MANAGERIAL ECONOMICS

Name Roll No. Program Subject Code Learning Centre

RATI BHAN 511022630 MBA Managerial Economics [Set 1] MB0042 IICM KINGSWAY CAMP

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Q1. Mention the demand function. What is elasticity of demand? Describe the determinants of elasticity of demand. Demand Function: The demand for a product or service is affected by its price, the income of the individual, the price of other substitutes, population, and habit. Hence we can say that demand is a function of the price of the product, and others as mentioned above. Demand function is a comprehensive formulation which specifies the factors that influence the demand for a product. Mathematically, a demand function can be represented in the following manner. Dx = f (Px, Ps, Pc, Ep, Y, Ey, T, W, A, U….etc) Where Dx = Demand for commodity X Pc = Price of the complements T = Tastes and preferences Ps = Price of substitutes Px = Price of a commodity X Y = Income of the consumer A = Advertisement and its impact Ep = Expected future price

Ey= Expected income in the future W= Wealth of the consumer U = All other determinants Elasticity of demand In economics the term elasticity refers to a ratio of the relative changes in two quantities. It measures the responsiveness of one variable to the changes in another variable. Elasticity of demand is generally defined as the responsiveness or sensitiveness of demand to a given change in the price of a commodity. It refers to the capacity of demand either to stretch or shrink to a given change in price. Elasticity is an index of reaction. Elasticity of demand indicates a ratio of relative changes in two quantities.ie, price and demand.

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According to professor Boulding: “Elasticity of demand measures the responsiveness of demand to changes in price”. In the words of Marshall,” The elasticity (or responsiveness) of demand in a market is great or small according to as the amount demanded much or little for a given fall in price, and diminishes much or little for a given rise in price” Different Degree of Price Elasticity of Demand Perfectly Elastic Demand: In this case, a very small change in price leads to an infinite change in demand. The demand curve is a horizontal line and parallel to OX axis. The numerical coefficient of perfectly elastic demand is infinity (ED=infinity)

Perfectly Inelastic Demand : In this case, whatever may be the change in price, quantity demanded will remain perfectly constant. The demand curve is a vertical straight line and parallel to OY axis. Quantity demanded would be 10 units, irrespective of price changes from Rs. 10.00 to Rs. 2.00. Hence, the numerical coefficient of perfectly inelastic demand is zero. ED = 0

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Relative Elastic Demand: In this case, a slight change in price leads to more than proportionate change in demand. One can notice here that a change in demand is more than that of change in price. Hence, the elasticity is greater than one. For e.g., price falls by 3 % and demand rises by 9 %. Hence, the numerical coefficient of demand is greater than one.

Relatively Inelastic Demand: In this case, a large change in price, say 8 % fall price, leads to less than proportionate change in demand, say 4 % rise in demand. One can notice here that change in demand is less than that of change in price. This can be represented by a steeper demand curve. Hence, elasticity is less than one.

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In all economic discussion, relatively elastic demand is generally called as ‘elastic demand’ or ‘more elastic’ demand while relatively inelastic demand is popularly known as ‘inelastic demand’ or ‘less elastic demand’. Unitary elastic Demand: In this case, proportionate change in price leads to equal proportionate change in demand. For e.g., 5 % fall in price leads to exactly 5 % increase in demand. Hence, elasticity is equal to unity. It is possible to come across unitary elastic demand but it is a rare phenomenon.

Out of five different degrees, the first two are theoretical and the last one is a rare possibility. Hence, in all our general discussion, we make reference only to two terms relatively elastic demand and relatively inelastic demand.

Determinants of Elasticity of Demand: The elasticity of demand depends on several factors of which the following are some of the important ones. 1. Nature of the Commodity Commodities coming under the category of necessaries and essentials tend to be inelastic because people buy them whatever may be the price. For example, rice, wheat, sugar, milk, vegetables etc. on the other hand, for comforts and luxuries, demand tends to be elastic e.g., TV sets, refrigerators etc. 2. Existence of Substitutes Substitute goods are those that are considered to be economically interchangeable by buyers. If a commodity has no substitutes in the market, demand tends to be inelastic because people have to pay higher price RATI BHAN, MBA (1ST SEM), SUBJECT CODE-MB042, SET-1Page 5 8/10/2010

