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Summer 2013

Master of Business Administration- MBA Semester 1
MB0042 – Managerial Economics - 4 Credits
Q1. Discuss the practical application of Price elasticity and Income elasticity of demand.
Ans: - Few examples on the practical application of price of elasticity of demand are as follows:
1. Production planning - It helps a producer to decide about the volume of production. If the
demand for his product is inelastic, specific quantities can be produced while he has to produce
different quantities, if the demand is elastic.
2. Helps in fixing the prices of different goods – It helps a producer to fix the price of his product.
If the demand for his product is inelastic, he can fix a higher price and if the demand is elastic, he
has to change a lower price. Thus, price-increase policy is to be followed if the demand is
inelastic in the market and price-decrease policy is to be followed if the demand is elastic.
Similarly, it helps
3. Helps in fixing the rewards for factor inputs – Factor rewards refer to the price paid for their
services in the production process. It helps the producer to determine the rewards for factors of
production. If the demand for any factor unit is inelastic, the producer has to pay higher reward
for it and vice-versa.
4. Helps in determining the foreign exchange rates – Exchange rate refers to the rate at which
currency of one country is converted in to the currency of another country. It helps in the
determination of the rate of exchange between the currencies of two different nations. For e.g. if
the demand for US dollar to an Indian rupee is inelastic, in that case, an Indian has to pay more
Indian currency to get one unit of US dollar and vice-versa.
5. Helps in determining the terms of trade – t is the basis for deciding the ‘terms of trade’
between two nations. The terms of trade implies the rate at which the domestic goods are
exchanged for foreign goods. For e.g. if the demand for Japan’s products in India is inelastic, we
have to pay more in terms of our commodities to get one unit of a commodity from Japan and
vice-versa.
6. Helps in fixing the rate of taxes – Taxes refer to the compulsory payment made by a citizen to
the government periodically without expecting any direct return benefit from it. It helps the
Finance Minister to formulate sound taxation policy of the country. He can impose more taxes on
those goods for which the demand is inelastic and lower taxes if the demand is elastic in the
market.
7. Helps in declaration of public utilities – Public utilities are those institutions which provide
certain essential goods to the general public at economical prices. The government may declare a
particular industry as ‘public utility’ or nationalise it, if the demand for its products is inelastic.
8. Poverty in the midst of plenty – The concept explains the paradox of poverty in the midst of
plenty. A bumper crop of rice or wheat, instead of bringing prosperity to farmers, may actually
bring poverty to them because the demand for rice and wheat is inelastic.

In spite of several changes and development of several alternative objectives. Both small and large firms consistently make an attempt to maximise their profit by adopting novel techniques in business. Thus. profit maximisation has remained as one of the single most important objectives of the firm. basic and major objectives of a firm. it helps a lot in managerial decisions of a firm. .Profit Maximisation Model Profit-making is one of the most traditional. Thus. 4. Profit-motive is the driving force behind all business activities of a company. Practical application of income elasticity of demand Few examples on the practical application of income elasticity of demand are as follows: 1. It is the ideal model to explain the normal behaviour of a firm. Helps in production planning and marketing – The knowledge of Ey is essential for production planning. the concept of price elasticity of demand has great practical application in economic theory.Thus. cost cutting and cost minimisation has become the slogan of a modern firm. in that case. Helps in estimating construction of houses – The rate of growth in incomes of the people also helps in housing programmes in a country. Helps in determining the rate of growth of the firm – If the growth rate of the economy and income growth of the people is reasonably forecasted. It is the primary measure of success or failure of a firm in the market. even today. One should also know whether rise or fall in income is permanent or temporary. In short. etc. it indicates the extent to which demand changes with a variation in consumer’s income. 5. Specific efforts have been made to maximise output and minimise production and other operating costs. Profit earning capacity indicates the position. Helps in ensuring stability in production – Proper estimation of different degrees of income elasticity of demand for different types of products helps in avoiding over-production or under production of a firm. 3. it helps in demand forecasting activities of a firm. formulating marketing strategy. Helps in the demand forecasting of a firm – It can be used in estimating future demand provided that the rate of increase in income and the Ey for the products are known. performance and status of a firm in the market. 2. it is possible to predict expected increase in the sales of a firm and vice-versa. Income elasticity of demand Income elasticity of demand may be defined as the ratio or percentage change in the quantity demanded of a commodity to a given percentage change in the income. Cost reduction. deciding advertising expenditure and nature of distribution channel. in the long run. The profit maximisation model is a very simple and unambiguous model. Q2. Ans :. Explain the profit maximisation model in detail.

