MANGERIAL ECONOMICS

(Important Questions and answers) 1. Define Managerial Economics. Managerial economics is a specialized discipline of management studies which deals with application of economic theory and techniques to business management. Managerial economics is evolved by establishing links on integration between economic theory and decision sciences (tools and methods of analysis) along with business management in theory and practice---for optimal solution to business/managerial decision problems. This means, managerial economics pertains to the overlapping area of economics along with the tools of decision sciences such as mathematical economics, statistics and econometrics as applied to business management problems. Managerial economics is a science which studies the economic aspects of behavior of the firm as an enterprise, and helps to allocate scarce resources to their alternative uses in such a manner as to optimize the firms ultimate objective, as an organization and a social institution, under conditions of the imperfect knowledge, risk and uncertainty. It provides principles, method, and techniques of analysis of economic behaviour and at the same time prescribe ways and means to optimize economic efficiency.

2. Discuss the nature and scope of Managerial Economics. What are the other related disciplines? Nature and Scope of Managerial Economics: All managerial decisions are basically economic in nature. The decisions are either directly related to Economics or have economic implications; they might not be based simply on economic calculations, and might involve several non-economic, social, political, legal and technological considerations as well. Managerial economics helps not only to analyze the economic content and implications of the managerial decisions but also to integrate several other aspects leading to sound decisions. Managerial economics incorporates elements of both micro and macroeconomics dealing with managerial problems in arriving at optimal decisions. It uses

analytical tools of mathematical economics and econometrics with two main approaches to economic methodology involving descriptive as well as prescriptive models. Managerial economics differs from traditional economics in one important respect that it is directly concerned in dealing with real people in real business situations. Managerial economics is concerned more about behavior on the practical side. Managerial economics deals with a thorough analysis of key elements involved in the business decision making. Most managerial decisions are made under conditions of varying degrees of uncertainty about the future. To reduce this element of uncertainty, it is essential to have homework of research/investigation on the problem solving before action is undertaken. Knowledge of managerial economics is a boon to the manager/businessman/entrepreneur. Modern businessman never believes in luck. He bangs on skilful management and appropriate timely economic decision making. This art is facilitated by the science of managerial economics. Other related disciplines: Managerial economics is closely related to and draws heavily upon several areas in economics such as Theory of the Firm, Microeconomics, Macroeconomics, Industrial Economics, and so on. Managerial economics is basically micro in nature in that it deals with the firms behaviour in three basic areas viz. Utility analysis, Theory of the Firm and Factor pricing. Managerial Economics draws a few aspects from Macroeconomics such as national income, technology forecasting, which are relevant to sales/demand forecasting. While Industrial Economics analyses the economic problems of the industry as a whole, Managerial Economics deals with the economic aspects of managerial decision making at a micro level irrespective of the sphere of activity. Macro Economics is not only related to but is also an integral part of the functional areas of management such as production, finance, accounting, marketing, operations research and personnel. To illustrate, Capital budgeting might be taught in finance and accounting as well as in Economics. While Economics would analyze the firms investment decisions and economic viability of projects, finance would study their financial viability. E.g. The Garland Project linking Himalayan

rivers to the southern plateau was considered feasible from the technical point of view, but it was thought to be financially not feasible as it involved investment beyond Indias capacity. Distinguish between Micro and Macro Economics. Broadly speaking, microeconomic analysis is individualistic, whereas macroeconomic analysis is aggregative. Microeconomics deals with the part (individual) units while macroeconomics deals with the whole (all units taken together) of the economy. 1. Difference in nature: Microeconomics is the study of the behavior of the individual units. Macroeconomics is the study of the behavior of the economy as a whole. 2. Difference in methodology: Microeconomics is individualistic; whereas macroeconomics is aggregative in its approach. 3. Difference in economic variables: Microeconomics is concerned with the behavior of micro variables or micro quantities. Macroeconomics is concerned with the behavior of macro variables and macro quantities. In short, microeconomics deals with the individual incomes and output, whereas macroeconomics deals with the national income and national output. 4. Difference in field of interest: Microeconomics primarily deals with the problems of pricing and income distribution. Macroeconomics pertains to the problems of the size of national income, economic growth and general price level.

