ms-09 mba assignment july dec 2010 Question 5

5. Write short notes on the following:-

a) Market Demand Schedule

            In economics, a market demand schedule is a table that lists the quantity of a good all consumers in a market will buy at every different price. A market demand schedule for a product indicates that there is an inverse relationship between price and quantity demanded. The graphical representation of a demand schedule is called a demand curve.

            In economics, the demand curve is the graph depicting the relationship between the price of a certain commodity, and the amount of it that consumers are willing and able to purchase at that given price. It is a graphic representation of a demand schedule. The demand curve for all consumers together follows from the demand curve of every individual consumer: the individual demands at each price are added together. Despite its name, it is not always shown as a curve, but sometimes as a straight line, depending on the complexity of the scenario.

            Demand curves are used to estimate behaviors in competitive markets, and are often combined with supply curves to estimate the equilibrium price (the price at which sellers together are willing to sell the same amount as buyers together are willing to buy, also known as market clearing price) and the equilibrium quantity (the amount of that good or service that will be produced and bought without surplus/excess supply or shortage/excess demand) of that market. In a monopolistic market, the demand curve facing the monopolist is simply the market demand curve.

b) Peak Load Pricing

            Peak load pricing is a type of third-degree price discrimination in which the discrimination base is temporal. We single out this particular form of price discrimination in part because of its widespread use. But remember that all forms of third-degree price discrimination, including peak load pricing, involve a seller attempting to capitalize on the fact that buyers’ demand elasticities vary. In the case of peak load pricing, customer demand elasticities vary with time. Very few, if any, business economic activities are characterized by an absolutely constant demand during all seasons of the year and at all times of day. For many, the variations, or fluctuations, are not large enough to be of concern; but for some activities, fluctuations in demand are significant. These variations are sometimes relatively stable and predictable. Telephone calls provide one good example. Telephone companies and their competitors use a pricing scheme for long-distance calls that encourages people to make such calls at slack times when equipment and personnel are less busy.

            Prices are the highest between 8:00 a.m. and 5:00 p.m., reduced between 5:00 p.m. and 11:00 p.m., and reduced still further from 11:00 p.m. to 8:00 a.m. The highest prices are charged during peak demand periods, and lower prices are charged at other times. This is an example of peak-load pricing. Consumers are encouraged to shift demand from peak to slack periods through the price mechanism, and those who use the phone system for long-distance calls during peak periods pay a relatively greater share of the cost of providing and maintaining the phone system. Whenever price discrimination is based on time differentials, the object of the selling firm is to charge a higher price for the product during the more inelastic period and a lower price during the more elastic interval.

c) Income Elasticity of Demand:

            The income elasticity of demand measures the responsiveness of sales to changes in income, ceteris paribus. It is defined as the percentage change in sales divided by the corresponding percentage change in income. The methods used to calculate arc income elasticity (EI) and point income elasticity (eI) are as follows:

            Given information on sales and income, the calculation of income elasticities is strictly analogous to the calculation of price elasticities. If the income elasticity of demand for a product is greater than one, the product is said to be income elastic; if it is less than one, the product is income inelastic. For normal goods, the income elasticity is greater than 0 because with rising incomes, consumers will purchase a greater quantity of such goods, ceteris paribus. If the income elasticity for a commodity is negative, the good is an inferior good; that is, people will choose to purchase less of the product when their income increases. Potatoes may represent examples of inferior goods for some households, as would purchases from the cheap stores. The reason is that some households consume certain goods only because of lack of purchasing power. As income increases it is possible the household will shift away from the purchase of these inferior goods.

