MB0042 – Managerial Economics

Master of Business Administration- MBA Semester 1

MB0042 – Managerial Economics-4 Credits

(Book ID :B1131)

Assignment Set- 1 (60 Marks)

Note: Each question carries 10 Marks. Answer all the questions.

·         What is Price Discrimination? Explain the basis of Price Discrimination.

The policy of price discrimination refers to the practice of a seller to charge different prices for different customers for the same commodity, produced under a single control without corresponding differences in cost.

Price Discrimination May Take The Following Forms: (Basis Of Price Discrimination)

1. Personal differences:  This is nothing but charging different prices for the same commodity because of personal differences arising out of ignorance and irrationality of consumers, preferences, prejudices and needs.

2. Place:  Markets may be divided on the basis of entry barriers, for e.g. price of goods will be high in the place where taxes are imposed. Price will be low in the place where there are no taxes or low taxes.

3. Different uses of the same commodity:  When a particular commodity or service is meant for different purposes, different rates may be charged depending upon the nature of consumption. For e.g. different rates may be charged for the consumption of electricity for lighting, heating and productive purposes in industry and agriculture.

4. Time:  Special concessions or rebates may be given during festival seasons or on important occasions.

5. Distance:  Railway companies and other transporters, for e.g., charge lower rates per KM if the distance is long and higher rates if the distance is short.

6. Special orders:  When the goods are made to order it is easy to charge different prices to different customers. In this case, particular consumer will not know the price charged by the firm for other consumers.

7. Nature of the product:  Prices charged also depends on nature of products e.g., railway department charge higher prices for carrying coal and luxuries and less prices for cotton, necessaries of life etc.

8. Quantity of purchase:  When customers buy large quantities, discount will be allowed by the sellers. When small quantities are purchased, discount may not be offered.

9. Geographical area:  Business enterprises may charge different prices at the national and international markets. For example, dumping – charging lower price in the competitive foreign market and higher price in protected home market.

10. Discrimination on the basis of income and wealth:  For e.g., A doctor may charge higher fees for rich patients and lower fees for poor patients.

11. Special classification of consumers:  For E.g., Transport authorities such as Railway and Roadways show concessions to students and daily travelers. Different charges for I class and II class traveling, ordinary coach and air conditioned coaches, special rooms and ordinary rooms in hotels etc.

12. Age:  Cinema houses in rural areas and transport authorities charge different rates for adults and children.

13. Preference or brands:  Certain goods will be sold under different brand names or trade marks in order to attract customers. Different brands will be sold at different prices even though there is not much difference in terms of costs.

14. Social and or professional status of the buyer:  A seller may charge a higher price for those customers who occupy higher positions and have higher social status and less price to common man on the street.

15. Convenience of the buyer:  If a customer is in a hurry, higher price would be charged. Otherwise normal price would be charged.

16. Discrimination on the basis of sex:  In selling certain goods, producers may discriminate between male and female buyers by charging low prices to females.

17. If price differences are minor, customers do not bother about such discrimination.

18. Peak season and off peak season services

·         Explain the price output determination under monopoly and oligopoly.

Price – Output determination under Monopoly

Assumptions

a. The monopoly firm aims at maximizing its total profit.

b. It is completely free from Govt. controls.

c. It charges a single & uniform high price to all customers.

It is necessary to note that the price output analysis and equilibrium of the firm and industry is one and the same under monopoly.

As output and supply are under the effective control of the monopolist, the market forces of demand and supply do not work freely in the determination of equilibrium price and output in case of the monopoly market. While fixing the price and output, the monopoly firm generally considers the following important aspects.

1. The monopolist can either fix the price of his product or its supply. He cannot fix the price and control the supply simultaneously. He may fix the price of his product and allow supply to be determined by the demand conditions or he may fix the output and leave the price to be determined by the demand conditions.

2. It would be more beneficial to the monopolist to fix the price of the product rather than fixing the supply because it would be difficult to estimate the accurate demand and elasticity of demand for the products.

3. While determining the price, the monopolist has to consider the conditions of demand, cost of the product, possibility of the emergence of substitutes, potential competition, import possibilities, government control policies etc.

4. If the demand for his product is inelastic, he can charge a relatively higher price and if the demand is elastic, he has to charge a relatively lower price.

