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IGNOU MBA MS -09 Solved Assignment 2011

Course Code : MS-9

Course Title : Managerial Economics

Assignment Code : 9/TMA/SEM-I/2011

Coverage : All Blocks

Attempt All the Questions.

1. Given the profit function of a firm in the form of table, calculate total profit, average profit and marginal profit and differentiate between incrementalism and marginalism.

Solution : In this case, Average Profit and Marginal Profit are same as there is only single value is available for Total Revenue &Total Cost. There are no fixed and variable costs are given. Hence the table is to be filled out as follows:

Unit of Output

(Q)

Total Revenue(TR)

Total Cost(TC)

Total Profit (TP) = T.R-T.C

Average Profit (AP) = TR/Q

Marginal Profit (MP)

1 10 5 5 10/1 = 10

10

2 30 18 12 30/2 = 15

15

3 50 29 21 50/3 = 16.66

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16.66

4 70 38 32 70/4 = 17.5

17.5

Differentiation between incrementalism and marginalism

Incrementalism is a method of working by adding to a project using many small (often unplanned), incremental changes instead of a few (extensively planned) large jumps. Wikipedia, for example, illustrates the concept by building an encyclopedia bit by bit, continually adding to it. In a similar vein, according to legend Virgil wrote the Aeneid in an incremental process, averaging three lines per day, and the Georgicseven more slowly at an average of one line per day. Logical incrementalism implies that the steps in the process are sensible. In public policy, incrementalism refers to the method of change by which many small policy changes are enacted over time in order to create a larger broad based policy change. This was the theoretical policy of rationality developed by Lindblom to be seen as a middle way between the Rational Actor Model and bounded rationality as both long term goal driven policy rationality and satisficing were not seen as adequate.

Marginalism refers to the use of marginal concepts in economic theory. Marginalism is associated with arguments concerning changes in the quantity used of a good or of a service, as opposed to some notion of the over-all significance of that class of good or service, or of some total quantity thereof.

The central concept of marginalism proper is that of marginal utility, but marginalists following the lead of Alfred Marshall were further heavily dependent upon the concept of marginal physical productivity in their explanation of cost; and the neoclassical tradition that emerged from British marginalism generally abandoned the concept of utility and gave marginal rates of substitution a more fundamental role in analysis.

Marginalism is now an integral part of mainstream economic theory

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Incrementalism is commonly employed in engineering, software design, Planning and industry. Whereas it is often criticized as "fire fighting", the progressive improvement of product designs characteristic, e.g., of Japanese engineering can create steadily improving product performance, which in certain circumstances outperforms more orthodox planning systems.

Another example would be in small changes that make way for a bigger overall change to get past unnoticed. A series of small steps toward an agenda would be less likely to be questioned than a large and swift change. An example could be the rise of gas prices, the company would only raise the price by a few cents every day, instead of a large change to a target price overnight. More people would notice and dispute a dramatic, 100% increase overnight, while a 100% increase over a span of a week would less likely be even noticed, let alone argued. This can be applied in many different ways, such as, economics, politics, a person's appearance, or laws.

On July 28, 2009, on the Fox News show Hannity, host Sean Hannity asked guest U.S. Senator John McCain if he thought that a possible agreement between majority Democrats and Blue Dog Democrats on health care

The marginal use of a good or service is the specific use to which an agent would put a given increase, or the specific use of the good or service that would be abandoned in response to a given decrease. Marginalism assumes, for any given agent, economic rationality and an ordering of possible states-of-the-world, such that, for any given set of constraints, there is an attainable state which is best in the eyes of that agent. Descriptive marginalism asserts that choice amongst the specific means by which various anticipated specific states-of-the-world (outcomes) might be affected is governed only by the distinctions amongst those specific outcomes; prescriptive marginalism asserts that such choice ought to be so governed.

On such assumptions, each increase would be put to the specific, feasible, previously unrealized use of greatest priority, and each decrease would result in abandonment of the use of lowest priority amongst the uses to which the good or service had been put.

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reform was incrementalism, to which McCain answered that he thought it was.

2. Define Price Elasticity. Explain the determinants of Price Elasticity.

Solution : Price elasticity of demand (PED or Ed) is a measure used in economics to show the responsiveness, or elasticity, of the quantity demanded of a good or service to a change in its price. More precisely, it gives the percentage change in quantity demanded in response to a one percent change in price (holding constant all the other determinants of demand, such as income). It was devised by Alfred Marshall.

