MANAGERIAL ECONOMICS

MB0026
SET – 1

MBA – 1 SEM

Name Mohammed Roohul Ameen

Roll Number
Learning Center SMU Riyadh (02543)
Subject Managerial Economics
Date of Submission 15th August 2009
Assignment Number MB0026
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Assignment MBA 1st Semester Subject: MB0026
1, Define Managerial Economics and discuss its importance and functions

Managerial economics (sometimes referred to as business economics), is a branch of economics that

applies microeconomic analysis to decision methods of businesses or other management units. As
such, it bridges economic theory and economics in practice. It draws heavily from quantitative
techniques such as regression analysis and correlation, Lagrangian calculus (linear). If there is a unifying
theme that runs through most of managerial economics it is the attempt to optimize business decisions
given the firm's objectives and given constraints imposed by scarcity, for example through the use of
operations research and programming.

Almost any business decision can be analyzed with managerial economics techniques, but it is most
commonly applied to:

 Risk analysis - various models are used to quantify risk and asymmetric information and to
employ them in decision rules to manage risk.
 Production analysis - microeconomic techniques are used to analyze production efficiency,
optimum factor allocation, costs, and economies of scale and to estimate the firm's cost
function.
 Pricing analysis - microeconomic techniques are used to analyze various pricing decisions
including transfer pricing, joint product pricing, price discrimination, price elasticity estimations,
and choosing the optimum pricing method.
 Capital budgeting - Investment theory is used to examine a firm's capital purchasing decisions.

Important Features of managerial Economics

 It is a highly specialized and separate branch by itself.

 It is more realistic, pragmatic and highlights on practical application of various economic

theories to solve business and management problems.

 It is a science of decision-making. It concentrates on decision-making process, decision

models and decision variables and their relationships.

 It is both conceptual and metrical and it helps the decision maker by providing
measurement of various economic variables and their interrelationships.

 It uses various macroeconomic concepts like national income, inflation, deflation, trade
cycles etc to understand and adjust its policies to the environment in which the firm
operates.

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Assignment MBA 1st Semester Subject: MB0026
  It also gives importance to the study of no economic variables having implications of
economic performance of the firm. For example, impact of technology, environmental
forces, sociopolitical and cultural factors etc.

 It uses the services of many other sister sciences like mathematics, statistics,
engineering, accounting, operation research and psychology etc to find solutions to
business and management problems.

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Assignment MBA 1st Semester Subject: MB0026
2. What is elasticity of demand? Explain the different degree of price elasticity with
suitable examples.

In economics, elasticity is the ratio of the percent change in one variable to the percent change in
another variable. It is a tool for measuring the responsiveness of a function to changes in parameters in
a relative way. Commonly analyzed are elasticity of substitution, price and wealth. Elasticity is a
popular tool among empiricists because it is independent of units and thus simplifies data analysis.

An "elastic" good is one whose price elasticity of demand has a magnitude greater than one. Similarly,
"unit elastic" and "inelastic" describe goods with price elasticity having a magnitude of one and less
than one respectively.

The degree to which a demand or supply curve reacts to a change in price is the curve's elasticity.
Elasticity varies among products because some products may be more essential to the consumer.
Products that are necessities are more insensitive to price changes because consumers would continue
buying these products despite price increases. Conversely, a price increase of a good or service that is
considered less of a necessity will deter more consumers because the opportunity cost of buying the
product will become too high.

A good or service is considered to be highly elastic if a slight change in price leads to a sharp change in
the quantity demanded or supplied. Usually these kinds of products are readily available in the market
and a person may not necessarily need them in his or her daily life. On the other hand, an inelastic
good or service is one in which changes in price witness only modest changes in the quantity
demanded or supplied, if any at all. These goods tend to be things that are more of a necessity to the
consumer in his or her daily life.

Price Elasticity of Demand:-

Price elasticity of demand is one of the important concepts of elasticity which is used to describe the
effect of change in price on quantity demanded.

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Assignment MBA 1st Semester Subject: MB0026
Different Degree of Price Elasticity of Demand

1. Perfectly Elastic Demand: In this case, a very small change in price leads to an infinite change in
demand. The demand cure is a horizontal line and parallel to OX axis. The numerical coefficient of
perfectly elastic demand is infinity (ED=00).

