Course

Managerial Economics

Course Code

5580

Teacher Name

Miss Saira Ahmed Awan

Semester

spring 2012

Assignment No.

01

Submitted By

Atif Attique

Roll Number

AP508210

Q. 1 (a)

Discuss the fundamental nature of management economies with respect to the three choice problems of the economy.

A close relationship between management and economics has led to the development of managerial economics. Management is the

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guidance, leadership and control of the efforts of a group of people towards some common objective. While this description does inform about the purpose or function of management, it tells us little about the nature of the management process. Koontz and ODonnell define management as the creation and maintenance of an internal environment in an enterprise where individuals, working together in groups, can perform efficiently and effectively towards the attainment of group goals. Thus, management is:

Coordination An activity or an ongoing process A purposive process An art of getting things done by other people.

On the other hand, economics as stated above is engaged in analyzing and providing answers to manifestations of the most fundamental problem of scarcity. Scarcity of resources results from two fundamental facts of life:

Human wants are virtually unlimited and insatiable, and Economic resources to satisfy these human demands are limited.

Thus, we cannot have everything we want; we must make choices broadly in regard to the following:

What to produce? How to produce? and For whom to produce?

These three choice problems have become the three central issues of an economy. Economics has developed several concepts and analytical tools to deal with the question of allocation of scarce resources among competing ends. The non-trivial problem that needs to be addressed is how an economy through its various institutions solves or answers the three crucial questions posed above. There are three ways by which this can be achieved. One, entirely by the market mechanism, two entirely by the government or finally and more reasonably by a combination of the first two approaches. Realistically all economies employ the last option, but the relative roles of the market and government vary across countries. According to the central deduction of economic theory, under certain conditions, markets allocate resources efficiently. Efficiency has a special meaning in this context. The theory says that markets will

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produce an outcome such that, given the economys scarce resources, it is impossible to make anybody better-off without making somebody else worse-off. (b) Managerial Economics serves as a link between traditional economics and decision making sciences. Discuss. Managerial economics is the science of directing scarce resources to manage cost effectively. Definition: 1. Managerial Economics is the use of economic modes of thought to analyse business solutions, McNair and Merriam. 2. Managerial Economics is the integration of economic theory with business practice for the purpose of facilitating decisionmaking and forward planning by management, Spencer and Siegel man. Common features of Managerial Economics: 1. 2. 3. 4. 5. M.E. is concerned with decision-making of economic nature. M.E. is goal-oriented and prescriptive. M.E. is pragmatic (realistic). M.E. is both conceptual and metrical. Managerial Economics is concerned with analysis which is prescriptive or normative in nature. 6. M.E. provides a link between traditional economics and the decision sciences for managerial-decision making.

Decision Problem Traditional Economics M.E. Decision Sciences

Optimal solution to business problems

Nature of Managerial Economics: -3-

Managerial economics is micro-economic in character, where the unit of study is a firm; Managerial economics is concerned with normative microeconomics not with positive micro-economics. Managerial economics concentrates on making economic theory more application-oriented. Managerial economics takes the help of macro-economic also so as to understand the external conditions which are relevant to business.

Scope of Managerial Economics: Objectives of a business firm Demand Analysis and Demand Forecasting Risk Analysis Production and Cost Competition Pricing and Output Profit Investment and Capital Budgeting Product policy, Sales promotion and Market Strategy Role of Managerial Economist in Business: After conducting a survey of British Industry, Alexander and Kemp concluded the functions of managerial economists as below: Demand Forecasting Production Scheduling Economic Analysis of the Industry Investment Appraisal Security Management Analysis Advice on Foreign Exchange Management Advice on trade Pricing and Related decisions Analyzing and forecasting environmental factors Managerial Economics and other disciplines Managerial Economics vs. Economics: Economics is the conceptual and fundamental counterpart of managerial economics Both economics and managerial economics are dealing with the problems of scarcity and allocation of resources The two major contributions of economics to managerial economics are:

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 To help in understanding the market conditions and general economic environment within which a firm operates. To provide a philosophy to understand and analyze resource allocation problems Managerial economics takes the help of economics and other business studies to deal with technical and economic efficiencies. Managerial Economics vs. Operations Research: Both are aimed at taking effective and rational decisions from a set of alternatives Managerial economics is a fundamental academic subject which seeks to understand and analyze problems of business decisionmaking. Operations research, on the other hand, is the functional activity carried out by specialists to help the manager to solve various decision problems Both managerial economics and operations research are concerned to model building. While managerial economics build models which are general and confined to broad economic decision-making, operations research models draw from various disciplines and are more job oriented. Some of the operations research models like queuing and linear programming are widely used in managerial economics. Comparing to Managerial Economics Operations research is often expensive and time-consuming so it must be applied only to those decision problems where the time and money spend are worth of it. Managerial Economics vs. Mathematics and Statistics Managerial Economics and the theory of decision making Basic economic concepts in ME: >> >> >> >> >> >> >> Incremental reasoning concept Marginal analysis Discounting principle Opportunity cost Time perspective Short run and long run Scarcity Uncertainty and risk Discuss the problem of moral hazard. Explain why moral hazard might be a problem in Insurance markets, and how private auto Insurance companies minimize moral hazard?

Q. 2 (a)

Moral Hazard

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Definition: Moral hazard is a situation in which one agent decides on how much risk to take, while another agent bears (parts of) the negative consequences of risky choices. Typical case: insurance. The person who buys an insurance is protected against monetary damages. Therefore, he may engage in more risky behavior than if he has to bear the risk himself. A moral hazard problem requires that there is asymmetric information after signing the contract, so that contracted payments cannot be conditioned on events that are only known to one of the parties. Asymmetric information may concern (i) The actions of the party who is insured. These actions cannot be fully observed or verified by the insurance (hidden action). (ii) The state of the world that influences the outcome of the actions of the insured person. The insured could respond to such events in order to minimize risk, but may lack an incentive to do so. Example: Insurance against theft of a bicycle without deductable. (i) The insured person buys a cheap lock that can be broken easily and, thus, raises the risk of the bicycle being stolen. (ii) The insured person knows that in certain street bicycles get stolen quite frequently, but leaves his bike there anyway. Examples from macroeconomics: Unemployment insurance with full payment of the former wage. Insured person has lower incentive to provide effort in his job or to find a new job, after becoming unemployed. Solutions of moral-hazard problems in insurance industry: - Some risks cannot be insured. - Deductable: if the insured person must cover a part of the damage himself, he has higher incentive to avoid risk. - Deductable + risk aversion: if the insured person is risk averse, even a small co-payment may be sufficient to eliminate moral hazard problems. The name comes originally from the insurance industry. Insurance companies worried that protecting their clients from risks (like fire, or car accidents) might encourage those clients to behave in riskier ways (like smoking in bed or not wearing seat belts). This problem may inefficiently discourage those companies from protecting their clients as much as the clients would like to be protected. Economists argue that this inefficiency results from information asymmetry. If insurance companies could perfectly observe the actions of their clients, they could deny coverage to clients choosing risky actions (like smoking in bed or not wearing seat belts), allowing them to provide thorough protection against risk (fire, accidents) without encouraging risky behavior. However, since insurance -6-

companies cannot perfectly observe their clients' actions, they are discouraged from providing the amount of protection that would be provided in a world with perfect information. Economists distinguish moral hazard from adverse selection, another problem that arises in the insurance industry, which is caused by hidden information rather than by hidden actions. The same underlying problem of non-observable actions also affects other contexts besides the insurance industry. It also arises in banking and finance: if a financial institution knows it is protected by a lender of last resort, it may make riskier investments than it would in the absence of this protection. In insurance markets, moral hazard occurs when the behavior of the insured party changes in a way that raises costs for the insurer, since the insured party no longer bears the full costs of that behavior. Because individuals no longer bear the cost of medical services, they have an added incentive to ask for pricier and more elaborate medical service, which would otherwise not be necessary. In these instances, individuals have an incentive to over consume, simply because they no longer bear the full cost of medical services. Two types of behavior can change. One type is the risky behavior itself, resulting in a before the event moral hazard. In this case, insured parties behave in a more risky manner, resulting in more negative consequences that the insurer must pay for. For example, after purchasing automobile insurance, some may tend to be less careful about locking the automobile or choose to drive more, thereby increasing the risk of theft or an accident for the insurer. After purchasing fire insurance, some may tend to be less careful about preventing fires (say, by smoking in bed or neglecting to replace the batteries in fire alarms). A second type of behavior that may change is the reaction to the negative consequences of risk, once they have occurred and once insurance is provided to cover their costs. This may be called ex post (after the event) moral hazard. In this case, insured parties do not behave in a more risky manner that results in more negative consequences, but they do ask an insurer to pay for more of the negative consequences from risk as insurance coverage increases. For example, without medical insurance, some may forgo medical treatment due to its costs and simply deal with substandard health. But after medical insurance becomes available, some may ask an insurance provider to pay for the cost of medical treatment that would not have occurred otherwise. -7-

