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Managerial Economics 2

What is Managerial Economics.? Explain the nature and scope of Managerial Economics.? Answer: Managerial Economics generally refers to the integration of economic theory with business practice. While economics provides the tool which explain various concepts such as demand, supply, price, competition etc. Managerial economics applies these tools to the management of business, in this sense managerial economics is also understood to refer to business economics or applied economics. Managerial economics lies on the border line of management and economics. It is a hybrid of two disciplines and it is primarily an applied branch of knowledge. Management deals with principles which help in decision making under uncertainty and improve effectiveness of organisation. Economics on the other hand provides a set of propositions for optimum allocation of scare resources to achieve the desired objectives. Nature of Managerial Economics: It is true that managerial economics aims at providing help in decision making by firms. For this purpose it draws heavily on the prepositions of micro economic theory. Note that micro economics studies the phenomenon at the individuals level and behavior of consumers, firms. The concepts of micro economics used frequently in managerial economics are elasticity, marginal cost, managerial revenue, market structure and their significance in primary policies. Some of these concepts however provide only the logical base and have to be modified in practice. Micro economics assists firms in forecasting. Note that micro economics theory studies the economy at the aggregative level and ignores the distinguishing features of individual observations. For example micro economics indicates the relationship between the Magnitude of Investment and Level of National Income Level of National Income and Level of Employment
Managerial Economics Level of Consumption and National Income etc. Therefore the postulates of microeconomics can be used to identify the level of demand at some future point in time, based on the relationship between the level of national income and demand for electric motors. Also the demand for durable goods such as refrigerators, air-conditioners, motor cars depends upon the level of national income. Managerial economics is decidedly applied branch of knowledge. Therefore the emphasis is laid on those prepositions which are likely to be useful to the management. The precision of a scientist is not motivating factor in research activity. Improvement in the quality of results is attempted, provided the additional cost is not very high and the decision maker can wait. For example it may be possible to have more accurate data on demand for the firms product by taking into consideration, additional factors. But this may not be the attempted because the decision has to be made without delay. Besides more accurate forecasts may not be justified on cost considerations. Management economics is perspective in nature and character. It recommends that it should be done alternate conditions. For example if the price of the synthetic yarn falls by 50% it may be desirable to increase its use in producing different types of textiles. Thus managerial economics is one of the normative sciences and reflects upon the desirability or otherwise of the prepositions. For example if the analysis suggests that the benefit-cost ratio is used as the criterion for project appraisal it is recommended that the firm should not install a large plant. Contract this with the positive sciences which state the prepositions without connecting upon what should be done. For example if the distribution of income has become more uneven it is stated without indicating what should be done to correct this phenomenon. Managerial economics to the extent that it is uses economic thought is a science, but it is an applied science. Economic thought uses deductive logic (if X is true, then Y is true). For example if the triangles ate congruent then angles are equal. To have confidence in the findings, the prepositions deducted are subject empirical verification. For example empirical studies try to verify whether cost curves faced by a firm are really U shaped as suggested by the theory. Furthermore there is an attempt to generalize the prepositions which provide a predictive character. For example empirical studies may suggest that every 1% rise in expenditure on advertising, the demand for the product shall increase by 5%. Managerial economics uses scientific approach. In practice, some firms may use simple rules based on past experience. However the quality of decisions made can be improved using a systematic approach. Scope of Managerial Economics: 3

Managerial Economics Scope means province or an area of study. There is hardly any uniform pattern as regards the scope of managerial economics as it is comparatively a new subject. 4 However, the scope of managerial economics may be discussed under following points. Whether managerial economics is normative or positive economics: Economics is divided in to positive economics and normative economics. Positive economics is that branch of economics which studies the things as they are. Normative economics deals with the things they ought to be or should be. Positive economics is descriptive in nature where as normative economics is prescriptive in nature. Managerial economics is considered to be the part of normative economics. It lays more emphasis on prescribing choice and action and less on explaining what happened. Managerial economics draws descriptive economics and tries to pass judgments to value in the context of time. Area of Study: Broadly speaking managerial economics deals with the following topics. Demand Analysis and Forecasting: Effective decision making at the firm level depends on accurate estimates of demand. Demand analysis aims at discovering the forces that determine sales. The demand analysis mainly relates to the study of demand, determinants, demand distinctions and demand forecasting. Cost and Production Analysis: Cost estimates are also essential for effective decision making and production planning at the firm level. Profit planning, cost control and sound pricing practices call for accurate cost and production analysis. Cost relations are production function and cost control. Pricing Decisions, Policies and Practices: Pricing is an important area of managerial economics. Success of a business firm largely depends on the accuracy of price decisions. Price determinations under different markets, pricing methods policies, product line pricing and price forecasting are some of the topics of this area. Profit Management: Business firms are mainly profit hunting institutions. The success of the firm is always measured in terms of profits. Nature and management of profit, profit policies and techniques and profit planning are the important aspects covered in this area. Capital Management: The most complex, troublesome problem faced by the business manager is the capital management. Capital management implies planning and control of capital expenditure. Cost of capital rate of return and selection of projects are the important points under this. Linear Programming and Theory of Games: Since managerial economics and operations research are closely connected with each other, managerial economics has started using such techniques of operations research as linear programming
Managerial Economics and the theory of games. Recently the linear programming and the theory of games have been brought as part of managerial economics. Profits a central point in managerial economics: Profit in other words is the central concept of managerial economics. Without profits business firms can not run. The maximization of profits is the main objective of any firm or a business unit. The survival of the firm is determined by the ability of a firm to earn profits. Profit is the main indicator of firms success. Optimisation: Optimisation is another important concept used in economic theory and managerial economics. Managerial economics often aims at optimising a given objective. In recent years, a new concept was found out called Sub-Optimisation. The greatest merit of this concept is its flexibility. 5

