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MS-9 Managerial Economics 9/TMA/SEM-I/2011 All Blocks

Attempt All the Questions. 1. Given the profit function of a firm in the form of table, calculate total profit, average profit and marginal profit and differentiate between incrementalism and marginalism. Solution : In this case, Average Profit and Marginal Profit are same as there is only single value is available for Total Revenue &Total Cost. There are no fixed and variable costs are given. Hence the table is to be filled out as follows:

Unit of Total Total Total Output Revenue(TR) Cost(TC) Profit (Q) (TP) = T.R-T.C 1 2 3 10 30 50 5 18 29 5 12 21

Average Marginal Profit Profit (AP) = (MP) TR/Q 10/1 10 30/2 15 50/3 = 10 = 15 = 16.66

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COM 16. Marginalism is now an integral part of mainstream economic theory Page 2 . or of some total quantity thereof. according to legend Virgil wrote the Aeneid in an incremental process. incremental changes instead of a few (extensively planned) large jumps.IGNOU4U. averaging three lines per day.5 Differentiation between incrementalism and marginalism Incrementalism is a method of working by adding to a project using many small (often unplanned).BLOGSPOT. incrementalism refers to the method of change by which many small policy changes are enacted over time in order to create a larger broad based policy change. Marginalism is associated with arguments concerning changes in the quantity used of a good or of a service. In public policy. Logical incrementalism implies that the steps in the process are sensible. The central concept of marginalism proper is that of marginal utility. and the Georgicseven more slowly at an average of one line per day.5 = 17. and the neoclassical tradition that emerged from British marginalism generally abandoned the concept of utility and gave marginal rates of substitution a more fundamental role in analysis. but marginalists following the lead of Alfred Marshall were further heavily dependent upon the concept of marginal physical productivity in their explanation of cost. illustrates the concept by building an encyclopedia bit by bit. Marginalism refers to the use of marginal concepts in economic theory. This was the theoretical policy of rationality developed by Lindblom to be seen as a middle way between the Rational Actor Model and bounded rationality as both long term goal driven policy rationality and satisficing were not seen as adequate. In a similar vein. for example.66 4 70 38 32 70/4 17. continually adding to it. Wikipedia. as opposed to some notion of the over-all significance of that class of good or service.

2009. e. feasible. instead of a large change to a target price overnight. Page 3 . the company would only raise the price by a few cents every day. An example could be the rise of gas prices. and each decrease would result in abandonment of the use of lowest priority amongst the uses to which the good or service had been put. software design. or the specific use of the good or service that would be abandoned in response to a given decrease. economics. previously unrealized use of greatest priority. A series of small steps toward an agenda would be less likely to be questioned than a large and swift change. More people would notice and dispute a dramatic. for any given set of constraints. there is an attainable state which is best in the eyes of that agent.COM Incrementalism is commonly employed in engineering. on the Fox News show Hannity. such that. let alone argued. On July 28. a person's appearance. or laws. such as.g. each increase would be put to the specific.. 100% increase overnight. Another example would be in small changes that make way for a bigger overall change to get past unnoticed. Planning and industry. of Japanese engineering can create steadily improving product performance. prescriptive marginalism asserts that such choice ought to be so governed. On such assumptions. Whereas it is often criticized as "fire fighting". Descriptive marginalism asserts that choice amongst the specific means by which various anticipated specific states-of-the-world (outcomes) might be affected is governed only by the distinctions amongst those specific outcomes. economic rationality and an ordering of possible states-of-theworld.IGNOU4U. the progressive improvement of product designs characteristic. while a 100% increase over a span of a week would less likely be even noticed. host Sean Hannity asked The marginal use of a good or service is the specific use to which an agent would put a given increase. Marginalism assumes. This can be applied in many different ways.BLOGSPOT. for any given agent. which in certain circumstances outperforms more orthodox planning systems. politics.

