Managerial Economics

Case 1

Q1 What are the factors responsible for this excess demand for electricity?

(i) Due to satellite towns like Noida, Ghaziabad, Greater Noida, etc. that are emerging as new industrial hubs; therefore there is growing demand for infrastructure facilities like power, transport, health, education, road, shopping malls, multiplexes, etc. in these cities. These are all factors responsible for excess of demand for electricity.

Secondly, reorganization of UP which could only retain 516 MW of low cost hydel power while the balance was allocated to Uttaranchal. Hence, due to unavailability of low cost hydel power the demand for electricity was on rise.

Q2 The demand supply gap is reformed by the government intervention. Explain this phenomenon by a demand supply model.

(ii) There is a change in demand due to low or constant supply in favour of the good. This is illustrated graphically in the figure below. The initial demand curve D1D1 and initial supply curve S1S1 determine the equilibrium quantity at Q* & price at P*. Now an increase in demand is manifested through shift of demand curve to the right (from D1D1 to D2D2). This shifts the equilibrium to E1E1, where the new demand curve D2D2 intersects the supply curve S1S1.The equilibrium price rises from Q* to Q1 and the equilibrium prices increases from P* to P1. Therefore an increase in demand with no change in supply results in a rise in equilibrium price & quantity.

D2 S1

Power Generation D1

Capacity

E2

6500 MW (P1)

E14000 MW (P*) D2

D1 S1

4000 6500 11,250 14,200 (Q*) (Q1) (Q3) (Q4)

Q3 What do you think will happen to the price of electricity?

The cost of electricity will increase due to increase in demand & slow rate of capacity generation

Case 2Q1 Identify the most important factors of production in case of automobile industry. Also attempt to explain the relative significance of each of these factors.

The most important factors of production in case of Automobile industry are : 

1. Labour: Workers employed directly in the car industry; engineers, designers, paint sprayers, testers, management staff, transport & distribution workers etc

 2. Land: Natural resources used in manufacturer, land for plant and equipment

 3. Capital: Fixed capital: machinery, technology, buildings + Working capital: i.e. stocks of raw materials

and components 

4. Entrepreneurship (sometimes seen as a separate factor): management, risk-taker

Each one of these factors is extremely important to every business operation. A company must balance these resources and consider their cost in order for them to stay profitable.

1. Natural resources include all items that occur naturally. A few examples of this are land, water, and other things that are not man-made. Even the most basic level, all companies must buy land in order to have a place to do business. Though some companies might not rely directly on natural resources to produce their product, but the products that they buy from other companies are likely to at some point have been derived from natural resources.

2. Capital another factor in play a huge role in the formation and expansion of the company. Capital includes things like tools, machines, and other things that a business uses in order to produce their goods or services. At some level, all companies rely on their capital in order to successfully run. Without these things, the company would not be able to produce anything. These things can be very expensive, so this can be a hard part for the owner to finance.

3. Yet another factor of production is human resources. Human resources deals with everybody that works within the company. All companies need labor in order to function. Everyone from the manual workers, to the owner of the company falls under the classification of human resources. Without this factor, there would be no company at all because nobody would be working there.

4. The final factor production is entrepreneurship. Entrepreneurs are the people that start their own business, taking all the necessary risks in order to, hopefully, make a profit. Without these people and their ideas, no companies would ever start. Starting a business extremely risky, because there is no way to tell if it will be profitable until after you've tried. However, if you manage the company well and people want your goods or services, there's a good chance he will be successful in the end. In order to take this risk, entrepreneur must collect the necessary resources needed to start the company. If he or she does not have natural resources, capital, and human resources, then there is no way to get the company off the ground. Without these factors, company will never amount to anything more than an idea.

Q2 What more information would you like to obtain in order to draw a production function for Maruti Udyog? Explain with logic.

The task of a production unit is to organize a production process—a process of combining the different factors in some proportion so that those inputs can be efficiently transformed into products or outputs.

Various terms are used for inputs and outputs.INPUTS OUTPUTSFactors Quantity (Q)Factors of production Total Product (P)Resources Product

A production function defines the relationship between inputs and the maximum amount that can be produced within a given period of time with a given level of technology.Decisions on input and output are taken after considering various technological specifications. The technological information is summarized in the equation

Q = Q (L, N, K.................)