Sometimes moral hazard is so severe it makes insurance policies impossible. Coinsurance, co-payments, and deductibles reduce the risk of moral hazard by increasing the out-of-pocket spending of consumers, which decreases their incentive to consume. Thus, the insured have a financial incentive to avoid making a claim. John Nyman suggests that two types of moral hazard exist: efficient and inefficient moral hazard. Efficient moral hazard is the viewpoint that the over consumption of medical care brought forth by insurance does not always produce a welfare loss to society. Rather, individuals attain better health through the increased consumption of medical care, making them more productive and netting an overall benefit to societal welfare. Also, Nyman suggests that individuals purchase insurance to obtain an income transfer when they become ill, as opposed to the traditionalist stance that individuals diversify risk via insurance.
(b) Analyze monitoring systems and incentive schemes to resolve moral hazard.

Monitoring systems and incentive schemes (a) Complementary approaches to resolve moral hazard: monitoring systems (e.g., time clock, vehicle log, random checks by supervisors, customer reports) and incentive schemes. (b) Incentive schemes align incentives of the party subject to moral hazard with those of the less-informed party by tying payments to some observable measure of performance. They depend on: i. A link between the unobservable action and some observable measure of performance. ii. Information provided by monitoring systems. (c) Performance pay is an incentive scheme that bases pay on some measure of performance (e.g., a commission per delivery). i. An incentive scheme is stronger (resulting in higher level of workers effort) if it provides a higher personal marginal benefit for effort. (d) A performance quotas a minimum standard of performance (set at the economic efficient level of effort, e.g., minimum number of deliveries), below which penalties (e.g., deferral of promotion, pay reduction, dismissal) apply. i. A performance quota is cost effective. It does not reward effort below or above the economically efficient level. (e) An economically efficient scheme (one that maximizes net benefit) must balance the incentive for effort with the cost of risk. i. Risk arises whenever incentives are based on an indicator that depends on extraneous factors (deliveries made by a delivery person depends on traffic, weather, customers orders...etc.) and the party

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subject to moral hazard has imperfect information about those extraneous factors. ii. The costs of risk depend on 3 factors: (1).The structure of the incentive scheme: the stronger the scheme, the higher the risk to the party subject to moral hazard. (2).The degree of risk aversion of the party subject to moral hazard, and (3).The importance of extraneous factors: when the indicator is sensitive to these factors and the factors are subject to wide swings, the higher the risk. Note: Incentive schemes based on relative performance (e.g., fixed pay plus a commission for each delivery above an average level) are an effective way of reducing risk due to common extraneous factors (whose effect is cancelled out to the extent they affect all workers equally). iii. Stronger schemes should be adopted when the party subject to moral hazard is less risk adverse and extraneous factors are weaker. (f) A party may be subject to moral hazard with respect to multiple responsibilities, i.e., when one partys multiple actions (as opposed to a single action) affect but are not observed by another party with whom it has a conflict of interest. i. An incentive scheme should balance the multiple responsibilities: monitoring each of the unobservable actions and with incentives based on each of the corresponding indicators. ii. An incentive scheme that focuses on one responsibility may aggravate moral hazard associated with other functions. iii. When there are responsibilities for which it is difficult to measure performance, a deliberate use of weak incentives is a way to achieve the necessary balance among responsibilities. Q. 3 (a) The main determinant of elasticity is the availability of substitutes. Explain this statement in the context of price elasticity of demand.

