Managerial economics

Master of Business Administration

Semester I

MB0042 – Managerial Economics

Assignment

Set- 1

Q1. What is a business cycle? Describe the different phases of a business cycle.

Ans.

The business cycle describes the phases of growth and decline in an economy. The goal
of economic policy is to keep the economy in a healthy growth rate -- fast enough to create jobs
for everyone who wants one, but slow enough to avoid inflation. Unfortunately, life is not so
simple. Many factors can cause an economy to spin out of control, or settle into depression. The
most important, over-riding factor is confidence -- of investors, consumers, businesses and
politicians. The economy grows when there is confidence in the future and in policymakers, and
does the opposite when confidence drops.

The phase of the Business Cycle

There are four stages that describe the business cycle. At any point in time you are in one
of these stages:

1. Contraction - When the economy starts slowing down.

2. Trough - When the economy hits bottom, usually in a recession.

3. Expansion - When the economy starts growing again.

4. Peak - When the economy is in a state of "irrational exuberance."

Who Determines the Business Cycle Stages?

The National Bureau of Economic Research (NBER) analyzes economic indicators to determine
the phases of the business cycle. The Business Cycle Dating Committee uses quarterly GDP growth rates as
the primary indicator of economic activity. The Bureau also uses monthly figures, such as employment,
real personal income, industrial production and retail sales.

What GDP Can You Expect in Each Business Cycle Phase?

In the Contraction phase, GDP growth rates usually slow to the 1%-2% level before actually
turning negative. The 2008 recession was so nasty because the economy immediately
shrank 1.8% in the first quarter 2008, grew just 1.3% in the second quarter, before falling
another 3.9% in the third quarter, and then plummeting a whopping 8.9% in the fourth quarter.
The economy received another wallop in the first quarter of 2009, when the economy contracted
a brutal 6.9%.

Q2. What is monetary policy?

Explain the general objectives and instruments of monetary policy?

Ans.

Monetary Policy

Monetary policy, in its narrow concept, is defined as the measures focused on regulating money
supply. In harmony with monetary policy goals, as will be shown later, and adopting the most
common concept of monetary policy as one of the central bank‘s functions, monetary policy is
defined as ― the set of procedures and measures taken by monetary authorities to manage money
supply, interest and exchange rates and to influence credit conditions to achieve certain
economic objectives‖. We find this definition more consistent with the practical applications of
monetary policy, particularly with respect to the difference from one country to another in
objectives selected as a link between the instruments of monetary policy and its ultimate goals.

First: Monetary Policy and General Economic Policies

Monetary policy is basically a type of stabilization policy adopted by countries to deal with
different economic imbalances. Since monetary policy covers the monetary aspect of the general
economic policy, a high level of co-ordination is required between monetary policy and other
instruments of economic policy. Further, the effectiveness of monetary policy and its relative
importance as a tool of economic stabilization various from one economy to another, due to
differences among economic structures, divergence in degrees of development in money and
capital markets resulting in differing degree of economic progress, and differences in prevailing
economic conditions. However, we may briefly mention that the weak effectiveness which is
usually attributed to monetary policy in developing countries is caused by the fact that the
economic problems in these countries are mainly structural and not monetary in nature, while the
limited effectiveness of monetary policy in countries which lack developed money markets
occurs because monetary policy is deprived of one of its major tools, the instrument of open
market operations.

Also, there are those who belittle the effectiveness of monetary policy in time of recession,
comparing the use of this policy in controlling recession as ―pressing on a spring‖. Many others
see monetary policy as ineffective in controlling the inflation that results from an imbalance
between the demand and supply of goods and services originating from the supply side, while
they confirm the effectiveness of monetary policy in controlling inflation that results from
increased demand. However, this does not preclude the effectiveness of monetary policy as a
flexible instrument allowing the authorities to move quickly to achieve stabilization, apart from
its importance in realizing external equilibrium in open economies.

Monetary Policy Instruments

The set of instruments available to monetary authorities may differ from one country to another,
according to differences in political systems, economic structures, statutory and institutional
procedures, development of money and capital markets and other considerations. In most
advanced capitalist countries, monetary authorities use one or more of the following key
instruments: changes in the legal reserve ratio, changes in the discount rate or the official key
bank rate, exchange rates and open market operations. In many instances, supplementary
instruments are used, known as instruments of direct supervision or qualitative instruments.
Although the developing countries use one or more of these instruments, taking into
consideration the difference in their economic growth levels, the dissimilarity in the patterns of
their production structures and the degree of their of their link with the outside world, many
resort to the method of qualitative supervision, particularly those countries which face problems
arising from the nature of their economic structures. Although the effectiveness of monetary
policy does not necessarily depend on using a wide range of instruments, coordinated use of
various instruments is essential to the application of a rational monetary policy.

Q3. A firm supplied 3000 pens at the rate of Rs 10. Next month, due to a rise of in the
price to 22 Rs. per pen the supply of the firm increases to 5000 pens. Find the elasticity of
supply of the pens.

Ans.

Of course, consumption is not the only thing that changes when prices go up or down.
Businesses also respond to price in their decisions about how much to produce. Economists
define the price elasticity of supply as the responsiveness of the quantity supplied of a good to its
market price.

More precisely, the price elasticity of supply is the percentage change in quantity supplied
divided by the percentage change in price.

Suppose the amount supplied is completely fixed, as in the case of perishable pen brought to
market to be sold at whatever price they will fetch. This is the limiting case of zero elasticity, or
completely inelastic supply, which is a vertical supply curve.

At the other extreme, say that a tiny cut in price will cause the amount supplied to fall to zero,
while the slightest rise in price will coax out an indefinitely large supply. Here, the ratio of
the percentage change in quantity supplied to percentage change in price is extremely large and
gives rise to a horizontal supply curve. This is because the polar case of infinitely elastic supply.