ms-09 mba assignment july dec 2010 Question 4

 4. Does Price Discrimination exist in the real world? Discuss with reference to any particular product or service.

PRICE DISCRIMINATION

            Price discrimination is usually termed monopoly price discrimination. This label is appropriate because price discrimination cannot happen in a perfectly competitive industry in equilibrium. Monopoly power must be present in a market for price discrimination to exist. This seems a trivial point, when you understand, the definition of price discrimination; the practice of charging different prices to various consumers for a given product. In a competitive market, consumers would simply buy from the cheapest seller, and producers would sell to the highest bidders, and that would be that. With monopoly power, however, the opportunity may exist for the firm to offer different terms (of which price is only one component) to different purchasers, thus dividing the market–a practice known as market segmentation. Price discrimination refers to the situation where a monopoly firm charges different prices for exactly the same product. The monopoly firm (a single seller in the market) can discriminate between different buyers by charging them different prices because it has the power to control price by changing its output. The buyers of its product have no choice but to buy from it as the product has no close substitutes. There are three types of price discrimination – First Degree price discrimination, Second Degree price discrimination, and Third Degree price discrimination.

            First degree price discrimination refers to a situation where the monopolist charges a different price for different units of output according to the willingness to pay of the consumer. For example, a doctor who is the only super specialist in the town may charge different fee for conducting surgery from different patients based on their ability to pay.

            Second degree price discrimination refers to a situation where the monopolist charges different prices for different set of units of the same product. For example, the electricity charges per unit of the first 100 Kwh of power consumption may be different from the rate charged for the additional 100 Kwhs. Another example is railway passenger fares; the per kilometre fare is higher for the first few kilometers, which declines as the distance increases. Thus the discrimination is based on volume of purchases. When the monopolist firm divides the market (for its product) into two or more markets (groups of buyers or segments) and charges different price in each market, it is known as third degree price discrimination. Airline tickets are a common example of this form of price discrimination. For example, lower rates are applicable to senior citizens than business travellers, electricity rates applicable to residential users are lower than those applied to commercial establishments and so on.

a) First Degree Price Discrimination

            Monopolists engage in price discrimination when they can increase their profits by doing so. Even if sellers know the maximum amount that different customers are willing to pay, developing a pricing scheme that makes each customer pay that amount, a practice known as first degree price discrimination, can be difficult. Under first degree price discrimination, the full benefit from the trade between buyer and seller accrues to the seller. One strategy to achieve first degree price discrimination is to sell to the highest bidders through sealed bid auctions. The auction approach is best suited for situations where the volume of sales are low (usually due to scarcity of the product), where there are many potential buyers who are unable to co-operate among themselves and where buyers all have access to the same information about the product’s characteristics. The auction approach would enable to seller to identify those buyers with the highest willingness to pay and would yield the highest possible revenues for the same production costs. This is a common strategy for the sale of very special types of products such as art objects, antique furniture or the rights to the mining and exploration of plots of land. It is not suitable for most bulk-produced products such as cans of cola or computers. Perfect, or first-degree price discrimination can occur when a firm knows the maximum price the individual is willing to pay for each successive unit. The firm could then charge that highest price for each successive unit and capture the entire consumer surplus. Remember that all forms of price discrimination involve some monopoly power, but perfect price discrimination involves a degree of monopoly power rarely found in the real world.

b) Second Degree Price Discrimination

            Where the auction approach is not feasible, the company must do its best to approximate the first degree outcome using its pricing structure. This is based on the notion that an individual consumer derives diminishing satisfaction from each successive unit of any product consumed. This form of price discrimination, which is based on the volume of consumer purchases, is very common and is known as second degree price discrimination. Other forms of second degree price discrimination include two-tier tariffs, i.e. prices where the consumer must pay a flat fee for access and then a separate fee (which may be zero) for usage. This is typical of many clubs, amusement parks and transport facilities offering monthly or annual passes. The idea in the case of travel pass, for example, is that the traveller who travels infrequently pays on average, a higher price per trip because the fixed access cost is spread over fewer trips. On the other hand, the high volume user spreads this fixed cost over so many trips that he or she may actually sit next to the infrequent traveller, consume the exact same services (meals, fuel and so on), but end up paying a lower average price for any given trip. Second-degree price discrimination is also referred to as multipart pricing. It is a block, or step, type of pricing, in which the first set of units is sold at one price, a second set at a lower price, a third set at a still lower price, and so on. Note that this is different from a quantity discount in which the lower (discounted) price applies to all units purchased. In second-degree price discrimination, the lower price applies only to units purchased in that block. The buyer must have already paid the higher price for the earlier units. Some familiar examples should make this clear:

