managerial economics mb 0042

8/2/2019 Managerial Economics MB 0042

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MB0042 Managerial Economics(Book ID B1131)

Set 1

Q1. What is a business cycle? Describe the different phases of a businesscycle.

Answer:

The business cycle phases define long-term pattern of changes in Gross Domestic Product(GDP) that follows four basic stages: expansion, prosperity, contraction, and recession. Aftera recessionary phase, the expansionary phase starts again.

The business cycle phases are characterized by changing employment, industrialproductivity, and interest rates. Stock analysts believe that stock prices lead the businesscycle phases. This economic cycle provides the strategic framework for business activity andinvesting. Moreover, the business cycle phases affect employees, employers and investors.

A business cycle is identified as a sequence of four phases:

Expansion Phase: The economy is strong, people are employed and making money.Demand for goods -- food, consumer appliances, electronics, and services -- increasesto the point where it outstrips supply. This demand fuels a rise in prices, or inflation.

Prosperity Phase: As prices increase, people ask for higher wages. Higheremployment costs translate into higher prices for goods, fueling an upward spiraleffect.

Contraction Phase: When prices get too high, consumers and companies curtail their

spending, as goods and services are too expensive. This decreases demand. Whendemand decreases, companies cut expenses that includes laying off workers, sincethey do not need to make as many goods or provide as much service.

Recession Phase: Decreasing demand fuels declining prices, declining GDP, andrising unemployment. This means the economy is in a recession.

Expansion Phase begins again: Lower prices eventually spurs demand. As demandpicks up, people begin buying again, fueling the need for greater supply, expansion ofcredit, new jobs and a growing economy.

When the business cycle doesn't run as expected, it can have consequences that can be asdisastrous as the Great Depression. That's why governments intervene to try to manage the

economy. If it appears that inflation is rising too quickly, the Federal Reserve (the centralbank of the U.S. charged with handling monetary policy) may decide to raise interest rates tocurtail price increases. On the other hand, if the economy is performing poorly, thegovernment may lower taxes to spur consumption and investment and the Federal Reservemay lower interest rates to reduce the cost of borrowing.

Interest rates and the yield curve play a very important role in determining economic activity,the phases of the business cycle and the performance of the stock market. Higher interestrates increase the costs to businesses and individuals. Companies must pay more to borrowmoney for capital investments or to fund daily business operations. Individuals pay more formortgages, as well as other loans they may take out to purchase products. Higher interestrates also increase the demand for money to invest in bonds, competing for money to invest

in the stock market.
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The phases of the business cycle have implications for markets and investors. Broadly, arecession often corresponds with a sustained period of weak stock prices, or a bear market.And a healthy, expanding economy that keeps inflation from rising too quickly oftencorresponds with a bull market, or period of sustained market growth.

Sector Rotation

Fortunately, there are investment strategies for each phase of the business cycle. SamStovall's Sector Investing, 1996 states that different sectors are stronger at different businesscycle phases. The table below describes this theoretical model showing the phases of the

business cycle.

Phase:ConsumerExpectations:Industrial Production:Interest Rates:Yield Curve:

Full RecessionRevivingBottoming OutFalling

Normal

Early RecoveryRisingRisingBottoming Out

Normal (Steep)

Full RecoveryDecliningFlatRising Rapidly (Fed)Flattening Out

Early RecessionFalling SharplyFallingPeakingFlat/Inverted

The graph below, courtesy ofStockCharts.com, shows these relationships and the alignmentof the key sectors as they respond to the business cycle. The stock market cycle tends to

precede the business cycle by six months on average, as investors try to anticipate when themarket will respond to changes in the economy. This means investors are more likely to beatthe market, if they invest in the sectors that line up with the current and next phase of the

business cycle.

Sector Rotation Model:

Legend: Market Cycle

Economic CycleAs shown above the stock market is a leading indicator of the economic or phases of the

business cycle. Since the market leads the economy, investors need to pay particular attentionto the early signs of a change in each phase of the business cycle.

Many people believe that GDP is the primary indicator of the business cycle. TheNationalBureau of Economic Research (NBER) gives relatively low weight to GDP as a primary

business cycle indicator, since the GDP is subject to frequent revisions after the fact. Inaddition, it is only reported on a quarterly basis. The NBER is the official organization thatdefines when the U.S. is in a recession and when it comes out of one.

The NBER relies on indicators that are reported monthly to identify the business cycle phases

including: Employment, especially new unemployment claims;
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Personal income;

Industrial production;

Sales in key sectors such as housing, autos, durable goods and retail sales;

Interest rates and the yield curve; and

Commodity prices.By following these indicators carefully, investors can anticipate when to expect changes inthe business cycle. These indicators tend to change their trajectory over several months,giving investors ample time to identify a change in the trend. If you believe a change in the

phase of the business cycle is underway then it is time to close out sectors that will go out offavor and start new positions in sectors that will come into favour. This strategy will positionyou to beat the market using the phases of the business cycle as a guide.

Our stock market strategy begins with an understanding of where we are in the businesscycle. Assessing the business cycle phases is the first of five steps in our stock marketstrategy that we use to beat the market.

Q2. What is monetary policy? Explain the general objectives andinstruments of monetary policy

Answer:

Monetary policy is the process by which the monetary authority of a country controls thesupply of money, often targeting a rate of interest for the purpose of promoting economicgrowth and stability.[1] [2] The official goals usually include relatively stable prices and lowunemployment. Monetary theory provides insight into how to craft optimal monetary policy.It is referred to as either being expansionary or contractionary, where an expansionary policyincreases the total supply of money in the economy more rapidly than usual, andcontractionary policy expands the money supply more slowly than usual or even shrinks it.

Expansionary policy is traditionally used to try to combat unemployment in a recession bylowering interest rates in the hope that easy credit will entice businesses into expanding.Contractionary policy is intended to slow inflation in hopes of avoiding the resultingdistortions and deterioration of asset values.

