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Questionanswers 100202064114-phpapp02
Questionanswers 100202064114-phpapp02
Questionanswers 100202064114-phpapp02
Questionanswers 100202064114-phpapp02
Questionanswers 100202064114-phpapp02
Questionanswers 100202064114-phpapp02
Questionanswers 100202064114-phpapp02
Questionanswers 100202064114-phpapp02
Questionanswers 100202064114-phpapp02
Questionanswers 100202064114-phpapp02
Questionanswers 100202064114-phpapp02
Questionanswers 100202064114-phpapp02
Questionanswers 100202064114-phpapp02
Questionanswers 100202064114-phpapp02
Questionanswers 100202064114-phpapp02
Questionanswers 100202064114-phpapp02
Questionanswers 100202064114-phpapp02
Questionanswers 100202064114-phpapp02
Questionanswers 100202064114-phpapp02
Questionanswers 100202064114-phpapp02
Questionanswers 100202064114-phpapp02
Questionanswers 100202064114-phpapp02
Questionanswers 100202064114-phpapp02
Questionanswers 100202064114-phpapp02
Questionanswers 100202064114-phpapp02
Questionanswers 100202064114-phpapp02
Questionanswers 100202064114-phpapp02
Questionanswers 100202064114-phpapp02
Questionanswers 100202064114-phpapp02
Questionanswers 100202064114-phpapp02
Questionanswers 100202064114-phpapp02
Questionanswers 100202064114-phpapp02
Questionanswers 100202064114-phpapp02
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Questionanswers 100202064114-phpapp02

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  • 1. MANAGERIAL ECONOMICS (Important Questions and suggested model answers)1. Define Managerial Economics.Managerial economics is a specialized discipline of management studieswhich deals with application of economic theory and techniques to businessmanagement. Managerial economics is evolved by establishing links onintegration between economic theory and decision sciences (tools andmethods of analysis) along with business management in theory andpractice---for optimal solution to business/managerial decision problems.This means, managerial economics pertains to the overlapping area ofeconomics along with the tools of decision sciences such as mathematicaleconomics, statistics and econometrics as applied to business managementproblems.“Managerial economics is a science which studies the economic aspectsof behaviour of the firm as an enterprise, and helps to allocate scarceresources to their alternative uses in such a manner as to optimize thefirm’s ultimate objective, as an organization and a social institution,under conditions of the imperfect knowledge, risk and uncertainty. Itprovides principles, method, and techniques of analysis of economicbehaviour and at the same time prescribes ways and means to optimizeeconomic efficiency.”2. Discuss the nature and scope of Managerial Economics. What are theother related disciplines?Nature and Scope of Managerial Economics:All managerial decisions are basically economic in nature. The decisions areeither directly related to Economics or have economic implications; theymight not be based simply on economic calculations, and might involveseveral non-economic, social, political, legal and technologicalconsiderations as well. Managerial economics helps not only to analyse theeconomic content and implications of the managerial decisions but also tointegrate several other aspects leading to sound decisions. 1
  • 2. Managerial economics incorporates elements of both micro andmacroeconomics dealing with managerial problems in arriving at optimaldecisions. It uses analytical tools of mathematical economics andeconometrics with two main approaches to economic methodologyinvolving ‘descriptive’ as well as ‘prescriptive’ models.Managerial economics differs from traditional economics in one importantrespect that it is directly concerned in dealing with real people in realbusiness situations. Managerial economics is concerned more aboutbehaviour on the practical side.Managerial economics deals with a thorough analysis of key elementsinvolved in the business decision making.Most managerial decisions are made under conditions of varying degrees ofuncertainty about the future. To reduce this element of uncertainty, it isessential to have homework of research/investigation on the problem solvingbefore action is undertaken.Knowledge of managerial economics is a boon to the manager/businessman/entrepreneur. Modern businessman never believes in luck. He bangs onskilful management and appropriate timely economic decision making. Thisart is facilitated by the science of managerial economics.Other related disciplines:Managerial economics is closely related to and draws heavily upon severalareas in economics such as Theory of the Firm, Microeconomics,Macroeconomics, Industrial Economics, and so on. Managerial economics isbasically micro in nature in that it deals with the firm’s behaviour in threebasic areas viz. Utility analysis, Theory of the Firm and Factor pricing.Managerial Economics draws a few aspects from Macroeconomics such asnational income, technology forecasting, which are relevant to sales/demandforecasting. While Industrial Economics analyses the economic problems ofthe industry as a whole, Managerial Economics deals with the economicaspects of managerial decision making at a micro level irrespective of thesphere of activity. 2
  • 3. Macro Economics is not only related to but is also an integral part of thefunctional areas of management such as production, finance, accounting,marketing, operations research and personnel. To illustrate, Capitalbudgeting might be taught in finance and accounting as well as inEconomics. While Economics would analyse the firm’s investmentdecisions and economic viability of projects, finance would study theirfinancial viability. E.g. The Garland Project linking Himalyan rivers to thesouthern plateau was considered feasible from the technical point of view,but it was thought to be financially not feasible as it involved investmentbeyond India’s capacity.Distinguish between Micro and Macro Economics.Broadly speaking, microeconomic analysis is individualistic, whereasmacroeconomic analysis is aggregative. Microeconomics deals with the part(individual) units while macroeconomics deals with the whole (all unitstaken together) of the economy.1. Difference in nature: Microeconomics is the study of the behaviour of theindividual units. Macroeconomics is the study of the behaviour of theeconomy as a whole.2. Difference in methodology: Microeconomics is individualistic; whereasmacroeconomics is aggregative in its approach.3. Difference in economic variables: Microeconomics is concerned with thebehaviour of microvariables or microquantities.. Macroeconomics isconcerned with the behaviour of macrovariables and macroquantities. Inshort, microeconomics deals with the individual incomes and output,whereas macroeconomics deals with the national income and nationaloutput.4. Difference in field of interest: Microeconomics primarily deals with theproblems of pricing and income distribution. Macroeconomics pertains tothe problems of the size of national income, economic growth and generalprice level. 3
