Master of Business Administration

Assignment Set-1
MB0042 Managerial Economics

Name: Richa Bansal Roll No.: Semester-1

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Master of Business Administration - MBA Semester I MB0042 Managerial Economics - 4 Credits (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. Ans A behavioral relationship between quantity consumed and a person's maximum willingness to pay for incremental increases in quantity. It is usually an inverse relationship where at higher (lower) prices, less (more) quantity is consumed. Other factors which influence willingness-to- pay are income, tastes and preferences, and price of substitutes. Demand function specifies what the consumer would buy in each price and wealth situation, assuming it perfectly solves the utility maximization problem. The quantity demanded of a good usually is a strong function of its price. Suppose an experiment is run to determine the quantity demanded of a particular product at different price levels, holding everything else constant. Presenting the data in tabular form would result in a demand schedule. Elasticity of demand is the economists way of talking about how responsive consumers are to price changes. For some goods, like salt, even a big increase in price will not cause consumers to cut back very much on consumption. For other goods, like vanilla ice cream cones, even a modest price increase will cause consumers to cut back a lot on consumption. Elasticity of demand is an elasticity used to show the responsiveness of the quantity demanded of a good or service to a change in its price. More precisely, it gives the percentage change in demand one might expect after a one percent change in price. Elasticity is almost always negative, although analysts tend to ignore the sign even though this can lead to ambiguity. Only goods which do not conform to the law of demand, such as Veblen and Giffen goods have a positive elasticity demand. Goods with a small elasticity demand (less than one) are said to be inelastic: changes in price do not significantly affect demand e.g. drinking water. Goods with large elasticity demands (greater than one) are said to be elastic: even a slight change in price may cause a dramatic change in demand. Revenue is maximized when price is set so as to create a ED of
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exactly one; elasticity demands can also be used to predict the incidence of tax. Various research methods are used to calculate price elasticity, including test markets, analysis of historical sales data and conjoint analysis. There is a neat way of classifying values of elasticity. When the numerical value of elasticity is less than one, demand is said to be inelastic. When the numerical value of elasticity is greater than one, demand is elastic. So elastic demand means that people are relatively responsive to price changes (remember the vanilla ice cream cone). Inelastic demand means that people are relatively unresponsive to price changes (remember salt). An important relationship exists between the elasticity of demand for a good and the amount of money consumers want to spend on it at different prices. Spending is price times quantity, p times Q. In general, a decrease in price leads to an increase in quantity, so if price falls spending may either increase or decrease, depending on how much quantity increases. If demand is elastic, then a drop in price will increase spending, because the percent increase in quantity is larger than the percent decrease in price. On the other hand, if demand is inelastic a drop in price will decrease spending because the percent increase in quantity is smaller than the percent decrease in price. The price elasticity of demand measures how responsive the quantity demanded of a good is to a change in its price. The value illustrates if the good is relatively elastic (PED is greater than 1) or relatively inelastic (PED is less than 1).
A good's PED is determined by numerous factors, these include;

Number of substitutes: the larger the number of close substitutes for the good then the easier the household can shift to alternative goods if the price increases. Generally, the larger the number of close substitutes, the more elastic the price elasticity of demand. Degree of necessity: If the good is a necessity item then the demand is unlikely to change for a given change in price. This implies that necessity goods have inelastic price elasticitys of demand. Price of the good as a proportion of income: It can be argued that goods that account for a large proportion of disposable income tend to be elastic. This is due to consumers being more aware of
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small changes in price of expensive goods compared to small changes in the price of inexpensive goods.
The following example illustrates how to determine the price elasticity of demand for a good.