of demand is one of the important laws of economic theory .It explains the general tendency of the consumers to buy more of a good at a lower price and less of it at a higher price lower price attracts consumers to buy more goods .thus law of demand expresses an inverse relationship b/w the price and the quantity demanded of a commodity other things being equal.According to Lipsey A fall in the price of a commodity cause a household to buy more of that commodity and less of the other commodity which compete with it, while rise in price causes the household to buy less of this commodity & more of the competing commodities The law of demand indicates only the direction of change of demand corresponding the change in the price. This can be illustrated through a demand curve. Price is measured in theY axis&quantity in the X axis.DD is the demand curve of the good under consideration.At price OP1the quantiy demanded is OQ1 if price of the good falls into OP2 the quantity demanded rises to OQ2 the demand curve is sloping downwards which is in accordance to the law of demand all the determinants of demand are assumed to be constant





Managerial Economics
O Q Q1 Quantity X

Law of demand states the inverse relationship between price of a commodity and quantity demanded, other things remaining the same. The demand of a commodity is more at a lower price and less at a higher price. That is why the demand curve slopes downward. The factors responsible for the downward slope of demand curve are : (a) Law of diminishing marginal utility: The law of diminishing marginal utility states that as the consumption of a commodity by a consumer increases the satisfaction obtained by the consumer from each additional unit of the commodity goes on diminishing. (b) Income effect: A fall in the price of the commodity increase the purchasing power of the consumer, in otherwords the consumer has to spend less to buy the same quantity of the commodity as before. The money so saved because of a fall in the price of the commodity can be spent by the consumer in ways he likes. He will spend a part of this money on buying some more units of the same commodity whose price has fallen. Thus a fall in the price of this commodity increases its demand. This is called income effect. (c) Substitution effect: This also increases demand as a result of a fall in the price of the commodity and viceversa. When the price of a commodity falls it becomes relatively cheaper than other commodity whose prices have not fallen. So the consumer substitute this commodity for other commodities which are now relatively dearer. This is know as substitution or complementarily effect. (d) Changes in the number of consumers: Many people cannot afford to buy a commodity at a high price. When price of a commodity falls, the number of persons who could not afforded at a higher price can purchase it at a reduced price. This increases the consumer of the commodity. Thus at a lower price the quantity demand of the commodity increases because of increase in the number of consumers of the commodity and vice versa. (e) Diverse Uses of the commodity: Many commodities can be put to several uses. The commodity having several uses is set to have composite demand. All the above factors are responsible for the downward slope of demand curve. These factors explain the operations of the Law of Demand. The important of these factors depends upon the circumstances of the case. Exceptions to the Law of Demand: Under certain circumstances the inverse relationship between price and demand does not hold good. These are know as the exceptions to the law of demand. Some of the important exceptions are :
Managerial Economics (a)Giffen Goods: These are special type of inferior goods. A rise in the price of giffen 7 goods leads to a rise in their demand and viceversa. E.g. A poor household who spends a major portion of his money on an inferior goods like coarse grain, say bajra. If the price of bajra goes up the household will be forced to maintain the earlier consumption level of consumption of this good, he will be left with lesser income to spend on other commodities that he used to consume earlier. The household will be forced to cut down the consumption of other commodities still further to compensate itself for the loss of consumption of bajra. Conversely, a fall in price of bajra will enable the household to release more money for other commodities and may substitute consumption of bajra by consumption of other superior commodities. The bajra will be considered as gifen goods to which law demand does not apply. (b)Conspicuous necessities: Another exception occur in case of such commodities as though their constant use is because of fashion or prestige value attached to them have become necessity of life. Eventhough their price rises continuously their demand does show any tendency to fall. Conspicuous consumption: A few goods like diamond etc. purchased by rich persons of the society because the prices of those goods are so high that they are beyond the reach of the common man. More of these commodities is demanded when their prices go up very high. The law of demand does not apply. (d)Future changes in price: Household also act as speculators when the price are rising, the house hold tend to buy larger quantity of the commodity out of apprehension that the prices may go up further. Likewise when prices are expected to fall further a reduced price may not be sufficient incentive to induce the household to buy more. E.g. share market. (e)Emergencies: Emergencies like war, famine, flood etc. may negate the operations of lay of demand. At such time the household may behave in a abnormal way. Household accentuate scarcity and induce further price rises by making increase purchases even at higher prices during such period. During depression, on the other hand, no amount of falling price is sufficient inducement for consumer to demand more. (f)Change in fashion: A change fashion entails effect demand for a commodity. (g)Ignorance: Consumers ignorance is another factor that at times induces him to buy more of commodity at a higher price. This happens when the consumer thinks that a high price commodity is better in quality than low price commodity.

