MB0042- MANAGERIAL ECONOMICS

Q.(1) Inflation is a global Phenomenon which is associated with high price causes decline in the value for money. It exists when the amount of money in the country is in excess of the physical volume of goods and services. Explain the reasons for this monetary phenomenon.

ANS. Inflation is commonly understood as a situation of substantial and rapid increase in the level of prices and consequent deterioration in the value of money over a period of time. It refers to the average rise in the general level of prices and fall in the value of money. Inflation is statistically measured in terms of percentage increase in the price index, as a rate (percent) per unit of time- usually a year or a month.

Demand side:-

Increase in aggregative effective demand is responsible for inflation. In this case, aggregate demand exceeds aggregate supply of goods and services. Demand rises much faster than supply. We can enumerate the following reasons for increase in effective demand.

Increase in money supply – Supply of money in circulation increases on account of the following reasons: deficit financing by the government, expansion in public expenditure, expansion in bank credit and repayment of past debt by the government to the people, increase in legal tender money and public borrowing.

Increase in disposable income – Aggregate effective demand rises when disposable income of the people increases. Disposable income rises on account of the following reasons: reduction in the rates of taxes, increase in national income while tax level remains constant, and decline in the level of savings.

Increase in private consumption expenditure and investment expenditure – An increase in private expenditure both on consumption and on investment leads to emergence of excess demand in an economy. When business is prosperous, business expectations are optimistic and prices are rising. More investments are made by private entrepreneurs causing an increase in factor prices. When the income of the factors rise, there is more expenditure on consumer goods.

Increase in exports – An increase in the foreign demand for a country’s exports reduces the stock of goods available for home consumption. This creates shortages in the country leading to a rise in price level.

High rates – Higher rates of indirect taxes would lead to a rise in prices.

SUPPLY SIDE:-

Shortage in the supply of factors of production – When there is shortage in the supply of factors of production like raw materials, labour, capital equipments, etc. there will be a rise in

their prices. Thus, when supply falls short of demand, a situation of excess demand emerges creating inflationary pressures in an economy.

Operation of law of diminishing returns – When the law of diminishing returns operates, increase in production is possible only at a higher cost which demotivates the producers to invest in large amounts. Thus, production will not increase proportionately to meet the increase in demand. Hence, supply falls short of demand.

ROLE OF EXPECTATIONS:-

Expectations also play a significant role in accentuating inflation.If people expect further rise in price, the current aggregate demand increases, which in turn causes a rise in the prices.Expectations about higher wages and salaries affect the prices of related goods. Expectations of wage increase often induce some business houses to increase prices even before upward wage revisions are actually made.

Q.(2) Monopoly is the situation there exists a single control over the market producing a commodity having no substitutes with no possibilities for anyone to enter the industry to compete. In that situation, they will not charge a uniform price for all the customers in the market and also the pricing policy followed in that situation.

ANS. Monopoly means existence of a single seller in the market. Monopoly is that market form in which a single producer controls the whole supply of a single commodity which has no close substitutes. Monopoly may be defined, as a condition of production in which a single firm has the power to fix the price of the commodity or the output of the commodity. It is a situation there exists a single control over the market producing a commodity having no substitutes with no possibilities for any one to enter the industry to compete.

Anti-thesis of competition – Absence of competition in the market creates a situation of monopoly and hence, the seller faces no threat of competition.

Existence of a single seller – There will be only one seller in the market who exercises single control over the market.

Absence of substitutes – There are no close substitutes for the seller’s product with a strong cross elasticity of demand. Hence, buyers have no alternatives.

Control over supply – Seller will have complete control over output and supply of the commodity.

Price maker – The monopolist is the price maker and in taking decisions on price fixation, he or she is independent. He or she can set the price to the best of his or her advantage. Hence, the monopolist can either charge a high price for all customers or adopt price discrimination policy if there are different types of buyers.

Entry barriers – Entry of new firms is difficult. Hence, monopolist will not have direct competitors in the market.

Firm and industry is same – There will be no difference between the firm and an industry.

Nature of firm – The monopoly firm may be a proprietary concern, partnership concern, Joint Stock Company or a public utility which pursues an independent price-output policy.

Existence of super normal profits – There will be opportunities for supernormal profits under monopoly, because market price is greater than the cost of production.

Price discrimination are commonly seen:-

Discrimination of the first degree – Under price discrimination of the first degree, the producer exploits the consumers to the maximum possible extent, by asking to pay the maximum he/she is prepared to pay rather than go without the commodity. In this case, the monopolist will not allow any consumer’s surplus to the consumer. This type of price discrimination is called perfect discrimination.

Discrimination of the third degree – In case of discrimination of the third degree, the markets are divided into many sub-markets or subgroups. The price charged in each case roughly depends on the ability to pay of different subgroups in the market. This is the most common type of discrimination followed by a monopolist.

Q.(3) Define monopolistic competition and explain its characteristics.

