Master of Business Administration- MBA Semester 1

MB0042 – Managerial Economics - 4 Credits

(Book ID: B1131)
Assignment Set- 2

Ques1. Define Pricing Policy. Explain the various objective of pricing policy.

Ans. Pricing Policies

A detailed study of the market structure gives us information about the way in which prices are
determined under different market conditions. However, in reality, a firm adopts different policies
and methods to fix the price of its products. Pricing policy refers to the policy of setting the
price of the product or products and services by the management after taking into
account of various internal and external factors, forces and its own business objectives.
Pricing Policy basically depends on price theory that is the corner stone of economic theory.
Pricing is considered as one of the basic and central problems of economic theory in a modern
economy. Fixing prices are the most important aspect of managerial decision making because
market price charged by the company affects the present and future production plans, pattern of
distribution, nature of marketing etc.
Generally speaking, in economic theory, we take into account of only two parties, i.e., buyers
and sellers while fixing the prices. However, in practice many parties are associated with pricing
of a product. They are rival competitors, potential rivals, middlemen, wholesalers, retailers,
commission agents and above all the Govt. Hence, we should give due consideration to the
influence exerted by these parties in the process of price determination.

Broadly speaking, the various factors and forces that affect the price are divided into two
categories.
They are as follows:

I External Factors (Outside factors)

1. Demand, supply and their determinants.
2. Elasticity of demand and supply.
3. Degree of competition in the market.
4. Size of the market.
5. Good will, name, fame and reputation of a firm in the market.
6. Trends in the market.
7. Purchasing power of the buyers.
8. Bargaining power of customers
9. Buyers behavior in respect of particular product

II. Internal Factors (Inside Factors)

1. Objectives of the firm.
2. Production Costs.
3. Quality of the product and its characteristics.
4. Scale of production.
5. Efficient management of resources.
6. Policy towards percentage of profits and dividend distribution.
7. Advertising and sales promotion policies.
8. Wage policy and sales turn over policy etc.
9. The stages of the product on the product life cycle.
10. Use pattern of the product.

Objectives of the Price Policy:

A firm has multiple objectives today. In spite of several objectives, the ultimate aim of every
business concern is to maximize its profits. This is possible when the returns exceed costs. In
this context, setting an ideal price for a product assumes greater importance. Pricing objectives
has to be established by top management to ensure not only that the company’s profitability is
adequate but also that pricing is complementary to the total strategy of the organization. While
formulating the pricing policy, a firm has to consider various economic, social, political and other
factors. The
Following objectives are to be considered while fixing the prices of the product.

1. Profit maximization in the short term

The primary objective of the firm is to maximize its profits. Pricing policy as an instrument to
achieve this objective should be formulated in such a way as to maximize the sales revenue and
profit. Maximum profit refers to the highest possible of profit. In the short run, a firm not
only should be able to recover its total costs, but also should get excess revenue over costs.
This will build the morale of the firm and instill the spirit of confidence in its operations.
2. Profit optimization in the long run
The traditional profit maximization hypothesis may not prove beneficial in the long run. With the
sole motive of profit making a firm may resort to several kinds of unethical practices like
charging exorbitant prices, follow Monopoly Trade Practices (MTP), Restrictive Trade Practices
(RTP) and Unfair Trade Practices (UTP) etc. This may lead to opposition from the people. In
order to over- come these evils, a firm instead of profit maximization, and aims at profit
optimization. Optimum profit refers to the most ideal or desirable level of profit. Hence,
earning the most reasonable or optimum profit has become a part and parcel of a sound pricing
policy of a firm in recent years.
3. Price Stabilization
Price stabilization over a period of time is another objective. The prices as far as possible
should not fluctuate too often. Price instability creates uncertain atmosphere in business circles.
Sales plan becomes difficult under such circumstances. Hence, price stability is one of the pre
requisite conditions for steady and persistent growth of a firm. A stable price policy only can win
the confidence of customers and may add to the good will of the concern. It builds up the
reputation and image of the firm.
4. Facing competitive situation
One of the objectives of the pricing policy is to face the competitive situations in the market. In
many cases, this policy has been merely influenced by the market share psychology. Wherever
companies are aware of specific competitive products, they try to match the prices of their
products with those of their rivals to expand the volume of their business. Most of the firms are
not merely interested in meeting competition but are keen to prevent it. Hence, a firm is always
busy with its counter business strategy.
5. Maintenance of market share
Market share refers to the share of a firm’s sales of a particular product in the total sales
of all firms in the market. The economic strength and success of a firm is measured in terms
of its market share. In a competitive world, each firm makes a successful attempt to expand its
market share. If it is impossible, it has to maintain its existing market share. Any decline in
market share is a symptom of the poor performance of a firm. Hence, the pricing policy has to
assist a firm to maintain its market share at any cost.
Ques2. Explain the important features of long run AC curve.

