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(Important Questions and suggested model 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 firm’s 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 firm’s 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 firm’s 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 India’s 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.
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. Normative Economics prescribes what it ought to be”. Aggregate demand covers all market demands. Is Managerial Economics a Positive or Normative Science? Discuss. the ultimate object of the study of any science is to contribute to human welfare. Not only economists should build up the economic theory but also at the same time they should provide policy measures. This is because when we say that this ought to be like this. According to economists like Marshall and Pigou. political etc. after all. According to Prof. Macroeconomics uses aggregates which relate to the entire economy or to a large sector of the economy. not only economic considerations but also many other considerations such as ethical. 4 . a search for truth and therefore. It should be able to prescribe guidelines for the conduct of economic activities. economics is a positive science. while normative sciences simply prescribe. economics should study the truth as it is and not as it ought to be. It should be able to suggest policy measure to the politicians. In a study of a problem at a given point of time. Positive sciences simply describe. Theories of Income and employment are core topics in macroeconomics. Demarcation in areas of study: Theories of value and economic welfare are major areas in microeconomics. 6. Positive Economics explains the economic phenomenon as “What is. must be considered. 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. Thus economics should be a normative science.5. A policy decision is taken after weighing the relative importance of all these factors. Robbins. Science is. we presume that our point of view is correct. what was and what it will be.
though the discipline may be treated primarily as a positive science. Chart: 5 .We must strike a balance between these two extreme views. It is positive when it is confined to statements about causes and effects and to functional relations of economic variables. “The main function of economics is not to provide a body of settled conclusions immediately applicable to policy. Managerial Economics is confined to the following three major fields: (1) Pricing (2) Distribution (3) Welfare.” Managerial economics is a blending of pure or positive science with applied or normative science. It provides a method or a technique of thinking. 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. It is normative when it involves norms and standards. One cannot disregard the normative functions of managerial economics. Briefly discuss the three fundamental concepts of Managerial Economics. Normative approach in managerial economics has ethical considerations and involves value judgments based on philosophical. mixing them with causeeffect analysis. which enables its possessor to draw correct conclusions. As Keynes put it. cultural and religious positions of the community.
profits. • Theory of production and cost or the analysis of producer behavior. In other words. It seeks to explain how rewards of the individual factors of production such as land. Price theory explains how the price of a particular commodity is determined in the commodity market. 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. welfare economics is also concerned with social welfare. wages. labors. and interest. overall economic efficiency or ‘Pareto optimality’ condition is reached. Since demand and supply of each of these factors are different. Thus the field of distribution includes general theory of distribution and theories of rent. wages. Along with individual economic welfare. interest and profits. Distribution: The theory of distribution basically deals with factor pricing. In a free market economy. Such a situation can raise the standard of living of the population and maximize social welfare.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. as the respective rewards of land. For in depth analysis of price determination it contains: • Theory of demand of the analysis of consumer behavior. capital and enterprise are determined for their productive contribution. labour. When maximum individual wants are satisfied at the best possible optimum level by a production pattern through efficient allocation of resources. • Theory of product [pricing or price determination under different market structures. 6 . which is based on overall economic efficiency of the system. it is concerned with rent. To explain the allocation of resources. capital and enterprise respectively. there are separate theories to these. the allocation of resources is based on the relative prices and profitability of different goods. microeconomics seeks to explain the pricing phenomenon.
Managerial economists assist them in making a rational choice. 7 . Microeconomics unrealistically assumes ‘laissez-faire’ policy and pure capitalism. 8. It explains the phenomena of International Trade. It has direct relevance in business decision-making. Microeconomics studies only parts and not the whole of the economic system. By assuming independence of wants and production in the system. Microeconomics in dealing with macroeconomic system unrealistically assumes full employment. In modern business. 5. Microeconomics misleads when one tries to generalize from the individual behavior. 3. managers constantly face the major problem of choice among alternative ways of producing goods and allied business decisions. 4. 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. 5. Most of the microeconomic theories are static – based on ceteris paribus. Most of the micro-economic theories are abstract. It serves as the basis for welfare economics. It is useful in determination of economic policies of the Government. It teaches the art of economizing. 6. “other things being equal”. It cannot explain the functioning of the economy at large. 7.What are the important uses and limitation of microeconomics? Importance and Uses: 1. 2. 7. market share. 6. Limitations: 1. Their job lies in designing the course of operations to maintain and improve the ‘systems’ of the firm in terms of productivity.e. 2. load factor percentage and so on and prepare reports for helping the decision makers to cope with current as well as anticipated future problems. 4. microeconomics has failed to consider their ‘dependent effect’ on economic welfare. It explains price determination and the allocation of resources. It serves as a guide for business’ production planning. 3. i. It serves as a basis for prediction.