5. He can sell larger quantities at lower price or smaller quantities at a higher price.

6. He should charge the most reasonable price which is neither too high nor too low.

7. The most ideal price is that under which the total profit of the monopolist is the highest.

Price – Output Determination under Oligopoly

It is necessary to note that there is no one system of pricing under oligopoly market. Pricing policy followed by a firm depends on the nature of oligopoly and rivals reactions. However, we can think of three popular types of pricing under oligopoly. They are as follows:

Independent pricing: (non-collusive oligopoly)

When goods produced by different oligopolists are more or less similar or homogeneous in nature, there will be a tendency for the firms to fix a common pricing. A firm generally accepts the “Going price” and adjusts itself to this price. So long as the firm earns adequate profits at this price, it may not endeavor to change this price, as any effort to do so may create uncertainty. Hence, a firm follows what is called is “Acceptance pricing” in the market.

When goods produced by different firms are different in nature (differentiated oligopoly), each firm will be following an independent pricing policy as in the case of monopoly. In this case, each firm is aware of the fact that what it does would be closely watched by other oligopolists in the industry. However, due to product differentiation, each firm has some monopoly power. It is referred, to as monopoly behavior of the Oligopolist. On the contrary, it may lead to Price-wars between different firms and each firm may fix price at the competitive level. A firm tends to charge prices even below their variable costs. They occur as a result of one firm cutting the prices and others following the same. It is due to cut-throat competition in oligopoly. The actual price fixed by a firm may fall in between the upper limit laid down by the monopoly price and the lower limit fixed by the competitive price. It may be similar to that of the pricing under monopolistic competition.
However, independent pricing in reality leads to antagonism, friction, rivalry, infighting, price-wars etc., which may bring undesirable changes in the market. The Oligopolist may realize the harmful effects of competition and may decide to avoid all kinds of wastes. It encourages a tendency to come together. This leads to pricing under collusion. In other words independent pricing can be followed only for a short period and it cannot last for a long period of time.

·         Give a brief description of:

(a) Total Revenue and Marginal Revenue

(b) Implicit and Explicit Cost

Total revenue (TR):  Total revenue refers to the total amount of money that the firm receives 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 total output produced over a given period of time. We may show total revenue as a 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. 5 per unit, then TR would be

TR = P x Q = 5 x 5000 = 25,000.00.

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 the seller.

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 the product falls to Rs.12 per unit, then the marginal revenue will not be equal to Rs.12 at which the 5^th unit is sold. 4 units, which were sold at the price of Rs.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 loss on the previous units will be equal to Rs.8. Therefore, this loss of 8 rupees should be deducted from the price of Rs.12 of the 5^th unit while calculating the marginal revenue. The marginal revenue in this case, therefore, will be Rs.12 – Rs.8 =Rs.4 and not Rs.12 which is the average revenue.

Marginal revenue can also be directly calculated by finding out the difference between the total revenue before and after selling the additional unit of the product.

Total revenue when 4 units are sold at the price of Rs.14 = 4 X 14 = Rs.56

Total revenue when 5 units are sold at the price of Rs.12 = 5 X 12 = Rs.60

Therefore, Marginal revenue or the net revenue earned by the 5^th unit = 60-56 = Rs.4.

Thus, Marginal revenue of the nth unit = difference in total revenue in increasing the sale from n-1 to n units or

Marginal revenue = price of nth unit minus loss in revenue on previous units resulting from price reduction.

The concept is important in micro economics because a firm’s optimal output (most profitable) is where its marginal revenue equals its marginal cost i.e. as long as the extra revenue from selling one more unit is greater than 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 of a firm and that of a market, because lower prices are needed to achieve higher sales or demand respectively.

MR = = where D TR represents change in TR

And D Q indicates change in total quantity sold.

Also MR = TRn – TRn-1

Marginal 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)

Units	Price	TR	AR	MR
1	20	20	20	-
2	18	36	18	16
3	16	48	16	12
4	14	56	14	8
5	12	60	12	4

There is another way to see why marginal revenue will be less than price when a demand curve slopes downward. Price is average revenue. If the firm sells 4 units for Rs.14, the average 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 the marginal revenue is below price, pulling the average down.

If one knows marginal revenue, one can tell what happens to total revenue if sales change. If selling another unit increases total revenue, the marginal revenue must be greater than zero. If marginal revenue is less than zero, then selling another unit takes away from total revenue. If marginal revenue is zero, than selling another does not change total revenue. This relationship exists because marginal revenue measures the slope of the total revenue curve.

