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Managerial Economics
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Managerial Economics
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Managerial Economics
Q2. State and Explain the Law of Demand. What are its
exceptions?
Ans. The law of demand states that if price declines, then the quantity
demanded of the product will increase. The inverse relationship
between price and quantity leads to the downward sloping demand
curve. This section provides a graphical derivation of the law of
demand.
The law of demand and it's application to fundamental analysis of
commodities rests upon an understanding of consumer behavior. The
factors which characterize consumer choice, and how individual
consumer responses are reflected in the market place are key
components of this economic theory. Understanding what factors have
affected demand in the past will help to develop expectations about
demand in the future and the impact on market price.
Demand for a particular product or service represents how much
people are willing to purchase at various prices. Thus, demand is a
relationship between price and quantity, with all other factors
remaining constant. Demand is represented graphically as a downward
sloping curve with price on the vertical axis and quantity on the
horizontal axis (figure above)
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sloping curve with price on the vertical axis and quantity on the
horizontal axis (figure above)
Generally the relationship between price and quantity is negative. This
means that the higher is the price level the lower will be the quantity
demanded and, conversely, the lower the price the higher will be the
quantity demanded. Market demand is the sum of the demands of all
individuals within the marketplace. Market demand will be affected by
other variables in addition to price, such as various value added
services including handling, packaging, location, quality control, and
financing. Thus the demand for an agricultural commodity is typically
derived from the demand for a finished product.
It is important for you to understand that a free market economy is
driven not by producers but by consumers. Ultimately the market value
for any good or service is determined by its value to the consumer.
Higher prices mean higher profits and higher profits provide you with
the incentive and the means to expand production of those goods and
services that consumers value the most. So profit driven expansion is
the market’s response to stronger buyer demand. On the other hand,
when consumers are unwilling to buy what is offered at the current
price, the seller will have to lower the price ultimately resulting in
lower profits or losses to you the producer. Losses reduce the
producer’s incentive to produce things that have weak demand, which
will ultimately force production cuts as farmers lose more and more
money.
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Effective Demand
The concept of effective may be regarded as a logical starting point of
Keyne’s theory of Income & Employment. It refers to that level of
demand in the economy, which is fully met by the corresponding
supply so that there is no tendency on the part of the entrepreneurs to
either expand or contract production.
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Determination of Equilibrium
We have defined aggregate demand price as the amount of receipts
which all the firms taken together expect to receive from the sale of
their products. We have also defined aggregate supply price as the
amount of receipts which all firms taken together must get.
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Firms will expand the level of employment & output as long as the
receipts they expect to get are more than the receipts they must get.
In other words, as long as the demand curve lies above the supply
curve the firms will expand the level of employment & output
conversely, if the aggregate demand curve lies below the aggregate
supply curve, the firm is compelled to reduce the level of employment
& output. The equilibrium will be established at the point where the
aggregate supply function interests the aggregate demand further.
MONOPOLY
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The difference of output between the competitive firm & monopoly firm
can be explained with the help of a diagram as below:
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Ans.
Pricing methods
There are two main types of pricing methods, these are: cost based
pricing methods and market orientated pricing methods.
With cost based pricing methods, no account is taken of market
requirements but a set amount is added to the costs. The disadvantage
is that if costs increase, the price of the product must also increase.
The following are examples of cost based pricing methods:
Absorption cost pricing: Used mainly in large department stores. The
price of each product is dependant on how many costs it creates.
Target pricing: A target price is made and then costs are adjusted so
that that price can be achieved.
Market based pricing methods depend on accurate analysis of the
market and consumer requirements. The following are examples of
market based pricing methods:
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Debentures
A debenture ‘includes debenture stock, bonds and any other securities
of a company, whether constituting a charge on the assets of the
company or not’. A company may issue debentures which are payable
to the registered holder, and also debentures which are payable to
bearer. In the latter case, the debenture is transferable by delivery. It is
possible for the company to issue irredeemable debentures or
debentures which carry rights of conversion to fully paid ordinary
shares at a later date.
If the debenture does not create any charge on particular assets, the
holders will rank with general creditors for repayment of their loan in
the event of the winding-up of the company. If the debenture is not
charged on any of the company's assets, the holder has only
contractual rights thereunder. An alternative form of borrowing is by
debenture stock. In such a case, the sum borrowed is secured under
one document, and each stock holder is entitled to repayment of a
fraction of that loan.
Shares
A shareholder's liability to contribute to the company's capital is
restricted to the issue value of his shares. A shareholder will also be
entitled to receive dividends paid out of the company's profits on a pro
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rata basis, based on the class rights of his shares and the size of his
shareholding.
Further control of the company's affairs rests ultimately with the
shareholders, who exercise votes in accordance with the class rights
and number of shares held. Finally, entitlements on distribution of
surplus assets in the event of the winding up of a company are
determined by the class rights and size of shareholdings.
Authorised capital
This is the maximum amount a company is permitted to raise by way
of share capital. That amount may be increased by a procedure set out
in statute or the company's articles.
Paid up capital
The ‘paid up’ share capital is the amount of issued share capital that
has actually been paid up to the company by its shareholders.
Called up capital
The ‘called up’ share capital is the total sum the company has
requested from members, and will be a greater sum than the paid up
share capital in the event that subscribers still owe the company
moneys for their shares.
