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# Managerial economics

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### Managerial economics

1. 1. Managerial Economics Q1) Write short notes on any TWO of the following i.Cost output relationship in the long run and short run Cost-output relationship has 2 aspects:  Cost-output relationship in the short run,  Cost-output relationship in the long run The Short Run is a period which doesn’t permit alterations in the fixed equipment (machinery, building etc.) & in the size of the organization. The Long Run is a period in which there is sufficient time to alter the equipment (machinery, building, land etc.) & the size of the organization, output can be increased without any limits being placed by the fixed factors of production Short Run may be studied in terms of  Average Fixed Cost  Average Variable Cost  Average Total cost Total, average & marginal cost Total cost (TC) = TFC + TVC, rise as output rises Average cost (AC) = TC/output Marginal cost (MC) = change in TC as a result of changing output by one unit Fixed cost & variable cost Total fixed cost (TFC) = cost of using fixed factors = cost that does not change when output is changed Total variable cost (TVC) = cost of using variable factors = cost that changes when output is changed, Average Fixed Cost and Output The greater the output, the lower the fixed cost per unit, i.e. the average fixed cost. Total fixed costs remain the same & do not change with a change in output. Average Variable Cost and output The average variable costs will first fall & then rise as more & more units are produced in a given plant. Variable factors tend to produce somewhat more efficiently near a firm‟s optimum output than at very low levels of output. Greater output can be obtained but at much greater average variable cost, E.g. if more & more workers are appointed, it may ultimately lead to overcrowding, moreover, workers may have to be paid higher wages for overtime work. Average Total cost and output Average total cost, also known as average costs would decline first & then rise upwards. Managerial Economics Page 1
2. 2. Average cost consists of average fixed cost plus average variable cost. Average fixed cost continues to fall with an increase in output while avg. variable cost first declines & then rises. So, as average variable cost declines the average total cost will also decline. But after a point the average variable cost will rise. When the rise in AVC is more than the drop in average fixed costthe average total cost will show a rise. Cost-output Relationship In The Long-Run Long run period enables the producers to change the entire factor & he will be able to meet the demand by adjusting supply. Change in Fixed factors like building, machinery, managerial staff etc.. All factors become variable in the long run. In the long run we have only 3 costs i.e. total cost, Average cost & Marginal Cost Total cost (TC) = TFC + TVC, rise as output rises Average cost (AC) = TC/output Marginal cost (MC) = change in TC as a result of changing output by one unit When all the short run situations are combined, it forms the long run industry. During the Short Run, demand is less & the plant‟s capacity is limited. When demand rises, the capacity of the plant is expanded. When Short Run average cost curves of all such situations are depicted, we can derive a long run cost curve out of that. Managerial Economics Page 2
3. 3. We can make a Long Run cost curve by joining the tangency points of all Short Run curves We use long run costs to decide scale issues, for example mergers. In the long run, we can build any size factory we wish, based on anticipated demand, profits, and other considerations. Once the plant is built, we move to the short run. Therefore, it is important to forecast the anticipated demand. Too small a factory and marginal costs will be high as the factory is stretched to over produce. Conversely too large a factory results in large fixed costs (e.g.. air conditioning, or taxes) and low profitability. ii.Law of diminishing marginal utility The law of diminishing marginal utility describes a fundamental tendency of human behavior. As a consumer consumes more and more of units of a specific commodity, the utility value from the successive units goes on diminishing, in other words, the incremental utility value of the successive units will be diminishing to the extent of becoming non incremental. The law of diminishing marginal utility is based upon three facts  Total wants of a consumer are unlimited, but each single want can be satisfied. As a consumer gets more and more units of a commodity, his desire for the said goods witnesses a fall, ie. It reaches a point where the consumer no longer wants anymore Managerial Economics Page 3
4. 4. units of that good, primarily since the utility value of the good move towards a nonincremental phase from an incremental phase  Different goods are not perfect substitutes for each other in the satisfaction of various particular wants. As such leading to decrement in the marginal utility value as the consumer continues to get additional units of a specific good  The marginal utility value of the money is a constant given the consumers wealth The basis of this law is the fundamental feature of wants. It states that when people go to a market for the purchase of commodity, they do not attach equal importance to all the commodities which they are exposed to or which they end up buying. While at the same time, there are some commodities, for which the consumers are willing to pay more (a premium). There are two primary reasons for this difference in demand  The liking of the consumer for the commodity (which depends on the consumers then need – more need based most of the times)  The quantity of the commodity which the consumer has with himself The more consumer commodity, he would its additional the has a the less prefer units. The customer across the counter says “I ate one hamburger, and it tasted great. The next two tasted okay. I wish I hadn’t have eaten the 5th. I can’t finish the 6th” It explains that the UTILITY (Satisfaction) value decreases as more of the same product is consumed Managerial Economics Page 4