Goals of Monetary policy

The goals of monetary policy have developed with the evolution central banking thought andthe changes in both the behaviour and performance of different economies. There isworldwide agreement that the ultimate goals of monetary policy at present in both thedeveloped and developing countries are price stability and high employment rates, enhancingeconomic growth rates and controlling imbalances in external payments, including the

protection of the external purchasing power of the currency through maintaining relativelystable levels of exchange rates. These goals, though interrelated by their nature, may becontradictory. This explains the importance of co-ordination among different economic

policies on the one hand, and the importance of diagnosing the economic problem beforetaking appropriate treatment measures on the other. The significance of this issue becomesevident when we stress the need to apply rational monetary policies, particularly with regardto the practicality of goals pursed by the monetary authorities and the possibility of achievingthese goals without economic consequences that might aggravate economic problems.

Besides the above goals, some people believe that monetary policy should have otherimportant goals, such as high and stable share prices, while others would include themaintenance of low interest rates as a major goal. Others stress increasing the efficiency of

the financial system and maintaining the soundness of the banking system. In fact, each ofthese goals has special significance and directly relates either to the monetary policy goalsdiscussed above or to the intermediate objectives of monetary policy, which represent the


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link between monetary procedures and the influence of these procedures on the path ofeconomic activity. I believe, however, that despite the differences in viewpoints towards thegoals of monetary policy, the goal of increasing the efficiency of the financial system andmaintaining the soundness and stability of the banking system should rank first. Thisconviction may be supported by the fact that the effects of monetary policy measures on theeconomy occur through the banking and financial systems, which makes the systemsresponse to monetary variables a very important issue. Furthermore, the increased relativeimportance of deposit money makes the protection of the banking system and enhancingconfidence in it one of the major goals of central banks, as it means protecting the mechanismof the payments system in the economy.

Talking about the monetary policy goals as shown above should not mitigate the importantrole central banks may play in other economic areas, especially in the area of developingmoney and capital markets in countries where these markets are lacking. The development ofsuch markets will enable central banks to use one of the important instruments of monetary

policy, i.e. open market operations.

Monetary Policy Instruments

The set of instruments available to monetary authorities may differ from one country toanother, according to differences in political systems, economic structures, statutory andinstitutional procedures, development of money and capital markets and other considerations.In most advanced capitalist countries, monetary authorities use one or more of the followingkey instruments: changes in the legal reserve ratio, changes in the discount rate or the officialkey bank rate, exchange rates and open market operations. In many instances, supplementaryinstruments are used, known as instruments of direct supervision or qualitative instruments.Although the developing countries use one or more of these instruments, taking intoconsideration the difference in their economic growth levels, the dissimilarity in the patternsof their production structures and the degree of their of their link with the outside world,many resort to the method of qualitative supervision, particularly those countries which face

problems arising from the nature of their economic structures. Although the effectiveness ofmonetary policy does not necessarily depend on using a wide range of instruments,coordinated use of various instruments is essential to the application of a rational monetary

policy.

Intermediate Objectives of Monetary Policy

The intermediate objectives of monetary policy are defined as a number of variables linkingthe instruments of monetary policy with their ultimate goals. These variables are moneysupply, interest rates, disposable credit, the monetary base or any other variable deemed bythe monetary authorities as an appropriate intermediate objective for monetary policy. Inmany instances, these objectives can be used as indicators of the effects of the applied

monetary policy. This issue, thought it is a major pivot of the monetary policy framework, isstill a subject of major viewpoint differences among economists. While monetarists believethat monetary authorities must select quantitative targets for their monetary policy throughcontrolling growth levels in money supply and thereby adopting mostly the monetary baseapproach, non-monetarists, despite their recognition of the importance of money, see thatchanges in different components of aggregate demand have significant impact on the level ofeconomic activity and, therefore, they give basic consideration to the adoption of priceobjectives through the selection of the interest rate as an intermediate objective representing alink between money and production.

The monetarists choice of money supply as a target is based on a number of hypotheses orprinciples. For instance, they believe that money supply is an exogenous variable that is

controllable in the long run, and that the direction of causal relations in the exchangeequation moves from money to prices and production. Furthermore, the strongest final effectwill be represented by high prices, given the stability in the function of demand for money


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and a time lag for the effect of monetary policy, thus avoiding the adoption of fiscal policiesas a stimulus. This is a lengthy issue, and it would not be appropriate to discuss it in detailhere. We can sum up our point of view as follows:

a. The selection of intermediate objectives for monetary policy should be madeaccording to the structural characteristics of the concerned economies and according

to analytical studies on economic behaviour, including the demand function formoney and the directions of the general economic policy. The dispute arising betweenmonetarists and non-monetarists relates to other issues than simply the behaviour ofthe monetary policy to be applied. These issues may affect the nature of the role to be

played by the state in the economy.

b. The choice of a certain intermediate objective by the monetary authorities does notnecessarily mean that these authorities should adhere to that objective all the time. Theobjective should be reviewed in the light of structural and behavioural changes in theeconomy. Further, both the prevailing economic situation and the change in the priorities ofmonetary policy objectives may provide the monetary authorities with sufficient justificationto shift from one objective to another.

c. Central banking is an art, which gives a strong reason to believe that the effects ofmonetary procedures may be transferred through several channels, such as the volume ofdisposable credit, interest rates, money supply and the general liquidity position in theeconomy. We believe that the estimation based on all relevant data is still the best approachfor formulating monetary policy.

Q3. A firm supplied 3000 pens at the rate of Rs 10. Next month, due to arise of in the price to 22 rs per pen the supply of the firm increases to 5000pens. Find the elasticity of supply of the pens.