Managerial Economics Q3. Demand forecasting is an attempt to foresee the future by examining the past .Business firms can estimate and minimize the future risk & uncertainty through 8 forecasting &forward planning .It is an essential tool in developing new products scheduling production determining necessary inventory levels&creating a distribution system . Its essence is estimating future events acc to the past patterns and applying judgement to those projections .Virtually all types of national & intl organisations Govt ,social &business engage in some type of demand forecasting the goal of course is better mgt ability to plan &control operations churches try to predict future revenues from members contributions to develop reasonable budgets. School administrators use Enrolment forecasts to determine faculty sizes, supplies &classroom requirements .Demand forecasting is a crucial activity for planning survival &growth of a corporate unit. Demand forecasts may be passive or active the former predict the future demand by extrapolating the demands of the previous years in the absence of any action by the firm Here the things are assumed to continue the way they have been in the past these forecasts are used only to assess the impact of new policies on the market while the latter estimate the future scenario inclusive of own future actions &strategies of the firm itself These forecasts are more meaningful as they take into account the likely changes in the relevant variable in estimating future demand here the firm manipulates the demand by changing price,product quality etc.Demand forecasts methods vary acc to whether they apply to a large aggregate such as the whole economy(macro forecasts)or to a component of this aggregate such as an industry or a co. (micro forecasts) a frequent practice is to translate forecasts of overall levels into industry forecasts by trade associations &to use this in turn to generate co. forecasts.However small firms cannot afford these sophisticated techniques . Methods of demand forecasting : The imp. Of selecting the right type of forecasting method cannot be overstated however the choice is complicated bcoz each situation might require a different method mgt. should be aware of the factors favoring one method over another in a given demand forecasting situation in some cases mgrs are interested in the total demand for a product service in other circumstances the projection may focus on the firms probable mkt share forecasts can also provide inft. on the product mix major decisions in large business houses are generally based on forecasts on some type in some cases the forecasts may be little more than an intuitive assessment or value judgement of the future by those involved in the decision .Thus no forecasting method is suitable for all situations.Selection of a forecasts has to be appropriate to the situation that is objective, urgency data availability ,nature of the product etc. The firm can afford acurracy level required.

Managerial Economics 9

Forecasting Methods

Survey Methods

Statistical Methods


opinion method

Market experiment

Time series Analysis

Regression analysis



Moving average


Survey methods : Under this approach are conducted about the intentions of the consumers (individuals, firms or industries) opinion of experts or of mkt .Under census survey, all consumers\ experts mkts are surveyed.While in sample survey a selected subset of them are surveyed and through their study, inferences abt the whole popln. are drawn .These methods are usually suitable for short-term forecast due to volatile nature of consumers intentions.New products demand forecasting also makes use of survey approach,as data availability problem is overcome through surveys of consumers.

Consumer Survey Method: Surveys of managerial plans can be one of the impt. Methods of forecasting .The rationale for conducting such surveys is that plans generally form the basis for future actions by using this method, a firm can ask consumers what & How much they are planing to buy it at various prices of the product for the forthcoming time period, usually a year. If the product happens to be a consumer good
Managerial Economics the consumers are firms or industries using that product the survey may involve a complete enumeration of all consumers of the given product, whose demand is to be 10 forecasted. Collective Opinion Method: Under this method(also called sales- force polling), salesman or experts are required to estimate expected future demand of the product in their respective territories &sections the rationale of this method is that salesman, being the closest to the customers, are likely to have the most intimate feel of the market i.e customer reaction to the product of the firm &their sales trends the estimates of individual salesman are averaged or consolidated to find out the total estimated sales the final sales forecast would emerge after these factors are being taken into account.This method is known as the collective opinion method, as it takes advantage of the collective wisdom of the salesmen,departmental heads like prod.mgr sales.mgr etc&the top executives. Market Experiments Method: Under this method, the main determinants of the demand of a product like prices, advt, product design, packaging,etc are identified. These factors are then varied separately over different markets or time periods holding other factors constant. The effect of the experiment on consumer behaviour is studied under actual or controlled mkt conditions which is used for overall forecasting purpose. Statistical methods: These methods make use of historical data as a basis for extrapolating quantitative relationships to arrive at the future demand pattern and trends. The data a may also be analyzed through econometric models. These are used for long term forecasting and for products for larger levels of aggregation. They are based on scientific base of estimation which are logical, unbiased and proven to be useful. Time series analysis: It is an arrangement of statistical data in a chronological order, i.e. in accordance with its time of occurrence. It reflects the dynamic pace of steady movement of a phenomenon over a period of time. Most of the variables in business, economic and commerce be it a series related to price, production, consumption, projects,sales, etc. at all time series data spread over long period of time. Graphical Methods: This method gives the basic tendency of a series to grow, decline or remain steady over a period of time. This method is useful in forecasting population, demand etc.where the future is not too much different from average of the past. Theperiod time in the trend analysis is always long; but the concept of trend does not include short time oscillations and fluctuations. Semi Average Method: According to this method the date is divided into two parts preferably with the same number of years. The averages of the first and second part

Managerial Economics are calculated separately. These averages are called semi averages which are plotted as 11 points against middle point of the respective time period covered by each part. Moving Averages Method: This is a very simple and flexible method of measuring trend which consists of obtaining a series of moving averages of successes overlapping groups of the time series. The averaging process smoothens out fluctuation as well as the ups and down in the given data. Least square method:The principle of least squares provides us an analytical tool to obtain an objective fit to the trend of the given time series. Most of the data relating to economic and business time series conform to definite laws of growth or decay. Thus, in such situation, trend fittings will be most reliable way of forecasting. Regression Analysis:This is also a popular method of forecasting among the economists. It is a mathematical analysis of the average relation between two or more variables in terms of original units of the data. Here the data analysis should be based on logic of economic theory. Demand Forecasting of New Products:Projecting demand of new products is different from those of established products. This requires an intensive study of the economic and competitive characteristics of the product. Product Life Cycle Analysis:Many products ar distinct when it degenerates over the years into a common product. Innovation of a new product and its degeneration into a common product is termed as Life Cycle of a Product. The forecaster must identify the phase of product cycle at which the industry is operating at the time of prediction. Test Markting:Under test marketing the product is introduced in selected area often at different prices. Th number of area selected depends on the representatives and cost of marketing. The selected area must have an average competition, presence of chain of departmental stores, optimum size of population, etc. The duration of testing depends upon the average purchase period, the competitive situation and cost of testing. Survey of Consumer Intention: This method involves interviewing the consumer by sending questionnaires to elicit replies so as to make short term prediction of demand. Samples may be given for this purpose. This method is most useful when bulk of the sales is made to industrial producers. Here the burden of forecasting is shifted to consumer. Evolutionary Approach: The demand for a new product may be projected as an outgrowth and evolution of an existing old product. This approach is useful when the new product is nearly an improvement of an existing product.

