Managerial Economics [SET 1]

Code: MB 0026

Course: MBA

Name: Jayamohan R

Roll No. 520935280

Learning Centre: EDUWAY ACADEMY PVT. LTD., [Code 1736]CBD Belapur, Navi Mumbai

1

1. The demand function of a good is as follows:

Q1=100-6P1-4P2+2P3+0.003Y

WHERE P1 and Q1 are the price and quantity values of good 1

P2 and P3 are the prices of good 2 and good 3 and Y

is the income of the consumer. The initial values are given:

P1 =7

P2 =15

P3 =4

Y=8000

Q1 =30

You are required to:

a) Using the concept of cross elasticity determine the

relationship between good 1 and others

Let’s consider the case when the price of good1 increases from 7 to 10

P2 = (Q1-100+6P1-2P3-0.003Y)/4

= (30 – 100 + 6 x 10 - 2 x 4 – 0.003 x 8000) / 4

= 10.5

P3 = (Q1-100+6 P1+4P2-0.003Y)/2

= (30 – 100 + 6 x 10 + 4 x 15 – 0.003 x 8000) / 2

= 13

From the above function equation it can be seen that when the price of

good1 increases from say 7 to 10 the price of good2 decreases from 15 to

10.5 and that of good 3 increases from 4 to 13.

This shows that when the demand for good1 increases and the demand

for good 2 falls bringing down its price. So good1 and good2 are having a

complementary relationship. An example is the case of the increase in fuel

price causing the demand for fuel inefficient vehicles to fall and

consequently bringing down their price. In this case the cross elasticity is

negative.

2

Whereas in the case of good1 and good3 they are increasing in tandem.

This shows that good1 and good3 are substitutes. The increase in price of

one increases the demand for the other as it is also an equal substitute

and so is expected to sell more. In this case the cross elasticity will be

infinite.

b) Determine the effect on Q1 due to a 10 % increase in the

price of good 2 and good 3.

A 10% increase in the price of good2 means its price goes up to 16.5 and

the price of good3 increases by 10% to 4.4. Then Q1 = 100 - 6x7- 4x16.5

+ 2 x 4.4 + 0.003 x 8000

= 24.8

This shows that if there is a 10% rise in the prices of good2 and good3

then the demand for good1 will fall to 24.8 ie a fall of 17.33%

2. What are the factors that determine the Demand curve?

Explain.

The Demand Curve

The quantity demanded of a good usually is a strong function of its price. Suppose an experiment is run to determine the quantity demanded of a particular product at different price levels, holding everything else constant. Presenting the data in tabular form would result in a demand schedule, an example of which is shown below.

Demand Schedule

PriceQuantityDemanded

5 10

4 17

3 26

3

2 38

1 53

The demand curve for this example is obtained by plotting the data:

Demand Curve

By convention, the demand curve displays quantity demanded as the independent variable (the x axis) and price as the dependent variable (the y axis).

The law of demand states that quantity demanded moves in the opposite direction of price (all other things held constant), and this effect is observed in the downward slope of the demand curve.

For basic analysis, the demand curve often is approximated as a straight line. A demand function can be written to describe the demand curve. Demand functions for a straight-line demand curve take the following form:

Quantity = a - (b x Price)

where a and b are constants that must be determined for each particular demand curve.

When price changes, the result is a change in quantity demanded as one moves along the demand curve.

Shifts in the Demand Curve

When there is a change in an influencing factor other than price, there may be a shift in the demand curve to the left or to the right, as the quantity demanded increases or

4

decreases at a given price. For example, if there is a positive news report about the product, the quantity demanded at each price may increase, as demonstrated by the demand curve shifting to the right:

Demand Curve Shift

A number of factors may influence the demand for a product, and changes in one or more of those factors may cause a shift in the demand curve. Some of these demand-shifting factors are:

Customer preference Prices of related goods

o Complements - an increase in the price of a complement reduces demand, shifting the demand curve to the left.

o Substitutes - an increase in the price of a substitute product increases demand, shifting the demand curve to the right.

