Managerial Economics

[Set-I]

MB0042

Master of Business Administration-MBA Semester 1 Managerial Economics (60 Marks) - 4 Credits MB0042 (Book ID: B1131) Assignment Set- 2

Managerial Economics

[Set-I]

MB0042

Q.1 Income elasticity of demand has various applications. Explain each application with the help of an example. Ans :Income elasticity of demand may be defined as the ratio or proportionatechange in the quantity demanded of a commodity to a given proportion change inthe income. In short, it indicates the extent to which demand changes with a variation in consumers income. Thefollowing formula helps to measure the income elasticity (Ey).OrWhere Ey is income elasticity of demand D is change in demand D is original demand Y is change in income Y is original income Example Original demand=400 units Original income= 4000 unitsNew demand =700 units New income= 6000 unitsChange in demand= 700-400= 300 units change in income=6000-4000=2000 Hence Ey=300/2000*4000/400=1.5Generally speaking Ey is positive. This is because there is a direct relationshipbetween income and demand, i.e. higher the income; higher would be the demandand vice versa. On the basis of the numerical value of the co-efficient, Ey isclassified as greater than one, less than one, equal to one, equal to zero andnegative. The concept of ey helps us in classifying commodities in todifferent categories.1. When Ey is positive, the commodity is normal (used in day-to-day life)2. When Ey is negative, the commodity is inferior. ( for example jowar, beedi etc)3. When Ey is positive and greater than one, the commodity is luxury.4. When

Managerial Economics

[Set-I]

MB0042

Ey is positive but less than one, the commodity is essential.5. When Ey is zero, the commodity is neutral. E.g. salt, match box etc. Practical application of income elasticity of demand1. Helps in determining the rate of growth of the firm. If the growth rate of the economy and income growth of the people is reasonableforecasted, in that case it is possible predict expected increase in the sales of a firmand vice versa. 2. Helps in the demand forecasting of a firm. It can be in estimating future demand provided the rate of increase in income andEy for the products are known. Thus, it helps in demand forecasting activities of afirm. 3. Helps in production planning and marketing. The knowledge of Ey is essential for production planning, formulating marketingstrategy, deciding advertising expenditures and nature of distribution channel etc inthe long run. 4. Helps in ensuring stability in production. Proper estimation of different degrees of income elasticity of demand for differenttypes of product helps in avoiding over-production or under-production of a firm.One should know whether rise or fall in income is permanent or temporary. 5. Helps in estimating construction of houses. The rate of growth in incomes of people also helps in housing programs in acountry.Thus it helps a lot in managerial decisions of a firm.

Q.2 When is the opinion survey method used and what is the effectiveness of the method. Ans : Survey of buyers intention or preference is one of the important methods of demand forecasting. It is also called Opinion Survey Method. Under this method, consumer buyers are requested to indicate their preference and willingness about a particular product. They are about to reveal their futurepurchase plans with respect to specific items.They are expected to give answer to question like what items they intends to buy,in what quantity, why, where, what quality they expect, how much they areplanning to spend etc.Generally, the field surveys are conducted by the marketing research departmentsof the company or hiring the services of outside research organization consisting of learned and highly qualified professionals.The heart of the survey is questionnaire. It is a comprehensive one covering almostall questions either directly or indirectly in a most intelligent manner. It is preparedby an expert body who are specialist in the field or marketing.The questionnaire is distributed among the consumer either through mail or inperson by the company. Consumers are requested to furnish all relevant and correctinformation.The next step is to collect the questionnaire from the consumers for the purpose of evaluation. The materials collected will be classified, edited and analyzed. If anybias prejudices, exaggerations,

Managerial Economics

[Set-I]

