Spring 2012

Master of Business Administration - Semester 1

MB 0042: “Managerial Economics” (4 credits) (Book ID: B1131)

ASSIGNMENT- Set 1 Marks 60

*Note: Each Question carries 10 marks.

Q.1 Define Managerial Economics and explain its main characteristics.

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

The same idea has been expressed by Spencer and Seigelman in the following words. “Managerial Economics is the integration of economic theory with business practice for the purpose of facilitating decision making and forward planning by the management”. According to Mc Nair and Meriam, “Managerial economics is the use of economic modes of thought to analyze business situation”. Brighman and Pappas define managerial economics as,” the application of economic theory and methodology to business administration practice”. Joel dean is of the opinion that use of economic analysis in formulating business and management policies is known as managerial economics.

Characteristics of managerial economics are as follows:a) It is more realistic, pragmatic and highlights on practical application of

various economic theories to solve business and management problems.b) It is science of decisions-making. It concentrates on decision-making

process, decision-models and decision variables and their relationships.c) It is both conceptual and metrical and it helps the decision maker by

providing measurement of various variables and their interrelationships.d) It uses various macroeconomic concepts like national income, inflation,

deflation, trade cycles etc to understand and adjust its policies to the environment in which the firm operates.

e) It also gives importance to the study of non-economic variables having implications of economic performance of the firm. For example, impact of technology, environment forces, socio-political and cultural factors etc.

f) It uses the services of many other sisters like mathematics, statistics, engineering, accounting, operation research and psychology etc to find solutions to business and management problems.

Q2. State and explain the law of demand.

Ans: The term of demand is different from desire, want, will or wish. In the language of economics, demand has different meaning. Any want or desire will not constitute demand. The term demand refers to total or given quantity of a commodity or a service that are purchased by the consumer in the market at a particular price and at a particular time.

The Law of Demand:It explains the relationship between price and quantity demanded of a commodity. It says that demand varies inversely with the price. The law can be explained in the following manner: “Keeping other factors that affect demand constant, a fall in price of a product leads to increase in quantity demanded and a rise in price leads to decrease in quantity demanded for the product”. The law can be expressed in mathematical terms as “Demand is a decreasing function of price”. Symbolically, thus D = F (p) where, D represents Demand, P stands for Price and F denotes the Functional relationship. The law explains the cause and effect relationship between the independent variable [price] and the dependent variable [demand]. The law explains only the general tendency of consumers while buying a product. A consumer would buy more when price falls due to the following reasons:

A product becomes cheaper.[Price effect] Purchasing power of a consumer would go up.[Income effect] Consumers can save some amount of money. Cheaper products are substituted for costly products [substitution effect].

Important Features of Law of Demand: There is an inverse relationship between price and quantity demanded. Price is an independent variable and demand is a dependent variable It is only a qualitative statement and as such it does not indicate quantitative

changes in price and demand. Generally, the demand curve slopes downwards from left to right.

The operation of the law is conditioned by the phrase “Other things being equal”. It indicates that given certain conditions, certain results would follow. The inverse relationship between price and demand would be valid only when tastes and preferences, customs and habits of consumers, prices of related goods, and income of consumers would remain constant.

Exceptions to the Law of Demand:Generally speaking, customers would buy more when price falls in accordance with the law of demand. Exceptions to law of demand states that with a fall in price, demand also falls and with a rise in price demand also rises. This can be represented by rising demand curve. In other words, the demand curve slopes

upwards from left to right. It is known as an exceptional demand curve or unusual demand curve

Q3. What is Demand Forecasting? Explain in brief various methods of forecasting demand.