1. Electricity:

            In many parts of the developed world residential electricity users are billed at different rates for different blocks of consumption. For example, the first 100 kilowatt-hours may be priced at $0.62 per kilowatt-hour, the next 100 kilowatt-hours may be priced at $.059 per kilowatt-hour, and everything over 200 kilowatt-hours may be priced at $.057 per kilowatt-hour. This is an example of three-block second degree price discrimination. You cannot buy the second 100 kilowatt-hours at the lower price until you have already purchased the first 100 at the higher price. 2. Long-distance phone calls: When you make a long-distance phone call, you are usually charged a higher rate for the first three minutes than for subsequent time. It is  impossible to buy just the second three minutes of a phone call. You must first have used the initial three minutes. This is also an example of second degree price discrimination. Now, let’s look at second-degree price discrimination in a more formal graphic model. In figure 14.1, the seller faces the demand curve (D) of one typical consumer. Although the cost function is not shown in the figure, assume that marginal revenue and marginal cost intersect and lead to an optimal price of P*. The consumer would choose to buy the quantity Q* at this price. The shaded area of the figure represents the consumer’s surplus. It may be, however, that the firm uses multipart pricing to capture a portion of this surplus. Suppose that the firm sets a price of P1 for the first Q1 units purchased and that additional units sell for P2 (a two-stage pricing scheme). The consumer buys Q1 units at price P1 and Q2 units at price P2.  that portion of the consumer surplus labeled P1BCP2 is now captured by the firm rather than by the consumer. This still leaves a rather large portion of the consumer surplus still in the consumer’s hands. The firm’s management would prefer to capture it all, and could do so by using more parts in a multipart pricing strategy. However, to do so, management needs to know a great deal about the consumer’s demand.

            In this example of second-degree price discrimination, or multipart pricing, the first block of units (Q1 units) is sold at the price P1, and the second block (Q2 units) is old at the price P2. This allows the seller to capture that part of the consumer’s surplus represented by the area P1BCP2.

c) Third Degree Price Discrimination

            Pricing based on what type of consumer is doing the purchasing rather than the volume of purchase is an approach known as third degree price discrimination. This is very common in the sales of air and rail travel, movie tickets and other products where consumers can be segmented into different groups, who are likely to differ reatly in their willingness to pay based on certain easily identifiable attributes. Thus, third-degree price discrimination, or market segmentation, requires that the seller be able to (1) segment, or separate, the market so that goods sold in one market cannot be resold by the buyers in another; and (2) identify distinct demand curves with different price elasticities for each market segment. Students are one of the main beneficiaries of third degree price discriminations schemes, since their demand is more sensitive than the population at large. Other often identified groups include senior citizens and the young, both of whom also tend to be more price sensitive, and business purchasers, who are often less price sensitive and may be willing to pay a lot for small quality improvements. Suppose, for example, there are only two types of travellers; students and businessmen. Students pay for their travel out of their own pockets, while businessmen charge their travel to their employers who in turn deduct these expenses from their taxable income. Since a typical student is likely to be willing to pay less for a travel ticket, all else being equal, than a typical businessmen, it makes sense for the company selling travel services to price higher to the businessman and lower to the tourist to get the largest possible volume of business out of each customer group.

ms-09 mba assignment july dec 2010 Question 3

3. Briefly describe the Optimal Combination of inputs with the help of an example.

THE OPTIMAL COMBINATION OF INPUTS

            The introduction of this unit one of the decision problems that concerns a production process manager is, which input combination to use. That is, what is the optimal input combination? While all the input combinations are technically efficient, the final decision to employ a particular input combination is purely an economic decision and rests on cost (expenditure). Thus, the production manager can make either of the following two input choice decisions:

1. Choose the input combination that yields the maximum level of output with a given level of expenditure.

2. Choose the input combination that leads to the lowest cost of producing a given level of output.

            Thus, the decision is to minimize cost subject to an output constraint or maximize the output subject to a cost constraint. We will now discuss these two fundamental principles. Before doing this we will introduce the concept isocost, which shows all combinations of inputs that can be used for a given cost.