Ans: Long run AC curves

Long run is defined as a period of time where adjustments to changed conditions are
complete. It is actually a period during which the quantities of all factors, variable as well as
fixed factors can be adjusted. Hence, there are no fixed costs in the long run. In the short run, a
firm has to carry on its production within the existing plant capacity, but in the long run it is not
tied up to a particular plant capacity. If demand for the product increases, it can expand output
by enlarging its plant capacity. It can construct new buildings or hire them, install new machines,
employ administrative and other permanent staff. It can make use of the existing as well as new
staff in the most efficient way and there is lot of scope for making indivisible factors to become
divisible factors.
On the other hand, if demand for the product declines, a firm can cut down its production
permanently. The size of the plant can also be reduced and other expenditure can be
minimized.
Hence, production cost comes down to a greater extent in the long run.
As all costs are variable in the long run, the total of these costs is total cost of production.
Hence, the distinction between fixed and variables costs in the total cost of production
will disappear in the long run. In the long run only the average total cost is important and
considered in taking long term output decisions.

Important features of long run AC curve

1. Tangent curve
Different SAC curves represent different operational capacities of different plants in the short
run.
LAC curve is locus of all these points of tangency. The SAC curve can never cut a LAC curve
though they are tangential to each other. This implies that for any given level of output, no SAC
curve can ever be below the LAC curve. Hence, SAC cannot be lower than the LAC in the ling
run. Thus, LAC curve is tangential to various SAC curves.

2. Envelope curve
It is known as Envelope curve because it envelopes a group of SAC curves appropriate to
different levels of output.

3. Flatter Unshaped or dish-shaped curve.

The LAC curve is also U shaped or dish shaped cost curve. But It is less pronounced and
much flatter in nature. LAC gradually falls and rises due to economies and diseconomies of
scale.

4. Planning curve.
The LAC cure is described as the Planning Curve of the firm because it represents the least
cost of producing each possible level of output. This helps in producing optimum level of output
at the minimum LAC. This is possible when the entrepreneur is selecting the optimum scale
plant. Optimum scale plant is that size where the minimum point of SAC is tangent to the
minimum point of LAC.
5. Minimum point of LAC curve should be always lower than the minimum point of SAC
curve.
This is because LAC can never be higher than SAC or SAC can never be lower than LAC. The
LAC curve will touch the optimum plant SAC curve at its minimum point.
A rational entrepreneur would select the optimum scale plant. Optimum scale plant is that size
at which SAC is tangent to LAC, such that both the curves have the minimum point of tangency.
In the diagram, OM2 is regarded as the optimum scale of output, as it has the least per unit
cost. At OM2 output LAC = SAC.
LAC curve will be tangent to SAC curves lying to the left of the optimum scale or right side of the
optimum scale. But at these points of tangency, neither LAC is minimum nor will SAC be
minimum. SAC curves are either rising or falling indicating a higher cost.
Ques3. Explain the changes in market equilibrium and effects of shifts in supply and
demand.

Ans: 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 shit 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

Y S

D1

D2

P1 E1

Price P E D1

P2 E2 D

D2

Q2 Q Q1

Demand & Supply

Quantity demanded and supplied is shown on OX axis, Price is shown on OY axis. SS is the
supply curve which remains unchanged. DD is the demand curve. Demand and supply curves
intersect each other at point E. Thus OP is the equilibrium price and OQ is the equilibrium
quantity demanded and supplied. Now, suppose the demand increases. The demand curve
shifts forward to D1D1. The new demand curve intersects the supply curve at point E1, where
the quantity demanded increases to OQ1 and price to OP1. In the same way, if the demand
curve shifts backwards and assumes the position D2D2, the new equilibrium will be at E2 and
the quantity demanded will be OQ2, price will be
OP2. Thus the market equilibrium price and quantity demanded will change when there is an
increase or decrease in demand.

Effects of Shifts in Supply

To study of the effects of changes in supply on market equilibrium we assume the demand to
remain constant. An increase in supply is represented by a shift of the supply curve to the right
and a decrease in supply is represented by a shift to the left. The general rule is, if supply
increases, price falls and if supply decreases price rises. We can show the effects of shifts in
supply with the help of a diagram

D S2
Y

S1

P2 E2

P S2 E

P1 E1

S1 D

0 X

Q2 Q Q1

Demand & Supply

Ques4. Describe the trend projection method of demand forecasting with illustration.