Between these extremes, we call elastic or inelastic depending upon whether the percentage
change in quantity is larger or smaller than the percentage change in price. Price elasticity of
demand is a ratio of two pure numbers, the numerator is the percentage change in the quantity
demanded and the denominator is the percentage change in price of the commodity. It is
measured by the following formula:

Ep = Percentage change in quantity demanded/ Percentage changed in price Applying the
provided data in the equation: Percentage change in quantity demanded = (5000 –
3000)/3000Percentage changed in price = (22 – 10) / 10

Ep = ((5000 – 3000)/3000) / ((22 – 10)/10)
= 1.2.

Q4. Give a brief description of:

a. Implicit and explicit cost

b. Actual and opportunity cost

Ans.

a. Implicit and explicit cost

Implicit cost

In economics, an implicit cost, also called an imputed cost, implied cost, or notional cost, is
the opportunity cost equal to what a firm must give up in order using factors which it neither
purchases nor hires. It is the opposite of an explicit cost, which is borne directly. In other words,
an implicit cost is any cost that results from using an asset instead of renting, selling, or lending
it. The term also applies to forgone income from choosing not to work.

Implicit costs also represent the divergence between economic profit (total revenues minus total
costs, where total costs are the sum of implicit and explicit costs) and accounting profit (total
revenues minus only explicit costs). Since economic profit includes these extra opportunity costs,
it will always be less than or equal to accounting profit

Explicit cost

An explicit cost is a direct payment made to others in the course of running a business, such as
wage, rent and materials, as opposed to implicit costs, which are those where no actual payment
is made. It is possible still to underestimate these costs, however: for example, pension
contributions and other "perks" must be taken into account when considering the cost of labour.

Explicit costs are taken into account along with implicit ones when considering economic
profit. Accounting profit only takes explicit costs into account.

b. Actual and opportunity cost

Actual cost

An actual amount paid or incurred, as opposed to estimated cost or standard cost. In contracting,
actual costs amount includes direct labor, direct material, and other direct charges.

Cost accounting information is designed for managers. Since managers are taking decisions
only for their own organization, there is no need for the information to be comparable to
similar information from other organizations. Instead, the important criterion is that the
information must be relevant for decisions that managers operating in a particular environment
of business including strategy make. Cost accounting information is commonly used in financial
accounting information, but first we are concentrating in its use by managers to take decisions.
The accountants who handle the cost accounting information generate add value by providing
good information to managers who are taking decisions. Among the better decisions, the better
performance of one's organization, regardless if it is a manufacturing company, a bank, a non-
profit organization, a government agency, a school club or even a business school. The cost-
accounting system is the result of decisions made by managers of an organization and the
environment in which they make them.

Opportunity cost

Opportunity cost is the cost of any activity measured in terms of the value of the next best
alternative forgone (that is not chosen). It is the sacrifice related to the second best choice
available to someone, or group, who has picked among several mutually exclusive choices. The
opportunity cost is also the cost of the forgone products after making a choice. Opportunity cost
is a key concept in economics, and has been described as expressing "the basic relationship
between scarcity and choice". The notion of opportunity cost plays a crucial part in ensuring that
scarce resources are used efficiently. Thus, opportunity costs are not restricted to monetary or
financial costs: the real cost of output forgone, lost time, pleasure or any other benefit that
provides utility should also be considered opportunity costs.

Opportunity costs in production

Opportunity costs may be assessed in the decision-making process of production. If the workers
on a farm can produce either one million pounds of wheat or two million pounds of barley, then
the opportunity cost of producing one pound of wheat is the two pounds of barley forgone
(assuming the production possibilities frontier is linear). Firms would make rational decisions by
weighing the sacrifices involved.

Q5. Explain in brief the relationship between TR, AR, and MR under different market
condition.

Ans.

Meaning and Different Types of Revenues

Revenue is the income received by the firm. There are three concepts of revenue –

1. Total revenue (T.R)
2. Average revenue (A.R)
3. Marginal revenue (M.R)

1. Total revenue (TR):

Total revenue refers to the total amount of money that the firm receives from the sale of its
products, i.e. .gross revenue. In other words, it is the total sales receipts earned from the sale of
its total output produced over a given period of time. In brief, it refers to the total sales proceeds.
It will vary with the firm‘s output and sales. We may show total revenue as a function of the total
quantity sold at a given price as below.

TR = f (q). It implies that higher the sales, larger would be the TR and vice-versa. TR is
calculated by multiplying the quantity sold by its price. Thus, TR = PXQ. For e.g. a firm sells
5000 units of a commodity at the rate of Rs. 5 per unit, then TR would be

2. Average revenue (AR)

Average revenue is the revenue per unit of the commodity sold. It can be obtained by
dividing the TR by the number of units sold. Then, AR = TR/Q AR = 150/15= 10.

When different units of a commodity are sold at the same price, in the market, average revenue
equals price at which the commodity is sold for e.g. 2 units are sold at the rate of Rs.10 per unit,
then total revenue would be Rs. 20 (2×10). Thus AR = TR/Q 20/2 = 10. Thus average revenue
means price. Since the demand curve shows the relationship between price and the quantity
demanded, it also represents the average revenue or price at which the various amounts of a
commodity are sold, because the price offered by the buyer is the revenue from seller‘s point of
view. Therefore, average revenue curve of the firm is the same as demand curve of the
consumer.

Therefore, in economics we use AR and price as synonymous except in the context of price
discrimination by the seller. Mathematically P = AR.

3. Marginal Revenue (MR)

Marginal revenue is the net increase in total revenue realized from selling one more unit of a
product. It is the additional revenue earned by selling an additional unit of output by the
seller.

MR differs from the price of the product because it takes into account the effect of changes in
price. For example if a firm can sell 10 units at Rs.20 each or 11 units at Rs.19 each, then the
marginal revenue from the eleventh unit is (10 × 20) - (11 × 19) = Rs.9.