Price elasticities are almost always negative, although analysts tend to ignore the sign even though this can lead to ambiguity. Only goods which do not conform to the law of demand, such as Veblen and Giffen goods, have a positive PED. In general, the demand for a good is said to be inelastic (or relatively inelastic) when the PED is less than one (in absolute value): that is, changes in price have a relatively small effect on the quantity of the good demanded. The demand for a good is said to be elastic (or relatively elastic) when its PED is greater than one (in absolute value): that is, changes in price have a relatively large effect on the quantity of a good demanded.

Revenue is maximised when price is set so that the PED is exactly one. The PED of a good can also be used to predict the incidence (or "burden") of a tax on that good. Various research methods are used to determine price elasticity, including test markets, analysis of 

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PED is derived from the percentage change in quantity (%ΔQd) and percentage change in price (%ΔP)

PED is a measure of responsiveness of the quantity of a good or service demanded to changes in its price.[1] The formula for the coefficient of price elasticity of demand for a good is:

The above formula usually yields a negative value, due to the inverse nature of the relationship between price and quantity demanded, as described by the "law of demand".[3] For example, if the price increases by 5% and quantity demanded decreases by 5%, then the elasticity at the initial price and quantity = −5%/5% = −1. The only classes of goods which have a PED of greater than 0 are Veblen and Giffen goods.[5] Because the PED is negative for the vast majority of goods and services, however, economists often refer to price elasticity of demand as a positive value (i.e., in absolute value terms).

This measure of elasticity is sometimes referred to as the own-price elasticity of demand for a good, i.e., the elasticity of demand with respect to the good's own price, in order to distinguish it from the elasticity of demand for that good with respect to the change in the price of some other good, i.e., a complementary or substitute good.[1] The latter type of elasticity measure is called a cross -price elasticity of demand .

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As the difference between the two prices or quantities increases, the accuracy of the PED given by the formula above decreases for a combination of two reasons. First, the PED for a good is not necessarily constant; as explained below, PED can vary at different points along the demand curve, due to its percentage nature.

Elasticity is not the same thing as the slope of the demand curve, which is dependent on the units used for both price and quantity.

Second, percentage changes are not symmetric; instead, the percentage changebetween any two values depends on which one is chosen as the starting value and which as the ending value. For example, if quantity demanded increases from 10 units to 15 units, the percentage change is 50%, i.e., (15 − 10) ÷ 10 (converted to a percentage). But if quantity demanded decreases from 15 units to 10 units, the percentage change is −33.3%, i.e., (15 − 10) ÷ 15.

Two alternative elasticity measures avoid or minimise these shortcomings of the basic elasticity formula: point-price elasticity and arc elasticity.

Point-price elasticity

One way to avoid the accuracy problem described above is to minimise the difference between the starting and ending prices and quantities. This is the approach taken in the definition of point-price elasticity, which uses differential calculus to calculate the elasticity for an infinitesimal change in price and quantity at any given point on the demand curve: [14]

In other words, it is equal to the absolute value of the first derivative of quantity with respect to price (dQd/dP) multiplied by the point's price (P) divided by its quantity (Qd).

In terms of partial-differential calculus, point-price elasticity of demand can be defined as follows:[16] let   be the demand of goods   as a function of parameters price and wealth, and let   be the demand for good  . The elasticity of demand for good   with respect to price pk is

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However, the point-price elasticity can be computed only if the formula for the demand function, Qd = f(P), is known so its derivative with respect to price, dQd / dP, can be determined.

Arc elasticity

A second solution to the asymmetry problem of having a PED dependent on which of the two given points on a demand curve is chosen as the "original" point and which as the "new" one is to compute the percentage change in P and Q relative to the average of the two prices and the average of the two quantities, rather than just the change relative to one point or the other. Loosely speaking, this gives an "average" elasticity for the section of the actual demand curve—i.e., the arc of the curve—between the two points. As a result, this measure is known as the arc elasticity, in this case with respect to the price of the good. The arc elasticity is defined mathematically as:[13][17][18]

This method for computing the price elasticity is also known as the "midpoints formula", because the average price and average quantity are the coordinates of the midpoint of the straight line between the two given points.

However, because this formula implicitly assumes the section of the demand curve between those points is linear, the greater the curvature of the actual demand curve is over that range, the worse this approximation of its elasticity will be.

