ASSIGNMENT

Course Code : MS-9

Course Title : Managerial Economics

Assignment No. : MS-9/TMA/SEM-II/2020

Coverage : All Blocks

Note: Attempt all the questions and submit this assignment to the Coordinator of your Study
Centre on or before 31st October, 2020.

1. Discuss the three choice problems as a central issue of an economy.

2. Distinguish between the three important sources of data used in forecasting:-

(a) Expert Opinion

(b) Surveys
(c) Market experiments

3. Briefly analyze the behavior of cost functions in the short run.

4. Explain the classification of markets based on their characteristics

5. What is Price Discrimination? Explain first, second and third degree price
discrimination.

6. Write short notes on the following:-

(a) Managerial Economics and other disciplines

(b) Arc Price Elasticity
(c) Economies and Diseconomies of Scale
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ASSIGNMENT REFERENCE MATERIAL (July20 to Dec20)

MS-09

MANAGERIAL ECONOMICS

Q1. Discuss the three choice problems as a central issue of an economy.

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Ans:- These three choice problems have become the three central issues of an economy as
shown in figure below. Economics has developed several concepts and analytical tools to
deal with the question of allocation of scarce resources among competing ends. The non-
trivial problem that needs to be addressed is how an economy through its various institutions
solves or answers the three crucial questions posed above. There are three ways by which this
can be achieved. One, entirely by the market mechanism, two, entirely by the government or

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finally, and more reasonably, by a combination of the first two approaches. Realistically all
economies employ the last option, but the relative roles of the market and government vary
across countries. For example, in India the market has started playing a more important role
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in the economy while the government has begun to withdraw from certain activities. Thus,
the market mechanism is gaining importance. A similar change is happening all over the
world, including in China. But there are economies such as Myanmar and Cuba where the
government still plays an overwhelming part in solving the resource allocation problem.

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Essentially, the market is supposed to guide resources to their most efficient use. For example
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if the salaries earned by MBA degree holders continue to rise, there will be more and more
students wanting to earn the degree and more and more institutes wanting to provide such
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degrees to take advantage of this opportunity. The government may not force this to happen,
it will happen on its own through the market mechanism. The government, if anything, could
provide a regulatory function to ensure quality and consumer protection.
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According to the central deduction of economic theory, under certain conditions, markets
allocate resources efficiently. ‘Efficiency’ has a special meaning in this context. The theory
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says that markets will produce an outcome such that, given the economy’s scarce resources, it
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is impossible to make anybody better-off without making somebody else worse-off.

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Unlimited Choice Limited Resources

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SCARCITY

For whom to produce?

What to produce?
How to produce?

Figure: Three Choice Problems of an Economy

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Q2. Distinguish between the three important sources of data used in forecasting:-

(a) Expert Opinion

(b) Surveys

(c) Market experiments

Ans:- Three important sources of data used in forecasting are expert opinion, surveys, and
market experiments.

Expert Opinion:-The collective judgment of knowledgeable persons can be an important

source of information. In fact, some forecasts are made almost entirely on the basis of the

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personal insights of key decision makers. This process may involve managers conferring to
develop projections based on their assessment of the economic conditions facing the firm. In
other circumstances, the company’s sales personnel may be asked to evaluate future
prospects. In still other cases, consultants may be employed to develop forecasts based on
their knowledge of the industry. Although predictions by experts are not always the product
of "hard data," their usefulness should not be underestimated. Indeed, the insights of those

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closely connected with an industry can be of great value in forecasting.

Methods exist for enhancing the value of information elicited from experts. One of the most
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useful is the Delphi technique. Its use can be illustrated by a simple example. Suppose that a
panel of six outside experts is asked to forecast a firm’s sales for the next year. Working
independently, two panel members forecast an 8 percent increase, three members predict a 5

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percent increase, and one person predicts no increase in sales. Based on the responses of the
other individuals, each expert is then asked to make a revised sales forecast. Some of those
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expecting rapid sales growth may, based on the judgments of their peers, present less
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optimistic forecasts in the second iteration. Conversely, some of those predicting slow growth
may adjust their responses upward. However, there may also be some panel members who
decide that no adjustment of their initial forecast is warranted.
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Surveys:- Surveys of managerial plans can be an important source of data for forecasting.
The rationale for conducting such surveys is that plans generally form the basis for future
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actions. For example, capital expenditure budgets for large corporations are usually planned
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well in advance. Thus, a survey of investment plans by such corporations should provide a
reasonably accurate forecast of future demand for capital goods.
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Several private and government organizations conduct periodic surveys. The annual National
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Council of Applied Economic Research (NCAER) survey of Market Information of

Households is well recognized. Many private organizations like ORG-MARG and TNS-
MODE conduct surveys relating to consumer demand across certain geographical areas.