Managerial Economics Growth Curve Approach: Roll of growth and demand for new product may be estimated on the basis of pattern of growth of some existing substitute established 12 product.

What are the determinant of Demand.? Answer: Demand for a commodity depends upon number of factors. Factors influencing individual demand. An individuals demand for a commodity is generally determined by factors such as: Price of the Product: Price is always a basic consideration in determining the demand for a commodity. Normally a larger quantity is demanded at a lower price than at a higher price. Income: Income is an equally important determinant of demand. Obviously with the increase in income one can buy more goods. Thus a rich consumer usually demands more goods than poor consumer. Tastes and Habits: Demand for many goods depend on the persons tastes, habits and preferences. Demand for several products like ice-creams, chocolates, cool drinks etc., depend on an individuals taste. Demand for tea, betel, tobacco etc., is a matter of habit. People with different tastes and habits have different preferences for different goods. A strict vegetarian will have no demand for meat at any price., whereas a non-vegetarian who has liking for chicken may demand it even at a high price. Similar is the case with demand for cigarettes by smokers and non-smokers. Relative prices of Other Goods: How much the consumer would like to buy of a given commodity, however also depends on the relative prices of other related goods such as substitutes or complementary goods to a commodity. When a want can be satisfied by alternate similar goods, they are called substitutes. For example, peas and beans, ground nuts oil and sun-flower oil, tea and coffee etc., are substitutes of each other. The demand for commodity depends on the relative process f its substitutes. If the substitutes are relatively costly, then there will be more demand for the commodity is question at a given price than in case its substitutes are relatively cheaper.

Managerial Economics Substitutes and Complementary Products: The demand for a commodity is also affected by its complementary products. In order to satisfy a given want, two or more goods are 13 needed in combination, these goods are referred as complementary goods. For example car and petrol, pen and ink, tea and sugar, shoes and sacks, gun and bullets etc., are complementary products to each other. Complementary goods are always in joint demand. Thus if a given commodity is a complementary product, its demand will be relatively high when its related commoditys price is lower, than otherwise. When the price of one commodity decreases the demand for its complementary product will tend to increase and vice versa. For example, a fall in price of cars will lead to increase in the demand for petrol. Similarly a steep rise in the price of petrol will cause a decrease in demand of petrol driven cars and its accessories. Consumers Expectations: Consumers expectations about the future changes in the price of a given commodity also may affect its demand. When consumer expects its prices to fall in future, they will tend to buy less at the present prevailing price. Similarly if they expects its prices to rise in future they will tend to buy more at present. Advertisement Effect: In modern times the preferences of a consumer can be altered by advertisement and sales propaganda, albeit to certain extent only. Thus demand for many products like tooth pastes, toilet soaps, washing powder, processed foods etc. is particularly caused by the advertisement effect. . What is Demand Forecasting.? Briefly review the methods of Demand Forecasting? Answer: Demand Forecasting is the method of predicting the future demand for the firms product. It is guess or anticipation or prediction of what is likely to happen in the future. Forecast can be done for several things. It is based on the experience. Techniques or methods of Demand Forecasting: Method of Demand Forecasting is based on whether the good is Established Good or new good. Methods of Demand Forecasting for established goods: Information of the established good is available so the forecast can be based on this information. Two basic methods of demand forecasting for the established goods are: Interview and Survey Approach (for short period forecast): Interview and Survey Approach collects information in the different way. Depending upon how the information is collected, we have different sub methods as follows: Opinion-Polling Method: This method tries to collect information from the customer directly or indirectly through market research department of the
Managerial Economics firm or through the whole sellers or the retailers. Consumers are contacted through mails or phones or Internet and information regarding their 14 expected expenditure is collected. This method is useful when consumers are small in number. Limitations: It is difficult and costly to contact all the customers It is suitable only for short period Consumers are not sure of their purchase plans Collective Opinion Method: Large firms have organized sales department. The salesman has the technical training as how to collect the information from the buyers. This information is further used for forecasting the demand. Limitations: It is difficult and costly to contact all the customers It is suitable only for short period This is based on judgment & has no scientific basis. Sample Survey Method: The total number of consumers for the firms product is very large called as population. It is practically not possible to contact all the consumers. Only few of them are contacted and this forms the sample. The sample forecasts are then generalized for the whole population through advanced statistical methods available. Limitations: Information collected may not be accurate. Sample is not a random sample. Consumers do not have the correct idea of their purchases in future. Panel of experts: Panel of experts consists of persons either from within the firm or from outside the firm. These experts come together and forecast the demand for their product that is purely based on the judgment of these experts so they are less accurate. But if based on the scientific method the forecast would be accurate. Composite management opinion: The opinions of the experienced person within the firm are collected and manger analyses this information. This
Managerial Economics method is quick, easy and saves time, but is not based on the scientific 15 analysis and thus may not give very accurate results. In this method past Projection Approach(for long period forecast): experience is projected into the future. This can be done with the help of statistical methods. Correlation and Regression Analysis: Past data regarding the factors affecting the demand can be collected. It is possible to express this on the graph. This is a scatter diagram. Example: If we collect the past data about the sales and advertising expenditure of the firm, it is possible to express in the form of scatter diagram as shown below:

A * * ** * * * * * * * **

X O Advertisement Expenditure

In the above diagram we get the functional relationship as line AA. Here Advertisement Expenditure is the independent variable and Sales is the dependent variable. The relationship between these variables is correlation and the technique of establishing this relationship is regression. In simple
Managerial Economics correlation we establish relationship between 2 variables and more than 2 16 variables in multiple correlation. Limitations: Assumption made is that correlation between two variables will continue in future also, this might not happen. Time Series Analysis: Demand forecasts for a period of 2-3 years are based on time series analysis. It is similar to the correlation analysis. It is based on the assumption that the relationship between the dependent and the independent variable continues to hold in the future.

