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www.cbseignou.com product selling prohibited

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ASSIGNMENT

Course Code : MS-9

Course Title : Managerial Economics

Assignment Code : MS-9/TMA/SEM-I/2012

Coverage : All Blocks

Note : Answer all the questions and submit this assignment on or before April 30,

2012, to the coordinator of your study center.

1. Why is decision making under uncertainty necessarily subjective?

Explain giving examples.Sol Decision-making under uncertainty

Typically, personal and professional decisions can be made with little difficulty.Either the best course of action is clear or the ramifications of the decision are notsignificant enough to require a great amount of attention. On occasion, decisionsarise where the path is not clear and it is necessary to take substantial time and effortin devising a systematic method of analyzing the various courses of actionSometimes managers are reluctant to give even subjective estimates of theprobabilities of various events or states-of-nature. This tends to be the case when thereis very little information to go on regarding the success or failure of a project, becausethe characteristics of the situation are entirely new and cannot be easily comparedwith previous projects. Table 11.2 illustrates this situation, where payoffs can be

estimated but not their associated probabilities.There are a number of decision rulesthat can be used in this type of situation, but there is no single best criterion that iswidely used. The two main rules are now discussed.a. Maximin criterion. This criterion concentrates entirely on the worst possibleoutcome, meaning the minimum payoff, from each possible decision, and

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selects the decision that maximizes this minimum payoff. Given the situation inTable 11.2, the minimum payoff from investing is _60 and the minimum payoff fromnot investing is 0. Therefore the maximin criterion would dictate the decision not toinvest. It can be seen that this is a very conservative decision rule, and many peoplewould find it inappropriate in most cases. For example, taking an everyday situation,this decision rule would mean that we would never cross a road; taking the decisionwhether to cross a road or not to cross, crossing would always involve a lowerpossible payoff (death) than not crossing.Note, however, that this is really an inappropriate situation for using such a criterion;

although people do not actually consciously estimate probabilities of success orfailure in crossing a road, it is quite possible to do so on the basis of historicalexperience. This issue is discussed further in the next chapter, in connection withgovernment policy.b. Minimax regret criterion. Regret in this context refers to opportunity cost. Theopportunity cost of each decision and each state-of-nature is calculated, and this canbe shown in a regret or opportunity cost matrix. The regret matrix corresponding toTable 11.2 is shown in Table 11.3. The decision rule in this case is to select thedecision that minimizes the maximum regret or opportunity cost; since the maximumregret from investing is 60 and the maximum regret from not investing is 80, thedecision in this case would be to invest. As with the previous criterion, a number ofobjections can be made to its use

2. Define Point Price Elasticity. Calculate Point Price Elasticity from theprice and quantity given below.

Price (P) Quantity (Q) Point Price Elasticity

100 090 30

80 60

70 9060 120

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50 150

Sol price elasticity of demand, its coefficient value can be calculated from:

If 10 percent of increase in price causes 20 percent decrease in quantitydemanded, the price elasticity of demand is 20% / 10% = -2.Point elasticity measures The value of elasticity can be calculated using twomethods, namely, point elasticity, and arc elasticity or midpoint elasticity.The formula to calculate point elasticity is as shown below:

where, Q0 is the initial quantity and Q1 is the new quantity, while P0 is the initialprice and P1 is the new price. The symbol is used to represent change, forexample:

Q = Q1Q2

Now let us find equationLET P= A+BQ ___(1)

P=100 , Q=0P=90 ,Q=30

WE GET A=100 put in eq 1 we get

1

3

EQUATION IS P=100-3

Q=300-3P

3Now point elasticity =

Q

Q

dQ P P

dP Q Q

=

=

TABLE

Price (P) Quantity (Q) Point Price Elasticity

100 0 90 30 -9

80 60 -4

70 90 -2.33

60 120 -1.5

50 150 -1

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3. Explain the various types of statistical analyses used for estimation of aproduction function.

Sol In the process of decision-making, a manager should understand clearly the relationship

between the inputs and output on one hand and output and costs on the other. The short

run production estimates are helpful to production managers in arriving at the optimal mix

of inputs to achieve a particular output

target of a firm. This is referred to as the least cost combination of inputs in production

analysis. Also, for a given cost, optimum level of output can be

found if the production function of a firm is known. Estimation of the long run production

function may help a manager in understanding and taking decisions of long term nature

such as capital expenditure. Estimation of cost curves will help production manager in

understanding the nature and shape of cost curves and taking useful decisions. Both short

run cost function and the long run cost function must be estimated, since both sets of

information will be required for some vital decisions. Knowledge of the short run cost

functions allows the decision makers to judge the optimality of present output levels and to

solve decision problems of production manager.Knowledge of long run cost functions is

important when considering the expansion or contraction of plant size, and for confirming

that the present plant size is optimal for the output level that is being produced. In the

present Unit, we will discuss different approaches to examination of production and cost

functions, analysis of some empirical estimates of thesefunctions, and managerial uses of

the estimated functions.