Iso cost Lines:

            Recall that a universally accepted objective of any firm is to maximise profit. If the firm maximises profit, it will necessarily minimise cost for producing a given level of output or maximise output for a given level of cost. Suppose there are 2 inputs: capital (K) and labour (L) that are variable in the relevant time period. What combination of (K,L) should the firm choose in order to maximise output for a given level of cost? If there are 2 inputs, K,L, then given the price of capital (Pk) and the price of labour (PL), it is possible to determine the alternative combinations of (K,L) that can be purchased for a given level of expenditure. Suppose C is total expenditure, then

            C= PL* L + Pk* K

            If only capital is purchased, then the maximum amount that can be bought is C/Pk shown by point A in figure 7.7. If only labour is purchased, then the maximum amount of labour that can be purchased is C/PL shown by point B in the figure. The 2 points A and B can be joined by a straight line. This straight line is called the isocost line or equal cost line. It shows the alternative combinations of (K,L) that can be purchased for the given expenditure level C. Any point to the right and above the isocost is not attainable as it involves a level of expenditure greater than C and any point to the left and below the isocost such as P is attainable, although it implies the firm is spending less than C.

EXAMPLE:

Consider the following data:

PL = 10, Pk = 20 Total Expenditure = 200.

            Let us first plot the various combinations of K and L that are possible. We consider only the case when the firm spends the entire budget of

200.

            The slope of this isocost is –½. What will happen if labour becomes more expensive say PL increases to 20? Obviously with the same budget the firm can now purchase lesser units of labour. The isocost still meets the Y–axis at point A (because the price of capital is unchanged), but shifts inwards in the direction of the arrow to meet the X-axis at point C. The slope therefore changes to –1.

ms-09 mba assignment july dec 2010 Question 2

2. Given a firm’s demand function, P = 24 - 0.5Q and the average cost function, AC = Q² – 8Q + 36  + 3/Q, calculate the level of output Q which

a)  Maximizes total revenue

Since demand function is P = 24-0.5 Q

The total revenue will be TR =PQ=( 24-0.5Q) Q= 24-0.5Q²

To maximize TR , we find the derivative and set it to 0.

Hence  first order condition dR/dQ =24 – 2 ( 0.5 ) Q

                                                         = 24 – Q = 0

                                                      Q = 24.

The second order derivation d²R/dQ² to be negative .

Since dR/dQ² = -1

Which is negative, hence total revenue is maximized when output is 24 units .

b) From profit function.

P = TR – TC

TC    = AC X Q

        = ( Q2 – 8 Q + 36 + 3 / Q ) X Q

        = Q^{3 -} 8 Q² + 36 Q + 3

TR = (24 – O.5 Q ) Q

       = 24Q – 0.5 Q² after substituting TR & TC  we get

      P    =  ( 24 Q – 0.5 Q² ) – ( Q³- 8 Q² + 36 Q + 3 )

dP/dQ = ( 24 – Q – 3 Q² + 16 Q – 36 )

            = - 3Q^{2  _15 Q} -12

Now set = dπ /dQ = 0

-3Q^{2 +} 15 Q – 12 = 0

Dividing by 3 we get q2 +5 q – 4 = 0

(Q - 4 ) (Q – 1) = Q = 4 or 1 

ms-09 mba assignment july dec 2010 Question 1

1. “A close relationship between management and economics has led to the development of managerial economics.” Explain this statement

            The primary role of economics in management is in making optimizing decisions where constraints apply. The application of the principles of managerial economics will help managers ensure that resources are allocated efficiently within the firm, and that the firm makes appropriate reactions to changes in the economic environment.

            A close relationship between management and economics has led to the development of managerial economics. Management is the guidance, leadership and control of the efforts of a group of people towards some common objective. While this description does inform about the purpose or function of management, it  tells us little about the nature of the management process. Koontz and O’Donell define management as the creation and maintenance of an internal environment in an enterprise where individuals, working together in groups, can perform efficiently and effectively towards the attainment of group goals. Thus, management is –

·         Coordination

·         An activity or an ongoing process

·         A purposive process

·         An art of getting things done by other people

            On the other hand, economics as stated above is engaged in analysing and providing answers to manifestations of the most fundamental problem of scarcity. Scarcity of resources results from two fundamental facts of life:

·         Human wants are virtually unlimited and insatiable, and

·         Economic resources to satisfy these human demands are limited.