Managerial Economics Methods of Demand Forecasting for new products: Indirect methods of forecasting are used to estimate demand for new products. Following are the methods suggested: Evolutionary Method: Some new goods evolve from already established goods. Demand forecast for such new good is based on already established good from which they are evolved. For example Demand for the color TV can be calculated from Demand for the black and white TV, from which it is actually evolved. Limitations: The product should have been evolved from the existing product. It ignores the problem of how the new product differs from the old product. Substitution Method: Some new goods are substituted of already established goods. For example VCR substituted with VCD player. Limitations: New product may have many uses and each use has different substitutability When the substitute is added is added into market existing firm may react by changing the prices. Opinion Polling Method: Expected buyers and the consumers are directly contacted and opinion about the product is directly taken from them. If the population is large then sample is selected and results are generalized for the population. Limitations: It is difficult and costly to contact all the customers It is suitable only for short period Consumers are not sure of their purchase plans Sample Survey Method: New product are first introduced in the sample market and the results seen in the sample market are generalized for the total market. Limitations: Information collected may not be accurate Tastes and the preferences may differ from market to market
Managerial Economics

17 Indirect Opinion Polling Method: Opinion of the consumers is indirectly 18 collected through the dealers who are aware of the needs of the customers. Limitations: It is based on the judgment Limited Scope

State and explain the Law of Variable Proportion. Ans. Statement of the Law: 1. As equal increments of one input are added; the inputs of other productive services being held, constant, beyond a certain point the resulting increments of product will decrease, i.e., the marginal product will diminish. (G. Stigler) 2. As the proportion of one factor in a combination of factors is increased, after a point, first the marginal and then the average product of that factor will diminish. (F. Benham) 3. An increase in some inputs relative to other fixed inputs will, in a given state of technology, cause output to increase; but after a point the extra output resulting from the same additions of extra inputs will become less and less. (P.A. Samulson)

Managerial Economics Explanation of the Law of Diminishing Returns (Variable Proportion) with 19 the help of a table: Fixed Factor K K K K K K K K K K K K K Variable Factor 1 2 3 4 5 6 7 8 9 10 11 12 13 Total Product 5 15 30 50 70 90 105 115 120 124 127 127 118 Average Product 5 7.5 10 12.5 14.0 15 15 14.3 13.3 12.4 11.5 10.50 9.07 Marginal Product 5 10 Increasing Returns 15 20 20 Constant Returns 20 15 10 5 4 Diminishing Returns 3 0 -9 Negative Returns

Average Marginal Relationship: The above table shows that eventually the total product also starts declining. But first to decline is the marginal product. The relationship between them is as follows. As long as the average product is rising, marginal product would be larger than the average product. M.P. is less than A.P., when A.P. is decreasing. The A.P. remains constant when M.P. and A.P. are equal. Also, when A.P. is maximum M.P. equals A.P. Total product is maximum when M.P. is zero. M.P. becomes negative when T.P. falls. In the table, when 1 to 4 workers are employed, the marginal product goes on increasing. This is the phase of Increasing Returns. When workers 4,5 and 6 are employed, M.P. is constant i.e. 20. This is the phase when the Law of constant returns is in operation. From 7 to 11 workers, though the T.P. is increasing, the M.P. goes on decreasing. This is the phase of Diminishing Returns.

Managerial Economics 20 Diagrammatic illustration of the law of diminishing returns The following figure is a diagrammatic presentation of the Law of returns roughly representing the figures in the table given before