the quantity. in the course of its/his business operations. • Evaluation of capital budgets. 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. The Managerial economist helps the businessman or the manager in arriving at correct decisions. quality. • Briefing the management on current domestic and global economic issues and challenges. • Advising on pricing.A Managerial economist is an economic adviser to a firm or businessman. • Assisting the business planning process of the firm. cost. the business economist while helping in the decision making process. such as: • Demand estimation and forecasting. • Analysis of the market survey to determine the nature and extent of competition. has to take a number of decisions which are vital to the survival and growth of the business. • Discovering new and possible fields of business endeavour and its cost-benefit analysis as well as feasibility studies. Most models may be prediction oriented. • Building micro and macro economic models of particular aspects of the firm’s activities that are useful in solving specific business problems. Such decisions may pertain to the nature of the product to be produced. A firm or entrepreneur. In short. price and its distribution. He is an effective model builder. renewal of worn out equipments and machinery. He deals with the business problems in a sharp manner with a deep probing. • Preparation of business forecasts. Indeed a business economist is greatly helpful to the management by virtue of his studies of economic analysis. Forecasting is a fundamental activity of the Managerial economist. A Managerial economist in a business firm may carry on a wide range of duties. to provide forecasts of changes in costs and business conditions based on market research and policy analysis. • Analysing the issues and problems of the concerned industry. • Directing economic research activity. 8 . etc. planning and diversification of business. investment and capital budgeting policies. modernization.
Factors influencing individual demands are: • • • • • • • Price of the products. • General standards of living and spending habits of the people. money or purchasing power) and willingness to pay for it. Consumer’s expectations about future price of the commodity. • Number of buyers in the market and the growth of population. Habits and Preferences. • Age structure and sex ratio of the population. Income of the buyer. Prices are determined on the basis of market demand.DEMAND What is Demand? Demand is the effective desire or wants for a commodity. • Level of taxation and Tax structure. Relative prices of substitute and complementary products. Relative prices of other goods. Market demand is the sum total of individual demand. • Future expectations. • Community’s common habits and scale of preferences. The demand can be expressed as actual and potential. • Customs 9 .e. Tastes. • Inventions and Innovations. Factors influencing Market Demand: • Price of the product. Consumer demand has two levels: a) Individual Demand and b) Market Demand. • Fashions • Climate and weather conditions. • Distribution of Income and Wealth. Market demand serves as a guidepost to producers in adjusting their supplies in a market economy. Advertisement effect. The demand for a product refers to the amount of it which will be bought per unit of time at a particular price. which is backed up by the ability (i.
Dx – Quantity demanded = f (Px) – function of price. Demand Function: At any point in time. Px = Price of X. 3 and suggests that it is downward sloping. Px Price of X) 2 1 10 0 Y . u) Dx = Demand for X. Here all other determining variables are assumed to be constant. Demand function is not the quantity demanded at a given price. without assuming them as constant.• Advertisement and Sales propaganda. demand function is Dx = f (Px. N = Number of buyers u = Unknown other determinants. Ps = Price of Substitute of X. the quantity demanded of a given product (goods or services) depends upon a number of key variables or determinants. keeping only price as variable. Pc = Price of Complementary Goods. but quantity demanded at each level of price. T = Taste of the buyer or preference. b is the slope ( vertical length ÷ horizontal length) of the demand curve. + Ps + Pc + Yd +T. Dx = 20 – of b = functional relationship between P – Price and D – Demand (constant parameter) 5 Linear demand function is expressed as D = a – bP. A. A = Advertising effect. If the demand function is to be stated taking into account all variables. b has minus (-) sign to denote a negative function. a = signifies initial demand irrespective2Px price (constant parameter). N. Dx = 20 – 2Px (Dx is Quantity demanded of X. Yd = Disposable Income. A demand function in mathematical terms expresses the functional relationship between the demand for the product and its various determining variables. Demand is decreasing 4 function of price.