Ans: Meaning of Demand Forecasting

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. In fact it is
the very soul of good business because every business decision is based on some assumptions
about the future whether right or wrong, implicit or explicit. The art of successful business lies in
avoiding or minimizing the risks involved as far as possible and faces the uncertainties in a most
befitting manner

Trend Projection Method Demand Forecasting

An old firm operating in the market for a long period will have the accumulated previous data on
either production or sales pertaining to different years. If we arrange them in chronological
order, we get what is called as ‘time series’. It is an ordered sequence of events over a period of
time pertaining to certain variables. It shows a series of values of a dependent variable say,
sales as it changes from one point of time to another. In short, a time series is a set of
observations taken at specified time, generally at equal intervals. It depicts the historical pattern
under normal conditions.
This method is not based on any particular theory as to what causes the variables to change but
merely assumes that whatever forces contributed to change in the recent past will continue to
have the same effect. On the basis of time series, it is possible to project the future sales
of a company.

An important question in this connection is how to ascertain the trend in time series? A
statistician, in order to find out the pattern of change in time series may make use of the
following methods.

1. The Least Squares method.

2. The Free hand method.
3. The moving average method.
4. The method of semi – averages.
The method of Least Squares is more scientific, popular and thus more commonly used when
compared to the other methods. It uses the straight line equation Y= a + bx to fit the trend to the
data.

Illustration:

Under this method, the past data of the company are taken into account to assess the nature of
present demand. On the basis of this information, future demand is projected. For e.g., a
businessman will collect the data pertaining to his sales over the last 5 years. The statistics
regarding the past sales of the company is given below.
The table indicates that the sales fluctuate over a period of 5 years. However, there is an up-
trend in the business. The same can be represented in a diagram.
Diagrammatic Representation:-

a) Deriving sales Curve. Y

Year Sales
(Rs.) 50

45 Sales Curve
1990 30
40
Sales
1991 40
35
1992 35
30
1993 50

1994 45
0 90 91 92 93 94 X

We can find out the trend values for each of the 5 years and also for the subsequent years
making use of a statistical equation, the method of Least Squares. In a time series, x denotes
time and y denotes variable. With the passage of time, we need to find out the value of the
variable.
To calculate the trend values i.e., Yc, the regression equation used is

Yc = a+ bx.
As the values of ‘a’ and ‘b’ are unknown, we can solve the following two normal equations
simultaneously.

(i) åY = Na + båx

(ii) åXY = aåx + båx 2

Where,

åY = Total of the original value of sales ( y)

N = Number of years,
åX = total of the deviations of the years taken from a central period.
åXY = total of the products of the deviations of years and corresponding sales (y)
åX 2 = total of the squared deviations of X values .

When the total values of X. i.e., åX = 0

 Year = n Sales in Deviation Square of Product Computed
Rs Lack from Deviation sales trend
Y assumed X2 and time values Yc
year X Deviation XY
1990 30 -2 +4 -60 32
1991 40 -1 +1 -40 36
1992 35 0 0 0 40
1993 50 +1 +1 +50 44
1994 45 +2 +4 +90 48
N =5 ∑ Y=200 ∑ X=0 ∑X 2 =10 ∑XY = 40

Regression equation = Yc = a + bx
To find the value of a = åY/N = 200/5 = 40
To find out the value of b = åXY/ åX 2 = 40/10 = 4

For 1990 Y = 40+(4x2)

Y = 408
= 32
For 1991 Y = 40+(4x1)
Y = 404
= 36
For 1992 Y = 40+(40x0)
Y = 40+0 = 40
For 1993 Y = 40+(4X1)
Y = 40+4 = 44
For 1994 Y = 40+(4X2)
Y = 40+8 = 48

For the next two years, the estimated sales would be:

For 1995 Y = 40+(4X3)

Y = 40+12 = 52
For 1996 Y = 40+(4X4)
Y = 40+16 = 56
Ques5. Discuss any one method of measuring price elasticity of demand.

Ans: Price Elasticity of Demand

Price elasticity of demand is one of the important concepts of elasticity which is used to describe
the effect of change in price on quantity demanded. In the words of
Prof. .Stonier and Hague, price elasticity of demand is a technical term used by economists to
explain the degree of responsiveness of the demand for a product to a change in its price. Price
elasticity of demand is a ratio of two pure numbers, the numerator is the percentage change in
quantity demanded and the denominator is the percentage change in price of the commodity. It
is measured by using the following formula.
Percentage change in quantity demanded
Ep = -------------------------------------------------------
Percentage change in price

Demand rises by 80%, ie + 80 Demand falls by 80%, ie -80

--------- = -4 ------ = -4
Price falls by 20%, ie - 20 Price rises by 20%, ie +20

Measurement of price elasticity of demand

There are different methods to measure the price elasticity of demand and among them the
following two methods are most important ones.
1. Total expenditure method.
2. Point method.
3. Arc method.

1. Total Expenditure Method

Under this method, the price elasticity is measured by comparing the total expenditure of
the consumers (or total revenue i.e., total sales values from the point of view of the
seller) before and after variations in price. We measure price elasticity by examining the
change in total expenditure as a result of change in the price and quantity demanded for a
commodity.

