Great Land College

Department of MBA
Individual Assignment of: Managerial Economics (MBA 662)

Submitted to Mr. Demeke

Name: Elfinesh Alemayehu

ID: GLC/0395/12

June 2020
 1. Managerial Economics in Relation with other Disciplines
      Managerial economics has a close linkage with other disciplines and fields of study. The
subject has gained by the interaction with Economics, Mathematics and Statistics and has
drawn upon Management theory and Accounting concepts. Managerial economics
integrates concepts and methods from these disciplines and brings them to bear on
managerial problems.

Managerial Economics and Economics:

         Managerial Economics is economics applied to decision making. It is a special branch

of economics, bridging the gap between pure economic theory and managerial practice.
Economics has two main branches—micro-economics and macro-economics.

Micro-economics:

                ‘Micro’ means small. It studies the behaviour of the individual units and small
groups of units. It is a study of particular firms, particular households, individual prices,
wages, incomes, individual industries and particular commodities. Thus micro-economics
gives a microscopic view of the economy.

                The roots of managerial economics spring from micro-economic theory. In price
theory, demand concepts, elasticity of demand, marginal cost marginal revenue, the short
and long runs and theories of market structure are sources of the elements of micro-
economics which managerial economics draws upon. It makes use of well known models in
price theory such as the model for monopoly price, the kinked demand theory and the
model of price discrimination.

Macro-economics:

                ‘Macro’ means large. It deals with the behaviour of the large aggregates in the
economy. The large aggregates are total saving, total consumption, total income, total
employment, general price level, wage level, cost structure, etc. Thus macro-economics is
aggregative economics.

                It examines the interrelations among the various aggregates, and causes of
fluctuations in them. Problems of determination of total income, total employment and
general price level are the central problems in macro-economics.

                Macro-economies is also related to managerial economics. The environment, in
which a business operates, fluctuations in national income, changes in fiscal and monetary
measures and variations in the level of business activity have relevance to business
decisions. The understanding of the overall operation of the economic system is very useful
to the managerial economist in the formulation of his policies.

                Macro-economics contributes to business forecasting. The most widely used
model in modern forecasting is the gross national product model.

Managerial Economics and Theory of Decision Making:

                The theory of decision making is relatively a new subject that has a significance
for managerial economics. In the process of management such as planning, organising,
leading and controlling, decision making is always essential. Decision making is an
integral part of today’s business management. A manager faces a number of problems
connected with his/her business such as production, inventory, cost, marketing, pricing,
investment and personnel.

                Economist are interested in the efficient use of scarce resources hence they are
naturally interested in business decision problems and they apply economics in
management of business problems. Hence managerial economics is economics applied in
decision making.

Managerial Economics and Operations Research:

                Mathematicians, statisticians, engineers and others join together and developed
models and analytical tools which have grown into a specialised subject known as
operation research. The basic purpose of the approach is to develop a scientific model of the
system which may be utilised for policy making.

                The development of techniques and concepts such as Linear Programming,
Dynamic Programming, Input-output Analysis, Inventory Theory, Information Theory,
Probability Theory, Queuing Theory, Game Theory, Decision Theory and Symbolic Logic.

Managerial Economics and Statistics:

                Statistics is important to managerial economics. It provides the basis for the
empirical testing of theory. It provides the individual firm with measures of appropriate
functional relationship involved in decision making. Statistics is a very useful science for
business executives because a business runs on estimates and probabilities.

                Statistics supplies many tools to managerial economics. Suppose forecasting has
to be done. For this purpose, trend projections are used. Similarly, multiple regression
technique is used. In managerial economics, measures of central tendency like the mean,
median, mode, and measures of dispersion, correlation, regression, least square, estimators
are widely used.

                Statistical tools are widely used in the solution of managerial problems. For eg.
sampling is very useful in data collection. Managerial economics makes use of correlation
and multiple regression in business problems involving some kind of cause and effect
relationship.

Managerial Economics and Accounting:

                Managerial economics is closely related to accounting. It is recording the finan-
cial operation of a business firm. A business is started with the main aim of earning profit.
Capital is invested / employed for purchasing properties such as building, furniture, etc
and for meeting the current expenses of the business.

                Goods are bought and sold for cash as well as credit. Cash is paid to credit
sellers. It is received from credit buyers. Expenses are met and incomes derived. This goes
on the daily routine work of the business. The buying of goods, sale of goods, payment of
cash, receipt of cash and similar dealings are called business transactions.

                The business transactions are varied and multifarious. This has given rise to the
necessity of recording business transaction in books. They are written in a set of books in a
systematic manner so as to facilitate proper study of their results.