that with a fall in price. No change in the distribution of income and wealth of the community. The price is measured on the Y – axis and Demand on the X. No change in consumer’s preferences. the demand varies inversely to changes in price. No change in the Price of Related Goods. Exceptions to the Law of Demand: Sometimes it may be observed. the higher the price of a commodity. Thus the demand curve is shown as downward sloping. No change in weather conditions. The demand curve in such cases will be typically unusual and will be upward sloping.What is law of demand? What are its exceptions? Why does a Demand Curve slope downward? Law of Demand: Ceteris paribus. sex ratio of the population. demand also falls and with a rise in price. larger the quantity demanded. demand increases. No change in the range of goods available to the consumers. No expectation of Future price changes of shortages. age composition. The downward slope of demand curve implies that the consumer tends to buy more when the price falls. demand also rises. When the price falls.axis. This is apparently contrary to the law of demand. The demand curve is downward sloping indicating an inverse relationship between price and demand. Dx = f (Px). Other things remaining unchanged. 11 . No change in size. No change in government policy. the smaller is the quantity demanded and lower the price. No change in the Fashion. What are the assumptions underlying law of demand? Assumptions underlying the law of demand: No change in Consumer’s income.
In the stock exchange. Change in substitutes. These goods are purchased by few rich people who use them as status symbol. They satisfy the aristocratic desire to preserve the exclusiveness for unique goods. Changes in taste. Speculation: When people are convinced that the price of a particular commodity will rise further. certain commodities are demanded just because they happen to be expensive or prestige goods and have a ‘snob appeal’. Rolls Royce car is another example. pucca rice. Change in population. Reasons for change (increase or decrease) in demand: Change in income. thinking that these goods on ‘sale’ are of inferior quality.There are few such exceptional cases: Giffen Goods: In the case of certain Giffen goods. they will not contract their demand. as against good potatoes. habits and preference. Change in fashions and customs Change in distribution of wealth. Advertisement and publicity persuasion. E. cheap bread. cake. basmati rice and pure ghee. etc. when price falls. When prices of articles like diamonds rise. Change in the value of money.g. people tend to buy more and more when prices are rising and unload heavily when prices start falling. quite often less quantity will be purchased because of the negative income effect and people’s increasing preference for a superior commodity with rise in their real income. 12 . their demand rises. staple foods such as cheap potatoes. on the contrary they may purchase more for profiteering. vegetable ghee. Consumer’s 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. Change in demand of position of complementary goods. Articles of Snob appeal (Veblen effect): Sometimes.
But at this price. Initially these goods are meant to serve the Veblen effect. and the demand may be added up from the new common buyers. 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: 13 . But when these goods are produced in larger quantity. After that the product demand is determined just by its functional utility. five star hotels. Further increase in output will lead to further price reduction. demand is Q2. Though the market demand for such a commodity tends to rise when its price falls. When the price is lowered to P2. the product loses its exclusivity or snob effect and the richer sections exclusive demand will fall. ((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. At high prices. there exists an inherent paradox. The demand curve DD has changing slopes at a and b points. When a prestige good loses its snob value. Change in the level of taxation. So the demand will expand initially. At price P1. The product will now be purchased on account of its functional utility and will be competing in the market with other similar goods. their prices fall. palatial buildings. its market demand from the snobbish buyers will decrease with fall in its price.e. leads to a fall in demand as the brand loses exclusivity appeal. In certain branded goods such as ‘Ray Ban’ or ‘Levis’ products i. business or executive class of air travel. the demand is Q1. Explain Veblen effect and draw up the market demand curve for veblen effect product. It will carry mass appeal to upper middle class. exclusive or designer products. A further reduction of price to P3. there is limited but good demand from the richer sections. the individual demand of the snobbish buyer will fall. Expectation of future changes in price.
the Hicksian scale of preference needs no information as to how much satisfaction is gained but it aims only at knowing whether a consumer’s satisfaction level is greater than. 14 .It is more realistic. It expresses the conditions of consumer equilibrium in a better way: In Marshallian analysis. between the various combinations of two goods. Marshall assumes cardinal measurement of utility. less than or equal to. independent of his income. it is practically measurable. the consumer equilibrium condition is MUx = MUy. 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. which is unrealistic. 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. The replacement of the law of MU by MRS is a positive change in a more scientific manner. Unlike Marshall. considers at least two goods in combination. It uses the concept of scale of preferences with lesser assumptions than the Marshallian concept of utility. On the other hand. It is wider in scope: Marshallian demand theory deals with a single commodity taken exclusively. Px Py In Hicksian analysis. the complementarity’s and substitutability aspects of goods are being explicitly considered in Hicksian analysis. The scale of preference is laid down on the basis of a consumer’s tastes and likings. The indifference curve technique makes an ordinal comparison of utility and the level of satisfaction. the indifference curve approach rests on the principle of diminishing marginal rate of substitution. such assumption is not needed. Thus. It dispenses with the assumption of constant marginal utility of money. In the indifference curve analysis. Marshallian analysis assumes that to the consumer the marginal utility of money remains constant. Hick’s ordinal approach. the equilibrium condition is expressed as MRSxy = Px/Py which is measurable. this condition is impracticable. Since utility cannot be measured numerically.