Implicit or Imputed Costs and Explicit Costs:  Explicit costs are those costs which are in the nature of contractual payments and are paid by an entrepreneur 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 be estimated 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 the books of accounts. They are the earnings of owner-employed resources. For example, the factor inputs owned by the entrepreneur himself like capital that can be utilized by himself or can be supplied to others for a contractual sum if he himself does not utilize them in the business. It is to be remembered that the total cost is a sum of both implicit and explicit costs.

4.  Explain the Law of Variable Proportion.

The Law of Variable Proportions:  This law is one of the most fundamental laws of production. It gives us one of the key insights to the working out of the most ideal combination of factor inputs. All factor inputs are not available in plenty. Hence, in order to expand the output, scarce factors must be kept constant and variable factors are to increased in greater quantities. Additional units of a variable factor on the fixed factors will certainly mean a variation in output. The law of variable proportions or the law of non-proportional output will explain how variation in one factor input give place for variations in outputs.

The law can be stated as the following. As the quantity of different units of only one factor input is increased to a given quantity of fixed factors, beyond a particular point, the marginal, average and total output eventually decline.

The law of variable proportions is the new name for the famous “Law of Diminishing Returns” of classical economists. This law is stated by various economists in the following manner – According to Prof. Benham, “As the proportion of one factor in a combination of factors is increased, after a point, first the marginal and then the average product of that factor will diminish”1.

The same idea has been expressed by Prof.Marshall in the following words. An increase in the quantity of a variable factor added to fixed factors, at the end results in a less than proportionate increase in the amount of product, given technical conditions.

Assumptions of the Law

1. Only one variable factor unit is to be varied while all other factors should be kept constant.

· Different units of a variable factor are homogeneous.

· Techniques of production remain constant.

· The law will hold good only for a short and a given period.

· There are possibilities for varying the proportion of factor inputs.

Illustration

A hypothetical production schedule is worked out to explain the operation of the law.

Fixed factors = 1 Acre of land + Rs 5000-00 capital. Variable factor = labor.

Total Product  or Output:  (TP) It is the output derived from all factors units, both fixed & variable employed by the producer. It is also a sum of marginal output.

Average Product or Output: (AP) It can be obtained by dividing total output by the number of variable factors employed.

Marginal Product or Output: (MP) It is the output derived from the employment of an additional unit of variable factor unit

Trends in output

From the table, one can observe the following tendencies in the TP, AP, & MP.

1. Total output goes on increasing as long as MP is positive. It is the highest when MP is zero and TP declines when MP becomes negative.

2. MP increases in the beginning, reaches the highest point and diminishes at the end.

3. AP will also have the same tendencies as the MP. In the beginning MP will be higher than AP but at the end AP will be higher than MP.

Diagrammatic Representation

In the above diagram along with OX axis, we measure the amount of variable factors employed and along OY – axis, we measure TP, AP & MP. From the diagram it is clear that there are III stages.

Stage Number I. The Law of Increasing Returns

The total output increases at an increasing rate (More than proportionately) up to the point P because corresponding to this point P the MP is rising and reaches its highest point. After the point P, MP decline and as such TP increases gradually.

The first stage comes to an end at the point where MP curve cuts the AP curve when the AP is maximum at N.

The I stage is called as the law of increasing returns on account of the following reasons.

1. The proportion of fixed factors is greater than the quantity of variable factors. When the producer increases the quantity of variable factor, intensive and effective utilization of fixed factors become possible leading to higher output.

2. When the producer increases the quantity of variable factor, output increases due to the complete utilization of the “Indivisible Factors”.

3. As more units of the variable factor is employed, the efficiency of variable factors will go up because it creates more opportunity for the introduction of division of labor and specialization resulting in higher output.

Stage Number II. The Law of Diminishing Returns

In this case as the quantity of variable inputs is increased to a given quantity of fixed factors, output increases less than proportionately. In this stage, the T.P increases at a diminishing rate since both AP & MP are declining but they are positive. The II stage comes to an end at the point where TP is the highest at the point E and MP is zero at the point B. It is known as the stage of “Diminishing Returns” because both the AP & MP of the variable factor continuously fall during this stage. It is only in this stage, the firm is maximizing its total output.