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for such articles. For example, salt, onions, garlic, ginger etc. In case of commodities having different substitutes, demand tends to be elastic. For example, blades, tooth pastes, soaps etc. 3. Number of uses for the commodity Single-use goods are those items which can be used for only one purpose and multiple-use goods can be used for a variety of purposes. If a commodity has only one use (singe use product) then demand tends to be inelastic because people have to pay more prices if they have to use that product for only one use. For example: all kinds of eatables, seeds, fertilizers, pesticides etc. On the contrary, commodities having several uses, demand tends to be elastic. For example, coal, electricity, steel etc. 4. Durability and reparability of a commodity Durable goods are those which can be used for a long period of time. Demand tends to be elastic in case of durable and repairable goods because people do not buy them frequently. For example, table, chair, vessels etc. On the other hand, for perishable and non-repairable goods, demand tends to be inelastic e.g., milk, vegetables, electronic watches etc. 5. Possibility of postponing the use of a commodity In case there is no possibility to postpone the use of a commodity to future, the demand tends to be inelastic because people have to buy them irrespective of their prices. For example: medicines. If there is possibility to postpone the use of a commodity, demand tends to be elastic e.g., buying a TV set, motor cycle, washing machine or a car etc. 6. Level of Income of the people Generally speaking, demand will be relatively inelastic in case of rich people because any change in market price will not alter and affect their purchase plans. On the contrary, demand tends to be elastic in case of poor. 7. Range of Prices There are certain goods or products like imported cars, computers, refrigerators, TV etc, which are costly in nature. Similarly, a few other goods like nails; needles etc. are low priced goods. Hence, demand for them is inelastic in nature. However, commodities having normal prices are elastic in nature. 8. Proportion of the expenditure on a commodity RATI BHAN, MBA (1ST SEM), SUBJECT CODE-MB042, SET-1Page 6 8/10/2010

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When the amount of money spent on buying a product is either too small or too big, in that case demand tends to be inelastic. For example, salt, newspaper or a site or house. On the other hand, the amount of money spent is moderate; demand in that case tends to be elastic. For example, vegetables and fruits, cloths, provision items etc. 9. Habits When people are habituated for the use of a commodity, they do not care for price changes over a certain range. For example: in case of smoking, drinking, use of tobacco etc. In that case, demand tends to be inelastic. If people are not habituated for the use of any products, then demand generally tends to be elastic. 10. Period of time Price elasticity of demand varies with the length of the time period. Generally speaking, in the short period, demand is inelastic because consumption habits of the people, customs and traditions etc. do not change. On the contrary, demand tends to be elastic in the long period where there is possibility of all kinds of changes. 11. Level of Knowledge Demand in case of enlightened customer would be elastic and in case of ignorant customers, it would be inelastic. 12. Existence of complementary goods Goods or services whose demands are interrelated, such that, an increase in the price of one of the products, results in a fall in the demand for the other. For example, pen and ink, vehicles and petrol, shoes and socks etc have inelastic demand for this reason. If a product does not have complements, in that case demand tends to be elastic. For example, biscuits, chocolates, ice creams etc. In this case the use of a product is not linked to any other products. 13. Purchase frequency of a product If the frequency of purchase is very high, the demand tends to be inelastic. For e.g., coffee, tea, milk, match box etc. on the other hand, if people buy a product occasionally, demand tends to be elastic. For example, durable goods like radio, tape recorders, refrigerators etc. Q2. How is demand forecasting useful for managers? RATI BHAN, MBA (1ST SEM), SUBJECT CODE-MB042, SET-1Page 7 8/10/2010

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In the short run: Demand forecasts for short periods are made on the assumption that the company has a given production capacity and the period is too short to change the existing production capacity. Generally it would be one year period. Production planning: It helps in determining the level of output at various periods and avoiding under or over production. Helps to formulate right purchase policy: It helps in better material management of buying inputs and control its inventory level, which cuts down cost of operation. Helps to frame realistic pricing policy: A rational pricing policy can be formulated to suit short run and seasonal variations in demand. Sales forecasting: It helps the company to set realistic sales targets for each individual salesman and for the company as a whole. Helps in estimating short run financial requirements: It helps the company to plan the finances required for achieving the production and sales targets. The company will be able to raise the required finance well in advance at reasonable rates of interest. Reduce the dependence on chances: The firm would be able to plan its production properly and face the challenges of competition efficiently. Helps to evolve a suitable labor policy: A proper sales and production policy, helps to determine the exact number of laborers to be employed, in the short run. In the long run: Long run forecasting of probable demand for a product of a company is generally for a period of 3 to 5 or 10 years. Business planning: It helps to plan expansion of the existing unit or a new production unit. Capital budgeting of a firm is based on long run demand forecasting. Financial planning: It helps to plan long run financial requirements and investment programs by floating shares and debentures in the open market. RATI BHAN, MBA (1ST SEM), SUBJECT CODE-MB042, SET-1Page 8 8/10/2010

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Manpower planning: It helps in preparing long term planning for imparting training to the existing staff and recruit skilled and efficient labor force for its long run growth. Business control: Effective control over total costs and revenues of a company helps to determine the value and volume of business. This in its turn helps to estimate the total profits of the firm. Thus it is possible to regulate business effectively to meet the challenges of the market. Determination of the growth rate of the firm: A steady and well conceived demand forecasting determine the speed at which the company can grow. Establishment of stability in the working of the firm: Fluctuations in production cause ups and downs in business which retards smooth functioning of the firm. Demand forecasting reduces production uncertainties and help in stabilizing the activities of the firm. Indicates interdependence of different industries: Demand forecasts of particular products become the basis for demand forecasts of other related industries, e.g., demand forecast for cotton textile industry supply information to the most likely demand for textile machinery, color, dye-stuff industry etc., More useful in case of developed nations: It is of great use in industrially advanced countries where demand conditions fluctuate much more than supply conditions. Q3. Explain production function. How is it useful for business?

