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MS - 9

Managerial Economics
ASSIGNMENT SOLUTIONS GUIDE (2011-2012)

Q. 1. Why is decision making under uncertainty necessarily subjective? Explain giving examples. Ans. Mostly managerial decisions are economic in nature as the firms management is faced with the problems of choice in simple words various alternatives. And it is the managements responsibility to see that the resources are allocated appropriately as they are scarce in nature. As the firms operate in the market and are responsible for providing goods and services to the individuals, they are also affected by the economic environment they function in. Therefore, managerial economic provides for the study of allocation of resources available with firm vis--vis its activities, keeping in mind the best possible alternative available to the firm. The management is therefore responsible for taking rational decisions and future planning with regards to the economic concepts and problem analysis. As it needs to ensure that scarce resources are utilized to the utmost efficiency and that best results are achieved. The resource allocation decision may include taking decisions pertaining to production and transportation process. The mangers are also faced with inventory issues, which involve taking decisions pertaining to holding the appropriate levels of stock of raw materials and finished goods for a period of time. For which it is important to understand the demand and supply conditions in the market. The decision-making process also involves an important decision relating to fixing the prices of the products. For which various methods may be adopted keeping in mind that the price is neither too high nor too low. As, if the price is high, it will be

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out of reach for various individuals and if the price is too low then people may tend to have second thoughts about its quality. As the firms operate for profits thus accurate price decisions play a vital role in the growth of the organization as a whole. The managers are also faced with taking decisions regarding future planning. It relates to taking various investment decisions. Therefore, any management decision has a bearing either direct or indirect on the economic standing of the organization and vice-versa, any change in the economic environment, like changes in the government policies etc. have a bearing on the organizations business as well. Q. 2. Define Point Price Elasticity. Calculate Point Price Elasticity from the price and quantity given below. Price (P) 100 90 80 70 60 50 Quantity (Q) 0 Point Price Elasticity

Ans. Price elasticity of demand measures the responsiveness of the quantity sold to changes in the product's price. It is the percentage change in sales divided by a percentage change in price. The notation Ep will be used for the arc price elasticity of demand, and ep will be used for the point price elasticity of demand. If the absolute value of Ep (or ep ) is greater than one, a given percentage decrease (increase) in price will result in an even greater percentage increase (decrease) in sales. In such a case, the demand for the product is considered elastic; that is, sales are relatively responsive to price changes. Therefore, the percentage change in quantity demanded will be greater than the percentage change in the price. When the absolute value of the price elasticity of demand is less than one, the percentage change in sales is less than a given percentage change in price. Demand is then said to be inelastic with respect to price. Unitary price elasticity results when a given percentage change in

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30 60 90 120 150

price results in an equal percentage change in sales. The absolute value of the coefficient of price elasticity is equal to one in such cases. These relationships are summarized as follows: If |ep| or |Ep |> 1, demand is elastic If |ep| or |Ep| < 1, demand is inelastic If |ep| or |Ep| = 1, demand is unitarily elastic Point-price elasticity is equal to the absolute value of the first derivative of quantity with respect to (dQd/dP) multiplied by the point's price (P) divided by its quantity (Qd). Point price elasticity = dP Q Price (P) 100 90 80 70 60 50
dQ P

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Quantity (Q) 0 30 60 90 120 150

price

Point Price Elasticity

-9.00 -4.00 -2.33 -1.50 -1.00

Q. 3. Explain the various types of statistical analyses used for estimation of a production function. Ans. Different types of statistical analyses are used in the estimation of the production function, once the choice of the functional form of the production function has been done. Three types of statistical analysis used for the estimation are discussed below:
l

Time Series Analysis: Where the various inputs used in the various periods in the past and the amount of the output thus produced in each period is used for the estimation is called the time series data. The analysis of the time series data is usually considered appropriate for a single firm, which has not undergone major technological changes during the time period under consideration.

Cross Section Analysis: according to this analysis, the amount of inputs used and the output produced in various firms or sectors of the industry at a given time is called cross-section data.