MB0042

artificial or excess demand creation are found at thetime of answering they would be eliminated.The information so collected will now be consolidated and reviewed by the topexecutives with lot of experiences. It will be examined thoroughly. Inferences aredrawn and conclusions are arrived at. Finally a report is prepared and submitted tothe management for taking final decisions T he success of the survey method depends on many factors 1. The nature of the question asked.2. The ability of the surveyed.3. The representative of the sample4. Nature of the product5. Characteristics of the market6. Consumer behavior7. Techniques of analysis8. Conclusion drawn etc.The management should not entirely depend on the result of survey reports tproject future demand. Consumer may not express their honest and real views ands such they may give only the broad trends in the market. In order to arrive, atright conclusion, field surveys should be regularly checked and supervised.This method is simple and useful to the producers who produce goods in bulk. Here the burden of forecasting is put on the customers.However this method is not much useful in estimating the future demand of the household as they run in a large numbers and also do not freely express their future demand requirements. It is expensive and so difficult. Preparation of questionnaires not an easy task. At best it can be used for short term forecasting Q.3 Show how price is determined by the forces of demand and supply, by using forces of equilibrium. Ans The word equilibrium is derived from the Latin word aequilibrium which means equal balance. It means a state of even balance in which opposing forces ortendencies neutralize each other. It is a position of rest characterized by absence of change. It is a state where there is complete agreement of the economic plans of the various market participants so that no one has a tendency to revise or alter hisdecision. In the words of professor Mehta: Equilibrium denotes in economicsabsence of change in movement. Market Equilibrium There are two approaches to market equilibrium viz., partial equilibrium approachand the general equilibrium approach. The partial equilibrium approach to pricingexplains price determination of a single commodity keeping the prices of othercommodities constant. On the other hand, the general equilibrium approachexplains the mutual and simultaneous determination of the prices of all goods andfactors. Thus it explains a multi market equilibrium position.Earlier to Marshall, there was a dispute among economists on whether the force of demand or the force of supply is more important in determining price. Marshallgave equal importance to both demand and supply in the determination of value orprice. He compared supply and demand to a pair of scissors We might as reasonably dispute whether it is the upper or the under blade of a pair of scissorsthat cuts a piece of paper, as whether value is governed by utility or cost of

Managerial Economics

[Set-I]

MB0042

production. Thus neither the upper blade nor the lower blade taken separately can cut the paper; both have their importance in the process of cutting. Likewiseneither supply alone, nor demand alone can determine the price of a commodity,both are equally important in the determination of price. But the relativeimportance of the two may vary depending upon the time under consideration. Thus, the demand of all consumers and the supply of all firms together determinethe price of a commodity in the market. Equilibrium between demand and supply price: Equilibrium between demand and supply price is obtained by the interaction of these two forces. Price is an independent variable. Demand and supply aredependent variables. They depend on price. Demand varies inversely with price, arise in price causes a fall in demand and a fall in price causes a rise in demand.Thus the demand curve will have a downward slope indicating the expansion of demand with a fall in price and contraction of demand with a rise in price. On theother hand supply varies directly with the changes in price, a rise in price causes arise in supply and a fall in price causes a fall in supply. Thus the supply curve willhave an upward slope.At a point where these two curves intersect with each otherthe equilibrium price is established. At this price quantity demanded is equal to thequantity demanded. This we can explain with the help of a table and a diagram

Price in rs 30 25 20 10 5

Demand in units Supply in units 5 10 15 20 30 25 20 15 10 5

State of market D<S D<S D=S D>S D>S

Pressure on price P Decreases P Decreases Neutral P Increases P Increases

Managerial Economics

[Set-I]