There are three classes of accounts:

(i) Personal account,

(ii) Property accounts, and

(iii) Nominal accounts.

                Management accounting provides the accounting data for taking business
decisions. The accounting techniques are very essential for the success of the firm because
profit maximisation is the major objective of the firm.

Managerial Economics and Mathematics:

               Mathematics is another important subject closely related to managerial
economics. For the derivation and exposition of economic analysis, we require a set of
mathematical tools. Mathematics has helped in the development of economic theories and
now mathematical economics has become a very important branch of economics.

                Mathematical approach to economic theories makes them more precise and
logical. For the estimation and prediction of economic factors for decision making and
forward planning, mathematical method is very helpful. The important branches of math-
ematics generally used by a managerial economist are geometry, algebra and calculus.

                The mathematical concepts used by the managerial economists are the
logarithms and exponential, vectors and determinants, input-out tables. Operations
research which is closely related to managerial economics is mathematical in character.
2.

1. The areas of decision making where managerial economics prescribes specific solutions to
business problems
Managerial economics is concerned with the application of economic theory and methods of decision
sciences to analyze decision-making problems faced by business firms.
The other important decision-making problems facing business firms relate to what methods or
techniques of production are to be used in the production of commodities, and how much
advertisement expenditure is to be incurred for promoting the sales of their products. In deciding
about all these problems, a firm has to decide how it can use its limited resources to achieve its
objective most efficiently.
The resources at the disposal of a firm are scarce or limited. What product to be produced, what price
should be fixed, how much quantity of it should be produced, and what factor combination or
production technique be used for the production of goods involve resource allocation by a firm. It is
the task of a manager of a firm that it should take decisions regarding these resource allocation
problems in a way that ensure most efficient use of resources. Only this will enable the firm to achieve
the goal of maximization of profits.
2. Perfectly Elastic Demand and Perfectly Inelastic Demand
Perfectly Elastic Demand
Price elasticity refers to how the quantity demanded or supplied of a good changes when its price
changes. In other words, it measures how much people react to a change in the price of an item. Price
elasticity of demand refers to how changes to price affect the quantity demanded of a good.
Conversely, price elasticity of supply refers to how changes in price affect the quantity supplied of a
good.

When the percentage change in quantity demanded is infinite even if the percentage change in price is
zero, the demand is said to be perfectly elastic. Endless demand at given price.
If demand is perfectly elastic, it means that at a certain price demand is infinite (A good with a very
high elasticity of demand). In other words, if a firm increased the price by 1%, it would see all its
demand evaporate. If demand is perfectly elastic, then demand will be horizontal.
 Examples of Perfectly Elastic Demand
 Therefore, if one firm increased the price of dollars, above market equilibrium – no one would
buy from that firm. They would buy from cheaper alternatives.
 Similarly, if you are buying potatoes from Covent Garden, it is easy to check prices. Therefore,
if a farmer increases price above the equilibrium, demand will fall significantly meaning
demand is very elastic.
Perfectly Inelastic Demand
Inelastic demand occurs when changes in price cause a disproportionately small change in quantity
demanded. F
When the percentage change in quantity demanded is zero no matter how price is changed, the
demand is said to be perfectly inelastic

3. Discuss the steps to be followed during demand forecast.

Demand or sales forecasting is a scientific exercise. It has to go through a number of steps. At each
step, you have to make critical considerations. Such considerations are categorically listed below:

1) Nature of forecast: To begin with, you should be clear about the uses of forecast data- how it is
related to forward planning and corporate planning by the firm. Depending upon its use, you have to
choose the type of forecasts: short-run or long-run, active or passive, conditional or non-conditional
etc.
2) Nature of product: The next important consideration is the nature of product for which you are
attempting a demand forecast. You have to examine carefully whether the product is consumer
goods or producer goods, perishable or durable, final or intermediate demand, new demand or
replacement demand type etc. A couple of examples may illustrate the importance of this factor. The
demand for intermediate goods like basic chemicals is derived from the final demand for finished
goods like detergents. While forecasting the demand for basic chemicals, it becomes essential to
analyze the nature of demand for detergents. Promoting sales through advertising or price
competition is much less important in the case of intermediate goods compared to final goods. The
elasticity of demand for intermediate goods depends on their relative importance in the price of the
final product.

Time factor is a crucial determinant in demand forecasting. Perishable commodities such as fresh
vegetables and fruits can be sold over a limited period of time. Here skilful demand forecasting is
needed to avoid waste. If there are storage facilities, then buyers can adjust their demand according
to availability, price and income. The time taken for such adjustment varies from product to product.
Goods of daily necessities that are bought more frequently will lead to quicker adjustments. Whereas
in case of expensive equipment which is worn out and replaced after a long period of time, adaptation
of demand will be spread over a longer duration of time.