Production Function “A production Function” expresses the technological or engineering relationship between physical quantity of inputs employed and physical quantity of outputs obtained by a firm. It specifies a flow of output resulting from a flow of inputs during a specified period of time. It may be in the form of a table, a graph or an equation specifying maximum output rate from a given amount of inputs used. Since it relates inputs to outputs, it is also called “Input-output relation.” The production is purely physical in nature and is RATI BHAN, MBA (1ST SEM), SUBJECT CODE-MB042, SET-1Page 9 8/10/2010

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determined by the quantum of technology, availability of equipments, labor, and raw materials, and so on employed by a firm. A production function can be represented in the form of a mathematical model or equation as Q = f (L, N, K….etc) where Q stands for quantity of output per unit of time and L N K etc are the various factor inputs like land, capital, labor etc which are used in the production of output. The rate of output Q is thus, a function of the factor inputs L N K etc, employed by the firm per unit of time. Factor inputs are of two types 1. Fixed Inputs. Fixed inputs are those factors the quantity of which remains constant irrespective of the level of output produced by a firm. For example, land, buildings, machines, tools, equipments, superior types of labor, top management etc. 2. Variable inputs. Variable inputs are those factors the quantity of which varies with variations in the levels of output produced by a firm For example, raw materials, power, fuel, water, transport and communication etc. The distinction between the two will hold good only in the short run. In the long run, all factor inputs will become variable in nature. Short run is a period of time in which only the variable factors can be varied while fixed factors like plants, machineries, top management etc would remain constant. Time available at the disposal of a producer to make changes in the quantum of factor inputs is very much limited in the short run. Long run is a period of time where in the producer will have adequate time to make any sort of changes in the factor combinations. It is necessary to note that production function is assumed to be a continuous function, i.e. it is assumed that a change in any of the variable factors produces corresponding changes in the output. Generally speaking, there are two types of production functions. They are as follows. 1. Short Run Production Function In this case, the producer will keep all fixed factors as constant and change only a few variable factor inputs. In the short run, we come across two kinds of production functions:

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1. Quantities of all inputs both fixed and variable will be kept constant and only one variable input will be varied. For example, Law of Variable Proportions. 2. Quantities of all factor inputs are kept constant and only two variable factor inputs are varied. 2. Long Run Production Function In this case, the producer will vary the quantities of all factor inputs, both fixed as well as variable in the same proportion. Each firm has its own production function which is determined by the state of technology, managerial ability, organizational skills etc of a firm. If there are any improvements in them, the old production function is disturbed and a new one takes its place. It may be in the following manner – 1. The quantity of inputs may be reduced while the quantity of output may remain same. 2. The quantity of output may increase while the quantity of inputs may remain same. 3. The quantity of output may increase and quantity of inputs may decrease. Uses of Production Function Though production function may appear as highly abstract and unrealistic, in reality, it is both logical and useful. It is of immense utility to the managers and executives in the decision making process at the firm level. There are several possible combinations of inputs and decision makers have to choose the most appropriate among them. The following are some of the important uses of production function. 1. It can be used to calculate or work out the least cost input combination for a given output or the maximum output-input combination for a given cost. 2. It is useful in working out an optimum, and economic combination of inputs for getting a certain level of output. The utility of employing a unit of variable factor input in the production process can be better judged with the help of production function. Additional employment of a variable factor input is desirable only when the marginal revenue productivity of that variable factor input is greater than or equal to cost of employing it in an organization. 3. Production function also helps in making long run decisions. If returns to scale are increasing, it is wise to employ more factor units and increase RATI BHAN, MBA (1ST SEM), SUBJECT CODE-MB042, SET-1Page 11 8/10/2010

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production. If returns to scale are diminishing, it is unwise to employ more factor inputs & increase production. Managers will be indifferent whether to increase or decrease production, if production is subject to constant returns to scale. Thus, production function helps both in the short run and long run decision – making process.

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Q4. How do external and internal economies affect returns to scale?

Economies of Scale The study of economies of scale is associated with large scale production. Today there is a general tendency to organize production on a large scale basis. Large scale production is beneficial and economical in nature. “The advantages or benefits that accrue to a firm as a result of increase in its scale of production are called ‘Economies of Scale’. They help in reducing production cost and establishing an optimum size of a firm. Thus, they help a lot and go a long way in the development and growth of a firm. According to Prof. Marshall these economies are of two types, viz Internal Economies and External Economics. I. Internal Economies or Real Economies Internal Economies are those economies which arise because of the actions of an individual firm to economize its cost. They arise due to increased division of labor or specialization and complete utilization of indivisible factor inputs. Prof. Cairncross points out that internal economies are open to a single factory or a single firm independently of the actions of other firms. They arise on account of an increase in the scale of output of a firm and cannot be achieved unless output increases. The following are some of the important aspects of internal economies. 1. They arise “with in” or “inside” a firm. 2. They arise due to improvements in internal factors. 3. They arise due to specific efforts of one firm. 4. They are particular to a firm and enjoyed by only one firm. 5. They arise due to increase in the scale of production. 6. They are dependent on the size of the firm. 7. They can be effectively controlled by the management of a firm. 8. They are called as “Business Secrets “of a firm. Kinds of Internal Economies: 1. Technical Economies RATI BHAN, MBA (1ST SEM), SUBJECT CODE-MB042, SET-1Page 13 8/10/2010

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These economies arise on account of technological improvements and its practical application in the field of business. Economies of techniques or technical economies are further subdivided into five heads.