The price elasticity of demand for supermarket own produced strawberry jam is likely to be elastic. This is because there are a very large number of close substitutes (both in jams and other preserves), and the good is not a necessity item. Therefore, consumers can and will easily respond to a change in price. 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 Ans - 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 pricing decisions, in assessing future capacity requirements, or in making decisions on whether to enter a new market. Often forecasting demand is confused with forecasting sales. But, failing to forecast demand ignores two important phenomena [1]. There is a lot of debate in demand- planning literature about how to measure and represent historical demand, since the historical demand forms the basis of forecasting. The main question is whether we should use the history of outbound shipments or customer orders or a combination of the two as proxy for the demand. Stock effects The effects that inventory levels have on sales. In the extreme case of stock-outs, demand coming into your store is not converted to sales due to a lack of availability. Demand is also untapped when sales for an item are decreased due to a poor display location, or because the desired sizes are no longer available. For example, when a consumer electronics retailer does not display a particular flat-screen TV, sales for that model are typically lower than the sales for models on display. And in fashion retailing, once the stock level of a particular sweater falls to the point where standard sizes are no longer available, sales of that item are diminished. Market response effect The effect of market events that are within and beyond a retailers control. Demand for an item will likely rise if a competitor increases the price or if you promote the item in your weekly circular. The resulting sales increase reflects a change in demand as a result of consumers responding to stimuli that potentially drive additional sales. Regardless of the stimuli, these forces need to be factored into planning and managed within the demand forecast. In this case demand forecasting uses techniques in causal modeling. Demand forecast modeling considers the size of the market and the dynamics of market share versus competitors and its effect on firm demand over a period of time. In the manufacturer to retailer model, promotional
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events are an important causal factor in influencing demand. These promotions can be modeled with intervention models or use a consensus to aggregate intelligence using internal collaboration with the Sales and Marketing functions. 3. The supply of a product depends on the price. What are the other factors that will affect the supply of a product.? A production function is a function that specifies the output of a firm, an industry, or an entire economy for all combinations of inputs. Almost of all macroeconomic theories, like macroeconomic theory, real business cycle theory, neoclassical growth theory (classical and new) presuppose (aggregate) production function. Heckscher-Ohlin-Samuelson theory in international trade theory also presupposes production function. In this sense, production function is one of the key concepts of neoclassical macroeconomic theories. It is also important to know that there is a subversive criticism on the very concept of production function. A production function is a function that specifies the output of a firm, an industry, or an entire economy for all combinations of inputs. A meta-production function (sometimes met production function) compares the practice of the existing entities converting inputs X into output y to determine the most efficient practice production function of the existing entities, whether the most efficient feasible practice production or the most efficient actual practice production.[1] In either case, the maximum output of a technologically-determined production process is a mathematical function of input factors of production. Put another way, given the set of all technically feasible combinations of output and inputs, only the combinations encompassing a maximum output for a specified set of inputs would constitute the production function. Alternatively, a production function can be defined as the specification of the minimum input requirements needed to produce designated quantities of output, given available technology. It is usually presumed that unique production functions can be constructed for every production technology. By assuming that the maximum output technologically possible from a given set of inputs is achieved, economists using a production function in analysis are abstracting away from the engineering and managerial problems inherently associated with a particular production process. The engineering and managerial problems of technical efficiency are assumed to be solved, so
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that analysis can focus on the problems of allocative efficiency. The firm is assumed to be making allocative choices concerning how much of each input factor to use, given the price of the factor and the technological determinants represented by the production function. A decision frame, in which one or more inputs are held constant, may be used; for example, capital may be assumed to be fixed or constant in the short run, and only labour variable, while in the long run, both capital and labour factors are variable, but the production function itself remains fixed, while in the very long run, the firm may face even a choice of technologies, represented by various, possible production functions. The relationship of output to inputs is non-monetary, that is, a production function relates physical inputs to physical outputs, and prices and costs are not considered. But, the production function is not a full model of the production process: it deliberately abstracts away from essential and inherent aspects of physical production processes, including error, entropy or waste. Moreover, production functions do not ordinarily model the business processes, either, ignoring the role of management, of sunk cost investments and the relation of fixed overhead to variable costs. (For a primer on the fundamental elements of microeconomic production theory, see production theory basics). The primary purpose of the production function is to address allocative efficiency in the use of factor inputs in production and the resulting distribution of income to those factors. Under certain assumptions, the production function can be used to derive a marginal product for each factor, which implies an ideal division of the income generated from output into an income due to each input factor of production. Q.4 Show how producers equilibrium is achieved with isoquants and isocost curves. Ans - Economies of scale external to the firm (or industry wide scale economies) are only considered examples of network externalities if they are driven by demand side economies. In many industries, the production of goods and services and the development of new products requires the use of specialized equipment or support services. An individual company does not provide a large enough market for these services to keep the suppliers in business. A localized industrial cluster can solve this problem by bringing together many firms that provide a large
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enough market to support specialized suppliers. This phenomenon has been extensively documented in the semiconductor industry located in Silicon Valley. Labor Market Pooling A cluster of firms can create a pooled market for workers with highly specialized skills. It is an advantage for: Producers They are less likely to suffer from labor shortages. Workers They are less likely to become unemployed. Knowledge Spillovers Knowledge is one of the important input factors in highly innovative industries. The specialized knowledge that is crucial to success in innovative industries comes from: Research and development efforts Reverse engineering Informal exchange of information and ideas As firms become larger and their scale of operations increase they are able to experience reductions in their average costs of production. The firm is said to be experiencing increasing returns to scale. Increasing returns to scale results in the firm's output increasing at a great proportion than its inputs and hence its total costs. As a consequence its average costs fall. Thus initially the firm's long run average cost curve slopes downward as the scale of the enterprise expands. The firm enjoys benefits called internal economies of scale. These are cost reductions accruing to the firm as a result of the growth of the firm itself. (An external economy of scale is a benefit that the firms experience as a result of the growth of the industry.) After the firm has reached its optimum scale of output, where the long run average cost curves are at their lowest point, continued expansion means that its average costs may start to rise as the firm now experiences decreasing returns to scale. The long run average cost curve therefore