5. 5. Q2) Managerial economics studies the application of micro economic theory on business decision making in macro-economic environment. Discuss. In the world of business, succeeding means winning, in the marketplace. From CEO‟s of large corporations to managers of small, privately held companies & even nonprofit institutions cannot expect to succeed in business without a clear understanding of how market forces create both opportunities and constraints for business enterprise. Economic forces in the marketplace determine the demand for products, the prices of resources and costs for production, the number of rival firms, the nature of pricing strategy and ultimately the profitability of business investments. While it is certainly true that managers most constantly be aware of new developments in the marketplace, the economic way of thinking about business decisions making is timeless. Managerial economics provides a systematic and logical way of analyzing business decisions, both for today and tomorrow. Instead of presenting a detailed list of rules for specific decision making problems, such as how to design a successful automobile advertising campaign or how to obtain venture capital, managerial economics addresses the larger economic forces that shape both day-to-day operations and long run planning decisions. Managerial economics focuses on the application of micro-economic theory to business problems. Micro-economics is the study and analysis of the behavior of individual segments of the economy, individual consumers, workers & owners of resources, individual firms, industries and markets for goods and services. Micro-economics is concerned with topics such as how consumer choose the goods and services they purchase and how firms make hiring, pricing, production, advertising, R&D and investment decisions. Although economic theory is not the only tool used by successful managers, it is a powerful and essential tool, which may lead to the success of the business decision making – while at the same time, the success or failure of the business decision making is highly dependent on the mangers understanding or lack of understanding of fundamental economic relations. Managerial economics provides a systematic and logical way of analyzing business decisions that focuses on the economic forces that shape both day-to-day decisions and long run planning decisions. Managerial economic applies micro-economic theory, a study of the behavior of individual economic agents to business problems in order to teach business decision makers how to use economic analysis to make decisions that will achieve the firm‟s goal(s). The economic theory helps managers better understand real-world business problems by reducing business decision to their most essential components and then applying economic reasoning to reach profit-enhancing conclusions. Q3) Bring out the different methods of demand forecasting It is very important for any business firm to project accurate demand forecast so as to enable the firm to produce the required quantities well in advance by arranging factors of production. The vast majority of business decisions involve some degree of uncertainty Managerial Economics Page 5
6. 6. Managers seldom know exactly what the outcomes of their choices will be. One approach to reducing the uncertainty associated with decision making is to devote resources to forecasting. Forecasting involves predicting future economic conditions and assessing their effect on the operations of the firm. Demand forecasting is a specific type of forecasting, which enables the manager to minimize element of risk and uncertainty. The likely future event has to be given form and content in its order, intensity and duration, he can predict the future. If he is concerned with the course, in like of future variables like demand, price or profit, he can project the future. Different methods of Forecasts     Market Survey Studies The Collective Opinionalso called asSales Force Polling or Expert Opinion polls Analysis of Time Series and Trend Projections Use of Economic Indicators – Regression Analysis and Economic Model Building Market Survey Studies The most direct method of estimating demand in the short-run is to ask customers what they are planning to buy for the forthcomingtime period – usually a year. This is very useful when bulk of the sales is to industrial producers. Here the burden of forecasting is shifted to the consumer.In this method, customers may tend to exaggerate their requirements. Customers are numerous, making the method too laborious, impracticable and costly. This method “does not expose and measure the variables under the management‟s control”. Collective Opinion or Sales Force Polling or Expert Opinion PollsSalesmen are required to estimate expected sales in their territories.Salesmen being the closest to the customers, have most intimate feel of the market. The estimates of individual salesmen are consolidated to find out the total estimated sales.These estimates are reviewed to eliminate the bias of optimism orpessimism. Thereafter they are further revised in the light of factors proposed change in prices, product design, advertising budget, expected change in competition, changes in purchasing power, income distribution, employment, population etc.The final forecast will emerge after all these factors are taken into account.The method is known as collective opinion; it takes advantage of the collective wisdom of salesmen, departmental heads like production manager, sales manager, marketing manager, managerial economistand top executives, as well as dealers and distributors. Analysis of Time Series and Trend Projections A firm which has been in existence for some time, will have accumulated data on sales pertaining to past time periods. Such data when arranged chronologically yield „time series‟. Time series of sales represent the past pattern of effective demand for a particular product. Such data can be presented graphically or in tabular form. The most popular method of analysis of time series is to project the trend of the time series data. A trend line can be fittedthrough a series either visually or by means of statistical techniques such as method of least squares. Use of Economic Indicators – Regression Analysis and Economic Model Building Managerial Economics Page 6