Answer:

Price elasticity of demand is a ratio of two pure numbers, the numerator is the percentagechange in the quantity demanded and the denominator is the percentage change in price of thecommodity. It is measured by the following formula:

Ep = Percentage change in quantity demanded/ Percentage changed in price

Applying the provided data in the equation: Percentage change in quantity demanded = (5000 3000)/3000Percentage changed in price = (22 10) / 10 Ep = ((5000 3000)/3000) / ((22 10)/10) = 1.2

Q4. Give a brief description of

a. Implicit and explicit cost

b. Actual and opportunity cost

Implicit and Explicit cost

Explicit costs

are those costs which are in the nature of contractual payments and are paid by anentrepreneur 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 beestimated and calculated exactly and recorded in the books of accounts.

Implicit or imputed costs

are implied costs. They do not take the form of cash outlays and as such do not appear in thebooks of accounts. They are the earnings of owner employed resources. For example, thefactor inputs owned by the entrepreneur himself like capital can be utilized by him or can be


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supplied to others for a contractual sum if he himself does not utilize them in the business. Itis to be remembered that the total cost is a sum of both implicit and explicit costs.

(b) Actual and opportunity cost

Actual costs

are also called as outlay costs, absolute costs and acquisition costs. They are those costs thatinvolve 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 afirm. For example, wages paid to workers, expenses on raw materials, power, fuel and othertypes of inputs. They can be exactly calculated and accounted without any difficulty.

Opportunity cost

Opportunity cost of a good or service is measured in terms of revenue which could have beenearned 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 sacrificedalternatives. It implies that opportunity cost of anything is the alternative that has beenforegone. 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 booksof accounts. The knowledge of opportunity cost is of great importance to managementdecision. They help in taking a decision among alternatives. While taking a decision amongseveral alternatives, a manager selects the best one which is more profitable or beneficial bysacrificing other alternatives.

Q5. Explain in brief the relationship between TR, AR, and MR underdifferent market condition.

Answer:

Revenue is the income received by the firm.There are three concepts of revenue Total revenue, Average revenue and Marginal revenue.

1. Total revenue (TR):Unit 7Total revenue refers to the total amount of money that the firmreceives from the sale of its products, i.e. .gross revenue.In other words, it is the total sales receipts earned from the sale of its totaloutput produced over a given period of time. We may show total revenue asa function of the total quantity sold at a given price as below.TR = f (q). It implies that higher the sales, larger would be the TR Thus, TR

= PXQ. For e.g. a firm sells 5000 units of a commodity at the rate of Rs. 5per unit, then TR would beTR = P x Q = 5 x 5000 = 25,000.00.YTR0SalesX2. Average revenue (AR)Average revenue is the revenue per unit of the commodity sold. It can

be obtained by dividing the TR by the number of units sold. Then,

AR = TR/Q AR = 150/15= 10.Thus average revenue means price. Since the demand curve shows therelationship between price and the quantity demanded, it also represents


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the average revenue or price at which the various amounts of a commodityare sold, because the price offered by the buyer is the revenue from seller s

point of view. Therefore, average revenue curve of the firm is the sameas demand curve of the consumer.Therefore, in economics we use AR and price as synonymous except in the context of pricediscrimination by the seller. Mathematical y P = AR.

3. Marginal Revenue (MR)Marginal revenue is the net increase in total revenue realized from selling one more unit of a

product. It is the additional revenue earned by selling an additional unit of output by theseller.Suppose a firm is selling 4 units of the output at the price of Rs.14 per unit.

Now if it wants to sell 5 units instead of 4 units and thereby the price of theproduct falls to Rs.12 per unit, then the marginal revenue will not be equal toRs.12 at which the 5th unit is sold. 4 units, which were sold at the price ofRs.14 before, will all have to be sold at the reduced price of Rs.12 and that

Will mean the loss of 2 rupees on each of the previous 4 units. The total losson the previous units will be equal to Rs.8. Therefore, this loss of 8 rupeesshould be deducted from the price of Rs.12 of the 5th unit while calculatingthe marginal revenue. The marginal revenue in this case, therefore, will beRs.12 Rs.8 =Rs.4 and not Rs.12 which is the average revenue.Marginal revenue can also be directly calculated by finding out thedifference between the total revenue before and after selling the additionalunit of the product.Total revenue when 4 units are sold at the price of Rs.14 = 4 X 14 = Rs.56Total revenue when 5 units are sold at the price of Rs.12 = 5 X 12 = Rs.60Therefore, Marginal revenue or the net revenue earned by the 5th unit = 60-

56 = Rs.4.Thus, Marginal revenue of the nth unit = difference in total revenue inincreasing the sale from n-1 to n units orMarginal revenue = price of nth unit minus loss in revenue on previous unitsresulting from price reduction.The concept is important in micro economics because a firm's optimaloutput (most profitable) is where its marginal revenue equals its marginalcost i.e. as long as the extra revenue from selling one more unit is greaterthan the extra cost of making it, it is profitable to do so.It is usual for marginal revenue to fall as output goes up both at the level ofa firm and that of a market, because lower prices are needed to achieve higher sales or

demand respectively.

MR = TR = where TR represents change in TR Q

And Q indicates change in total quantity sold.Also MR = TRn TRn-1Marginal revenue is equal to the change in total revenue over the change in quantity.Marginal Revenue = (Change in total revenue) divided by (Change in sales)There is another way to see why marginal revenue will be less than price when a demandcurve slopes downward. Price is average revenue. If the firm sells 4 units for Rs.14, theaverage revenue for each unit is Rs.14.00.