It assumes transitivity condition. It has limited scope. the price consumption curve enables us to have the bifurcation of price effect into income and substitution effects. It is introspective.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. Thus the unsolved riddle about Giffen goods in the utility analysis is solved by the indifference curve analysis. 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. What are the shortcomings of the indifference curve approach? It does not provide any positive change in the utility analysis. 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 consumer’s typical behavior caused by negative income effect. 15 . It is weak in structure. It examines the Phenomenon of Giffen Paradox. It is not applicable to indivisible goods. In the indifference curve analysis. It represents the law of demand in a broader and more precise way. It retains the Marshallian assumption of diminishing marginal utility: It unrealistically assumes perfect knowledge of utility with the consumer.
Logically.ELASTICITY OF DEMAND Demand usually varies with price. Thus there can be many kinds of elasticity of demand. is termed as the price elasticity of demand. Most important are Price elasticity of demand Income elasticity of demand Cross elasticity of demand Marshallian classification of Price elasticity: 1. however. (e > 1) 3. elasticity of demand means price elasticity of demand. other demand determinants remaining constant. Sometimes the demand is greatly responsive to price changes. It is the ratio of relative change in demand variables to price variables. while at other times. Unit elasticity of demand (e = 1) 2. Elasticity of demand = % change in quantity demanded % change in detriment of demand Unless specified. Elastic demand . Elasticity is the extent of responsiveness to variation.elasticity greater than unity. The extent of variation of demand is not uniform. Inelastic demand – elasticity is less than unity (e<1) Explain with graphs how modern economists have classified price elasticity of demand. A ratio is made of the two variables for measuring the elasticity coefficient. it may be less responsive. Two factors are relevant for measuring the elasticity of demand – a) demand b) the detriment 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. 16 . the concept of elasticity should measure the responsiveness of demand to changes in variables concerned with demand function.
the demand is unit elastic. ∆P = change in price OR Proportionate change in quantity demanded = The above method is also known as percentage method. 17 . ∆Q = change in demand P = Original Price. 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. the total revenue falls. With a rise in price. total revenue also falls.Coeff. Total Revenue (or Total outlay) = Price x Quantity purchased (or sold) According to this method. the elasticity is more than unity. when the ratio is expressed as a percentage. the total revenue also rises and with a fall in price. Q P ΔP Q Q = Original demand. if the total revenue rises. e = %∆Q %∆P Revenue Method: Marshall suggested that the easiest way of ascertaining whether or not the demand is elastic. the demand is less than unity. or with a rise in price. With a fall in price. as demand changes in the same proportion as price.of price elasticity e = % change in quantity demanded % change in price ΔQ ÷ ΔP = ΔQ x P Proportionate change in price. if the total revenue remains unchanged with a change in the price.
it divides the line segment into lower and upper segments. Point elasticity = Lower Segment below the given point Upper segment above the given point. Arc elasticity method: To calculate price elasticity over some portion of the demand curve rather than at a 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. the concept of arc elasticity of demand is used. When a point is plotted on the demand curve. point elasticity rather than arc elasticity is commonly used. 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. ∆ Q = Q2 – Q1 For practical decision making. p2 = new price earc = -----x ---------Q1 original quantity demanded ∆P Q1 + Q2 Q2 new demand ∆ P = P2 – P1. Extend the demand curve to meet the two axes. The formula for arc elasticity is ∆Q P1 + P2 where. 18 . Arc elasticity is measured on a range on the demand curve between two points.Point elasticity method or Geometric Method: The simplest way of explaining the point method is to consider a straight line demand curve. it is better to use arc elasticity measure when price changes more than 5%. P1 is the original price. For all theoretical purposes.