Ans: Demand forecasting is the area of predictive analytics dedicated to understanding consumer demand for goods or services. That understanding is harnessed and used to forecast consumer demand. Knowledge of how demand will fluctuate enables the supplier to keep the right amount of stock on hand. If demand is underestimated, sales can be lost due to the lack of supply of goods. If demand is overestimated, the supplier is left with a surplus that can also be a financial drain. Understanding demand makes a company more competitive in the marketplace. Understanding demand and the ability to accurately predict it is imperative for efficient manufacturers, suppliers, and retailers. To be able to meet consumers’ needs, appropriate forecasting models are vital. Although no forecasting model is flawless, unnecessary costs stemming from too much or too little supply can often be avoided using data mining methods. Using these techniques, a business is better prepared to meet the actual demands of its customers.

Methods of Forecasting:Demand forecasting is a highly complicated process as it deals with the estimation of future demand. It requires the assistance and opinion of experts in the field of sales management. Demand forecasting, to become more realistic should consider the two aspects in a balanced manner. Application of commonsense is needed to follow a pragmatic approach in demand forecasting.

Broadly speaking, there are two methods of demand forecasting.

They are:1) Survey methods and2) Statistical methods

Figure: Methods of Demand Forecasting 

1) Survey Methods:Survey methods help us in obtaining information about the future purchase plans of potential buyers through collecting the opinions of experts or by interviewing the consumers. These methods are extensively used in short run and estimating the demand for new products. There are different approaches under survey methods. They are1. Consumer’s interview method: Under this method, efforts are made to collect the relevant information directly from the consumers with regard to their future purchase plans. In order to gather information from consumers, a number of alternative techniques are developed from time to time. Among them, the following are some of the important ones.a) Survey of buyer’s intentions or preferences:Under this method, consumer-buyers are requested to indicate their preferences and willingness about particular products. They are asked to reveal their ‘future purchase plans with respect to specific items.

b) Direct Interview Method:Under this method, customers are directly contacted and interviewed. Direct and simple questions are asked to them.

i. Complete enumeration method:Under this method, all potential customers are interviewed in a particular city or a region.

ii. Sample survey method or the consumer panel method:Under this method, different cross sections of customers that make up the bulk of the market are carefully chosen. Only such consumers selected from the relevant market through some sampling method are interviewed or surveyed.2. Collective opinion method or opinion survey method: Under this method, sales representatives, professional experts and the market consultants and others are asked to express their considered opinions about the volume of sales expected in the future.3. Delphi Method or Experts Opinion Method: Under this method, outside experts are appointed. They are supplied with all kinds of information and statistical data. The management requests the experts to express their considered opinions and views about the expected future sales of the company.4. End Use or Input – Output Method: Under this method, the sale of the product under consideration is projected on the basis of demand surveys of the industries using the given product as an intermediate product. 2) Statistical Method:

It is the second most popular method of demand forecasting. It is the best available technique and most commonly used method in recent years. Under this method, statistical, mathematical models, equations etc are extensively used in order to estimate future demand of a particular product. They are used for estimating long term demand. They are highly complex and complicated in nature. Some of them require considerable mathematical background and competence.1. Trend Projection Method: An old firm operating in the market for a long period will have the accumulated previous data on either production or sales pertaining to different years. If we arrange them in chronological order, we get what is called „time series‟. It is an ordered sequence of events over a period of time pertaining to certain variables. It shows a series of values of a dependent variable say, sales as it changes from one point of time to another. In short, a time series is a set of observations taken at specified time, generally at equal intervals. It depicts the historical pattern under normal conditions. This method is not based on any particular theory as to what causes the variables to change but merely assumes that whatever forces contributed to change in the recent past will continue to have the same effect. On the basis of time series, it is possible to project the future sales of a company.2. Economic Indicators:

Under this method, a few economic indicators become the basis for forecasting the sales of a company. An economic indicator indicates change in the magnitude of an economic variable. It gives the signal about the direction of change in an economic variable. This helps in decision making process of a company.Q4.Define the term equilibrium. Explain the changes in market equilibrium and effects of shifts in supply and demand.