ANS. Monopolistic Competition:-

Perfect competition and monopoly are two extreme forms of market situations, rarely to be found in the real world. Generally, markets are imperfect.It is a market structure in which a large number of small sellers sell differentiated products which are close, but not perfect substitutes for one another.

Characteristics of monopolistic competition:-

Existence of a large number of firms:- Under Monopolistic Competition, the number of firms producing a product will be large. The size of each firm is small. No individual firm can influence the market price. Hence, each firm will act independently without worrying about the policies followed by other firms. Each firm follows an independent price-output policy.

Market is characterised by imperfections:- Imperfections may arise due to advertisements, differences in transport cost, irrational preferences of consumers, ignorance about the availability of different brands of products and prices of products, etc., Sellers may also have inadequate knowledge about market and prices existing at different segments of markets.

Free entry and exit of firms:- Each firm produces a very close substitute for the existing brands of a product. Thus, differentiation provides ample opportunity for a firm to enter with the group or an industry. On the contrary, if the firm faces the problem of product obsolescence, it may be forced to go out of the industry.

Element of monopoly and competition:- Every firm enjoys some sort of monopoly power over the product it produces. However, it is neither absolute nor complete because each product faces competition from rival sellers selling different brands of the product.

Similar products but not identical:- Under monopolistic competition, the firm produces commodities which are similar to one another but not identical or homogenous. For example, toothpastes, blades, cigarettes, shoes, etc.

Non-price competition:- In this market, there will be competition among “Mini-monopolists” for their products and not for the price of the product. Thus, there is “product competition” rather than “price competition”.

Definite preference of the consumers:- Consumers will have definite preference for particular variety or brands loyalty owing to the special features of a product produced by a particular firm.

Product differentiation:- The most outstanding feature of monopolistic competition is product differentiation. Firms adopt different techniques to differentiate their products from one another.

More elastic demand curve:- Product differentiation makes the demand curve of the firm much more elastic. It implies that a slight reduction in the price of one product, assuming the price of all other products remaining constant leads, to a large increase in the demand for the given product.

Q.(4) When should a firm in perfectly competitive market shut down its operation?

ANS. according to perfect competition a perfectly competitive market is one in which the number of buyers and sellers are large, all engaged in buying and selling a homogeneousproduct without any artificial restriction and, possessing perfect knowledge of the market at a time. According to Bilas, “the perfect competition is characterised by the presence of many firms; they all sell the same product which is identical. The seller is the price-taker”. According to Prof. F. Knight, perfect competition entails “Rational conduct on the part of buyers and sellers, full knowledge, absence of friction, perfect mobility and perfect divisibility of factors of production and completely static conditions”.

A firm will implement a production shutdown if the revenue from the sale of goods produced cannot cover the variable costs of production. A perfectly competitive market is one in which the number of buyers and sellers are large, all engaged in buying and selling a homogeneous product without any artificial restriction and, possessing perfect knowledge of the market at a time. A competitive firm will reach equilibrium position at a point where short run MR equals MC. At this point, equilibrium output and price is determined.

The competitive firm, in the short run, will not be in a position to cover its fixed costs. But it must recover short run variable costs for its survival and continuance in the industry. A firm will not produce any output unless the price is at least equal to the minimum AVC. If short run price is just equal to AVC, it will not cover fixed costs and hence, there will be losses. However, it will continue in the industry with the hope that it will recover the fixed costs in the future. The

firm in the short run will have only temporary equilibrium. The short run equilibrium price is not a stable price. It is also called as a sub - normal price. Economic shutdown occurs within a firm when the marginal revenue is below average variable cost at the profit-maximizing output. When a shutdown is required the firm failed to achieve a primary goal of production by not operating at the level of output where marginal revenue equals marginal cost. If the revenue the firm is making is greater than the variable cost (R>VC) then the firm is covering it's variable costs and there is additional revenue to partially or entirely cover the fixed costs. If the variable cost is greater than the revenue being made (VC>R) then the firm is not even covering production costs and it should be shutdown. The decision to shut down production is usually temporary. If the market conditions improve, due to prices increasing or production costs falling, then the firm can resume production. When a shutdown last for an extended period of time, a firm has to decide whether to continue to business or leave the industry.

Q.(5) Discuss the practical application of Price elasticity and Income elasticity of demand.

ANS. Practical application of price elasticity of demand:-

Production planning – It helps a producer to decide about the volume of production. If the demand for his products is inelastic, specific quantities can be produced while he has to produce different quantities, if the demand is elastic.

Helps in fixing the prices of different goods – It helps a producer to fix the price of his product. If the demand for his product is inelastic, he can fix a higher price and if the demand is elastic, he has to charge a lower price. Thus, price-increase policy is to be followed if the demand is inelastic in the market and price-decrease policy is to be followed if the demand is elastic. Similarly, it helps a monopolist to practise price discrimination on the basis of elasticity of demand.