Relationship between Total revenue, Average revenue and Marginal Revenue concepts

In order to understand the relationship between TR, AR and MR, we can prepare a hypothetical
revenue schedule.

From the table, it is clear that:

MR falls as more units are sold.
TR increases as more units are sold but at a diminishing rate.TR is the highest when MR is zero
TR falls when MR become negative
AR and MR both falls, but fall in MR is greater than AR i.e., MR falls more steeply than AR.

Relationship between AR and MR and the nature of AR and MR curves under difference
market conditions

1. under Perfect Market

Under perfect competition, an individual firm by its own action cannot influence the market
price. The market price is determined by the interaction between demand and supply forces. A
firm can sell any amount of goods at the existing market prices. Hence, the TR of the firm
would increase proportionately with the output offered for sale. When the total revenue increases
in direct proportion to the sale of output, the AR would remain constant. Since the market price
of it is constant without any variation due to changes in the units sold by the individual firm, the
extra output would fetch proportionate increase in the revenue. Hence, MR & AR will be equal
to each other and remain constant. This will be equal to price.

Under perfect market condition, the AR curve will be a horizontal straight line and parallel to
OX axis. This is because a firm has to sell its product at the constant existing market price. The
MR cure also coincides with the AR curve. This is because additional units are sold at the same
constant price in the market.

2. under Imperfect Market

Under all forms of imperfect markets, the relation between TR, AR, and MR is different. This
can be understood with the help of the following imaginary revenue schedule.

From the above table it is clear that:

In order to increase the sales, a firm is reducing its price, hence AR falls
As a result of fall in price, TR increase but at a diminishing rate

TR will be higher when MR is zero
TR falls when MR becomes negative

From the above table it is clear that:
In order to increase the sales, a firm is reducing its price, hence AR falls.
As a result of fall in price, TR increase but at a diminishing rate.
TR will be higher when MR is zero
TR falls when MR becomes negative
AR and MR both declines. But fall in MR will be greater than the fall in AR.

The relationship between AR and MR curves is determined by the elasticity of
demand on the average revenue curve.

Under imperfect market, the AR curve of an individual firm slope downwards from
left to right. This is because; a firm can sell larger quantities only when it reduces the
price. Hence, AR curve has a negative slope.

The MR curve is similar to that of the AR curve. But MR is less than AR. AR and MR
curves are different. Generally MR curve lies below the AR curve.

The AR curve of the firm or the seller and the demand curve of the buyer is the same

Since, the demand curve represents graphically the quantities demanded by the buyers at various
prices it shows the AR at which the various amounts of the goods that are sold by the seller. This
is because the price paid by the buyer is the revenue for the seller (One man‘s expenditure is
another man‘s income). Hence, the AR curve of the firm is the same thing as that of the demand
curve of the consumers.

Suppose, a consumer buys 10 units of a product when the price per unit is Rs.5 per unit.

Hence, the total expenditure is 10 x 5 = Rs.50/-. The seller is selling 10 units at the rate of Rs.5
per unit. Hence, his total income is 10 x 5 = Rs.50/-.

Thus, it is clear that AR curve and demand curve is really one and the same.

Q6. Distinguish between a firm and an industry. Explain the equilibrium of a firm and
industry under perfect competition.

Ans.

Distinguish between a firm and an industry

An industry is the name given to a certain type of manufacturing or retailing environment.

For example, the retail industry is the industry that involves everything from clothes to
computers, anything in the shops that get sold to the public. The retail industry is very vast and
has many sub divisions, such as electrical and cosmetics. More specialized industries deal with a
specific thing. The steel industry is a more specialized industry, dealing with the making of steel
and selling it on to buyers.
The difference between this and a firm is that a firm is the company that operates within the
industry to create the product. The firm might be a factory, or the chain of stores that sells the
clothes, within its industry. For example, one firm that makes steel might be Aveda steel. They
create the steel in that firm for the steel industry.

A firm is usually a corporate company that controls a number of chains in the industry it is
operating within.

For example in retail, the firm Arcadia stores own the clothing chains Top shop, Dorothy
Perkins, Miss Selfridge, and Evans. These all operate for the firm Arcadia within the industry of
retail.
Several firms can operate in one industry to ensure that there is always competition to keep
prices reasonable and stop the market becoming a monopoly, which is where one firm is in
charge of the whole industry. Sometimes, a firm is not necessary within the industry and
independent chains and retailers can enter straight into the market without a firm behind them,
although this is risky. This is because one of the advantages of having a firm behind you is that it
is a safeguard against possible bankruptcy because the firm can support the chain that it owns.

The equilibrium of a firm and industry under perfect competition

According to Miller, ―Firm is an organization that buys and hires resources and sells goods and
services‖. Lipsey has defined as ―firm is the unit that employs factors of production to produce
commodities that it sells to other firms, to households, or to the government.‖

Industry is a group of firms producing standardized products in a market. According to
Lipsey, ―Industry is a group of firms that sells a well defined product or closely related set of
products.‖

Conditions of Equilibrium of the Firm and Industry

A firm is in equilibrium when it has no propensity to modify its level of productivity. It
requires neither extension nor retrenchment. It wants to earn maximum profits in by equating its
marginal cost with its marginal revenue, i.e. MC = MR. Diagrammatically, the conditions of
equilibrium of the firm are (1) the MC curve must equal the MR curve.

This is the first order and essential condition. But this is not a sufficient condition which may be
fulfilled yet the firm may not be in equilibrium.

(2) The MC curve must cut the MR curve from below and after the point of equilibrium it must
be above the MR.

This is the second order condition. Under conditions of perfect competition, the MR curve of a
firm overlaps with the AR curve. The MR curve is parallel to the X axis. Hence the firm is in
equilibrium when MC = MR = AR.