5. Difference in outlook and scope: The concept of industry in microeconomics is an aggregate concept but it refers to all firms producing homogenous goods taken together. Macroeconomics uses aggregates which relate to the entire economy or to a large sector of the economy. Aggregate demand covers all market demands.

6. Demarcation in areas of study: Theories of value and economic welfare are major areas in microeconomics. Theories of Income and employment are core topics in macroeconomics.

Is Managerial Economics a Positive or Normative Science? Discuss. Positive Economics explains the economic phenomenon as What is, what was and what it will be. Normative Economics prescribes what it ought to be. Positive sciences simply describe, while normative sciences simply prescribe. According to Prof. Robbins, economics is a positive science. Science is, after all, a search for truth and therefore, economics should study the truth as it is and not as it ought to be. This is because when we say that this ought to be like this, we presume that our point of view is correct. In a study of a problem at a given point of time, not only economic considerations but also many other considerations such as ethical, political etc. must be considered. A policy decision is taken after weighing the relative importance of all these factors. There are bound to be differences in respect of policy prescription and it is better to keep away from areas which are controversial and study the facts as they are. According to economists like Marshall and Pigou, the ultimate object of the study of any science is to contribute to human welfare. Thus economics should be a normative science. It should be able to suggest policy measure to the politicians. It should be able to prescribe guidelines for the conduct of economic activities. Not only economists should build up the economic theory but also at the same time they should provide policy measures.

We must strike a balance between these two extreme views. As Keynes put it, The main function of economics is not to provide a body of settled conclusions immediately applicable to policy. It provides a method or a technique of thinking, which enables its possessor to draw correct conclusions. Managerial economics is a blending of pure or positive science with applied or normative science. It is positive when it is confined to statements about causes and

effects and to functional relations of economic variables. It is normative when it involves norms and standards, mixing them with cause-effect analysis. One cannot disregard the normative functions of managerial economics, though the discipline may be treated primarily as a positive science. Normative approach in managerial economics has ethical considerations and involves value judgments based on philosophical, cultural and religious positions of the community. The value judgments and normative aspect and counseling in managerial economic studies can never be dispensed with altogether. We may thus conclude that Managerial Economics is both a Positive and Normative Science. Briefly discuss the three fundamental concepts of Managerial Economics. Managerial Economics is confined to the following three major fields: (1) Pricing (2) Distribution (3) Welfare. Chart:

Pricing: Microeconomics assumes the total quantity of resources available in an economic society as given and seeks to explain how these shall be allocated to the production of particular goods for the satisfaction of chosen wants. In a free market economy, the allocation of resources is based on the relative prices and profitability of different goods. To explain the allocation of resources, microeconomics seeks to explain the pricing phenomenon. Price theory explains how the price of a particular commodity is determined in the commodity market. For in depth analysis of price determination it contains: Theory of demand of the analysis of consumer behavior. Theory of production and cost or the analysis of producer behavior.

 Theory of product [pricing or price determination under different market structures. Distribution: The theory of distribution basically deals with factor pricing. It seeks to explain how rewards of the individual factors of production such as land, labors, capital and enterprise are determined for their productive contribution. In other words, it is concerned with rent, wages, and interest, profits, as the respective rewards of land, labour, capital and enterprise respectively. Since demand and supply of each of these factors are different, there are separate theories to these. Thus the field of distribution includes general theory of distribution and theories of rent, wages, interest and profits. Welfare: The theory of economic welfare explains how an individual consumer maximizes his satisfaction when production efficiency is achieved by allocation of resources in such a way as to maximize output from a limited set of input. Along with individual economic welfare, welfare economics is also concerned with social welfare, which is based on overall economic efficiency of the system. When maximum individual wants are satisfied at the best possible optimum level by a production pattern through efficient allocation of resources, overall economic efficiency or Pareto optimality condition is reached. Such a situation can raise the standard of living of the population and maximize social welfare. What are the important uses and limitation of microeconomics? Importance and Uses: 1. It explains price determination and the allocation of resources. 2. It has direct relevance in business decision-making. 3. It serves as a guide for business production planning. 4. It serves as a basis for prediction. 5. It teaches the art of economizing. 6. It is useful in determination of economic policies of the Government. 7. It serves as the basis for welfare economics. 8. It explains the phenomena of International Trade. Limitations: 1. Most of the micro-economic theories are abstract. 2. Most of the microeconomic theories are static based on ceteris paribus, i.e. other things being equal.

