5. Managerial Economics Ass-2 (P-11)

7/30/2019 5. Managerial Economics Ass-2 (P-11)

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Spring / February 2012

Master of Business Administration MBA Semester 1

MB0042 Managerial Economics 4 Credits

(Book ID: B1131)

AssignmentSet 2 (60 Marks)

Q1. Define Managerial Economics and explain its maincharacteristics.Answer:

Managerial economics is a science that deals with the application of various

economic theories, principles, concepts and techniques to business

management in order to solve business and management problems. It dealswith the practical application of economic theory and methodology to

decision-making problems faced by private, public and non-profit making

organizations.

The same idea has been expressed by Spencer and Seigelman in the

following words. Managerial Economics is the integration of economic theory

with business practice for the purpose of facilitating decision making and

forward planning by the management. According to Mc Nair and Meriam,

Managerial economics is the use of economic modes of thought to analyze

business situation. Brighman and Pappas define managerial economics as,

the application of economic theory and methodology to businessadministration practice. Joel dean is of the opinion that use of economic

analysis in formulating business and management policies is known as

managerial economics.

Features of managerial Economics

1. It is more realistic, pragmatic and highlights on practical application of

various economic theories to solve business and management problems.

2. It is a science of decision-making. It concentrates on decision-making

process, decision-models and decision variables and their relationships.

3. It is both conceptual and metrical and it helps the decision-maker by

providing measurement of various economic variables and their

interrelationships.

4. It uses various macro economic concepts like national income, inflation,

deflation, trade cycles etc to understand and adjust its policies to the

environment in which the firm operates.

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5. It also gives importance to the study of non-economic variables having

implications of economic performance of the firm. For example, impact of

technology, environmental forces, socio-political and cultural factors etc.

6. It uses the services of many other sister sciences like mathematics,

statistics, engineering, accounting, operation research and psychology

etc to find solutions to business and management problems.It should be clearly remembered that Managerial Economics does not provide

ready-made solutions to all kinds of problems faced by a firm. It provides only

the logic and methodology to find out answers and not the answers

themselves. It all depends on the managers ability, experience, expertise

and intelligence to use different tools of economic analysis to find out the

correct answers to business problems.

Q2. State and explain the law of demand.

Answer:-

The Law of Demand

It explains the relationship between price and quantity demanded of acommodity. It says that demand varies inversely with the price. The law canbe explained in the following manner: Keeping other factors that affectdemand constant, a fall in price of a product leads to increase inquantity demanded and a rise in price leads to decrease in quantitydemanded for the product. The law can be expressed in mathematicalterms as Demand is a decreasing function of price. Symbolically, thus D = F(p) where, D represents Demand, P stands for Price and F denotes the

Functional relationship. The law explains the cause and effect relationshipbetween the independent variable [price] and the dependent variable[demand]. The law explains only the general tendency of consumers whilebuying a product. A consumer would buy more when price falls due to thefollowing reasons:

1. A product becomes cheaper.[Price effect]

2. Purchasing power of a consumer would go up.[Income effect]

3. Consumers can save some amount of money.

4. Cheaper products are substituted for costly products [substitution effect].

Important Features of Law of Demand

1. There is an inverse relationship between price and quantity demanded.

2. Price is an independent variable and demand is a dependent variable

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3. It is only a qualitative statement and as such it does not indicatequantitative changes in price and demand.

4. Generally, the demand curve slopes downwards from left to right.

The operation of the law is conditioned by the phrase Other things beingequal. It indicates that given certain conditions, certain results wouldfollow. The inverse relationship between price and demand would be validonly when tastes and preferences, customs and habits of consumers, pricesof related goods, and income of consumers would remain constant.

Q3. What is Demand Forecasting? Explain in brief various methods offorecasting demand.

Answer:

Demand forecasting seeks to investigate and measure the forces thatdetermine sales for existing and new products. Generally companies plantheir business - production or sales in anticipation of future demand. Henceforecasting future demand becomes important. The art of successful businesslies in avoiding or minimizing the risks involved as far as possible and facethe uncertainties in a most befitting manner. Thus Demand Forecastingrefers to an estimation of most likely future demand for productunder given conditions.

A. Qualitative Methods (Survey Methods)

1. Expert Opinion Method:

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In this method, the firm makes an effort to obtain the opinion of

experts who have longstanding experience in the field of enquiry related to

the product under consideration. If the forecast is based on the opinion of

several experts then the approach is called forecasting through the use of

panel consensus. Although the panel consensus method usually results in

forecasts that embody the collective wisdom of consulted experts, it may be

at times unfavorably affected by the force of personality of one or few key

individuals.