But as seller sells more, the average revenue (or price) drops, and this can only happen if themarginal revenue is below price, pulling the average down.If one knows marginal revenue, one can tell what happens to total revenue if


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sales change. If selling another unit increases total revenue, the marginalrevenue must be greater than zero. If marginal revenue is less than zero,then selling another unit takes away from total revenue. If marginal revenueis zero, than selling another does not change total revenue. This relationshipexists because marginal revenue measures the slope of the total revenuecurve.Relationship between Total revenue, Average revenue and MarginalRevenue conceptsIn order to understand the relationship between TR, AR and MR, we can prepare ahypothetical revenue schedule.Relationship between AR and MR and the nature of AR and MR curvesunder difference market conditions1. Under Perfect MarketUnder perfect competition, an individual firm by its own action cannotinfluence the market price. The market price is determined by the interaction

between demand and supply forces. A firm can sell any amount of goodsat the existing market prices. Hence, the TR of the firm would increase

proportionately with the output offered for sale. When the total revenueincreases in direct proportion to the sale of output, the AR would remainConstant. Since the market price of it is constant without any variation dueto changes in the units sold by the individual firm, the extra output wouldfetch proportionate increase in the revenue. Hence, MR & AR will be equal to each other andremain constant. This will be equal to price.Under perfect market condition, the AR curve will be a horizontal straightline and parallel to OX axis. This is because a firm has to sell its product atthe constant existing market price. The MR cure also coincides with the ARcurve. This is because additional units are sold at the same constant pricein the market.

2. Under Imperfect MarketUnder all forms of imperfect markets, the relation between TR, AR, and MRis different. This can be understood with the help of the following imaginaryrevenue schedule.

Q6. Distinguish between a firm and an industry. Explain the equilibrium ofa firm and industry under perfect competition.

Answer:

Monopolistic competitionAn industry in monopolistic competition is one made up of a large number of small firmswho produce goods which are only slightly different from that of all other sellers. It is similarto perfect competition with freedom of entry and exit for firms and any supernormal profitsearned in the short-run will be competed away in the long-run as new firms enter the industryand compete away the profits.Short Run Equilibrium


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Short-run equilibrium of the firm undermonopolistic competition. The firm maximizes its profits and produces a quantity where thefirms marginal revenue (MR) is equal to its marginal cost (MC). The firm is able to collect a

price based on the average revenue (AR) curve. The difference between the firms averagerevenue and average cost, multiplied by the quantity sold (Qs), gives the total profit.

Long Run Equilibrium

Long-run equilibrium of the firm under monopolistic competition. The firm still produceswhere marginal cost and marginal revenue are equal; however, the demand curve (and AR)has shifted as other firms entered the market and increased competition. The firm no longersells its goods above average cost and can no longer claim an economic profit.

b) Perfect Competition is a more desirable market form than monopolistic competition.Discuss.Perfect competition is considered as the ideal or the standard against which everything is

judged. Perfect competition is characterized as having:Many buyers and sellers. Nobody has power over the market.

Perfect knowledge by all parties. Customers are aware of all the products on offer and theirprices.Firms can sell as much as they want, but only at the price ruling. Thus sellers have no controlover market price. They are price takers, not price makers.All firms produce the same product, and all products are perfect substitutes for each other, i.e.goods produced are homogenous.There is no advertising.There is freedom of entry and exit from the market. Sunk costs are few, if any. Firms can,and will come and go as they wish.Companies in perfect competition in the long-run are both productively and allocativelyefficient.

In perfect competition, the market is the sum of all of the individual firms. The market ismodelled by the standard market diagram (demand and supply) and the firm is modelled bythe cost model (standard average and marginal cost curves). The firm as a price taker simply
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takes and charges the market price (P* in Figure 1 below). This price represents theiraverage and marginal revenue curve. Onto this we superimpose the marginal and averagecost curves and this gives us the equilibrium of the firm.Firms in equilibrium in perfect competition will make just normal profit. This level of profitis just enough to keep them in the industry and since profits are adequate they have noincentive to leave.Normal profits

Normal profit is the level of profit that is required for a firm to keep the resources they areusing in their current use. In other words it is enough profit to keep them in the industry.Anything in excess of normal profits is called abnormal or supernormal profits.Any profit above normal profit is a bonus for the firms, as it is more than they need to keepthem in the industry. We call this supernormal (or abnormal) profit. However, thissupernormal profit will be a signal to other firms and will attract more firms into the industry.If firms are making consistently below normal profits then they will choose to leave theindustry.

MB0042 Managerial Economics(Book ID B1131)

Set 2

Q1.Suppose your manufacturing company planning to release a newproduct into market, Explain the various methods forecasting for a newproduct.

Answer:
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To deliver the right products to the right customers portablyrequires a fundamental shift in retail decision making from art toscience; and from one that is based on human intuition to one that isdriven by customer data.

Demand Forecasting for a New Product

Demand forecasting for new products is quite different from that forestablished products. Here the firms will not have any past experience orpast data for this purpose. An intensive study of the economic andcompetitive characteristics of the product should be made to makeefficient forecasts.Professor Joel Dean, however, has suggested a few guidelines tomake forecasting of demand for new products.

a) Evolutionary approach-

The demand for the new product may be considered as an outgrowth ofan existing product. For e.g., Demand for new Tata Indica, which is amodified version of Old Indica can most effectively be projectedbased on the sales of the old Indica, the demand for new Pulsar canbeforecasted based on the a sales of the old Pulsor. Thus when a newproduct is evolved from the old product, the demand conditions of the oldproduct can be taken as a basis for forecasting the demand for the newproduct.

b) Substitute approach-

If the new product developed serves as substitute for the existing product,the demand for the new produc t ma y be wor ked out on thebasis of a marke t s hare . The growth s of demand for al l theproducts have to be worked out on the basis of intelligentforecasts for independent variables that influence the demand for thesubstitutes. After that, a portion of the market can be sliced out forthe new product. For e.g., a moped as a substitute for a scooter, acell phone as a substitute for a land line. In some cases price plays animportant role in shaping future demand for the product.