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starts to curve upwards. This occurs because the firm is now experiencing internal diseconomies of scale.
Types of internal economies of scale Types of internal economies of scale Financial The farm has been able to gain loans and assistance at preferential interest rates from the EIB, World Bank and the EU Marketing It has managed to dedicate resources to its strategy of niche marketing Technical The access to finance has allowed it to invest in sophisticated Israeli irrigation technology Managerial It large size enables it to employ specialised personnel such as estate managers Risk bearing The farm has used some of its land to diversify into producing fresh vegetables for export as well as continue producing maize. These large scale farms are attracting a considerable amount of overseas development aid funding from organisations such as the World Bank and the European Union as they are see as being an integral part of the export earning capacity of the country.

Q.5 Discuss the full cost pricing and marginal cost pricing method. Explain how the two methods differ from each other . Ans - The profit maximization principle stresses on the fact that the motive of business firms to maximize profit is solely justified as being a method of maximizing the income of their shareholders. Firms may maximize profit by maximizing sales, stock price, market share or cash flow. In order to achieve maximum profit the firm needs to find out the point where the difference between total revenue and total cost is the highest. The rules that apply for profit maximization are: i. increase output as long as marginal profit increases ii. Profit will increase as long as marginal revenue (MR) > marginal cost (MC) iii. Profit will decline if MR < MC iv. Summing up (ii) and (iii), profit is maximized when MR = MC
Profit Maximization model means a scenario where the business is ruined by the motive of profit making and keep the cost low.

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The business firm is the productive unit in an exchange economy. In order to survive, a firm must deal with three constraints: the demand for its product, the production function, and the supply of its inputs. When the firm successfully deals with these constraints, it makes a profit. These readings explore the assumption that firms maximize profits, pointing out some of the ambiguities of this assumption. It then explores how the rules of maximization apply to the firm. It considers two ways in which the maximization principle can be used: to determine the proper levels of inputs or to determine the proper level of output. The first leads to the rule that marginal resource cost should equal marginal revenue product, and the second to the rule that marginal cost should equal marginal revenue. The readings show that these two rules are equivalent and simply represented different ways of using the information from the three constraints that a firm faces. Much of this material is quite technical, but it is at the core of microeconomics.
Profit is maximized where MR = MC. Profit maximization rule: Produce until the point where the change in revenue from producing 1 more unit equals the change in cost from producing 1 more unit. Why? Suppose MR > MC. If I produce 1 more unit, my revenues increase by more than my costs.