To counter this disadvantage of panel consensus, another approach isdeveloped called the delphi method. In this method a panel of experts isindividually presented a series of questions pertaining to theforecasting problem. Responses acquired from the experts are analyzed byan independent party that will provide the feedback to the panel members.Based on the responses of other individuals, each expert is then asked tomake a revised forecast. This process continues till a consensus is reached or

until further iterations generate no change in estimates.

The advantage of Delphi technique is that it helps individual panel

members in assessing their forecasts. However Delphi method is quite

expensive. Often, the most knowledgeable experts in the industry will

command more fees. Besides, those who consider themselves as experts

may be reluctant to be influenced by the opinions of others on the panel.

If the number of experts is large and their predictions are different

then a simple average or weighted average is found so as to lead to unique

forecasts. This method of forecasting is called the hunch method.

The main advantage of the Experts Opinion Survey Method is its

simplicity. It does not require extensive statistical or mathematical

calculations However this method has its own limitations. It is purely

subjective. It substitutes opinion in place of analysis of the situation. Experts

may have different forecasts or any one among them may influence others.

Who knows experts may be biased or have their own intentions behind

providing their opinions. If the consulted experts are genuinely reliable then

panel consensus could be perhaps the best method of forecasting.

2. Consumers Survey Method:

Survey methods constitute another important forecasting tool,

especially for short-term projections. The most direct method of estimating

demand in the short- run is to conduct the survey of buyers intentions. The

consumers are directly approached and are asked to give their opinions

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about the particular product. The questionnaire must be carefully prepared

bearing in mind the qualities of a good questionnaire. It must be simple and

interesting so as to evoke consumers response.

Consumers Survey may acquire three forms:

I. Complete Enumeration SurveyII. Sample Survey

III. End-Use Method.

I. Complete Enumeration Survey: Complete Enumeration Survey covers allthe consumers. It resembles the Census Data Collection which considers theentire population. In this case all the consumers are covered and informationis obtained from all regarding the prospective demand for the product underconsideration. The method of Complete Enumeration has the advantage ofbeing absolutely unbiased as far as consumer opinions are concerned. Wecan obtain complete information by contacting every possible present, pastor would be consumers of the product. No doubt it is not very easy to carry

out the survey on such a large scale. Even the collected information will bedifficult and too tedious to be analyzed. The reliability on such consumersinformation may be questionable, if the opinions are not authentic.

II. Sample Survey: In case of the sample survey method, few consumers areselected to represent the entire population of the consumers of thecommodity consumed. The total demand for the product in the market isthen projected on the basis of the opinion collected from the sample. Themost important advantage of this method is that it is less expensive and lesstedious compared to the method of complete enumeration. The samplechosen should not be too small or too large. This method if applied carefullywill yield reliable results especially in case of new brands and new products.

III. End Use Method: A given product may have different end uses. Forexample: milk may have different end uses such as milk powder, chocolates,sweet -meats like barfi etc. Therefore the end users of milk are identified. Asurvey is planned of the end user sand the estimated demands from allsegments of end users are added. This method of demand forecasting is easyto manage if the number of end-users is limited. In this method theinvestigator expects the end- users to provide correct information well inadvance of their respective production schedules.

Although the Survey Method is the most direct method of estimating

demand in the short-run; Joel Dean criticized this method by saying

\u201cthere are formidable barriers to learning the buying intentions of the

household consumers. He adds consumers are often inconsistent. The

inability to foresee what choice the consumers will make when faced with

multiple alternatives in the market; restrict the usefulness of this method of

forecasting.

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B. Quantitative Methods (Statistical Methods)

The Quantitative Methods of demand include the Time Series Analysis,

Moving Averages, Exponential Smoothing, Index Numbers, Regression

Analysis as well as Econometric Models and Input-Output Analysis.

1. Time Series Analysis (Trend Projection):

Time Series Analysis is used to estimate future demand. The Time SeriesMethod is based on obtaining the historical data regarding the demand forthe product so as to project future concurrencies on the basis of what hashappened in the past. The Time Series data are chronologically arranged datafrom a population at different points of time. For example: demand for steelin India maybe plotted for years beginning from 1951 to 2003. Based on thedata plotted on the graph, a line or curve is drawn. This helps to establish atrend over a period of time. This pattern is then smoothed to eliminate theeffect of random fluctuations and it can then be extrapolated into the future

to provide a forecast. The Time Series forecasting models are based onhistorical observations of the values of the variable that is being forecast.

The Time Series data would indicate different types of fluctuations

which can be classified as Secular Trends, Cyclical Variations, Seasonal

Variations and Random Fluctuations.

I. Secular Trend refers to the long run increase or decrease in the series.

II. Cyclical Fluctuation refers to the rhythmic variations in the economic

series.