3. Microeconomics unrealistically assumes laissez-faire policy and pure capitalism. 4. Microeconomics studies only parts and not the whole of the economic system. It cannot explain the functioning of the economy at large. 5. By assuming independence of wants and production in the system, microeconomics has failed to consider their dependent effect on economic welfare. 6. Microeconomics misleads when one tries to generalize from the individual behavior. 7. Microeconomics in dealing with macroeconomic system unrealistically assumes full employment. How does Managerial Economists help the Manager in decision making and forward planning? Managerial Economists act as operations researchers and systems analysts in the management services department of large business firms usually in the private sector. Their job lies in designing the course of operations to maintain and improve the systems of the firm in terms of productivity, market share, load factor percentage and so on and prepare reports for helping the decision makers to cope with current as well as anticipated future problems. In modern business, managers constantly face the major problem of choice among alternative ways of producing goods and allied business decisions. Managerial economists assist them in making a rational choice. A Managerial economist is an economic adviser to a firm or businessman. A firm or entrepreneur, in the course of its/his business operations, has to take a number of decisions which are vital to the survival and growth of the business. Such decisions may pertain to the nature of the product to be produced, the quantity, quality, cost, price and its distribution, planning and diversification of business, renewal of worn out equipments and machinery, modernization, etc. The Managerial economist helps the businessman or the manager in arriving at correct decisions. In short, the business economist while helping in the decision making process, measures a number of micro and macro variables by applying intelligently certain quantitative and qualitative techniques to the practical aspects and problems encountered by a business firm in its business activity. Forecasting is a fundamental activity of the Managerial economist. Indeed a business economist is greatly helpful to the management by virtue of his studies of economic analysis. He is an effective model builder. He deals with the business problems in a sharp manner with a deep probing.

A Managerial economist in a business firm may carry on a wide range of duties, such as: Demand estimation and forecasting. Preparation of business forecasts; to provide forecasts of changes in costs and business conditions based on market research and policy analysis. Analysis of the market survey to determine the nature and extent of competition. Analysing the issues and problems of the concerned industry. Assisting the business planning process of the firm. Discovering new and possible fields of business endeavour and its costbenefit analysis as well as feasibility studies. Advising on pricing, investment and capital budgeting policies. Evaluation of capital budgets. Building micro and macro economic models of particular aspects of the firms activities that are useful in solving specific business problems. Most models may be prediction oriented. Directing economic research activity. Briefing the management on current domestic and global economic issues and challenges. DEMAND What is Demand? Demand is the effective desire or wants for a commodity, which is backed up by the ability (i.e. money or purchasing power) and willingness to pay for it. The demand for a product refers to the amount of it which will be bought per unit of time at a particular price. The demand can be expressed as actual and potential. Consumer demand has two levels: a) Individual Demand and b) Market Demand. Market demand is the sum total of individual demand. Prices are determined on the basis of market demand. Market demand serves as a guidepost to producers in adjusting their supplies in a market economy. Factors influencing individual demands are: Price of the products. Income of the buyer. Tastes, Habits and Preferences. Relative prices of other goods. Relative prices of substitute and complementary products.

 Consumers expectations about future price of the commodity. Advertisement effect. Factors influencing Market Demand: Price of the product. Distribution of Income and Wealth. Communitys common habits and scale of preferences. General standards of living and spending habits of the people. Number of buyers in the market and the growth of population. Age structure and sex ratio of the population. Future expectations. Level of taxation and Tax structure. Inventions and Innovations. Fashions Climate and weather conditions. Customs Advertisement and Sales propaganda. Demand Function: At any point in time, the quantity demanded of a given product (goods or services) depends upon a number of key variables or determinants. A demand function in mathematical terms expresses the functional relationship between the demand for the product and its various determining variables. Dx Quantity demanded = f (Px) function of price. Here all other determining variables are assumed to be constant, keeping only price as variable. If the demand function is to be stated taking into account all variables, without assuming them as constant, demand function is Dx = f (Px, + Ps + Pc + Yd +T, A, N, u) Dx = Demand for X. Px = Price of X, Ps = Price of Substitute of X, Pc = Price of Complementary Goods, Yd = Disposable Income, T = Taste of the buyer or preference, A = Advertising effect, N = Number of buyers u = Unknown other determinants.