Similar aspects:
• Transfer procedures
• Issue to the public
Differences:
• Holders of debentures are company creditors where shareholders
are members
• Debentures can be purchased by the company itself but the
same situation does not apply for shares
• Debentures can be issued at discount where shares cannot
Production Function
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When most people think of fundamental tasks of a firm, they think first
of production. Economists describe this task with the production
function, an abstract way of discussing how the firm gets output from
its inputs. It describes, in mathematical terms, the technology
available to the firm.
A production function can be represented in a table such as the one
below. In this table five units of labor and two of capital can produce 34
units of output. It is, of course, always possible to waste resources and
to produce fewer than 34 units with five units of labor and two of
capital, but the table indicates that no more than 34 can be produced
with the technology available. The production function thus contains
the limitations that technology places on the firm.
A Production Function
Labor
5 30 34 37
4 26 30 33
3 21 25 28
2 16 20 23
1 10 13 15
1 2 3
Capital
There is one rule that seems to hold for all production functions, and
because it always seems to hold, it is called a law. The law of
diminishing returns says that adding more of one input while holding
other inputs constant results eventually in smaller and smaller
increases in added output. To see the law in the table above, one must
follow a column or row. If capital is held constant at two, the marginal
output of labor (which economists usually call marginal product of
labor) is shown in the table below. The first unit of labor increases
production by 13, and as more labor is added, the increases in
production gradually fall.
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The law of diminishing returns does not take effect immediately in all
production functions. It is possible for the first unit of labor to add only
four units of output, the second to add six, and the third to add seven.
If a production function had this pattern, it would have increasing
returns between the first and third worker. What the law of diminishing
returns says is that as one continues to add workers, eventually one
will reach a point where increasing returns stop and decreasing returns
set in.
The law of diminishing returns is not caused because the first worker
has more ability than the second worker, and the second is more able
than the third. By assumption, all workers are the same. It is not ability
that changes, but rather the environment into which workers (or any
other variable input) are placed. As additional workers are added to a
firm with a fixed amount of equipment, the equipment must be
stretched over more and more workers. Eventually, the environment
becomes less and less favorable to the additional worker. People's
productivity depends not only on their skills and abilities, but also on
the work environment they are in.
The law of diminishing returns was a central piece of economic theory
in the 19th century and accounted for economists' gloomy
expectations of the future. They saw the amount of land as fixed, and
the number of people who could work the land as variable. If the
number of people expanded, eventually adding one more person would
result in very little additional food production. And if population had a
tendency to expand rapidly, as economists thought it did, one would
predict that (in equilibrium) there would always be some people almost
starving. Though history has shown the gloomy expectations wrong,
the idea had an influence on the work of Charles Darwin and traces of
it still float around today among environmentalists.
If one increases all inputs in equal proportions, one travels out from the
origin on a ray. There is no law to predict what will happen to output in
this case. If a 10% increase in all inputs yields more than a 10%
increase in output, the production function has increasing returns to
scale. If it yields less than a 10% increase in output, the production
function has decreasing returns to scale. And if it yields exactly a 10%
increase in output, it has constant returns to scale.
Returns to scale are important for determining how many firms will
populate an industry. When increasing returns to scale exist, one large
firm will produce more cheaply than two small firms. Small firms will
thus have a tendency to merge to increase profits, and those that do
not merge will eventually fail. On the other hand, if an industry has
decreasing returns to scale, a merger of two small firms to create a
large firm will cut output, raise average costs, and lower profits. In
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such industries, many small firms should exist rather than a few large
firms.
Most products require many more than two inputs, but showing a
production function with more than two inputs with graphs or tables is
difficult. Products require various types of labor and capital, energy of
various sorts, and raw materials. One of the key inputs, especially in
larger firms, is managerial ability. Inputs do not combine by themselves
to produce output. Someone must have knowledge of how to combine
inputs and to coordinate the production process.
Profit Maximization
Economic theory is based on the reasonable notion that people
attempt to do as well as they can for themselves, given the constraints
facing them. For example, consumers purchase things that they
believe will make them feel more satisfied, but their purchases are
limited (at least in the long run) by the amount of income they earn. A
consumer can borrow to finance current purchases but must (if honest)
repay the loans at a later date.
Business owners also attempt to manage their businesses so as to
improve their well being. Since the real world is a complicated place, a
business owner may improve his well being in a number of ways. For
example, if the business doesn't lack customers, the owner could
respond by reducing operating hours and enjoying more leisure. Or,
the business owner may seek satisfaction by earning as much profit as
possible. This is the alternative we will focus on in class - for a very
good reason. If a business faces tough competition, the only way the
business can survive is to pay attention to revenues and costs. In many
industries, profit maximization is not simply a potential goal; it's the
only feasible goal, given the desire of other businesspeople to drive
their competitors out of business.
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the number of units sold. Total opportunity cost includes both the costs
of all inputs into the production process plus the value of the highest-
valued alternatives to which owned resources could be put. For
example, a firm that has Rs.100,000 in cash could invest in new, more
efficient, machines to reduce its unit production costs. But the firm
could just as well use the Rs.100,000 to purchase bonds paying a 7%
rate of interest. If the firm uses the money to buy new machinery, it
must recognize that it is giving up Rs.7000 per year in forgone interest
earnings. The Rs.7000 represents the opportunity cost of using the
funds to buy the machinery.
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