Production Function states that Q is the maximum amount of an output which the firm can produce if it combines the inputs (Land L, Labor N, and Capital K). The ratio of the factor-combination depends on the form of the estimated production function. The existence of such a function implies that the firm has undertaken on set of optimally calculations whereby they have examined the many alternative ways in which the inputs L, N and K can be combined to produce an output in the different technological process available for use in the productive process, and that it is on the basis of these calculations, that it has been found that Q is the maximum amount of a given output possible with the given set of inputs (L, N, K).

Mathematically, the production function can also be shown as:Q = f (X1, X2 ...............Xk)where Q = Output Production FunctionX1..............Xk = Inputs used.

For purposes of analysis, the equation can be reduced to two inputs X and Y. Restating,Q = f(X,Y)where Q = OutputX = LaborY = Capital

Two special features of a production function are given below:(a) Labour and capital are both inevitable inputs to produce any quantity of goods, and(b) Labour and capital are substitutes to each other in production.

Further, The Cobb-Douglas equation is derived as

Q = A, K α L where K = Capital, Q = Output, L= Labour, A, α = positive constants

Properties of Cobb-Douglas Production function1. This function assumes the returns to scale to be constant.2. If one of the input is zero, output also will be zero.

Hence, In the case of Maruti Udyog,

Land: No details has been made available such as location, cost of land etc

Capital: 100 million+ 50 million from suppliers = 150 million

Labour: No information on Labour required is available, hence due to absence of these factors, production equation for Maruti Udyog cannot be derived

Q3 Automobile industry is a good example of capital augmenting technical progress. Discuss.

As per Davos Report 2006,

1. India is largest three wheeler market in the world; 2. 2nd largest two wheeler market; 3. 4th largest tractor market; 4. 5th largest commercial vehicle market and 5. 11th largest passenger car market in the world and 6. expected to be the seventh largest by 2016.

India is among few countries that are showing a growth rate of 30 per cent in demand for passenger cars. The industry currently accounts for nearly 4% of the GNP and 17% of the indirect tax revenue.

As per another report,

1. every commercial vehicle manufactured, creates 13.31 jobs, while 2. every passenger car creates 5.31 jobs and 3. every two-wheeler creates 0.49 jobs in the country.

Besides, the automobile industry has an output multiplier of 2.24, i.e., for every additional rupee of output in the auto industry, the overall output of the Indian economy increases by Rs. 2.24.

4% 13%

79%

4%

Vehicle Segment wise Market Share 2005-06

Commercial Vehicles

Passanger Vehicles

Two Wheelers

Three Wheelers

This growth will primarily be fuelled by the increasing number of vehicles on the road, as well as the aggressive expansion of independent and foreign players. While current margins for the industry remain attractive, players across the value chain may see margins reducing to the lower levels observed in developed economies. Therefore, to

sustain profitability, it is imperative that players evaluate additional ways of capturing value, including expanding service networks, developing branded generic parts, forward integrating and building scale. Looking ahead, revenue pools remain large across the value chain, hence if players are able to pursue appropriate strategies, significant profits can be made in this sector.

Case 3

Q1 Do you think cement industry in India presents a good explanation of oligopoly? Which characteristics of oligopoly do you find in the above case?

Yes. This is because competition even if temporarily ensured, as it seems to have been in the cement industry, which has for some time now been freed of restrictions on entry as well as controls on prices. Liberalization did initially spur competition, which led to increased capacity, an improved demand-supply balance and better prices for the consumer.

Behind these protective barriers the demand-constrained industry has been witnessing a substantial change in structure. The industry has seen a process of growing consolidation of capacity in a few hands as a result of a spate of mega-mergers and acquisitions.

Features of an Oligopoly market and its application to the Cement Industry

1.Only a few firms supply the entire market with a product that may be standardized or differentiated.Cement IndustryThe large cement plants accounts for over 94 percent of the total installed capacity. However two large groups, viz. the Aditya Birla Group and the Holcim Group; together control more than 40 per cent of total capacity. This apart, more than 25 per cent of total capacity is controlled by global majors.