Ans: Meaning of equilibriumThe word equilibrium is derived from the Latin word “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.”

 

Changes in Market Equilibrium:The changes in equilibrium price will occur when there will be shift either in demand curve or in supply curve or both:

Effects of Shift in demand:Demand changes when there is a change in the determinants of demand like the income, tastes, prices of substitutes and complements, size of the population etc. If demand raises due to a change in any one of these conditions the demand curve shifts upward to the right. If, on the other hand, demand falls, the demand curve shifts downward to the left. Such rise and fall in demand are referred to as increase and decrease in demand.

A change in the market equilibrium caused by the shifts in demand can be explained with the help of a diagram.

Effects of Changes in Demand and Supply:

Changes can occur in both demand and supply conditions. The effects of such changes on the market equilibrium depend on the rate of change in the two variables. If the rate of change in demand is matched with the rate of change in supply there will be no change in the market equilibrium, the new equilibrium shows expanded market with increased quantity of both supply and demand at the same price.

This is made clear from the diagram below:

Similar will be the effects when the decrease in demand is greater than the decrease in supply on the market equilibrium.

 

Q.5. Explain features of LAC curve with a diagram.

Ans: Features of long run AC curves: 1. Tangent curve: Different SAC curves represent different operational capacities of different plants in the short run. LAC curve is locus of all these points of tangency. The SAC curve can never cut a LAC curve though they are tangential to each other. This implies that for any given level of output, no SAC curve can ever be below the LAC curve. Hence, SAC cannot be lower than the LAC in the long run. Thus, LAC curve is tangential to various SAC curves.2. Envelope curve: It is known as Envelope curve because it envelopes a group of SAC curves appropriate to different levels of output.3. Flatter U-shaped or dish-shaped curve: The LAC curve is also U shaped or dish shaped cost curve. But it is less pronounced and much flatter in nature. LAC gradually falls and rises due to economies and diseconomies of scale.4. Planning curve: The LAC cure is described as the Planning Curve of the firm because it represents the least cost of producing each possible level of output. This helps in producing optimum level of output at the minimum LAC. This is possible when the entrepreneur is selecting the optimum scale plant. Optimum scale plant is that size where the minimum point of SAC is tangent to the minimum point of LAC.5. Minimum point of LAC curve should be always lower than the minimum point of SAC curve: This is because LAC can never be higher than SAC or SAC can never be lower than LAC. The LAC curve will touch the optimum plant SAC curve at its minimum point.A rational entrepreneur would select the optimum scale plant. Optimum scale plant is that size at which SAC is tangent to LAC, such that both the curves have the minimum point of tangency. In the diagram, OM2 is regarded as the optimum scale of output, as it has the least per unit cost. At OM2 output LAC = SAC.

LAC curve will be tangent to SAC curves lying to the left of the optimum scale or right side of the optimum scale. But at these points of tangency, neither LAC is minimum nor will SAC be minimum. SAC curves are either rising or falling indicating a higher cost

Managerial Use of LAC:The study of LAC is of greater importance in managerial decision making process.

1. It helps the management in the determination of the best size of the plant to be constructed or when a new one is introduced in getting the minimum cost output for a given plant. But it is interested in producing a given output at the minimum cost.

2. The LAC curve helps a firm to decide the size of the plant to be adopted for producing the given output. For outputs less than cost lowering combination at the optimum scale i.e., when the firm is working subject to increasing returns to scale, it is more economical to under use a slightly large plant operating at less

than its minimum cost – output than to overuse smaller unit. Conversely, at output beyond the optimum level, that is when the firm experience decreasing return to scale, it is more economical to over use a slightly smaller plant than to under use a slightly larger one. Thus, it explains why it is more economical to over use a slightly small plant rather than to under use a large plant.

3. LAC is used to show how a firm determines the optimum size of the plant. An optimum size of plant is one that helps in best utilization of resources in the most economical manner.