c) Opinion Poll approach-

Under th is approach the potent ia l buyers are d irect lyco nt ac te d, or th rou gh th e us e of samples of the new product andtheir responses are found out. These are finally blown up to forecast thedemand for the new product.

d) Sales experience approach-Offer the new product for sale in a sample market; say supermarkets orbig bazaars in big cities, which are also big marketing centers. Theproduct may be offered for sale through one super market andthe est imate of sa les obtained may be b lown up to arr iveat estimated demand for the product.

e) Growth Curve approach-


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According to this, the rate of growth and the ultimate level of demand forthe new productare estimated on the basis of the pattern of growthof established products. For e.g., An Automobile Co., whileintroducing a new version of a car will study the level of demand for theexisting car.

f) Vicarious approach-A firm will survey consumers reactions to a new product indirectlythrough getting in touch with some specialized and informed dealers whohave good knowledge about the market, about the different varieties ofthe product already available in the market, the consumers preferencesetc. This helps in making a more efficient estimation of future demand.These methods are not mutually exclus ive. The management canuse a combination of several of them, supplement and cross checkeach other.

Q2.Define the term equilibrium. Explain the changes in marketequilibrium and effects to shifts in supply and demand.

Answer:

The word equilibrium is derived from the Latin word aequilibrium whichmeans equal balance. It means a state of even balance in which opposing

forces or tendencies neutralize each other. It is a position of restcharacterized by absence of change. It is a state where there is completeagreement of the economic plans of the various market participants sothat no one has a tendency to revise or alter his decision. In the words ofprofessor Mehta: Equilibrium denotes in economics absence of change inmovement.

Market Equilibrium

There are two approaches to market equilibrium viz., partial equilibriumapproach and the general equilibrium approach. The partial

equilibriumapproach to pricing explains price determination of a singlecommodity keeping the prices of other commodities constant. On theother hand, the general equilibrium approach explains the mutual andsimultaneous determination of the prices of all goods and factors. Thus itexplains a multi market equilibrium position.

Earlier to Marshall, there was a dispute among economists on whether theforce of demand or the force of supply is more important in determiningprice. Marshall gave equal importance to both demand and supply in thedetermination of value or price. He compared supply and demand to a

pair of scissors We might as reasonably dispute whether it is the upperor the under blade of a pair of scissors that cuts a piece of paper, aswhether value is governed by utility or cost of production. Thus neither


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the upper blade nor the lower blade taken separately can cut the paper;both have their importance in the process of cutting. Likewise neithersupply 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 allfirms together determine the price of a commodity in the market.

Equilibrium between demand and supply price:Equilibrium between demand and supply price is obtained by theinteraction of these two forces. Price is an independent variable. Demandand supply are dependent variables. They depend on price. Demandvaries inversely with price; arise in price causes a fall in demand and a fallin price causes a rise in demand. Thus the demand curve will have adownward slope indicating the expansion of demand with a fall in priceand contraction of demand with a rise in price. On the other hand supply

varies directly with the changes in price, a rise in price causes arise insupply 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 other theequilibrium price is established. At this price quantity demanded is equalto the quantity demanded. This we can explain with the help of a tableand a diagram.

Price in RsDemand in

unitsSupply in

unitsState ofmarket Pressure on price

30 5 25 DS P-

In the table at Rs.20 the quantity demanded is equal to the quantitysupplied. Since the price is agreeable to both the buyer and sellers, therewill be no tendency for it to change; this is called equilibrium price.Suppose the price falls to Rs.5 the buyer will demand 30 units while theseller will supply only 5 units. Excess of demand over supply pushes the


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price upward until it reaches the equilibrium position supply is equal tothe demand. On the other hand if the price rises to Rs.30 the buyer willdemand only 5 units while the sellers are ready to supply 25 units. Sellerscompete with each other to sell more units of the commodity. Excess ofsupply over demand pushes the price downward until it reaches the

equilibrium. This process will continue till the equilibrium price of Rs.20 isreached. Thus the interactions of demand and supply forces acting uponeach other restore the equilibrium position in the market.

In the diagram DD is the demand curve, SS is the supply curve. Demandand supply are in equilibrium at point E where the two curves intersecteach other. OQ is the equilibrium output. OP is the equilibrium price.Suppose the price OP2 is higher than the equilibrium price OP. at thispoint price quantity demanded is P2D2. ThusD2S2 is the excess supplywhich the seller wants to push into the market, competition among thesellers will bring down the price to the equilibrium level where the supply

is equal to the demand. At price OP1, the buyers will demand P1D1quantity while the sellers are ready to sell P1S1. Demand exceeds supply.Excess demand for goods pushes up the price; this process will go untilequilibrium is reached where supply becomes equal to demand.

Changes in Market Equilibrium The changes in equil ibrium price wil l occur when there wil l beshift either in demand curve or in supply curve or both:

Effects of Shift in demand:

Demand changes when there is a change in the determinants of demandlike the income, tastes, prices of substitutes and complements, sizeof the population etc. If demand raises due to a change in any one ofthese conditions the demand curve shifts upward to the right. If, on theother hand, demand falls, the demand curve shifts downward to the left.Such rise and fall in demand are referred to as increase and decrease indemand.

A change in the market equilibrium caused by the shifts in demand can beexplained with the help of a diagram

Effects of Changes in Both Demand and Supply


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Changes can occur in both demand and supply conditions. Theeffects of such changes on the market equilibrium depend on the rateof change in the two variables. If the rateof change in demand ismatched with the rate of change in supply there wi l l be nochange in the market equilibrium, the new equilibrium shows

expanded market with increased quantity of both supply and demandat the same price.

This is made clear from the diagram below:

Similar will be the effects when the decrease in demand is greater thanthe decrease insupply on the market equilibrium

Q3.Explain how a product would reach equilibriumposition with the help of ISO-Quants and ISO-Cost curve.