Demand function is not the quantity demanded at a given price, but quantity demanded at each level of price. a = signifies initial demand irrespective of price (constant parameter). b = functional relationship between P Price and D Demand (constant parameter) Linear demand function is expressed as D = a bP. b has minus (-) sign to denote a negative function. Demand is decreasing function of price. b is the slope ( vertical length horizontal length) of the demand curve, and suggests that it is downward sloping. Dx = 20 2Px (Dx is Quantity demanded of X, Px Price of X)

What is law of demand? What are its exceptions? Why does a Demand Curve slope downward? Law of Demand: Ceteris paribus, the higher the price of a commodity, the smaller is the quantity demanded and lower the price, larger the quantity demanded. Other things remaining unchanged, the demand varies inversely to changes in price. D x = f (Px). The demand curve is downward sloping indicating an inverse relationship between price and demand. The price is measured on the Y axis and Demand on the X- axis. When the price falls, demand increases. The downward slope of demand curve implies that the consumer tends to buy more when the price falls. Thus the demand curve is shown as downward sloping. What are the assumptions underlying law of demand? Assumptions underlying the law of demand: No change in Consumers income. No change in consumers preferences.

No change in the Fashion. No change in the Price of Related Goods. No expectation of Future price changes of shortages. No change in size, age composition, sex ratio of the population. No change in the range of goods available to the consumers. No change in the distribution of income and wealth of the community. No change in government policy. No change in weather conditions.

Exceptions to the Law of Demand: Sometimes it may be observed, that with a fall in price, demand also falls and with a rise in price, demand also rises. This is apparently contrary to the law of demand. The demand curve in such cases will be typically unusual and will be upward sloping.

There are few such exceptional cases: Giffen Goods: In the case of certain Giffen goods, when price falls, quite often less quantity will be purchased because of the negative income effect and peoples increasing preference for a superior commodity with rise in their real income. E.g. staple foods such as cheap potatoes, cheap bread, pucca rice, vegetable ghee, etc. as against good potatoes, cake, basmati rice and pure ghee. Articles of Snob appeal (Veblen effect): Sometimes, certain commodities are demanded just because they happen to be expensive or prestige goods and have a snob appeal. They satisfy the aristocratic desire to preserve the exclusiveness for unique goods. These goods are purchased by few rich people who use them as status symbol. When prices of articles like diamonds rise, their demand rises. Rolls Royce car is another example. Speculation: When people are convinced that the price of a particular commodity will rise further, they will not contract their demand; on the contrary they may purchase more for profiteering. In the stock exchange, people tend to buy more and more when prices are rising and unload heavily when prices start falling. Consumers psychological bias or illusion: When the consumer is wrongly biased against the quality of a commodity with reduction in the price such as in the case of a stock clearance sale and does not buy at reduced prices, thinking that these goods on sale are of inferior quality.

Reasons for change (increase or decrease) in demand: Change in income. Changes in taste, habits and preference. Change in fashions and customs Change in distribution of wealth. Change in substitutes. Change in demand of position of complementary goods. Change in population. Advertisement and publicity persuasion. Change in the value of money. Change in the level of taxation. Expectation of future changes in price.

Explain Veblen effect and draw up the market demand curve for veblen effect product. ((2/2004) Thorstein Veblen argued that the affluent class in the society has a tendency to demonstrate their superiority of high class By spending on frivolous goods and services super luxury items such as diamonds, five star hotels, palatial buildings, business or executive class of air travel. Though the market demand for such a commodity tends to rise when its price falls, the individual demand of the snobbish buyer will fall. When a prestige good loses its snob value, its market demand from the snobbish buyers will decrease with fall in its price; and the demand may be added up from the new common buyers. In certain branded goods such as Ray Ban or Levis products i.e. exclusive or designer products, there exists an inherent paradox. Initially these goods are meant to serve the Veblen effect. At high prices, there is limited but good demand from the richer sections. But when these goods are produced in larger quantity, their prices fall. It will carry mass appeal to upper middle class. So the demand will expand initially. Further increase in output will lead to further price reduction. But at this price, the product loses its exclusivity or snob effect and the richer sections exclusive demand will fall. The product will now be purchased on account of its functional utility and will be competing in the market with other similar goods. The demand curve DD has changing slopes at a and b points. At price P1, the demand is Q1. When the price is lowered to P2, demand is Q2. A further reduction