  • 4. 5. Difference in outlook and scope: The concept of ‘industry’ inmicroeconomics is an aggregate concept but it refers to all firms producinghomogenous goods taken together. Macroeconomics uses aggregates whichrelate to the entire economy or to a large sector of the economy. Aggregatedemand covers all market demands.6. Demarcation in areas of study: Theories of value and economic welfareare major areas in microeconomics. Theories of Income and employment arecore topics in macroeconomics.Is Managerial Economics a Positive or Normative Science? Discuss.Positive Economics explains the economic phenomenon as “What is,what was and what it will be. Normative Economics prescribes what itought to be”. Positive sciences simply describe, while normative sciencessimply prescribe.According to Prof. Robbins, economics is a positive science. Science is,after all, a search for truth and therefore, economics should study the truth asit is and not as it ought to be. This is because when we say that this ought tobe like this, we presume that our point of view is correct. In a study of aproblem at a given point of time, not only economic considerations but alsomany other considerations such as ethical, political etc. must be considered.A policy decision is taken after weighing the relative importance of all thesefactors. There are bound to be differences in respect of policy prescriptionand it is better to keep away from areas which are controversial and studythe facts as they are.According to economists like Marshall and Pigou, the ultimate object of thestudy of any science is to contribute to human welfare. Thus economicsshould be a normative science. It should be able to suggest policy measure tothe politicians. It should be able to prescribe guidelines for the conduct ofeconomic activities. Not only economists should build up the economictheory but also at the same time they should provide policy measures. 4
  • 5. We must strike a balance between these two extreme views. As Keynes putit, “The main function of economics is not to provide a body of settledconclusions immediately applicable to policy. It provides a method or atechnique of thinking, which enables its possessor to draw correctconclusions.”Managerial economics is a blending of pure or positive science with appliedor normative science. It is positive when it is confined to statements aboutcauses and effects and to functional relations of economic variables. It isnormative when it involves norms and standards, mixing them with cause-effect analysis.One cannot disregard the normative functions of managerial economics,though the discipline may be treated primarily as a positive science.Normative approach in managerial economics has ethical considerations andinvolves value judgments based on philosophical, cultural and religiouspositions of the community.The value judgments and normative aspect and counselling in managerialeconomic studies can never be dispensed with altogether.We may thus conclude, that Managerial Economics is both a Positive andNormative Science.Briefly discuss the three fundamental concepts of ManagerialEconomics.Managerial Economics is confined to the following three major fields:(1) Pricing (2) Distribution (3) Welfare.Chart: 5
  • 6. Pricing: Microeconomics assumes the toal quantity of resources available inan economic society as given and seeks to explain how these shall beallocated to the production of particular goods for the satisfaction of chosenwants. In a free market economy, the allocatioin of resources is based on therelative prices and profitability of different goods. To explain the allocationof resources, microeconomics seeks to explain the pricing phenomenon.Price theory explains how the price of a particular commodity is determinedin the commodity market. For in depth analysis of price determination itcontains: • Theory of demand of the analysis of consumer behaviour. • Theory of production and cost or the analysis of producer behaviour. • Theory of product [pricing or price determination under different market structures.Distribution: The theory of distributioin basically deals with factor pricing.It seeks to explain how rewards of the individual factors of production suchas land, labour, capital and enterprise are determined for their productivecontribution. In other words, it is concerned with rent, wages, interest,profits, as the respective rewards of land, labour, capital and enterpriserespectively.Since demand and supply of each of these factors are different, there areseparate theories to these. Thus the field of distribution includes, generaltheory of distribution and theories of rent, wages, interest and profits.Welfare: The theory of economic welfare explains how an individualconsumer maximizes his satisfaction when production efficiency is achievedby allocation of resources in such a way as to maximize output from alimited set of input.Along with individual economic welfare, welfare economics is alsoconcerned with social welfare, which is based on overall economicefficiency of the system. When maximum individual wants are satisfied atthe best possible optimum level by a production pattern through efficientallocation of resources, overall economic efficiency or ‘Pareto optimality’condition is reached. Such a situation can raise the standard of living of thepopulation and maximize social welfare. 6
  • 7. What are the important uses and limitation of microeconomics?Importance and Uses:1. It explains price determination and the allocation of resources.2. It has direct relevance in business decision-making.3. It serves as a guide for business’ production planning.4. It serves as a basis for prediction.5. It teaches the art of economizing.6. It is useful in determination of economic policies of the Government.7. It serves as the basis for welfare economics.8. It explains the phenomena of International Trade.Limitations:1. Most of the micro-economic theories are abstract.2. Most of the microeconomic theories are static – based on ceteris paribus,i.e. “other things being equal”.3. Microeconomics unrealistically assumes ‘laissez-faire’ policy and purecapitalism.4. Microeconomics studies only parts and not the whole of the economicsystem. It cannot explain the functioning of the economy at large.5. By assuming independence of wants and production in the system,microeconomics has failed to consider their ‘dependent effect’ on economicwelfare.6. Microeconomics misleads when one tries to generalize from theindividual behaviour.7. Microeconomics in dealing with macroeconomic system unrealisticallyassumes full employment.How does Managerial Economists help the Manager in decision makingand forward planning?Managerial Economists act as operations researchers and systems analysts inthe management services department of large business firms usually in theprivate sector. Their job lies in designing the course of operations tomaintain and improve the ‘systems’ of the firm in terms of productivity,market share, load factor percentage and so on and prepare reports forhelping the decision makers to cope with current as well as anticipatedfuture problems. In modern business, managers constantly face the majorproblem of choice among alternative ways of producing goods and alliedbusiness decisions. Managerial economists assist them in making a rationalchoice. 7