MB0042

.In the table at Rs.20 the quantity demanded is equal to the quantity supplied. Sincethe price is agreeable to both the buyer and sellers, there will be no tendency for itto change; this is called equilibrium price. Suppose the price falls to Rs.5 the buyerwill demand 30 units while the seller will supply only 5 units. Excess of demandover supply pushes the price upward until it reaches the equilibrium positionsupply is equal to the demand. On the other hand if the price rises to Rs.30 thebuyer will demand only 5 units while the sellers are ready to supply 25 units.Sellers compete with each other to sell more units of the commodity. Excess of supply over demand pushes the price downward until it reaches the equilibrium.This process will continue till the equilibrium price of Rs.20 is reached. Thus the interactions of demand and supply forces acting upon each other restore theequilibrium position in the market.In the diagram DD is the demand curve, SS is the supply curve. Demand andsupply are in equilibrium at point E where the two curves intersect each other. OQis the equilibrium output. OP is the equilibrium price. Suppose the price OP2 ishigher than the equilibrium price OP. at this point price quantity demanded isP2D2. Thus D2S2 is the excess supply which the seller wants to push into themarket, competition among the sellers will bring down the price to the equilibriumlevel where the supply is equal to the demand. At price OP1, the buyers willdemand P1D1 quantity while the sellers are ready to sell P1S1. Demand exceedssupply. Excess demand for goods pushes up the price; this process will go untilequilibrium is reached where supply becomes equal to demand

Managerial Economics

[Set-I]

MB0042

Q.4 Distinguish between fixed cost and variable cost using an example. Ans: Fixed cost: These costs are incurred on fixed factors like land, building,equipments, plants, superior types of labour, top management etc. fixed costs in theshort run remains constant because the firm does not change the size of plant andthe amount of the fixed factors employed. Fixed costs do not vary with eitherexpansion or contraction in output. These cost are to be incurred by a firm evenoutput is zero. Even if the firm close down its operation for sometime temporarily in the short run, but remains in business, these cost have to beborne by it.Hence, these costs are independent of output and are referred to as unavoidablecontractual cost.Prof. Marshall called fixed cost as supplementary costs. They include such items as contractual rent payments, interest on capital borrowed, insurance premium, depreciation and maintenance allowance, administrative expenses like managers salary or salary of the permanent staff, property and business taxes, license fees,etc. They are called as over- head costs because these costs are to incurred whether there is production or not. These costs are to be distributed on each units of outputproduced by a firm. Hence, they are called as indirect costs. Variable Costs: The costs corresponding to variable factors are described as variable costs. These costs are incurred on raw materials, ordinary labour,transport, power, fuel, water etc, which directly vary in the short runs. Variable costs are directly and proportionately increases or decreases with the levelof output. If a firm shut down for some times in the short run; then it will not usethe variable factors of production and will not therefore incurs any variable costs.Variable costs are incurred only when some amount of output is produced. Total variable cost increases with the level of increase in the level of production andvice-versa. Prof. Marshall called variable costs as prime costs or direct costs because the volume of output produced by a firm depends directly upon them.It is clear from the above description that a production cost consists of both fixedas well as variable costs. The difference between the two is meaningful and relevant only in the short run. In the long run all costs become variable because all factors of production become adjustable and variable in the long run. However, the distinction between the fixed and variable costs is very important intheshort because it influences the average costs behavior of the firm. In the shortrun, even if a firm wants to close down its operation but wants to remain in the business, it will have to incur fixed costs but it must cover at least its variable costs. Q.5 Discuss Marris Growth Maximization model and show how it is different from the Sales maximization model.

Profit maximization is traditional objective of a firm. Sales maximization objectiveis explained by Prof. Boumal. On similar lines, Prof. Marris has developed anotheralternative growth maximization model in recent years. It is a common factor toobserve that each firm aims at maximizing its growth rate as this goal wouldanswer many of the objectives of a firm.Marris points out that a firm has to maximize its balanced growth rate over aperiod of time.Marris assumes

Managerial Economics

[Set-I]