input and output quantity to maximise its profit. it may adopt penetration pricing policy i. 3. Describe the objectives of pricing Policies. Maximum profit refers to the highest possible profit. It may follow skimming price policy. Profit maximisation is the main goal of the firm. Pricing policy as an instrument to achieve this objective should be formulated in such a way as to maximise the sales revenue and profit. but also should get excess revenue over costs. Optimum profit refers to the most ideal or desirable level of profit. i. A firm attempts to change its prices. Preventing entry of competition – Firms try to match the prices of their products with those of their rivals to expand the volume of their business. earning the most reasonable or optimum profit has become a part and parcel of a sound pricing policy of a firm in recent years.Main propositions of the profit-maximisation model The model is based on the assumption that each firm seeks to maximise its profit given certain technical and market constraints. Hence.. Maintenance of market share – Market share refers to the share of a firm’s sales of a particular product in the total sales of all firms in the market. 2. A firm is a producing unit which converts various inputs into outputs of higher value. 4. Q3.. Profit optimisation in the long run – The traditional profit maximisation hypothesis may not prove beneficial in the long run. A firm operates under given market conditions. 2. 3. 2. A firm selects that alternative course of action which helps to maximise consistent profits.e. 5. The following are the main propositions of the model: 1. Alternatively. Ans:-The Objectives of Pricing Polices The following objectives are to be considered while fixing the prices of the product: 1.e. They are as follows: 1. by employing certain techniques of production. a firm not only should be able to recover its total costs. charging a very high price when the product is launched to cater to the needs of only a few sections of people. Price stabilisation – Price stabilisation over a period of time is another objective. 4. The economic strength and success of a firm . charging a relatively lower price in the later stages in the long run so as to attract more customers and capture the market. A stable price policy only can win the confidence of customers and may add to the goodwill of the concern. In the short run. Rational behaviour on the part of the firm to achieve its goal of profit maximisation. It builds up the reputation and image of the firm. 5. Profit maximisation in the short term – The primary objective of the firm is to maximise its profits. Assumptions of the model The profit maximisation model is based on three important assumptions. The basic objective of each firm is to earn maximum profit. Most of the firms are not merely interested in meeting competition but are keen to prevent it. 3. The firm is managed by owner-entrepreneur.

sales and capital investment. The targets are set according to the position of the individual firm. Objective of the pricing policy has to be designed in such a way as to fulfil the long run interests of the firm keeping internal conditions and external environment in mind. sometimes. The price set by a firm has to be so attractive that the buyers in other markets have to switch over to the products of the candidate firm. 13. Ability to pay – Pricing decisions are sometimes taken on the basis of the ability to pay of the customers. pricing policy should be based on certain ethical principles. market share expansion. 6. 9. They are laid down on the basis of past experience and future expectations. Deeper penetration is the first step in the direction of capturing and dominating the market in the later stages. diversification in its activities. maintenance of comfortable liquidity position. 12. It may prove beneficial in the long run. firms make special attempts to enter into new markets. there are various other objectives such as promotion of new items. Deeper penetration of the market – The pricing policy has to be designed in such a manner that a firm can make inroads into the market with minimum difficulties. Instead of squeezing customers. 8. Entry into new markets – Apart from growth. Hence. the firm fixes a lower price for its product and at other times. A rational pricing policy should always keep in view the entire product line and maximum total sales revenue from the sale of all products. Although profit is one of the most important objectives. a firm cannot earn it in a moral vacuum. prices of the products are so calculated as to earn the target return on cost of production. 7. Besides these goals. a firm has to charge moderate prices for its products. 10. 11. The pricing policy has to secure reasonable amount of profits to a firm to preserve the interests of the community and promote its welfare. Long run welfare of the firm – A firm has multiple objectives. Hence. maintaining regular . Target profit on the entire product line irrespective of profit level of individual products – The price set by a firm should increase the sale of all the products rather than yield a profit on one product only. higher price can be charged to those who can afford to pay. Capturing the market – Another objective in recent years is to capture the market. Hence. Different target returns may be fixed for different products or brands or markets but. Such a policy is generally followed by those people who supply different types of services to their customers. While setting the prices. Simultaneous achievement of all objectives is necessary for the overall growth of a firm. A product line may be defined as a group of products which have similar physical features and perform generally similar functions. making quick money.is measured in terms of its market share. such returns should be related to a single overall rate of return target. steady working of plants. some moral standards are to be followed. the pricing policy has to assist a firm to maintain its market share. Ethical pricing – Basically. In order to achieve this goal. dominate the market and. Achieving a target return – A predetermined target return on capital investment and sales turnover is another long run pricing objective of a firm. command and control the market in the long run. In a product line. Such a pricing is generally followed in price sensitive markets. Business without ethics is a sin. it may even sell at a loss in the short term.e. i. a proper balance in pricing is required. a few products are regarded as less profit earning products and others are considered as more profit earning..