  • 8. A Managerial economist is an economic adviser to a firm or businessman. Afirm or entrepreneur, in the course of its/his business operations, has to takea number of decisions which are vital to the survival and growth of thebusiness. Such decisions may pertain to the nature of the product to beproduced, the quantity, quality, cost, price and its distribution, planning anddiversification of business, renewal of worn out equipments and machinery,modernization, etc. The Managerial economist helps the businessman or themanager in arriving at correct decisions. In short, the business economist while helping in the decision making process, measures a number of micro and macro variables by applying intelligently certain quantitative and qualitative techniques to the practical aspects and problems encountered by a business firm in its business activity. Forecasting is a fundamental activity of the Managerial economist. Indeed a business economist is greatly helpful to the management by virtue of his studies of economic analysis. He is an effective model builder. He deals with the business problems in a sharp manner with a deep probing. A Managerial economist in a business firm may carry on a wide range of duties, such as: • Demand estimation and forecasting. • Preparation of business forecasts; to provide forecasts of changes in costs and business conditions based on market research and policy analysis. • Analysis of the market survey to determine the nature and extent of competition. • Analysing the issues and problems of the concerned industry. • Assisting the business planning process of the firm. • Discovering new and possible fields of business endeavour and its cost-benefit analysis as well as feasibility studies. • Advising on pricing, investment and capital budgeting policies. • Evaluation of capital budgets. • Building micro and macro economic models of particular aspects of the firm’s activities that are useful in solving specific business problems. Most models may be prediction oriented. • Directing economic research activity. • Briefing the management on current domestic and global economic issues and challenges. 8
  • 9. DEMANDWhat is Demand?A demand is the effective desire or want for a commodity, which is backedup by the ability (i.e. money or purchasing power) and willingness to pay forit. The demand for a product refers to the amount of it which will be boughtper unit of time at a particular price. The demand can be expressed as actualand potential.Consumer demand has two levels: a) Individual Demand and b) MarketDemand.Market demand is the sum total of individual demand. Prices are determinedon the basis of market demand. Market demand serves as a guidepost toproducers in adjusting their supplies in a market economy.Factors influencing individual demands are : • Price of the products. • Income of the buyer. • Tastes, Habits and Preferences. • Relative prices of other goods. • Relative prices of substitute and complementary products. • Consumer’s expectations about future price of the commodity. • Advertisement effect.Factors influencing Market Demand: • Price of the product. • Distribution of Income and Wealth. • Community’s common habits and scale of preferences. • General standards of living and spending habits of the people. • Number of buyers in the market and the growth of population. • Age structure and sex ratio of the population. • Future expecations. • Level of taxation and Tax structure. • Inventions and Innovations. • Fashions • Climate and weather conditions. • Customs 9
  • 10. • Advertisement and Sales propaganda.Demand Function:At any point in time, the quantity demanded of a given product (goods orservices) depends upon a number of key variables or determinants. Ademand function in mathematical terms expresses the functionalrelationship between the demand for the product and its variousdetermining variables.Dx – Quantity demanded = f(Px) – function of price.Here all other determining variables are assumed to be constant, keepingonly price as variable.If the demand function is to be stated taking into account all variables,without assuming them as constant, demand function isDx = f (Px, + Ps + Pc + Yd +T, A, N, u)Dx = Demand for X. Px = Price of X, Ps = Price of Substitute of X, Pc =Price of Complementary Goods, Yd = Disposable Income, T = Taste ofthe buyer or preference, A = Advertising effect, N = Number of buyersu = Unknown other determinants.Demand function is not the quantity demanded at a given price, butquantity demanded at each level of price.a = signifies initial demand irrespective of price (constant parameter).b = functional relationship between P – Price and D – Demand (constantparameter) Linear demand function is expressed as D = a – bP.b has minus (-) sign to denote a negative function. Demand is decreasingfunction of price.b is the slope ( vertical length ÷ horizontal length) of the demand curve,and suggests that it is downward sloping. 10
  • 11. Dx = 20 – 2Px (Dx is Quantity demanded of X, Px Price of X)Y Dx = 20 – 2Px54 What is law of demand? What are its exceptions? Why does a Demand Curve slope downward?3 Law of Demand: Ceteris paribus, the higher the price of a commodity, the smaller is the quantity demanded and lower the price, larger the quantity2 demanded. Other things remaining unchanged, the demand varies inversely to changes in price. Dx = f(Px). The demand curve is downward sloping indicating an inverse relationship between price and demand.1 The price is measured on the Y – axis and Demand on the X- axis. When the price falls, demand increases. The downward slope of demand curve implies0 that the consumer tends to buy more when the price falls. Thus the demand curve is shown as downward sloping. What are the assumptions underlying law of demand? Assumptions underlying the law of demand:  No change in Consumer’s income.  No change in consumer’s preferences.  No change in the Fashion.  No change in the Price of Related Goods.  No expectation of Future price changes of shortages.  No change in size, age composition, sex ratio of the population.  No change in the range of goods available to the consumers.  No change in the distribution of income and wealth of the community.  No change in government policy.  No change in weather conditions. Exceptions to the Law of Demand: Sometimes it may be observed, that with a fall in price, demand also falls and with a rise in price, demand also rises. This is apparently contrary to the 11