More precisely.S. the demand for a good is said to be inelastic (or relatively inelastic) when the PED is less than one (in absolute value): that is. have a positive PED. In general. The demand for a good is said to be elastic (or relatively elastic) when its PED is greater than one (in absolute value): that is. Revenue is maximised when price is set so that the PED is exactly one. such as Veblen and Giffen goods.COM guest U. Solution : Price elasticity of demand (PED or Ed) is a measure used in economics to show the responsiveness.BLOGSPOT. It was devised by Alfred Marshall. Explain the determinants of Price Elasticity. Senator John McCain if he thought that a possible agreement between majority Democrats and Blue Dog Democrats on health care reform was incrementalism. it gives the percentage change in quantity demanded in response to a one percent change in price (holding constant all the other determinants of demand. of the quantity demanded of a good or service to a change in its price. Various research methods are used to determine price elasticity. The PED of a good can also be used to predict the incidence (or "burden") of a tax on that good. changes in price have a relatively small effect on the quantity of the good demanded. including test markets. analysis of Page 4 . Define Price Elasticity. to which McCain answered that he thought it was. or elasticity. Price elasticities are almost always negative. Only goods which do not conform to the law of demand. changes in price have a relatively large effect on the quantity of a good demanded. although analysts tend to ignore the sign even though this can lead to ambiguity. 2. such as income).IGNOU4U.

however.e.[3] For example. Page 5 . then the elasticity at the initial price and quantity = í5%/5% = í1.e. if the price increases by 5% and quantity demanded decreases by 5%.[5] Because the PED is negative for the vast majority of goods and services.. the elasticity of demand with respect to the good's own price.COM PED is derived from the percentage change in quantity (% Qd) and percentage change in price (% P) PED is a measure of responsiveness of the quantity of a good or service demanded to changes in its price. a complementary or substitute good.[1] The latter type of elasticity measure is called a cross-price elasticity of demand. This measure of elasticity is sometimes referred to as the own-price elasticity of demand for a good. i. in order to distinguish it from the elasticity of demand for that good with respect to the change in the price of some other good.BLOGSPOT. i. due to the inverse nature of the relationship between price and quantity demanded. in absolute value terms). as described by the "law of demand"...e.[1] The formula for the coefficient of price elasticity of demand for a good is: The above formula usually yields a negative value. The only classes of goods which have a PED of greater than 0 are Veblen and Giffen goods. economists often refer to price elasticity of demand as a positive value (i.IGNOU4U.

BLOGSPOT. First. (15 í 10) ÷ 15.. But if quantity demanded decreases from 15 units to 10 units. instead. The elasticity of demand for good with respect to price pk is Page 6 .e. Second. as explained below. Point-price elasticity One way to avoid the accuracy problem described above is to minimise the difference between the starting and ending prices and quantities. the percentage changebetween any two values depends on which one is chosen as the starting value and which as the ending value. i. if quantity demanded increases from 10 units to 15 units.3%. and let be the demand for good . the accuracy of the PED given by the formula above decreases for a combination of two reasons. which uses differential calculus to calculate the elasticity for an infinitesimal change in price and quantity at any given point on the demand curve: [14] In other words. which is dependent on the units used for both price and quantity. percentage changes are not symmetric. due to its percentage nature. the percentage change is 50%. Elasticity is not the same thing as the slope of the demand curve. i. (15 í 10) ÷ 10 (converted to a percentage). For example. the percentage change is í33.COM As the difference between the two prices or quantities increases. PED can vary at different points along the demand curve..e.IGNOU4U. the PED for a good is not necessarily constant. Two alternative elasticity measures avoid or minimise these shortcomings of the basic elasticity formula: point-price elasticity and arc elasticity. This is the approach taken in the definition of point-price elasticity. point-price elasticity of demand can be be the demand of goods as a defined as follows:[16] let function of parameters price and wealth. In terms of partial-differential calculus. it is equal to the absolute value of the first derivative of quantity with respect to price (dQd/dP) multiplied by the point's price (P) divided by its quantity (Qd).