Helps in fixing the rewards for factor inputs – Factor rewards refer to the price paid for their services in the production process. It helps the producer to determine the rewards for factors of production. If the demand for any factor unit is inelastic, the producer has to pay higher reward for it and vice-versa.

Helps in determining the foreign exchange rates – Exchange rate refers to the rate at which currency of one country is converted in to the currency of another country. It helps in the determination of the rate of exchange between the currencies of two different nations. For e.g. if the demand for US dollar to an Indian rupee is inelastic, in that case, an Indian has to pay more Indian currency to get one unit of US dollar and vice-versa.

Helps in determining the terms of trade – t is the basis for deciding mthe ‘terms of trade’ between two nations. The terms of trade implies the rate at which the domestic goods are exchanged for foreign goods. For e.g. if the demand for Japan’s products in India is inelastic, we have to pay more in terms of our commodities to get one unit of a commodity from Japan and vice-versa.

Practical application of income elasticity of demand:-

Helps in determining the rate of growth of the firm – If the growth rate of the economy and income growth of the people is reasonably forecasted, in that case, it is possible to predict expected increase in the sales of a firm and vice-versa.

Helps in the demand forecasting of a firm – It can be used in estimating future demand provided that the rate of increase in income and the Ey for the products are known. Thus, it helps in demand forecasting activities of a firm.

Helps in production planning and marketing – The knowledge of Ey is essential for production planning, formulating marketing strategy, deciding advertising expenditure and nature of distribution channel, etc. in the long run.

Helps in ensuring stability in production – Proper estimation of different degrees of income elasticity of demand for different types of products helps in avoiding over-production or under production of a firm. One should also know whether rise or fall in income is permanent or temporary.

Helps in estimating construction of houses – The rate of growth in incomes of the people also helps in housing programmes in a country. Thus, it helps a lot in managerial decisions of a firm.

Q.(6) Discuss the scope of managerial economics.

ANS. Managerial economics is a science that deals with the application of various economic theories, principles, concepts and techniques to business management in order to solve business and management problems. It deals with the practical application of economic theory and methodology in decision-making problems faced by private, public and non-profit making organisations.

Scope of Managerial Economics:-

Objectives of a firm:- Historically, profit maximisation has been considered as the main objective of a business unit. All business organisations have multiple objectives which are multidimensional out of which some are supplementary and some are competitive. Few others are inter-connected and few others are opposing. There are various goals like social, economic, organisational, human, and national. All the objectives are determined by various factors and forces such as corporate environment, socio-economic conditions, nature of power in the organisation and external constraints under which a firm operates. However, in the midst of several objectives, even today, the traditional profit maximisation objective has a very high place. All other policies and programmes of a firm revolve round this objective.

Demand analysis and forecasting:- Mostly, a firm is a producing unit. It produces different kinds of goods and services. It has to meet the requirements of consumers in the market. The basic problems like: what to produce; where to produce; for whom to produce; how to produce; how much to produce and how to distribute them in the market, are to be answered by a firm. Hence, the firm has to study in detail about the various determinants of demand, nature,

composition and characteristics of demand, elasticity of demand, demand distinctions, demand forecasting, etc. The production plan prepared by a firm should include all these points.

Production and cost analysis:- Production means conversion of inputs into the final output. It may be either in physical or in monetary terms. Physical production deals with the production of outputs by a firm, by employing different factor inputs in proper proportions. Always, the most basic goal of any firm is to increase the output. Production analysis deals with production function, laws of returns, returns to scale, economies of scale, etc.

Pricing decisions, policies and practices:- Pricing decisions means to fix the prices for all the goods and services ofany firm. This is based on the pricing policy and practices of that particular firm. Amongst all the policies the most important policy of any firm would be the price setting policy. The pricing decision depends on the revenue (amount), income (level) and profits (volume) earned by a firm. Hence, we have to study price-output determination under different market conditions, objectives and considerations of pricing policies, pricing methods, practices, policies, etc. We also study price forecasting, marketing channel, distribution channel, sales promotion policies, etc.

Profit management:- Basically, a firm can be a commercial or a business unit. Consequently, its success or failure is measured in terms of the amount of profit it is able to earn in a competitive market. The management gives top most priority to this aspect. There are many theories in profit management, like emergence of profit, functions of profit and its measurement, profit policies, techniques, profit planning, profit forecasting and break even point.

Capital management:- This is one of the essential areas of business unit. The success of any business is based on proper management and adequate capital investment. Business managers, as part of cost-benefit analysis, have to study the cost of employing capital and the rate of return expected from each and every project. Under capital management, managers should assess capital requirement, methods of capital mobilization, capital budgeting, optimal allocation of capital, selection of highly profitable projects, cost of capital, return on capital, planning and control of capital expenditure, etc.

Market structure and conditions: - The information on market structure and conditions of various markets is the most important part of the business. The nature, extent and degree of competition, number of sellers and buyers, etc. determine the nature of policies to be adopted by a firm in the market.