  • 12. law of demand. The demand curve in such cases will be typically unusualand will be upward sloping.There are few such exceptional cases:-  Giffen Goods: In the case of certain Giffen goods, when price falls, quite often less quantity will be purchased because of the negative income effect and people’s increasing preference for a superior commodity with rise in their real income. E.g. staple foods such as cheap potatoes, cheap bread, pucca rice, vegetable ghee, etc. as against good potatoes, cake, basmati rice and pure ghee.  Articles of Snob appeal (Veblen effect) : Sometimes, certain commodities are demanded just because they happen to be expensive or prestige goods and have a ‘snob appeal’. They satisfy the aristocratic desire to preserve the exclusiveness for unique goods. These goods are purchased by few rich people who use them as status symbol. When prices of articles like diamonds rise, their demand rises. Rolls Royce car is another example.  Speculation: When people are convinced that the price of a particular commodity will rise further, they will not contract their demand; on the contrary they may purchase more for profiteering. In the stock exchange, people tend to buy more and more when prices are rising and unload heavily when prices start falling.  Consumer’s phychological bias or illusion: When the consumer is wrongly biased against the quality of a commodity with reduction in the price such as in the case of a stock clearance sale and does not buy at reduced prices, thinking that these goods on ‘sale’ are of inferior quality.Reasons for change (increase or decrease) in demand:  Change in income.  Changes in taste, habits and preference.  Change in fashions and customs  Change in distributioin of wealth.  Change in substitutes.  Change in demand of position of complementary goods.  Change in population.  Advertisement and publicity persuasion. 12
  • 13.  Change in the value of money.  Change in the level of taxation.  Expectation of future changes in price.Explain Veblen effect and draw up the market demand curve for vebleneffect product. ((2/2004)Thorstein Veblen argued that the affluent class in the society has a tendencyto demonstrate their superiority of ‘high class’By spending on frivolous goods and services – super luxury items such asdiamonds, fivestar hotels, palatial buildings, business or executive class ofair travel. Though the market demand for such a commodity tends to risewhen its price falls, the individual demand of the snobbish buyer will fall.When a prestige good loses its snob value, its market demand from thesnobbish buyers will decrease with fall in its price; and the demand may beadded up from the new common buyers.In certain branded goods such as ‘Ray Ban’ or ‘Levis’ products i.e.exclusive or designer products, there exists an inherent paradox. Initiallythese goods are meant to serve the Veblen effect. At high prices, there islimited but good demand from the richer sections. But when these goods areproduced in larger quantity, their prices fall. It will carry mass appeal toupper middle class. So the demand will expand initially. Further increase inoutput will lead to further price reduction. But at this price, the product losesits exclusivity or snob effect and the richer sections exclusive demand willfall. The product will now be purchased on account of its functional utilityand will be competing in the market with other similar goods.The demand curve DD has changing slopes at a and b points. At price P1,the demand is Q1. When the price is lowered to P2, demand is Q2. A furtherreduction of price to P3, leads to a fall in demand as the brand losesexclusivity appeal. After that the product demand is determined just by itsfunctional utility.How is an indifference curve technique an improvement overMarshallian utility analysis?The indifference curve approach is considered superior to the Marshallianutility analysis of consumer demand in the following respects: 13
  • 14. It is more realistic. Marshall assumes cardinal measurement of utility,which is unrealistic. The indifference curve technique makes an ordinalcomparison of utility and the level of satisfaction.It uses the concept of scale of preferences with lesser assumptions thanthe Marshallian concept of utility. The scale of preference is laid down onthe basis of a consumer’s tastes and likings, independent of his income.Unlike Marshall, the Hicksian scale of preference needs no information as tohow much satisfaction is gained but it aims only at knowing whether aconsumer’s satisfaction level is greater than, less than or equal to, betweenthe various combinations of two goods.It dispenses with the assumption of constant marginal utility of money.Marshallian analysis assumes that to the consumer the marginal utility ofmoney remains constant. In the indifference curve analysis, suchassumption is not needed.It is wider in scope: Marshallian demand theory deals with a singlecommodity taken exclusively. Hick’s ordinal approach, considers at leasttwo goods in combination. Thus, the complementarity and substitutabilityaspects of goods are being explicitly considered in Hicksian analysis. It uses concept of Marginal Rate of Substitution which is scientific andmeasurable: The utility approach is based on the law of diminishingmarginal utility. On the other hand, the indifference curve approach rests onthe principle of diminishing marginal rate of substitution. The concept ofmarginal rate of substitution is superior to that of marginal utility because itconsiders two goods together and also because it is a ratio expressed inphysical units of two goods and as such, it is practically measurable. Thereplacement of the law of MU by MRS, is a positive change in a morescientific manner.It expresses the conditions of consumer equilibrium in a better way: InMarshallian analysis, the consumer equilibrium condition is MUx = MUy .Since utility cannot be measured numerically, this condition isimpracticable. Px PyIn Hicksian analysis, the equilibrium condition is expressed as MRSxy = Px/Py which is measurable. 14
  • 15. It is more comprehensive as it recognizes the fact that equilibrium inpurchasing one commodity depends on the price of other goods and theirstocks as well.It analyses the price effect in a better way: The Marshallian demand curvehas no means to separate the price effect into income and substitutioneffects. In the indifference curve analysis, the price consumption curveenables us to have the bifurcation of price effect into income andsubstitution effects. It examines the Phenomenon of Giffen Paradox. Marshall views the GiffenParadox as an exception to the law of demand, whereas the case of Giffengoods is incorporated in the price consumption curve to examine theconsumer’s typical behaviour caused by negative income effect. Thus theunsolved riddle about Giffen goods in the utility analysis is solved by theindifference curve analysis. It represents the law of demand in a broader andmore precise way.What are the shortcomings of the indifference curve approach?It does not provide any positive change in the utility analysis.It retains the Marshallian assumption of diminishing marginal utility:It unrealisitically assumes perfect knowledge of utility with theconsumer.It is weak in structure.It has limited scope.It is introspective.It is not applicable to indivisible goods.It assumes transitivity condition. 15