Answer:

Economies of scale external to the firm (or industry wide scale economies)are only considered examples of network externalities if they are drivenby demand side economies. In many industries, the production of goodsand services and the development of new products requires the use of

specialized equipment or support services. An individual company doesnot provide a large enough market for these services to keep thesuppliers in business. A localized industrial cluster can solve this problem


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by bringing together many firms that provide a large enough market tosupport specialized suppliers. This phenomenon has been extensivelydocumented in the semiconductor industry located in Silicon Valley.

Labor Market Pooling -

A cluster of firms can create a pooled market for workers with highlyspecialized skills.

It is an advantage for:Producers -- They are less likely to suffer from labor shortages.Workers -- They are less likely to become unemployed.Knowledge Spillovers -- Knowledge is one of the important input factorsin highly innovative industries.

The specialized knowledge that is crucial to success in innovativeindustries comes from :

Research and development efforts.Reverse engineering.Informal exchange of information and ideas.

As firms become larger and their scale of operations increase they areable to experience reductions in their average costs of production. Thefirm is said to be experiencing increasing returns to scale. Increasingreturns to scale results in the firm's output increasing at a greatproportion than its inputs and hence its total costs. As a consequence itsaverage costs fall.

Thus initially the firm's long run average cost curve slopes downward asthe scale of the enterprise expands. The firm enjoys benefits calledinternal economies of scale. These are cost reductions accruing to thefirm as a result of the growth of the firm itself. (An external economy ofscale is a benefit that the firms experience as a result of the growth of theindustry).After the firm has reached its optimum scale of output, where the long runaverage cost curves are at their lowest point, continued expansion meansthat its average costs may start to rise as the firm now experiencesdecreasing returns to scale. The long run average cost curve therefore

starts to curve upwards. This occurs because the firm is now experiencinginternal diseconomies of scale.

Types of internal economies of scale -

FinancialThe farm has been able to gain loans and assistance at preferentialinterest rates from the EIB, World Bank and the EU.MarketingIt has managed to dedicate resources to its strategy of niche marketing.Technical

The access to finance has allowed it to invest in sophisticated Israeliirrigation technology.


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ManagerialIts large size enables it to employ specialized personnel such as estatemanagers.Risk bearingThe farm has used some of its land to diversify into producing fresh

vegetables for export as well as continue producing maize.

These large scale farms are attracting a considerable amount of overseasdevelopment aid funding from organizations such as the World Bank andthe European Union as they see as being an integral part of the exportearning capacity of the country.

Q4.Critically examine the Marris growth maximizingmodel.

Answer:

Profit maximization is traditional objective of a firm. Sales maximizationobjective is explained by Prof. Boumal. On similar lines, Prof. Marris hasdeveloped another alternative growth maximization model in recentyears. It is a common factor to observe that each firm aims at maximizingits growth rate as this goal would answer many of the objectives of a firm.Marris points out that a firm has to maximize its balanced growth rate

over a period of time.

Marris assumes that the ownership and control of the firm is in the handsof two groups of people, i.e. owner and managers. He further points outthat both of them have two distinctive goals. Managers have a utilityfunction in which the amount of salary, status, position, power, prestigeand security of job etc are the most import variable where as in case ofare more concerned about the size of output, volume of profits, marketshares and sales maximization.

Utility function of the manager and that the owner are expressedin the following manner-Uo= f [size of output, market share, volume of profit, capital, publicesteem etc.]

Um= f [salaries, power, status, prestige, job security etc.]

In view of Marris the realization of these two functions would depend onthe size of the firm. Larger the firm, greater would be the realization ofthese functions and vice-versa. Size of the firm according to Marrisdepends on the amount of corporate capital which includes total volume

of the asset, inventory level, cash reserve etc. He further points out thatthe managers always aim at maximizing the rate of growth of the firmrather than growth in absolute size of the firms. Generally managers like


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to stay in a grouping firm. Higher growth rate of the firm satisfy thepromotional opportunity of managers and also the share holders as theyget more dividends.Marris identifies two constraints in the rate of growth of a firm:

1. There is a limit up to which output of a firm can be increased moreeconomically, limit t o m an a g e t h e f i r m e f f i c i e n t l y , l i m i t t oem pl oy h i gh ly qu a l i f ie d an d ex pe r i en ce d managers, limit toresearch and development and innovation etc.

2 . T h e a m b i t i o n o f j o b s e c u r i t y p u t s a l i m i t t o t h eg ro w t h r a te of t h e f i r m i t s e l f deliberately. If growth reachesthe maximum, then there would be no opportunity to e xpa ndfurther and as such the managers may loose their job s.Ra pi d gr owth an d financial soundness should go together.Managers hesitate to take unwanted risks and uncertainties in the

organization at the cost of their jobs they would like to avoid riskyinvestment projects, concentrate on generating more internalfunds and invest more finance on only those products and serviceswhich brings more profits Hence, managers would like to seek their jobsecurity through adoption of a cautious and prudent financial policy.

He further points out that a h igh r isk- loving managementwould l ike to maintain a re lat ively low amount of cash onhan d and inv es t mor e on bus ine ss , bor ro w mor e external fundsand invest more in business expansion and keep low profit levels. On the

other hand, a h ighly r isk-avert ing manageme nt may haveexac tl y opp os it e pol icy. Ultimately, it is the job security whichputs a constraint on business decisions by the managers.

The Marris growth maximization model. Highlights on achieving abalanced growth rate of a firm. Maximum growth rate [g] is equal to twoimportant variables-1. The rate of demand for the products [gd]2. Growth rate of capital [gc]Hence, Max g = gd = gc.The growth rate of the firm depends on two factors- a] the rate of

diversification [d]and [b] the average profit margin.