If data from existing sources do not meet its specific needs, a firm may conduct its own
survey. Perhaps the most common example involves companies that are considering a new
product or making a substantial change in an existing product. But with new or modified
products, there are no data on which to base a forecast. One possibility is to survey
households regarding their anticipated demand for the product. Typically, such surveys
attempt to ascertain the demographic characteristics (e.g., age, education, and income) of

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those who are most likely to buy the product and find how their decisions would be affected
by different pricing policies.

Q3. Briefly analyze the behavior of cost functions in the short run.

Ans:- Short-run costs are important to understanding costs in economics. The distinction
between short-run and long-run based on fixed and variable factors of production makes the
concept of understanding short run costs simpler. Let us understand the concepts by way of
examples, diagrams for graphical representation.

It is key to understand the concept of the short run in order to understand short run costs. In
economics, we distinguish between short run and long run through the application of fixed or
variable inputs.

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Total Fixed Cost

Fixed cost refers to the cost of fixed inputs. It does not change with the level of output (thus,
fixed). Fixed inputs include building, machinery etc. Hence the cost of such inputs such as
rent or cost of machinery constitutes fixed costs. Also referred to as overhead costs,

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supplementary costs or indirect costs, these costs remain the same irrespective of the level of
output.
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Hence, if we plot the Total Fixed Cost (TFC) curve against the level of output on the
horizontal axis, we get a straight line parallel to the horizontal axis. This indicates that these
costs remain the same and that they have to be incurred even if the level of output is zero.

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Total Variable Cost

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The cost incurred on variable factors of production is called Total Variable Cost (TVC).
These costs vary with the level of output or production. Thus, when production level is zero,
TVC is also zero. Thus, the TVC curve begins from the origin.
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The shape of the TVC is peculiar. It is said to have an inverted-S shape. This is because, in
the initial stages of production, there is scope for efficient utilization of fixed factor by using
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more of the variable factor (eg. Workers employing machinery).

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Total Cost
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Total cost (TC) refers to the sum of fixed and variable costs incurred in the short-run. Thus,
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the short-run cost can be expressed as

TC = TFC + TVC

Note that in the long run, since TFC = 0, TC =TVC. Thus, we can get the shape of the TC
curve by summing over TFC and TVC curves.

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The following can be noted about the TC curve:

• The TC curve is inverted-S shaped. This is because of the TVC curve. Since the TFC
curve is horizontal, the difference between the TC and TVC curve is the same at each
level of output and equals TFC. This is explained as follows: TC – TVC = TFC
• The TFC curve is parallel to the horizontal axis while the TVC curve is inverted-S

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shaped.

Table : Numer of well-known studies estimating short run average and marginal cost curves
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Q4. Explain the classification of markets based on their characteristics
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Ans:- The term ‘market structure’ refers to the degree of competition prevailing in that
particular market. The power of an individual firm to control the market price by changing
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its own output determines the degree of competition and this power varies inversely with the
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degree of competition. The higher the degree of competition, the less market power the firm
has and vice-versa. Market power is generally thought to be the ability of the firm to
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influence price.
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The structure of a particular market plays an important role in defining the determinants that
affect these market structures. The four characteristics used to classify market structures are :
i) Number and size distribution of sellers, ii) Number and size distribution of buyers, iii)
Product differentiation and iv) Conditions of entry and exit.

i) Number and size distribution of sellers

The firm’s ability to affect the price and the quantity of a product supplied to the market is
related to the number of firms offering the same product. If there are a large number of
sellers, the influence of any one firm is likely to be less. Consider the number of firms selling
fruits and vegetables in your locality. It is unlikely that any one of them will exercise a great

