JK INSTITUTE OF TECHNOLOGY & MANAGEMENT

MANAGERIAL ECONOMICS (PROF. PREETI DUGGAL)

ASSIGNMENT ANSWERS

1. What is the difference between incremental and marginal analysis?

• The difference between incremental and marginal analysis is as

follows: - Marginal cost-effectiveness refers to the change in costs and
health benefits from a one-unit expansion or contraction of service
from a particular health care intervention (e.g. an extra day in the
hospital or an extra dose of medication per day).

• Incremental cost-effectiveness represents the change in costs and

health benefits when one health care intervention is compared to an
alternative one (e.g. outpatient surgery vs. short-stay surgery).

Types of analysis Considers the differences in costs

and health benefits...
Marginal cost- ...within a given alternative
effectiveness
Incremental cost- ...between alternatives
effectiveness

2. If demand for a commodity increase from 100 units o 200 units per
week when income rises from Rs. 2,000 o R. 3,000 find the income
elasticity of demand by point and Arc Method.

3. Explain the managerial use of production function.

The marginal product function

A useful concept when thinking about how the output of a firm varies as it
changes one input, holding all other inputs fixed, is the rate of increase of
the total product, known as the marginal product of the variable input. The
marginal product for any value of the variable input is the slope of the total
product function at that point. In particular, if the total product function is
differentiable, the marginal product is the derivative of the total product
function

The Marginal Product of Labor

Labor Marginal Output
First 13
Second 7
Third 5
Fourth 5
Fifth 4

4. Explain the price rigidity in oligopoly with the help of kinked demand
model.

i) If the firm reduces its price the producer expects other

competitors to introduce a similar price cut; the market
demand will increase but the share of the firm will remain unaltered.

ii) If the firm raises the price then other competing firms will not follow the
price rise. There will be a very small rise in demand but a significant
reduction in the sales of the firm.

The two assumptions suggest that neither a fall nor a rise in price would
benefit the firm. Oligopoly price is rigidly fixed. Moreover, such price
rigidity causes a Kink in the demand curve with its lower segment steeper or
inelastic and its upper segment flatter and more flexible. Consequently there
is no incentive to alter price under oligopoly. This will be clearer when
explained with the help of a figure.

The lower segment ED1 of the demand curve is steeper. Even with a
significant fall in price from P to P1 increase in the quantity demanded
QQ1 is very small. Reduction in price will then result in a smaller
total revenue for the firm. On the other hand, any attempt to cause a small
rise in price as PP2 on the flatter portion ED of the demand curve causes a
significant fall in the quantity demanded from Q to Q2. This again will cause
total revenue of the oligopolist to be smaller at higher price. The oligopolist
is rigidly fixed at E, the point of Kink with P as the price. This therefore is
also called sticky price solution.

5. How GDP is estimated?

DEF “The total market value of all final and services produced in
a country in a given year, equal to total consumer, investment and
government spending, plus the value of exports, minus the value of imports.

6. What is a Budget Line? Graphically show the consumer equilibrium

point on a budget line.

A consumer's budget line characterizes on a graph the maximum amounts of

goods that the consumer can afford. In a two good case, we can think of
quantities of good X on the horizontal axis and quantities of good Y on the
vertical axis. The term is often used when there are many goods, and without
reference to any actual graph.”

7. Describe the behavior of short run productivity curves of variable input.

“The short run is a period of time in which at least one input used for
production and under the control of the producer is variable and at least one
input is fixed.” And a variable input is “A variable input is an input used in
production and under the control of the producer that does change during the
time period of analysis (the short run).” so when they are put together their
behavior is as follows:-
The short run is defined in economics as a period of time where at least one
factor of production is assumed to be in fixed supply i.e. it cannot be
changed. We normally assume that the quantity of capital inputs (e.g. plant
and machinery) is fixed and that production can be altered by suppliers
through changing the demand for variable inputs such as labour,
components, raw materials and energy inputs. Often the amount of land
available for production is also fixed.