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a) Economies of superior techniques: These economies are the result of the application of the most modern techniques of production. When the size of the firm grows, it becomes possible to employ bigger and better types of machinery. The latest and improved techniques give place for specialized production. It is bound to be cost reducing in nature. For example, cultivating the land with modern tractors instead of using age old wooden ploughs and bullock carts, use of computers instead of human labor etc. b) Economies of increased dimension: It is found that a firm enjoys the reduction in cost when it increases its dimension. A large firm avoids wastage of time and economizes its expenditure. Thus, an increase in dimension of a firm will reduce the cost of production. For example, operation of a double decker instead of two separate buses. c) Economies of linked process: It is quite possible that a firm may not have various processes of production with in its own premises. Also it is possible that different firms through mutual agreement may decide to work together and derive the benefits of linked processes, for example, in diary farming, printing press, nursing homes etc. d) Economies arising out of research and by – products: A firm can invest adequate funds for research and the benefits of research and its costs can be shared by all other firms. Similarly, a large firm can make use of its wastes and by-products in the most economical manner by producing other products. For example, cane pulp, molasses, and bagasse of sugar factory can be used for the production of paper, varnish, distilleries etc. e) Inventory Economies. Inventory management is a part of better materials management. A big firm can save a lot of money by adopting latest inventory management techniques. For example, Just-In-Time or zero level inventory techniques. The rationale of the Just-In-Time technique is that instead of having huge stocks worth of lakhs and crores of rupees, it can ask the seller of the inputs to supply them just before the commencement of work in the production department each day. 2. Managerial Economies: They arise because of better, efficient, and scientific management of a firm. Such economies arise in two different ways. a) Delegation of details: The general manager of a firm cannot look after the working of all processes of production. In order to keep an eye on each production process he has to delegate some of his powers or functions to trained or specialized personnel and thus relieve himself for co-ordination, planning and executing the plans. This will enable him to bring about RATI BHAN, MBA (1ST SEM), SUBJECT CODE-MB042, SET-1Page 15 8/10/2010

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improvements in production process and in bringing down the cost of production. b) Functional Specialization: It is possible to secure economies of large scale production by dividing the work of management into several separate departments. Each department is placed under an expert and the rest of the work is left into the hands of specialists. This will ensure better and more efficient productive management with scientific business administration. This would lead to higher efficiency and reduction in the cost of production.

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3. Marketing or Commercial economies: These economies will arise on account of buying and selling goods on large scale basis at favorable terms. A large firm can buy raw materials and other inputs in bulk at concessional rates. As the bargaining capacity of a big firm is much greater than that of small firms, it can get quantity discounts and rebates. In this way economies may be secured in the purchase of different inputs. A firm can reduce its selling costs also. A large firm can have its own sales agency and channel. The firm can have a separate selling organization, marketing department manned by experts who are well versed in the art of pushing the products in the market. It can follow an aggressive sales promotion policy to influence the decisions of the consumers. 4. Financial Economies They arise because of the advantages secured by a firm in mobilizing huge financial resources. A large firm on account of its reputation, name and fame can mobilize huge funds from money market, capital market, and other private financial institutions at concessional interest rates. It can borrow from banks at relatively cheaper rates. It is also possible to have large overdrafts from banks. A large firm can float debentures and issue shares and get subscribed by the general public. Another advantage will be that the raw material suppliers, machine suppliers etc., are willing to supply material and components at comparatively low rates, because they are likely to get bulk orders. Thus, a big firm has an edge over small firms in securing sufficient funds more easily and cheaply. 5. Labor Economies These economies will arise as a result of employing skilled, trained, qualified and highly experienced persons by offering higher wages and salaries. As a firm expands, it can employ a large number of highly talented persons and get the benefits of specialization and division of labor. It can also impart training to existing labor force in order to raise skills, efficiency and productivity of workers. New schemes may be chalked out to speed up the work, conserve the scarce resources, economize the expenditure and save labor time. It can provide better working conditions, promotional opportunities, rest rooms, sports rooms etc, and create facilities like subsidized canteen, crèches for infants, recreations. All these measures will definitely raise the average productivity of a worker and reduce the cost per unit of output. 6. Transport and Storage Economies RATI BHAN, MBA (1ST SEM), SUBJECT CODE-MB042, SET-1Page 17 8/10/2010