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influence over price. On the contrary, if there are only few sellers in the market, an
individual firm can exercise greater control over price and total supply of the product.
Considering this fact the number of firms can be classified into large, few, two and one.

ii) Number and size distribution of buyers:- Markets can also be characterized by the
number and size distribution of buyers, where there are many small buyers of a product and
all are likely to pay about the same price. Consider a big firm in a city. For example, TISCO
in Jamshedpur is a large and perhaps the only firm in the area. TISCO will thus be able to
exercise considerable influence on the price at which it buys inputs from suppliers in the area.
Similarly, Maruti Udyog Limited (MUL) in Gurgaon is one of the large automobile
manufacturers and has considerable influence over the price at which it buy inputs such as
glass, radiator caps and accessories from other suppliers located in the region. Both MUL and
TISCO are firms that are said to have ‘monopsony’ power in their buying decisions.

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However, if there are a large number of buyers they will be unable to demand lower prices
from sellers. One reason why large firms are able to negotiate lower prices is because of
large volume purchases.

iii) Product Differentiation:- If the products competing in the market are not identical or
homogeneous, they are said to be differentiated and hence ‘product differentiation’ exists in

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the market. Product differentiation is a fact of like and there is some amount of
differentiation for almost all products that we buy in markets. For example, ingredients in
different soaps could be different as can be the packaging, advertising etc. Even seemingly
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homogeneous goods such as apples and bananas are at present differentiated on the basis of
the orchards where they have been grown and the way these are marketed. Wheat is a good
example of a product that can be considered undifferentiated. The degree of substitutability

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or product differentiation is measured by cross-elasticity of demand between two competing
products. Products can be classified into perfect substitutes or homogeneous products, close
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substitutes like soaps of different brands, remote substitutes like radio and television and no
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substitutes like cereals and soaps. Further, perfect substitutes for one consumer may not be
so for another. For example, Rahul may feel that Coke and Pepsi are perfect substitutes while
Sachin may have a strong brand preference for Pepsi. Product differentiation is a basis for a
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lot of advertising that is seen in the media where the focus is to create a strong brand
preference for the product being advertised.
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iv) Conditions of Entry and Exit:- Entry of exit of firms to an industry refers to the difficulty
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or ease with which a new firm can enter or exit a market. In short run, where the capital of
firms is fixed, entry and exit does not make much difference. Ease of entry and exit is
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however a crucial determinant of the nature of a market in the long run. When it is difficult
for firms to enter the market, existing firms will have much greater freedom in pricing and
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output decisions than if they had to worry about new entrants. Consider a firm such as
Ranbaxy that has a patent on a particular drug. A patent is an exclusive right to market the
product for a given period of time, say 12 years. If there are no close substitutes to that drug,
the firm will be free from competition for the duration of the patent. Thus the barriers to
entry in the market for this drug are high. Similarly, since Indian Railways, is a public
monopoly no new entrant can enter the market. Microsoft too has been able to create
substantial entry barriers in the market making it difficult for new firms to enter in the
market. On the other hand, retail outlets and the restaurant business witness several new
firms entering the market periodically, implying that entry barriers are relatively low.

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Q5. What is Price Discrimination? Explain first, second and third degree price
discrimination.

Ans:- PRICE DISCRIMINATION

Meaning of and conditions for price discrimination

Price discrimination refers to the charging of different prices for different quantities of a
product, at different times, to different customer groups or in different markets, when these
price differences are not justified by cost differences. For example, telephone companies
usually charge a given price per call for a given number of calls and a lower price for
additional batches of calls, charge higher prices for calls during business hours than in
evenings and on holidays, and charge higher prices to businesses than to households.

