Spring / February 2012 Master of Business Administration MBA Semester 1 MB0042 Managerial Economics 4 Credits (Book ID: B1131)

31) Assignment Set 2 (60 Marks)

Q1. Define Managerial Economics and explain its main characteristics. 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 deals with 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 business administration 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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Spring / February 2012 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 a commodity. It says that demand varies inversely with the price. The law can be explained in the following manner: Keeping other factors that affect demand constant, a fall in price of a product leads to increase in quantity demanded and a rise in price leads to decrease in quantity demanded for the product. The law can be expressed in mathematical terms 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 relationship between the independent variable [price] and the dependent variable [demand]. The law explains only the general tendency of consumers while buying a product. A consumer would buy more when price falls due to the following 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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Spring / February 2012 3. It is only a qualitative statement and as such it does not indicate quantitative 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 being equal. It indicates that given certain conditions, certain results would follow. The inverse relationship between price and demand would be valid only when tastes and preferences, customs and habits of consumers, prices of related goods, and income of consumers would remain constant. Q3. What is Demand Forecasting? Explain in brief various methods of forecasting demand. Answer: Demand forecasting seeks to investigate and measure the forces that determine sales for existing and new products. Generally companies plan their business - production or sales in anticipation of future demand. Hence forecasting future demand becomes important. The art of successful business lies in avoiding or minimizing the risks involved as far as possible and face the uncertainties in a most befitting manner. Thus Demand Forecasting refers to an estimation of most likely future demand for product under given conditions.

A. Qualitative Methods (Survey Methods) 1. Expert Opinion Method:

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Spring / February 2012 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 is developed called the delphi method. In this method a panel of experts is individually presented a series of questions pertaining to the forecasting problem. Responses acquired from the experts are analyzed by an independent party that will provide the feedback to the panel members. Based on the responses of other individuals, each expert is then asked to make 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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Spring / February 2012 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 Survey II. Sample Survey III. End-Use Method. I. Complete Enumeration Survey: Complete Enumeration Survey covers all the consumers. It resembles the Census Data Collection which considers the entire population. In this case all the consumers are covered and information is obtained from all regarding the prospective demand for the product under consideration. The method of Complete Enumeration has the advantage of being absolutely unbiased as far as consumer opinions are concerned. We can obtain complete information by contacting every possible present, past or 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 be difficult and too tedious to be analyzed. The reliability on such consumers information may be questionable, if the opinions are not authentic. II. Sample Survey: In case of the sample survey method, few consumers are selected to represent the entire population of the consumers of the commodity consumed. The total demand for the product in the market is then projected on the basis of the opinion collected from the sample. The most important advantage of this method is that it is less expensive and less tedious compared to the method of complete enumeration. The sample chosen should not be too small or too large. This method if applied carefully will yield reliable results especially in case of new brands and new products. III. End Use Method: A given product may have different end uses. For example: milk may have different end uses such as milk powder, chocolates, sweet -meats like barfi etc. Therefore the end users of milk are identified. A survey is planned of the end user sand the estimated demands from all segments of end users are added. This method of demand forecasting is easy to manage if the number of end-users is limited. In this method the investigator expects the end- users to provide correct information well in advance 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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Spring / February 2012 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 Series Method is based on obtaining the historical data regarding the demand for the product so as to project future concurrencies on the basis of what has happened in the past. The Time Series data are chronologically arranged data from a population at different points of time. For example: demand for steel in India maybe plotted for years beginning from 1951 to 2003. Based on the data plotted on the graph, a line or curve is drawn. This helps to establish a trend over a period of time. This pattern is then smoothed to eliminate the effect of random fluctuations and it can then be extrapolated into the future to provide a forecast. The Time Series forecasting models are based on historical 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. II. III. IV. Secular Trend refers to the long run increase or decrease in the series. Cyclical Fluctuation refers to the rhythmic variations in the economic series. Seasonal Variation refers to the variations caused by weather patterns social habits such as festivals etc. 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 ROLL No. - 511223187 6

