MB0026 Managerial Economics (3 credits) Assignment 1 (6 10 = 60 Marks) Answer the following questions: 1.

. Briefly explain the factors influencing the price elasticity of demand. 2. Explain the techniques adopted by a company to forecast the demand for a new product. 3. Distinguish the following: a) Income elasticity and cross elasticity of demand; b) Monopoly and perfect competition; and c) Fixed cost and variable cost 4. Critically evaluate the economist theory of firm. 5. Explain the law of variable proportions with suitable diagrams. 6. The Cost concept is important for decision making Elucidate

1. Briefly explain the factors influencing the price elasticity of demand The price elasticity of demand depends on several factors of which the following are some of the important ones. a. Nature of 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 elastic e.g.TV sets, refrigerators etc. b. Existence of substitutes Substitutes goods are those that are considered to be economically interchangeable by buyers. If a commodity has no substitutes in the market, demands tend 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 tend to be elastic. For example blades, tooth paste soaps etc. c. Number of Uses for the commodity Single uses 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 then demand tends to be inelastic because people have to pay for more price if they have to use that product for only one use. E.g. all knid of eatable, seeds, fertilizers etc. On the contrary commodities having several uses demand tends to elastic e.g. coal, electricity, steel etc. d. Durability and repairability of commodity Durable goods are those which can be used for a long period of time. Demand tens to be elastic in case of durable and repairable goods because people do not buy them frequently. E.g. table, chair, vessels etc. On the other hand for perishable goods and non-perishable goods demand tends tobe in elastic e.g. milk, vegetables.etc. e. Possibility of postponing the use of the commodity In case there is no possibility to postpone the use of a commodity to future the demand tends to inelastic because people have to buy them irrespective of their prices. E.g.medicines. If there is a possibility to postpone the use of acommodity, demand tends to be elastic e.g. buying a TV set, motor cycle, washing machine. f. 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. g. Range of prices. There are goods of products like imported cars, computers etc which are costly in nature. Similarly a few other goods like nails, needles etc. are low priced. In all

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these cases a small fall or rises in prices will be insignificant effect on their demand. Hence demand for them is inelastic in nature. However having normal prices are elastic in nature. 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 demands tend to inelastic. For example salt, newspaper, or house. On the other hand the amount of money spent is moderate; demand in that case tend to be elastic. For example vegetables and fruits, cloths, provision items etc. Habits When people are habituated for the use of a commodity, they do not care for price change over a certain range. E.g. in case smoking drinking etc. In that case demand is inelastic in nature. On the contrary demand tends to be elastic in the long period where there is a possibility of all kind of changes. Level of knowledge Demand in case of enlightened customers would be elastic and in case of ignorant customers, it would be inelastic. Existence of complimentary goods. Goods or service whose demand 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 . e.g. pen and ink, vehicle and petrol etc. have inelastic demand for this reason. If the product does not have complements that case demand tends to be elastic. E.g. buiscits, chocolates etc. in this case product is not linked to any other product. Purchase frequency of a product. If the frequency of purchase is very high, the demand tends to be inelastic e.g.coffee, tea, milk etc. On the other hand if people buy product occasionally demand tends to be elastic. E.g. durable goods like radio, TV etc.

2. Explain the techniques adopted by a company to forecast the demand for a new product. Demand forcasting for a new product is quite different from that for established products. Here the firms will not have any experience or past data for this purpose. An intensive study of the economic and competitive characteristics of the product should be made to make efficient forecasts. Prof.Joel Dean, however, has suggested a few guidelines to make forecasting of demand for new products. 1. Evolutionary approach. The demand for the new product may be considered as an outgrowth of an existing product..e.g. Demand for new Tata Indica, which is a modified version of Old Indica can most effectively be projected base on the sales of the old Indica, the demand for new Pulsar can be forcasted based on the sales of the old Pulsar. Thus when a new product is evolved from the old product, the demand conditions