3) Determinants of demand: Once you have identified the nature of product for which you are to build
a forecast, your next task is to locate clearly the determinants of demand for the product. Depending
on the nature of product and nature of forecasts, different determinants will assume different degree
of importance in different demand functions.

In the preceding unit, you have been exposed to a number of price-income factors or determinants-
own price, related price, own income-disposable and discretionary, related income, advertisement,
price expectation etc. In addition, it is important to consider socio-psychological determinants,
specially demographic, sociological and psychological factors affecting demand. Without considering
these factors, long-run demand forecasting is not possible.

Such factors are particularly important for long-run active forecasts. The size of population, the age-
composition, the location of household unit, the sex-composition-all these exercise influence on
demand in. varying degrees. If more babies are born, more will be the demand for toys; if more
youngsters marry, more will be the demand for furniture; if more old people survive, more will be the
demand for sticks. In the same way buyers’ psychology-his need, social status, ego, demonstration
effect etc. —also effect demand. While forecasting you cannot neglect these factors.

4) Analysis of   factors &determinants: Identifying the determinants alone would not do, their analysis
is also important for demand forecasting. In an analysis of statistical demand function, it is customary
to classify the explanatory factors into (a) trend factors, which affect demand over long-run, (b)
cyclical factors whose effects on demand are periodic in nature, (c) seasonal factors, which are a little
more certain compared to cyclical factors, because there is some regularly with regard to their
occurrence, and (d) random factors which create disturbance because they are erratic in nature; their
operation and effects are not very orderly.

An analysis of factors is especially important depending upon whether it is the aggregate demand in
the economy or the industry’s demand or the company’s demand or the consumers; demand which is
being predicted. Also, for a long-run demand forecast, trend factors are important; but for a short-run
demand forecast, cyclical and seasonal factors are important.

5) Choice of techniques: This is a very important step. You have to choose a particular technique
from among various techniques of demand forecasting. Subsequently, you will be exposed to all such
techniques, statistical or otherwise. You will find that different techniques may be appropriate for
forecasting demand for different products depending upon their nature. In some cases, it may be
possible to use more than one technique. However, the choice of technique has to be logical and
appropriate; for it is a very critical choice. Much of the accuracy and relevance of the forecast data
depends accuracy required, reference period of the forecast, complexity of the relationship postulated
in the demand function, available time for forecasting exercise, size of cost budget for the forecast
etc.

6) Testing accuracy: This is the final step in demand forecasting. There are various methods for
testing statistical accuracy in a given forecast. Some of them are simple and inexpensive, others
quite complex and difficult. This stating is needed to avoid/reduce the margin of error and thereby
improve its validity for practical decision-making purpose. Subsequently you will be exposed briefly to
some of these methods and their uses.

4. Explain the factors influencing the elasticity of supply in the market with an example.
Elastics of supply is a measure of the degree of change in the quantity of the product in response to a
change in its price. The elasticity of supply cannot be the same under all circumstances. This is
because it is influenced by a number of factors. These factors are:

1. Nature of a product
The product’s nature is an important factor that influences the elasticity of supply. For
example, if the commodity is perishable we cannot increase the supply when the price
increase because they can be out of use within short period of time.
2. Production techniques
Production techniques used by organizations also have a great influence on the supply of
their products. E.g. If organizations use the latest techniques of production, the supply can
be faster with respect to the change in the price of products.
3. Time period
It affects the elasticity of supply to a great extent. For instance, in the short run, elasticity
of supply is low due to various factors, such as obsolete production techniques. Therefore,
 changes in prices do not affect the supply of products immediately. If the price remains
high for a longer period, the supply of products is increased.

4. Scale of production: Small scale producer’s supply is inelastic in nature compared to the
large producers. E.g. large scale producer increases their production while the price of the
good increase.
5. Size of the firm and number of products: If the firm is a large scale industry and has more variety
of products then it can easily transfer the resources. Therefore, supply of such products is highly
elastic. If the firm can produce in large scale and have variety of product it reduces production of
other product and increase the one that price increase in the markets.
6. Natural factors (Agriculture products): Natural calamities can affect the production of
agricultural products so they are relatively inelastic. E.g. it is difficult to increase or decrease the
supply of agricultural product as price increase because it takes time from ploughing to harvest and
affected by rain, sunlight and humidity.
7. Explain the concepts : AFC,AVC,ATCandMC.
Average Fixed Cost (AFC): The average fixed cost is the total fixed cost divided by the
number of units produced. Hence, if TFC is the total fixed cost and Q is the number of units
produced, then
AFC = TFC/Q
Average Variable Costs: Average variable cost (AVC) is found by dividing total variable
cost (TVC) by the corresponding output (Q):
AVC = TVC/Q, AFC+ AVC = ATC, ATC/ Q = MC