The time periods used in textbook economics are somewhat arbitrary

because they differ from industry to industry. The short run for the
electricity generation industry or the telecommunications sector varies from
that appropriate for newspaper and magazine publishing and small-scale
production of foodstuffs and beverages. Much depends on the time scale that
permits a business to alter all of the inputs that it can bring to production.

In the short run, the law of diminishing returns states that as we add more
units of a variable input (i.e. labour or raw materials) to fixed amounts of
land and capital, the change in total output will at first rise and then fall.
Diminishing returns to labour occurs when marginal product of labour starts
to fall. This means that total output will still be rising – but increasing at a
decreasing rate as more workers are employed. As we shall see in the
following numerical example, eventually a decline in marginal product leads
to a fall in average product.

What happens to marginal product is linked directly to the productivity of

each extra worker employed. At low levels of labour input, the fixed factors
of production - land and capital, tend to be under-utilised which means that
each additional worker will have plenty of capital to use and, as a result,
marginal product may rise. Beyond a certain point however, the fixed factors
of production become scarcer and new workers will not have as much
capital to work with so that the capital input becomes diluted among a larger
workforce.
As a result, the marginal productivity of each worker tends to fall – this is
known as the principle of diminishing returns.

An example of the concept of diminishing returns is shown below. We

assume that there is a fixed supply of capital (e.g. 20 units) available in the
production process to which extra units of labour are added from one person
through to eleven.

• Initially the marginal product of labour is rising.

• It peaks when the sixth worked is employed when the marginal
product is 29.
• Marginal product then starts to fall. Total output is still increasing as
we add more labour, but at a slower rate. At this point the short run
production demonstrates diminishing returns.

The Law of Diminishing Returns

Capital Input Labour Input Total Output Marginal Product Average Product of Labour
20 1 5 5
20 2 16 11 8
 20 3 30 14 10
20 4 56 26 14
20 5 85 28 17
20 6 114 29 19
20 7 140 26 20
20 8 160 20 20
20 9 171 11 19
20 10 180 9 18
20 11 187 7 17

Average product will continue to rise as long as the marginal

product is greater than the average – for example when the seventh worker is
added the marginal gain in output is 26 and this drags the average up from
19 to 20 units. Once marginal product is below the average as it is with the
ninth worker employed (where marginal product is only 11) then the average
will decline.

8. The total cost and revenue functions are given as: TC = 300+ 5x, TR
= 30x, where ‘x’ is the quantity sold.

a. Calculate break-even point

b. Determine the profit at the output of 40 units.

9. What are the reasons for the negative slope of the demand curve?

The reason for the negative slope of the demand curve is as follows: - The
demand curve slopes downwards due to the following reasons
(1) Substitution effect: When the price of a commodity falls, it becomes
relatively cheaper than other substitute commodities. This induces the
consumer to substitute the commodity whose price has fallen for other
commodities, which have now become relatively expensive. As a result of
this substitution effect, the quantity demanded of the commodity, whose
price has fallen, rises.
 (2) Income effect: When the price of a commodity falls, the consumer can
buy more quantity of the commodity with his given income, as a result of a
fall in the price of the commodity, consumer's real income or purchasing
power increases. This increase induces the consumer to buy more of that
commodity. This is called income effect.
(3) Number of consumers: When price of a commodity is relatively high,
only few consumers can afford to buy it, And when its price falls, more
numbers of consumers would start buying it because some of those who
previously could not afford to buy may now afford to buy it, Thus, when the
price of a commodity falls, the number of its consumers increases and this
also tends to raise the market demand for the commodity.
(4) Various uses of a commodity
(5) Law of diminishing marginal utility