Long Run Marginal cost:

A long-run marginal cost curve can be derived from the long-run average cost curve. Just as the SMC is related to the SAC, similarly the LMC is related to the LAC and, therefore, we can derive the LMC directly from the LAC. In the diagram we have taken three plant sizes (for the sake of simplicity) and the corresponding three SAC and SMC curves. The LAC curve is drawn by enveloping the family of SAC curves. The points of tangency between the SAC and the LAC curves indicate different outputs for different plant sizes.

If the firm wants to produce ON output in the long run, it will have to choose the plant size corresponding to SAC1. The LAC curve is tangent to SAC1 at point A. For ON output, the average cost is NA and the corresponding marginal cost is NB If LAC curve is tangent to SAC1 curve at point A, the corresponding LMC curve will have to be equal to SMC1 curve at point B. The LMC will pass through point B. In other words, where LAC is equal to SAC curve (for a given output) the LMC will have to be equal to a given SMC.

If output OQ is to be produced in the long run, it will be done at point c which is the point of tangency between SAC2 and the LAC. At point C, the short –run average cost (SAC2) and the short-run marginal cost (SMC2) are equal and, therefore, the LAC for output OQ is QC and the corresponding LMC is also QC. The LMC curve will, therefore pass through point C.

Finally, for output OR, at point D the LAC is tangent to SAC3. For OR output at point E LMC is passing through SMC3. By connecting points B, C and E, we can draw the long-run marginal cost curve.

Q6. Explain cost output relationship with reference to

a. Total fixed cost and output

b. Total variable cost and output

c. .Total cost and output.

Ans: TFC refers to total money expenses incurred on fixed inputs like plant, machinery, tools & equipments in the short run. Total fixed cost corresponds to the fixed inputs in the short run production function. TFC remains the same at all levels of output in the short run. It is the same when output is nil. It indicates that whatever may be the quantity of output, whether 1 to 6 units, TFC remains constant. The TFC curve is horizontal and parallel to OX-axis, showing that it is constant regardless of output per unit of time. TFC starts from a point on Y-axis indicating that the total fixed cost will be incurred even if the output is zero. In our example, Rs 360=00 is TFC. It is obtained by summing up the product or quantities of the fixed factors multiplied by their respective unit price.

B. Total variable cost and output: TVC refers to total money expenses incurred on the variable factor inputs like raw materials, power, fuel, water, transport and communication etc, in the short run. Total variable cost corresponds to variable inputs in the short run production

function. It is obtained by summing up the production of quantities of variable inputs multiplied by their prices. The formula to calculate TVC is as follows. TVC = TC-TFC. TVC = f (Q) i.e. TVC is an increasing function of output. In other words TVC varies with output. It is nil, if there is no production. Thus, it is a direct cost of output. TVC rises sharply in the beginning, gradually in the middle and sharply at the end in accordance with the law of variable proportion. The law of variable proportion explains that in the beginning to obtain a given quantity of output, relative variation in variable factors-needed are in less proportion, but after a point when the diminishing returns operate, variable factors are to be employed in a larger proportion to increase the same level of output.TVC curve slope upwards from left to right. TVC curve rises as output is expanded. When output is Zero, TVC also will be zero. Hence, the TVC curve starts from the origin.

C. Total cost and output: The total cost refers to the aggregate money expenditure incurred by a firm to produce a given quantity of output. The total cost is measured in relation to the production function by multiplying the factor prices with their quantities. TC = f (Q) which means that the T.C. varies with the output. Theoretically speaking TC includes all kinds of money costs, both explicit and implicit cost. Normal profit is included in the total cost as it is an implicit cost. It includes fixed as well as variable costs. Hence, TC = TFC +TVC.TC varies in the same proportion as TVC. In other words, a variation in TC is the result of variation in TVC since TFC is always constant in the short run.