Income - an increase in income shifts the demand curve of normal goods to the right.

Number of potential buyers - an increase in population or market size shifts the demand curve to the right.

Expectations of a price change - a news report predicting higher prices in the future can increase the current demand as customers increase the quantity they purchase in anticipation of the price change.

3. A firm supplied 3000 pens at the rate of Rs 10. Next month,

due to a rise of in the price to 22 rs per pen the supply of the

firm increases to 5000 pens. Find the elasticity of supply of

5

the pens.

Initail supply of pens = 3000 nos

Final supply of pens = 5000 nos

% Change in supply = ((5000-3000)/3000) x 100 = 66.67%

Initial Price of the pens = Rs 10/-

Final price = Rs 32/-

% Change in pen price = (32-10)/10x100 = 220%

Now Elasticity of supply =

ES = % change in supply / % change in price

= 66.67/220 = 0.303

4. Briefly explain the profit-maximization model.

PROFIT MAXIMIZATION:

The process of obtaining the highest possible level of profit through the production and sale of goods and services. The profit-maximization assumption is the guiding principle underlying production by a firm. In particular, it is assumed that firms undertake actions and make the decisions that increase profit. The profit-maximization assumption is the production counterpart to the utility-maximization assumption for consumer behavior. Profit is the difference between the total revenue received from selling output and the total cost of producing that output. The profit-maximization assumption means that firms seek a production level that generates the greatest difference between total revenue and total cost. If a firm maximizes profit, then it is generating the highest possible reward for entrepreneurship resources.

The Profit Maximizing ChoiceConsider how profit maximization might work for The Walchand Company. Suppose that The Walchand Company generates Rs.100,000 of profit by producing 100,000 Stuffed Amigos. This profit is the difference between Rs.1,000,000 of revenue and Rs.900,000 of cost.

If profit falls from this Rs.100,000 level when Walchand Company produces more (100,001) or fewer (99,999) Stuffed Amigos, then it is maximizing profit at 100,000.

Alternatively, if profit can be increased by producing more or less, then Walchand Company is NOT maximizing profit.

Suppose, for example, that producing 100,001 Stuffed Amigos adds an extra Rs.11 to revenue but only Rs.9 to cost. In this case, profit can be increased

6

by Rs.2, reaching Rs.100,002, by producing one more Stuffed Amigos. As such 100,000 is NOT the profit maximizing level of production.

In contrast, suppose that producing 99,999 Stuffed Amigos reduces cost by Rs.11 but only reduces revenue by only Rs.9. In this case, profit can also be increased by Rs.2, reaching Rs.100,002, by producing one fewer Stuffed Amigos. As such, 100,000 is NOT the profit maximizing level of production.

While this assumption has numerous questions concerning its validity in the real world (do firms ACTUALLY try to maximize profit?), it does provide an excellent method of economic analysis.

Marginal Equality

The economic analysis of short-run production reveals that firms maximize profit by producing a quantity that equates marginal revenue with marginal cost. This equality holds regardless of the market structure (perfect competition, monopoly, monopolistic competition, or oligopoly) under study. While the implications of profit maximization for different market structures also differ, the process of maximizing profit is the essentially the same.

Other ObjectivesOn a day-to-day basis most firms likely pursue goals other than profit maximization. Three most noted objectives are sales maximization, personal welfare, and social welfare.

Sales Maximization: Many firms make decisions designed to increase or maximize production and the amount of output sold. More sales means more revenue, but not necessarily more profit.

Personal Welfare: Firms are occasionally motivate to increase the personal welfare of owners or employees, especially the employees who control the operation of the firm. Profit is usually sacrificed in the process.

Social Welfare: Some firms are also inclined to take actions that they deem will improve the overall well-being of society. These actions also tend to reduce profit.