The first order figure (1), the MC curve cuts the MR curve first at point X. It contends the
condition of MC = MR, but it is not a point of maximum profits for the reason that after point X,
the MC curve is beneath the MR curve. It does not pay the firm to produce the minimum output
OM when it can earn huge profits by producing beyond OM. Point Y is of maximum profits
where both the situations are fulfilled.

Amidst points X and Y it pays the firm to enlarges its productivity for the reason that it‘s MR >
MC. It will nevertheless stop additional production when it reaches the OM1 level of
productivity where the firm fulfils both the circumstances of equilibrium. If it has any plants to
produce more than OM1 it will be incurring losses, for its marginal cost exceeds its marginal
revenue beyond the equilibrium point Y. The same finale hold good in the case of straight line
MC curve and it is presented in the figure.

An industry is in equilibrium, first when there is no propensity for the firms either to leave or
either the industry and next, when each firm is also in equilibrium. The first clause entails that
the average cost curves overlap with the average revenue curves of all the firms in the industry.

They are earning only normal profits, which are believed to be incorporated in the average cost
curves of the firms. The second condition entails the equality of MC and MR. Under a perfectly
competitive industry these two circumstances must be fulfilled at the point of equilibrium i.e.
MC = MR….

(1), AC = AR…. (2), AR = MR.

Hence MC = AC = AR. Such a position represents full equilibrium of the industry.

Short Run Equilibrium of the Firm and Industry

1. Short Run Equilibrium of the Firm

A firm is in equilibrium in the short run when it has no propensity to enlarge or contract its
productivity and needs to earn maximum profit or to incur minimum losses.

The short run is an epoch of time in which the firm can vary its productivity by changing the
erratic factors of production. The number of firms in the industry is fixed since neither the
existing firms can leave nor new firms can enter it.

Postulations

All firms use standardised factors of production
Firms are of diverse competence
Cost curves of firms are dissimilar from each other
All firms sell their produces at the equal price ascertained by demand and supply of the
industry so that the price of each firm, P (Price) = AR = MR
Firms produce and sell various volumes
The short run equilibrium of the firm can be described with the helps of marginal study
and total cost revenue study.

Marginal Cost, Marginal Revenue analysis – During the short run, a firm will produce only its
price equals average variable cost or is higher than the average variable cost (AVC).
Furthermore, if the price is more than the averages total costs, ATC, i.e. P = AR > ATC the firm
will be earning super normal profits. If price equals the average total costs, i.e. P = AR = ATC
the firm will be earning normal profits or break even.

If price equals AVC, the firm will be incurring losses. If price drops even a little below AVC, the
firm will shut down since in order to produce it must cover atleast it‘s AVC through short run.
So during the short run, under perfect competition, affirm is in equilibrium in all the above
mentioned stipulations.

Super normal profits – The firm will be earning super normal profits in the short run when price
is higher than the short run average cost.

Normal Profits = The firm may earn normal profits when price equals the short run average
costs.

Total Cost – Total Revenue Analysis – The short run equilibrium of the firm can also be
represented with the help of total cost and total revenue curves. The firm is able to maximise its
profits when the positive discrimination between TR and TC is the greatest.

Short Run Equilibrium of the Industry

An industry is in equilibrium in the short run when its total output remains steady there being no
propensity to enlarge or contract its productivity. If all firms are in equilibrium the industry is
also in equilibrium. For full equilibrium of the industry in the short run all firms must be earning
normal profits.

But full equilibrium of the industry is by sheer accident for the reason that in the short rum some
firms may be earning super normal profits and some losses. Even then the industry is in short run
equilibrium when its quantity demanded and quantity supplied is equal at the price which clears
the market.

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Other topics under Product Pricing:

Applications of Demand and Supply Analysis under Perfect Competition
Concepts of Revenue
Derived Demand, Joint Supply
Determination of Profit Maximization under monopolist situation
Duopoly and Oligopoly
Forms of Market Structure
Importance of Time Element in Price Theory
Joint Demand Supply
Linear Programming
Long Run Equilibrium of Firm and Industry
Market Structures
Monopolistic Competition
Monopsony and Bilateral Monopoly, Price output Determination
Objectives of Business Firm
Oligopoly, Cornet‘s Oligopoly Model
Pricing of Public Undertakings
Profit Maximization, Full cost, Pricing and Sales Maximization
Pricing Under Perfect Competition - Demand Supply - Basic Framework
Profit Price Policy
Resource allocation under monopoly
Short, Long Run Supply Curve of the Firm and Industry
Similarities and Dissimilarities between Monopoly Competition and Perfect Competition
Supply Its Law - Elasticity and Curve
The Nature of Costs and Cost Curves
Williamson's Utility Maximization

Set 2

Q1. Suppose your manufacturing company planning to release a new product into market,
Explain the various methods forecasting for a new product.

Ans.

When a manufacturing companies planning to release a new product into themarket, it should
perform the demand forecasting to check the demand of the product in the market and also the
availability of similar product in the market.

Demand forecasting for new products is quite different from that for established products. Here
the firms will not have any past experience or past data for this purpose. An intensive study of
the economic and competitive characteristics of the product should be made to make efficient
forecasts.