BLOGSPOT. this gives an "average" elasticity for the section of the actual demand curve²i.COM However. the arc of the curve²between the two points. this measure is known as the arc elasticity. As a result.. because this formula implicitly assumes the section of the demand curve between those points is linear.IGNOU4U. The arc elasticity is defined mathematically as:[13][17][18] This method for computing the price elasticity is also known as the "midpoints formula". the worse this approximation of its elasticity will be. Qd = f(P). Interpreting values of price elasticity coefficients Page 7 . can be determined. However. the greater the curvature of the actual demand curve is over that range. the point-price elasticity can be computed only if the formula for the demand function. rather than just the change relative to one point or the other. Loosely speaking. because the average price and average quantity are the coordinates of the midpoint of the straight line between the two given points. in this case with respect to the price of the good. dQd / dP. Arc elasticity A second solution to the asymmetry problem of having a PED dependent on which of the two given points on a demand curve is chosen as the "original" point and which as the "new" one is to compute the percentage change in P and Q relative to the average of the two prices and the average of the two quantities. is known so its derivative with respect to price.e.

unit elasticity. or unitarily elastic demand Ed = .IGNOU4U.COM Perfectly inelastic demand Perfectly elastic demand[10] Elasticities of demand are interpreted as follows: Value Descriptive Terms Ed = 0 Perfectly inelastic demand . and conversely.1 < Ed < 0 Inelastic or relatively inelastic demand Unit elastic.’ < Ed < Elastic or relatively elastic demand 1 Ed = . quantity Page 8 . unitary elasticity.BLOGSPOT.1 .’ Perfectly elastic demand A decrease in the price of a good normally results in an increase in the quantity demanded by consumers because of the law of demand.

while a decrease in price will tend to decrease revenue. But in determining whether to increase or decrease prices. That is. unit elasticity. and perfectly inelastic demand as a vertical line. while a decrease in unit price will tend to lead to more units sold.) Page 9 . Elasticity provides the answer: The percentage change in total revenue is equal to the percentage change in quantity demanded plus the percentage change in price.e. unit elastic. perfectly elastic demand is represented graphically as a horizontal line. the other negative. or unitarily elastic demand when the percentage change in quantity demanded is equal to the percentage change in price (so that Ed = .COM demanded decreases when price rises. unitary elasticity.BLOGSPOT.1).IGNOU4U. the demand for a good is called:    relatively inelastic when the percentage change in quantity demanded is less than the percentage change in price (so that Ed > . by the inverse of that slope). Effect on total revenue   A firm considering a price change must know what effect the change in price will have on total revenue. and relatively elastic when the percentage change in quantity demanded is greater than the percentage change in price (so that Ed < . a firm needs to know what the net effect will be.1). as well as the onlycases in which the PED is determined solely by the slope of the demand curve (or more precisely. the quantity effect : an increase in unit price will tend to lead to fewer units sold. As summarized in the table above. the two effects affect total revenue in opposite directions. the law of demand). the PED for a good or service is referred to by different descriptive terms depending on whether the elasticity coefficient is greater than.. (One change will be positive. equal to. As the two accompanying diagrams show. These are the only cases in which the PED and the slope of the demand curve (¨P/¨Q) are both constant.1). Because of the inverse nature of the relationship between price and quantity demanded (i. or less than í1. Generally any change in price will have two effects: the price effect : an increase in unit price will tend to increase revenue.