2. Perfectly Inelastic Demand: In this case, whatever may be the change in price, quantity demanded
will remain perfectly constant. The demand curve is a vertical straight line and parallel to OY axis.
Quantity demanded would be 10 units, irrespective of price changes from Rs. 10.00 to Rs. 2.00. Hence,
the numerical coefficient of perfectly inelastic demand is zero. ED = 0

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3. Relative Elastic Demand: In this case, a slight change in price leads to more than proportionate
change in demand. One can notice here that a change in demand is more than that of change in price.
Hence, the elasticity is greater than one. For e.g., price falls by 3 % and demand rises by 9 %. Hence, the
numerical coefficient of demand is greater than one.

4. Relatively Inelastic Demand: In this case, a large change in price, say 8 % fall price, leads to less than
proportionate change in demand, say 4 % rise in demand. One can notice here that Change in demand
is less than that of change in price. This can be represented by a steeper demand curve. Hence,
elasticity is less than one

5. Unitary elastic demand: In this case, proportionate change in price leads to equal proportionate
change in demand. For e.g., 5 % fall in price leads to exactly 5 % increase in demand. Hence, elasticity is
equal to unity. It is possible to come across unitary elastic demand but it is a rare phenomenon.

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Out of five different degrees, the first two are theoretical and the last one is a rare possibility. Hence, in
all our general discussion, we make reference only to two terms relatively elastic demand and relatively
inelastic demand.

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3) Suppose your manufacturing company planning to release a new product into
market, Explain the various methods forecasting for a new product

Business forecasting has always been one component of running an enterprise. However, forecasting
traditionally was based less on concrete and comprehensive data than on face-to-face meetings and
common sense. In recent years, business forecasting has developed into a much more scientific
endeavor, with a host of theories, methods, and techniques designed for forecasting certain types of
data. The development of information technologies and the Internet propelled this development into
overdrive, as companies not only adopted such technologies into their business practices, but into
forecasting schemes as well.

There are two major types of forecasting, which can be broadly described as macro and micro:

Macro forecasting is concerned with forecasting markets in total. This is about determining the existing
level of Market Demand and considering what will happen to market demand in the future.

Micro forecasting is concerned with detailed unit sales forecasts. This is about determining a product's
market share in a particular industry and considering what will happen to that market share in the
future.

The selection of which type of forecasting to use depends on several factors:

(1) The degree of accuracy required - if the decisions that are to be made on the basis of the sales
forecast have high risks attached to them, then it stands to reason that the forecast should be prepared
as accurately as possible. However, this involves more cost

(2) The availability of data and information - in some markets there is a wealth of available sales
information (e.g. clothing retail, food retailing, holidays); in others it is hard to find reliable, up-to-date
information

(3) The time horizon that the sales forecast is intended to cover. For example, are we forecasting next
weeks' sales, or are we trying to forecast what will happen to the overall size of the market in the next
five years?

(4) The position of the products in its life cycle. For example, for products at the "introductory" stage of
the product life cycle, less sales data and information may be available than for products at the
"maturity" stage when time series can be a useful forecasting method.

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The first stage in creating the sales forecast is to estimate Market Demand. A company’s share of
market demand depends on how its products, services, prices, brands and so on are perceived relative
to the competitors. All other things being equal, the company’s market share will depend on the size
and effectiveness of its marketing spending relative to competitors.

Develop the Sales Forecast

The Sales Forecast is the expected level of company sales based on a chosen marketing plan and an
assumed marketing environment.

Note that the Sales Forecast is not necessarily the same as a “sales target” or a “sales budget”.

A sales target (or goal) is set for the sales force as a way of defining and encouraging sales effort. Sales
targets are often set some way higher than estimated sales to “stretch” the efforts of the sales force.

A sales budget is a more conservative estimate of the expected volume of sales. It is primarily used for
making current purchasing, production and cash-flow decisions. Sales budgets need to take into
account the risks involved in sales forecasting. They are, therefore, generally set lower than the sales
forecast.

Obtaining information on existing market demand

As a starting point for estimating market demand, a company needs to know the actual industry sales
taking place in the market. This involves identifying its competitors and estimating their sales.

