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IGNOU MBA MS -09 Solved Assignment

2011

Course Code : MS-9

Course Title : Managerial Economics

Assignment Code : 9/TMA/SEM-I/2011

Coverage : All Blocks

Attempt All the Questions.

1. Given the profit function of a firm in the form of table, calculate total
profit, average profit and marginal profit and differentiate between in-
crementalism and marginalism.

Solution : In this case, Average Profit and Marginal Profit are same as there is
only single value is available for Total Revenue &Total Cost. There are no fixed
and variable costs are given. Hence the table is to be filled out as follows:

Unit of Total Total Total Average Marginal

Output Revenue(TR Cost(TC) Profit Profit Profit
(Q) ) (TP) = (AP) = (MP)
T.R-T.C TR/Q
1 10 5 5 10/1 = 10
10
2 30 18 12 30/2 = 15
15
3 50 29 21 50/3 = 16.66

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4 70 38
Differentiation between incrementalism and marginalism
Incrementalism is a method of working
by adding to a project using many small
(often unplanned), incremental changes
instead of a few (extensively planned)
large jumps. Wikipedia, for example,
illustrates the concept by building
an encyclopedia bit by bit, continually
adding to it. In a similar vein, according
to legend Virgil wrote the Aeneid in an
incremental process, averaging three
lines per day, and the Georgicseven
more slowly at an average of one line
per day. Logical incrementalism implies
that the steps in the process are sensible.
In public policy, incrementalism refers
to the method of change by which many
small policy changes are enacted over
time in order to create a larger broad
based policy change. This was the
theoretical policy of rationality
developed by Lindblom to be seen as a
middle way between the Rational Actor
Model and bounded rationality as both
long term goal driven policy rationality
and satisficing were not seen as
adequate.
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16.66
32 70/4 = 17.5
17.5
Marginalism refers to the use
of marginal
concepts in economic theory.
Marginalism is associated with
arguments concerning changes in the
quantity used of a good or of a service,
as opposed to some notion of the over-all
significance of that class of good or
service, or of some total quantity thereof.
The central concept of marginalism
proper is that of marginal utility, but
marginalists following the lead of Alfred
Marshall were further heavily dependent
upon the concept of marginal physical
productivity in their explanation of cost;
and the neoclassical tradition that
emerged from British marginalism
generally abandoned the concept
of utility and gave marginal rates of
substitution a more fundamental role in
analysis.
Marginalism is now an integral part of
mainstream economic theory
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Incrementalism is commonly employed
in engineering, software
design, Planning and industry. Whereas
it is often criticized as "fire fighting", the
progressive improvement of product
designs characteristic, e.g.,
of Japanese engineering can create
steadily improving product performance,
which in certain circumstances
outperforms more orthodox planning
systems.
Another example would be in small
changes that make way for a bigger
overall change to get past unnoticed. A
series of small steps toward an agenda
would be less likely to be questioned
than a large and swift change. An
example could be the rise of gas prices,
the company would only raise the price
by a few cents every day, instead of a
large change to a target price overnight.
More people would notice and dispute a
dramatic, 100% increase overnight,
while a 100% increase over a span of a
week would less likely be even noticed,
let alone argued. This can be applied in
many different ways, such as,
economics, politics, a person's
appearance, or laws.
On July 28, 2009, on the Fox News
show Hannity, host Sean Hannity asked
guest U.S. Senator John McCain if he
thought that a possible agreement
between majority Democrats and Blue
Dog Democrats on health care
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The marginal use of a good or service is
the specific use to which an agent would
put a given increase, or the specific use
of the good or service that would be
abandoned in response to a given
decrease. Marginalism assumes, for any
given agent, economic rationality and
an ordering of possible states-of-the-
world, such that, for any given set of
constraints, there is an attainable state
which is best in the eyes of that
agent. Descriptive marginalism asserts
that choice amongst the specific means
by which various anticipated specific
states-of-the-world (outcomes) might be
affected is governed only by the
distinctions amongst those specific
outcomes; prescriptive marginalism
asserts that such choice ought to be so
governed.
On such assumptions, each increase
would be put to the specific, feasible,
previously unrealized use of greatest
priority, and each decrease would result
in abandonment of the use of lowest
priority amongst the uses to which the
good or service had been put.
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reform was incrementalism, to which

McCain answered that he thought it was.