ESTIMATION OF PRODUCTION FUNCTION

The principles of production theory discussed in Unit 7 are fundamental in understanding

economics and provide an important conceptual framework for

analysing managerial problems. However, short run output decisions and long run planning

often require more than just this conceptual framework. That is, quantitative estimates of

the parameters of the production functions are required for some decisions.Functional

Forms of Production Function

The production function can be estimated by regression techniques (refer to MS-8, course

on Quantitative Analysis for Managerial Applications to know

about regression techniques) using historical data (either time-series data, or cross-section

data, or engineering data). For this, one of the first tasks is to select a functional form,

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that is, the specific relationship among the relevant economic variables. We know that the

general form of production function is, Q = f (K,L) Where, Q = output, K = capital and L =

labour. Although, a variety of functional forms have been used to describe production

relationships, only the Cobb-Douglas production function is discussed here. The general

form of Cobb-Douglas function is expressed as: Q = AKa Lb where A, a, and b are the

constants that, when estimated, describe the quantitative relationship between the inputs

(K and L) and output (Q). The marginal products of capital and labour and the rates of the

capital and labour inputs are functions of the constants A, a, and b and. That is,

The sum of the constants (a+b) can be used to determine returns to scale. That is,

(a+b) > 1 increasing returns to scale,

(a+b) = 1 constant returns to scale, and

(a+b) < 1 decreasing returns to scale.

Having numerical estimates for the constants of the production function provides significant

information about the production system under study. The

marginal products for each input and returns to scale can all be determined from the

estimated function. The Cobb-Douglas function does not lend itself directly to estimation

by the regression methods because it is a nonlinear relationship. Technically, an equation

must be a linear function of the parameters in order to use the ordinary least-squares

regression method of estimation. However, a linear equation can be derived by taking the

logarithm of each term. That is,

This function can be estimated directly by the least-squares regression technique and the

estimated parameters used to determine all the important

production relationships. Then the antilogarithm of both sides can be taken, which

transforms the estimated function back to its conventional multiplicative form. We will not

be studying here the details of computing production function since there are a number of

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computer programs available for this purpose. Instead, we will provide in the following

section some empirical estimates of Cobb-Douglas production function and their

interpretation in the process of decision making.

Types of Statistical Analyses

Once a functional form of a production function is chosen the next step is to select the type

of statistical analysis to be used in its estimation. Generally,

there are three types of statistical analyses used for estimation of a production function.

These are: (a) time series analysis, (b) cross-section analysis and(c) engineering analysis.

a) Time series analysis: The amount of various inputs used in various periods in the past

and the amount of output produced in each period is

called time series data. For example, we may obtain data concerning the amount of labour,

the amount of capital, and the amount of various raw

materials used in the steel industry during each year from 1970 to 2000. On the basis of

such data and information concerning the annual output of

steel during 1970 to 2000, we may estimate the relationship between the amounts of the

inputs and the resulting output, using regression techniques.

Analysis of time series data is appropriate for a single firm that has not undergone

significant changes in technology during the time span analysed.

That is, we cannot use time series data for estimating the production function of a firm

that has gone through significant technological changes.

There are even more problems associated with the estimation a production function for an

industry using time series data. For example, even if all

firms have operated over the same time span, changes in capacity, inputs and outputs may

have proceeded at a different pace for each firm. Thus,

cross section data may be more appropriate.

b) Cross-section analysis: The amount of inputs used and output produced in various firms

or sectors of the industry at a given time is called crosssection

data. For example, we may obtain data concerning the amount of labour, the amount of

capital, and the amount of various raw materials used

in various firms in the steel industry in the year 2000. On the basis of such data and

information concerning the year 2000, output of each firm, we may

use regression techniques to estimate the relationship between the amounts of the inputs

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and the resulting output.

c) Engineering analysis: In this analysis we use technical information supplied by the

engineer or the agricultural scientist. This analysis is

undertaken when the above two types do not suffice. The data in this analysis is collected

by experiment or from experience with day-to-dayworking of the technical process. There

are advantages to be gained from and approaching the measurement of the production

function from this angle because the range of applicability of the data is known, and,

unlike time series and cross-section studies, we are not restricted to the narrow range of

actual observations.