What are the factors influencing elasticity of demand? 1. 11. But with large changes. 3. demand will be elastic. 2. Availability of close substitutes – demand will be elastic. Complementary goods. 5. Influence of habit and custom 9. Possibility of postponement. Recurrence of demand. 6. demand less elastic with small change in price. Nature of the commodity – according to the nature of satisfaction the goods give. Time – less elastic during short periods generally. relatively inelastic. Consumer’s income – demand from low income group will be elastic while from very rich persons. Proportion of expenditure 7. Height of price and range of price change – highly priced goods. 10. 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. 4. Luxury goods are price elastic. 12. % ∆M OR ∆ Q x M Q ∆M or ∆ Q . Goods which are jointly demanded are less elastic. Income elasticity = % change in quantity demanded = em = %∆ Q % change in income. 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. 8. M ∆ M Q 19 . Durability of the commodity.
Ec or e xy = ∆Qx x ∆Py Qx Py = ∆Qx x ∆Py Px Qx Proportionate or percentage change in Proportionate or percentage change in the Advertising or Promotional elasticity of demand: eA = Percentage or proportionate change in sales Percentage or proportionate change in ad expenditure. Cross elasticity of demand : demand for X price of Y. Arc Advertising elasticity: ∆Q x A1 + A2 ∆A Q1 + Q2 What is demand forecasting? Demand forecasting is not a speculative exercise into the unknown. It is based on mathematical laws of probability. But.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. it gives a reliable approximation regarding the possible outcome. It is based on the statistical data about past behavior and empirical relationships of the demand determinants. with a reasonable accuracy. 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. Demand forecasting is an estimate of the future demand. 20 . It cannot be hundred per cent precise. It is essentially a reasonable judgment of future probabilities of the market events based on scientific background.
there should be possibility of changes to be incorporated in the relationships entailed in forecast procedure. Plausibility: It implies management’s understanding of the method used for forecasting. While conducting an opinion poll. Market Survey or Opinion Poll: A market survey is also called an opinion survey or opinion poll. Quickness: It should yield quick results. Its costs must be compared against the benefits of forecasts. For example. Simplicity: A simpler method is always more comprehensive than the complicated one. Flexibility: Not only the forecast is to be maintained up to date. the respondents should be chosen correctly after ascertaining whose opinion is valuable in the matter.What are the criteria of a good forecasting method? Criteria of a good forecasting method: Joel Dean lays down the following criteria of a good forecasting method: Accuracy: Forecast should be accurate as far as possible. Economy: It should involve lesser costs as far as possible. A time consuming method may delay the decision making process. 21 . It is essential for a correct interpretation of the results. in order to estimate the demand for newly designed electric meters. time to time. the opinion of the engineers in the purchase and service departments of electric companies is important and not that of the ultimate consumers who have no say in the matter. Explain the survey methods of demand forecasting. Its accuracy must be judged by examining the past forecasts in the light of the present situation.
(3) cyclical movements which are oscillatory and periodic. under such constraints. selected on the basis of their share in sales (iv) customers visiting retail outlets responded to the questionnaire (v) different strata of general population. The first three are systematic while the last one is unsystematic. (ii) all wholesalers (iii) a few retailers in the city. A time series is dis-aggregated into four components or elements (i) Trend (T) (ii) Seasonal component (S) (iii) Cycle (C) and (iv) an irregular or random component. The multiplicative form can be written in the additive form by taking the log as “log y = log T + log S + log C + log R.1. The project report including the survey had to be completed within 60 days without any financial commitment on the part of the company under study. Representative sample: For conducting a survey. would naturally have its own limitations. Discuss the popular time series analysis techniques used for demand forecasting. selecting a few samples from each group. each with its own character. Within these constraints a sample of 200 persons was collected. confined to a big city. 2. taking a few samples from each. A case: A student was asked to find out the image of a big cotton textile mill as her project. which at one time or the other purchased the products of the mill – regrouped according to age. The results were quite encouraging. Time series analysis: Time series analysis helps to identify: (1) a long-run movement of the variable.” 22 . The residue after eliminating the systematic components falls in random component. In the additive form it is assumed that there is no interaction among the different components whereas in the multiplicative form there is interaction. education and status. (2) seasonal fluctuations which are oscillatory but confined to one year. The degree of the accuracy of the survey would depend upon the representative character of the sample population. These components can be written in two forms additive or multiplicative – T+S+C+R OR TSCR. A percentage of each group can be surveyed in order to get varying opinions. the headquarters of the company. The population was broadly classified into: (i) employees sub-grouped into different strata. income. The student chose the method of stratified sampling. A study. It can then be classified into different groups. The values of the movements are repeated between peaks and troughs. The sample population has to be as representative of the total population as possible. a sample population is selected from the total population.