            Thus, we cannot have everything we want; we must make choices broadly in regard to the following:

·         What to produce?

·         How to produce? and

·         For whom to produce?

            These three choice problems have become the three central issues of an economy as shown in figure 1.1. Economics has developed several concepts and analytical tools to deal with the question of allocation of scarce resources among competing ends. The non-trivial problem that needs to be addressed is how an economy through its various institutions solves or answers the three crucial questions posed above. There are three ways by which this can be achieved. One, entirely by the market mechanism, two, entirely by the government or finally, and more reasonably, by a combination of the first two approaches. Realistically all economies employ the last option, but the relative roles of the market and government vary across countries. For example, in India the market has started playing a more important role in the economy while the government has begun to withdraw form certain activities. Thus, the market mechanism is gaining importance.

            A similar change is happening all over the world, including in China. But there are economies such as Myanmar and Cuba where the government still plays an overwhelming part in solving the resource allocation problem. Essentially, the market is supposed to guide resources to their most efficient use. For example if the salaries earned by MBA degree holders continue to rise, there will be more and more students wanting to earn the degree and more and more institutes wanting to provide such degrees to take advantage of this opportunity. The government may not force this to happen, it will happen on its own through the market mechanism. The government, if anything, could provide a regulatory function to ensure quality and consumer protection. According to the central deduction of economic theory, under certain conditions, markets allocate resources efficiently. ‘Efficiency’ has a special meaning in this context. The theory says that markets will produce an outcome such that, given the economy’s scarce resources, it is impossible to make anybody better-off without making somebody else worse-off.

            Managerial economics is concerned with the application of economic concepts and analysis to the problem of formulating rational managerial decisions. There are four groups of problem in both decisions-making and forward planning.

Resource Allocation:

            Scare resources have to be used with utmost efficiency to get optimal results. These include production programming and problem of transportation etc. How does resource allocation take place within a firm.

            Naturally, a manager decides how to allocate resources to their respective uses within the firm, while as stated above, the resource allocation decision outside the firm is primarily done through the market. Thus, one important insight you can draw about the firm is that within it resources are guided by the manager in a manner that achieves the objectives of the firm.

Inventory and queuing problem:

            Inventory problems involve decisions about holding of optimal levels of stocks of raw materials and finished goods over a period. These decisions are taken by considering demand and supply conditions. Queuing problems involve decisions about installation of additional machines or hiring of extra labour in order to balance the business lost by not undertaking these activities.

Pricing Problem:

            Fixing prices for the products of the firm is an important decision-making process. Pricing problems involve decisions regarding various methods of prices to be adopted.

Investment Problem:

            Forward planning involves investment problems. These are problems of allocating scarce resources over time. For example, investing in new plants, how much to invest, sources of funds, etc.

            Study of managerial economics essentially involves the analysis of certain major subjects like:

·         The business firm and its objectives

·         Demand analysis, estimation and forecasting

·         Production and Cost analysis

·         Pricing theory and policies

·         Profit analysis with special reference to break-even point

·         Capital budgeting for investment decisions

·         Competition.

            Demand analysis and forecasting help a manager in the earliest stage in choosing the product and in planning output levels. A study of demand elasticity goes a long way in helping the firm to fix prices for its products. The theory of cost also forms an essential part of this subject. Estimation is necessary for making output variations with fixed plants or for the purpose of new investments in the same line of production or in a different venture. The firm works for profits and optimal or near maximum profits depend upon accurate price decisions. Theories regarding price determination under various market conditions enable the firm to solve the price fixation problems. Control of costs, proper pricing policies, break-even analysis, alternative profit policies are some of the important techniques in profit planning for the firm which has to work under conditions of uncertainty. Thus managerial economics tries to find out which course is likely to be the best for the firm under a given set of conditions.