The total cost curve is rising upwards from left to right. In our example the TC curve starts from Rs. 360-00 because even if there is no output, TFC is a positive amount. TC and TVC have same shape because an increase in output increases them both by the same amount since TFC is constant. TC curve is derived by adding up vertically the TVC and TFC curves. The vertical distance between TVC curve and TC curve is equal to TFC and is constant throughout because TFC is constant.

Spring 2012

Master of Business Administration - Semester 1 MB 0042: “Managerial Economics” (4 credits) (Book ID: B1131)

ASSIGNMENT- Set 2 Marks 60

*Note: Each Question carries 10 marks

Q1. Explain the relationship between revenue concepts and price elasticity of demand.

Ans: Relationship between Revenue Concepts and Price Elasticity of Demand

Elasticity of Demand, Average Revenue and Marginal Revenue

There is a very useful relationship between elasticity of demand, average revenue and marginal revenue at any level of output. Elasticity of demand at any point on a consumer’s demand curve is the same thing as the elasticity on the given point on the firm’s average revenue curve. With the help of the point elasticity of demand, we can study the relationship between average revenue, marginal revenue and elasticity of demand at any level of output.

In the diagram AR and MR respectively are the average revenue and the marginal revenue curves. Elasticity of demand at point R on the average revenue curve = RT/Rt Now in the triangles PtR and MRT.

tPR = RMT (right angles)

tRP = RTM (corresponding angles)

PtR= MRT (being the third angle)

Therefore, triangles PtR and MRT are equiangular.

Hence RT / Rt = RM / tP

In the triangles PtK and KRQ

PK = RK

PKt = RKQ (vertically opposite)

tPK = KRQ (right angles )

Therefore, triangles PtK and RQK are congruent (i.e., equal in all respects).

Hence Pt = RQ

Elasticity at R = RT / Rt = RM / tP = RM / RQ

Hence elasticity at R = RM / RM – QM

It is also clear from the diagram that RM is average revenue and QM is the marginal revenue at the output OM which corresponds to the point R on the average revenue curve. Therefore elasticity at R = Average Revenue / Average Revenue – Marginal Revenue

If A stands for Average Revenue, M stands for Marginal Revenue and e stands for point elasticity on the average revenue curve Then e = A / A – M.

Thus, elasticity of demand is equal to AR over AR minus MR.

By using the above elasticity formula, we can derive the formula for AR and MR separately.

eA – eM = A bringing A’s together, we have

eA – A = eM

A ( e – 1 ) = eM

A = eM / e – 1

A =M (e / e – 1)

Therefore Average Revenue or price = M (e / e – 1)

Thus the price (i.e., AR) per unit is equal to marginal revenue x elasticity over elasticity minus one. The marginal revenue formula can be written straight away as

M = A ((e – 1) / e)

The general rule therefore is: at any output,

Average Revenue = Marginal Revenue x (e / e – 1) and

Marginal Revenue = Average Revenue x (e – 1 / e)

Where, e stands for point elasticity of demand on the average revenue curve. With the help of these formulae, we can find marginal revenue at any point from average revenue at the same point, provided we know the point elasticity of demand on the average revenue curve. Suppose that the price of a product is Rs.8 and the elasticity is 4 at that price. Marginal revenue will be:

M = A (( e – 1) / e)

= 8 ((4 – 1 / 4)

= 8 x 3 /4

= 24 / 4

= 6.

Marginal Revenue is Rs. 6.

Suppose that the price of a product is Rs.4 and the elasticity coefficient is 2 then the corresponding MR will be:

M = A ( ( e-1) / e)

= 4 ( ( 2 – 1) / 4)

= 4 x 1 / 4

= 4 / 4

= 1

Marginal revenue is Rs. 1

Suppose that the price of commodity is Rs.10 and the elasticity coefficient at that price is 1 MR will be:

M = A ((e-1) / e)

=10 ((1-1) /1)

=10 x 0/1

= 0

Whenever elasticity of demand is unity, marginal revenue will be zero, whatever be the price (or AR). It follows from this that if a demand curve shows unitary elasticity throughout its length the corresponding marginal revenue will be zero throughout, that is, the x axis itself will be the marginal revenue curve.