Interpreting values of price elasticity coefficients

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Perfectly inelastic demand

Perfectly elastic demand[10]

Elasticities of demand are interpreted as follows:

Value Descriptive Terms

Ed = 0 Perfectly inelastic demand

- 1 < Ed < 0 Inelastic or relatively inelastic demand

Ed = - 1Unit elastic, unit elasticity, unitary elasticity, or unitarily elastic demand

- ∞ < Ed < - 1

Elastic or relatively elastic demand

Ed = - ∞ Perfectly elastic demand

A decrease in the price of a good normally results in an increase in the quantity demanded by consumers because of the law of demand, and conversely, quantity

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demanded decreases when price rises. As summarized in the table above, the PED for a good or service is referred to by different descriptive terms depending on whether the elasticity coefficient is greater than, equal to, or less than −1. That is, the demand for a good is called:

relatively inelastic when the percentage change in quantity demanded is less than the percentage change in price (so that Ed > - 1);

unit elastic, unit elasticity, unitary elasticity, or unitarily elastic demand when the percentage change in quantity demanded is equal to the percentage change in price (so that Ed = - 1); and

relatively elastic when the percentage change in quantity demanded is greater than the percentage change in price (so that Ed < - 1).

As the two accompanying diagrams show, perfectly elastic demand is represented graphically as a horizontal line, and perfectly inelastic demand as a vertical line. These are the only cases in which the PED and the slope of the demand curve (∆P/∆Q) are both constant, as well as the onlycases in which the PED is determined solely by the slope of the demand curve (or more precisely, by the inverse of that slope).

Effect on total revenue

A firm considering a price change must know what effect the change in price will have on total revenue. Generally any change in price will have two effects: the price effect : an increase in unit price will tend to increase revenue, while a decrease in price will tend to decrease revenue.

the quantity effect : an increase in unit price will tend to lead to fewer units sold, while a decrease in unit price will tend to lead to more units sold.

Because of the inverse nature of the relationship between price and quantity demanded (i.e., the law of demand), the two effects affect total revenue in opposite directions. But in determining whether to increase or decrease prices, a firm needs to know what the net effect will be. Elasticity provides the answer: The percentage change in total revenue is equal to the percentage change in quantity demanded plus the percentage change in price. (One change will be positive, the other negative.)

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As a result, the relationship between PED and total revenue can be described for any good: When the price elasticity of demand for a good is perfectly inelastic (Ed = 0), changes in the price do not affect the quantity demanded for the good; raising prices will cause total revenue to increase.

When the price elasticity of demand for a good is relatively inelastic (- 1 < Ed < 0), the percentage change in quantity demanded is smaller than that in price. Hence, when the price is raised, the total revenue rises, and vice versa.

When the price elasticity of demand for a good is unit (or unitary) elastic (Ed = -1), the percentage change in quantity is equal to that in price, so a change in price will not affect total revenue.

When the price elasticity of demand for a good is relatively elastic (- ∞ < Ed < - 1), the percentage change in quantity demanded is greater than that in price. Hence, when the price is raised, the total revenue falls, and vice versa.

When the price elasticity of demand for a good is perfectly elastic (Ed is − ∞), any increase in the price, no matter how small, will cause demand for the good to drop to zero. Hence, when the price is raised, the total revenue falls to zero.

Hence, as the accompanying diagram shows, total revenue is maximised at the combination of price and quantity demanded where the elasticity of demand is unitary

It is important to realise that price-elasticity of demand is not necessarily constant over all price ranges. The linear demand curve in the accompanying diagram illustrates that changes in price also change the elasticity: the price elasticity is different at every point on the curve.

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A set of graphs shows the relationship between demand and total revenue (TR) for a linear demand curve. As price decreases in the elastic range, TR increases, but in the inelastic range, TR decreases. TR is maximised at the quantity where PED = 1.

3. ‘To an economist the fixed costs are overhead costs and to an accountant these are indirect costs.’ Substantiate this statement with the help of an example.

Solution : For a long time, there has been a considerable disagreement among economists and accountants on how costs should be treated. The reason for the difference of opinion is that the two groups want to use the cost data for dissimilar purposes. Accountants always have been concerned with firms’ financial statements. Accountants tend to take a retrospective look at firms finances because they keep trace of assets and liabilities and evaluate past performance. The accounting costs are useful for managing taxation needs as well as to calculate profit or loss of the firm. On the other hand, economists take forward-looking view of the firm. They are concerned with what cost is expected to be in the future and how the firm might be able to rearrange its resources to lower its costs and improve its profitability. They must therefore be concerned with opportunity cost. Since the only cost that matters for business decisions are the future costs, it is the

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economic costs that are used for decision-making. Accountants and economists both include explicit costs in their calculations.

