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A) Concepts in managerial economics

1. Long run and Short run

This is the time period when there is no fixed factors of production. All
factors of production and all costs of production are variable hence there
are no contraints preventing changes in the level of output. For example in
the long run firms are able to adjust all costs
Short run concepts brings out the fact that some factors are variable and
others are fixed. For example in the short run firms are only able to
influence prices through adjustments made in production, short run may
also vary based on the contracts that the company holds like lease
contracts that would fix the rent of a firm for a given period, while some
factors of production remain variable.
2. Sunk Costs and Variable Costs
Sunk cost is a cost that has already been incurred and cannot be
recovered. Sunk costs should not be key criteria in making the optimal
decision, most companies would consider future costs rather than sunk
costs when making decisions. For example a company that has spent $10
million building a factory that is not yet complete, has to consider the $10
million sunk, since it cannot get the money back.
Variable Costs are costs that change with the change in the level of
production. They do not remain constant. For example costs related to raw
materials purchase, production labor, and sales commission costs will
fluctuate with the number of spark plugs produced and sold, so they are
variable costs.
3. Increasing returns to scale and Decreasing returns to scale
Increasing Returns to Scale
This will happen when output increases more than increase in inputs for
instance doubling inputs would lead to more than double the output.
For example, in year one a firm employs 200 workers, uses 50 machines,
and produces 1,000 products. In year two it employs 400 workers, uses
100 machines (inputs doubled), and produces 2,500 products (output
more than doubled)

Decreasing returns to scale

This occurs when output increases by less than increase in inputs for
instance doubling inputs lead to less than double the output. An increase
in all inputs leads to less than proportional increase in output. For
example, in year one, a firm employs 200 workers, uses 50 machines, and
produces 1,000 products. In year two it employs 400 workers, uses 100
machines (inputs doubled), and produces 1,500 products (output less than

) Monopolistic competitors demand function is P = 280 - 8Q and total cost function is TC = 200
+ 10Q2.

How many units should this firm produce so as to maximize total profit?
TR = P * Q
= (280 8Q) Q
= 280Q 8Q2
MR = dTR/dQ = 280 16Q
TC = 200 + 10Q2
MC = dTC/ dQ = 20Q
Finding Q
280 16Q = 20Q
36Q = 280
Q = 280/36 = 7.7 approx. 8 units


What price should the firm charge?

P = 280 8Q
= 280 8(8)
= 280 64 = 216 per unit.


What is the level of profit?

Total Profit = TR TC
= 280Q 8Q2 (200 + 10Q2)
= 280Q 8Q2 200 10Q2
= 280Q 18Q2 200
TR = 280(8) 8(8)2 200
= 2240 1152 200
= 888


Distinguish between transfer pricing and price skimming

Transfer pricing is a pricing strategy that mostly relates to international

transactions done between related parties and it covers all sorts of
Example of the













Price skimming is a pricing strategy where by a firm charges high
prices in the initial stages of product launch or pioneering stage. When
demand is either unknown or more inelastic at this stage, market is
divided into segments on the basis of different degree of elasticity of
demand of different consumers. This is a short period device for
pricing. The demand for new products is likely to be less price elastic in
the early stages, that is, the initial high price helps to Skim the
Cream of the market which is relatively insensitive to price.