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They arise on account of the provision of better, highly organized and cheap transport and storage facilities and their complete utilization. A large company can have its own fleet of vehicles or means of transport which are more economical than hired ones. Similarly, a firm can also have its own storage facilities which reduce cost of operations. 7. Over Head Economies These economies will arise on account of large scale operations. The expenses on establishment, administration, book-keeping, etc, are more or less the same whether production is carried on small or large scale. Hence, cost per unit will be low if production is organized on large scale. 8. Economies of Vertical integration A firm can also reap this benefit when it succeeds in integrating a number of stages of production. It secures the advantages that the flow of goods through various stages in production processes is more readily controlled. Because of vertical integration, most of the costs become controllable costs which help an enterprise to reduce cost of production. 9. Risk-bearing or survival economies These economies will arise as a result of avoiding or minimizing several kinds of risks and uncertainties in a business. A manufacturing unit has to face a number of risks in the business. Unless these risks are effectively tackled, the survival of the firm may become difficult. Hence many steps are taken by a firm to eliminate or to avoid or to minimize various kinds of risks. Generally speaking, the risk-bearing capacity of a big firm will be much greater than that of a small firm. Risk is avoided when few firms amalgamate or join together or when competition between different firms is either eliminated or reduced to the minimum or expanding the size of the firm. A large firm secures risk-spreading advantages in either of the four ways or through all of them. · Diversification of output Instead of producing only one particular variety, a firm has to produce multiple products. If there is loss in one item, it can be made good in other items. · Diversification of market: Instead of selling the goods in only one market, a firm has to sell its products in different markets. If consumers in one market desert a product, it can cover the losses in other markets. · Diversification of source of supply: Instead of buying raw materials and other inputs from only one source, it is better to purchase them from different sources. If one person fails to supply, a firm can buy from several sources. RATI BHAN, MBA (1ST SEM), SUBJECT CODE-MB042, SET-1Page 18 8/10/2010

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· Diversification of the process of manufacture: Instead adopting only one process of production to manufacture a commodity, it is better to use different processes or methods to produce the same commodity so as to avoid the loss arising out of the failure of any one process. II. External Economies or Pecuniary Economies External economies are those economies which accrue to the firms as a result of the expansion in the output of whole industry and they are not dependent on the output level of individual firms. These economies or gains will arise on account of the overall growth of an industry or a region or a particular area. They arise due to benefit of localization and specialized progress in the industry or region. Prof. Stonier & Hague points out that external economies are those economies in production which depend on increase in the output of the whole industry rather than increase in the output of the individual firm The following are some of the important aspects of external economies. 1. They arise ‘outside’ the firm. 2. They arise due to improvement in external factors. 3. They arise due to collective efforts of an industry. 4. They are general, common & enjoyed by all firms. 5. They arise due to overall development, expansion & growth of an industry or a region. 6. They are dependent on the size of industry. 7. They are beyond the control of management of a firm. 8. They are called as “open secrets” of a firm. Kinds of External Economies 1. Economies of concentration or Agglomeration They arise because in a particular area a very large number of firms which produce the same commodity are established. In other words, this is an advantage which arises from what is called ‘Localization of Industry’. The following benefits of localization of industry is enjoyed by all the firmsprovision of better and cheap labor at low or reasonable rates, trained, educated and skilled labor, transport and communication, water, power, raw materials, financial assistance through private and public institutions at low RATI BHAN, MBA (1ST SEM), SUBJECT CODE-MB042, SET-1Page 19 8/10/2010

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interest rates, marketing facilities, benefits of common repairs, maintenance and service shops, services of specialists or outside experts, better use of byproducts and other such benefits. Thus, it helps in reducing the cost of operation of a firm. 2. Economies of Information These economies will arise as a result of getting quick, latest and up to date information from various sources. Another form of benefit that arises due to localization of industry is economies of information. Since a large number of firms are located in a region, it becomes possible for them to exchange their views frequently, to have discussions with others, to organize lectures, symposiums, seminars, workshops, training camps, demonstrations on topics of mutual interest. Revolution in the field of information technology, expansion in inter-net facilities, mobile phones, e-mails, video conferences, etc. has helped in the free flow of latest information from all parts of the globe in a very short span of time. Similarly, publication of journals, magazines, information papers etc have helped a lot in the dissemination of quick information. Statistical, technical and other market information becomes more readily available to all firms. This will help in developing contacts between different firms. When inter-firm relationship strengthens, it helps a lot to economize the expenditure of a single firm.

3. Economies of Disintegration These economies will arise as a result of dividing one big unit in to different small units for the sake of convenience of management and administration. When an industry grows beyond a limit, in that case, it becomes necessary to split it in to small units. New subsidiary units may grow up to serve the needs of the main industry. For example, in cotton textiles industry, some firms may specialize in manufacturing threads, a few others in printing, and some others in dyeing and coloring etc. This will certainly enhance the efficiency in the working of a firm and cut down unit costs considerably. 4. Economies of Government Action These economies will arise as a result of active support and assistance given by the government to stimulate production in the private sector units. In recent years, the government in order to encourage the development of private industries has come up with several kinds of assistance. It is granting tax-concessions, tax-holidays, tax-exemptions, subsidies, development rebates, financial assistance at low interest rates etc. RATI BHAN, MBA (1ST SEM), SUBJECT CODE-MB042, SET-1Page 20 8/10/2010

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It is quite clear from the above detailed description that both internal and external economies arise on account of large scale production and they are benefits to a firm and cost reducing in nature. 5. Economies of Physical Factors These economies will arise due to the availability of favorable physical factors and environment. As the size of an industry expands, positive physical environment may help to reduce the costs of all firms working in the industry. For example, Climate, weather conditions, fertility of the soil, physical environment in a particular place may help all firms to enjoy certain physical benefits. 6. Economies of Welfare These economies will arise on account of various welfare programs under taken by an industry to help its own staff. A big industry is in a better position to provide welfare facilities to the workers. It may get land at concessional rates and procure special facilities from the local governments for setting up housing colonies for the workers. It may also establish health care units, training centers, computer centers and educational institutions of all types. It may grant concessions to its workers. All these measures would help in raising the overall efficiency and productivity of workers. Q5. Discuss the profit maximization model.?