Thus, the higher the elasticity coefficient, the closer is the MR to AR / price. When elasticity coefficient is one for any given price, the corresponding marginal revenue will be zero, marginal revenue is always positive when the elasticity coefficient is greater than one and marginal revenue is always negative when the elasticity coefficient is less than one.

Kinked Demand curve and the corresponding Marginal Revenue curve

We measure quantity on the x axis and price on the Y axis. The demand curve AD has a kink at point B, thus exhibiting two different characteristics. From A to B it is elastic but from B to D it is inelastic. Because the demand is elastic from A to B a very small fall in price causes a very big rise in demand, but to realize the same increase in demand a very big fall in price is required as the demand curve assumes inelastic shape after point B. The corresponding marginal revenue curve initially falls smoothly, though at a greater rate. In the diagram there is a gap in MR between output 300 and 350.

Generally an Oligopolists who faces a kinked demand curve will make a good gain when he reduces the price a little before the kink (point B), but if he lowers the price below B; the rival firms will lower their prices too; accordingly the price cutting firm will not be able to increase its sales correspondingly or may not be able to increase its sales at all. As a result, the demand curve of price cutting firm below B is more inelastic. The corresponding MR curve is not smooth but has a gap or discontinuity between G and L. In certain cases, the kinked demand curve may show a high elasticity in the lower portion of the demand curve beyond the kink and low elasticity in higher portion of the demand curve before the kink Marginal revenue to such a demand curve will show a gap but instead of at a lower level, it will start at a higher level.

Relationship between AR, MR, TR and Elasticity of DemandIn the diagram AR is the average revenue curve, MR is the marginal revenue curve and OD is the total revenue curve. At the middle point C of average revenue curve elasticity is equal to one. On its lower half it is less than one and on the upper half it is greater than one. MR corresponding to the middle point C of the AR curve is zero. This is shown by the fact that MR curve cuts the x axis at Q which corresponds to the point C on the AR curve. If the quantity is greater than OQ it will correspond to that portion of the AR curve where e<1 marginal revenue is negative because MR goes below the x axis. Likewise for a quantity less than OQ, e>1 and the marginal revenue is positive. This means that if quantity greater than OQ is sold, the total revenue will be diminishing and for a quantity less than OQ the total revenue TR will be increasing. Thus the total revenue TR will be maximum at the point H where elasticity is equal to one and marginal revenue is zero.

Significance of Revenue curvesThe relationship between price elasticity of demand and total revenue is important because every firm has to decide whether to increase or decrease the price depending on the price elasticity of demand of the product. If the price elasticity of demand for his product is relatively elastic it will be advantageous to reduce price as it increases his total revenue. On the other hand, if the price elasticity of demand for his product is relatively inelastic he should raise the price as it increases his total revenue.

Average revenue, which is the price per unit, considered along with average cost will show to the firm whether it is profitable to produce and sell. If average revenue is greater than average cost, the firm is getting excess profit; if it is less than average cost, the firm is running at a loss.

Firm’s profit is maximum at a point where Marginal revenue is equal to Marginal cost. Any increase in output beyond that point will mean loss on additional units produced; restriction of output before that point will mean lower profit. Thus the concept of average revenue is relevant to find out whether the firm is running on profit or loss; the concept of marginal revenue together with marginal cost will show profit maximizing output for the firm.

Q2. Explain the emergence of Consumers’ surplus with their practical application.

Ans: Consumer surplus is a measure of the welfare that people gain from the consumption of goods and services, or a measure of the benefits they derive from the exchange of goods.