Given the significance of price elasticity of demand, it is important to know how responsive demand is to price changes. For our gas station operator considering a price increase, it would matter a good deal if the elasticity was -.5 rather than -2. As we will see in the section on revenue, if the elasticity were -.5, then the price hike would raise total revenue while if it were -2, the price hike would lower revenues. In one case the strategy is a win - in the other it is a loss. The bad news is that it is not easy to estimate elasticity of demand. The good news is that there are some rules of thumb that we can use to get a handle on elasticity.

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Availability of substitutes affects price elasticity of demand. In general we will find demand becomes more responsive as the number of substitutes increases. If we were to look at the demand for Hood milk we would expect it to be elastic since there are many substitutes for Hood milk. When we look at the demand for milk, however, we may expect to find demand to be less responsive since there are not many very close substitutes to milk - unless you see soda or juice as a good substitute. This would be where we would see the influence of loyalty. When a firm successfully creates brand loyalty what it is doing is effectively reducing the availability of substitutes in the minds of buyers. Because the buyers no longer believe the other products are close substitutes, the increase in price is less likely to lower demand for the product. Size matters. Price elasticity of demand is also likely to be smaller when your total expenditure on the item is small - when it is a small ticket item. For example, if the price of paper clips rose substantially it is unlikely that you would reduce your demand since total expenditures on paper clips is still very small and the change would have virtually no impact on your total budget. There is also the question of durability. If you have an item that is durable, you would expect demand to be more responsive to price changes. When an item is durable you will not need to buy it if the price rises because you can put off your purchase and still receive the benefits from your previous purchase. If the price of garden tools rose, you could use your old tools because they are durable, but if the price of milk rose, it is unlikely that you will be able to get by with using milk that you bought last month. Time matters. If you give people longer to adjust their behavior, they will be able to make larger adjustments. For example, if the price of gas rises rapidly then your initial reaction is likely to be minimal. You will still buy the same amount of gas because your driving habits will not have changed. If you are given a longer period to adjust, however, you may find that you buy a new, more gas efficient car which will lower your demand for gas. The generalization to be drawn from this is that elasticity increases with the time horizon. Here is where habit enters the picture. Because habits are slow to break, a change in price is not likely to have a large immediate impact on demand. If you give people a chance to adjust, however, they may very well be able to 'break' their habits and thus we could expect a larger response to the price change in the long-run. - 10 -

When we switch to supply, we can expect that time horizon will have a significant effect on the price elasticity of supply. For example, if the price of rentals increased in the Kingston area in September as URI students returned to school, you would expect to see little increase in the supply of rental housing since the housing stock is fixed in the short-term. By next fall, however, if landlords believed that the price increases were going to last and they could make money on new construction, then the supply of housing would tend to increase as a result of the new construction. The same would be true if the price of gasoline rose rapidly and consumers drove up the price of small, gas efficient cars. In the short-term the auto companies could not shift assembly lines to produce the small cars so supply would tend to be inelastic. Once there was enough time to shift the assembly lines, the supply increase associated with the price increase would be greater and supply elasticity would be higher.

availability of substitutes o more substitutes - more responsive importance o smaller expense - less responsive durability o more durable - more responsive time o more time to adjust - more responsive

Now that you have the determinants of price elasticity of demand a. b. c. d. socks homes leather jackets automobiles

To answer this we need to return to the discussion of the determinants of demand elasticity. Automobiles and homes would, all other things equal, tend to have higher elasticity because they are big ticket items. If the price went up it would have a potentially big impact on your expenses so you might be 'persuaded' by the price increase to cut back on your purchases. The same would be true of leather jackets. Demand for homes and autos would also tend to be more responsive because they are both durable, and maybe the same could be said of leather jackets. This would tend to make demand for these items more responsive to price changes because you could continue to use what you have if the price went up - you could forestall consumption. The winner in terms of inelasticity would be socks, a small ticket item on which people probably do not even check the price.