Profit Maximization Model Profit-making is one of the most traditional, basic and major objectives of a firm. Profit-motive is the driving-force behind all business activities of a company. It is the primary measure of success or failure of a firm in the market. Profit earning capacity indicates the position, performance and status of a firm in the market. In spite of several changes and development of several alternative objectives, profit maximization has remained as one of the single most important objectives of the firm even today. Both small and large firms consistently make an attempt to maximize their profit by adopting novel techniques in business. Specific efforts have been made to maximize output and minimize production and other operating costs. Cost reduction, cost cutting and cost minimization has become the slogan of a modern firm. It is a very simple and unambiguous model. It is the single most ideal model that can explain the normal behavior of a firm. Main propositions of the profit-maximization model RATI BHAN, MBA (1ST SEM), SUBJECT CODE-MB042, SET-1Page 21 8/10/2010

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The model is based on the assumption that each firm seeks to maximize its profit given certain technical and market constraints. The following are the main propositions of the model. 1. A firm is a producing unit and as such it converts various inputs into outputs of higher value under a given technique of production. 2. The basic objective of each firm is to earn maximum profit. 3. A firm operates under a given market condition. 4. A firm will select that alternative course of action which helps to maximize consistent profits 5. A firm makes an attempt to change its prices, input and output quantity to maximize its profit. The model Profit-maximization implies earning profits during a given period of time. highest possible amount of

A firm has to generate largest amount of profits by building optimum productive capacity both in the short run and long run depending upon various internal and external factors and forces. There should be proper balance between short run and long run objectives. In the short run a firm is able to make only slight or minor adjustments in the production process as well as in business conditions. The plant capacity in the short run is fixed and as such, it can increase its production and sales by intensive utilization of existing plants and machineries, having over time work for the existing staff etc. Thus, in the short run, a firm has its own technical and managerial constraints. But in the long run, as there is plenty of time at the disposal of a firm, it can expand and add to the existing capacities build up new plants; employ additional workers etc to meet the rising demand in the market. Thus, in the long run, a firm will have adequate time and ample opportunity to make all kinds of adjustments and readjustments in production process and in its marketing strategies. It is to be noted with great care that a firm has to maximize its profits after taking in to consideration of various factors in to account. They are as follows – 1. Pricing and business strategies of rival firms and its impact on the working of the given firm. RATI BHAN, MBA (1ST SEM), SUBJECT CODE-MB042, SET-1Page 22 8/10/2010

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2. Aggressive sales promotion policies adopted by rival firms in the market. 3. Without inducing the workers to demand higher wages and salaries leading to rise in operation costs. 4. Without resorting to monopolistic and exploitative practices inviting government controls and takeovers. 5. Maintaining the quality of the product and services to the customers. 6. Taking various kinds of risks and uncertainties in the changing business environment. 7. Adopting a stable business policy. 8. Avoiding any sort of clash between short run and long run profits in the business policy and maintaining proper balance between them. 9. Maintaining its reputation, name, fame and image in the market. 10. Profit maximization is necessary in both perfect and imperfect markets. In a perfect market, a firm is a price-taker and under imperfect market it becomes a price-searcher. Assumptions of the model The profit maximization model is based on tree important assumptions. They are as follows – 1. Profit maximization is the main goal of the firm. 2. Rational behavior on the part of the firm to achieve its goal of profit maximization. 3. The firm is managed by owner-entrepreneur. Determination of profit – maximizing price and output Profit maximization of a firm can be explained in two different ways. a) Total Revenue and Total Cost approach. b) Marginal Revenue and Marginal Cost approach. Profits of a firm are estimated by making comparison between total revenue and total costs. Profit is the difference between TR and TC. In other words, RATI BHAN, MBA (1ST SEM), SUBJECT CODE-MB042, SET-1Page 23 8/10/2010

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excess of revenue over costs is the profits. Profit = TR – TC. If TR is equal to TC in that case, there will be break even point. If TR is less than TC, in that case, a firm will be incurring losses. In this case, we take in to account of total cost and total revenue of the firm while measuring profits. It is clear from the following diagram how profit arises when TR is greater than that of TC.

2. MR and MC approach In this case, we take in to account of revenue earned from one unit and cost incurred to produce only one unit of output. A firm will be maximizing its profits when MR= MC and MC curve cuts MR curve from below. If MC curve cuts MR curve from above either under perfect market or under imperfect market, no doubt MR equals MC but total output will not be maximized and hence total profits also will not be maximized. Hence, two conditions are necessary for profit maximization1. MR = MC. 2. MC curve cut MR curve from below. It is clear from the following diagrams.