Diminishing returns arise due to the following reasons:

1. The proportion of variable factors is greater than the quantity of fixed factors. Hence, both AP & MP decline.

2. Total output diminishes because there is a limit to the full utilization of indivisible factors and introduction of specialization. Hence, output declines.

3. Diseconomies of scale will operate beyond the stage of optimum production.

4. Imperfect substitutability of factor inputs is another cause. Up to certain point substitution is beneficial. Once optimum point is reached, the fixed factors cannot be compensated by the variable factor. Diminishing returns are bound to appear as long as one or more factors are fixed and cannot be substituted by the others.

The III Stage The Stage of Negative Returns:

In this case, as the quantity of variable input is increased to a given quantity of fixed factors, output becomes negative. During this stage, TP starts diminishing, AP continues to diminish and MP becomes negative. The negative returns are the result of excessive quantity of variable factors to a constant quantity of fixed factors. Hence, output declines. The proverb “Too many cooks spoil the broth” and “ Too much is too bad” aptly applies to this stage. Generally, the III stage is a theoretical possibility because no producer would like to come to this stage.

The producer being rational will not select either the stage I (because there is opportunity for him to increase output by employing more units of variable factor) or the III stage (because the MP is negative). The stage I & III are described as NON-Economic Region or Uneconomic Region. Hence, the producer will select the II stage (which is described as the most economic region) where he can maximize the output. The II stage represents the range of rational production decision.

It is clear that in the above example, the most ideal or optimum combination of factor units = 1 Acre of land+ Rs. 5000 – 00 capital and 9 laborers.

All the 3 stages together constitute the law of variable proportions. Since the second stage is the most important, in practice we normally refer this law as the law of Diminishing Returns.

5.  What is Elasticity of Demand? Explain the factors determining it.

Elasticity of demand is generally defined as the responsiveness or sensitiveness of demand to a given change in the price of a commodity. It refers to the capacity of demand either to stretch or shrink to a given change in price. Elasticity of demand indicates a ratio of relative changes in two quantities.ie, price and demand. According to prof. Boulding. “Elasticity of demand measures the responsiveness of demand to changes in price” 1 In the words of Marshall,” The elasticity (or responsiveness) of demand in a market is great or small according to the amount demanded much or little for a given fall in price, and diminishes much or little for a given rise in price” 2.

Determinants of Price Elasticity of Demand

The elasticity of demand depends on several factors of which the following are some of the important ones.

1. Nature of the Commodity:  Commodities coming under the category of necessaries and essentials tend to be inelastic because people buy them whatever may be the price. For example, rice, wheat, sugar, milk, vegetables etc. on the other hand, for comforts and luxuries, demand tends to be elastic e.g., TV sets, refrigerators etc.

2. Existence of Substitutes: Substitute goods are those that are considered to be economically interchangeable by buyers. If a commodity has no substitutes in the market, demand tends to be inelastic because people have to pay higher price for such articles. For example. Salt, onions, garlic, ginger etc. In case of commodities having different substitutes, demand tends to be elastic. For example, blades, tooth pastes, soaps etc.

3. Number of uses for the commodity:  Single-use goods are those items which can be used for only one purpose and multiple-use goods can be used for a variety of purposes. If a commodity has only one use (singe use product) then demand tends to be inelastic because people have to pay more prices if they have to use that product for only one use. For example, all kinds of. eatables, seeds, fertilizers, pesticides etc. On the contrary, commodities having several uses, [multiple-use-products] demand tends to be elastic. For example, coal, electricity, steel etc.

4. Durability and reparability of a commodity:  Durable goods are those which can be used for a long period of time. Demand tends to be elastic in case of durable and repairable goods because people do not buy them frequently. For example, table, chair, vessels etc. On the other hand, for perishable and non-repairable goods, demand tends to be inelastic e.g., milk, vegetables, electronic watches etc.

5. Possibility of postponing the use of a commodity:  In case there is no possibility to postpone the use of a commodity to future, the demand tends to be inelastic because people have to buy them irrespective of their prices. For example, medicines. If there is possibility to postpone the use of a commodity, demand tends to be elastic e.g., buying a TV set, motor cycle, washing machine or a car etc.