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(b) The demand function is unit elastic at the point where marginal revenue is zero and total revenue is at a maximum. Below this point, demand is inelastic, marginal revenue is negative and price increase total revenue. Above this point, demand is elastic and the firm can increase total revenue by reducing price. Critically review the statement with the help of practical examples. Elasticity A rubber band when I think of elasticity and the harder you pull on it the more elastic it is. In economics when we say that something is elastic we mean that it responds to a change in another variable. The equation we use to find the elasticity of demand is:

E OR

The graph below shows that above the midpoint the demand curve is inelastic and below M it is elastic. At point M the curve is unitary elastic.

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The graphs below show inelastic and elastic demand curves.

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To put numbers with pictures, the top graph would have a 0<e<1 and the bottom graph would have an elasticity of e>1. Without having have points on the graph or the demand function we cannot pinpoint the actual elasticity. The top graph is inelastic so the quantity demanded is not as responsive to large changes in price. The bottom graph is elastic which means that small fluctuations in price have a large effect on quantity. Now lets look at what perfectly inelastic and perfectly elastic demand looks like. If demand is perfectly inelastic means that the graph is vertical and the quantity demanded is pegged at a fixed amount over multiple prices. Perfectly elastic demand means that price is pegged at a certain amount. This means that consumers have only one price over multiple quantities. We see this in the graphs below.

Now that we understand the different types of elasticity lets look at marginal and total revenue.

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Substitutes Substitutes can cause the elasticity of demand to be more elastic or inelastic. Take oil for example, it has an elasticity of .05. This means that oil is extremely inelastic. An easy way of thinking about is if there is a major increase in the price of oil there is not a sharp increase in the quantity demanded. This means that there is no other close substitutes for oil. People might start riding the bus more but it will not have a large enough impact on the quantity demanded. On the other side of this if a good has a high elasticity such as metals. If the price of copper, which is a metal, increase then people looking to put plumbing in their house would look at putting in plastic pipes. The elasticity for metal is 1.52 which means it is elastic. So if there is a small increase in price than there will be a larger decrease in the quantity demanded. Income and Elasticity Income has a direct effect on the elasticity of demand. If individuals spend more of their income on a good than it will be more elastic. A good example to look at is the relationship between beer and housing. When the price of beer doubles you will normally consume the same amount of beer as before. This is because a large amount of your income was not put toward the consumption of beer. Housing on the other hand takes up a large amount of your income. So if the cost of renting an apartment doubles then your demand for housing will decrease. This is due to the large amount of your income that is spent towards housing. Timing when more time has passed since the last price change then demand will be more elastic. This is because it gives people the chance to change their behavior. If the price of gasoline increases by 100% today, people will still purchase gas at the same level of consumption. This means that the price of oil is inelastic. If more time passes from the last price hike and technology in cars and planes increase so that the quantity demanded decreases then the elasticity will become more elastic. Total Revenue and Marginal Revenue

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Total Revenue is the amount of funds the firm receives for producing their goods and services. The function for total revenue is: TR=P*Q This means that you take the price of the good or service times the quantity demand to find total revenue. The Total Revenue graph is a parabola that opens downward and the peak is the maximum revenue the firm can make. At the highest point of the graph elasticity is unitary.

There is another curve on this graph and that is Marginal Revenue. Marginal Revenue is the additional revenue you receive to produce one more good or service. This curve is downward slope because as you produce more people are not willing to pay more but less. How do we find marginal revenue? The easiest way to find marginal revenue is to subtract the total revenue at one level of output by another. This would mean that the prices and quantities are in a table. Pric Quantit - 16 -

e y 2 50 4 40 6 30 8 20 10 10 In the table above we see that the Total Revenue = 6 (P) * 30 (Q) = 180. This is the maximum revenue point from the table. To find marginal revenue we need to derive the demand curve function. By taking two points we can find the linear function of the demand curve. P=12-1/5Q To find the marginal revenue we need to substitute the demand equation into the total revenue equation. Once we do this we need find the derivitive of teh Total Revenue function. TR=(12-1/5Q)*Q TR=12Q-1/5Q2 MR=12-2/5Q This equation tells the marginal revenue of producing one more unit of output. You can also find marginal revenue by taking the change in total revenue divided by the change in quantity demanded.