will cause demand for the good to drop to zero. the total revenue falls to zero. Page 10 . the total revenue falls. total revenue is maximised at the combination of price and quantity demanded where the elasticity of demand is unitary It is important to realise that price-elasticity of demand is not necessarily constant over all price ranges. any increase in the price. when the price is raised. and vice versa. changes in the price do not affect the quantity demanded for the good. when the price is raised. Hence. the total revenue rises. when the price is raised. The linear demand curve in the accompanying diagram illustrates that changes in price also change the elasticity: the price elasticity is different at every point on the curve. the percentage change in quantity demanded is smaller than that in price. Hence. Hence. the percentage change in quantity is equal to that in price. the relationship between PED and total revenue can be described for any good: When the price elasticity of demand for a good is perfectly inelastic (Ed = 0). Hence.IGNOU4U. raising prices will cause total revenue to increase.COM      As a result.BLOGSPOT. the percentage change in quantity demanded is greater than that in price. When the price elasticity of demand for a good is unit (or unitary) elastic (Ed = -1).’ < Ed < 1). so a change in price will not affect total revenue.1 < Ed < 0). When the price elasticity of demand for a good is relatively inelastic (. as the accompanying diagram shows. no matter how small. When the price elasticity of demand for a good is perfectly elastic (Ed is í ’). When the price elasticity of demand for a good is relatively elastic (. and vice versa.

TR is maximised at the quantity where PED = 1. but in the inelastic range.¶ Substantiate this statement with the help of an example. Solution : For a long time. On the other hand. Since the only cost that matters for business decisions are the future costs. TR increases. µTo an economist the fixed costs are overhead costs and to an accountant these are indirect costs. The accounting costs are useful for managing taxation needs as well as to calculate profit or loss of the firm.BLOGSPOT. there has been a considerable disagreement among economists and accountants on how costs should be treated. They are concerned with what cost is expected to be in the future and how the firm might be able to rearrange its resources to lower its costs and improve its profitability. it is the Page . Accountants always have been concerned with firms¶ financial statements. TR decreases. Accountants tend to take a retrospective look at firms finances because they keep trace of assets and liabilities and evaluate past performance.COM A set of graphs shows the relationship between demand and total revenue (TR) for a linear demand curve. As price decreases in the elastic range. 3. The reason for the difference of opinion is that the two groups want to use the cost data for dissimilar purposes.IGNOU4U. economists take forward-looking view of the firm. They must therefore be concerned with opportunity cost.

when an economist says that a firm is just covering its costs. Accounting profits are the firm¶s total revenue less its explicit costs. Accountants and economists both include explicit costs in their calculations. no monitory transaction has occurred (and thus would not appear as an accounting cost). Although. Accountants and economists use the term µprofits¶ differently. The economist takes into account the implicit costs (including a normal profit) in addition to explicit costs in order to retain resources in a given line of production. the business nonetheless incurs an opportunity cost because the owner could have earned a competitive salary by working elsewhere. The demand curve for all consumers together follows from the demand curve of every individual consumer: the individual demands at each price are added together. Demand curves are used to estimate behaviors in competitive markets. What effect does change in demand have on price and quantity? Discuss with reference to pricing analysis of markets by giving illustrations. depending on the complexity of the scenario. the residual accruing to the entrepreneur is called an economic profit. and that. the entrepreneur is receiving a return just large enough to retain his/ her talents in the present line of production. 4. Therefore.COM economic costs that are used for decision-making. or pure profit. Despite its name. and are often combined with supply curves to estimate the equilibrium price (the price at which sellers together are willing to sell the same amount as buyers together are Page 12 .IGNOU4U. explicit costs are important because they involve direct payments made by a firm. But economists define profits differently.BLOGSPOT. These explicit costs are also important for economists as well because the cost of wages and materials represent money that could be useful elsewhere. and the amount of it that consumers are willing and able to purchase at that given price. Solution : In economics. It is a graphic representation of a demand schedule. the demand curve is the graph depicting the relationship between the price of a certain commodity. it is meant that all explicit and implicit costs are being met. but sometimes as a straight line. If a firm¶s total receipts exceed all its economic costs. For accountants. Economic profits are total revenue less all costs (explicit and implicit costs). it is not always shown as a curve.