Stage II

Stage I Stage III

T.P. Curve

A.P. Curve M M.P. Curve

In the above figure the T.P. curve goes on increasing to a point and after than it starts declining. A.P. and M.P. curves also rise and then decline. M.P. curve starts declining earlier than the A.P. curve. The behavior of the output when the varying quantity of one factor is combined with a fixed quantity of other can be divided into three distinct stages. Stage I: In this stage T.P. to a point increases at an increasing rate. In the figure from the origin to the point F, slope of the total product curve T.P. is increasing i.e. up to the point F, i.e. T.P. increases at an increasing rate, which means that M.P. rises. From the point F onwards during the Stage I, the T.P. curve goes on rising but its slope is declining which means that from point F onwards the T.P. increases at a diminishing rate i.e. M.P. falls but it is positive. The point F where the total product stops at an increasing rate and starts increasing at a diminishing rate is called the point of inflexion. Corresponding vertically to this point of inflexion,
Managerial Economics M.P. is maximum, after which it slopes downward. The stage I ends where the AP curve reaches its highest point S. Stage I is known as the stage of increasing 21 returns because A.P. of the variable factor increases throughout this stage. Stage II: In stage II, the T.P. continues to increase at a diminishing rate until it reaches its maximum point H where the second stage ends. In this stage both the M.P. and A.P. of the variable factor is zero, when T.P. is highest as shown by point H. Stage II is important because the firm will seek to produce in its range. This stage is known as the stage of diminishing returns as both the A.P. and M.P. continuously fall during this stage. Stage III: In stage III, T.P. declines and therefore T.P. curve slopes downward. As a result M.P. of the variable factor in negative and the M.P. curve goes below the X-axis. This stage is called the stage of negative returns, since the M.P. of the variable factor is negative during this stage. Explanation of the various stages 1. Increasing returns: In the beginning, the quantity of fixed factor is abundant relative to the quantity of the variable factor. As more and more units of variable factors are added to constant quantity of fixed factor then fixed factor gets more intensively and effectively utilized and production increases at a rapid rate. In the given example, throughout the three stages fixed variable i.e. machinery remains constant. The variable factor i.e. no. of workers increase as a firm expands its production. A worker contributes 5 units per day to the firms output. The total product reaches 50 units per day when the 4th worker contributes to the production. Fuller utilization of capital is possible due to the addition of a variable factor. When the fourth worker joins it is possible to use the full potential of the capital. Diminishing Returns: The peculiar feature of this stage is that the 2. marginal product falls through out the stage and finally touches to zero. Corresponding vertically is the point h, which is the highest point of the TP curve. Here the stage II ends. In the table given, the third stage is set in by hiring 7th worker who adds only 15 units per day as compared to 20 units per day added by the 6th worker. Total Product increases but gain from 7th worker is not as great as gain from the 6th
Managerial Economics worker. Explanation to this can be given as once the point is reached at which variable factor is sufficient to ensure full utilization of fixed factor, then further 22 increase in variable factor will cause MP as well as AP to fall because fixed factor has now become inadequate relative to the quantity of variable factors. In stage II fixed factor is scarce as compared to variable factor. Negative returns: In this stage, marginal product falls below X-axis i.e. 3. negative because total product starts falling. In our example this is set in by hiring 13th worker. The total product falls from 127 units to 118 units. The large number of variable factors impairs the efficiency of the fixed factor. The excessive variable factor as compared to less fixed factor results in a fall of total output. In such a situation, a reduction in the units of the variable factor will increase the total output.

Explain the features of Monopoly.? Answer: The following features are seen under simple or limited monopoly. Single Producer: For monopoly to exist only one producer should be in the market. The producer may be an individual, a partnership firm, an enterprise, the government or a joint stock company. No close Substitute: To avoid any possibility of competition in the market, there should be no close substitutes for the product of the monopolist. This means that the crosselasticity of demand for the monopolists product is low. Barriers to entry of firm: The basis of monopoly is the barriers or restrictions of new firms into the market, those can be either natural barriers or artificial barriers. Demand curve under monopoly: The above mentioned features explain the demand curve or the average revenue(AR) curve under the monopoly. The demand curve for a firm(which means the industry under monopoly) is downward sloping. It is the monopolist who is the price- market in the market.

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Demand Curve under Monopoly

Average Revenue Price

Quantity Demanded

Under the monopoly, there is only one seller who controls the entire supply in the market. Since this is the only producer and seller, he can fix the price of his product. In order to maximize his profit, he may rise the price frequently. He may exploit the consumers by charging an excessive price. Since there are no sellers, the buyers have no alternative than to buy from the monopolist. Indeed all buyers are put at that mercy of the monopolist. Many times, monopolies are created under law. Urban transport, supply of gas and electricity, nowadays cable television system and such other public utilities are usually managed as monopolies. Such monopolies are called natural monopolies. On the other hand if a producer acquires monopoly on the basis of patent laws, it is called an artificial monopoly. Explain how price is determined under monopoly.? Answer: Pure monopoly or simply monopoly is a market situation where there is only a single seller of goods with no close substitutes. Good example are public unit utility such as water , electricity , telephone undertaking
Managerial Economics Being the sole seller of goods without close substitute the monopolist has substantial 24 control over the price he charges. He may lower the price and increase the quantity soled or he may lower the quantity soled and raise the price thus a monopolist is a price maker or price searcher who is in search of the price quality combination that will maximize his profit. Under the monopoly, there is only one seller who controls the entire supply in the market. Since this is the only producer and seller, he can fix the price of his product. In order to maximize his profit, he may rise the price frequently. He may exploit the consumers by charging an excessive price. Since there are no sellers, the buyers have no alternative than to buy from the monopolist. Monopoly price during the short run : During the short run a monopolist cannot expand or contract the size of his plan. Thus in the equilibrium situation in the short run a monopolist firm may likely to face three situation : It may earn abnormal profit, when firm AR > AC . It may suffer losses, when firm AR < AC. It may earned normal profit, when firm AR = AC Abnormal Profit: At equilibrium level of output a monopoly firm may earned abnormal profits when the firms average revenue exceeds the average cost of production.

D Cost/ Revenue A




The equilibrium level is determined at the point k where marginal cost = marginal revenue . the firm get profit per unit equal to CB. The total profit enjoy by the firm is shown by the shaded area DABC .Thus the monopolist will produce OQ output at CQ price . Losses: At equilibrium level of output a firm may suffer losses when is average revenue is less than average cost .

Managerial Economics


D Cost/ Revenue A




The equilibrium level is determined at point and where marginal cost is equal to marginal revenue. The total loss suffered by the firm is equal to the shaded portion ABCD . Equilibrium output is OQ Normal Profit: At equilibrium output is determined at the point a firm may earned normal profit when its average revenue is equal to average cost of production.

D Cost/ Revenue A




The equilibrium level is determined at point K where marginal cost is equal to marginal revenue . equilibrium output is OQ . at this our put firms average revenue is equal to average cost . there for firm earns only normal profit .

Monopoly price during long period: A monopoly firm during the long run will necessarily receive abnormal profit . The two reason for this are : Managerial Economics Entry of new firm is difficult . If the monopolist does not receive profit he will have no attraction to stay in 26 the market .