2. Define Price Elasticity. Explain the determinants of Price Elasticity.

Solution : Price elasticity of demand (PED or Ed) is a measure used in economics
to show the responsiveness, or elasticity, of the quantity demanded of a good or
service to a change in its price. More precisely, it gives the percentage change in
quantity demanded in response to a one percent change in price (holding constant
all the other determinants of demand, such as income). It was devised by Alfred
Marshall.
Price elasticities are 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 PED. In
general, the demand for a good is said to be inelastic (or relatively inelastic) when
the PED is less than one (in absolute value): that is, changes in price have a
relatively small effect on the quantity of the good demanded. The demand for a
good is said to be elastic (or relatively elastic) when its PED is greater than one (in
absolute value): that is, changes in price have a relatively large effect on the
quantity of a good demanded.
Revenue is maximised when price is set so that the PED is exactly one. The PED
of a good can also be used to predict the incidence (or "burden") of a tax on that
good. Various research methods are used to determine price elasticity,
including test markets, analysis of

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PED is derived from the percentage change in quantity (%ΔQd) and

percentage change in price (%ΔP)

PED is a measure of responsiveness of the quantity of a good or service

demanded to changes in its price.[1] The formula for the coefficient of price
elasticity of demand for a good is:

The above formula usually yields a negative value, due to the inverse nature of the
relationship between price and quantity demanded, as described by the "law of
demand".[3] For example, if the price increases by 5% and quantity demanded
decreases by 5%, then the elasticity at the initial price and quantity = −5%/5% =
−1. The only classes of goods which have a PED of greater than 0 are Veblen and
Giffen goods.[5] Because the PED is negative for the vast majority of goods and
services, however, economists often refer to price elasticity of demand as a
positive value (i.e., in absolute value terms).

This measure of elasticity is sometimes referred to as the own-price elasticity of

demand for a good, i.e., the elasticity of demand with respect to the good's own
price, in order to distinguish it from the elasticity of demand for that good with
respect to the change in the price of some other good, i.e.,
a complementary or substitute good.[1] The latter type of elasticity measure is called
a cross-price elasticity of demand.

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As the difference between the two prices or quantities increases, the accuracy of
the PED given by the formula above decreases for a combination of two reasons.
First, the PED for a good is not necessarily constant; as explained below, PED can
vary at different points along the demand curve, due to its percentage nature.

Elasticity is not the same thing as the slope of the demand curve, which is
dependent on the units used for both price and quantity.

Second, percentage changes are not symmetric; instead, the percentage

changebetween any two values depends on which one is chosen as the starting
value and which as the ending value. For example, if quantity demanded
increases from 10 units to 15 units, the percentage change is 50%, i.e., (15 − 10) ÷
10 (converted to a percentage). But if quantity demanded decreases from 15
units to 10 units, the percentage change is −33.3%, i.e., (15 − 10) ÷ 15.

Two alternative elasticity measures avoid or minimise these shortcomings of the

basic elasticity formula: point-price elasticity and arc elasticity.

Point-price elasticity
One way to avoid the accuracy problem described above is to minimise the
difference between the starting and ending prices and quantities. This is the
approach taken in the definition of point-price elasticity, which uses differential
calculus to calculate the elasticity for an infinitesimal change in price and quantity
at any given point on the demand curve: [14]

In other words, it is equal to the absolute value of the first derivative of

quantity with respect to price (dQd/dP) multiplied by the point's price (P)
divided by its quantity (Qd).
In terms of partial-differential calculus, point-price elasticity of demand can be
defined as follows:[16] let be the demand of goods as a
function of parameters price and wealth, and let be the demand for good .
The elasticity of demand for good with respect to price pk is

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However, the point-price elasticity can be computed only if the formula for
the demand function, Qd = f(P), is known so its derivative with respect to
price, dQd / dP, can be determined.
Arc elasticity
A second solution to the asymmetry problem of having a PED dependent on which
of the two given points on a demand curve is chosen as the "original" point and
which as the "new" one is to compute the percentage change in P and Q relative to
the average of the two prices and the average of the two quantities, rather than just
the change relative to one point or the other. Loosely speaking, this gives an
"average" elasticity for the section of the actual demand curve—i.e., the arc of the
curve—between the two points. As a result, this measure is known as the arc
elasticity, in this case with respect to the price of the good. The arc elasticity is
defined mathematically as:[13][17][18]

This method for computing the price elasticity is also known as the "midpoints
formula", because the average price and average quantity are the coordinates of the
midpoint of the straight line between the two given points.
However, because this formula implicitly assumes the section of the demand curve
between those points is linear, the greater the curvature of the actual demand curve
is over that range, the worse this approximation of its elasticity will be.