Average Total Costs: Average total cost (ATC) can be found by dividing total cost (TC) by
total output (Q) or, by adding AFC and AVC for each level of output. That is:
ATC = TC/Q = AFC + AVC
Marginal Cost (MC): is defined as the extra, or additional, cost of producing one more
unit of output. MC can be determined for each additional unit of output simply by noting
the change in total cost which that unit’s production entails:
MC = TC/ Q
5. Explain briefly the various types of costs with suitable examples.
Accounting cost: The cost or expenditure which a firm incurs for producing or acquiring a good or
service. Purchase of cotton for production of clothes
Opportunity cost: The revenue which could have been earned by employing that good or service in some
other alternative uses. Eg. Rather than selling raw material the revenue earned by farther processing is
opportunity cost.
Sunk costs  – a sunk cost (also known as retrospective cost) is a cost that has already been
incurred and cannot be recovered. Sunk costs are contrasted with prospective costs, which
are future costs that may be avoided if action is taken.
Economic costs: are related to future. They play a vital role in business decisions as the costs
considered in decision - making are usually future costs. Example, need for production expansion.
Shut down cost: Cost incurred if the firm temporarily stops its operation. Cost of maintenance of
machine that leads to firm’s temporary stoppage.
 Controllable cost: Costs which can be controllable by the executives are called as controllable cost. Eg
excessive budget for leaders for refreshment and extravagances
Transaction cost: The cost associated with the exchange of goods and services.
Social cost: Total cost incurred by the society on account of production of a good or service.Eg some
water industry pays certain money to environmental protection from their revenue.
Implicit cost: If the factors of production are owned by a firm then its cost is implicit cost.
Incremental cost: Is the addition to costs resulting from a change in the nature of level of business
activity. Change in cost caused by a given managerial decision.
Explicit cost: Cost actually paid by the firm. If the factors of production are hired or rented then it is an
explicit cost.
6. What is the difference between monopoly and monopolistic competition?
Monopoly: In this situation there is just one producer of a product. The firm has substantial
control over the price: only one seller but many buyers of the same good, there is no
substituent and entry and exits have restriction.
In this market there is no competitor.
Monopolistic: implies a market structure with a large number of firms selling differentiated
products. Different supplies enter the market and support competition. Where in products that
are sold in the market vary in style, quality standards, trademarks and brands. This helps
buyers in differentiating among the available products in more than one way. However, under
monopolistic competition, products are close substitutes of each other and easy entry and exit.
7. Distinguish between oligopoly and duopoly market.
Oligopoly: is a market situation in which a firm determines its marketing policies on the basis
of the expected behavior of close competitors. Oligopoly is a type of imperfect competition,
wherein there are few sellers dealing either in homogenous or differentiated products. It’s is
characterized by existence of few sellers, identical or differentiated products, mutually
interdependence.
Duopoly: A duopoly is a situation where  two companies together own all, or nearly all, of the
market for a given product or service. Only two firms compete for the market.
8. Define production function and Cobb-Douglas production function.
The production function provides a quantitative perception of the relationship between the
inputs and outputs. The inputs are the various factors of production- land, labor, capital, and
enterprise whereas the outputs are the goods and services. Cobb Douglas Production
Function assumes that all factors categorized into two groups labor and capital. The general
equilibrium for the production function is
𝑄 = 𝑓 (𝐾, 𝐿)
In general Cobb-Douglas production function (Quadratic equation) is widely used
𝑄 = 𝐴𝐾𝛼𝐿𝛽
Q = the maximum rate of output for a given rate of capital (K) and labor (L).
9. Production function and Cobb-Douglas production function
In economics and econometrics, the Cobb–Douglas production function is a particular
functional form of the production function, widely used to represent the technological
relationship between the amounts of two or more inputs (particularly physical capital and
 labor) and the amount of output that can be produced by those inputs. The Cobb–Douglas
form was developed and tested against statistical evidence by Charles Cobb and Paul Douglas
during 1927–1947.[1]

Formulation

In its most standard form for production of a single good with two factors, the function is

where:

 Y = total production (the real value of all goods produced in a year or 365.25 days)
 L = labor input (the total number of person-hours worked in a year or 365.25 days)

 K = capital input (a measure of all machinery, equipment, and buildings; the value of capital
input divided by the price of capital)[clarification needed]

 A = total factor productivity

 α and β are the output elasticity’s of capital and labor, respectively. These values are
constants determined by available technology.