D Cost/ Revenue A



The long run equilibrium of the monopoly firm is obtained where the long run marginal cost is equal to long term marginal revenue The equilibrium level is determined at point K where LMR = LMC . the equilibrium level of output is OQ . the total shaded area ABCD represent the profit earned by the firm. Monopoly price during the long run is always more than long run average cost (P>LAC).

Managerial Economics Write Short Notes On: Answer: e) Fiscal Policy: It is one of the important economic policies to achieve economic stability. Fiscal Policy refers to variation in taxation and public expenditure programs by the government to achieve predetermined objectives. Taxation is transferring of funds from private purses to public (Government) coffers. It is the withdrawal of funds from private use. Public expenditure on the other hand increases the flow of funds into the private economy. Since the tax-revenue and public expenditure form two sides of the government budget, the taxation and public expenditure policies are also jointly called the Budgetary Policy. Fiscal or Budgetary Policy is regarded as powerful instrument of economic stabilization. The importance of fiscal policy as an instrument of economic stabilization rests on the fact that government activities in the modern economies are greatly enlarged, and government tax-revenue and expenditure account for a considerable proportion of GNP, ranging from 10-25 per cent. Therefore the government may affect the private economic activities to same extent through variation in taxation and public expenditure. Besides fiscal policy is considered to be more effective than monetary policy because the former directly affects the private decisions while later does so indirectly. If the fiscal policy is formulated that it is during the period of expansion, it is known as counter-cyclical fiscal policy. 27

f) Monetary Policy: Monetary Policy refers to the program of Central Banks variations, in the total supply of money and cost of money to achieve certain predetermined objectives. One of the primary objectives of monetary policy is to achieve economic stability. The traditional instrument through which Central Bank carries out the Monetary Policies are: Quantitative Credit Control measures such as open market operations, changes in bank rates (or discount rates), and changes in the statutory reserve ratios. Briefly speaking, open market operations by the Central Bank are the sale and purchase of government bonds, treasure bills, securities, etc., to and from public. Bank rate
Managerial Economics is the rate at which Central Bank discounts the commercial banks bills of exchange or first class bill. The statutory reserve ratio is the proportion of 28 commercial banks time and demand deposit, which they are required to deposit with Central Bank or keep cash-in-vault. All these instruments when operated by the Central Bank reduce (or enhance) directly and indirectly the credit creation capacity of the commercial banks and thereby reduce (or increase) the flow of funds from the banks to the public. In addition these instruments, Central Bank use also various selective credit control measures and moral suasion. The selective credit controls are intended to control the credit flows to particular sectors without affecting the total credit, and also to change the composition of credit from undesirable to desirable pattern. Moral suasion is a persuasive method to convince the commercial banks to behave in accordance with the demand of the time and in the interest of the nation. The fiscal and monetary policies may be alternatively used to control the business cycles in the economy, though monetary policy is considered to be more effective to control inflation than to control depression. It is however, always desirable to adopt a proper mix of fiscal and monetary policies to check the business cycles.

k) Economic Problem and its universal nature: The same basic economic problem unlimited wants and relatively limited resources arises at all levels of human organization. Thus whether we are thinking of grampanchayat, or of zilla parishad, or club or hospital or national government, all have to face the basic economic problem. Thus whether it is Government of India or America, the problem of economy is always there.

Managerial Economics The Government of India with annual revenue of about 1,00,000/- crores has innumerable demands on its resources such as meeting mounting defense 29 expenditure, expanding expenditure in respect of development that is to be brought about in various sectors like agriculture, industries, transport, education and so on. The Government of India therefore continually faces the basic problem of economy of how to make best use of its limited resources. In the same way, the federal government of America, the richest government faces some basic economic problem. Though in absolute terms, its annual revenues are enormous running into billions or trillions of dollars, its needs are also unlimited. Expanding and modernizing the defense forces, establishing military bases all over the world giving military assistance to the friendly countries, expenditure on space and military research etc., and therefore even the richest government of US is always confronted by the same basic economic problem of limited resources to fulfill unlimited wants. Every nation, poor or rich, small or big with small or huge population, has to face the basic economic problem. No nation can escape it. Thus we can conclude that that there is something universal about problem of economy. The basic economic arises in the case of an native, a villager, a city resident, in the case of poor or rich, in case of associations like clubs, schools, hospitals and government organization right from the village level to national level. The problem of economy unlimited wants and limited means with alternative uses - has been forever confronting the mankind. The economic problem is the universal problem. Economy problem does not recognize boundaries of caste, creed, color, religion and culture.

l) Profit maximization goal: The conventional economic theory assumes profit maximization as the only objective of the business firms. It forms the basis for the conventional price theory. Profit maximization is regarded as the most reasonable and analytically most productive business objective. Besides, profit maximization assumption has a great predictive power. It helps in predicting the behavior of business firms in the real world and also the behavior of the price and output under different market conditions. There are two conditions that must be fulfilled for the profit maximization: The necessary condition requires that Marginal Revenue (MR) must be equal to marginal cost (MC). Marginal Revenue is obtained from production and sales of one additional unit of output. Marginal cost is the cost incurred due to one additional unit of output.
Managerial Economics The secondary condition requires that necessary condition must be 30 satisfied under the condition of decreasing MR and increasing MC. The fulfillment of two condition makes the sufficient condition. Objections to this approach: Profit maximization assumption is too simple to explain the business phenomenon in the real world. In fact, businessman themselves are not aware of this objective attributed to them. It is claimed that there are alternative and equally simple objectives of business firms that explains better the real world business phenomenon. Ex: Sales maximization, Market share. Firm do not have the necessary knowledge and priori data to equalize MR and MC. In defense of Profit Maximization assumption: Firms continue to survive in the long run in a competitive market, which are able to make reasonable profit. This assumption has been accurate in predicting the firms behavior. It is time honored objective of firm Profit is one of the most efficient and reliable measures of efficiency of a firm.