Therefore, if MR > MC, producing more will increase my profit. If I can increase my profit by changing how much I produce, then when producing where MR > MC can't be profitmaximizing. Suppose MR < MC. If I produce 1 less unit, my revenues decrease by less than my costs decrease. Therefor, if MR < MC, I can increase profit by decreasing output. If I can increase profit when MR < MC, then choosing q such that MR < MC can not be profit-maximizing.
So, in order to maximize profit, I must choose a quantity q such that MR = MC. MR = MC is an equilibrium in the sense that it is the only place where there is no incentive to change the production level.

This rule, the profit maximization rule, is just an application of the marginal principle (MB = MC). Why? This MB of producing an extra unit is the extra revenue you get. MR is the MB. So the 2 statements are equivalent. The marginal principle is more general, and the profit maximization rule is specific to the firm production decision.

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Q.6 Discuss the price output determination using profit maximization under perfect competition in the short run. Ans - There is a predictable relationship between revenue and elasticity. Depending on PED, one may raise revenue either by increasing prices and sacrificing quantity or by reducing them and outputting more. Revenues or revenue is income that a company receives from its normal business activities, usually from the sale of goods and services to customers. In many countries, such as the United Kingdom, revenue is referred to as turnover. Some companies receive revenue from interest, dividends or royalties paid to them by other companies. In general usage, revenue is income received by an organization in the form of cash or cash equivalents. Sales revenue or revenues is income received from selling goods or services over a period of time. Tax revenue is income that a government receives from taxpayers. In more formal usage, revenue is a calculation or estimation of periodic income based on a particular standard accounting practice or the rules established by a government or government agency. Two common accounting methods, cash basis accounting and accrual basis accounting, do not use the same process for measuring revenue. Corporations that offer shares for sale to the public are usually required by law to report revenue based on generally accepted accounting principles or International Financial Reporting Standards. Revenues from a business's primary activities are reported as sales, sales revenue or net sales. This excludes product returns and discounts for early payment of invoices. Most businesses also have revenue that is incidental to the business's primary activities, such as interest earned on deposits in a demand account. This is included in revenue but not included in net sales. Sales revenue does not include sales collected by the business. Other revenue (a.k.a. non-operating revenue) is revenue from peripheral (non-core) operations. For example, a company that manufactures and sells automobiles would record the revenue from the sale of an automobile as "regular" revenue. If that same company also rented a portion of one of its buildings, it would record that revenue as other revenue and disclose it separately on its income statement to show that it is from something other than its core operations. A firm considering a price change must know what effect the change in price will have on total revenue. Generally any change in price will have two effects: the price effect: an increase in unit price will tend to increase revenue, while a decrease in price will tend to decrease revenue. The quantity effect: an increase in unit price will tend to lead to fewer units sold, while a decrease in
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unit price will tend to lead to more units sold. Because of the inverse nature of the price-demand relationship the two effects offset each other; in determining whether to increase or decrease prices a firm needs to know what the net effect will be. Elasticity provides the answer. In short, the percentage change in revenue is equal to the change in quantity demanded plus the percentage change in price. In this way, the relationship between PED and revenue can be described for any particular good: When the price elasticity of demand for a good is perfectly inelastic (Ed = 0), changes in the price do not affect the quantity demanded for the good; raising prices will cause revenue to increase. When the price elasticity of demand for a good is inelastic (|Ed| < 1), the percentage change in quantity demanded is smaller than that in price. Hence, when the price is raised, the total revenue of producers rises, and vice versa. When the price elasticity of demand for a good is unit elastic (or unitary elastic) (|Ed| = 1), the percentage change in quantity is equal to that in price and a change in price will not affect revenue. When the price elasticity of demand for a good is elastic (|Ed| > 1), the percentage change in quantity demanded is greater than that in price. Hence, when the price is raised, the total revenue of producers falls, and vice versa. When the price elasticity of demand for a good is perfectly elastic (Ed is infinite i.e. undefined), any increase in the price, no matter how small, will cause demand for the good to drop to zero. Hence, when the price is raised, the total revenue of producers falls to zero.
Hence, to maximize revenue, a firm ought to operate close to its unit-elasticity price

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