Interpreting values of price elasticity coefficients

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Perfectly inelastic demand

Perfectly elastic demand[10]

Elasticities of demand are interpreted as follows:

Value Descriptive Terms

Ed = 0 Perfectly inelastic demand

- 1 < Ed < 0 Inelastic or relatively inelastic demand

Unit elastic, unit elasticity, unitary elasticity, or unitarily elastic

Ed = - 1
demand

- ∞ < Ed < -
Elastic or relatively elastic demand
1

Ed = - ∞ Perfectly elastic demand

A decrease in the price of a good normally results in an increase in the quantity

demanded by consumers because of the law of demand, and conversely, quantity
demanded decreases when price rises. As summarized in the table above, the PED

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for a good or service is referred to by different descriptive terms depending on

whether the elasticity coefficient is greater than, equal to, or less than −1. That is,
the demand for a good is called:

 relatively inelastic when the percentage change in quantity demanded is less

than the percentage change in price (so that Ed > - 1);
 unit elastic, unit elasticity, unitary elasticity, or unitarily elastic demand
when the percentage change in quantity demanded is equal to the percentage
change in price (so that Ed = - 1); and
 relatively elastic when the percentage change in quantity demanded
is greater than the percentage change in price (so that Ed < - 1).

As the two accompanying diagrams show, perfectly elastic demand is represented

graphically as a horizontal line, and perfectly inelastic demand as a vertical line.
These are the only cases in which the PED and the slope of the demand curve
(∆P/∆Q) are both constant, as well as the onlycases in which the PED is
determined solely by the slope of the demand curve (or more precisely, by
the inverse of that slope).

Effect on total revenue

 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 unit price will tend to lead to more units sold.

Because of the inverse nature of the relationship between price and quantity
demanded (i.e., the law of demand), the two effects affect total revenue in opposite
directions. But in determining whether to increase or decrease prices, a firm needs
to know what the net effect will be. Elasticity provides the answer: The percentage
change in total revenue is equal to the percentage change in quantity demanded
plus the percentage change in price. (One change will be positive, the other
negative.)

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 As a result, the relationship between PED and total revenue can be described
for any 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 total revenue to increase.
 When the price elasticity of demand for a good is relatively inelastic (- 1 <
Ed < 0), the percentage change in quantity demanded is smaller than that in
price. Hence, when the price is raised, the total revenue rises, and vice versa.
 When the price elasticity of demand for a good is unit (or unitary)
elastic (Ed = -1), the percentage change in quantity is equal to that in price, so a
change in price will not affect total revenue.
 When the price elasticity of demand for a good is relatively elastic (- ∞ <
Ed < - 1), the percentage change in quantity demanded is greater than that in
price. Hence, when the price is raised, the total revenue falls, and vice versa.
 When the price elasticity of demand for a good is perfectly elastic (Ed is
− ∞), 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 falls to
zero.

Hence, as the accompanying diagram shows, total revenue is maximised at the

combination of price and quantity demanded where the elasticity of demand is
unitary
It is important to realise that price-elasticity of demand is not necessarily constant
over all price ranges. The linear demand curve in the accompanying diagram
illustrates that changes in price also change the elasticity: the price elasticity is
different at every point on the curve.

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A set of graphs shows the relationship between demand and total revenue (TR) for
a linear demand curve. As price decreases in the elastic range, TR increases, but in
the inelastic range, TR decreases. TR is maximised at the quantity where PED = 1.

3. ‘To an economist the fixed costs are overhead costs and to an accountant
these are indirect costs.’ Substantiate this statement with the help of an
example.

Solution : For a long time, there has been a considerable disagreement among
economists and accountants on how costs should be treated. The reason for the
difference of opinion is that the two groups want to use the cost data for dissimilar
purposes. Accountants always have been concerned with firms’ financial
statements. Accountants tend to take a retrospective look at firms finances because
they keep trace of assets and liabilities and evaluate past performance. The
accounting costs are useful for managing taxation needs as well as to calculate
profit or loss of the firm. On the other hand, economists take forward-looking
view of the firm. They are concerned with what cost is expected to be in the future
and how the firm might be able to rearrange its resources to lower its costs and
improve its profitability. They must therefore be concerned with opportunity cost.
Since the only cost that matters for business decisions are the future costs, it is the

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economic costs that are used for decision-making. Accountants and economists
both include explicit costs in their calculations.

For accountants, explicit costs are important because they involve direct payments
made by a firm. These explicit costs are also important for economists as well
because the cost of wages and materials represent money that could be useful
elsewhere.