2.At least some firms have large market shares and thus can influence the price of the product.Cement IndustryThe industry has seen a process of growing consolidation of capacity in a few hands as a result of a spate of mega-mergers and acquisitions. All this is occurring in an industry where already capacity with the top six players accounts for more than 60 per cent of total production.Such a high concentration index is a factor that strongly indicates anoligopolistic market structure

3.There is an indeterminateness of the demand curve facing oligopolist firmsCement IndustryDemand or consumption of cement has been analyzed across the five respective regions. From the graph, it is evident that March 06 and Sep 06 witnessed sudden surge in demand after the previous months have faced demand shocks. Another apparent feature is that demand for cement is highly volatile across all zones. Shocks in demand are followed by sudden surges. Such high demand variability is a characteristic of oligopoly markets

4.Firms in an Oligopoly market exhibit increasing sales but decreasing expense to sales ratio.Cement IndustryThe expense (or cost to sales) ratio per annum of the cement companies has decreased over the years. Though the total sales have picked up, the cost of  producing cement has not increased at the same pace. The sharp increase in sales without a corresponding increase in cost does indicate possibility of cartel behaviour which is a characteristic of oligopoly markets.

5.The oligopoly market is concerned with group behavior Cement IndustryThe cement industry has seen a process of growing consolidation of capacity in a few h a n d s a s a r e s u l t o f m e g a - m e r g e r s a n d a c q u i s i t i o n s . B u t w h a t i s d i s t u r b i n g i s t h a t t h e  process of consolidation has been accompanied by growing evidence of monopolistic  practices.

6.The firms in an oligopolistic industry are aware of their interdependence and always consider their rivals reactions when selecting prices and other business policies.Cement IndustryDuring last four years (2003-2007) cement prices have gradually increased from around Rs 150 per bag to Rs 230 per bag in 2007. Average industry ROCE has reached more than 26% due to the recent burst in cement prices. Encouraged by such lucrative returns cement manufacturers have decided to increase capacity by more than 97 million tonnes over next three years of which 43.7 million tonnes is likely to complete in FY 2009.

Q2 How has decontrolling of cement prices helped the growth of this industry?

Cement industry has been decontrolled from price and distribution on 1st March 1989 and de-licensed on 25th July 1991. While the decontrol of cement ensured better profitability, the economic liberalization ensured steady rising demand for this core infrastructure product. 

Cement manufacturers control over market can be gauged by the fact that even 20-25% freight hike was straight passed on to consumers. Average industry ROCE has reached more than 26% due to the recent burst in cement prices. Encouraged by such lucrative returns cement manufacturers have decided to increase capacity by more than 97 million tonnes over next three years of which 43.7 million tonnes is likely to complete in FY 2009. Thus, the cement supply will increase by more than 11% in next three years.

The continuous capacity addition, though resulting in sporadic surplus situation, is a reflection of the expectation of the industry that notwithstanding the cyclical fall in demand the general tenor would that be of a high trajectory growth in cement demand arising out of the huge infrastructure gap that Indian economy has and which needs to be addressed in the coming years. The four years prior to that the industry achieved an average growth of about 9 to 10 per cent while prior to that the demand growth has been in the range of 8 to 8.5 per cent.

    % Increase in Cement Production YoY  

                   12                  11                  10                  9                  

8         

 12.40      

7                  6                5                9.00  4        7.07          3                  2    5.19              

1                 

                   

    2004   2005   2006   2007  

It is expected that construction activity would get the desired focus, be it that of the infrastructure or that of houses and as such one can reasonably expect that the cement industry would clock demand growth in double digit for at least next two decades.

Q3 Do you see possibilities of cartel or implicit collusion in the above case? How?

Yes. Cartelisation is & will be prelevant in every sector where oligopoly exists. Cartelisation reduces efficiency of the manufacturing sector if it operates on the supply of the raw material side, thereby increasing prices of the end products. Cartelisation artificially increases costs for the consumer goods manufactures and gives them a no leeway for boosting their bottomline.

In India, cartelisation exists in various sectors and subsectors of the economy and is partly responsible for the rapid rise in inflation. The sector has been accused of cartelisation many times in the past. Indian cement sector includes three major players which control one third of the cement volumes in India.