calculating the trend equation directly may not give the correct results. If the order is changed. The decomposition of time series analysis has certain implicit assumptions: 1) The order of removal should be trend. both the fluctuations are to be removed first in order to attain better accuracy. is to be estimated. seasonal.A common method of decomposition is to calculate the trend and eliminate it from the original series by dividing throughout as TSCR/T. Thus. 2) Effects are independent of each other. Separation of trend and cycle may be dubious as both may be the result of the same set of factors. The decomposition of the time series is an artificial attempt imposed by the analyst. the scheme is seriously deficient. 23 . Irregular variations may outweigh the others and the phenomenon of the business cycle may not be very relevant in a planned economy. in recent years. In the additive form an element is removed by subtracting it from the series. if the growth rate of a variable. as agriculture is subject to both seasonal and cyclical fluctuations. Much depends on the purpose. Because of these shortcomings. but as an explanatory device for isolating different facts. For example. say agricultural production. It is because. changed values will result. in the same way other elements can be separated out. and 3) The trend is linear and the cycle is regular. and cyclical. the deterministic hypothesis underlying the systematic part is open to doubt from the point of view of behavior of economic agents. the emphasis in the study of time series has shifted to analysis of probabilistic processes. Criticism of the Method: These assumptions have been questioned. As a descriptive device this may be adequate.
The most distinguishing factor of monopolistic competition is that the products are all branded and identified. is insignificant. The large number of firms in the same line of production leads to competition. Large number of buyers: 24 . There is no homogeneity of products though they may be similar. There are less chances of collusion between them to eliminate competition and rig prices. as the number is quite large. Competition is keen but impure because there is no homogeneity of products offered. They sell closely related but not identical products. It is essentially competition with differentiated products. Product Differentiation: The firm’s independence under monopolistic competition is attributed to the degree of product differentiation it adopts. The quantity supplied by an individual firm is relatively small compared to the total market shared by all the firms. Monopolistic Competition is a blend of perfect competition and monopoly. In determining pricing and output policy. Following are the main features: Large number of sellers: There are fairly large numbers of sellers. the impact of such an action by an individual firm. How is price-output determined under monopolistic competition? Monopolistic competition as the name suggests entails the attributes of both monopoly and competition. The number of firms being large enough. Through such product differentiation. Thus there is very limited degree of control over the market price by any firm. Discuss. each firm can afford to ignore reaction by rivals.MONOPOLISTIC COMPETITION Q. each seller acquires certain degree of monopoly power.
25 . (2) There is non-price competition in terms of product differentiation and spending on selling costs in order to capture a bigger share of the market. Success in achieving this increase. Hence price competition. But buyers have preference for specific brands. This market situation is more similar to perfect competition than monopoly. where products are homogenous without brand name. This kind of heavy expenditure on sales promotion is because products are identified and differentiated by their brand names unlike in perfect competition.There are numerous buyers. Increase in demand is achieved through advertisement and sales promotional efforts i. These outlays are termed as selling costs. depends on how effective is the product differentiation and preference achieved through advertisement. Two dimensional competition: There are two aspects in monopolistic competition: (1) there cannot be too much variation in price and the product has to be competitively prices. abnormal profits are usually competed away in the long run. There are no barriers. This makes the competition stiff because of close substitutes but with different brand names produced by new entrants. Buying here is by choice not by chance. There is unrestricted entry of new firms into the group till it reaches complete equilibrium. Buyers are literally patrons of a particular seller. needing no advertisement at all and firms experiencing perfectly elastic demand curves. Free entry: Entry and exit of buyers is freely possible. Selling costs: Advertising and other forms of sales promotion are an integral part of monopolistic competition.e. by increase in selling costs. Firms will seek to realize pure economic profits once again by advertising and innovation in products and processes resorting to nonprice competition – competition in product variation as well as increase in advertising expenditure. Selling efforts are required to affect a shift in demand in order to capture a better share of the market. Owing to unrestricted entry of new firms.