The diversificat ion rate depends on the number of new productsintroduced per unit of time and the rate of success of new products inthe market. The success of new products is determined by its changes infashion styles, consumption habits, the range of products offered etc.More over diminishing marginal returns would operate in anybusiness and as such there is a limit to diversification. Similarly,market price of the given product, avai labi li ty of al te rn at iv esubst i tute products and their re lat ive pr ices, publ ic i ty ,propaganda and advertisements, R&D expenses and utility andcomparative value of the product etc would decide the profit ratio.


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Higher expenditure on sales promotion and R&D would certainlyreduce profits level as there are limits to them.

T h e r a t e o f c a p i t a l g r o w t h i s d e t e r m i n e d b y e i t h e ri s s u e o f n e w s h a r e s t o o b t a i n additional funds and external

funds and generation of more internal surplus. Generally a firm wouldselect the last one to avoid higher degrees of risks in the business.

The Marr is model s tates that in order to maximize ba lancedgrowth rate or reach equilibrium position, there should be equalitybetween the growth rate in demand for the products and growthrate in supply of capita l . This impl ies the sat isfact ion of three conditions.1. The management has to maintain a low liquidity ratio, ie, liquidasset / total assets. But thi s r ati o s hou ld not cre ate anyfin anc ial emb arr ass men t to mee t the req uir ed payments to all

the concerned parties.2. The management has to maintain a proper leverage ratio betweenvalue of debts/Total assets so that it will have enough money to invest inorder to stimulate growth.3. The management has to keep a high level of retained profits for furtherexpansion and development but it should not displease theshareholders i.e. (Retained Profits / Total Profits) by giving lowdividends.

In this case, the mangers would maximize their utility functionand the owners would maximize their utility functions. Themanagers are able to get their job security with a high rate ofgrowth of the firm and share holder would become happy as they gethigher amount of dividends.

Demerits 1 . It is doubtful whether both managers and owners would maximize theirutility functions simultaneously always.2. The assumption of constant price and production costs are not correct.3. It is difficult to achieve both growth maximization and profitmaximization together.

Q5.What do you mean by pricing policy? Explain the various objective ofpricing policy of a firm.

Answer:Pricing Policies

A detailed study of the market structure gives us information about the way in whichprices are determined under different market conditions. However, in reality, a firmadopts different policies and methods to fix the price of its products. Pricing

policy refers to the policy of setting the price of the product orproducts and services by the management after taking intoaccount of various internal and external factors, forces and its


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own business objectives. Pricing Policy basically depends on price theory thatis the corner stone of economic theory. Pricing is considered as one of the basic andcentral problems of economic theory in a modern economy. Fixing prices are themost important aspect of managerial decision making because market pricecharged by the company affects the present and future production plans, pattern of

distribution, nature of marketing etc.Generally speaking, in economic theory, we take into account of only two parties,i.e., buyers and sellers while fixing the prices. However, in practice many parties areassociated with pricing of a product. They are rival competitors, potential rivals,middlemen, wholesalers, retailers, commission agents and above all the Govt.Hence, we should give due consideration to the influence exerted by these partiesin the process of price determination.

Broadly speaking, the various factors and forces that affect the price are divided intotwo categories.They are as follows:

I External Factors (Outside factors)1. Demand, supply and their determinants.2. Elasticity of demand and supply.3. Degree of competition in the market.4. Size of the market.5. Good will, name, fame and reputation of a firm in the market.6. Trends in the market.7. Purchasing power of the buyers.8. Bargaining power of customers.

9. Buyers behavior in respect of particular product.

II. Internal Factors (Inside Factors)1. Objectives of the firm.2. Production Costs.3. Quality of the product and its characteristics.4. Scale of production.5. Efficient management of resources.6. Policy towards percentage of profits and dividend distribution.7. Advertising and sales promotion policies.8. Wage policy and sales turn over policy etc.

9. The stages of the product on the product life cycle.10. Use pattern of the product.

Objectives of the Price Policy:A firm has multiple objectives today. In spite of several objectives, the ultimate aimof every business concern is to maximize its profits. This is possible when the returnsexceed costs. In this context, setting an ideal price for a product assumes greaterimportance. Pricing objectives has to be established by top management to ensurenot only that the companys profitability is adequate but also that pricing iscomplementary to the total strategy of the organization. While formulating thepricing policy, a firm has to consider various economic, social, political and otherfactors.


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Following objectives are to be considered while fixing the pricesof the product:

1. Profit maximization in the short termThe primary objective of the firm is to maximize its profits. Pricing policy as an

instrument to achieve this objective should be formulated in such a way as tomaximize the sales revenue and profit. Maximumprofit refers to thehighest possible of profit. In the short run, a firm not only should be able torecover its total costs, but also should get excess revenue over costs. This will buildthe morale of the firm and instill the spirit of confidence in its operations.

2. Profit optimization in the long runThe traditional profit maximization hypothesis may not prove beneficial in the longrun. With the sole motive of profit making a firm may resort to several kinds ofunethical practices like charging exorbitant prices, follow Monopoly Trade Practices(MTP), Restrictive Trade Practices (RTP) and Unfair Trade Practices (UTP) etc. This

may lead to opposition from the people. In order to over- come these evils, a firminstead of profit maximization, and aims at profit optimization. Optimum profitrefers to the most ideal or desirable level of profit. Hence, earningthe most reasonable or optimum profit has become a part and parcel of a soundpricing policy of a firm in recent years.

3. Price StabilizationPrice stabilization over a period of time is another objective. The prices as far aspossible should not fluctuate too often. Price instability creates uncertainatmosphere in business circles. Sales plan becomes difficult under such

circumstances. Hence, price stability is one of the prerequisite conditions for steadyand persistent growth of a firm. A stable price policy only can win the confidence ofcustomers and may add to the good will of the concern. It builds up the reputationand image of the firm.