Although, no monitory transaction has occurred (and thus would not appear as an
accounting cost), the business nonetheless incurs an opportunity cost because the
owner could have earned a competitive salary by working elsewhere. Accountants
and economists use the term ‘profits’ differently. Accounting profits are the firm’s
total revenue less its explicit costs. But economists define profits differently.
Economic profits are total revenue less all costs (explicit and implicit costs). The
economist takes into account the implicit costs (including a normal profit) in
addition to explicit costs in order to retain resources in a given line of production.
Therefore, when an economist says that a firm is just covering its costs, it is meant
that all explicit and implicit costs are being met, and that, the entrepreneur is
receiving a return just large enough to retain his/ her talents in the present line of
production. If a firm’s total receipts exceed all its economic costs, the residual
accruing to the entrepreneur is called an economic profit, or pure profit.

4. What effect does change in demand have on price and quantity? Discuss
with reference to pricing analysis of markets by giving illustrations.
Solution : In economics, the demand curve is the graph depicting the relationship
between the price of a certain commodity, and the amount of it that consumers are
willing and able to purchase at that given price. It is a graphic representation of a
demand schedule. The demand curve for all consumers together follows from the
demand curve of every individual consumer: the individual demands at each price
are added together. Despite its name, it is not always shown as a curve, but
sometimes as a straight line, depending on the complexity of the scenario.
Demand curves are used to estimate behaviors in competitive markets, and are
often combined with supply curves to estimate the equilibrium price (the price at
which sellers together are willing to sell the same amount as buyers together are

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willing to buy, also known as market clearingprice) and the equilibrium quantity
(the amount of that good or service that will be produced and bought without
surplus/excess supply or shortage/excess demand) of that market
In a monopolistic market, the demand curve facing the monopolist is simply the
market demand curve.

An example of a demand curve shifting

Characteristics
According to convention, the demand curve is drawn with price on the vertical axis
and quantity on the horizontal axis. The function actually plotted is the inverse
demand function.
The demand curve usually slopes downwards from left to right; that is, it has a
negative association. The negative slope is often referred to as the "law of
demand", which means people will buy more of a service, product, or resource as
its price falls. The demand curve is related to the marginal utility curve, since the
price one is willing to pay depends on the utility. However, the demand directly
depends on the income of an individual while the utility does not. Thus it may
change indirectly due to change in demand for other commodities.
Changes that increase demand
Some circumstances which can cause the demand curve to shift out include:

 increase in price of a substitute

 decrease in price of complement
 increase in income if good is a normal good

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 decrease in income if good is an inferior good

Changes that decrease demand

Some circumstances which can cause the demand curve to shift in include:

 decrease in price of a substitute

 increase in price of a complement
 decrease in income if good is normal good
 increase in income if good is inferior good

Movement along a demand curve

There is movement along a demand curve when a change in price causes the
quantity demanded to change. It is important to distinguish between movement
along a demand curve, and a shift in a demand curve. Movements along a demand
curve happen only when the price of the good changes.When a non-price
determinant of demand changes the curve shifts. These "other variables" are part of
the demand function. They are "merely lumped into intercept term of a simple
linear demand function." Thus a change in a non-price determinant of demand is
reflected in a change in the x-intercept causing the curve to shift along the x axis.

5.Write short notes on the following :-

a. Market Experiments
b. Bundling of services
c. Product Differentiation

Solution : Market Experiments

An alternative method of collecting necessary information regarding demand

is to carry out market studies and experiments on consumer’s behaviour
under actual, though controlled, market conditions. This method is known in
common parlance as market experiment method. Under this method, forms
first select some areas of representative markets- three or four cities having
similar features, viz., population, income levels, etc. Then they carry out
market experiments by changing prices, advertisement expenditure and other

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controllable variables in the demand function under the assumption that

other things remain same. The controllable variables may be changed over
time. After such changes are introduced, the consequent changes in the
demand over a period of time are recorded. On the basis of data collected,
elasticity coefficients are computed. These coefficients are then used along
with the variables of the demand function to assess the demand for the
product.

Bundling of services
Product bundling is a marketing strategy that involves offering several products for
sale as one combined product. This strategy is very common in
the software business (for example: bundle a word processor, aspreadsheet, and
a database into a single office suite), in the cable television industry (for example,
basic cable in the United States generally offers many channels at one price), and
in the fast food industry in which multiple items are combined into a complete
meal. A bundle of products is sometimes referred to as a package deal or
a compilation or an anthology.
Bundling is most successful when:

 There are economies of scale in production,

 There are economies of scope in distribution,
 Marginal costs of bundling are low.
 production set-up costs are high,
 Customer acquisition costs are high.
 Consumers appreciate the resulting simplification of the purchase decision
and benefit from the joint performance of the combined product.
 Consumers have heterogeneous demands and such demands for different
parts of the bundle product are inversely correlated. For example, assume
consumer A values word processor at $100 and spreadsheet processor at $60,
while consumer B values word processor at $60 and spreadsheet at $100. Seller
can generate maximum revenue of only $240 by setting $60 price for each
product - both consumers will buy both products. Revenue cannot be increased

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without bundling because as seller increases the price above $60 for one of the
goods, one of the consumers will refuse to buy it. With bundling, seller can
generate revenue of $320 by bundling the products together and selling the
bundle at $160.