4. Products can be related in production as well as demand.Examine thisstatement with reference to Pricing of Joint Products.

Sol Joint Products are two or more products, produced from the same process or

operation, considered to be of relative equal importance. Pricing for joint products is a

little more complex than pricing for a single product. To begin with there are two demand

curves. The characteristics of each demand curve could be different. Demand for one product

could be greater than for the other product. Consumers of one product could be more price

elastic than the consumers of the other product (and therefore more sensitive to changes in

the product's price).

To complicate things further, both products, because they are produced jointly, share a

common marginal cost curve. There are complexities in the production function also. Their

production could be linked in the sense that they are bi-products (referred to as complements

in production), or they could be linked in the sense that they can be produced by the same

inputs (referred to as substitutes in production). Also, production of the joint product could be

in fixed proportions or in variable proportions.

When setting prices in a situation as complex as this, microeconomic marginal analysis is

helpful. In a simple case of a single product, price is set at that quantity demanded where

marginal cost exactly equals marginal revenue. This is exactly what is done when joint

products are produced in variable proportions. Each product is treated separately. In fact, it

might even be possible to construct separate cost functions. In the diagram below, to

determine optimal pricing for joint products produced in variable proportions, you find the

intersection point of marginal revenue (product A) with the joint marginal cost curve. You then

extend that quantity, up to the demand curve for product A, and that gives you the profit

maximizing price for product A (point Pa in the diagram). You do the same for product B,

yielding price point Pb1

.

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Pricing of Joint Products

If the products are produced in fixed proportions (example: cow hides and cow steaks), then

one of the products will very likely be produced in quantities different from the profit

maximizing amount considered separately. In fact the profit maximizing quantity and price of

the second half of the joint product, will be different from the profit maximizing amount

considered separately. In the diagram, product B is produced in greater amounts than theprofit maximizing amount considered separately, and sold at a lower price (point Pb2) than

the profit maximizing price considered separately (point Pb1). Although price is lower and

output is higher, marginal cost is also higher. Yet this is a profit maximizing solution to this

situation. Quantity supplied of product B is increased to the point that marginal revenue

becomes zero (i.e.: the point where the marginal revenue curve intersects the horizontal axis).

Calculating the Profit-Maximizing Prices for Joint ProductsAssume a rancher sells hides and beef. The two goods are assumed to be jointlyproduced in fixed proportions. The marginal cost equation for the beef-hide productpackage is given byMC = 30 +5Q

The demand and marginal revenue equations for the two products are

What prices should be charged for beef and hides? How many units for the product

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package should produced? Summing the two marginal revenue (MRT) equationsgivesMRT = 140 6QThe optimal quantity is determined by equating MR T and MC and solving for Q.Thus140-6Q = 30 +5Qand, hence, Q = 10Substituting Q =10 into the demand curves yields a price of $50 for beef and $60 for hides.However, before concluding that these prices maximize profits, the marginal revenue at thisoutput rate should be computed for each product to assure that neither is negative.Substituting Q=10 into the two marginal revenue equations gives 40 for each good. Becauseboth marginal revenues are positive, the prices just given maximize profits. If marginalrevenue for either product is negative, the quantity sold of that product should be reduced tothe point where marginal revenue equals zero.

Q What is an Isocost Line? Discuss the shifting of Isocost line.

Sol In economics, an isocost line represents all combinations of inputs which cost thesame total amount. Although, similar to the budget constraint in consumer theory, the

use of the isocost line pertains to cost-minimisation in production, as opposed toutility maximisation. For the two production inputs, labour and capital, with fixed unitcosts of the inputs, the equation of the isocost line is

Where w represents the wage rate of labour, r represents the interest rate of capital,K is the amount or units of capital used, L is the amount of labour used and C is thetotal cost of acquiring these inputs.The absolute value of the slope of the isocost line, with capital plotted vertically andlabour plotted horizontally, equals the ratio of the prices of inputs of labour andcapital. The isocost line is combined with the isoquant map to determine the optimal

production. This optimality is arrived at a point where an isoquant and the isocostcurves are tangent to each other. It ensures that the firm attains the highest level ofpossible output with a given isocost line. Consequently, the output is produced at withleast cost or most efficiently. This tangency can also be interpreted as one where theslopes of the isoquant and the isocost are equal. This entails that tangency ensures thatthe marginal productivities of the two inputs are proportional to the ratios of the pricesof the two inputs. Specifically, the point of tangency between an isoquant and anisocost line gives the lowest-cost combination of inputs that can produce the level ofoutput associated with that.The isocost line is an important component when analysing producers behaviour. Theisocost line illustrates all the possible combinations of two factors that can be used atgiven costs and for a given producers budget. In simple words, an isocost line

represents a combination of inputs which all cost the same amount.