Textiles. This causes change in demand conditions and other factors associated with the process of group equilibrium. “A firm under monopolistic competition is a price maker”. Soaps and Detergents. the firm can adopt an independent price policy with least consideration for the varieties produced and the prices charged by other 26 . products of each firm. “A firm under monopolistic competition is a price maker. when price is the only variable factory. Electronics. We cannot conceive of an industry – such as automobile or bicycle industry in an analytical sense – in the monopolistic competition. Price determination in the short run: In the short run. Automobiles. Paper.The Group: The firms involved in monopolistic competition are termed as “group” and not “industry”. Cosmetics. Cement. In reality. Firms produce similar but not identical goods. Footwear. The market share of an individual firm in the total market of all the firms in the group is insignificant to cause any serious effect on the market share of others by any downward price revision by the firm to increase the market share. The firm has to determine a suitable price for its product which yields maximum total profit. Q. There are a variety of product groups such as . is similar to pure monopoly. is identifiable and each firm is an industry in itself. however. A group is a cluster of firms producing very related but differentiated products. Assuming a given variety of products and constant selling outlays. Foods and Beverages. Metals and Metal Products. a major difference is noticeable in the equilibrium process. short run analysis of price adjustment. due to entry of new firms competing away the abnormal profits. Drugs and Chemicals. Construction etc. Computers. major companies control a large number of products over a wide spectrum of the industrial economy. In the long run. Monopolistic competition is characterized by product differentiation. Confectionery. On account of product differentiation. Explain how price is determined under monopolistic competition. just like a monopoly form. there is pricing problem. Unlike perfect competition.
The demand curve of a firm in monopolistic competition is more elastic than in pure monopoly. The firm being rational in determining the price will seek to maximize the total profits. There is a definite demand schedule as the quality of the product is given. The degree of elasticity depends on the number of firms in the group and the extent of product differentiation. while it will be less elastic if the number is small. standardized products will tend to have more or less identical demand and cost conditions. No doubt these assumptions very much simplify the model but they are not altogether unrealistic. So the demand curve or sales curve is downward sloping. In the case of retail shops such as provision stores and chemist shops. If the number of firms is large. Figure: We have assumed the case of a firm with hypothetical cost and revenue data in a monopolistically competitive market. the demand will be highly elastic. In order to maximize its total profits in the short run. 27 . as their product differentiation is confined to only location differences. the firm produces that level of output at which marginal cost is equal to marginal revenue (MC = MR). For simplicity sake. Equilibrium output is determined at the point of intersection of MR and MC. These are bold assumptions made by Chamberlin.producers. it is assumed that demand and cost conditions are identical for all the firms in the group. The product is differentiated.
the firms may be producing either homogenous products or product differentiation in a given line of production. as the group is open. Consequently. The following are the distinguishing features of an oligopolistic market:• Few Sellers: Homogeneous or differentiated products supplied by a few firms.Equilibrium point E is determined where SMC = SMR. competition in product variation as well as by increasing their advertising expenditure (selling costs). manufacture of electrical appliances etc.e. the firm will earn only normal profits. The oligopoly model fits well into such industries as automobile. monopoly profits are usually competed away in the long run. On account of rivals’ entry. Firms consider the possible action and reaction of its competitors while making changes in price or output. in the long run. firms will resort to non-price competition i. OLIGOPOLY Oligopoly is a market situation comprising only a few firms in a given line of production. in our country. OP price. some new firms will be attracted to enter the business. • High cross elasticity’s: Firms under oligopoly have high degree of cross elasticity’s and are always in fear of retaliation by rivals. OQ output. The price and output policy of oligopolistic firms are interdependent. Owing to the unrestricted entry of new firms. Price determination in the Long-run: When firms earn super-normal profits in the short-run. • Interdependence: Firms have a high degree of dependence in their business policies. 28 . Gradually. price and output fixation. Monopolistic competition implies severe competition between a large numbers of firms producing close substitute products. In an Oligopolistic market. Hence this market situation is more similar to perfect competition than monopoly. ٱPABC profit. the share of the firm in the total market will be reduced due to competition from an increasing number of close substitutes.
firms in an oligopolistic market. • Lack of uniformity: There is lack of uniformity in the size of different oligopolies.• Each firm tries to attract customers towards its product by incurring excessive advertisement expenditure. • Lack of certainty: In oligopolistic competition firms have two conflicting motives – 1) to remain independent in decision making and 2) to maximize profits despite being interdependent. • Price rigidity: Each firm sticks to its own price due to constant fear of retaliation from rivals in case of reduction in price. To pursue these ends. 29 . KINKED DEMAND HYPOTHESIS OF AN OLIGOPOLY MARKET: The kinked Demand Curve or the Average Revenue Curve of an Oligopoly Firm. has two segments: 1) the relatively elastic segment and (2) relatively inelastic segment. • Kinked Demand Curve: According to Paul Sweezy. they act and react to the price-output variation of one another in an unending atmosphere of uncertainty. • Constant struggle: Competition in Oligopoly consists of constant struggle of rivals against rivals and is unique. It is only under oligopoly that advertising comes fully into its own. have a kinky demand curve for their products. The firm rather resorts to non-price competition by advertising heavily.