of price to P3, leads to a fall in demand as the brand loses exclusivity appeal. After that the product demand is determined just by its functional utility. How is an indifference curve technique an improvement over Marshallian utility analysis? The indifference curve approach is considered superior to the Marshallian utility analysis of consumer demand in the following respects: It is more realistic. Marshall assumes cardinal measurement of utility, which is unrealistic. The indifference curve technique makes an ordinal comparison of utility and the level of satisfaction. It uses the concept of scale of preferences with lesser assumptions than the Marshallian concept of utility. The scale of preference is laid down on the basis of a consumers tastes and likings, independent of his income. Unlike Marshall, the Hicksian scale of preference needs no information as to how much satisfaction is gained but it aims only at knowing whether a consumers satisfaction level is greater than, less than or equal to, between the various combinations of two goods. It dispenses with the assumption of constant marginal utility of money. Marshallian analysis assumes that to the consumer the marginal utility of money remains constant. In the indifference curve analysis, such assumption is not needed. It is wider in scope: Marshallian demand theory deals with a single commodity taken exclusively. Hicks ordinal approach, considers at least two goods in combination. Thus, the complementaritys and substitutability aspects of goods are being explicitly considered in Hicksian analysis. It uses concept of Marginal Rate of Substitution which is scientific and measurable: The utility approach is based on the law of diminishing marginal utility. On the other hand, the indifference curve approach rests on the principle of diminishing marginal rate of substitution. The concept of marginal rate of substitution is superior to that of marginal utility because it considers two goods together and also because it is a ratio expressed in physical units of two goods and as such, it is practically measurable. The replacement of the law of MU by MRS is a positive change in a more scientific manner.

It expresses the conditions of consumer equilibrium in a better way: In Marshallian analysis, the consumer equilibrium condition is MUx = MUy. Since utility cannot be measured numerically, this condition is impracticable. Px Py In Hicksian analysis, the equilibrium condition is expressed as MRSxy = Px/Py which is measurable. It is more comprehensive as it recognizes the fact that equilibrium in purchasing one commodity depends on the price of other goods and their stocks as well.

It analyses the price effect in a better way: The Marshallian demand curve has no means to separate the price effect into income and substitution effects. In the indifference curve analysis, the price consumption curve enables us to have the bifurcation of price effect into income and substitution effects. It examines the Phenomenon of Giffen Paradox. Marshall views the Giffen Paradox as an exception to the law of demand, whereas the case of Giffen goods is incorporated in the price consumption curve to examine the consumers typical behavior caused by negative income effect. Thus the unsolved riddle about Giffen goods in the utility analysis is solved by the indifference curve analysis. It represents the law of demand in a broader and more precise way. What are the shortcomings of the indifference curve approach? It does not provide any positive change in the utility analysis. It retains the Marshallian assumption of diminishing marginal utility: It unrealistically assumes perfect knowledge of utility with the consumer. It is weak in structure. It has limited scope. It is introspective. It is not applicable to indivisible goods. It assumes transitivity condition.

ELASTICITY OF DEMAND Demand usually varies with price. The extent of variation of demand is not uniform. Sometimes the demand is greatly responsive to price changes, while at other times, it may be less responsive. Elasticity is the extent of responsiveness to variation. Two factors are relevant for measuring the elasticity of demand a) demand b) the detriment of demand. A ratio is made of the two variables for measuring the elasticity coefficient. Elasticity of demand = % change in quantity demanded % change in detriment of demand Unless specified, elasticity of demand means price elasticity of demand. Logically, however, the concept of elasticity should measure the responsiveness of demand to changes in variables concerned with demand function. Thus there can be many kinds of elasticity of demand. Most important are Price elasticity of demand Income elasticity of demand Cross elasticity of demand Marshallian classification of Price elasticity: 1. Unit elasticity of demand (e = 1) 2. Elastic demand - elasticity greater than unity. (e > 1) 3. Inelastic demand elasticity is less than unity (e<1) Explain with graphs how modern economists have classified price elasticity of demand. What are the managerial uses of price elasticity of demand? Price elasticity of demand: Ratio Method: The extent of responsiveness of demand for a commodity to a given change in price, other demand determinants remaining constant, is termed as the price elasticity of demand. It is the ratio of relative change in demand variables to price variables. Coeff.of price elasticity e = % change in quantity demanded % change in price OR