Natural SelectionNatural selection is the notion that firms best suited to the economic environment

on the ones that tend to survive. Those firms that approximate the goal of profit-

maximization, whether intentionally or accidently, are the ones most likely to

survive and remain in business. This provides justification for presuming that

business firms seek to maximize profit, even though they might pursue other

goals on a day-to-day basis. Even if firms do NOT actively, consciously pursue

the profit-maximization goal, assuming they do is not necessarily unreasonable.

5. What is Cyert and March’s behavior theory? What are the

7

demerits?

Before Cyert and March, the prevailing theory about the firm is based on the

two rational assumptions:

1. Firms seek to maximize profits

2. Firms operate with perfect knowledge.

Cyert and March first raise questions to these two assumptions. These arguments

are pretty close to our view of the firms today. First, there are sociological and

psychological facts that are obviously omitted by the traditional approach about

firms. In most regions today we still assume rationality of agent and maximization

profit of a firm or utility of an investor, etc. And people continuously raise

sociological and psychological evidences to repute the rational theories. By

rationality we easily get linear systems which we can solve. There are conflicts

between reality and people’s ability.

The goal of an organization

Cyert and March first consider the goal of the firm. They notice that individual

person has goal, but collectivities of people do not. Nevertheless, for a well-

defined theory of organizational decision making, we do need a goal, or

whatever analogous to the individual goal, for a firm.

The Cyert and March answer to this question is that the goals of a business

firm are a series of more or less independent constraints imposed on the

organization through a process of bargaining among potential coalition

members and elaborated over time in response to short-run pressures. Three

things are important here. First, there is no consensus goal for a firm. There

are only constrains for the participants. And the participants bargain with

each other for these constraints. Second, the internal organizational process

of control should go stabilized and elaborated. Third, the process of 8

adjustment to experience should be altered by environmental changes.

Cyert and March adopt two major organizing devices to analyse the goal (as

well as Organization expectations and choices we will come into). The first set

is for exhaustive variable categories, the second set for the relational

concepts. For example, as for the goal of the firm, the first set influences the

dimensions of the goals, or what type of things are viewed as important by

some or all participants. The second set of variables influences the aspiration

level on any particular goal dimension. The second set is composed by past

performance, past goal, and past performance of other comparable

organizations.

The Cyert and March correctly state that conflicting goals exist for most

organizations at most of the time. Because we know that for a maximization

problem we can either use constraints or we can use Langrange Multiplier to

let these constraints enter the objective function directly. Therefore this is just

to phrase the same problem in another way. This doesn’t give out a way to

eliminate the conflict problem.

The Organizational expectations and Choices

To Cyert and March, expectations are seen as the result of drawing

inferences from available information. Therefore a good theory for the

organizational expectations should consider variables that affect either the

process of drawing inferences or the process by which information is made

available to the organization. The latter process could also be viewed as

search the information.

At the time of proposing this theory, game theory was not ready yet. So in the

Cyert and March’ explanation, even though they realize the importance of the

search and format of the information, they do not mention specifically the

agency principal problem. Neither do they emphasize the importance of the

incentive in collecting and reporting true information. Instead, they look at the

9

direction of search and the intensity and success of search. Thus they view

the information problem as a flow. The key point for them is to first decide

what type of information is important and second how to successfully get it.

We have seen that this is still an important approach in a modern society.

Just that they still view the firm as a sole identity, so the information problem

is for the firm to collect the information. While in a modern contract theory,

there is no single distinction for the firm and the outside. Each participant

searches his interested information and makes decision based on his contract

and his information. Nevertheless, the Cyert and March’ traditional view is

still important for management decision making.

Based on the information and alternatives, the firm makes decisions. The

variables that affect choice are those that influence the definition of a problem

within the organization, those that influence the standard decision rules, and

those that affect the order of consideration of alternative. Especially, the

standard decision rules are affected primarily by the past experience of the

organization and/or the past record of organizational slack.

We have seen that the Cyert and March have used very technical analysis.