MB0042

that the ownership and control of the firm is in the hands of twogroups of people, i.e. owner and managers. He further points out that both of themhave two distinctive goals. Managers have a utility function in which the amountof salary, status, position, power, prestige and security of job etc are the mostimport variable where as in case of are more concerned about the size of output,volume of profits, market shares and sales maximization.Utility function of the manager and that the owner are expressed in the followingmanner-Uo= f [size of output, market share, volume of profit, capital, public esteem etc.]Um= f [salaries, power, status, prestige, job security etc.]In view of Marris the realization of these two functions would depend on the sizeof the firm.Larger the firm, greater would be the realization of these functions and vice-versa.Size of the firm according to Marris depends on the amount of corporate capitalwhich includes total volume of the asset, inventory level, cash reserve etc. Hfurther points out that the managers always aim at maximizing the rate of growthof the firm rather than growth in absolute size of the firms. Generally managers like to stay in a grouping firm. Higher growth rateof the firm satisfy the promotional opportunity of managers and also the shareholders as they get more dividends

Q.6 Explain how fiscal policy is used to achieve economic stability. In order to achieve a stable economic condition, fiscal policy has to play a positiveand constructive role both in developed and developing nations. The specific roleto be played by fiscal policy can be discussed as follows: To act as optimum allocator of resources: As most of the resources arescarce in their supply, careful planning is needed in its allocation so as to achievethe set targets.Rational allocation would ensure fulfillment of various objectives. To act as a saver: 1. It should follow a rational consumption policy reduces the MPC and raises theMPS.2. Taxation policy has to be modified to raise the rates of old taxes, introduces newadditional taxes, and extends the tax-nets.3. Profit earning capacity of public sector units are to be raise substantially to mop-up financial resources.4. The government should borrow more money both in the country and outside thecountry. 5. Higher the rate of interest are to be offered for government bonds and security. To act as an investor: Mere mobilization of financial resources is not an end initself. It should result in the creation of real resources which are more important inaccelerating the growth process. Rapid economic growth depends upon the volumeof investment.Hence, fiscal policies have to be ensuring higher volume of investment in bothprivate and public sectors. To act as price stabilizer: price stability is of paramount of importance in aneconomy.Extreme levels of both inflation and deflation would disrupt and disturbthe normal and regular working of an economic system. This would come in theway of stable and persistent growth. Hence all measures are to be taken to check these two dangerous situations so as to create necessary congenial atmosphere toprepare the background for rapid economic growth. To act as an economic stabilizer:

Managerial Economics

[Set-I]

MB0042

Price stability would create the necessarybackground for over all economics stability. Upswing and downswing in the levelof economic activities are to be avoided. If an economy is subject to frequentfluctuation in the form of trade cycle, certainly, it would undermine and disturb thegrowth process. Instability would come in the way of persistent and consistentgrowth in a country. Hence all measure to be taken to ensure economic stability. To act as an employment generator: Fiscal policy should help in mobilizingmore financial resources, convert them in to investment and create moreemployment opportunity to absorb the huge unemployed man power. To act as balancer: There must be proper balance between aggregate saving and aggregate investment, demand and supply, income and output and expenditure,economic overhead capital and social overhead capital etc. Any sort of imbalancewould result in either surpluses or scarcity in different sectors of the economyleading to fast growth in some sectors followed by lagging of some other sectors. To act as growth promoter: The basic objective of any economic policy is toensure higher economic growth rates. This is possible when there is higher nationalsavings, investment, production, employment and income. Hence, fiscal policy isto be designed in such a manner so as to promote higher growth in an economy. To act as in come redistribute: Fiscal policy has to minimize inequalities andensure distributive justice in an economy. This is possible when a rational taxationand public expenditure policy is adopted. More money is collected from richersection of the society through various imaginative taxation policies and a largeramount of money is to be spent in favor of poorer sections of the society. Thus,inequality is to be reduced to the minimum. To act as stimulator of living standards of people: the final objective is to raise the level of living standards of the people. This is possible when there is higheroutput, income and employment leading to higher purchasing power in the handsof common man. Hence, fiscal policy should help in creating more wealth in theeconomy. If there is economic prosperity, then it is possible to have a satisfactory, contended and peaceful life.Thus, fiscal policy has to play a major role in promoting economic growth in a country