licence fees. production and employment. Administrative revenues are the bi-products of administrate functions of the government. The amount of new money printed by the government depends on the absorption capacity of the economy. Public expenditure policy: It refers to the expenditure incurred by the public authorities like central. Public debt or public borrowing policy: All loans taken by the government constitutes public debt. 2. On the contrary. escheats and special assessment. It refers to the borrowings made by the government to meet the ever-rising expenditure. 3. It concerns itself with the aggregate effects of government expenditure and taxation on income. when the income declines. which firms may consider while taking pricing decisions. It is classified into two parts . Explain the kinds and the basis of Price discrimination under monopoly. automatic increase in taxes or reduction in transfer payments or government expenditures will tend to moderate the rise in income. Built in stabilisers or automatic stabilisers (BIS): The automatic or built-in stabilisers imply automatic changes in tax collections and transfer payments or public expenditure programmes so that it may reduce the destabilising effect on aggregate effective demand. continued survival. Taxes are the main source of revenue to a government. 5. tax falls automatically and transfers and government expenditure will rise and thus built-in stabilisers cushion the fall in income. Plan expenditure includes income-generating projects like development of basic industries. rapid growth of the firm etc. There are two types of taxes. Instruments of fiscal policy The instruments of fiscal policy include: 1. it refers to the budgetary policy of the government. state and local governments. They are direct taxes such as personal and corporate income tax. interest payments and debt servicing changes. excise duties. It is of two types.income to the company. price of public goods and services.tax-revenue and non-tax revenue. Non-plan expenditure includes defence expenditure. Q4. and the policy related to treasury or government exchequer is known as fiscal policy. Q5. They include fees. development of transport and communications and construction of dams. . Define Fiscal Policy and the instruments of Fiscal policy. public debt or public borrowings. Deficit financing: It is an extraordinary technique of financing the deficits in the budgets. 4. generation of electricity. It implies printing of fresh and new currency notes by the government by running down the cash balances with the central bank. fines. Fiscal policy is a package of economic measures of the Government regarding public expenditure. expenditure tax. It is of two kinds: development or plan expenditure and non-development or non-plan expenditure. public revenue. internal borrowings and external borrowings. subsidies. Public revenue: It refers to the income or receipts of public authorities. property tax.. When income expands. In short. and indirect taxes such as customs duties. sales tax (now called VAT). Ans: .Fiscal Policy Meaning The term “fisc” in English language means “treasury”.

This method is adopted by railway companies. This is the most common type of discrimination followed by a monopolist. 3. Distance Railway companies and other transporters. the markets are divided into many sub-markets or sub-groups. (Basis of price discrimination) 1. The price charged in each case roughly depends on the ability to pay of different subgroups in the market. by asking to pay the maximum he/she is prepared to pay rather than go without the commodity. The monopolist will leave a certain amount of consumer’s surplus with the consumers. prejudices and needs. 6. for example. necessities of life. Different uses of the same commodity When a particular commodity or service is meant for different purposes. 3. the monopolist will not allow any consumer’s surplus to the consumer. Place Markets may be divided on the basis of entry barriers. the monopolist charges different prices for markets of the same commodity. Special orders When the goods are made to order. 2. preferences. different rates may be charged depending upon the nature of consumption. 7. but not at a maximum possible rate but at a lower rate. Personal differences This refers to charging different prices for the same commodity due to personal differences arising out of ignorance and irrationality of consumers. It is as follows: 1. different rates may be charged for the consumption of electricity for lighting. for example. 5. Discrimination of the second degree – In case of discrimination of the second degree. Time Special concessions or rebates may be given during festival seasons or on important occasions. a particular consumer will not know the price charged by the firm for other consumers. Price will be low in the place where there are no taxes or low taxes. Nature of the product Prices charged also depends on the nature of products. For example. the producer exploits the consumers to the maximum possible extent.Ans:. 4. heating and productive purposes in the industry and in agriculture.Kinds of price discrimination: Three kinds of price discrimination are commonly seen. for example. 2. charge lower rates/km if the distance is long and higher rates if the distance is short. Discrimination of the third degree – In case of discrimination of the third degree. it is easy to charge different prices to different customers. . In this case. railways charge higher prices for carrying coal and luxuries and lower prices for cotton. This type of price discrimination is called perfect discrimination. price of goods will be high in the place where taxes are imposed. This is done to keep the consumers satisfied and prevent the entry of potential rivals. etc. In this case. Discrimination of the first degree – Under price discrimination of the first degree.