10. Explain the practical implications of price elasticity of demand.

A critical factor in any business is developing an effective pricing policy that

will maximize profits. Maximum profit does not necessarily result from
selling goods at the highest possible profit margins. There is a relationship
between the price, volume sold, cost of merchandise, and operational
expenses that ultimately determines profitability. Although increasing price
may result in a decrease in sales volume, this approach may actually
generate a greater total profit. If sales volume is too low, however it may
decrease total profits. Alternatively, dropping prices may create a large
enough increase in sales volume to generate greater total profits. Again, if
volume is not increased enough a lower profit total may result. Knowing the
cost per item of each product and your actual cost of doing business is of
primary concern when developing your pricing policy. It may take some
time to come up with the necessary information. Although you can’t be
expected to determine these numbers with complete exactness, it is
important that your estimates be as close as possible to reality. It does,
however, need to be fairly accurate since failing to calculate all actual costs
properly to ensure that the profit margin is enough to cover those costs is a
frequent cause of business failure. Many business owners actually end up
selling their products at a loss without even knowing it. You will need to
determine the approximate cost of product research and development,
indirect overhead expense, raw materials and labor before setting the final
price of each item. Since costs may change over time you should update
these numbers regularly. The method for costing products is basic regardless
of the sales and pricing strategy that is used to maximize profits. The four
main categories to be accounted for are Labor Expense per Unit, Cost of
Materials per Unit, Estimated Overhead per Unit and Desired Profit per
Unit.

11. Show the economic region of long run production function with help
of ridge line.

12. What is a learning curve? Explain the usefulness of learning curve as

a managerial tool.

Learning curve means: - The term learning curve refers to a graphical

representation of the changing rate of learning (in the average person) for
a given activity or tool. Typically, the increase in retention of information
is sharpest after the initial attempts, and then gradually evens out,
meaning that less and less new information is retained after each
repetition. Applications of learning curve are as follows:

• Formulae for Determining the Slope

• Cost Estimation

• Warranty Maintenance and Maintenance Force

• Work-Accident Experience

• Make or Buy Decisions

 • External Reporting

• Standard Costs and Efficiency Variance Analysis

• Price Estimation

• Cost Reduction

• Break-Even Analysis

13.Explain the different phases of Business Cycles.-

Contraction: That features slow down in economic activity.

Trough: Turning point of business cycle where contraction shifts to

expansion.

Expansion: Growth in economic activity.

Peak: Upper turning point of business cycle.

14.Where do the models of managerial economics fit in the arenas of

managerial decision making?

15. What is law of supply? Show graphically the market equilibrium price
and quantities with the help of demand and supply curve.

Def of law of supply “the law of supply is the tendency of suppliers to offer
more of a good at a higher price. The relationship between price and
quantity supplied is usually a positive relationship. A rise in price is
associated with a rise in quantity supplied” The market price is determined
by the interaction of market supply (producers) and market demand
(consumers).
The point at which the quantity demanded equals the quantity supplied is the
equilibrium point. This point states the price of the good (P1) and the market
quantity (Q1).

Assuming that neither curve shifts, then market forces will maintain the
equilibrium price. For instance, assume that the price rises above P1, then
the firms will react by wishing to supply more (the price is higher, therefore,
the revenue will be higher), at the same time consumers will demand less.
The outcome is that there is excess supply. In other words, supply is greater
than demand.
This situation results in producers having unsold stocks. In this case,
producers will wish to sell stocks as they cost money to produce and
maintain. Therefore, to sell them they will reduce the price of the good
(contraction in supply). The lower price will encourage more demand for the
good (extension in demand). This process continues until the supply and
demand are again in equilibrium.
If the position of either the demand and / or supply curve shifts, then the
equilibrium price and quantity will change. For instance, if the good
becomes more fashionable, then the demand curve will shift from D1 to D2.
The new equilibrium price will be P2.
16. Explain the concept of national income. Discuss its
relevance to business.

A variety of measures of national income and output are used

in economics to estimate total economic activity in a country or region,
including gross domestic product (GDP), gross national product (GNP), and
net national income (NNI). All are concerned with counting the total amount
of goods and services produced within some "boundary". The boundary may
be defined climatologically, or by citizenship; and limits on the type of
activity also form part of the conceptual boundary; for instance, these
measures are for the most part limited to counting goods and services that
are exchanged for money: production not for sale but for barter, for one's
own personal use, or for one's family, is largely left out of these measures,
although some attempts are made to include some of those kinds of
production by imputing monetary values to them.