As per Professor Joel Dean, few guidelines to make forecasting of demand for new
products are:

a. Evolutionary approach

The demand for the new product may be considered as an outgrowth of an existing product. For
e.g., Demand for new Tata Indica, which is a modified version of Old Indica can most effectively
be projected based on the sales of the old Indica, the demand for new Pulsor can be forecasted
based on the sales of the old Pulsar. Thus when a new product is evolved from the old product,
the demand conditions of the old product can be taken as a basis for forecasting the demand for
the new product.

b. Substitute approach

If the new product developed serves as substitute for the existing product, the demand for the
new product may be worked out on the basis of a ‗market share‘. The growths of demand for all
the products have to be worked out on the basis of intelligent forecasts for independent variables
that influence the demand for the substitutes. After that, a portion of the market can be sliced out
for the new product. For e.g., A moped as a substitute for a scooter, a cell phone as a substitute
for a land line. In some cases price plays an important role in shaping future demand for the
product.

c. Opinion Poll approach

Under this approach the potential buyers are directly contacted, or through the use of samples of
the new product and their responses are found out. These are finally blown up to forecast
the demand for the new product.

d. Sales experience approach

Offer the new product for sale in a sample market; say supermarkets or big bazaars in big cities,
which are also big marketing centers. The product may be offered for sale through one super
market and the estimate of sales obtained may be ‗blown up‘ to arrive at estimated demand for
the product.

e. Growth Curve approach

According to this, the rate of growth and the ultimate level of demand for the new product are
estimated on the basis of the pattern of growth of established products. For e.g., An Automobile
Co., while introducing a new version of a car will study the level of demand for the existing car.

f. Vicarious approach

A firm will survey consumers‘ reactions to a new product indirectly through getting in touch
with some specialized and informed dealers who have good knowledge about the market, about
the different varieties of the product already available in the market, the consumers‘ preferences
etc. This helps in making a more efficient estimation of future demand.

Q2. Define the term equilibrium. Explain the changes in market equilibrium and effects to
shifts in supply and demand.

Ans.

Equilibrium

The word equilibrium is derived from the Latin word a ―equilibrium‖ which means equal
balance. It means a state of even balance in which opposing forces or tendencies neutralize each
other. It is a position of rest characterized by absence of change. It is a state where there is
complete agreement of the economic plans of the various market participants so that no one has a
tendency to revise or alter his decision. In the words of professor Mehta: ―Equilibrium denotes
in economics absence of change in movement‖.

Market Equilibrium

There are two approaches to market equilibrium viz., partial equilibrium approach and the
general equilibrium approach. The partial equilibrium approach to pricing explains price
determination of a single commodity keeping the prices of other commodities constant. On the
other hand, the general equilibrium approach explains the mutual and simultaneous
determination of the prices of all goods and factors. Thus it explains a multi market equilibrium
position.

Earlier to Marshall, there was a dispute among economists on whether the force of demand or
the force of supply is more important in determining price. Marshall gave equal importance to
both demand and supply in the determination of value or price. He compared supply and demand
to a pair of scissors

We might as reasonably dispute whether it is the upper or the under blade of a pair of scissors that
cuts a piece of paper, as whether value is governed by utility or cost of production. Thus neither
the upper blade nor the lower blade taken separately can cut the paper; both have their
importance in the process of cutting. Likewise neither supply alone, nor demand alone
can determine the price of a commodity, both are equally important in the determination of price.
But the relative importance of the two may vary depending upon the time under consideration.
Thus, the demand of all consumers and the supply of all firms together determine the price of
a commodity in the market.

Equilibrium between demand and supply price:

Equilibrium between demand and supply price is obtained by the interaction of these two forces.
Price is an independent variable. Demand and supply are dependent variables. They depend on
price. Demand varies inversely with price; arise in price causes a fall in demand and a fall in
price causes a rise in demand. Thus the demand curve will have a downward slope indicating the
expansion of demand with a fall in price and contraction of demand with a rise in price. On the
other hand supply varies directly with the changes in price, a rise in price causes arise in supply
and a fall in price causes a fall in supply. Thus the supply curve will have an upward slope. At a
point where these two curves intersect with each other the equilibrium price is established. At
this price quantity demanded is equal to the quantity demanded.

This we can explain with the help of a table and a diagram

In the table at Rs.20 the quantity demanded is equal to the quantity supplied. Since the price is
agreeable to both the buyer and sellers, there will be no tendency for it to change; this is called
equilibrium price. Suppose the price falls to Rs.5 the buyer will demand 30 units while the seller
will supply only 5 units. Excess of demand over supply pushes the price upward until it reaches
the equilibrium position supply is equal to the demand. On the other hand if the price rises to
Rs.30 the buyer will demand only 5 units while the sellers are ready to supply 25 units. Sellers
compete with each other to sell more units of the commodity. Excess of supply over demand
pushes the price downward until it reaches the equilibrium. This process will continue till the
equilibrium price of Rs.20 is reached. Thus the interactions of demand and supply forces acting
upon each other restore the equilibrium position in the market. In the diagram DD is the demand
curve, SS is the supply curve. Demand and supply are in equilibrium at point E where the two

curves intersect each other. OQ is the equilibrium output. OP is the equilibrium price. Suppose
the price OP2 is higher than the equilibrium price OP. at this point price quantity demanded
isP2D2. Thus D2S2 is the excess supply which the seller wants to push into the market,
competition among the sellers will bring down the price to the equilibrium level where the
supply is equal to the demand. At price OP1, the buyers will demand P1D1 quantity while the
sellers are ready to sell P1S1. Demand exceeds supply. Excess demand for goods pushes up the
price; this process will go until equilibrium is reached where supply becomes equal to demand.

Q3. Explain how a product would reach equilibrium position with the help of ISO - Quants
and ISO-Cost curve.

Ans.

When producing a good or service, how do suppliers determine the quantity of factors to hire?
Below, we work through an example where a representative producer answers this question.
Let‘s begin by making some assumptions. First, we shall assume that our producer chooses
varying amounts of two factors, capital (K) and labor (L). Each factor was a price that does not
vary with output.
That is, the price of each unit of labor (w) and the price of each unit of capital (r) are assumed
constant. We‘ll further assume that w = $10 and r = $50. We can use this information to
determine the producer‘s total cost. We call the total cost equation an iso-cost line (it‘s similar to
a budget constraint).
The producer‘s iso-cost line is:
10L + 50K = TC (1)

The producer‘s production function is assumed to take the following form:
q = (KL) 0.5 (2)

Our producer‘s first step is to decide how much output to produce. Suppose that quantity is 1000
units of output. In order to produce those 1000 units of output, our producer must get a
combination of L and K that makes (2) equal to 1000. Implicitly, this means that we must find a
particular isoquant.