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Second Degree price discrimination refers to a situation where the monopolist charges
different prices for different set of units of the same product. An example is railway
passenger fares; the per kilometer fare is higher for the first few kilometers, which declines as
the distance increases. When the monopolist firm divides the market (for its product) into
two or more markets (groups of buyers of segments) and charges different price in each

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market, it is known as third degree price discrimination.

a) First Degree Price Discrimination

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Monopolists engage in price discrimination when they can increase their profits by doing so.
Even if sellers know the maximum amount that different customers are willing to pay,

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developing a pricing scheme that makes each customer pay that amount, a practice known as
first degree price discrimination can be difficult. Under first degree price discrimination, the
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full benefit from the trade between buyer and seller accrues to the seller. One strategy to
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achieve first degree price discrimination is to sell to the highest bidders through sealed bid
auctions. The auction approach is best suited for situations where the volume of sales are low
(usually due to scarcity of the product), where there are many potential buyers who are
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unable to co-operate among themselves and where buyers all have access to the same
information about the product’s characteristics. The auction approach would enable to seller
to identify those buyers with the highest willingness to pay and would yield the highest
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possible revenues for the same production costs. This is a common strategy for the sale of
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very special types of products such as art objects, antique furniture or the rights to the mining
and exploration of plots of land. It is not suitable for most bulk-produced products such as
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cans of cola or computers. Perfect, or first-degree price discrimination can occur when a firm
knows the maximum price the individual is willing to pay for each successive unit. The firm
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could then charge that highest price for each successive unit and capture the entire consumer
surplus. Remember that all forms of price discrimination involve some monopoly power, but
perfect price discrimination involves a degree of monopoly power rarely found in the real
world.

b) Second Degree Price Discrimination

When the auction approach is not feasible, the company must do its best to approximate the
first degree outcome using its pricing structure. This is based on the notion that an individual
consumer derives diminishing satisfaction from each successive unit of any product
consumed.

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This form of price discrimination, which is based on the volume of consumer purchases, is
very common and is known as second degree price discrimination. Other forms of second
degree price discrimination include two-tier tariffs, i.e. prices where the consumer must pay a
flat fee for access and then a separate fee (which may be zero) for usage. This is typical of
many clubs, amusement parks and transport facilities offering monthly or annual passes.

c) Third Degree Price Discrimination

Pricing based on what type of consumer is doing the purchasing rather than the volume of
purchase is an approach known as third degree price discrimination. This is very common in
the sales of air and rail travel, movie tickets and other products where consumers can be
segmented into different groups, who are likely to differ greatly in their willingness to pay
based on certain easily identifiable attributes. Thus, third-degree price discrimination, or

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market segmentation, requires that the seller be able to (1) segment, or separate, the market so
that goods sold in one market cannot be resold by the buyers in another; and (2) identify
distinct demand curves with different price elasticities for each market segment.

Third degree price discrimination is the most common in actual practice in the real world.

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Consider a monopolist facing the following demand and cost curves.

P = 100 - 4Q, C = 50 + 20Q

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Suppose, the firm is able to separate its customers in two distinct markets with the following
demand functions.

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P1 P
= 80 - 50 Q1 , 2 = 180 – 20Q
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It can be easily verified that the aggregate demand curve remains unchanged at
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P = 100 – 4Q

The two demand equations can be written in terms of quantities

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80 − P1
Q1 =
5
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180 − P2
Q2 =
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20

The total demand at any price P will be the summation of the two quantities.

80 − P 180 − P
∴ Q = Q1 + Q2 = +
5 20

= 16 – 0.2P + 9 – 0.05P

= 25 – 0.25P

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Solving the equation for P, we get: P = 100 – 4Q

P = 100 – 4 Q

For each market, the marginal revenue will be obtained as under:

P1 * Q=
1 R=
1 80Q1 − 5Q12
∴ MR1 =80 − 10Q1
=
Similarly MR2 180 − 40 Q2

Q6. Write short notes on the following:-

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(a) Managerial Economics and other disciplines

Ans:- (i) Micro Economics : The roots of managerial economics spring from micro-
economic theory, price theory, demand concepts and theories of market structure are few
elements of micro economics used by managerial economists. It has an applied bias as it

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applies economic theories in order to solve real world problems of enterprise.

(ii) Macro Economics : This field has little relevance for managerial economics but at least
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some part of it is incorporated in managerial economics i.e. national income forecasting. The
latter could be an important aid to business condition analysis, which in turn could be a
valuable input for forecasting the demand for specific product groups.

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(iii) Operational Research: This field is used in managerial economics to find out the best of
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all possibilities Linear programming is a great aid in decision making in business and
industry as it can help in solving problems like determination of facilities on machine
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scheduling, distribution of commodities and optimum product mix etc.