For accountants, explicit costs are important because they involve direct payments made by a firm. These explicit costs are also important for economists as well because the cost of wages and materials represent money that could be useful elsewhere.

Although, no monitory transaction has occurred (and thus would not appear as an accounting cost), the business nonetheless incurs an opportunity cost because the owner could have earned a competitive salary by working elsewhere. Accountants and economists use the term ‘profits’ differently. Accounting profits are the firm’s total revenue less its explicit costs. But economists define profits differently. Economic profits are total revenue less all costs (explicit and implicit costs). The economist takes into account the implicit costs (including a normal profit) in addition to explicit costs in order to retain resources in a given line of production. Therefore, when an economist says that a firm is just covering its costs, it is meant that all explicit and implicit costs are being met, and that, the entrepreneur is receiving a return just large enough to retain his/ her talents in the present line of production. If a firm’s total receipts exceed all its economic costs, the residual accruing to the entrepreneur is called an economic profit, or pure profit.

4. What effect does change in demand have on price and quantity? Discuss with reference to pricing analysis of markets by giving illustrations.

Solution : In economics, the demand curve is the graph depicting the relationship between the price of a certain commodity, and the amount of it that consumers are willing and able to purchase at that given price. It is a graphic representation of a demand schedule. The demand curve for all consumers together follows from the demand curve of every individual consumer: the individual demands at each price are added together. Despite its name, it is not always shown as a curve, but sometimes as a straight line, depending on the complexity of the scenario.

Demand curves are used to estimate behaviors in competitive markets, and are often combined with supply curves to estimate the equilibrium price (the price at which sellers together are willing to sell the same amount as buyers together are

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willing to buy, also known as market clearingprice) and the equilibrium quantity (the amount of that good or service that will be produced and bought without surplus/excess supply or shortage/excess demand) of that market

In a monopolistic market, the demand curve facing the monopolist is simply the market demand curve.

An example of a demand curve shifting

Characteristics

According to convention, the demand curve is drawn with price on the vertical axis and quantity on the horizontal axis. The function actually plotted is the inverse demand function.

The demand curve usually slopes downwards from left to right; that is, it has a negative association. The negative slope is often referred to as the "law of demand", which means people will buy more of a service, product, or resource as its price falls. The demand curve is related to the marginal utility curve, since the price one is willing to pay depends on the utility. However, the demand directly depends on the income of an individual while the utility does not. Thus it may change indirectly due to change in demand for other commodities.

Changes that increase demand

Some circumstances which can cause the demand curve to shift out include:

increase in price of a substitute decrease in price of complement increase in income if good is a normal good

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decrease in income if good is an inferior goodChanges that decrease demand

Some circumstances which can cause the demand curve to shift in include:

decrease in price of a substitute increase in price of a complement decrease in income if good is normal good increase in income if good is inferior goodMovement along a demand curve

There is movement along a demand curve when a change in price causes the quantity demanded to change. It is important to distinguish between movement along a demand curve, and a shift in a demand curve. Movements along a demand curve happen only when the price of the good changes.When a non-price determinant of demand changes the curve shifts. These "other variables" are part of the demand function. They are "merely lumped into intercept term of a simple linear demand function." Thus a change in a non-price determinant of demand is reflected in a change in the x-intercept causing the curve to shift along the x axis.

5.Write short notes on the following :-a. Market Experimentsb. Bundling of servicesc. Product Differentiation

Solution : Market Experiments

An alternative method of collecting necessary information regarding demand is to carry out market studies and experiments on consumer’s behaviour under actual, though controlled, market conditions. This method is known in common parlance as market experiment method. Under this method, forms first select some areas of representative markets- three or four cities having similar features, viz., population, income levels, etc. Then they carry out market experiments by changing prices, advertisement expenditure and other controllable variables in the demand function under the assumption that

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other things remain same. The controllable variables may be changed over time. After such changes are introduced, the consequent changes in the demand over a period of time are recorded. On the basis of data collected, elasticity coefficients are computed. These coefficients are then used along with the variables of the demand function to assess the demand for the product.

Bundling of services

Product bundling is a marketing strategy that involves offering several products for sale as one combined product. This strategy is very common in the software business (for example: bundle a word processor, aspreadsheet, and a database into a single office suite), in the cable television industry (for example, basic cable in the United States generally offers many channels at one price), and in the fast food industry in which multiple items are combined into a complete meal. A bundle of products is sometimes referred to as a package deal or a compilation or an anthology.