Set (2) equal to 1000 units of output, and solve for K. Doing so, we get the following equation
for a specific iso-quant (one of many possible iso-quants):
K = 1,000,000/L (2a)

For any given value of L, (2a) gives us a corresponding value for K. Graphing these values, with
K on the vertical axis and L on the horizontal axis, we obtain the blue line on the graph below.
Each point on this curve is represented as a combination of K and L that yields an output level of
1000 units. Therefore, as we move along this iso-quant output is constant (much like the fact that
utility is constant as A basic understanding of statistics is a critical component of informed
decision making.

Q4. Critically examine the Marris growth maximizing model??

Ans.

Profit maximization is traditional objective of a firm. Sales maximization objective is explained
by Prof. Boumal. On similar lines, Prof. Marris has developed another alternative growth
maximization model in recent years. It is a common factor to observe that each firm aims at
maximizing its growth rate as this goal would answer many of the objectives of a firm. Marris
points out that a firm has to maximize its balanced growth rate over a period of time.

Marris assumes that the ownership and control of the firm is in the hands of two groups of
people, i.e. owner and managers. He further points out that both of them have two distinctive
goals. Managers have a utility function in which the amount of salary, status, position, power,
prestige and security of job etc are the most import variable where as in case of are more
concerned about the size of output, volume of profits, market shares and sales maximization.

Utility function of the manager and that the owner are expressed in the following manner-

Uo= f [size of output, market share, volume of profit, capital, public esteem etc.]

Um= f [salaries, power, status, prestige, job security etc.]

In view of Marris the realization of these two functions would depend on the size of the firm.
Larger the firm, greater would be the realization of these functions and vice-versa. Size of the
firm according to Marris depends on the amount of corporate capital which includes total volume
of the asset, inventory level, cash reserve etc. He further points out that the managers always aim
at maximizing the rate of growth of the firm rather than growth in absolute size of the firms.
Generally managers like to stay in a grouping firm. Higher growth rate of the firm satisfy the
promotional opportunity of managers and also the share holders as they get more dividends.

B ou mal ’s S al es Maxi mi zati on mod el :

Sales maximization model is an alternative for profit maximization model. This model is
developed by Prof. W.J. Boumal, an American economist. This alternative goal has assumed
greater significance in the context of the growth of the oligopolistic firms. The model highlights
that the primary objective of the firm is to maximize its sales rather than profit maximization. It
states that the goal of the firm is maximization of sales revenue subject to a minimum profit
constraint. The minimum profit constraint is determined by the expectation of the share holders.
This is because no company can displease the shareholders. It is to be noted here that
maximization of sales does not mean maximization of physical sales but maximization of total
sales revenue. Hence, the managers are more interested in increasing sales rather than profit. The
basic philosophy is that when sales are maximized automatically profits of the company would

also go up. Hence, attention is diverted to increase the sales of the company in recent years in the
context of highly competitive market.

How Profit Maximization model differs from Sales Maximization model:

The sale maximization model differs on the following grounds:

Emphasis is given on maximizing sales rather than profit.

Increase the competitive and operational ability of the company.

The amount of slack earning and salaries of the top managers are directly linked to it.

It helps in enhancing the prestige and reputation of top management, distributes more
dividends to share holders and increases the wage of the workers and keeps them happy.

The financial and other lending institutions always keep a watch on the sales revenue of a
firm as it is an indication of financial health of the firm.

Q5. Define Pricing Policy. Explain the various objective of pricing policy.

Ans.

Pricing Policies

A detailed study of the market structure gives us information about the way in which prices are
determined under different market conditions. However, in reality, a firm adopts different
policies and methods to fix the price of its products.

Pricing policy refers to the policy of setting the price of the product or products and services by
the management after taking into account of various internal and external factors, forces and its
own business objectives.

Pricing Policy basically depends on price theory that is the corner stone of economic theory.
Pricing is considered as one of the basic and central problems of economic theory in a modern
economy. Fixing prices are the most important aspect of managerial decision making because
market price charged by the company affects the present and future production plans, pattern of
distribution, nature of marketing etc. Generally speaking, in economic theory, we take into
account of only two parties, i.e., buyers and sellers while fixing the prices. However, in practice
many parties are associated with pricing of a product. They are rival competitors, potential rivals,
middlemen, wholesalers, retailers, commission agents and above all the Govt. Hence, we should
give due consideration to theinfluence exerted by these parties in the process of price
determination. Broadly speaking, the various factors and forces that affect the price are divided
into two categories.

They are as follows:

I External Factors (Outside factors)

1. Demand, supply and their determinants.

2. Elasticity of demand and supply.

3. Degree of competition in the market.

4. Size of the market.

5. Good will, name, fame and reputation of a firm in the market.

6. Trends in the market.

7. Purchasing power of the buyers.

8. Bargaining power of customers

9. Buyers behavior in respect of particular product

II. Internal Factors (Inside Factors)

1. Objectives of the firm.

2. Production Costs.

3. Quality of the product and its characteristics.

4. Scale of production.

5. Efficient management of resources.

6. Policy towards percentage of profits and dividend distribution.

7. Advertising and sales promotion policies.

8. Wage policy and sales turn over policy etc.

9. The stages of the product on the product life cycle.

10. Use pattern of the product.

Objectives of the Price Policy:

A firm has multiple objectives today. In spite of several objectives, the ultimate aim of every
business concern is to maximize its profits. This is possible when the returns exceed costs. In this
context, setting an ideal price for a product assumes greater importance. Pricing objectives has to
be established by top management to ensure not only that the company‘s profitability is adequate
but also that pricing is complementary to the total strategy of the organization. While
formulating the pricing policy, a firm has to consider various economic, social, political and
other factors.