Engineering Analysis: As per this analysis the technical information supplied by the engineer or the agricultural scientist is used. It is on the basis of experiments or day-to-day working experiences of the technical process that the data is collected for the analysis.

time series and cross-section analysis, Assumption of all variable values pertaining to the same firm to the limitation of the time series data of covering the technical ef ficiency factor are provided for. After the estimation of the production analysis the chapter provides for the introduction to the topic of cost functions. Cost function is the representation of the relationship between cost and its determinants. The cost function may be expressed as follows: C = f (S, O, P, T, E)

where, C = cost (it can be unit cost or total cost) S represents the plant size

O stands for the output level P represents the prices of inputs used in production T stands for nature of technology E represents the managerial efficiency

Though there is no standard fixed with regards to the factors, as they tend to vary from one firm to another in the same industry or from one industry to another industry. Plant size is considered as an important variable in the process of determination of cost. As the scale of operations or the plant size and the unit cost have an inverse relation. In other words, it can be said that with an increase in the plant size the unit cost decreases and vice-versa. This further causes the cost function to be a downward sloping curve, which provides for only engineering estimates of cost. The output level and the total cost depict positive relationship with each other. As the total cost increases with an increase in the output and with a decrease in the total

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This chapter also takes into account the various limitations attached with the same in the form of restrictions to a relatively narrow range of observed values in case of

cost the output also decreases. The cost also gets affected with any change in the prices of inputs, which is dependent on the relative usage of the inputs and relative changes in their prices. That is because of the fact that with an increase in the cost of the inputs more money needs to be paid, with no reduction in the cost from other sources. With any improvement in technology provides for an increase in the productivity of the firm, which further leads to a decrease in the cost of production. A higher managerial efficiency leads to less cost of production. However, it is very

with the help of the three broad approaches, namely, l Accounting method,
l l

Engineering method, and Econometric method

The chapter then explains the three common types of functional forms of cost function in terms of the total cost function, which are:
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Linear Cost Function, where TC = a1 + b1Q AC = (TC)/Q = (a1/Q) + b1 MC = d (TC)/dQ = b1 Quadratic Cost Function, where TC = a2 + b2Q + c2 Q2 AC = (a 2/Q) + b2 +c2Q

MC = b2 + 2c2Q Cubic Cost Function, where

TC = a3 + b3Q + c3Q2 + d3Q3 AC = (a 3/Q) + b3 + c3Q + d3Q2

MC = b3 + 2c3Q + 3d3Q2 In the end, the chapter provides for the various problems faced in the estimation of the cost function, which may include, from appropriate pairing of cost and output data, collecting data pertaining to the relatively even rate to the variations and obstacles faced in the collection and recording of the data by an accountant and by an economist. Q. 4. "Products can be related in production as well as demand."Examine this statement with reference to Pricing of Joint Products.

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difficult to measure the managerial efficiency in quantitative terms. After the determination, the unit provides for the estimation of the cost function

Ans. Products can be related in production as well as demand. One type of production interdependency exists when goods are jointly produced in fixed proportions. The process of producing meat and hides in a slaughterhouse is a good example of fixed proportions in production. Each carcass provides a certain amount of meat and one hide. There is little that the slaughterhouse can do to alter the proportions of the two products. When goods are produced in fixed proportions, they should be thought of as a "product package." Because there is no way to produce one part of this package without also producing the other part, there is no conceptual basis for allocating total production costs between the two goods. These costs have meaning only in terms of the product package. Calculating the Profit-Maximizing Prices for Joint Products Assume a rancher sells hides and meat. The two goods are assumed to be jointly produced in fixed proportions. The marginal cost equation for the meat-hide product package is given by MC = 30 +5Q The demand and marginal revenue equations for the two products are Meat Hides

P = 60 1Q

MR = 60 2Q

What prices should be charged for meat and hides? How many units for the product package should produced? Summing the two marginal revenue (MRT) equations gives MRT = 140 6Q The optimal quantity is determined by equating MRT and MC and solving for Q. Thus 140 6Q = 30 + 5Q

and, hence, Q = 10 Substituting Q =10 into the demand curves yields a price of Rs 50 for beef and Rs 60 for hides. However, before concluding that these prices maximize profits, the marginal revenue at this output rate should be computed for each product to assure

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P = 80 -2Q MR = 80 -4Q

that neither is negative. Substituting Q=10 into the two marginal revenue equations gives 40 for each good. Because both marginal revenues are positive, the prices just given maximize profits. If marginal revenue for either product is negative, the quantity sold of that product should be reduced to the point where marginal revenue equals zero. Q. 5. What is an Isocost Line? Discuss the shifting of Isocost line. Ans. A universally accepted goal of any firm is to optimize profit. If the firm maximises profit, it will necessarily minimise cost for producing a given level of output or maximise output for a given level of cost. If there are two inputs: capital (K) and labour (L) that are variable in the relevant time period. What combination of (K, L) should the firm choose in order to maximise output for a given level of cost? If there are two inputs, K,L, then given the price of capital (Pk) and the price of labour (PL), it is possible to determine the alternative combinations of (K,L) that can be purchased for a given level of expenditure. Suppose C is total expenditure, then C= PL* L + Pk* K This linear function can be plotted on a graph. If only capital is purchased, then the maximum amount that can be bought is C/ Pk shown by point A in figure 1. If only labour is purchased, then the maximum amount of labour that can be purchased is C/PL shown by point B in the figure. The 2 points A and B can be joined by a straight line. This straight line is called the isocost line or equal cost line. It shows the alternative combinations of (K,L) that can be purchased for the given expenditure level C. Any point to the right and above the isocost is not attainable as it involves a level of expenditure greater than C and any point to the left and below the isocost such as P is attainable, although it implies the firm is spending less than C. You should verify that the slope of the isocost is1 Consider the following data:

PL = 10, Pk = 20 Total Expenditure = 200. Let us first plot the various combinations of K and L that are possible. We consider only the case when the firm spends the entire budget of 200. The alternative combinations are shown in the figure 2.

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The slope of this isocost is -. What will happen if labour becomes more expensive say PL increases to 20? Obviously with the same budget the firm can now purchase lesser units of labour. The isocost still meets the Y-axis at point A (because the price of capital is unchanged), but shifts inwards in the direction of the arrow to meet the X-axis at point C. The slope therefore changes to -1. You should work out the effect on the isocost curve on the following: (i) Fall in the price of labour (ii) Rise in the price of capital (iii) Fall in the price of capital

(iv) Rise in the firms budget with no change in the price of labour and capital. Q. 6. Write short notes on the following :(a) Engineering method of Cost Estimation Ans. The engineering method of cost estimation is based on the relationship of inputs to output, and uses the price of inputs to determine costs. This method of estimating real world cost function rests clearly on the knowledge that the shape of any cost function is dependent on: (a) the production function and (b) the price of inputs. For a given the production function and input prices, the optimum input combination for a given output level can be determined. The resultant cost curve can then be formulated by multiplying each input in the least cost combination by its price, to develop the cost function. This method is called engineering method as the estimates of least cost combinations are provided by engineers. The assumption made while using this method is that both the technology and factor prices are constant. This method may not always give the correct estimate of costs as the technology and factor prices do change substantially over a period of time. Therefore, this method is more relevant for the short run. Also, this method may be useful if good historical data is difficult to obtain. But this method requires a sound understanding of engineering and a detailed sampling of the different processes under controlled conditions, which may not always be possible. (b) Price Leadership Ans. There are two types of price leadership. They are: (a) In order to avoid tough competition, the alternative co-operative method,

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which is used, is referred to as price leadership. According to this methodology, one firm is the price setter and the other firms the followers. Usually it is the largest firm in the industry, which sets the price under the dominant price leadership method. It is on the same level of a monopolistic market structure. It is important for the small firms to conform the price decision to the large firm so as to be able to survive in the market. The perfect example of this can be seen in the Airline Industry in India. The Indian Airlines (IA) sets the prices and the others like Jet and Sahara follow the price changes by IA. (b) In order to avoid tough competition, the alternative co-operative method, which is used, is referred to as price leadership. According to this methodology, one firm is the price setter and the other firms the followers. Usually it is the firm, which has a good reputation in the industry, which sets the price under the barometric price leadership method and not the dominant firm. It is because of its behaviour that even though it is quite ambiguous in nature it is still the most common and legally accepted way of price leadership in the market. The price is set accordingly so as to maximize the profits and the firm, which sets the price, is treated as a barometer. The other firms only follow when they feel that the firm in action is acting fairly. The perfect example of a barometric price leadership is visible in case of the automobile sector. (c) The Law of Demand Ans. As per the Law of Demand are as follows:

1. The relationship between price and quantity demand is inverse. That is, if the price rises-demand falls and the vice-versa. 2. Under the Law of Demand, it is the effect of price on demand which is examined, and not the effect of demand on price. When demand rises, the prices would rise and when demand falls, the price would fall. But the law of demand does not concern with this kind of behaviour or phenomenon. In other words, in the law of demand price is regarded as independent variable and demand a dependent variable. 3. The law of demand assume that other factors remain constant. In other words, there should be no change in the other factors influencing demand except price. If, however, any one or more of the other factors influencing demand except price. If,

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however, any one or more of the other factors, say, income, substitutes price, consumers tastes and preferences, advertising outlays, etc. vary, the demand may rise, in spite of a rise in price, or alternatively, the demand may fall in spite of a fall in price. 4. The inverse relation between price and demand as stated by the Law of Demand can be explained in terms of two reasons viz. (a) Income Effect; (b) Substitution Effect. s s

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