Since the market structure in India is rather fragmented, the dominant players in cement market control the production, distribution and selling prices and have been acting in concert through price & quality control, thus making it prone to cartelisation. They have been indulging in restrictive and unfair trade practices, which are prejudicial to public interest and consumers generally. The consolidation of the cement industry in few hands is not advisable. They come together and collude leading to a decline in competition.

Case 4

Q1 Which factors, according to you, are prompting organisations to adopt a package instead of traditional salary?

1. Ensuring a motivational climate, 2. Encouraging efficiency and productivity for attainment of strategic goals, and 3. Gaining control over labour costs.4. May increase employee motivation5. Link compensation to performance appraisal6. Productivity enhancement7. Employee Performance Improvement

Q2 Do you think package compensation is more suitable in modern globalised business? Can you draw some lessons from marginal productivity theory?

Yes, package compensation is the foundation for total compensation, since it establishes the standard of living for employees. It also serves as the primary indication of the value the organization places on the role an employee plays and on the contributions the employee makes. For this reason the subject elicits great emotion and is often the source of conflict between the employee and the organization. It is therefore critical that base pay rates are viewed by both the organization and by employees as being:

• Internally equitable.

• Externally competitive.

• Affordable/cost effective.

• Legal/defensible.

• Understandable.

• Appropriate for the organization.

• Appropriate for the workforce.

This will address the challenges of paying people in a manner that elicits their best and that attracts and retains the best people. This quest is of course futile and the answer to “what is best” is “what fits.” What fits the organization (or portion of the organization), what fits the employees (or category of employees) and what is both effective and affordable may be “all of the above.” Therefore the one must understand all the approaches, assess the context and fit the program to that context.

The marginal productivity theory states that under perfect competition, every employee of same ability and competence in a given group will collect a wage equivalent to the worth of the marginal creation of that category of labor.

We may state that the marginal product of labor in any business is the total by which the productivity would be amplified if one more worker was employed while the magnitudes of other aspects of production employed in the industry re-named constant. In short, it is the output attributed to a single worker unaccompanied by any change in other factors of production. The value of the marginal product of labor is the price at which the marginal product can be sold in the market.

Under conditions of perfect competition, an employer will go on hiring labors until the worth of the product of the final laborer he hires is equivalent to the marginal or supplementary cost of hiring the final worker. Added, the condition of perfect competition implies that the marginal cost of labor is always equivalent to the wage charge, irrespective of the workers hired. Every industry being ultimately subject to law of diminishing returns, this marginal product must begin reducing at some point. Labor Wages not changing, the manager stops hiring workers at that position where the worth of the marginal product of a worker is equivalent to the wage charge.

So far we have assumed that the magnitudes of other aspects don’t change while that of labor only amplifies. This, though, is not exact; factor magnitude amplifies all-round though this may not be factual in the short run.

The theory may thus finally be re-stated as follows: Under conditions of perfect competition in the labor market and in the market for the products of the industry, and irrespective of the number employed, every worker will receive a wage equal to the value of marginal net product of his labor, which well supports the idea of focus on skill based compensation, rewards essentially linked to performance & negotiability, in the above case

Q3 Do you think that the case supports the efficiency wage theory or bargaining theory? Give arguments in support of your logic.

The above case supports the “Efficiency wage theory”.

The bargaining theory states that the wages paid are equivalent to the bargaining ability of the employees. This theory sets a competitive bargaining environment in companies and suggests that an employee should seek to increase his effective bargaining potential to earn higher wages. This theory became the foundation for collective bargaining systems.

The idea of the efficiency wage theory is that it may benefit firms to pay workers a wage higher than their marginal revenue product.

The argument is that paying workers a higher wage may lead to increased productivity from the worker. If a worker gets a relatively higher wage, he may feel more loyal and devoted to the company. With a higher wage, he may also fear being made unemployed and so will work harder to make sure he keeps his job. Therefore, although the firm pays more, they get more productivity from their workers.

It could also be the case that a monopsonist, .i.e when a firm has market power in employing workers, pays less than the MRP leading to demotivated workers; in this case, raising wage could lead to higher productivity.

In practice, many factors determine worker morale and productivity, wages are just one of them. Often other factors are more important such as work conditions, management, etc.