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of the old product can be taken as a basis for forcasting the demand for the new product. Substitute Approach If the new product developed serves as substitute for the existing product, the demand for the new product may be worked out on the basis of a market share. The growth of demand for all the products have to be worked out on the basis of independent variables that influence the demand for the substitutes. After that, a protion of the market can be sliced out for the new produict.e.g. a moped as a substutte for a scooter, a cell phone as a substitute of land line. In some cases price plays an important role in shaping future demand for the product. Opinion Poll approach Under this approach the potential buyers are directly contacted, or through the use of samples of the new product and their responses are found out. These are finally blown up to forecast for the new product. Sales experience approach Offer the new product for sale in a sample market; say super markets or big bazaars in big cities, which are also big marketing centres. The product may be offered for sale through one super market and the estimate of sales obtained may be blown up to arrive at estimated demand for the product. Growth curve approach According to this, the rate of growth and the ultimate level of demad for the new product are estimated on the basis of the pattern of growth of established products.e.g. an automobile co. while introducing a new version of a car will study the level of demand for the existing car. Vicarious approach A firm will survey consumers reactions to a new product indirectly through getting in touch with some specialized and informed dealers who have good knowledge about the market, about different varieties of the product already available in the market, the consumers preferences etc. This helps in making a more efficient estimation of future demand. These methods are not mutually exclusive. The management can use a combination of several of them supplement and cross check each other.

3. Distinguish the following: a) Income elasticity and cross elasticity of demand; b) Monopoly and perfect competition; and c) Fixed cost and variable cost

a) Income elasticity and cross elasticity of demand

Cross Elasticity of demand This measures the % change in QD for a good after the change in price of another. XED = % change in QD good A % change in price good B for example if there is an increase in the price of tea by 10% and QD of coffee increases by 2%, then XED = +0.2 Substitute goods are alternative. There XED will be positive,

The weak substitutes like tea and coffee will have a low XED. Tesco bread and Sainsburys bread are close substitutes so XED is higher

Complements goods, these are goods which are used together, therefore XED is negative.

If the price of DVD players fall, then there will be a increase in demand for DVD disks, When setting prices firms will have to look at what alternatives the consumer has, if there are no close substitutes they will be able to increase the price. For this reason firms spend a lot of money on advertising to differentiate their products.

Income Elasticity of Demand YED This measures the responsiveness of demand to a change in income. e.g. if your income increase by 5 % and your demand for mobile phones increased 20% then the YED = 20/ 5 = 4. YED = % change in Q.D % change in Income INFERIOR GOOD This occurs when an increase in income leads to a fall in demand. Therefore YED<0.

E.g. clothes from charity shops, cheap bread When your income increase you buy better quality goods NORMAL GOOD This occurs when an increase in income leads To an increase in demand for the good, Therefore YED>0 LUXURY GOOD This occurs when an increase in demand causes a bigger % increase in demand, therefore YED>1.

Luxury goods will also be normal goods and we can say They will be income Elastic Income inelastic This means an increase in income leads to a smaller % increase in demand. Therefore 0> YED <1 Firms will make use of YED by producing more luxury goods during periods of economic growth, similarly there will be less demand for inferior goods.

b. MONOPOLY AND PERFECT COMPETITION: Monopoly and perfect competition represent two extremes along a continuum of market structures. At the one extreme is perfect competition, representing the ultimate of efficiency achieved by an industry that has extensive competition and no market control. Monopoly, at the other extreme, represents the ultimate of inefficiency brought about by the total lack of competition and extensive market control. Monopoly is a market structure with complete market control. As the only seller in the market, a monopoly controls the supply-side of the market. Perfect competition, in contrast, is a market structure in which each firm has absolutely no market control. No firm in perfect competition can influence the market price in any way. The best way to compare monopoly and perfect competition is the four characteristics of perfect competition: (1) large number of relatively small firms, (2) identical product, (3) freedom of entry and exit, and (4) perfect knowledge.

Number of Firms: Perfect competition is an industry comprised of a large number of small firms, each of which is a price taker with no market control. Monopoly is an industry comprised of a single firm, which is a price maker with total market control. Phil the zucchini grower is one of gadzillions of zucchini growers. Feet-First Pharmaceutical is the only firm that sells Amblathan-Plus, a drug that cures the deadly (but hypothetical) foot ailment known as amblathanitis.