4. Facing competitive situationOne of the objectives of the pricing policy is to face the competitive situations in themarket. In many cases, this policy has been merely influenced by the market sharepsychology. Wherever companies are aware of specific competitive products, theytry to match the prices of their products with those of their rivals to expand thevolume of their business. Most of the firms are not merely interested in meeting

competition but are keen to prevent it. Hence, a firm is always busy with its counterbusiness strategy.

5. Maintenance of market shareMarket share refers to the share of a firms sales of a particularproduct in the total sales of all firms in the market. The economicstrength and success of a firm is measured in terms of its market share. In acompetitive world, each firm makes a successful attempt to expand its marketshare. If it is impossible, it has to maintain its existing market share. Any decline inmarket share is a symptom of the poor performance of a firm. Hence, the pricingpolicy has to assist a firm to maintain its market share at any cost.


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Q6.Discuss the various measures that may be taken by a firmto counteract the evil effects of trade cycle.

Answer:

Control of trade cycle has become an important objective of all most all economies atpresent. Broadly speaking, the remedial measures can be classified under three heads, viz.,monetary, fiscal and miscellaneous measures.

1. Monetary measures-According to hawtrey, Hicks and many others expansion and contraction of supply of moneyis the major cause of operation of trade cycle.

Monetary policy and the expansionary phase: When the economy is moving fast in theupward direction, the monetary measures should aim at (i) restricting the issue of legal tendermoney. (ii) putting restrictions to the expansion of bank credit by adopting both quantitativeand qualitative techniques of credit control. As expansionary phase is mainly supported by

bank credit, adoption of a dear money policy can put an effective check on further expansion.A rise in the Bank Rate, by raising the lending rates of the commercial banks, making creditcostly will have a discouraging effect on more borrowings. A check can be imposed on theliquidity position of the commercial bank by raising the Cash Reserve Ratio and StatutoryLiquidity Ratio. Open market sale of securities can also be conducted to make bank rate moreeffective. Selective techniques, like raising of margin requirements, rationing of credit, moralsuasion, direct action, publicity etc., can also be used efficiently to tighten the credit situationin the economy. Apart from these direct measures indirect measures like wages control, pricecontrol etc., can also be adopted to put a check on the inflationary trend in the economy. Suchmonetary measures are found fairly successful in controlling unwieldy expansion of the

economy. Many countries like U.K., U.S.A., France, Germany and India have used monetarymeasures to control inflation.

Monetary policy and the phase of depression: During the period of depression, to enlargeemployment opportunities and raise the level of income all out measures are to be adopted toincrease the level of investment. To encourage investment activity the central bank has tofollow a cheap money policy. The bank rate and the lending rates of the commercial banksshould be reduced; money should be made available freely by reducing the CRR and SLR.Through open market sale of securities, Cash reserves with the bank should be increased toenable them to lend money easily for various investment activities. Various qualitativetechniques of credit control like reducing the margin requirements, moral suasion etc., may

be adopted to encourage businessmen to borrow and invest.Cheap money policy, to induce businessmen to borrow and invest is not very effective asinvestment is more guided by the marginal efficiency of capital than the rate of interest.Because of low level of income and low price and the low profit margins entrepreneurs donot come forward to borrow and invest in spite of the low rates of interest. One can take ahorse to the water but cannot force to have it; a plethora of money cannot induce the publichorse to have it. Thus monetary policy as a remedy to solve depression has its ownlimitations.

2. Fiscal policy-During the period of inflation or uptrend in the economy, when the private enterprise is over

enthusiastic and there is over expansion and over production government can use taxationand licensing policy as very effective instruments to check such unwieldy growth. Pricecontrol measures can be adopted. Government should adopt surplus budget, reduce public


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expenditure and resort to public borrowing. The cumulative result of these measures wouldreduce the supply of money in circulation, purchasing power and demand.

On the contrary, during the period of depression government should adopt deficit budget,Increase the volume of public expenditure, redeem public debt and resort to external

borrowings, indulge in a moderate dose of deficit financing, reduce tax rates, grant subsidies,development rebates, tax-concessions, tax-reliefs and freight concessions etc. as a result ofthese measures, supply of money in circulation will increase. This in its turn would raise the

purchasing power, demand for goods and services, production and employment etc.J.M.Keynes recommended a number of public works programmers to be launched by thegovernment to cure depression. The New Deal policy of President Roosevelt in the U.S.A.and Blum experiment in France were based on this very belief.

3. Physical controls-During the period of inflation, a price control policy has to be adopted where as duringdepression a price-support policy has to be followed. During the period of contractionunemployment insurance schemes, proper management of savings, investments, production,distribution, expansion of income and employment etc., are needed depending upon thenature of economic fluctuations.

4. Miscellaneous measures-i) Introduction of automatic stabilizers: An automatic stabilizer (or built in stabilizer) is aneconomic shock absorber that helps to smoothen the cyclical business fluctuations of its ownaccord, without requiring deliberate action on the part of government e.g., progressivetaxation policy, unemployment Insurance scheme adopted in the U.S.A.ii) Price support policy followed in the U.S.A. during the post war period to fight the

prospects of depression.iii) The policy of stabilization of the prices of agricultural products in India through

procurement and building up of buffer stock aim at economic stability.iv) Foreign aid is also used for influencing the aggregate demand and supply of goods in acountry.v) Granting of aid might help in recovering from slump.

In addition to these, some of the measures can be adopted at international level to mitigate theadverse effects of trade cycle and promote stability in the world economic growth like controlof private investment, control and distribution of essential goods, regulation of internationalinvestments in developing nations, creation of international buffer stocks etc. thus, severalmeasures are to be taken to smoothen the cyclical movements and to ensure economicstability in an economy.

managerial economics mb 0042

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