Relationship Demand

of

Marginal

Revenue

to

Price

Elasticity

of

Companies can change their total revenue by knowing how elastic or inelastic their demand curve is. Total Revenue Test Price Decrea se Increas e Decrea se Increas e Total Revenue Increase Decrease Decrease Increase Elastici ty Elastic Elastic Inelasti c Inelasti c

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By increasing and decreasing the firm is trying to get to the midpoint on the demand curve. If demand is elastic and a decrease in price raises total revenue then the marginal revenue is positive. If demand is inelastic and a price increase raises total revenue then marginal revenue is positive. If demand is unit elastic and a price increase brings no change in revenue then marginal revenue is zero.

Q. 4

(a)Explain the concept of consumer equilibrium and describe how do income and price changes after consumer equilibrium?

"The term consumers equilibrium refers to the amount of goods and services which the consumer may buy in the market given his income and given prices of goods in the market". The aim of the consumer is to get maximum satisfaction from his money income. Given the price line or budget line and the indifference map: A consumer is said to be in equilibrium at a point where the price line is touching the highest attainable indifference curve from below". Conditions: Thus the consumers equilibrium under the indifference curve theory must meet the following two conditions: First: A given price line should be tangent to an indifference curve or marginal rate of satisfaction of good X for good Y (MRS xy) must be equal to the price ratio of the two goods. i.e. MRSxy = Px / Py Second: The second order condition is that indifference curve must be convex to the origin at the point of tangency.

Assumptions:

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The following assumptions are made to determine the consumers equilibrium position. (i) Rationality: The consumer is rational. He wants to obtain maximum satisfaction given his income and prices. (ii) Utility is ordinal: It is assumed that the consumer can rank his preference according to the satisfaction of each combination of goods. (iii) Consistency of choice: It is also assumed that the consumer is consistent in the choice of goods. (iv) Perfect competition: There is perfect competition in the market from where the consumer is purchasing the goods. (v) Total utility: The total utility of the consumer depends on the quantities of the good consumed. Explanation: The consumers consumption decision is explained by combining the budget line and the indifference map. The consumers equilibrium position is only at a point where the price line is tangent to the highest attainable indifference curve from below. (1) Budget Line should be Tangent to the Indifference Curve: The consumers equilibrium in explained by combining the budget line and the indifference map. Diagram/Figure:

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In the diagram 3.11, there are three indifference curves IC 1, IC2 and IC3. The price line PT is tangent to the indifference curve IC 2 at point C. The consumer gets the maximum satisfaction or is in equilibrium at point C by purchasing OE units of good Y and OH units of good X with the given money income. The consumer cannot be in equilibrium at any other point on indifference curves. For instance, point R and S lie on lower indifference curve IC1 but yield less satisfaction. As regards point U on indifference curve IC3, the consumer no doubt gets higher satisfaction but that is outside the budget line and hence not achievable to the consumer. The consumers equilibrium position is only at point C where the price line is tangent to the highest attainable indifference curve IC2 from below. (2) Slope of the Price Line to be Equal to the Slope of Indifference Curve: The second condition for the consumer to be in equilibrium and get the maximum possible satisfaction is only at a point where the price line is a tangent to the highest possible indifference curve from below. In fig. 3.11, the price line PT is touching the highest possible indifferent curve IC2 at point C. The point C shows the combination of the two commodities which the consumer is maximized when he buys OH units of good X and OE units of good Y. Geometrically, at tangency point C, the consumers substitution ratio is equal to price ratio Px / Py. It implies that at point C, what the consumer is willing to pay i.e., his personal exchange rate between X and Y (MRSxy) is equal to what he actually pays i.e., the market exchange rate. So the equilibrium condition being Px / Py being satisfied at the point C is: Price of X / Price of Y = MRS of X for Y The equilibrium conditions given above states that the rate at which the individual is willing to substitute commodity X for commodity Y must equal the ratio at which he can substitute X for Y in the market at a given price. (3) Indifference Curve should be Convex to the Origin: The third condition for the stable consumer equilibrium is that the indifference curve must be convex to the origin at the point of equilibrium. In other words, we can say that the MRS of X for Y must be diminishing at the point of equilibrium. It may be noticed that in fig. - 20 -