  • 16. ELASTICITY OF DEMANDDemand usually varies with price. The extent of variation of demand is notuniform. Sometimes the demand is greatly responsive to price changes,while at other times, it may be less responsive. Elasticity is the extent ofresponsiveness to variation. Two factors are relevant for measuring theelasticity of demand – a) demand b) the detriment of demand. A ratio ismade of the two variables for measuring the elasticity coefficient.Elasticity of demand = % change in quantity demanded % change in detriment of demandUnless specified, elasticity of demand means price elasticity of demand.Logically, however, the concept of elasticity should measure theresponsiveness of demand to changes in variables concerned with demandfunction. Thus there can be many kinds of elasticities of demand. Mostimportant are Price elasticity of demand Income elasticity of demand Cross elasticity of demandMarshallian classification of Price elasticity: 1. Unit elasticity of demand (e = 1) 2. Elastic demand - elasticity greater than unity. (e > 1) 3. Inelastic demand – elasticity is less than unity (e<1)Explain with graphs how modern economists have classified priceelasticity of demand. What are the managerial uses of price elasticity ofdemand?Price elasticity of demand:Ratio Method:The extent of responsiveness of demand for a commodity to a given changein price, other demand determinants remaining constant, is termed as theprice elasticity of demand. It is the ratio of relative change in demandvariables to price variables. 16
  • 17. Coeff.of price elasticity e = % change in quantity demanded OR % change in price proportionate change in quantity demanded =ΔQ ÷ ΔP = ΔQ x P proportionate change in price. Q P ΔP QQ = Original demand, ∆Q = change in demandP = Original Price, ∆P = change in priceThe above method is also known as percentage method, when the ratio isexpressed as a percentage.e = %∆Q %∆PRevenue Method:Marshall suggested that the easiest way of ascertaining whether or not thedemand is elastic, is to examine the change in total outlay of the consumeror total revenue of the seller corresponding to change in price of the product.Total Revenue (or Total outlay) = Price x Quantity purchased (or sold)According to this method, if the total revenue remains unchanged with achange in the price, the demand is unit elastic, as demand changes in thesame proportion as price.With a fall in price, if the total revenue rises, or with a rise in price, the totalrevenue falls, the elasticity is more than unity.With a rise in price, the total revenue also rises and with a fall in price, totalrevenue also falls, the demand is less than unity. 17
  • 18. Point elasticity method or Geometric Method:The simplest way of explaining the point method is to consider a straightline demand curve. Extend the demand curve to meet the two axes. When apoint is plotted on the demand curve, it divides the line segment into lowerand upper segments.Point elasticity is measured by the ratio of the lower segment of the demandcurve below the given point to the upper segment above the given point.Point elasticity = Lower Segment below the given point Upper segment above the given point.This measure is called ‘point elasticity’ measurement because it effectivelymeasures elasticity of demand at a point on the demand curve assuminginfinitesimally small changes in price and quantity variables.Arc elasticity method:To calculate price elasticity over some portion of the demand curve ratherthan at a point, the concept of arc elasticity of demand is used.Arc elasticity is measured on a range on the demand curve between twopoints. The formula for arc elasticity is ∆Q P1 + P2 where, P1 is the original price, p2 = new priceearc = -----x ---------- Q1 original quantity demanded ∆P Q1 + Q2 Q2 new demand ∆ P = P2 – P1, ∆ Q = Q2 – Q1For practical decision making, it is better to use arc elasticity measure whenprice changes more than 5%.For all theoretical purposes, point elasticity rather than arc elasticity iscommonly used. 18
  • 19. What are the factors influencing elasticity of demand?1. Nature of the commodity – according to the nature of satisfaction thegoods give. Luxury goods are price elastic.2. Availability of close substitutes – demand will be elastic.3. Number of uses the commodity can be put to – Single use goods willhave less elastic demand but demand becomes elastic if it can be put toseveral uses.4. Consumer’s income – demand from low income group will be elasticwhile from very rich persons, relatively inelastic.5. Height of price and range of price change – highly priced goods,demand less elastic with small change in price. But with large changes,demand will be elastic.6. Proportion of expenditure7. Durability of the commodity.8. Influence of habit and custom9. Complementary goods. Goods which are jointly demanded are lesselastic.10.Time – less elastic during short periods generally.11. Recurrence of demand.12. Possibility of postponement.Income Elasticity of Demand:Income elasticity of demand is defined as the ratio of percentage orproportional change in the quantity demanded to the percentage orproportional change in income.Income elasticity = % change in quantity demanded = em = %∆ Q % change in income. % ∆M OR ∆ Q x M or ∆ Q . M Q ∆M ∆ M Q 19
  • 20. Cross elasticity of demand:The cross elasticity of demand refers to the degree of responsiveness ofdemand for a commodity to a given change in the price of some relatedcommodity.The cross elasticity of demand between two goods is measured by dividingthe proportionate change in the quantity demanded of X by the proportionatechange in the price of Y.Cross elasticity of demand : Proportionate or percentage change indemand for X Proportionate or percentage change in theprice of Y.Ec or e xy = ∆Qx x ∆Py = ∆Qx x Px Qx Py ∆Py QxAdvertising or Promotional elasticity of demand :eA = Percentage or proportionate change in sales Percentage or proportionate change in ad.expenditure.Arc Advertising elasticity : ∆Q x A1 + A2 ∆A Q1 + Q2What is demand forecasting?Demand forecasting is not a speculative exercise into the unknown. It isessentially a reasonable judgment of future probabilities of the market eventsbased on scientific background. Demand forecasting is an estimate of thefuture demand. It cannot be hundred per cent precise. But, it gives areliable approximation regarding the possible outcome, with a reasonableaccuracy. It is based on the statistical data about past behaviour andempirical relationships of the demand determinants. It is based onmathematical laws of probability. 20
