autonomous demand; it is the amount of demand not

dependent on any variables
b, c, d, and e are coefficients; they reflect the amount that a change in one variable will
affect the demand for the good in question

The + and - signs are important; they show whether a change in the amount of one
variable will increase or decrease demand for the good in question - note in particular that
a complementary good has a negative sign, indicating that an increase in the price of one
good will decrease the demand for a complemenatary good; and a substitute good has a
positive sign, indicating that an increase in the price of one good will increase the
demand for a substitute.

Q4. a) Problem

Q4 ii) Distinguish between linear and non linear demands functions.

Q5 eplain the trend projection method of demand foresacting

Trend projection method is a classical method of business forecasting. This method is

essentially concerned with the study of movement of variable through time. The use of
this method requires a long and reliable time series data. The trend projection method is
used under the assumption that the factors responsible for the past trends in variables to
be projected (e.g. sales and demand) will continue to play their part in future in the same
manner and to the same extend as they did in the past in determining the magnitude and
direction of the variable.

There are three (3) techniques of trend projection based on time – series data.

1. Graphical Method: - under this method, annual sales data is plotted on a graph
paper and a line is drawn through the plotted points. Then a free hand line is so
drawn that the total distance between the line and the point is minimum. Although
this method is very simple and least expensive, the projections made through this
method are not very reliable. The reason is that the extension of the trend line
involves subjectivity and personal bias of the analysis.
Sale

Years /Trend Projection

2. Fitting Trend Equation: Least square method: - Fitting trend equation is a

formal technique of projecting the trend in demand. Under this method, a trend
line (or curve) is fitted to the time – series data with the aid of statistical
techniques. The form of the trend equation that can be fitted to the time series data
is determined either by plotting the sales data or by trying different forms of trend
equations for the best fit.
o When plotted, a time series date may show various trends. The most
common types of trend equation are
1) liner and
2) exponential trends

• Linear Trend: - When a time series data reveals a rising trend in sales than a
straight-line trend equation of the following form is fitted. (S = A + BT ; Where S
= annual sales , T = Time (in year) , A & B are constant. The parameter b given
the measure of annual increase in sales)

• Exponential trend:- When sales ( or any dependent variable) have increased over
the past years at an increasing rate or at a constant percentage rate, than the
appropriate trend equation to be used is an exponential trend equation of any of
the following type ( Y = aebt , Or its semi – logarithmic form -> Log y = = log a +
bt; This form of trend equation is used when growth rate is constant.)

3. Double log trend equation of equation

• Y = aTB
• Or it’s double logarithmic form
• Log y = log a + b log t
• This form of trend equation is used when growth rate is increasing.

Limitation

The first limitations of this method arise out of the assumption that the past rate of change
in the dependent variable will persist in the future too. Therefore, the forecast based on
this method may be considered to be reliable only for the period during which this
assumption holds.

Second, this method cannot be used for short-term estimates. Also it cannot be used
where trend is cyclical with sharp turning points of trough and perks.

Assignment B
Q1:Explain the concepts of return to scale and return to a factor

Definition and Explanation of Law of Returns to Scale:

The law of returns are often confused with the law of returns to scale. The law of returns
operates in the short period. It explains the production behavior of the firm with one factor
variable while other factors are kept constant. Whereas the law of returns to scale operates in the
long period. It explains the production behavior of the firm with all variable factors. There is no
fixed factor of production in the long run. The law of returns to scale describes the relationship
between variable inputs and output when all the inputs, or factors are increased in the same
proportion. The law of returns to scale analysis the effects of scale on the level of output. Here we
find out in what proportions the output changes when there is proportionate change in the
quantities of all inputs. The answer to this question helps a firm to determine its scale or size in
the long run.

It has been observed that when there is a proportionate change in the amounts of inputs, the
behavior of output varies. The output may increase by a great proportion, by in the same
proportion or in a smaller proportion to its inputs. This behavior of output with the increase in
scale of operation is termed as increasing returns to scale, constant returns to scale and
diminishing returns to scale. These three laws of returns to scale are now explained, in brief,
under separate heads.

(1) Increasing Returns to Scale:

If the output of a firm increases more than in proportion to an equal percentage increase in all
inputs, the production is said to exhibit increasing returns to scale. For example, if the amount of
inputs are doubled and the output increases by more than double, it is said to be an increasing
returns returns to scale. When there is an increase in the scale of production, it leads to lower
average cost per unit produced as the firm enjoys economies of scale.

(2) Constant Returns to Scale:

When all inputs are increased by a certain percentage, the output increases by the same
percentage, the production function is said to exhibit constant returns to scale. For example, if a
firm doubles inputs, it doubles output. In case, it triples output. The constant scale of production
has no effect on average cost per unit produced.

(3) Diminishing Returns to Scale:

The term 'diminishing' returns to scale refers to scale where output increases in a smaller
proportion than the increase in all inputs. For example, if a firm increases inputs by 100% but the
output decreases by less than 100%, the firm is said to exhibit decreasing returns to scale. In
case of decreasing returns to scale, the firm faces diseconomies of scale. The firm's scale of
production leads to higher average cost per unit produced.

The three laws of returns to scale are now explained with the help of a graph below:

The figure 11.6 shows that when a firm uses one unit of labor and one unit of capital, point a, it
produces 1 unit of quantity as is shown on the q = 1 isoquant. When the firm doubles its outputs
by using 2 units of labor and 2 units of capital, it produces more than double from q = 1 to q =
3. So the production function has increasing returns to scale in this range. Another output from
quantity 3 to quantity 6. At the last doubling point c to point d, the production function has
decreasing returns to scale. The doubling of output from 4 units of input, causes output to
increase from 6 to 8 units increases of two units only.

When it comes to finances, a factor return can refer to an evaluation process that helps
companies to make sure they are earning the greatest possible return on the goods and
services they offer, or to a specific type of remuneration generated by a particular
business service. In both scenarios, the goal is to make sure that all parties involved are
receiving the greatest degree of satisfaction from their efforts with specific amount of
return achieved. Should the return not be satisfactory, calculating a factor return can
sometimes help identify ways to refine the process so that an equitable level of
satisfaction is achieved.

A factor return is the amount of return that is generated as a result of the performance of a
given element or factor that is relevant to the production and sale of the goods or
services. The purpose of calculating this type of return is to determine if the resources
utilized to create sales and some sort of profit are actually performing at peak efficiency.
Assessing the factor return can make it possible to identify expenses that are not actually
helping to generate return, eliminate or replace them, and increase the bottom line.

One example of a factor return would be to examine the contribution made by a specific
raw material used in the production of a particular good. The idea is to determine if the
investment that is made in the purchase of this raw material is in fact making a
contribution to the success of the finished product in any significant manner. For
instance, a company that makes household cleaners may determine that the inclusion of
orange oil in the cleaning formula helps to increase the efficiency of the product, and has
resulted in increased sales as consumers begin to favor the improved product over the
competition. In this instance, calculating the factor return will determine if the additional
expense of including the orange oil is offset by the increased revenue earned from sales,
allowing the company to earn a higher return on the production of the product.

In the business world, the factor return can also apply to a type of business service known
as factoring. Factoring companies essentially purchase the accounts receivable of a
business in advance, allowing that business to receive a significant amount of the value of
those invoices without waiting for clients to issue payments. In exchange for this
factoring service, the factoring company retains a small percentage of the payments as
they are received. Once the clients have paid all invoices that were purchased in a given
batch, the factoring company releases the remainder of the funds due the business,
retaining only that small percentage as its fee. With this application, the factor return is
the amount of the fee that the factoring company retains in exchange for its services.