As can be imagined, arriving at a figure for the total

production of goods and services in a large region like a country entails an
enormous amount of data-collection and calculation. Although some
attempts were made to estimate national incomes as long ago as the 17th
century, the systematic keeping of national accounts, of which these figures
are a part, only began in the 1930s, in the United States and some European
countries. The impetus for that major statistical effort was the Great
Depression and the rise of Keynesian economics, which prescribed a greater
role for the government in managing an economy, and made it necessary for
governments to obtain accurate information so that their interventions into
the economy could proceed as much as possible from a basis of fact.

In order to count a good or service it is necessary to assign

some value to it. The value that all of the measures discussed here assign to
a good or service is its market value – the price it fetches when bought or
sold. No attempt is made to estimate the actual usefulness of a product – its
use-value – assuming that to be any different from its market value.

Three strategies have been used to obtain the market values

of all the goods and services produced: the product (or output) method, the
expenditure method, and the income method. The product method looks at
the economy on an industry-by-industry basis. The total output of the
economy is the sum of the outputs of every industry. However, since an
output of one industry may be used by another industry and become part of
the output of that second industry, to avoid counting the item twice we use,
not the value output by each industry, but the value-added; that is, the
difference between the value of what it puts out and what it takes in. The
total value produced by the economy is the sum of the values-added by
every industry.

The expenditure method is based on the idea that all

products are bought by somebody or some organisation. Therefore we sum
up the total amount of money people and organisations spend in buying
things. This amount must equal the value of everything produced. Usually
expenditures by private individuals, expenditures by businesses, and
expenditures by government are calculated separately and then summed to
give the total expenditure. Also, a correction term must be introduced to
account for imports and exports outside the boundary.

The income method works by summing the incomes of all

producers within the boundary. Since what they are paid is just the market
value of their product, their total income must be the total value of the
product. Wages, proprietor’s incomes, and corporate profits are the major
subdivisions of income.

The names of all of the measures discussed here consist of

one of the words "Gross" or "Net", followed by one of the words "National"
or "Domestic", followed by one of the words "Product", "Income", or
"Expenditure". All of these terms can be explained separately.

"Gross" means total product, regardless of the use to which it is

subsequently put.
 "Net" means "Gross" minus the amount that must be used to offset
depreciation – i.e., wear-and-tear or obsolescence of the nation's fixed
capital assets. "Net" gives an indication of how much product is
actually available for consumption or new investment.

"Domestic" means the boundary is geographical: we are counting all

goods and services produced within the country's borders, regardless
of by whom.

"National" means the boundary is defined by citizenship (nationality).

We count all goods and services produced by the nationals of the
country (or businesses owned by them) regardless of where that
production physically takes place.

The output of a French-owned cotton factory in Senegal

counts as part of the Domestic figures for Senegal, but the National
figures of France.

"Product", "Income", and "Expenditure" refer to the three counting

methodologies explained earlier: the product, income, and expenditure
approaches. However the terms are used loosely.

"Product" is the general term, often used when any of the three
approaches was actually used. Sometimes the word "Product" is used
and then some additional symbol or phrase to indicate the
methodology; so, for instance, we get "Gross Domestic Product by
income", "GDP (income)", "GDP (I)", and similar constructions.

"Income" specifically means that the income approach was used.

"Expenditure" specifically means that the expenditure approach was

used.

Note that all three counting methods should in theory give the
same final figure. However, in practice minor differences are obtained from
the three methods for several reasons, including changes in inventory levels
and errors in the statistics. One problem for instance is that goods in
inventory have been produced (therefore included in Product), but not yet
sold (therefore not yet included in Expenditure). Similar timing issues can
also cause a slight discrepancy between the value of goods produced
(Product) and the payments to the factors that produced the goods (Income),
particularly if inputs are purchased on credit, and also because wages are
collected often after a period of production.