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Justification for profit maximization 1. Basic objective of traditional economic theory. The traditional economic theory assumes that a firm is owned and managed by the entrepreneur himself and as such he always aims at maximum return on his capital invested in the business. Hence profit-maximization becomes the natural principle of a firm. 2. A firm is not a charitable institution. A firm is a business unit. It is organized on commercial principles. A firm is not a charitable institution. Hence, it has to earn reasonable amount of profits. 3. To predict most realistic price-output behavior. This model helps to predict usual and general behavior of business firms in the real world as it provides a practical guidance. It also helps in predicting the reasonable behavior of a firm with more accuracy. Thus, it is a very simple, plain, realistic, pragmatic and most useful hypothesis in forecasting price output behavior of a firm. 4. Necessary for survival It is to be noted that the very existence and survival of a firm depends on its capacity to earn maximum profits. It is a timehonored hypothesis and there is common agreement among businessmen to make highest possible profits both in the short run and long run. 5. To achieve other objectives. In recent years several other objectives have become much more popular and all these objectives have become highly RATI BHAN, MBA (1ST SEM), SUBJECT CODE-MB042, SET-1Page 25 8/10/2010

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relevant in the context of modern business set up. But it is to be remembered that they can be achieved only when a firm is making maximum profits. Criticisms 1. Ambiguous term. The term profit maximization is ambiguous in nature. There is no clear cut explanation whether a firm has to maximize its net profit, total profit or the rate of profit in a business unit. Again maximum amount of profit cannot be precisely defined in quantitative terms. 2. It may not always be possible. Profit maximization, no doubt is the basic objective of a firm. But in the context of highly competitive business environment, always it may not be possible for a firm to achieve this objective. Other objectives like sales maximization, market share expansion, market leadership building its own image, name, fame and reputation, spending more time with members of the family, enjoying leisure, developing better and cordial relationship with employees and customers etc. also has assumed greater significance in recent years. 3. Separation of ownership and management. In many cases, to-day we come across the business units are organized on partnership or joint stock company or cooperative basis. In case of many large organizations, ownership and management is clearly separated and they are run and managed by salaried managers who have their own self interests and as such always profit maximization may not become possible. 4. Difficulty in getting relevant information and data. In spite of revolution in the field of information technology, always it may not be possible to get adequate and relevant information to take right decisions in a highly fluctuating business scenario. Hence, profits may not be maximized. 5. Conflict in inter-departmental goals. A firm has several departments and sections headed by experts in their own fields. Each one of them will have its own independent goals and many a times there is possibility of clashes between the interests of different departments and as such always profits may not be maximized. 6. Changes in business environment. In the context of highly competitive and changing business environment and changes in consumer’s tastes and requirements, a firm may not be able to cope up with the expectations and adjust its policies and as such profits may not be maximized. 7. Growth of oligopolistic firms. In the context of globalization, growth of oligopoly firms has become so common through mergers, amalgamations and takeovers. Leading firms dominate the market and the small firms have to RATI BHAN, MBA (1ST SEM), SUBJECT CODE-MB042, SET-1Page 26 8/10/2010

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follow the policies of the leading firms. Hence, in many cases, there are limited chances for making maximum profits. 8. Significance of other managerial gains. Salaried managers have limited freedom in decision making process. Some of them are unable to forecast the right type of changes and meet the market challenges. They are more worried about their salaries, promotions, perquisites, security of jobs, and other types of benefits. They may lack strong motivations to make higher profits as profits would go to the organization. They may be contented with only satisfactory level of profits rather than maximum profits. 9. Emphasis on non-profit goals. Many organizations give more stress on non-profit goals. From the point of view of today’s business environment, productivity, efficiency, better management, customer satisfaction, durability of products, higher quality of products and services etc. have gained importance to cope with business competition. Hence, emphasis has been shifted from profit maximization to other practical aspects. 10. Aversion to reduction in power. In case of several small business units, the owners do not want to share their powers with many new partners and hence, they try to keep maximum powers in their hands. In such cases, keeping more power becomes more important than profit maximization. 11. Official restrictions over profits of public utilities. Public utilities or public corporations are legally prohibited to make huge profits in many developing countries like India. Thus, it is clear that a firm cannot maximize its profits always. There are many constraints in the background of multiple objectives. Each one of the objectives has its own merits and demerits and a firm has to strike a balance between all kinds of objectives.

Q6. Examine the relationship between revenue concepts and price elasticity of demand. Elasticity of Demand, Average Revenue and Marginal Revenue. There is a very useful relationship between elasticity of demand, average revenue and marginal revenue at any level of output. Elasticity of demand at any point on a consumer’s demand curve is the same thing as the elasticity on the given point on the firm’s average revenue curve. With the help of the point elasticity of demand, we can study the relationship between average revenue, marginal revenue and elasticity of demand at any level of output.