The kinked average revenue curve in turn. the price output combination at the kink tends to remain unchanged even though marginal cost may change.OUTPUT Corresponding To the given price OP. He thinks it worthwhile to follow the prevailing price and not to make any change. The firm’s marginal cost curve can fluctuate between MC1 and MC2 within the range of the gap in the MR curve without disturbing the equilibrium price and output position of 30 . Thus. In an oligopolistic market. would contract sales considerably as demand tends to be more elastic to change in price. The price rigidity is on account of price interdependence indicated by the kinked demand curve. Kink implies an abrupt change in the slope of the demand curve. Lower of price. whether by collusion or by price leadership or through some formal agreement. once a general price level is reached. Demand curve is flatter before the kink and steeper after the kink. implies a discontinuous marginal revenue curve MA – BR. the kinky marginal revenue curve explains the phenomenon of price rigidity in the theory of oligopoly prices. it tends to remain unchanged over a long period of time. rising of price. In this case. An important point involved in kinked demand curve is that it accounts for the kinked average revenue curve to the oligopoly firm. will lead to retaliation from rivals owing to close interdependence of price-output movement in the oligopolistic market. The kink indicates the indeterminateness of the course or demand for the product of the seller concerned. there is a kink at point K on the demand curve DD. seller will not expect much rise in sales because of price reduction. on the other hand. while KD is the inelastic segment of the curve. DK is the elastic segment. Hence. Discontinuity of the oligopoly firm’s marginal revenue curve at the point of equilibrium price.
PERFECT COMPETION What are the features of perfect competition? Explain. The price remains the same at the level of OP. 31 . Iso-quant curve can be easily labeled. as physical units out output are measurable. Difference between Iso-quant curve and Indifference curve 1. Indifference curve refers to two commodities. ‘quant’ stands for ‘quantity’.the firm. Iso-quant measures a quantum of production resulting from alternative combination of two variable inputs. 2. All these curves together form the Iso-quant map. What are ISOquants? What are their properties? What is the difference between ISOquant curve and Indifference curve? ‘ISO’ means ‘equal’. So it cannot be labeled. and output OQ. Iso-quant curve relates to combination of two factors of production. Is-quant curve indicates quantity of output. No numerical measurement of satisfaction is possible. The equal product curve is called Iso-quant or ‘production iso-quant’. A number of curves can be drawn for different specific quantities of output. It signifies a definite measurable quantity of output. Each Iso-quant curve stands for a specific quantity of output. 3. Indifference curve indicates level of satisfaction. despite change in the margin costs. It represents all the combinations of two factor inputs which produce a given quantity of product.
MRTS measures the rate of reduction in one factor for an additional unit of another factor in combination for producing the same quantity of output. The convexity of the isoquant curve suggests that MRTS is diminishing. keeping the output constant. Since it is not possible to produce a product with a single factor. which give the same level of output. At each point on the iso-quant curve. we get a combination of two factors. when quantity of one factor is increased. the end portion of the curves are regarded as uneconomical and the curves are oval shaped. Isoquants do not intercept either X or Y axis. that of the other is decreased. If two Isoquants intersect each other. we can measure the exact difference between quantities represented by one curve and another. In such cases. Each Isoquant represents a specific quantum of output. But in Iso-quant map. 32 . Tangents of Iso-quants in an Iso-quant map represent the loci of equilibrium when different quantities of output are produced by the firm at minimum costs under the situation of two variable factor-inputs with their fixed price ratio. when the amount of one factor is increased. If an Isoquant touches any axis. The extent of difference of satisfaction is not quantifiable in the Indifference map. If relatively small amount of one factor is combined with relatively large amount of another factor. meaning. The slope of the isoquant measures the marginal rate of technical substitution of one factor input (say labour) for the other factor inpur (say capital). it would lead to a logical contradiction as Isoquant representing a smaller quantity cannot be on a line representing a larger quantity. Isoquants do not meet either axis. Properties of Iso-quants: Isoquants have a negative slope. Isoquants are convex to the origin. In order to maintain one level of output. the less of another factor will be given up. marginal productivity tends to be negative resulting in decline in total output. it means that any one factor can be taken as zero. Iso-quant is an oval shape curve.4. Iso-quants do not intersect.
33 .Solved Problem in Isoquants: Refer to Problems.
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