  • 21. What are the criteria of a good forecasting method?Criteria of a good forecasting method:Joel Dean lays down the following criteria of a good forecasting method:Accuracy: Forecast should be accurate as far as possible. Its accuracy mustbe judged by examining the past forecasts in the light of the presentsituation.Plausibility: It implies management’s understanding of the method used forforecasting. It is essential for a correct interpretation of the results.Simplicity:A simpler method is always more comprehensive than thecomplicated one.Economy: It should involve lesser costs as far as possible. Its costs must becompared against the benefits of forecasts.Quickness: It should yield quick results. A time consuming method maydelay the decision making process.Flexibility: Not only the forecast is to be maintained up to date, there shouldbe possibility of changes to be incorporated in the relationships entailed inforecast procedure, time to time.Explain the survey methods of demand forecasting.Market Survey or Opinion Poll:A market survey is also called an opinion survey or opinion poll. Whileconducting an opinion poll, the respondents should be chosen correctly afterascertaining whose opinion is valuable in the matter. For example, in orderto estimate the demand for newly designed electric meters, the opinion of theengineers in the purchase and service departments of electric companies isimportant and not that of the ultimate consumers who have no say in thematter. 21
  • 22. 1. Representative sample: For conducting a survey, a sample population isselected from the total population. It can then be classified into differentgroups, each with its own character. A percentage of each group can besurveyed in order to get varying opinions. The sample population has to beas representative of the total population as possible. The degree of theaccuracy of the survey would depend upon the representative character ofthe sample population.2. A case: A student was asked to find out the image of a big cotton textilemill as her project. The project report including the survey had to becompleted within 60 days without any financial commitment on the part ofthe company under study. A study, under such constraints, would naturallyhave its own limitations. The student chose the method of stratifiedsampling, confined to a big city, the headquarters of the company. Thepopulation was broadly classified into: (i) employees sub-grouped intodifferent strata, taking a few samples from each. (ii) all wholesalers (iii) afew retailers in the city, selected on the basis of their share in sales (iv)customers visiting retail outlets responded to the questionnaire (v) differentstrata of general population, which at one time or the other purchased theproducts of the mill – regrouped according to age, income, education andstatus, selecting a few samples from each group. Within these constraints asample of 200 persons was collected. The results were quite encouraging.Discuss the popular time series analysis techniques used for demandforecasting.Time series analysis:Time series analysis helps to identify: (1) a long-run movement of thevariable; (2) seasonal fluctuations which are oscillatory but confined to oneyear; (3) cyclical movements which are oscillatory and periodic.The values of the movements are repeated between peaks and troughs.A time series is dis-aggregated into four components or elements (i) Trend(T) (ii) Seasonal component (S) (iii) Cycle (C) and (iv) an irregular orrandom component. The first three are systematic while the last one isunsystematic. The residue after eliminating the systematic components fallsin random component.These components can be written in two formsadditive or multiplicative – T+S+C+R OR TSCR. In the additive form it isassumed that there is no interaction among the different componentswhereas in the multiplicative form there is interaction. The multiplicativeform can be written in the additive form by taking the log as “ log y = log T+ log S + log C + log R.” 22
  • 23. A common method of decomposition is to calculate the trend and eliminateit from the original series by dividing throughout as TSCR/T; in the sameway other elements can be separated out. In the additive form an element isremoved by subtracting it from the series.Much depends on the purpose. For example, if the growth rate of a variable,say agricultural production, is to be estimated, calculating the trend equationdirectly may not give the correct results, as agriculture is subject to bothseasonal and cyclical fluctuations. Thus, both the fluctuations are to beremoved first in order to attain better accuracy.The decomposition of time series analysis has certain implicit assumptions:1) the order of removal should be trend, seasonal, and cyclical. If the order ischanged, changed values will result.2) effects are independent of each other; and3) the trend is linear and the cycle is regular.Criticism of the Method: These assumptions have been questioned.Separation of trend and cycle may be dubious as both may be the result ofthe same set of factors. Irregular variations may outweigh the others and thephenomenon of the business cycle may not be very relevant in a plannedeconomy. The decomposition of the time series is an artificial attemptimposed by the analyst. As a descriptive device this may be adequate, but asan explanatory device for isolating different facts, th scheme is seriouslydeficient. It is because, the deterministic hypothesis underlying thesystematic part is open to doubt from the point of view of behaviour ofeconomic agents. Because of these shortcomings, in recent years, theemphasis in the study of time series has shifted to analysis of probabilisticprocesses. 23
  • 24. MONOPOLISTIC COMPETITIONQ. Monopolistic Competition is a blend of perfect competition andmonopoly. Discuss. How is price-output determined under monopolistic competition?Monopolistic competition as the name suggests entails the attributes of bothmonopoly and competition.Following are the main features:Large number of sellers:There are fairly large number of sellers. They sell closely related but notidentical products. The large number of firms in the same line of productionleads to competition. Competition is keen but impure because there is nohomogeneity of products offered. There are less chances of collusionbetween them to eliminate competition and rig prices, as the number is quitelarge.The quantity supplied by an individual firm is relatively small compared tothe total market shared by all the firms. Thus there is very limited degree ofcontrol over the market price by any firm.In determining pricing and output policy, each firm can afford to ignorereaction by rivals. The number of firms being large enough, the impact ofsuch an action by an individual firm, is insignificant.Product Differentiation:The firm’s independence under monopolistic competition, is attributed to thedegree of product differentiation it adopts. It is essentially competition withdifferentiated products. The most distinguishing factor of monopolisticcompetition is that the products are all branded and identified. There is nohomogeneity of products though they may be similar. Through such productdifferentiation, each seller acquires certain degree of monopoly power.Large number of buyers: 24