Available Substitutes: Every firm in a perfectly competitive industry produces exactly the same product as every other firm. An infinite number of perfect substitutes are available. A monopoly firm produces a unique product that has no close substitutes and is unlike any other product. Gadzillions of firms grow zucchinis, each of which is a perfect substitute for the zucchinis grown by Phil the zucchini grower. There are no substitutes for Amblathan-Plus. Feet-First Pharmaceutical is the only supplier. Resource Mobility: Perfectly competitive firms have complete freedom to enter the industry or exit the industry. There are no barriers. A monopoly firm often achieves monopoly status because the entry of potential competitors is prevented. Anyone can grow zucchinis. All they need is a plot of land and a few seeds. FeetFirst Pharmaceutical holds the patents on Amblathan-Plus. No other firm can enter the market. Information: Each firm in a perfectly competitive industry possesses the same information about prices and production techniques as every other firm. A monopoly firm, in contrast, often has information unknown to others. Everyone knows how to grow zucchinis (or can easily find out how). Feet-First Pharmaceutical has a secret formula used in the production of Amblathan-Plus. This information is not available to anyone else.

The consequence of these differences include: First, the demand curve for a perfectly competitive firm is perfectly elastic and the demand curve for a monopoly firm is THE market demand, which is negatively-sloped according to the law of demand. A perfectly competitive firm is thus a price taker and a monopoly is a price maker. Phil must sell his zucchinis at the going market price. It he does not like the price, then he does not sell zucchinis. Feet-First Pharmaceutical can adjust the price of Amblathan-Plus, either higher or lower, and so doing it can control the quantity sold. Second, the monopoly firm charges a higher price and produces less output than would be achieved with a perfectly competitive market. In particular, the monopoly price is not equal to marginal cost, which means a monopoly does not efficiently allocate resources. Although Feet-First Pharmaceutical charges several dollars per ounce of Amblathan-Plus, the cost of producing each ounce is substantially less. Phil, in contrast, just about breaks even on each zucchini sold. Third, while an economic profit is NOT guaranteed for any firm, a monopoly is more likely to receive economic profit than a perfectly competitive firm. In fact, a perfectly competitive firm IS guaranteed to earn nothing but a normal profit in the long run. The same cannot be said for monopoly. The price of zucchinis is so close to the cost of production, Phil never earns much profit. If the price is relatively high, other zucchini producers quickly flood the market, eliminating any profit. In contrast, Feet-First Pharmaceutical has been able to maintain a price above production cost for several years, with a handsome profit perpetually paid to the company shareholders year after year. Fourth, the positively-sloped marginal cost curve for each perfectly competitive firm is its supply curve. This ensures that the supply curve for a perfectly competitive market is also positively sloped. The marginal cost curve for a

monopoly is NOT, repeat NOT, the firm's supply curve. There is NO positivelysloped supply curve for a market controlled by a monopoly. A monopoly might produce a larger quantity if the price is higher, in accordance with the law of supply, or it might not. If the price of zucchinis rises, then Phil can afford to grow more. If the price falls, then he is forced to grow less. Marginal cost dictates what Phil can produce and supply. Feet-First Pharmaceutical, in comparison, often sells a larger quantity of Amblathan-Plus as the price falls, because they face decreasing average cost with larger scale production.