The Following objectives are to be considered while fixing the prices of the product.

1. Profit maximization in the short term

The primary objective of the firm is to maximize its profits. Pricing policy as an instrument to
achieve this objective should be formulated in such a way as to maximize the sales revenue and
profit. Maximum profit refers to the highest possible of profit.

In the short run, a firm not only should be able to recover its total costs, but also should get
excess revenue over costs. This will build the morale of the firm and instill the spirit of
confidence in its operations.

2. Profit optimization in the long run

The traditional profit maximization hypothesis may not prove beneficial in the long run. With the
sole motive of profit making a firm may resort to several kinds of unethical practices like
charging exorbitant prices, follow Monopoly Trade Practices (MTP), Restrictive Trade Practices
(RTP) and Unfair Trade Practices (UTP) etc. This may lead to opposition from the people. In
order to over- come these evils, a firm instead of profit maximization, and aims at profit
optimization.

Optimum profit refers to the most ideal or desirable level of profit.

Hence, earning the most reasonable or optimum profit has become a part and parcel of a sound
pricing policy of a firm in recent years.

3. Price Stabilization

Price stabilization over a period of time is another objective. The prices as far as possible should
not fluctuate too often. Price instability creates uncertain atmosphere in business circles. Sales
plan becomes difficult under such circumstances. Hence, price stability is one of the prerequisite
conditions for steady and persistent growth of a firm. A stable price policy only can win the
confidence of customers and may add to the good will of the concern. It builds up the reputation
and image of the firm.

4. Facing competitive situation

One of the objectives of the pricing policy is to face the competitive situations in the market. In
many cases, this policy has been merely influenced by the market share psychology. Wherever
companies are aware of specific competitive products, they try to match the prices of their
products with those of their rivals to expand the volume of their business. Most of the firms are
not merely interested in meeting competition but are keen to prevent it. Hence, a firm is always
busy with its counter business strategy.

5. Maintenance of market share

Market share refers to the share of a firm‘s sales of a particular product in the total sales of all
firms in the market.

The economic strength and success of a firm is measured in terms of its market share. In a
competitive world, each firm makes a successful attempt to expand its market share. If it is
impossible, it has to maintain its existing market share. Any decline in market share is a
symptom of the poor performance of a firm.

Hence, the pricing policy has to assist a firm to maintain its market share at any cost.

Q6. Discuss the various measures that may be taken by a firm to counteract the evil effects
of a trade cycle.

Ans.

FACTORS THAT SHAPE BUSINESS CYCLES

For centuries, economists in both the United States and Europe regarded economic downturns as
"diseases" that had to be treated; it followed, then, that economies characterized by growth and
affluence were regarded as "healthy" economies. By the end of the 19th century, however, many
economists had begun to recognize that economies were cyclical by their very nature, and studies
increasingly turned to determining which factors were primarily responsible for shaping the
direction and disposition of national, regional, and industry-specific economies. Today,
economists, corporate executives, and business owners cite several factors as particularly
important in shaping the complexion of business environments.

VOLATILITY OF INVESTMENT SPENDING

Variations in investment spending is one of the important factors in business cycles. Investment
spending is considered the most volatile component of the aggregate or total demand (it varies
much more from year to year than the largest component of the aggregate demand, the
consumption spending), and empirical studies by economists have revealed that the volatility of
the investment component is an important factor in explaining business cycles in the United
States. According to these studies, increases in investment spur a subsequent increase in
aggregate demand, leading to economic expansion. Decreases in investment have the opposite
effect. Indeed, economists can point to several points in American history in which the
importance of investment spending was made quite evident. The Great Depression, for instance,
was caused by a collapse in investment spending in the aftermath of the stock market crash of
1929. Similarly, prosperity of the late 1950s was attributed to a capital goods boom.

There are several reasons for the volatility that can often be seen in investment spending. One
generic reason is the pace at which investment accelerates in response to upward trends in sales.
This linkage, which is called the acceleration principle by economists, can be briefly explained
as follows. Suppose a firm is operating at full capacity. When sales of its goods increase, output
will have to be increased by increasing plant capacity through further investment. As a result,
changes in sales result in magnified percentage changes in investment expenditures. This
accelerates the pace of economic expansion, which generates greater income in the economy,
leading to further increases in sales. Thus, once the expansion starts, the pace of investment
spending accelerates. In more concrete terms, the response of the investment spending is related
to the rate at which sales are increasing. In general, if an increase in sales is expanding,
investment is spending rises, and if an increase in sales has peaked and is beginning to slow,
investment spending falls. Thus, the pace of investment spending is influenced by changes in the
rate of sales.

MOMENTUM

Many economists cite a certain "follow-the-leader" mentality in consumer spending. In situations
where consumer confidence is high and people adopt more free-spending habits, other customers
are deemed to be more likely to increase their spending as well. Conversely, downturns in
spending tend to be imitated as well.

TECHNOLOGICAL INNOVATIONS

Technological innovations can have an acute impact on business cycles. Indeed, technological
breakthroughs in communication, transportation, manufacturing, and other operational areas can
have a ripple effect throughout an industry or an economy. Technological innovations may relate
to production and use of a new product or production of an existing product using a new process.
The video imaging and personal computer industries, for instance, have undergone immense
technological innovations in recent years, and the latter industry in particular has had a
pronounced impact on the business operations of countless organizations. However,
technological innovations—and consequent increases in investment—take place at irregular
intervals. Fluctuating investments, due to variations in the pace of technological innovations,
lead to business fluctuations in the economy.