  • 25. There are numerous buyers. But buyers have preference for specific brands.Buyers are literally patrons of a particular seller. Buying here is by choicenot by chance.Free entry:Entry and exit of buyers is freely possible. There are no barriers. There isunrestricted entry of new firms into the group till it reaches completeequilibrium. This makes the competition stiff because of close substitutesbut with different brand names produced by new entrants. This marketsituation is more similar to perfect competition than monopoly. Owing tounrestricted entry of new firms, abnormal profits are usually competed awayin the long run. Firms will seek to realize pure economic profits once againby advertising and innovatioin in products and processes resorting to non-price competition – competition in product variation as well as increase inadvertising expenditure.Selling costs:Advertising and other forms of sales promotion are an integral part ofmonopolistic competition. These outlays are termed as selling costs. Thiskind of heavy expenditure on sales promotion is because products areidentified and differentiated by their brand names unlike in perfectcompetition, where products are homogenous without brand name, needingno advertisement at all and firms experiencing perfectly elastic demandcurves.Selling efforts are required to effect a shift in demand in order to capture abetter share of the market. Increase in demand is achieved throughadvertisement and sales promotional efforts i.e. by increase in selling costs.Success in achieving this increase, depends on how effective is the productdifferentiation and preference achieved through advertisement.Two dimensional competition:There are two aspects in monopolisitic competition: (1) There cannot be toomuch variation in price and the product has to be competitively prices.Hence price competition. (2) There is non-price competition in terms ofproduct differentiation and spending on selling costs in order to capture abigger share of the market. 25
  • 26. The Group:The firms involved in monopolistic competition are termed as “group” andnot “industry”. A group is a cluster of firms producing very related butdifferentiated products. Monopolistic competition is characterized byproduct differentiation. Firms produce similar but not identical goods. Wecannot conceive of an industry – such as automobile or bicycle industry inan analytical sense – in the monopolistic competition. On account of productdifferentiation, products of each firm, is identifiable and each firm is anindustry in itself, just like a monopoly form.In reality, major companies control a large number of products over a widespectrum of the industrial economy. There are a variety of product groupssuch as , Automobiles, Textiles, Footwear, Soaps and Detergents, Foodsand Beverages, Drugs and Chemicals, Cosmetics, Confectionery, Paper,Electronics, Computers, Cement, Metals and Metal Products, Constructionetc.Q. “A firm under monopolistic competition is a price maker”. Explainhow price is determined under monopolistic competition.“A firm under monopolistic competition is a price maker. Unlike perfectcompetition, there is pricing problem. The firm has to determine a suitableprice for its product which yields maximum total profit. Assuminga givenvariety of products and constant selling outlays, when price is the onlyvariable factory, shortrun analysis of price adjustment, is similar to puremonopoly. The market share of an individual firm in the total market of allthe firms in the group, is insignificant to cause any serious effect on themarket share of others by any downward price revision by the firm toincrease the market share. In the long run, however, a major difference isnoticeable in the equilibrium process, due to entry of new firms competingaway the abnormal profits. This causes change in demand conditions andother factors associated with the process of group equilibrium.Price determinatioin in the shortrun:In the short run, the firm can adopt an independent price policy with leastconsideration for the varieties produced and the prices charged by other 26
  • 27. producers. The firm being rational in determining the price, will seek tomaximize the total profits.There is a definite demand schedule as the quality of the product is given.The product is differentiated. So the demand curve or sales curve isdownward sloping. The demand curve of a firm in monopolistic competitionis more elastic than in pure monopoly.The degree of elasticity depends on the number of firms in the group and theextent of product differentiation. If the number of firms is large, the demandwill be highly elastic, while it will be less elastic if the number is small.In order to maximize its total profits in the short run, the firm produces thatlevel of output at which marginal cost is equal to marginal revenue (MC =MR). Equilibrium output is determined at the point of intersection of MRand MC. Figure:We have assumed the case of a firm with hypothetical cost and revenue datain a monopolistically competitive market. For simplicity sake, it is assumedthat demand and cost conditions are identical for all the firms in the group.These are bold assumptions made by Chamberlin. No doubt theseassumptions very much simplify the model but they are not altogetherunrealistic. In the case of retail shops such as provision stores and chemistshops, standardized products will tend to have more or less identical demandand cost conditions, as their product differentiation is confined to onlylocational differences. 27
  • 28. Equilibrium point E is determined where SMC = SMR, OP price, OQoutput, ‫ ٱ‬PABC profit.Price determination in the Long-run:When firms earn super-normal profits in the short-run, some new firms willbe attracted to enter the business, as the group is open. On account of rivals’entry, the share of the firm in the toal market will be reduced due tocompetition from an increasing number of close substitutes. Gradually, inthe long run, the firm will earn only normal profits.Monopolistic competition implies severe competition between a largenumber of firms producing close substitute products. Hence this marketsituation is more similar to perfect competition than monopoly. Owing to theunrestricted entry of new firms, monopoly profits are usually competedaway in the long run. Consequently, firms will resort to non-pricecompetition i.e. competition in product variation as well as by increasingtheir advertising expenditure (selling costs).OLIGOPOLYOligopoly is a market situation comprising only a few firms in a given lineof production. The price and output polisy of oligopolistic firms areinterdependent. The oligopoly model fits well into such industries asautomobile, manufacure of electrical appliances etc. in our country. In anOligopolistic market, the firms may be producing either homogenousproducts or product differentiation in a given line of production.The following are the distinguishing features of an oligopolistic market:- • Few Sellers : Homogeneous or differentiated products supplied by a few firms. • Interdependence: Firms have a high degree of dependence in their business policies, price and output fixation. • High cross elasticities: Firms under oligopoly have high degree of cross elasticities and are always in fear of retaliation by rivals. Firms consider the possible action and reaction of its competitors while making changes in price or output. 28