7. 7. The analyst chooses a plausible algebraic relation (linear, quadratic, logarithmic, etc.) between sales& the independent variable, time. The trend line is then projected into the future by extrapolation.This method is popular because it is simple and inexpensive. The basic assumption is that the past rate of change will continue in the future. Thus the technique yields acceptable results so long as the time series shows a persistent tendency to move in the same direction.The real challenge in forecasting is in the prediction of turning pointsrather than trends. Four sets of factors influence the time series – trend, seasonal variations, cyclical fluctuations and irregular or random forces. The basic approach is to treat the original time series data as (O) observed data as composed of four parts: secular trend (T), seasonal factor (S), cyclical element (C) and an irregular movement (I). It is assumed that the elements are bound in multiplicative relationship. The trend and seasonal factor can be forecast but the prediction of cycles is hazardous as there is no regularity in its behavior There are two assumptions in this approach:  The analysis of movements would be in the order of trend, seasonal variations and cyclical changes;  The effects of each component are independent of each other Use of Economic Indicators The use of this approach bases demand forecasting on certain economic indicators following these steps:  See whether a relationship exists between demand for the product and the economic indicator  Establish the relationship through the method of least squares and derive the regression equation. Assuming the relationship to be linear, the equation will be Y = a + bx  Once the regression equation is derived, the value ofY i.e. demand can be estimated for any given value of x Various steps to be followed in our approach to Forecasting  Identify and clearly state the objectives of forecasting – long-term, short-term, market share or industry as a whole.  Select appropriate method of forecasting  Identify variables affecting demand for the product and express them in appropriate forms.  Gather relevant data or approximations to relevant data to represent the variables  Through the use of statistical techniques, determine the most probable relationship between he dependent and independent variables  Prepare the forecast and interpret the results  For forecasting company‟s share in the demand, two different assumptions are made: o Ratio of company‟s sales to industry‟s sale will continue as in the past o On the basis of analysis of likely competition ad industry trends, company may assume a different market share o It is advisable to have two different forecastsbased on these two assumptions Managerial Economics Page 7
8. 8.  Forecast may be either in physical units or in rupee sales. Re sales may be converted to physical units dividing by sale price  Forecasts may be made in terms of product groups and then subdivided into individual products based on past percentage  Fore can be made on annual basis and subdivided month wise.  For month wise break-up of new products o Statistics of other firm‟s data, if available, may be made use of or o Some survey may be necessary. Q4) Explain the concept of production function. The term production means a process by which resources are transformed into a different more useful commodity or service. In general, production means transforming inputs into an output.In the economic sense production process may take a variety of forms other than manufacturing. For example transferring a commodity from one place to another where it can be used in the process of production is production Production function is a tool of analysis used to explain the input-output relationship. A production function describes the technological relationship between inputs and output in physical terms. In its general, it tells that production of a commodity depends on certain specific inputs. In its specific form, it represents the quantitative relationship between inputs and outputs. Accordingly there are 2 kinds of production functions  Short run production function  Long run production function Short run production functionrefers to that period of time in which the level of usage of one or more of the inputs in fixed. Therefore, in short run, changes in output must be accomplished exclusively by changes in the use of the variable inputs. Thus if producers wish to expand output in the short Run, they must do so by using more hours of labor which is a variable service and other variable inputs with the existing plant and equipment. Similarly if they wish to reduce output in the short run, they may discharge only certain inputs. It is expressed as Q = f(L, K) Where, the bar over K (capital) means that it is fixed. Since capital is fixed, output methods depends only on the level of usage of labor, so we could write the short run production simply as Q = f(L) Long run production functionrefers to that time in the future when all inputs are variable inputs. Thus in the long run output can be varied by changing the levels of both labor and capital and the long run production function is express as Q = f(L, K) Managerial Economics Page 8
9. 9. On a firm purchases and installs a particular amount of capital, however, it then operates in a short-run situation with the now fixed amount of capital. Thus in a sense, the long run consists of all possible short-run situations from which a firm may choose. For this reason, long-run production period is also called the firms planning horizon. A firm‟s long run planning horizon is the collection of all possible short run situations the firm may face. One short run situation for each level of capital, that can be chosen in the long run. Hence, naturally, in the long run a manager will choose the most advantageous amount of capital for its intended output, but as the changes in production levels occur in the short run, the firm may find itself with too much or too little capital. Managerial Economics Page 9