or resource as its price falls. since the price one is willing to pay depends on the utility. Thus it may change indirectly due to change in demand for other commodities. the demand curve facing the monopolist is simply the market demand curve. the demand curve is drawn with price on the vertical axis and quantity on the horizontal axis. The demand curve is related to the marginal utility curve. the demand directly depends on the income of an individual while the utility does not. which means people will buy more of a service. it has a negative association.IGNOU4U.BLOGSPOT. also known as market clearingprice) and the equilibrium quantity (the amount of that good or service that will be produced and bought without surplus/excess supply or shortage/excess demand) of that market In a monopolistic market. The demand curve usually slopes downwards from left to right. Changes that increase demand Some circumstances which can cause the demand curve to shift out include:    increase in price of a substitute decrease in price of complement increase in income if good is a normal good Page . An example of a demand curve shifting Characteristics According to convention. The function actually plotted is the inverse demand function. However. The negative slope is often referred to as the "law of demand". that is. product.COM willing to buy.

though controlled. Movements along a demand curve happen only when the price of the good changes. Product Differentiation Solution : Market Experiments An alternative method of collecting necessary information regarding demand is to carry out market studies and experiments on consumer¶s behaviour under actual.COM decrease in income if good is an inferior good Changes that decrease demand  Some circumstances which can cause the demand curve to shift in include: decrease in price of a substitute  increase in price of a complement  decrease in income if good is normal good  increase in income if good is inferior good Movement along a demand curve  There is movement along a demand curve when a change in price causes the quantity demanded to change." Thus a change in a non-price determinant of demand is reflected in a change in the x-intercept causing the curve to shift along the x axis. They are "merely lumped into intercept term of a simple linear demand function.When a non-price determinant of demand changes the curve shifts. forms first select some areas of representative markets. It is important to distinguish between movement along a demand curve.three or four cities having similar features. income levels. This method is known in common parlance as market experiment method. population. 5. viz. Market Experiments b. market conditions. Under this method. and a shift in a demand curve. advertisement expenditure and other controllable variables in the demand function under the assumption that Page 14 . etc. Then they carry out market experiments by changing prices. Bundling of services c.BLOGSPOT.. These "other variables" are part of the demand function.IGNOU4U.Write short notes on the following :a.

Customer acquisition costs are high. basic cable in the United States generally offers many channels at one price).BLOGSPOT. A bundle of products is sometimes referred to as a package deal or a compilation or an anthology. while consumer B values word processor at $60 and spreadsheet at $100. After such changes are introduced. aspreadsheet. seller can generate Page 15 . This strategy is very common in the software business (for example: bundle a word processor. Bundling is most successful when:        There are economies of scale in production. On the basis of data collected. one of the consumers will refuse to buy it. Seller can generate maximum revenue of only $240 by setting $60 price for each product both consumers will buy both products. Consumers have heterogeneous demands and such demands for different parts of the bundle product are inversely correlated. and in the fast food industry in which multiple items are combined into a complete meal. The controllable variables may be changed over time. elasticity coefficients are computed. in the cable television industry (for example. and a database into a single office suite). For example. the consequent changes in the demand over a period of time are recorded. assume consumer A values word processor at $100 and spreadsheet processor at $60.IGNOU4U. Consumers appreciate the resulting simplification of the purchase decision and benefit from the joint performance of the combined product. production set-up costs are high. These coefficients are then used along with the variables of the demand function to assess the demand for the product. With bundling. Bundling of services Product bundling is a marketing strategy that involves offering several products for sale as one combined product.COM other things remain same. There are economies of scope in distribution. Revenue cannot be increased without bundling because as seller increases the price above $60 for one of the goods. Marginal costs of bundling are low.