  • 29. • Each firm tries to attract customers towards its product by incurring excessive advertisement expenditure. It is only under oligopoly that advertising comes fully into its own. • Constant struggle: Competition in Oligopoly consists of constant struggle of rivals against rivals and is unique. • Lack of uniformity: There is lack of uniformity in the size of different oligopolies. • Lack of certainty: In oligopolistic competition firms hae two conflicting motives – 1) to remain independent in decision making and 2) to maximize profits despite being interdependent. To pursue these ends, they act and react to the price-output variation of one another in an unending atmosphere of uncertainty. • Price rigidity: Each firm sticks to its own price due to constant fear of retaliation from rivals in case of reduction in price. The firm rather resorts to non-price competition by advertising heavily. • Kinked Demand Curve: According to Paul Sweezy, firms in an oligopolistic market, have a kinky demand curve for their products. KINKED DEMAND HYPOTHESIS OF AN OLIGOPOLYMARKET:The kinked Demand Curve or the Average Revenue Curve of an OligopolyFirm, has two segments : 1) the relatively elastic segment and (2) relativelyinelastic segment. 29
  • 30. OUTPUTCorresponding To the given price OP, there is a kink at point K on thedemand curve DD. DK is the elastic segment, while KD is the inelasticsegment of the curve. Kink implies an abrupt change in the slope of thedemand curve.Demand curve is flatter before the kink and steeper after thekink.The kink indicates the indeterminateness of the course or demand for theproduct of the seller concerned. He thinks it worthwhile to follow theprevailing price and not to make any change. In this case, raising of price,would contract sales considerably as demand tends to be more elastic tochange in price. Lower of price, on the otherhand, will lead to retaliationfrom rivals owing to close interdependence of price-output movement in theoligopolistic market. Hence, seller will not expect much rise in sales becauseof price reduction.An important point involved in kinked demand curve is that it accounts forthe kinked average revenue curve to the oligopoly firm. The kinked averagerevenue curve in turn, implies a discontinuous marginal revenue curve MA –BR. Thus, the kinky marginal revenue curve explains the phenomenon ofprice rigidity in the theory of oligopoly prices.In an oligopolistic market, once a general price level is reached, whether bycollusion or by price leadership or through some formal agreement, it tendsto remain unchanged over a long period of time. The price rigidity is onaccount of price interdependence indicated by the kinked demand curve.Discontinuity of the oligopoly firm’s marginal revenue curve at the point ofequilibrium price, the price output combinatioin at the kink tends to remainunchanged even though marginal cost may change. The firm’s marginal costcurve can fluctuate between MC1 and MC2 within the range of the gap inthe MR curve without disturbing the equilibrium price and output position of 30
  • 31. the firm. The price remains the same at the level of OP, and output OQ,despite change in the margin costs.PERFECT COMPETIONWhat are the features of perfect competition? Explain.What are ISOquants? What are their properties? What is the differencebetween ISOquant curve and Indifference curve?‘ISO’ means ‘equal’. ‘quant’ stands for ‘quantity’. The equal product curveis called Iso-quant or ‘production iso-quant’. It represents all thecombinations of two factor inputs which produce a given quantity ofproduct. It signifies a definite measurable quantity of output. Each Iso-quantcurve stands for a specific quantity of output. A number of curves can bedrawn for different specific quantities of output. All these curves togetherform the Iso-quant map.Iso-quant measures a quantum of production resulting from alternativecombinatioin of two variable inputs.Difference between Iso-quant curve and Indifference curve1. Indifference curve refers to two commodities. Iso-quant curve relates tocombination of two factors of production.2. Indifference curve indicates level of satisfaction. Is-quant curve indicatesquantity of output.3. No numerical measurement of satisfaction is possible. So it cannot belabelled. Iso-quant curve can be easily labeled as physical units out output aremeasurable. 31
  • 32. 4. The extent of difference of satisfaction is not quantifiable in theIndifference map. But in Iso-quant map, we can measure the exact differencebetween quantitites represented by one curve and another.Properties of Iso-quants:Isoquants have a negative slope. In order to maintain one level of output,when the amount of one factor is increased, that of the other is decreased. Ateach point on the iso-quant curve, we get a combination of two factors,which give the same level of output.Isoquants are convex to the origin. The slope of the isoquant measures themarginal rate of technical substitution of one factor input (say labour) for theother factor inpur (say capital). MRTS measures the rate of reduction in onefactor for an additional unit of another factor in combination for producingthe same quantity of output. The convexity of the isoquant curve suggeststhat MRTS is diminishing, meaning, when quantity of one factor isincreased, the less of another factor will be given up, keeping the outputconstant.Iso-quants do not intersect. Each Isoquant represents a specific quantum ofoutput. If two Isoquants intersect each other, it would lead to a logicalcontradiction as Isoquant representing a smaller quantity cannot be on a linerepresenting a larger quantity.Isoquants do not intercept either X or Y axis. If an Isoquant touches anyaxis, it means that any one factor can be taken as zero. Since it is notpossible to produce a product with a single factor, Isoquants do not meeteither axis.Iso-quant is an oval shape curve. If relatively small amount of one factor iscombined with relatively large amount of another factor, marginalproductivity tends to be negative resulting in decline in total output. In suchcases, the end portion of the curves are regarded as uneconomical and thecurves are oval shaped.Tangents of Iso-quants in an Iso-quant map represent the loci ofequilibrium when different quantities of output are produced by thefirm at minimum costs under the situation of two variable factor-inputswith their fixed price ratio. 32
  • 33. Solved Problem in Isoquants: Refer to Problems. 33

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