mb0042 managerial economics assignment -semester 1

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

Master of Business Administration - MBA Semester I


(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.


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


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.


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.


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


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.


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


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

producer’s equilibrium, we have to integrate Iso-quant curve with that of Iso-cost line. Iso-

product 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


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


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 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.


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



Variable costs

Variable cost per unit 8.00

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:


• 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


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


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


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 monopolist’s likelihood of earning economic profit greater than that of purely

competitive firm’s

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 “market-

clearing” 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


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 long-

run 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


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


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.


Master of Business Administration - MBA Semester I


(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.


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 consumer‘s income. The

following formula helps to measure the income elasticity (Ey).

Or Where

Ey is income elasticity of demand

D is change in demand

D is original demand

Y is change in income

Y is original income

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=6000-

4000=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.


1. 1. When Ey is positive, the commodity is normal (used in day-to-day life) 2. 2. When Ey is negative, the commodity is inferior. ( for example jowar, beedi etc) 3. 3. When Ey is positive and greater than one, the commodity is luxury. 4. 4. When Ey is positive but less than one, the commodity is essential. 5. 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.


Q.2 When is the opinion survey method used and what is the effectiveness

of the method.

Survey of buyer‘s 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.


The success of the survey method depends on many factors:

1. 1. The nature of the question asked. 2. 2. The ability of the surveyed. 3. 3. The representative of the sample 4. 4. Nature of the product 5. 5. Characteristics of the market 6. 6. Consumer behavior 7. 7. Techniques of analysis 8. 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


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


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


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 manager‘s salary or salary of the


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.


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.


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.


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.


mb0042 managerial economics assignment -semester 1

Documents

mb0042 managerial

variablemarginal

partial equilibrium

marginal cost

managerial

opinion survey

optimum factor

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