Now suppose that a producer has a total budget of Rs 120 and and for producing acertain level of output, he has to spend this amount on 2 factors A and B. Price offactors A and B are Rs 15 and Rs. 10 respectively.

Combinations Units ofCapital Units ofLabour Total expenditure

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Price = 150Rs Price = 100 Rs ( in Rupees)A 8 0 120B 6 3 120C 4 6 120D 2 9 120E 0 12 120

The isocost line shows all the possible combinations of two factorsLabour and capital

THE ISO-COST LINE: Let us assume that the investment fund is given and the pricesof factors X and Y are also known. On the basis of these assumptions let us suppose thatthe firm were to spend the entire amount on employing units of only input X. Then itcould hire OB units of factor X. On the other hand if the producer wants to allocate hisentire investment outlay in employing factor Y then he could hire OA units of Y. Wehave now obtained the two extreme situations A and B.

When we join the points A and B we get the Iso-cost line . The Iso-cost line is so calledbecause whatever be the combination of factor inputs we select at any point on this linewe shall obtain that combination at the same total cost. Thus line AB is also called theequal cost line.

Superimposing the Iso-quant map on the Iso-cost line

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When we superimpose the Iso-quant map on the Iso-cost line then we observe thatcertain Iso-quants lie above the Iso-cost line. Some may lie below it. Others may cut andtouch it. The Iso-quant 200q lies above the Iso-cost line. Therefore it is beyond theeconomic reach ofthe producer. He would have preferred to ride on the Iso-quant 200qbut his investment outlay does not permit him to enjoy any such factor combinationwhich could yield 200q. His choice of factor inputs is thus restricted by a given

investment fund. Thus points similar to G on Iso-quants above the Iso-cost line arebeyond the producers economic reach. Let us now consider any point below the Iso-costline. Such points will be within the reach of the producer but will not exhaust hisinvestment outlay and thus will not fetch the maximum possible return . Points D andF are on the Iso-cost line itself, showing that the producer can afford these factor-combinations but they would yield only 100q. Thus between points D, E and F, point Ewould be most preferred; because at E the factor-input combination costs the same as atpoints D and F but the level of output at E is higher than at D or F. Therefore, theproducer will finally settle down at point E. At pointE, the Iso-cost line is a tangent tothe Iso-quant. Thus, the tangency between Iso-cost line and Iso-quant represents the

point of producers equilibrium.

At point E, the slope of Iso-cost line and the slope of Iso-quant is the same. Now

slope of Iso-quant gives us the MRTS and the slope of iso-cost line denotes the ratio ofprices of factors i.e. Px and since at point E, both slopes

Pyare the same; therefore at point E.

MRTS = PxPy

Thus, the producer is in equilibrium at the point of tangency between the Iso-costline and the Iso-product curve. This is the best possible point of factor combination withinthe budget constraints.

5. Write short notes on the following :-

a) Engineering method of Cost Estimation

Sol The engineering or "bottoms-up" method of cost analysis is the most detailed ofall the techniques and the most costly to implement. It reflects a detailed build-up oflabor, material and overhead costs. Estimating by engineering is typically performedafter Milestone C (i.e., Low Rate Initial Production (LRIP) approval) when the design

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is firm, minimal design changes are expected to occur, data is available to populatethe Work Breakdown Structure (WBS), drawings and specifications are complete andproduction operations are well-defined in terms of labor and material. This method isoften used by contractors and usually involves industrial engineers, price analysts, andcost accountants. Based on the system's specifications, engineers estimate the directlabor and material costs of a work package. In calculating labor costs, company or

industry standards are often used to estimate what labor categories are required andhow many hours will be required for the task. The remaining elements of the workpackage cost, such as tooling, quality control, other direct costs and various overheadcharges are calculated using factors based on the estimated direct labor and ormaterial content of the work.

Engineering cost estimates can be quite accurate since they are usually exhaustive incovering the work to be performed by the virtue of using the work breakdownstructure. These estimates also make use of insight into the specific resources andprocesses used in performing the work. However, a substantial amount of time andeffort is required to produce and document such an estimate, making it impractical touse this method for all elements of an acquisition program's costs. In addition,

insufficient information may exist to use this method effectively, particularly early inthe program when little is know about the details of the item design and productionprocesses. Finally, the factors used to extrapolate other costs from direct labor andmaterials may not accurately reflect the company's current business base or facilities.