3.11, the indifference curve IC2 is convex to the origin at point C. So at point C, all three conditions for the stable-consumers equilibrium are satisfied. Summing up, the consumer is in equilibrium at point C where the budget line PT is tangent to the indifference IC 2. The market basket OH of good X and OE of good Y yields the greatest satisfaction because it is on the highest attainable indifference curve. At point C: MRSxy = Px / Py (b) A consumer can choose any combination of apples and oranges. A, B, and C are three different points on his indifference curve. If he moves from A to B he gives up 2 oranges for 1 apple. If he moves from B to C then he gives up 1 orange for 1 apple. Does the consumers preference comply with the diminishing marginal rate of substitution? Explain. MRSxy = Px / Py From A to B MRS = 2/1 = 1 From B to C MRS = 1/1 = 1 Consumer theory uses indifference curves and budget constraints to generate consumer demand curves. For a single consumer, this is a relatively simple process. First, let one good be an example market e.g., Apple or orange, and let the other be a composite of all other goods. Budget constraints give a straight line on the indifference map showing all the possible distributions between the two goods; the point of maximum utility is then the point at which an indifference curve is tangent to the budget line (illustrated). This follows from common sense: if the market values a good more than the household, the household will sell it; if the market values a good less than the household, the household will buy it. The process then continues until the markets and households marginal rates of substitution are equal.

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Now, if the price of carrots were to change, and the price of all other goods were to remain constant, the gradient of the budget line would also change, leading to a different point of tangency and a different quantity demanded. These price / quantity combinations can then be used to deduce a full demand curve. A line connecting all points of tangency between the indifference curve and the budget constraint is called the expansion path. Q. 5 (a) Explain the relation between total product, marginal product and average product curves and describe the three stages of production. Total product Total product is defined as the the total quantity of output produced by a firm for a given quantity of input necessities. Total product identifies the specific outputs which are possible using variable levels of input. An understanding of total product is essential to the short-run analysis of a firm's production. Changes in total product are taken into account closely when there are changes in variable costs (labor) of production.

Average Product

Average product is defined as the product produced per unit of variable input employed when fixed inputs are held constant. It is commonly thought of as the amount of product produced by every worker.

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(Total Product)/ (Variable Inputs Employed) =Average Product Marginal Product Marginal product is similar to average product but is looked at from another perspective. Discrete marginal product is defined as the change in total product that comes as a result of a one unit increase in the variable input/capital level of a firm. Continuous marginal product is calculated as the derivative of total product with respect to the variable input employed. This can be represented as: (dTP)/ (dVI) =MP Where TP is total product, MP is marginal product and VI is variable inputs. The analysis of marginal product is foundational to explaining the law of supply (upward-sloping supply curve) via the Law of Diminishing Marginal Returns. The three stages of production characterized by the slope and shape of the total product curve. The first stage is characterized by an increasingly positive slope. The second stage by a decreasingly positive slope. And the third stage by a negative slope. Because the slope of the total product curve IS marginal product, these three stages are also seen with marginal product. In Stage I, marginal product is positive and increasing. In Stage II, marginal product is positive, but decreasing. And in Stage III, marginal product is negative.

(b) Describe with help of graphical diagrams the effect of change in output price on profit maximization and decision making process in production economy. In economics, profit maximization is the process by which a firm determines the price and output level that returns the greatest profit. There are several approaches to this problem. The total revenue -total cost method relies on the fact that profit equals revenue minus cost, and the marginal revenue -- marginal cost method is based on the fact that total profit in a perfect market reaches its maximum point where marginal revenue equals marginal cost. Basic Definitions Any costs incurred by a firm may be classed into two groups: fixed cost and variable cost. Fixed costs are incurred by the business at any level of output, including none. These may include equipment maintenance, rent, wages, and general upkeep. Variable costs change