Proportionate change in quantity demanded P = Q x P Proportionate change in price. P P Q Q = Original demand, Q = change in demand P = Original Price, P = change in price

= Q Q

The above method is also known as percentage method, when the ratio is expressed as a percentage. e = %Q %P Revenue Method: Marshall suggested that the easiest way of ascertaining whether or not the demand is elastic, is to examine the change in total outlay of the consumer or total revenue of the seller corresponding to change in price of the product. Total Revenue (or Total outlay) = Price x Quantity purchased (or sold) According to this method, if the total revenue remains unchanged with a change in the price, the demand is unit elastic, as demand changes in the same proportion as price. With a fall in price, if the total revenue rises, or with a rise in price, the total revenue falls, the elasticity is more than unity. With a rise in price, the total revenue also rises and with a fall in price, total revenue also falls, the demand is less than unity.

Point elasticity method or Geometric Method:

The simplest way of explaining the point method is to consider a straight line demand curve. Extend the demand curve to meet the two axes. When a point is plotted on the demand curve, it divides the line segment into lower and upper segments. Point elasticity is measured by the ratio of the lower segment of the demand curve below the given point to the upper segment above the given point. Point elasticity = Lower Segment below the given point Upper segment above the given point. This measure is called point elasticity measurement because it effectively measures elasticity of demand at a point on the demand curve assuming infinitesimally small changes in price and quantity variables. Arc elasticity method: To calculate price elasticity over some portion of the demand curve rather than at a point, the concept of arc elasticity of demand is used. Arc elasticity is measured on a range on the demand curve between two points. The formula for arc elasticity is Q P1 + P2 where, P1 is the original price, p2 = new price earc = -----x ---------Q1 original quantity demanded P Q1 + Q2 Q2 new demand P = P2 P1, Q = Q2 Q1 For practical decision making, it is better to use arc elasticity measure when price changes more than 5%. For all theoretical purposes, point elasticity rather than arc elasticity is commonly used.

What are the factors influencing elasticity of demand?

1. Nature of the commodity according to the nature of satisfaction the goods give. Luxury goods are price elastic. 2. Availability of close substitutes demand will be elastic. 3. Number of uses the commodity can be put to Single use goods will have less elastic demand but demand becomes elastic if it can be put to several uses. 4. Consumers income demand from low income group will be elastic while from very rich persons, relatively inelastic. 5. Height of price and range of price change highly priced goods, demand less elastic with small change in price. But with large changes, demand will be elastic. 6. Proportion of expenditure 7. Durability of the commodity. 8. Influence of habit and custom 9. Complementary goods. Goods which are jointly demanded are less elastic. 10. Time less elastic during short periods generally. 11. Recurrence of demand. 12. Possibility of postponement. Income Elasticity of Demand: Income elasticity of demand is defined as the ratio of percentage or proportional change in the quantity demanded to the percentage or proportional change in income. Income elasticity = % change in quantity demanded % change in income. OR Q x M Q M Cross elasticity of demand: The cross elasticity of demand refers to the degree of responsiveness of demand for a commodity to a given change in the price of some related commodity. or Q . M M Q = em = % Q % M

The cross elasticity of demand between two goods is measured by dividing the proportionate change in the quantity demanded of X by the proportionate change in the price of Y. Cross elasticity of demand : X Y. Ec or e xy = Qx x Py Qx Py = Qx x Px Py Qx Proportionate or percentage change in demand for Proportionate or percentage change in the price of

Advertising or Promotional elasticity of demand: eA = Percentage or proportionate change in sales Percentage or proportionate change in ad expenditure. Arc Advertising elasticity: Q x A1 + A2 A Q1 + Q2