In oligopolistic and monopolistic industries. Product bundling is most suitable for high volume and high margin (i. Research by Yannis Bakos and Erik Brynjolfsson found that bundling was particularly effective for digital "information goods" with close to zero marginal cost. a leader product is offered for discount if purchased with a non-leader product. to make it more Page 16 .COM revenue of $320 by bundling the products together and selling the bundle at $160. Empirical evidence and analytical models indicate that bundling improves content availability in those systems Both pure and mixed bundling are supported by BitTorrent. Product Differentiation A concept in Economics and Marketing proposed by Edward Chamberlin in his 1933 Theory of Monopolistic Competition. low marginal cost) products.. in leader bundling. Mixed-leader bundling is a variant of leader bundling with the added possibility of buying the leader product on its own. such as BitTorrent. and. product bundling can be seen as an unfair use of market power because it limits the choices available to the consumer. and could enable a bundler with an inferior collection of products to drive even superior quality goods out of the market place. Bundling in political economy is a type of product bundling in which the product is a candidate in an election who markets his bundle of attributes and positions to the voters. Pure bundling can be further divided into two cases: in joint bundling. Pure bundling occurs when a consumer can only purchase the entire bundle or nothing.IGNOU4U. In peer-to-peer swarming systems for content dissemination. product differentiation (also known simply as "differentiation") is the process of distinguishing a product or offering from others. the two products are offered together for one bundled price.BLOGSPOT. mixed bundlingoccurs when consumers are offered a choice between the purchasing the entire bundle or one of the separate parts of the bundle.e. bundling consists of disseminating multiple files together in a single swarm. In marketing. In these cases it is typically called product tying.

they can be merely a difference in packaging or an advertising theme.g. Vertical : based on a single characteristic and consumers are clear on its quality The brand differences are usually minor.COM attractive to a particular target market.g. Simple: based on a variety of characteristics 2. The term is used frequently when dealing withfreemium business Page 17 . or the resulting list of differences. The objective of differentiation is to develop a position that potential customers see as unique.IGNOU4U. Marketing or product differentiation is the process of describing the differences between products or services. how it is distributed and marketed. The major sources of product differentiation are as follows. hence causes of differentiation may be functional aspects of the product or service. This is done in order to demonstrate the unique aspects of a firm's product and create a sense of value. timing and location). The physical product need not change. There are three types of product differentiation: 1. This involves differentiating it from competitors' products as well as a firm's own product offerings. but it could. Differentiation can be a source of competitive advantage. Differentiation is due to buyers perceiving a difference. the changes themselves are not differentiation. which include the requirement that the products of competing firms should be perfect substitutes.      Differences in quality which are usually accompanied by differences in price Differences in functional features or design Ignorance of buyers regarding the essential characteristics and qualities of goods they are purchasing Sales promotion activities of sellers and. successful product differentiation leads to monopolistic competition and is inconsistent with the conditions for perfect competition. or who buys it.BLOGSPOT. Marketing textbooks are firm on the point that any differentiation must be valued by buyers (e. Although research in a niche market may result in changing a product in order to improve differentiation. advertising Differences in availability (e. in particular.) The term unique selling proposition refers to advertising to communicate a product's differentiation In economics. Horizontal : based on a single characteristic but consumers are not clear on quality 3.

they will be less sensitive to aspects of competing offers. Most people would say that the implication of differentiation is the possibility of charging a price premium. Differentiation makes customers in a given segment have a lower sensitivity to other features (non-price) of the product. A successful product differentiation strategy will move your product from competing based primarily on price to competing on non-price factors (such as product characteristics.distribution strategy. it is imperative that free and paid versions be effectively differentiated.IGNOU4U. Given they target a same group of customers. this is a gross simplification. Differentiation primarily impacts performance through reducing directness of competition: As the product becomes more different. however. Page 18 . categorization becomes more difficult and hence draws fewer comparisons with its competition.BLOGSPOT. or promotional variables). price may not be one of these aspects. in which businesses market a free and paid version of a given product.COM models. If customers value the firm's offer.

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