c. Fixed cost and variable cost Variable costs are costs that can be varied flexibly as conditions change. In the John Bates Clark model of the firm that we are studying, labor costs are the variable costs. Fixed costs are the costs of the investment goods used by the firm, on the idea that these reflect a long-term commitment that can be recovered only by wearing them out in the production of goods and services for sale. The idea here is that labor is a much more flexible resource than capital investment. People can change from one task to another flexibly (whether within the same firm or in a new job at another firm), while machinery tends to be designed for a very specific use. If it isn't used for that purpose, it can't produce anything at all. Thus, capital investment is much more of a commitment than hiring is. In the eighteen-hundreds, when John Bates Clark was writing, this was pretty clearly true. Over the past century, a) education and experience have become more important for labor, and have made labor more specialized, and b) increasing automatic control has made some machinery more flexible. So the differences between capital and labor are less than they once were, but all the same, it seems labor is still relatively more flexible than capital. It is this (relative) difference in flexibility that is expressed by the simplified distinction of long and short run. Of course, productivity and costs are inversely related, so the variable costs will change as the productivity of labor changes. Here is a picture of the fixed costs (FC), variable costs (VC) and the total of both kinds of costs (TC) for the productivity example in the last unit:

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Output produced is measured toward the right on the horizontal axis. The cost numbers are on the vertical axis. Notice that the variable and total cost curves are parallel, since the distance between them is a constant number -- the fixed cost. 4. Critically evaluate the economist theory of firm According to Economist theory of firm, a firm is a producing unit. It transforms or converts all kinds of inputs into outputs. The basic function a firm is to produce those goods and services which are demanded by consumers in the market. It produces various kinds of goods and services and supplies them in the market for the satisfaction of different groups of people either directly or indirectly. A firm is business unit and it is organized on commercial principles. In the process of production and sale of different goods and services, it aims at making profits. According to this theory, a traditional firm is a group with a particular organizational and management structure having command over its own property rights. It is legal entity on the basis of ownership and contractual relationship organized for production and sale of goods and services. In olden days a firm was called by various names like shops, firms, enterprise, production and business concerns etc. But today it is organized on various forms like a sole trader, partnership concern, joint stock company, cooperative society etc. A firm is formed , run, and managed by an owner, employer or an entrepreneur who has the following characteristics. 1. He has the legal permission to run an enterprise. 2. He can enter in to contract with any group of people who supply productive sources. 3. He can take his own decisions to maximize his economic gains. 4. He is entitled to enjoy the residual income after making payments to all productive resources in the form of rent, wages and salaries and interest. 5. He can transfer his rights and obligations to other individuals on the basis of contracts. 6. He can direct and dictate the suppliers of productive recources in the manner he likes of course on the basis of legal contracts.

7.He can change the nature of management according to his convenience. 8. He has all the rights to make changes in his organization which he feels the best. He can consult others or he can take his own final decisions. Thus a firm is managed by a private person who centralizes all his decisions on the basis of legal contracts and makes enough profits. He has his own personal interests to run the business unit. Such a type of business unit has emerged as dominant form of business organization over a period of time. It has its own advantages over other forms of organization. 1.He can take immediate and quick decisions to maximize his economic gains. 2. Direct control over the firm will ensure higher productivity, efficiency better supervision, better performance etc. Better control and management helps him to have time bound programs. 3. He can reward factor inputs on the basis of their performance and get best services from them. 4. He adopts a flexible business policy to suit the changing conditions without any loss of time. Thus the form of business organization has emerged as the classical entrepreneurial firm and has become most popular over a period of time. The above mentioned features of the classical firm have been described as the theory of firm by various economists. The traditional or classical firm basically engages itself in various kinds of economic activities which help in maximizing the profits. It concentrates on wealth-creation and through it surplus creation. Surplus value is nothing but the differences between the value of the final product and the value of various inputs employed in the production process. Surplus generation is possible when the firm produces maximum output with minimum costs. Hence a firm works out the most ideal factor combinations to avoid all kinds of wastages, cut down costs and maximize its output. When the firm produces maximum output with minimum costs then it will reach the equilibrium position. This is possible when the total revenue is equal to toal cost or marginal revenue is equal to marginal cost. At the equilibrium point, it is said that a firm will be maximizing profits. The nature of working of a firm depends on several factors like number of firms in the market, size of the firm, volume of production, entry and exit of firms, degree of competition, existence of alternative substitutes, prices of goods. Etc. Thus the traditional or classical firms aim at profit maximization and over the years this objective has been replaced by profit optimization. 5. Explain the law of variable proportions with suitable diagrams