(iv) Statistics: Statistics helps in empirical testing of theory. With its help, better decisions
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relating to demand and cost functions, production, sales or distribution are taken. Managerial
economics is heavily dependent on statistical methods.
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(v) Accounting: Maximisation of profit has been regarded as a central concept in the theory
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of the firm in microeconomics. In recent years, organisation theorists have talked about
“satisficing” instead of “maximixing” as an objective of the enterprise. Accounting data and
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statements constitute the language of business. In fact, the link is so close that “managerial
accounting” has developed as a separate and specialized field in itself.”
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(b) Arc Price Elasticity

Ans. Arch price elasticity

Consider the hypothetical prices of some product and the corresponding quantity demanded,
as given in Table. We could calculate the arc price elasticity between the two lowest prices
i.e. between Rs. 30 and Rs. 10 as follows:

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Ep =
( 360 − 280 ) / (10 − 30 ) = −.25
( 360 + 280 ) 10 + 30

Thus, demand is inelastic in this range. This value of Ep = – .25 means that a one percent
change in price results in a .25% change in the quantity demanded (in the opposite direction
of the price change) over this region of the demand function.

Table: Demand Schedule to Demonstrate Price Elasticities

Price ` (P) Quantity (units) Arc Elasticity Point Elasticity

(Q)
90 40 – 4.00 – 9.00

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70 120 – 1.50 – 2.33
50 200 – 0.67 – 1.00
30 280 – 0.25 – 0.43
10 360 – 0.11

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If we calculate the arc price elasticity between the prices of 50 and 70, we have

(=200 − 120 ) ( 50 − 70 )
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Ep / –1.5
( 200 + 120 ) 50 + 70

We would say that demand is price elastic in this range because the percentage change in

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sales is greater than the percentage change in price. We can calculate arc elasticity over any
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price range. As an exercise estimate the arc elasticity between the extremes of the demand
function shown in Table, i.e. between Rs. 90 and Rs. 10. Satisfy ourselves that the absolute
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value of arc elasticity between these two points is 1.

(c) Economies and Diseconomies of Scale

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Ans. The U-shaped LRAC curve is explainable in terms of what economists call economies
of scale and diseconomies of scale. Economies and diseconomies of scale are concerned with
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behaviour of average cost curve as the plant size is increased. If LRAC declines as output
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increases, then we say that the firm enjoys economies of scale. If, instead, the LRAC
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increases as output increases, then we have diseconomies of scale. Finally, if LRAC is

constant as output increases, then we have constant returns to scale implying we have neither
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economies of scale nor diseconomies of scale.

Economies of scale explain the down sloping part of the LRAC curve. As the size of the plant
increases, LRAC typically declines over some range of output for a number of reasons. The
most important is that, as the scale of output is expanded, there is greater potential for
specialization of productive factors. This is most notable with regard to labour but may apply
to other factors as well. Other factors contributing to declining LRAC include ability to use
more advanced technologies and more efficient capital equipment; managerial specialisation;
opportunity to take advantage of lower costs (discounts) for some inputs by purchasing larger
quantities; effective utilization of by products, etc.

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But, after sometime, expansion of a firm’s output may give rise to diseconomies, and
therefore, higher average costs. Further expansion of output beyond a reasonable level may
lead to problems of over- crowding of labour, managerial inefficiencies, etc., pushing up the
average costs.

In other words, we have analysed the relationship between firm’s output and its long-run
average costs. The economies of scale and diseconomies of scale are sometimes called as
internal economies of scale and internal diseconomies of scale respectively. This is because
the changes in long run average costs result solely from the individual firm’s adjustment of
its output. On the other hand, there may exist external economies of scale. The external
economies also help in cutting down production costs. With the expansion of an industry,
certain specialized firms also come up for working up the by-products and waste materials.
Similarly, with the expansion of the industry, certain specialised units may come up for

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supplying raw material, tools, etc., to the firms in the industry. Moreover, they can combine
together to undertake research, etc., whose benefit will accrue to all firms in the industry.
Thus, a firm benefits from expansion of the industry as a whole. These benefits are external
to the firm, in the sense that these have arisen not because of any effort on the part of the firm
but have accrued to it due to expansion of industry as a whole. All these external economies
help in reducing production costs.

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