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with the level of output, increasing as more product is generated. Materials consumed during production often have the largest impact on this category. Fixed cost and variable cost, combined, equal total cost. Revenue is the total amount of money that flows into the firm. This can be from any source, including product sales, government subsidies, venture capital and personal funds. Average cost and revenue are defined as the total cost or revenue divided by the amount of units output. For instance, if a firm produced 400 units at a cost of 20000 USD, the average cost would be 50 USD. Marginal cost and revenue, depending on whether the calculus approach is taken or not, are defined as either the change in cost or revenue as each additional unit is produced, or the derivative of cost or revenue with respect to quantity output. For instance, taking the first definition, if it costs a firm 400 USD to produce 5 units and 480 USD to produce 6, the marginal cost of the sixth unit is approximately 80 dollars, although this is more accurately stated as the marginal cost of the 5.5th unit due to linear interpolation. Calculus is capable of providing more accurate answers if regression equations can be provided. Total Cost-Total Revenue Method To obtain the profit maximizing output quantity, we start by recognizing that profit is equal to total revenue minus total cost. Given a table of costs and revenues at each quantity, we can either compute equations or plot the data directly on a graph. Finding the profitmaximizing output is as simple as finding the output at which profit reaches its maximum. That is represented by output Q in the diagram.

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Profit Maximization - The Totals Approach There are two graphical ways of determining that Q is optimal. Firstly, we see that the profit curve is at its maximum at this point (A). Secondly, we see that at the point (B) that the tangent on the total cost curve (TC) is parallel to the total revenue curve (TR), the surplus of revenue net of costs (B, C) is the greatest. Because total revenue minus total costs is equal to profit, the line segment C, B is equal in length to the line segment A, Q. Computing the price at which to sell the product requires knowledge of the firm's demand curve. The price at which quantity demanded equals profit-maximizing output is the optimum price to sell the product. Marginal Cost-Marginal Revenue Method If total revenue and total cost figures are difficult to procure, this method may also be used. For each unit sold, marginal profit equals marginal revenue minus marginal cost. Then, if marginal revenue is greater than marginal cost, marginal profit is positive, and if marginal revenue is less than marginal cost, marginal profit is negative. When marginal revenue equals marginal cost, marginal profit is zero. Since total profit increases when marginal profit is positive and total profit decreases when marginal profit is negative, it must reach a maximum where marginal profit is zero - or where marginal cost equals marginal revenue. This intersection of marginal revenue (MR) with marginal

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costs (MC) is shown in the next diagram as point A. If the industry is competitive (as is assumed in the diagram), the firm faces a demand curve (D) that is identical to its Marginal revenue curve (MR), and this is a horizontal line at a price determined by industry supply and demand. Average total costs are represented by curve ATC. Total economic profits are represented by area P, A, B, C. The optimum quantity (Q) is the same as the optimum quantity (Q) in the first diagram.

Profit Maximization - The Marginal Approach If the firm is operating in a non-competitive market, minor changes would have to be made to the diagrams. Modes of Operation It is assumed that all firms are following rational decision-making, and will produce at the profit-maximizing output. Given this assumption, there are four categories in which a firm's profit may be considered. A firm is said to be making an economic profit when its average total cost is greater than the price of the product at the profit-maximizing output. The economic profit is equal to the quantity output multiplied by the difference between the average total cost and the price. A firm is said to be making a normal profit when its economic profit equals zero. This occurs where total cost equals price at the profitmaximizing output average.

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If the price is between average total cost and average variable cost at the profit-maximizing output, then the firm is said to be in a lossminimizing condition. The firm should still continue to produce, however, since its loss would be larger if it was to stop producing. By continuing production, the firm can offset at least its fixed cost and part of its variable cost, but by stopping completely they would lose equivalent to their fixed cost. If the price is below average variable cost at the profit-maximizing output, the firm is said to be in shutdown. Losses are minimized by not producing at all, since any production would not generate returns significant enough to offset any fixed cost and part of the variable cost. By not producing, the firm loses only its fixed cost.

References: http://www.amazon.com http://tutor2u.net/ http://answers.yahoo.com/ http://en.wikipedia.org http://www.netmba.com/ http://www.google.com/ Books Managerial Economics by Nick Wilkinson Managerial Economics by James L Pappas Managerial Economics (AIOU)

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