The source and structure of an engineering estimate provides much more detail thanestimates by analogy or parametrics. Therefore, an engineering estimate enables bettervisibility into cost drivers. The tradeoff, however, is that producing an engineeringestimate is labor intensive, slow and expensive. In addition, there are still risks. Weoften apply factors or overhead rates (known as wrap rates) to the estimated costs toestimate those costs that are not directly attributed to parts and direct labor. A smallerror at a lower level can translate into a huge error once the wrap rates have beenapplied.

b) Price Leadership

Sol Price leadership is an informal position of a firm in roast oligopolstaindustries,Economics of scale or forms ability so forecast market conditionsaccurately or a combination of these factors. Typical case played by thedominant form the largest form in the industry thedominant from thelargest form in the industry, the dominant form takes lead in making

pricechanges $ the smaller ones follow.In the barometric price leadership one of thefirms not necessarily the dominant one takeslead in announcing change in price,part icular ly when such a change is due fat is not effectedd u e t ou n c e r t a i n t y i n t h e m a r k e t . S u c hp r i c e l e a d e r s h i p e x i s t o n l y number of forms issmall entry to the industry is restudies Products are, by large homogenous.demand for industry is inelastic $ has very low elasticity forms have almostsomeday cost curves

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In other words The price-leadership model ofoligopoly assumes that there is onedominant firm in the industry that sets the price and then all the other firms in theindustry behave like perfectly competitive price-taking firms. Once all the other smallfirms have chosen their desired quantity, the price leader will produce to meet theremaining demand at that price.

As the name implies, the price leadership model consists of a leader and a bunch offollowers. The leader, however, is always mindful of the demand and will set priceslow enough that a satisfactory demand remains after all the followers have madeproduction decisions.

This model implies that the dominant firm is better off with larger amounts of themarket share and less competition. As a result, the price leader may choose prices tominimize the participation of smaller firms. This pricing strategy is called predatorypricing.

c) The Law of Demand

Sol In economic terminology the term demand conveys a wider and definite meaning than in the

ordinary usage. Ordinarily demand means a desire, whereas in economic sense it is something more

than a mere desire. It is interpreted as a want backed up by the - purchasing power. Further demand is

per unit of time such as per day, per week etc. moreover it is meaningless to mention demand without

reference to price. Considering all these aspects the term demand can be defined in the following

words,

Demand for anything means the quantity of that commodity, which is bought, at a given price, per unit

of time.

Law Of Demand - Demand Price Relationship

This law explains the functional relationship between price of a commodity and the quantity demanded

of the same. It is observed that the price and the demand are inversely related which means that the two

move in the opposite direction. An increase in the price leads to a fall in the demand and vice versa.

This relationship can be stated as

Other things being equal, the demand for a commodity varies inversely as the price

or

The demand for a commodity at a given price is more than what it would be at a higher price and less

than what it would be at a lower price

Demand Schedule or Demand Table

These are the two devices to present the law. The demand schedule is a schedule or a table which

contains various possible prices of a commodity and different quantities demanded at them. It can be an

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individual demand schedule representing the demand of an individual consumer or can be the market

demand schedule showing the total demand of all the consumers taken together, this is indicated in the

following table.

It can be observed that with a fall in price every individual consumer buys a larger quantity than before

as a result of which the total market demand also rises. In case of an increase in price the situation will

be reserved. Thus the demand schedule reveals the inverse price-demand relationship, i.e. the Law of

Demand.

Demand Curve DD

It is a geometrical device to express the inverse price-demand relationship, i.e. the law of demand. A

demand curve can be obtained by plotting a demand schedule on a graph and joining the points so

obtained, like the demand schedule we can derive an individual demand curve as well as a market

demand curve. The former shows the demand curve of an individual buyer while the latter shows the

sum total of all the individual curves i.e. a market or a total demand curve. The following diagram shows

the two types of demand curves.

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In the above diagram, figure (A) shows an individual demand curve of any individual consumer while

figure (B) indicates the total market demand. It can be noticed that both the curves are negatively

sloping or downwards sloping from left to right. Such a curve shows the inverse relationship between the

two variables. In this case the two variable are price on Y axis and the quantity demanded on X axis. It

may be noted that at a higher price OP the quantity demanded is OM while at a lower price say OP1,

the quantity demanded rises to OM1 thus a demand curve diagrammatically explains the law of

demand.

Assumptions of the 'Law of Demand'

The law of demand in order to establish the price-demand relationship makes a number of assumptions

as follows:

1. Income of the consumer is given and constant.

2. No change in tastes, preference, habits etc.

3. Constancy of the price of other goods.

4. No change in the size and composition of population.

These Assumptions are expressed in the phrase other things remaining equal.

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