6. Level of Income of the people:  Generally speaking, demand will be relatively inelastic in case of rich people because any change in market price will not alter and affect their purchase plans. On the contrary, demand tends to be elastic in case of poor.

7. Range of Prices:  There are certain goods or products like imported cars, computers, refrigerators, TV etc, which are costly in nature. Similarly, a few other goods like nails; needles etc. are low priced goods. In all these cases, a small fall or rise in prices will have insignificant effect on their demand. Hence, demand for them is inelastic in nature. However, commodities having normal prices are elastic in nature.

8. Proportion of the expenditure on a commodity:  When the amount of money spent on buying a product is either too small or too big, in that case demand tends to be inelastic. For example, salt, newspaper or a site or house. On the other hand, the amount of money spent is moderate; demand in that case tends to be elastic. For example, vegetables and fruits, cloths, provision items etc.

9. Habits:  When people are habituated for the use of a commodity, they do not care for price changes over a certain range. For example, in case of smoking, drinking, use of tobacco etc. In that case, demand tends to be inelastic. If people are not habituated for the use of any products, then demand generally tends to be elastic.

10. Period of time:  Price elasticity of demand varies with the length of the time period. Generally speaking, in the short period, demand is inelastic because consumption habits of the people, customs and traditions etc. do not change. On the contrary, demand tends to be elastic in the long period where there is possibility of all kinds of changes.

11. Level of Knowledge:  Demand in case of enlightened customer would be elastic and in case of ignorant customers, it would be inelastic.

12. Existence of complementary goods:  Goods or services whose demands are interrelated so that an increase in the price of one of the products results in a fall in the demand for the other. Goods which are jointly demanded are inelastic in nature. For example, pen and ink, vehicles and petrol, shoes and socks etc have inelastic demand for this reason. If a product does not have complements, in that case demand tends to be elastic. For example, biscuits, chocolates, ice creams etc. In this case the use of a product is not linked to any other products.

13. Purchase frequency of a product:  If the frequency of purchase is very high, the demand tends to be inelastic. For e.g., coffee, tea, milk, match box etc. on the other hand, if people buy a product occasionally, demand tends to be elastic. For example, durable goods like radio, tape recorders, refrigerators etc.

Thus, the demand for a product is elastic or inelastic will depend on a number of factors.

6.  What is Marginal effeciency of Capital? Describe the factors determine MEC.

Marginal Efficiency of Capital:  It refers to productivity of capital. It may be defined as the highest rate of return over cost accruing from an additional unit of capital asset. Also it refers to the yield expected from a new unit of capital. The MEC in its turn depends on two important factors.

1. Prospective yield from the capital asset and

2. The supply price of the capital asset.

Determinants of MEC:

Several factors that affect MEC are given below.

1. Short run factors: Expectation of increased demand, higher MEC leads to larger investment and vice-versa.

2. Cost and Price: If the production costs are expected to decline and market prices to go up in future, MEC will be high leading to a rise in investment and vice-versa.

3. Higher Propensity to consume leading to a rise in MEC encourages higher investment.

4. Changes in income: An increase in income will simulate investment and MEC while a decline in the level of incomes will discourage investment.

5. Current state of expectations:  If the current rates of returns are high, the MEC is bound to be high for new projects of investment and vice-versa. This is because the future expectations to a very great extent depend on the current rate of earnings.

6. State of business confidence:  During the period of optimism (boom) the MEC will be generally high and during period of pessimism (depression), it will be generally less.

II Long run factors.

1. Rate of growth of population:  In a capitalist economy, a high rate of population growth leads to an increase in MEC because it leads to an increase in the demand for both consumption and investment goods. On the contrary, a decline in the population growth depresses MEC.

2. Development of new areas: Development activities in the new fields like transport and communications, generation of electricity, construction of irrigation projects, ports etc would lead to a rise in MEC.

3. Technological progress: Technological progress would lead to the development and use of highly sophisticated and latest machines, equipments and instruments. This will add to the productive capacity of the economy leading to an increase in MEC.

4. Productive capacity of existing capital equipments: Under utilised existing capital assets may be fully utilized if the demand for goods increases in the economy. In that case the MEC of the same asset will definitely rise.

5. The rate of current investment: If the current rate of investment is already high, there would be little scope for further investment and as such the MEC declines.

Thus, several factors both in the short run and in the long run affect the MEC of a capital asset.