Consumer surplus is the difference between the total amount that consumers are willing and able to pay for a good or service (indicated by the demand curve) and the total amount that they actually do pay (i.e. the market price for the product). The level of consumer surplus is shown by the area under the demand curve and above the ruling market price as illustrated in the diagram below:

Consumer surplus and price elasticity of demand

When the demand for a good or service is perfectly elastic, consumer surplus is zero because the price that people pay matches precisely the price they are willing to pay. This is most likely to happen in highly competitive markets where each individual firm is assumed to be a ‘price taker’ in their chosen market and must sell as much as it can at the ruling market price.

In contrast, when demand is perfectly inelastic, consumer surplus is infinite. Demand is totally invariant to a price change. Whatever the price, the quantity demanded remains the same. Are there any examples of products that have such a low price elasticity of demand?

The majority of demand curves are downward sloping. When demand is inelastic, there is a greater potential consumer surplus because there are some buyers willing

to pay a high price to continue consuming the product. This is shown in the diagram below:

Changes in demand and consumer surplus

When there is a shift in the demand curve leading to a change in the equilibrium market price and quantity, then the level of consumer surplus will alter. This is shown in the diagrams above. In the left hand diagram, following an increase in demand from D1 to D2, the equilibrium market price rises to from P1 to P2 and the quantity traded expands. There is a higher level of consumer surplus because more is being bought at a higher price than before.

In the diagram on the right we see the effects of a cost reducing innovation which causes an outward shift of market supply, a lower price and an increase in the quantity traded in the market. As a result, there is an increase in consumer welfare

shown by a rise in consumer surplus.Consumer surplus can be used frequently when analyzing the impact of government intervention in any market – for example the effects of indirect taxation on cigarettes consumers or the introducing of road pricing schemes such as the London congestion charge.

Applications of consumer surplus

Paying for the right to drive into the centre of London

In July 2005, the congestion charge was raised to £8 per day. How has the London congestion charge affected the consumer surplus of drivers?

Consider the entry of Internet retailers such as Last Minute and Amazon into the markets for travel and books respectively. What impact has their entry into the market had on consumer surplus? Have you benefited from you perceive to be lower prices and better deals as a result of using e-commerce sites offering large discounts compared to high street retailers?

Price discrimination and consumer surplus

Producers often take advantage of consumer surplus when setting prices. If a business can identify groups of consumers within their market who are willing and able to pay different prices for the same products, then sellers may engage in price discrimination – the aim of which is to extract from the purchaser, the price they are willing to pay, thereby turning consumer surplus into extra revenue.

Airlines are expert at practicing this form of yield management, extracting from consumers the price they are willing and able to pay for flying to different destinations are various times of the day, and exploiting variations in elasticity of demand for different types of passenger service. You will always get a better deal / price with airlines such as Easy Jet and Ryan Air if you are prepared to book weeks or months in advance. The airlines are prepared to sell tickets more cheaply then because they get the benefit of cash-flow together with the guarantee of a seat being filled. The nearer the time to take-off, the higher the price. If a businessman is desperate to fly from Newcastle to Paris in 24 hours time, his or her demand is said to be price inelastic and the corresponding price for the ticket will be much higher.

One of the main arguments against firms with monopoly power is that they exploit their monopoly position by raising prices in markets where demand is inelastic, extracting consumer surplus from buyers and increasing profit margins at the same time. We shall consider the issue of monopoly in more detail when we come on to our study of markets and industries.

Q3. What is monetary policy? Explain the general objectives of monetary policy.

Ans: Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability.[1] [2] the official goals usually include relatively stable prices and low unemployment. Monetary theory provides insight into how to craft optimal monetary policy. It is referred to as either being expansionary or contractionary, where an expansionary policy increases the total supply of money in the economy more rapidly than usual, and contractionary policy expands the money supply more slowly than usual or even shrinks it. Expansionary policy is traditionally used to try to combat unemployment in a recession by lowering interest in the hope that easy credit will entice businesses into expanding. Contractionary policy is intended to slow inflation in hopes of avoiding the resulting distortions and deterioration of asset values.