III. Seasonal Variation refers to the variations caused by weather patterns

social habits such as festivals etc.

IV. Random Fluctuation refers to the irregular and unpredictable shocks

to the system, such as wars, strikes, natural catastrophes etc. When

a forecast is to be made, the Seasonal, Cyclical and Random

variations are eliminated from the collected data leaving behind the

secular trend only. The Secular Trend is then projected. This trend

may be a linear trend or non linear. When the trend is linear then we

use the least squares method or the line-of-best fit.

Since the extrapolation technique assumes that a variable will follow its

established parts, the problem is to determine accurately the appropriate

trend curve. The selection of the appropriate curve is guided both by

empirical and theoretical considerations. The trend projection method is more

useful for long term forecasting then for short run estimation. The trend

projections assume that the historical relationships involved in the Time

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Series will continue in future, which need not always be the case. Finally

trend projections involve no analysis of causal relationship and hence offer no

help in analyzing as to why a particular series moves as it does or what would

be the impact of a particular policy decision on future movement of the

series.

2. Moving Averages: The method of Moving Average is useful when themarket demand is assumed to remain fairly steady over time. The MovingAverage for n months is found by simply summing up the demand duringthe past n months and then dividing this total by n.Moving Average = Demand in the previous n months n

3. Exponential Smoothing: In this technique more recent data are given moreweight age.

This is based on the argument that the more recent the observations, themore its impacton future and therefore is given relatively more weight than the earlier

observations.

4. Index Numbers: The Index Numbers offer a device to measure changes ina group of related variables over a period of time. In case of index numberswe select a Base Year which is given the value of 100 and then express allsubsequent changes as a movement of this number. The most commonlyused is the Laspeyres Price Index.

5. Regression Analysis: This Statistical method is undertaken to measure therelationship between two variables where correlation appears to exist. Forexample: we can establish a relationship between the age of the air conditionmachine and the annual repairs expenses. However this is purely based on

the availability of statistical data irrespective of the actual causes of damagefor which the repair expenses have to be incurred.

6. Econometric Models: The Econometric Models used in forecasting takesthe form of an equation or system of equation which seems best to expressthe most probable interrelationship between a set of economic variablesaccording to economic theory and statistical analysis. The EconometricModels can be quantitatively and qualitatively formulated. One of the firststeps in the construction of an Econometric Model is to determine all or mostof the factors influencing the series to be forecast. Then the influence ofthese factors is reflected in the form of an equation. These models aregenerally used by econometricians. One of the major limitations ofEconometric Model approach is the assumption that the relationshipsestablished in the past will continue to prevail in the future. The EconometricModels have failed in many cases but this does not imply that we shouldabandon them. Being analytical in nature and process oriented in approachthey throw more light on problems of a theoretical and statistical natureprovided the statistical data are reliable.

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7. Input-Output Analysis: The Input-Output Analysis provides perhaps themost complete examination of all the complex inter-relationships within aneconomic system. The Input-Output forecasting is based on a set of tablesthat explain the inter-relationship among the various components of theeconomy. The Input-Output Analysis shows how an increase or decrease inthe demand for cars will lead to increase in production of steel, glass, tyres

etc. The increase in demand for these materials will have second line effect.The Input-Output Analysis helps us to understand the inter-industryrelationships to provide information about the total impact on all industries asa result of the original increase in demand forecast.

Q4. Define the term equilibrium. Explain the changes in marketequilibrium and effects of shifts in supply and demand.

Answer:-

Meaning of equilibrium

The word equilibrium is derived from the Latin word a equilibrium whichmeans equal balance. It means a state of even balance in whichopposing forces or tendencies neutralize each other. It is a positionof rest characterized by absence of change. It is a state where thereis complete agreement of the economic plans of the various marketparticipants so that no one has a tendency to revise or alter hisdecision. In the words of professor Mehta: Equilibrium denotes ineconomics absence of change in movement.

Market Equilibrium

There are two approaches to market equilibrium viz., partial equilibrium

approach and the general equilibrium approach. The partial equilibriumapproach to pricing explains price determination of a single commoditykeeping the prices of other commodities constant. On the other hand, thegeneral equilibrium approach explains the mutual and simultaneousdetermination of the prices of all goods and factors. Thus it explains a multimarket 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 ofscissors We might as reasonably dispute whether it is the upper or theunder blade of a pair of scissors that cuts a piece of paper, as whether valueis governed by utility or cost of production. Thus neither the upper bladenor the lower blade taken separately can cut the paper; both have theirimportance in the process of cutting. Likewise neither supply alone, nordemand alone can determine the price of a commodity, both are equallyimportant in the determination of price. But the relative importance of thetwo may vary depending upon the time under consideration. Thus, thedemand of all consumers and the supply of all firms together

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determine the price of a commodity in the market. At a point wherethese two curves intersect with each other the equilibrium price isestablished.