Product bundling is most suitable for high volume and high margin (i.e., low
marginal cost) products. Research by Yannis Bakos and Erik Brynjolfsson found
that bundling was particularly effective for digital "information goods" with close
to zero marginal cost, and could enable a bundler with an inferior collection of
products to drive even superior quality goods out of the market place.
In oligopolistic and monopolistic industries, product bundling can be seen as an
unfair use of market power because it limits the choices available to the consumer.
In these cases it is typically called product tying.
Pure bundling occurs when a consumer can only purchase the entire bundle or
nothing, mixed bundlingoccurs when consumers are offered a choice between the
purchasing the entire bundle or one of the separate parts of the bundle.
Pure bundling can be further divided into two cases: in joint bundling, the two
products are offered together for one bundled price, and, in leader bundling, a
leader product is offered for discount if purchased with a non-leader
product. Mixed-leader bundling is a variant of leader bundling with the added
possibility of buying the leader product on its own.
Bundling in political economy is a type of product bundling in which the product is
a candidate in an election who markets his bundle of attributes and positions to the
voters.
In peer-to-peer swarming systems for content dissemination, such as BitTorrent,
bundling consists of disseminating multiple files together in a single swarm.
Empirical evidence and analytical models indicate that bundling improves content
availability in those systems
Both pure and mixed bundling are supported by BitTorrent.

Product Differentiation
A concept in Economics and Marketing proposed by Edward Chamberlin in his
1933 Theory of Monopolistic Competition.

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In marketing, product differentiation (also known simply as "differentiation") is the

process of distinguishing a product or offering from others, to make it more
attractive to a particular target market. This involves differentiating it
from competitors' products as well as a firm's own product offerings.
Differentiation can be a source of competitive advantage. Although research in
a niche market may result in changing a product in order to improve
differentiation, the changes themselves are not differentiation. Marketing or
product differentiation is the process of describing the differences between
products or services, or the resulting list of differences. This is done in order to
demonstrate the unique aspects of a firm's product and create a sense of value.
Marketing textbooks are firm on the point that any differentiation must be valued
by buyers (e.g.)
The term unique selling proposition refers to advertising to communicate a
product's differentiation
In economics, successful product differentiation leads to monopolistic
competition and is inconsistent with the conditions for perfect competition, which
include the requirement that the products of competing firms should be perfect
substitutes. There are three types of product differentiation: 1. Simple: based on a
variety of characteristics 2. Horizontal : based on a single characteristic but
consumers are not clear on quality 3. Vertical : based on a single characteristic and
consumers are clear on its quality
The brand differences are usually minor; they can be merely a difference
in packaging or an advertising theme. The physical product need not change, but it
could. Differentiation is due to buyers perceiving a difference, hence causes of
differentiation may be functional aspects of the product or service, how it is
distributed and marketed, or who buys it. The major sources of product
differentiation are as follows.

 Differences in quality which are usually accompanied by differences in price

 Differences in functional features or design
 Ignorance of buyers regarding the essential characteristics and qualities of
goods they are purchasing
 Sales promotion activities of sellers and, in particular, advertising
 Differences in availability (e.g. timing and location).

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The objective of differentiation is to develop a position that potential customers see

as unique. The term is used frequently when dealing withfreemium business
models, in which businesses market a free and paid version of a given product.
Given they target a same group of customers, it is imperative that free and paid
versions be effectively differentiated.
Differentiation primarily impacts performance through reducing directness of
competition: As the product becomes more different, categorization becomes more
difficult and hence draws fewer comparisons with its competition. A successful
product differentiation strategy will move your product from competing based
primarily on price to competing on non-price factors (such as product
characteristics,distribution strategy, or promotional variables).
Most people would say that the implication of differentiation is the possibility of
charging a price premium; however, this is a gross simplification. If customers
value the firm's offer, they will be less sensitive to aspects of competing offers;
price may not be one of these aspects. Differentiation makes customers in a given
segment have a lower sensitivity to other features (non-price) of the product.

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