Briefly review the various theories of profit? Ans. Various theories of profit are as follows:

a.) Risk Taking Theory: According to Hawley, profit arises because considerable amount of risk is involved in the business. But his was criticized for several reasons. Firstly the types of risks involved in the business are not classified. Also Cawer
Managerial Economics pointed out that profit is not the reward for risk taking but instead it is a reward for risk avoiding. Successful entrepreneur is the one who earns a 31 good profit by avoiding the risks, while mediocre businessman is not able to earn profit as he is unable to avoid risks.

b.) Uncertainty-Bearing Theory: In this theory the risks are classified into 2 types: Insurable Risks: These are the risks covered by the insurance company. Eg: risk of fire, accidents, risk of theft etc. Owner takes the insurance policy by paying the premium for the same. Non-Insurable Risks: The insurance company does not cover these risks. They may occur due to sudden increase in the price of raw material, introduction of new substitutes, raw material supply may be reduced. When the demand for the products suddenly falls large stock remains in the inventory. Also there can be sudden change in the fashion. All these factors are uncertain and cannot be insured. Losses arising of such uncertainty cannot be estimated with precision; hence profit can be considered as reward for uncertainty.

c.) Innovation Theory: According to this theory suggested by Schumpeter, profit is the reward for Innovation. It is up to the entrepreneur how he exploits the invention made by the scientist into innovation. But this theory of Schumpeter has been criticized on several grounds. He neglected the fact that profit is reward for risk and uncertainty bearing. Innovative characteristics of the producer may help him to earn super normal profits in the short run, but in the long run they will disappear, as it will further attract the new firms into the market. Thus it is said that profits caused by innovation are disappeared by imitation.

Managerial Economics d.) Dynamic theory of profit: The renowned economist J.B Clark developed this theory. He pointed out that whole world is dynamic and required of changes. He pointed out the following type of changes: Changes in the quality and quantity of human needs. Changes in the techniques of production Changes in the supply of capital Changes in the organization of business Changes in population 32

Techniques of production can be changed and improved machinery may be introduced. This may reduce the cost of production and improve the profit and output. Purchasing of improved machinery would involve lot of capital to be raised. Adding partners or converting the partnership firm into Joint Stock Company can solve this purpose. For this purpose producer has to keep on adjusting himself or he would lag behind in this dynamic everchanging world. Thus profit is the reward paid for dynamism. This theory was criticized for several reasons. He classified the changes under 5 categories but has failed to look at many other important changes like change in the government policy, monetary policy of Central Bank can lead to expansion and contraction of supply of money. These factors may drastically affect the smooth working of the business. ________________________________________________________________

Managerial Economics 33 Define Business Cycle. Explain various phases of business cycle. Ans. The term trade cycle or Business Cycle in economics refers to the wave-like fluctuations in the aggregate economic activity, particularly in employment, output and income. Mitchell defined trade cycle as a fluctuation in aggregate economic activity. According to Haberler, The business cycle in the general sense may be defined as an alternation of periods of prosperity and dispersion, of good and bad trade. Keynes points out A trade cycle is composed of periods of good trade characterized by rising prices and low unemployment percentages, altering with periods of bad trade characterized by falling prices and high unemployment percentages.

Phases of Business Cycle The ups and downs in the economy are reflected by the fluctuation in aggregate economic magnitudes, such as, production, investment, employment, prices, wages, bank credits, etc. The upward and downward movement in these magnitudes shows different phases of business cycle. Basically there are only two phases in a cycle, viz., prosperity and depression. But considering the intermediate stages between prosperity and depression, the various phases of trade cycle may be enumerated as follows: 1. Expansion 2. Peak 3. Recession 4. Trough 5. Recovery and expansion The five phases of a business cycle have been presented in the figure. The steady growth line shows the growth of the economy when there are no economic fluctuations. The various phases of business cycles are shown by the line of cycle which moves up and down the steady growth line. The line of cycle moving above the steady growth line marks the beginning of the period of expansion or prosperity in the economy. The phase of expansion is characterized by increase in output, employment, investment, aggregate demand, sales, profits, bank credits, wholesale and retail prices, per capital output and a rise in standard of living. The growth rate eventually slows down and reaches the peak. The phase of peak is generally characterized by slacking in the expansion rate, the highest level of prosperity, and downward slide in the economic activities from the peak.
Steady Growth Line Managerial Economics
Peak Expansion Prosperity Recession Prosperity Expansion Recovery



Line of Cycle


The phase of recession begins when the downward slide in the growth rate becomes rapid and steady. Output, employment, prices, etc. register a rapid decline, though the realized growth rate may still remain above the steady growth line. So long as growth rate exceeds or equals the expected steady growth rate, the economy enjoys the period of prosperity high and low. When the growth rate goes below the steady growth rate, it makes the beginning of depression in the economy. In a stagnated economy, depression begins when growth rate is less than zero, i.e. the total output, employment, prices, bank advances, etc., decline during the subsequent periods. The span of depression spreads over the period growth rate stays below the secular growth rate or zero growth rate in a stagnated economy. Trough is the phase during which the down trend in the economy slows down and eventually stops, and the economic activities once again register an upward movement. Trough is the period of most severe strain on the economy. When the economy registers a continuous and repaid upward trend in output, employment, etc., it enters the phase of recovery though the growth rate may still remain below the steady growth rate. And, when it exceeds this rate, the economy once again enters the phase of expansion and prosperity. If economic fluctuations are not controlled by the government, the business cycle continues to recur.

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Managerial Economics