Equilibrium between demand and supply price:

Equilibrium between demand and supply price is obtained by the interactionof these two forces. Price is an independent variable. Demand and supply aredependent variables. They depend on price. Demand varies inversely withprice, a rise in price causes a fall in demand and a fall in price causes a rise indemand. Thus the demand curve will have a downward slope indicating theexpansion of demand with a fall in price and contraction of demand with arise in price. On the other hand supply varies directly with the changes inprice, a rise in price causes a rise in supply and a fall in price causes a fall in

supply. Thus the supply curve will have an upward slope. At this pricequantity demanded equals the quantity supplied.

Changes in Market Equilibrium

The changes in equilibrium price will occur when there will be shifteither in demand curve or in supply curve or both:

Effects of Shift in demandDemand changes when there is a change in the determinants of demand likethe income, tastes, prices of substitutes and complements, size of thepopulation etc. If demand raises due to a change in any one of theseconditions the demand curve shifts upward to the right. If, on the other hand,demand falls, the demand curve shifts downward to the left. Such rise andfall in demand are referred to as increase and decrease in demand.A change in the market equilibrium caused by the shifts in demand can be

explained with the help of a diagram.

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Effects of Changes in Both Demand and SupplyChanges can occur in both demand and supply conditions. The effects of suchchanges on the market equilibrium depend on the rate of change in the twovariables. If the rate of change in demand is matched with the rate of changein supply there will be no change in the market equilibrium, the newequilibrium shows expanded market with increased quantity of both supplyand demand at the same price.

This is made clear from the diagram below:

Similar will be the effects when the decrease in demand is greater than thedecrease in supply on the market equilibrium.

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Q6. Explain cost output relationship with reference toa. Total fixed cost and outputb. Total variable cost and outputc. .Total cost and output

Answer:

A. Total fixed cost and output:

TFC refers to total money expenses incurred on fixed inputs like plant,

machinery, tools & equipments in the short run. Total fixed cost corresponds

to the fixed inputs in the short run production function. TFC remains the same

at all levels of output in the short run. It is the same when output is nil. It

indicates that whatever may be the quantity of output, whether 1 to 6 units,

TFC remains constant. The TFC curve is horizontal and parallel to OX-axis,

showing that it is constant regardless of output per unit of time. TFC starts

from a point on Y-axis indicating that the total fixed cost will be incurred even

if the output is zero. In our example, Rs 360=00 is TFC. It is obtained by

summing up the product or quantities of the fixed factors multiplied by theirrespective unit price.

B. Total variable cost and output:

TVC refers to total money expenses incurred on the variable factor inputs like

raw materials, power, fuel, water, transport and communication etc, in the

short run. Total variable cost corresponds to variable inputs in the short run

production function. It is obtained by summing up the production of

quantities of variable inputs multiplied by their prices. The formula to

calculate TVC is as follows. TVC = TC-TFC. TVC = f (Q) i.e. TVC is anincreasing function of output. In other words TVC varies with output. It is nil,

if there is no production. Thus, it is a direct cost of output. TVC rises sharply

in the beginning, gradually in the middle and sharply at the end in

accordance with the law of variable proportion. The law of variable proportion

explains that in the beginning to obtain a given quantity of output, relative

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variation in variable factors-needed are in less proportion, but after a point

when the diminishing returns operate, variable factors are to be employed in

a larger proportion to increase the same level of output.

TVC curve slope upwards from left to right. TVC curve rises as output is

expanded. When output is Zero, TVC also will be zero. Hence, the TVC curve

starts from the origin.

C. Total cost and output:

The total cost refers to the aggregate money expenditure incurred by a firm

to produce a given quantity of output. The total cost is measured in relation

to the production function by multiplying the factor prices with their

quantities. TC = f (Q) which means that the T.C. varies with the output.

Theoretically speaking TC includes all kinds of money costs, both explicit and

implicit cost. Normal profit is included in the total cost as it is an implicit cost.It includes fixed as well as variable costs. Hence, TC = TFC +TVC.

TC varies in the same proportion as TVC. In other words, a variation in TC is

the result of variation in TVC since TFC is always constant in the short run.

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The total cost curve is rising upwards from left to right. In our example the TC

curve starts from Rs. 360-00 because even if there is no output, TFC is a

positive amount. TC and TVC have same shape because an increase in outputincreases them both by the same amount since TFC is constant. TC curve is

derived by adding up vertically the TVC and TFC curves. The vertical distance

between TVC curve and TC curve is equal to TFC and is constant throughout

because TFC is constant.

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5. Managerial Economics Ass-2 (P-11)

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