An industry trade association will often collect and publish (sometime only to members) total industry
sales, although rarely listing individual company sales separately. By using this information, each
company can evaluate its performance against the whole market.

This is an important piece of analysis. Say, for example, that Company A has sales that are rising at 10%
per year. However, it finds out that overall industry sales are rising by 15% per year. This must mean
that Company A is losing market share – its relative standing in the industry.

Another way to estimate sales is to buy reports from a marketing research firm such as AC Neilsen,
Mintel etc. These are usually good sources of information for consumer markets – where retail sales
can be tracked in great detail at the point of sale. Such sources are less useful in industrial markets
which usually rely on distributors.

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Estimating Future Demand

So far we have identified how a company can determine the current position:

Current Company Demand = Current Market Demand x Current Market Share

How can future market demand and company demand be forecast?

Very few products or services lend themselves to easy forecasting. These tend to involve a product
whose absolute level or trend of sales is fairly constant and where competition is either non-existent
(e.g. monopolies such as public utilities) or stable (pure oligopolies). In most markets, total demand and
company demand are not stable – which makes good sales forecasting a critical success factor.

A common method of preparing a sales forecast has three stages:

(1) Prepare a macroeconomic forecast – what will happen to overall economic activity in the relevant
economies in which a product is to be sold.

(2) Prepare an industry sales forecast – what will happen to overall sales in an industry based on the
issues that influence the macroeconomic forecast;

(3) Prepare a company sales forecast – based on what management expect to happen to the
company’s market share

Sales forecasts can be based on three types of information:

(1) What customers say about their intentions to continue buying products in the industry?

(2) What customers are actually doing in the market?

(3) What customers have done in the past in the market?

There are many market research businesses that undertake surveys of customer intentions – and sell
this information to businesses that need the data for sales forecasting purposes. The value of a
customer intention survey increases when there are a relatively small number of customers, the cost of
reaching them is small, and they have clear intentions. An alternative way of measuring customer
intentions is to sample the opinions of the sales force or to consult industry experts

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Time Series Analysis

Many businesses prepare their sales forecast on the basis of past sales.

Time series analysis involves breaking past sales down into four components:

(1) The trend: are sales growing, “flat-lining” or in decline?

(2) Seasonal or cyclical factors. Sales are affected by swings in general economic activity (e.g. increases
in the disposable income of consumers may lead to increase in sales for products in a particular
industry). Seasonal and cyclical factors occur in a regular pattern;

(3) Erratic events; these include strikes, fashion fads, war scares and other disturbances to the market
which need to be isolated from past sales data in order to be able to identify the more normal pattern
of sales

(4) Responses: the results of particular measures that have been taken to increase sales (e.g. a major
new advertising campaign)

Using time series analysis to prepare an effective sales forecast requires management to:

Smooth out the erratic factors (e.g. by using a moving average)

Adjust for seasonal variation

Identify and estimate the effect of specific marketing responses

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Assignment MBA 1st Semester Subject: MB0026
Define the term equilibrium. Explain the changes in market equilibrium and effects to
shifts in supply and demand.

Market Equilibrium is a condition where a market price is established through competition such that
the amount of goods or services sought by buyers is equal to the amount of goods or services produced
by sellers. This price is often called the equilibrium price or market clearing price and will tend not to
change unless demand or supply change.

Changes in Market Equilibrium:-

When the price is above the equilibrium point there is a surplus of supply; where the price is below the
equilibrium point there is a shortage in supply. Different supply curves and different demand curves
have different points of economic equilibrium. In most simple microeconomic stories of supply and
demand in a market a static equilibrium is observed in a market; however, economic equilibrium can
exist in non-market relationships and can be dynamic. Equilibrium may also be multi-market or general,
as opposed to the partial equilibrium of a single market.

Effects of Changes in both Demand and Supply:

In economics equilibrium means "balance," here between supply forces and demand forces: for
example, an increase in supply will disrupt the equilibrium, leading to lower prices. Eventually, a new
equilibrium will be attained in most markets. Then, there will be no change in price or the amount of
output bought and sold — until there is an exogenous shift in supply or demand (such as changes in
technology or tastes). That is, there are no endogenous forces leading to the price or the quantity.