17. “Under perfect competition each firm is a price taker but

not price maker” - Explain.

In neoclassical economics and microeconomics, perfect

competition describes a market in which there are many small firms, all
producing homogeneous goods. In the short term, such markets are
productively inefficient as output will not occur where marginal cost is equal
to average cost, but allocatively efficient, as output under perfect
competition will always occur where marginal cost is equal to marginal
revenue, and therefore where marginal cost equals average revenue.
However, in the long term, such markets are both allocatively and
productively efficient. In general a perfectly competitive market is
characterized by the fact that no single firm has influence over the price of
the product it sells. Because the conditions for perfect competition are very
strict, there are few perfectly competitive markets.

A perfectly competitive market may have several

distinguishing characteristics, including:

• Infinite Buyers/Infinite Sellers – Infinite consumers with the

willingness and ability to buy the product at a certain price, Infinite
producers with the willingness and ability to supply the product at a
certain price.
• Zero Entry/Exit Barriers – It is relatively easy to enter or exit as a
business in a perfectly competitive market.
• Perfect Information - Prices and quality of products are assumed to be
known to all consumers and producers.
• Transactions are Costless - Buyers and sellers incur no costs in
making an exchange.
• Firms Aim to Maximize Profits - Firms aim to sell where marginal
costs meet marginal revenue, where they generate the most profit.
• Homogeneous Products – The characteristics of any given market
good or service do not vary across suppliers.
 Some subset of these conditions is presented in most textbooks
as defining perfect competition. More advanced textbooks try to reconcile
these conditions with the definition of perfect competition as equilibrium
price taking; that is whether or not firms treat price as a parameter or a
choice variable. It is this distinction which differentiates perfectly
competitive markets from imperfectly competitive ones.

The importance of perfect competition derives from the fact that

price taking by the firm guarantees that when firms maximize profits (by
choosing quantity they wish to produce, and the combination of factors of
production to produce it with) the market price will be equal to marginal
cost. An implication of this is that a factor's price (wage, rent, etc.) equals
the factor's marginal revenue product. This allows for derivation of the
supply curve on which the neoclassical approach is based (note that this is
also the reason why "a monopoly does not have a supply curve"). The
abandonment of price taking creates considerable difficulties to the
demonstration of existence of a general equilibrium except under other, very
specific conditions such as that of monopolistic competition .

18. Elucidate the significance of Cobb-Douglas production

function and its role in the modern economic theory.

In economics, the Cobb–Douglas functional form of

production functions is widely used to represent the relationship of an output
to inputs. It was proposed by Knut Wicksell (1851–1926), and tested against
statistical evidence by Charles Cobb and Paul Douglas in 1900–1928.

For production, the function is

Y = ALαKβ,

Where:

• Y = total production (the monetary value of all goods produced in a

year)
• L = labor input
• K = capital input
 • A = total factor productivity
• α and β are the output elasticities of labor and capital, respectively.
These values are constants determined by available technology.

Output elasticity measures the responsiveness of output to a change in levels

of either labor or capital used in production, ceteris paribus. For example if α
= 0.15, a 1% increase in labor would lead to approximately a 0.15% increase
in output.

Further, if:

α + β = 1,

the production function has constant returns to scale. That is, if L and K are
each increased by 20%, Y increases by 20%. If

α + β < 1,

returns to scale are decreasing, and if

α+β>1

returns to scale are increasing. Assuming perfect competition, α and β can be

shown to be labor and capital's share of output.

Cobb and Douglas were influenced by statistical evidence that appeared to

show that labor and capital shares of total output were constant over time in
developed countries; they explained this by statistical fitting least-squares
regression of their production function. There is now doubt over whether
constancy over time exists.

Report By: - Vineet. M. Ganvi.

For: - JKITM (MANAGERIAL ECONOMICS)