rising prices. Special classification of consumers For example. 9. . For example. If price differences are minor. ordinary coach and air conditioned coaches. 13. 11. When small quantities are purchased. normal price would be charged. Different brands will be sold at different prices even though there is not much difference in the terms of costs. customers do not bother about such discrimination. special rooms and ordinary rooms in hotels. etc. Urgency of the buyer If a customer is in a hurry. Define the term Business Cycle and also explain the phases of business or trade cycle in brief. higher price would be charged. Different charges for I class and II class traveling. Peak season and off peak season services Hotel and transport authorities charge different rates during peak season and off-peak seasons. Discrimination on the basis of income and wealth For example. 10. But recession and depression imply slackness in growth. Discrimination on the basis of sex In selling certain goods. producers may discriminate between male and female buyers by charging low prices to females. and increasing profits. etc. Age Cinema houses in rural areas and transport authorities charge different rates for adults and children. a doctor may charge higher fees for rich patients and lower fees for poor patients.8. increasing unemployment. Ans: . The firm gains due to rising demand. there is a business boom. 12. Social and/or professional status of the buyer A seller may charge a higher price. The expansionary phase has. 15. dumping – they charge a lower price in the competitive foreign market and a higher price in the protected home market. Otherwise. however. Geographical area Business enterprises may charge different prices at the national and international markets. for those customers who occupy higher positions and have a higher social status and a lower price for others. discount will be allowed by the sellers. output. Preference or brands Certain goods will be sold under different brand names or trademarks in order to attract customers. discount may not be offered. contraction of economic activity. transport authorities such as railways and roadways show concessions to students and daily travelers. During the expansionary phase. 14. Q6.Business Cycles and Business Decisions Business cycles affect the smooth growth of an economy. Business cycles have their effects on individual business firms as well. falling incomes. a favorable impact on income. 16. Quantity of purchase When customers buy large quantities. and employment. 17.

and depression. Apart from these measures. He/she should employ a flexible credit standard and avoid excessive borrowing. capital budgeting. distribution. investment. changes in general price level. A few measures are to be adopted to mitigate the harmful effects of contraction. (4) Adoption of new selling methods. market share. During this period. a businessman/businesswoman may also take up a few important steps in the best interest of the firm. A prudent businessman/businesswoman should adopt all possible precautionary measures to avoid and minimise the business problems as much as possible. marketing. and cyclical changes and the business of the given enterprise. prices of substitutes. But in a capitalist economy. (3) Improvement in quality. pricing. etc. . The firm will have to restructure its advertising policy to suit the circumstances. A business firm should have a comprehensive view of the entire market – internal and external factors affecting the business in order to adopt an efficient business programme and prevent the adverse effects of cyclical changes on business. Business decisions are to be made carefully after assessing the market situation properly. avoid purchase commitments. the phase of the trade cycle through which business is then passing. during the different phases of trade cycles. maintain satisfactory labour conditions. a firm may have to face some adverse effects. (1) Quick liquidation of inventories.Prosperity makes the business firms prosperous. (6) Careful management of the labour force. relation between cyclical changes and general business. etc. a business unit should be extraordinarily cautious. During the phase of contraction. The competition becomes intense. and create a sizable reserve fund. and overexpansion and also avoid excessive inventories of raw materials and finished goods. a firm has to make careful decisions with regard to finance. The rising prices and optimism in the market may encourage many new firms to enter the market and the existing firms to expand their output. in particular. It will have to choose a right pricing policy keeping in view the various factors like changing costs. There must be a strong psychological shift during this period. etc. overproduction. the basic objective is to fight against pessimism and to give a big boost to all kinds of business activities. He should have knowledge of the economic characteristics of the trade cycles and usual sequence of events during such periods. recession. A firm should gear up itself to face the challenges of cyclical changes in a most befitting manner. prosperity digs its own grave. Cyclical price adjustment poses the most challenging job for the firm. Thus. All these may result in raising the cost of production causing a rise in the product price. Increased demand for factors may cause a rise in their prices. The marketing and distribution costs may go up. An expansion in production and sale of goods should be so organised that they take full advantage of the situation without involving themselves into any kind of risk. cyclical movements in production and sales and in the prices of commodities purchased and sold. purchasing. production. During this expansionary period. Various such measures may help a firm in avoiding the harmful effects of business expansion. He/she should avoid overinvestment. He/she should check temporary diversification programme. By adopting a very cautious policy of planning during the period of contraction when all costs are low. (5) Development of new methods of organisation. The demand for investment funds increase. He/she should mainly see that the costs are kept under control. a firm can take up the expansion and extension programmes. (2) Reduction of cost of production.