Output elasticity measures the responsiveness of output to a change in levels of either labor or capital
used in production, ceteris paribus. For example, if α = 0.45, a 1% increase in capital usage would
lead to approximately a 0.45% increase in output.

Sometimes the term has a more restricted meaning, requiring that the function display constant
returns to scale, meaning that doubling the usage of capital K and labor L will also double output Y.
This holds if

α + β = 1,

If

α + β < 1,

returns to scale are decreasing, and if

α + β > 1,

returns to scale are increasing. Assuming perfect competition and α + β = 1, α and β can be shown to
be capital's and labor's shares of output.

In its generalized form, the Cobb-Douglas function models more than two goods. The Cobb–Douglas
function may be written as:[2]
 where:

 A is an efficiency parameter
 L is the total number of goods

 x1, ..., xL are the (non-negative) quantities of good consumed, produced, etc.

 is an elasticity parameter for good i

History

Paul Douglas explained that his first formulation of the Cobb–Douglas production function was
developed in 1927; when seeking a functional form to relate estimates he had calculated for workers
and capital, he spoke with mathematician and colleague Charles Cobb, who suggested a function of
the form Y = ALβK1−β, previously used by Knut Wicksell, Philip Wicksteed, and Léon Walras, although
Douglas only acknowledges Wicksteed and Walras for their contributions.[3]. Estimating this using
least squares, he obtained a result for the exponent of labour of 0.75—which was subsequently
confirmed by the National Bureau of Economic Research to be 0.741. Later work in the 1940s
prompted them to allow for the exponents on K and L to vary, resulting in estimates that subsequently
proved to be very close to improved measure of productivity developed at that time.[4]

A major criticism at the time was that estimates of the production function, although seemingly
accurate, were based on such sparse data that it was hard to give them much credibility. Douglas
remarked "I must admit I was discouraged by this criticism and thought of giving up the effort, but
there was something which told me I should hold on."[4] The breakthrough came in using US census
data, which was cross-sectional and provided a large number of observations. Douglas presented the
results of these findings, along with those for other countries, at his 1947 address as president of the
American Economic Association. Shortly afterwards, Douglas went into politics and was stricken by
ill health—resulting in little further development on his side. However, two decades later, his
production function was widely used, being adopted by economists such as Paul Samuelson and
Robert Solow.[4] The Cobb–Douglas production function is especially notable for being the first time
an aggregate or economy-wide production function had been developed, estimated, and then
presented to the profession for analysis; it marked a landmark change in how economists approached
macroeconomics from a microeconomics perspective.[5]

Criticisms

The function has been criticised for its lack of foundation. Cobb and Douglas were influenced by
statistical evidence that appeared to show that labor and capital shares of total output were constant
over time in developed countries; they explained this by statistical fitting least-squares regression of
their production function. There is now doubt over whether constancy over time exists.[citation needed]

The Cobb–Douglas production function was not developed on the basis of any knowledge of
engineering, technology, or management of the production process[citation needed]. This rationale may be
true given the definition of the Capital term. Labor hours and Capital need a better definition. If
capital is defined as a building, labor is already included in the development of that building. A
building is composed of commodities, labor and risks and general conditions.

It was instead developed because it had attractive mathematical characteristics[citation needed], such as
diminishing marginal returns to either factor of production and the property that the optimal
expenditure shares on any given input of a firm operating a Cobb Douglas technology are constant.
Initially, there were no utility foundations for it. In the modern era, some economists try to build
models up from individual agents acting, rather than imposing a functional form on an entire
economy[citation needed]. The Cobb–Douglas production function, if properly defined, can be applied at a
micro-economic level, up to a macro- economic level.

However, many modern authors[who?] have developed models which give microeconomically based
Cobb–Douglas production functions, including many New Keynesian models.[6] It is nevertheless a
mathematical mistake to assume that just because the Cobb–Douglas function applies at the
microeconomic level, it also always applies at the macroeconomic level. Similarly, it is not necessarily
the case that a macro Cobb–Douglas applies at the disaggregated level. An early microfoundation of
the aggregate Cobb–Douglas technology based on linear activities is derived in Houthakker (1955).[7]

A 2019 quantitative survey of 3186 estimates of the shape of the production function reported in 121
studies published in peer-reviewed journals finds that the empirical literature as a whole rejects the
Cobb-Douglas specification and that the elasticity of substitution between capital and labor is on
average close to 0.3 instead of 1, which would be necessary for the Cobb-Douglas production
function.[8]