There are many reasons why the pace of technological innovations varies. Major innovations do
not occur every day. Nor do they take place at a constant rate. Chance factors greatly influence
the timing of major innovations, as well as the number of innovations in a particular year.
Economists consider the variations in technological innovations as random (with no systematic
pattern). Thus, irregularity in the pace of innovations in new products or processes becomes a
source of business fluctuations.

VARIATIONS IN INVENTORIES

Variations in inventories—expansion and contraction in the level of inventories of goods kept by
businesses—also contribute to business cycles. Inventories are the stocks of goods firms keep on
hand to meet demand for their products. How do variations in the level of inventories trigger
changes in a business cycle? Usually, during a business downturn, firms let their inventories
decline. As inventories dwindle, businesses ultimately find themselves short of inventories. As a
result, they start increasing inventory levels by producing output greater than sales, leading to an
economic expansion. This expansion continues as long as the rate of increase in sales holds up
and producers continue to increase inventories at the preceding rate. However, as the rate of
increase in sales slows, firms begin to cut back on their inventory accumulation. The subsequent
reduction in inventory investment dampens the economic expansion, and eventually causes an
economic downturn. The process then repeats itself all over again. It should be noted that while
variations in inventory levels impact overall rates of economic growth, the resulting business
cycles are not really long. The business cycles generated by fluctuations in inventories are

called minor or short business cycles. These periods, which usually last about two to four years,
are sometimes also called inventory cycles.

FLUCTUATIONS IN GOVERNMENT SPENDING

Variations in government spending are yet another source of business fluctuations. This may
appear to be an unlikely source, as the government is widely considered to be a stabilizing force
in the economy rather than a source of economic fluctuations or instability. Nevertheless,
government spending has been a major destabilizing force on several occasions, especially
during and after wars. Government spending increased by an enormous amount during World
War II, leading to an economic expansion that continued for several years after the war.
Government spending also increased, though to a smaller extent compared to World War II,
during the Korean and Vietnam wars. These also led to economic expansions. However,
government spending not only contributes to economic expansions, but economic contractions as
well. In fact, the recession of 1953-54 was caused by the reduction in government spending after
the Korean War ended. More recently, the end of the Cold War resulted in a reduction in defense
spending by the United States that had a pronounced impact on certain defense-dependent
industries and geographic regions.

POLITICALLY GENERATED BUSINESS CYCLES

Many economists have hypothesized that business cycles are the result of the politically
motivated use of macroeconomic policies (monetary and fiscal policies) that are designed to
serve the interest of politicians running for re-election. The theory of political business cycles is
predicated on the belief that elected officials (the president, members of congress, governors,
etc.) have a tendency to engineer expansionary macroeconomic policies in order to aid their re-
election efforts.

MONETARY POLICIES

Variations in the nation's monetary policies, independent of changes induced by political
pressures, are an important influence in business cycles as well. Use of fiscal policy—increased
government spending and/or tax cuts—is the most common way of boosting aggregate demand,
causing an economic expansion. Moreover, the decisions of the Federal Reserve, which controls
interest rates, can have a dramatic impact on consumer and investor confidence as well.

FLUCTUATIONS IN EXPORTS AND IMPORTS

The difference between exports and imports is the net foreign demand for goods and services,
also called net exports. Because net exports are a component of the aggregate demand in the
economy, variations in exports and imports can lead to business fluctuations as well. There are
many reasons for variations in exports and imports over time. Growth in the gross domestic

product of an economy is the most important determinant of its demand for imported goods—as
people's incomes grow, their appetite for additional goods and services, including goods
produced abroad, increases. The opposite holds when foreign economies are growing—growth in
incomes in foreign countries also leads to an increased demand for imported goods by the
residents of these countries. This, in turn, causes U.S. exports to grow. Currency exchange rates
can also have a dramatic impact on international trade—and hence, domestic business cycles—as
well.

KEYS TO SUCCESSFUL BUSINESS CYCLE MANAGEMENT

Small business owners can take several steps to help ensure that their establishments weather
business cycles with a minimum of uncertainty and damage. "The concept of cycle management
may be relatively new," wrote Matthew Gallagher in Chemical Marketing Reporter, "but it
already has many adherents who agree that strategies that work at the bottom of a cycle need to
be adopted as much as ones that work at the top of a cycle. While there will be no definitive
formula for every company, the approaches generally stress a long-term view which focuses on a
firm's key strengths and encourages it to plan with greater discretion at all times. Essentially,
businesses are operating toward operating on a more even keel."

Specific tips for managing business cycle downturns include the following:

Flexibility — According to Gallagher, "part of growth management is a flexible business plan
that allows for development times that span the entire cycle and includes alternative recession-
resistant funding structures."

Long-Term Planning—Consultants encourage small businesses to adopt a moderate stance in
their long-range forecasting.

Attention to Customers—this can be an especially important factor for businesses seeking to
emerge from an economic downturn. "Staying close to the customers is a tough discipline to
maintain in good times, but it is especially crucial coming out of bad times," stated Arthur Daltas
in Industry Week. "Your customer is the best test of when your own upturn will arrive.
Customers, especially industrial and commercial ones, can give you early indications of their
interest in placing large orders in coming months."

Objectivity—Small business owners need to maintain a high level of objectivity when riding
business cycles. Operational decisions based on hopes and desires rather than a sober
examination of the facts can devastate a business, especially in economic down periods.

Study—"Timing any action for an upturn is tricky, and the consequences of being early or late
are serious," said Daltas. "For example, expanding a sales force when the markets don't
materialize not only places big demands on working capital, but also makes it hard to sustain the
motivation of the sales-people. If the force is improved too late, the cost is decreased market
share or decreased quality of the customer base. How does the company strike the right balance
between being early or late? Listening to economists, politicians, and media to get a sense of
what is happening is useful, but it is unwise to rely solely on their sources. The best route is to
avoid trying to predict the upturn. Instead, listen to your customers and know your own
response-time requirements."

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