When the Cyert and March write down divisions like variables, they should

have something like a mathematical function in their mind. For example, they

don’t give out a specific goal of the firm, but their views of the goal of the firm

look pretty like a Langrange function (or any other function) of goals of all

participants, with some cost functions representing the bargaining process

and changing to environment. Besides, the two sets of variables look like the

variables enter the goal function (the first set), and some rational expectation

of the level of the goal function determined by the second set. So the second

set is basically historical data and comparative role in the industry.

These types of analyses are deep in the mind of modern economic

researches. For example, when we study the stock return, we set up a one

period model. In this model the returns might be driven by macro (or any

10

other) variables. Then time series analysis is added to compare lagged

return with contemporary return.

When Cyert and March mention goals of participants, they might have a utility

function in their mind. Because this is the only way that goals could be

viewed as constraints. What’s behavioral here is just that after the

aggregating process we won’t easily get an aggregated rational goal function.

It is more like a chaotic system instead of a behavioral one. When we

remember the simple fact that even one individual could have role conflicts, it

is not that obvious that utility theory applies here directly. And once it is, as

Cyert and March assume, the theory of the firm has a solid rational

foundation. If we look at the aggregating of rational preference in the utility

theory, there is no surety that a representative rational preference exists. So

if only goal of conflicts exists, it is not that behavioral.

Major Relational concepts

Now let’s look at the second set more carefully. Cyert and March use 4 major

relational concepts for their analysis: quasi resolution of conflict, uncertainty

avoidance, problemistic search, and organizational learning.

Since it is inevitable for conflicting goals in any organization, it is natural to

see whether it is still useful to study the aggregating behavior of the firm.

Cyert and March suggest solving the conflicts ‘quasily’ by the following

process. List all the goals as independent constraints, then assume local

rationality to get some compromised goal. Attention should be given to the

acceptable level of the decision rules and the sequential attentions to the

goal. So here they believed that the conflicts could be smoothed. But in their

suggestion, the process is more or less problem driven. That is, in their setup

when there are conflicts, they treat the conflicts as constraints to solve the

possible acceptable solution. This process doesn’t solve the problem as a

whole. It just solves the specific problem and doesn’t go to the big picture.

11

Using a modern word, the uncertainty avoidance is to state that the firm is risk

averse. Of course, the risk has very general sense here. Cyert and March

suggest that the organizations avoid uncertainty in a way that short run,

instead of long run uncertainty will get more attention. Cyert and March

assume a feedback-react decision procedure such that the firms solve

emerging problems and wait for the next one. Besides, firms tend to find a

way to control the environment, rather than treat the environment as

exogenous and suffer the uncertainty.

As for the search, Cyert and March suggest that search is motivated, simple-

minded and biased. It seems that they are pretty close to the cost of

information. So it is a pity that they just accept the fact that search could be

biased but don’t go one step further to see how to reduce the biasness. Cyert

and March view the problem dynamically but mechanically. Here the biased

information in their view might just cost longer computing time for the true

solution to come out. And bias-information problem is ignored for most of the

time. Thus they might believe that the bias of information has some definite

distribution. Still, even in this case, a Baysian distribution should replace the

prior distribution. But these problems are ignored by Cyert and March.

Organization learning means that organizations exhibit adaptive behavior

over time. Especially, the firm adapts the goal, the attention rules, and the

search rules. This is pretty close to the dynamic view of the firm from the

contract theory. Still, Cyert and March treat organization as individual.

As we have seen, Cyert and March adopt a problem driven way of analysis.

That is, they solve out problems and wait for another. For example, when

there are conflicts, they let the firm to set these conflicts as constraints and

solve out a possible solution. As another example, the firm makes decision

on some given problems and waits for other problems to come. Even we

need to adopt dynamic systems to analyze problems, it is not necessary that

we can only solve problems one by one. For example, we know that for a

12

social contract, people use law to eliminate conflicts. At a firm level, common

knowledge like accounting system also helps to avoid conflicts. There is no

doubt that maximization problems at some level help people to make

decision. But on one hand the solution might not exist, on the other hand we

really want to find out ways to use the maximization problem as few as

possible, that is, to solve the problem as a whole.