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In the diagram AR and MR respectively are the average revenue and the marginal revenue curves. Elasticity of demand at point R on the average revenue curve = RT/Rt Now in the triangles PtR and MRT. tPR = RMT (right angles) tRP = RTM (corresponding angles) PtR= MRT (being the third angle) Therefore, triangles PtR and MRT are equiangular. Hence RT / Rt = RM / tP In the triangles PtK and KRQ PK = RK PKt = RKQ (vertically opposite) tPK = KRQ (right angles ) Therefore, triangles PtK and RQK are congruent (i.e., equal in all respects). Hence Pt = RQ Elasticity at R = RT / Rt = RM / tP = RM / RQ

It is clear from the diagram that Hence elasticity at R = RM / RM – QM

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It is also clear from the diagram that RM is average revenue and QM is the marginal revenue at the output OM which corresponds to the point R on the average revenue curve. Therefore elasticity at R = Average Revenue / Average Revenue – Marginal Revenue If A stands for Average Revenue, M stands for Marginal Revenue and e stands for point elasticity on the average revenue curve Then e = A / A – M. Thus, elasticity of demand is equal to AR over AR minus MR. By using the above elasticity formula, we can derive the formula for AR and MR separately.

e=

This can be changed into (through cross multiplication)

eA – eM = A bringing A’s together, we have eA – A = eM A ( e – 1 ) = eM A = eM / e – 1 A =M (e / e – 1) Therefore Average Revenue or price = M (e / e – 1) Thus the price (i.e., AR) per unit is equal to marginal revenue x elasticity over elasticity minus one. The marginal revenue formula can be written straight away as M = A ((e – 1) / e) The general rule therefore is: at any output, Average Revenue = Marginal Revenue x (e / e – 1) and Marginal Revenue = Average Revenue x (e – 1 / e) Where, e stands for point elasticity of demand on the average revenue curve. With the help of these formulae, we can find marginal revenue at any point from average revenue at the same point, provided we know the point elasticity of demand on the average revenue curve. Suppose that the price of a product is Rs.8 and the elasticity is 4 at that price. Marginal revenue will be: RATI BHAN, MBA (1ST SEM), SUBJECT CODE-MB042, SET-1Page 29 8/10/2010

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M = A (( e – 1) / e) = 8 (( 4 – 1 / 4) = 8 x 3 /4 = 24 / 4 = 6. Marginal Revenue is Rs. 6. Suppose that the price of a product is Rs.4 and the elasticity coefficient is 2 then the corresponding MR will be: M = A ( ( e-1) / e) = 4 ( ( 2 – 1) / 4) =4x1/4 =4/4 = 1 Marginal revenue is Rs. 1 Suppose that the price of commodity is Rs.10 and the elasticity coefficient at that price is 1 MR will be: M = A ( ( e-1) / e) =10 ( (1-1) /1) =10 x 0/1 =0 Whenever elasticity of demand is unity, marginal revenue will be zero, whatever be the price(or AR). It follows from this that if a demand curve shows unitary elasticity throughout its length the corresponding marginal revenue will be zero throughout, that is, the x axis itself will be the marginal revenue curve. Thus, the higher the elasticity coefficient, the closer is the MR to AR / price. When elasticity coefficient is one for any given price, the corresponding marginal revenue will be zero, marginal revenue is always positive when the elasticity coefficient is greater than one and marginal revenue is always negative when the elasticity coefficient is less than one.

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Kinked Demand curve and the corresponding Marginal Revenue curve

We measure quantity on the x axis and price on the Y axis. The demand curve AD has a kink at point B, thus exhibiting two different characteristics. From A to B it is elastic but from B to D it is inelastic. Because the demand is elastic from A to B a very small fall in price causes a very big rise in demand, but to realize the same increase in demand a very big fall in price is required as the demand curve assumes inelastic shape after point B. The corresponding marginal revenue curve initially falls smoothly, though at a greater rate. In the diagram there is a gap in MR between output 300 and 350. Generally an Oligopolies who faces a kinked demand curve will make a good gain when he reduces the price a little before the kink (point B), but if he lowers the price below B; the rival firms will lower their prices too; accordingly the price cutting firm will not be able to increase its sales correspondingly or may not be able to increase its sales at all. As a result, the demand curve of price cutting firm below B is more inelastic. The corresponding MR curve is not smooth but has a gap or discontinuity between G and L. In certain cases, the kinked demand curve may show a high elasticity in the lower portion of the demand curve beyond the kink and low elasticity in higher portion of the demand curve before the kink Marginal revenue to such a demand curve will show a gap but instead of at a lower level, it will start at a higher level.

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Relationship between AR, MR, TR and Elasticity of Demand In the diagram AR is the average revenue curve, MR is the marginal revenue curve and OD is the total revenue curve. At the middle point C of average revenue curve elasticity is equal to one. On its lower half it is less than one and on the upper half it is greater than one. MR corresponding to the middle point C of the AR curve is zero. This is shown by the fact that MR curve cuts the x axis at Q which corresponds to the point C on the AR curve. If the quantity is greater than OQ it will correspond to that portion of the AR curve where e<1 marginal revenue is negative because MR goes below the x axis. Likewise for a quantity less than OQ, e>1 and the marginal revenue is positive. This means that if quantity greater than OQ is sold, the total revenue will be diminishing and for a quantity less than OQ the total revenue TR will be increasing. Thus the total revenue TR will be maximum at the point H where elasticity is equal to one and marginal revenue is zero.

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