Spring / February 2012 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 the market demand is assumed to remain fairly steady over time. The Moving Average for n months is found by simply summing up the demand during the 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 more weight age. This is based on the argument that the more recent the observations, the more its impact on future and therefore is given relatively more weight than the earlier observations. 4. Index Numbers: The Index Numbers offer a device to measure changes in a group of related variables over a period of time. In case of index numbers we select a Base Year which is given the value of 100 and then express all subsequent changes as a movement of this number. The most commonly used is the Laspeyres Price Index. 5. Regression Analysis: This Statistical method is undertaken to measure the relationship between two variables where correlation appears to exist. For example: we can establish a relationship between the age of the air condition machine and the annual repairs expenses. However this is purely based on the availability of statistical data irrespective of the actual causes of damage for which the repair expenses have to be incurred. 6. Econometric Models: The Econometric Models used in forecasting takes the form of an equation or system of equation which seems best to express the most probable interrelationship between a set of economic variables according to economic theory and statistical analysis. The Econometric Models can be quantitatively and qualitatively formulated. One of the first steps in the construction of an Econometric Model is to determine all or most of the factors influencing the series to be forecast. Then the influence of these factors is reflected in the form of an equation. These models are generally used by econometricians. One of the major limitations of Econometric Model approach is the assumption that the relationships established in the past will continue to prevail in the future. The Econometric Models have failed in many cases but this does not imply that we should abandon them. Being analytical in nature and process oriented in approach they throw more light on problems of a theoretical and statistical nature provided the statistical data are reliable.

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Spring / February 2012 7. Input-Output Analysis: The Input-Output Analysis provides perhaps the most complete examination of all the complex inter-relationships within an economic system. The Input-Output forecasting is based on a set of tables that explain the inter-relationship among the various components of the economy. The Input-Output Analysis shows how an increase or decrease in the 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-industry relationships to provide information about the total impact on all industries as a result of the original increase in demand forecast. Q4. Define the term equilibrium. Explain the changes in market equilibrium and effects of shifts in supply and demand. Answer:Meaning of equilibrium The word equilibrium is derived from the Latin word a equilibrium which means equal balance. It means a state of even balance in which opposing forces or tendencies neutralize each other. It is a position of rest characterized by absence of change. It is a state where there is complete agreement of the economic plans of the various market participants so that no one has a tendency to revise or alter his decision. In the words of professor Mehta: Equilibrium denotes in economics 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 equilibrium approach to pricing explains price determination of a single commodity keeping the prices of other commodities constant. On the other hand, the general equilibrium approach explains the mutual and simultaneous determination of the prices of all goods and factors. Thus it explains a multi market equilibrium position. Earlier to Marshall, there was a dispute among economists on whether the force of demand or the force of supply is more important in determining price. Marshall gave equal importance to both demand and supply in the determination of value or price. He compared supply and demand to a pair of scissors We might as reasonably dispute whether it is the upper or the under blade of a pair of scissors that cuts a piece of paper, as whether value is governed by utility or cost of production. Thus neither the upper blade nor the lower blade taken separately can cut the paper; both have their importance in the process of cutting. Likewise neither supply alone, nor demand alone can determine the price of a commodity, both are equally important in the determination of price. But the relative importance of the two may vary depending upon the time under consideration. Thus, the demand of all consumers and the supply of all firms together

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Spring / February 2012 determine the price of a commodity in the market. At a point where these two curves intersect with each other the equilibrium price is established. Equilibrium between demand and supply price: Equilibrium between demand and supply price is obtained by the interaction of these two forces. Price is an independent variable. Demand and supply are dependent variables. They depend on price. Demand varies inversely with price, a rise in price causes a fall in demand and a fall in price causes a rise in demand. Thus the demand curve will have a downward slope indicating the expansion of demand with a fall in price and contraction of demand with a rise in price. On the other hand supply varies directly with the changes in price, 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 price quantity demanded equals the quantity supplied.

Changes in Market Equilibrium The changes in equilibrium price will occur when there will be shift either in demand curve or in supply curve or both: Effects of Shift in demand Demand changes when there is a change in the determinants of demand like the income, tastes, prices of substitutes and complements, size of the population etc. If demand raises due to a change in any one of these conditions 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 and fall 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 Supply Changes can occur in both demand and supply conditions. The effects of such changes on the market equilibrium depend on the rate of change in the two variables. If the rate of change in demand is matched with the rate of change in supply there will be no change in the market equilibrium, the new equilibrium shows expanded market with increased quantity of both supply and 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 the decrease in supply on the market equilibrium.

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Spring / February 2012 Q6. Explain cost output relationship with reference to a. Total fixed cost and output b. Total variable cost and output c. .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 their respective 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 an increasing 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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Spring / February 2012 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 output increases 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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