Bundling is most successful when:

There are economies of scale in production, There are economies of scope in distribution, Marginal costs  of bundling are low. production  set-up costs are high, Customer acquisition costs are high. Consumers appreciate the resulting simplification of the purchase decision and

benefit from the joint performance of the combined product. Consumers have heterogeneous demands and such demands for different parts

of the bundle product are inversely correlated. For example, assume consumer A values word processor at $100 and spreadsheet processor at $60, while consumer B values word processor at $60 and spreadsheet at $100. Seller can generate maximum revenue of only $240 by setting $60 price for each product - both consumers will buy both products. Revenue cannot be increased without bundling because as seller increases the price above $60 for one of the goods, one of the consumers will refuse to buy it. With bundling, seller can generate

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revenue of $320 by bundling the products together and selling the bundle at $160.

Product bundling is most suitable for high volume and high margin (i.e., low marginal cost) products. Research by Yannis Bakos and Erik Brynjolfsson found that bundling was particularly effective for digital "information goods" with close to zero marginal cost, and could enable a bundler with an inferior collection of products to drive even superior quality goods out of the market place.

In oligopolistic and monopolistic industries, product bundling can be seen as an unfair use of market power because it limits the choices available to the consumer. In these cases it is typically called product tying.

Pure bundling occurs when a consumer can only purchase the entire bundle or nothing, mixed bundlingoccurs when consumers are offered a choice between the purchasing the entire bundle or one of the separate parts of the bundle.

Pure bundling can be further divided into two cases: in joint bundling, the two products are offered together for one bundled price, and, in leader bundling, a leader product is offered for discount if purchased with a non-leader product. Mixed-leader bundling is a variant of leader bundling with the added possibility of buying the leader product on its own.

Bundling in political economy is a type of product bundling in which the product is a candidate in an election who markets his bundle of attributes and positions to the voters.

In peer-to-peer swarming systems for content dissemination, such as BitTorrent, bundling consists of disseminating multiple files together in a single swarm. Empirical evidence and analytical models indicate that bundling improves content availability in those systems

Both pure and mixed bundling are supported by BitTorrent.

Product Differentiation

A concept in Economics and Marketing proposed by Edward Chamberlin in his 1933 Theory of Monopolistic Competition.

In marketing, product differentiation (also known simply as "differentiation") is the process of distinguishing a product or offering from others, to make it more

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attractive to a particular target market. This involves differentiating it from competitors' products as well as a firm's own product offerings.

Differentiation can be a source of competitive advantage. Although research in a niche market may result in changing a product in order to improve differentiation, the changes themselves are not differentiation. Marketing or product differentiation is the process of describing the differences between products or services, or the resulting list of differences. This is done in order to demonstrate the unique aspects of a firm's product and create a sense of value. Marketing textbooks are firm on the point that any differentiation must be valued by buyers (e.g.)

The term unique selling proposition refers to advertising to communicate a product's differentiation

In economics, successful product differentiation leads to monopolistic competition and is inconsistent with the conditions for perfect competition, which include the requirement that the products of competing firms should be perfect substitutes. There are three types of product differentiation: 1. Simple: based on a variety of characteristics 2. Horizontal : based on a single characteristic but consumers are not clear on quality 3. Vertical : based on a single characteristic and consumers are clear on its quality

The brand differences are usually minor; they can be merely a difference in packaging or an advertising theme. The physical product need not change, but it could. Differentiation is due to buyers perceiving a difference, hence causes of differentiation may be functional aspects of the product or service, how it is distributed and marketed, or who buys it. The major sources of product differentiation are as follows.

Differences in quality which are usually accompanied by differences in price Differences in functional features or design Ignorance  of buyers regarding the essential characteristics and qualities of

goods they are purchasing Sales promotion activities of sellers and, in particular, advertising Differences in availability (e.g. timing and location).

The objective of differentiation is to develop a position that potential customers see as unique. The term is used frequently when dealing withfreemium business

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models, in which businesses market a free and paid version of a given product. Given they target a same group of customers, it is imperative that free and paid versions be effectively differentiated.

Differentiation primarily impacts performance through reducing directness of competition: As the product becomes more different, categorization becomes more difficult and hence draws fewer comparisons with its competition. A successful product differentiation strategy will move your product from competing based primarily on price to competing on non-price factors (such as product characteristics,distribution strategy, or promotional variables).

Most people would say that the implication of differentiation is the possibility of charging a price premium; however, this is a gross simplification. If customers value the firm's offer, they will be less sensitive to aspects of competing offers; price may not be one of these aspects. Differentiation makes customers in a given segment have a lower sensitivity to other features (non-price) of the product.

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