Not all economic equilibriums are stable. For an equilibrium to be stable, a small deviation from
equilibrium leads to economic forces that returns an economic sub-system toward the original
equilibrium. For example, if a movement out of supply/demand equilibrium leads to an excess supply
(glut) that induces price declines which return the market to a situation where the quantity demanded
equals the quantity supplied. If supply and demand curves intersect more than once, then both stable
and unstable equilibriums are found.

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Assignment MBA 1st Semester Subject: MB0026
5. Give a brief description of
(a) Implicit and Explicit cost
(b) Actual and opportunity cost

Implicit and Explicit Costs:-

Explicit costs are those costs which are in the nature of contractual payments and are paid by an
entrepreneur to the factors of production [excluding himself] in the form of rent, wages, interest and
profits, utility expenses, and payments for raw materials etc. They can be estimated and calculated
exactly and recorded in the books of accounts.

 Explicit cost is those which the entrepreneur has to pay from his own pocket.

 Explicit Costs require an outlay of money by the firm.

Implicit or imputed costs are implied costs. They do not take the form of cash outlays and as such do
not appear in the books of accounts. They are the earnings of owner employed resources. For example,
the factor inputs owned by the entrepreneur himself like capital can be utilized by him or can be
supplied to others for a contractual sum if he himself does not utilize them in the business. It is to be
remembered that the total cost is a sum of both implicit and explicit costs.

 A firm's use of its own capital. This is considered an implicit cost because the capital could have
been rented to another firm instead. This rental income foregone, or the implicit rental rate of
capital, is the firm's opportunity cost of using its own capital. This implicit rental rate can be
broken down beyond interest forgone.

 A firm's use of its owner's time and/or financial resources.

Actual costs and Opportunity Costs:-

Actual costs are also called as outlay costs, absolute costs and acquisition costs. They are those costs
that involve financial expenditures at some time and hence are recorded in the books of accounts. They
are the actual expenses incurred for producing or acquiring a commodity or service by a firm. For
example, wages paid to workers, expenses on raw materials, power, fuel and other types of inputs.
They can be exactly calculated and accounted without any difficulty.

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Opportunity cost of a good or service is measured in terms of revenue which could have been earned
by employing that good or service in some other alternative uses. In other words, opportunity cost of
anything is the cost of displaced alternatives or costs of sacrificed alternatives. It implies that
opportunity cost of anything is the alternative that has been foregone. Hence, they are also called as
alternative costs. Opportunity cost represents only sacrificed alternatives. Hence, they can never be
exactly measured and recorded in the books of accounts. The knowledge of opportunity cost is of great
importance to management decision. They help in taking a decision among alternatives. While taking a
decision among several alternatives, a manager selects the best one which is more profitable or
beneficial by sacrificing other alternatives. For example, a firm may decide to buy a computer which
can do the work of 10 laborers. If the cost of buying a computer is much lower than that of the total
wages to be paid to the workers over a period of time, it will be a wise decision. On the other hand, if
the total wage bill is much lower than that of the cost of computer, it is better to employ workers
instead of buying a computer. Thus, a firm has to take a number of decisions almost daily.

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Assignment MBA 1st Semester Subject: MB0026
6. Critically examine Boumal’s static and dynamic models.

Boumal's model highlights that the primary objective of a firm is to maximize its sales rather than profit
maximization. It states that the goal of a firm is maximization of sales revenue subject to a minimum
profit constraint.

Prof. Boumal has developed two models: 1st is Static Model and 2nd is Dynamic model

The Static Model:

This model is based on the following assumptions,

1. The model is applicable to a particular time period and the model does not operate at different
periods of time.

2. The firm aims at maximizing its sales revenue subject to a minimum profit constraint.

3. The demand curve of the firm slope downwards from left to right.

4. The average cost curve of the firm is U-shaped one.

Dynamic Model:

This model explains how changes in advertisement expenditure, a major determinant of demand,
would affect the sales revenue of a firm under severe competitions. Few assumptions of this model
are,

1. Higher advertisement expenditure would certainly increase sales of a firm.

2. Market price remains constant.

3. Demand and cost curves of the firm are conventional in nature.

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Assignment MBA 1st Semester Subject: MB0026