Total expenditure = Price per unit x Total quantity purchased

Price in Qty Total Nature

(Rs.) Demanded expenditure of PED
I Case 5.00 2000 10000 >1
4.00 3000 12000 >1
2.00 7000 14000 >1
II Case 5.00 2000 10000 =1
4.00 2500 10000 =1
2.00 5000 10000 =1
III Case 5.00 2000 10000 <1
4.00 2200 8800 <1
Note:
1. When new outlay is greater than the original outlay, then ED > 1.
2. When new outlay is equal to the original outlay then ED = 1.
3. When new outlay is less than the original outlay then ED < 1.

Graphical Representation

Y
A
E>1 ABCD is total expenditure curve
B

E=1

Price C

D E<1

0 Total Expenditure

From the diagram it is clear that

1. From A to B price elasticity is greater than one.
2. From B to C price elasticity is equal than one.
3. From C to D price elasticity is lesser than one.

Note:
§ It is to be noted that when total expenditure increases with the fall in price and decreases with
a rise in price, then the PED is greater that one.
§ When the total expenditure remains the same either due to a rise or fall in price, the PED is
equal to one.
§ When total expenditure, decrease with a fall in price and increase with a rise in price, PED is
said to be less than one.
Ques6. Give a brief description of
(a) Stock and ratio variables
(b) Equilibrium and Disequilibrium.

Ans: (A) Stock and ratio variables

(i) Stock variable

A stock variable is a quantity measured at a specific point of time. It may be referred to as a

certain amount or quantity at a specific point of time. For example, we can say that total
money supply in India as on 2722008 is Rs 80,000 crores. Stock variable has time reference.
In this case, both time and quantity is specified in clear terms and there is no ambiguity.

(ii) Ratio variables

Economic variables are measured in terms of ratio variables. A ratio variable expresses
quantitative relationship between two different variables at a certain time. For example,
average propensity to save expresses the ratio of total savings to total income. Similarly,
average propensity to consume expresses the relationship between total consumption to total
income. Hence,

Total savings Total Consumption

APS = APC
= Total income Total Income
These two examples come under flow ratio. Liquidity ratio shows relationship between liquid
assets and total assets where as Leverage ratio shows value of debts and total assets. Hence,

Liquid Assets Value of Debts

Liquidity Ratio =------------------- Leverage Ratio = -------------------
Total Assets Total Assets

These two examples come under stock ratio.

a. Dependent variable
A variable is dependent if its value varies as a result of variations in the value of some
other independent variables. In short value of one variable depends on the value of another
variable or variables.

b. Independent variable
In this case, the value of one variable will influence the value of another variable. If a change in
one variable cause changes in another variable, it is called as independent variable. An
independent variable cause changes in another variable.
For example, consumption function explains the relationship between changes in the level of
consumption as a result of changes in the level of income of consumers. It indicates how
consumption varies as income changes. It is expressed as C = f [Y] where C refers to
consumption and Y implies Income of consumers. In this case, consumption is dependent
variable and income is dependent variable.
It is to be noted that functional relationship may be related to either two or more variables. In
case of micro analysis, we explain that D = f [P] where demand depends on price of the
commodity concerned only. Similarly, we can explain that economic development, ED = f [C, L,
T …..]. This implies that economic development depends on several factors like capital, labor,
technology etc.

(B) Equilibrium and Disequilibrium.

These are the two terms which are frequently used in economic discussions. It is a position
where in two opposing forces tend to balance with each other so that there will be no
further changes. Hence, it is described as a position of rest in general. But in economics, it has
a different meaning. A state of rest implies that the various quantities used in the economic
system remain constant and with the help of these constant quantities, the economy continues
to churn over. There is movement or activity. But his movement is regular, smooth, certain and
constant. The equilibrium position is free from violent fluctuations, frequent variations and
sudden changes.
At the point of equilibrium, an economic unit is maximizing its benefits or gains. Hence, it
is described as the coziest position of an economic unit. Always there will be a tendency to
move towards this equilibrium position.

Disequilibrium on the other hand is a position where in the forces operating in the
system is not in balance. There is imbalance in different forces which are working in the
system. Hence, there are disturbances and disorders in the system.

Generally speaking in microeconomics we make reference to partial equilibrium analysis and in

macro economics general equilibrium analysis. We can explain these two concepts with the
help of two simple examples. When demand for a particular commodity is equal to its supply in
the market, equilibrium price is established at the micro level. Any imbalance between either
demand or supply would create disequilibrium.
At macro level, an economy is said to be in equilibrium when aggregate demand for goods and
services is equal to aggregate supply and total investment is equal to total savings. If aggregate
demand is either greater than aggregate supply or aggregate supply is greater than aggregate
demand, it would disturb the equilibrium in the economic system.