Another discussion comes from the distinguishing between behavior and

chaotic system. Any economic theory, if assuming the rationality of the

participants, should belong to rational theory, even some weird properties

could come out as a result of aggregation. At the same time, in modern

economic theory, there are very few studies about chaotic system, which is

formed by rational individuals but results in strange aggregating properties.

Nevertheless, chaotic system belongs to the rational world, just that no

prediction could be made.

6. What is Boumol’s Static and Dynamic ?

Sales maximization model is an alternative model for profit maximization. This model

is developed by Prof. W. J. Boumol, an American economist. This alternative goal

has assumed greater significance in the context of the growth of Oligopolistic firms.

The model highlights that the primary objective of a firm is to maximize its sales

rather than profit maximization. It states that the goal of the firm is maximization of

sales revenue subject to a minimum profit constraint. The minimum profit constraint

is determined by the expectations of the share holders, because no company can

displease the share holders. Maximization of sales means maximization of total

sales revenue. Hence, the idea is to maximize sales rather than profit. The means

that when sales are maximized automatically profits of the company would also

increase.

The assumptions in this model are:

13

1. Increasing sales and market share is a sign of healthy growth for a company.

2. It increases the competitiveness and enhances its market influence.

3. The amount of slack earnings and salaries of the top managers are directly

linked to profits from sales revenue maximisation.

4. It results in enhanced prestige and reputation for top management, more

dividends to share holders and increased wages for workers.

5. The lending institutions always keep a watch on the sales revenues of a firm

as it is an indication of the financial health of a firm.

6. It helps the managers to pursue a policy of steady performance with

satisfactory levels of profits rather than high degree of risk projects for

spectacular profit.

Prof. Boumol has developed the static model and the dynamic models.

The Static Model

This model is based on the following assumptions.1. The model is applicable to a particular time period and the model does not

operate at different periods of time.2. The firm aims at maximizing its sales revenue subject to a minimum profit

constraint.3. The demand curve of the firm slope downwards from left to right.4. The average cost curve of the firm is U-shaped one.

The following diagram can be used to explain sales maximization model subject to a minimum profit constraint.

14

At 0X1 level of output profit is maximum, TR is much higher than TC. If the firm chooses to produce 0X3 output, profit will fall to X3K though the TR is still in excess of TC. Profit constraint is less at 0X2 level of output as the firm earns X2N profit. Depending upon the market conditions a firm can determine the level of output with minimum profit constraint.

Sales maximization [dynamic model]

In order to include real world changes which affects business decisions, Boumol has developed the dynamic model. This model explains how changes in advertisement expenditure, a major determinant of demand, would affect the sales revenue of a firm under severe competitions.

Assumptions:1. Higher advertisement expenditure would certainly increase sales revenue of

a firm.2. Market price remains constant.3. Demand and cost curves of the firm are conventional in nature.

Generally under competitive conditions, a firm in order to increase its volume of sales and sales revenue would go for aggressive advertisements. This leads to a shift in the demand curve to the right. Forward shift in demand curve implies increased advertisement expenditure resulting in higher sales and sales revenue. A price cut may increase sales in general but increase in sales is more dependent on the demand for a product - elastic or inelastic. A price reduction policy may increase its sales only when the demand is elastic and if the demand is inelastic; such a policy would have adverse effects on sales. Hence, to promote sales, advertisements become an

15

effective instrument. It is generally observed that with an increase in advertisement expenditure, safes of the company would also go up. A sales maximizer would generally incur higher amounts of advertisement expenditure than a profit maximizer. However, the amount allotted for sales promotion should bring more than proportionate increase in sales and total profits of a firm. Otherwise, it will have a negative effect on business decisions.

Thus, by introducing, a non-price variable in to his model, Boumol successfully analyzes the behavior of a competitive firm under oligopoly market conditions. Under oligopoly conditions there are only a few big firms competing with each other either producing similar or differentiated products, would resort to heavy advertisements as an effective means to increase their sales and sales revenue. This the more realistic present day scenario.

16