General objective of monetary policy are described in detail:

a) Rapid Economic Growth: It is the most important objective of a monetary policy. The monetary policy can influence economic growth by controlling real interest rate and its resultant impact on the investment. If the RBI opts for a cheap or easy credit policy by reducing interest rates, the investment level in the economy can be encouraged. This increased investment can speed up economic growth. Faster economic growth is possible if the monetary policy succeeds in maintaining income and price stability.

b) Price Stability: All the economics suffer from inflation and deflation. It can also be called as Price Instability. Both inflation are harmful to the economy. Thus, the monetary policy having an objective of price stability tries to keep the value of money stable. It helps in reducing the income and wealth inequalities. When the economy suffers from recession the monetary policy should be an 'easy money policy' but when there is inflationary situation there should be a 'dear money policy'.

c) Exchange Rate Stability: Exchange rate is the price of a home currency expressed in terms of any foreign currency. If this exchange rate is very volatile leading to frequent ups and downs in the exchange rate, the international community might lose confidence in our economy. The monetary policy aims at maintaining the relative stability in the exchange rate. The RBI by altering the foreign exchange reserves tries to influence the demand for foreign exchange and tries to maintain the exchange rate stability.

d) Balance of Payments (BOP) Equilibrium: Many developing countries like India suffer from the Disequilibrium in the BOP. The Reserve Bank of India through its monetary policy tries to maintain equilibrium in the balance of payments. The BOP has two aspects i.e. the 'BOP Surplus' and the 'BOP Deficit'. The former reflects an excess money supply in the domestic economy, while the

later stands for stringency of money. If the monetary policy succeeds in maintaining monetary equilibrium, then the BOP equilibrium can be achieved.

e) Full Employment: The concept of full employment was much discussed after Keynes's publication of the "General Theory" in 1936. It refers to absence of involuntary unemployment. In simple words 'Full Employment' stands for a situation in which everybody who wants jobs get jobs. However it does not mean that there is Zero unemployment. In that senses the full employment is never full. Monetary policy can be used for achieving full employment. If the monetary policy is expansionary then credit supply can be encouraged. It could help in creating more jobs in different sector of the economy.

f) Neutrality of Money: Economist such as Wicksted, Robertson has always considered money as a passive factor. According to them, money should play only a role of medium of exchange and not more than that. Therefore, the monetary policy should regulate the supply of money. The change in money supply creates monetary disequilibrium. Thus monetary policy has to regulate the supply of money and neutralize the effect of money expansion. However this objective of a monetary policy is always criticized on the ground that if money supply is kept constant then it would be difficult to attain price stability.

g) Equal Income Distribution: Many economists used to justify the role of the fiscal policy are maintaining economic equality. However in recent years economists have given the opinion that the monetary policy can help and play a supplementary role in attainting an economic equality. Monetary policy can make special provisions for the neglect supply such as agriculture, small-scale industries, village industries, etc. and provide them with cheaper credit for longer term. This can prove fruitful for these sectors to come up. Thus in recent period, monetary policy can help in reducing economic inequalities among different sections of society.

Q4. What is a business cycle? Describe the different phases of a business cycle.

Ans: The business cycle or economic cycle refers to the fluctuations of economic

activity about its long-term growth trend. The cycle involves shifts over time

between periods of relatively rapid growth of output (recovery and prosperity), and

periods of relative stagnation or decline (contraction or recession). These

fluctuations are often measured using the real gross domestic product. Despite

being named cycles, these fluctuations in economic growth and declines do not

follow a purely mechanical or predictable periodic pattern.

Business cycle is a series of fluctuations in the economic activities of organized

communities over a long period of time.

Phases of the business cycle:

1. Depression, Contraction or downswing:

It is the first phase of a trade cycle. During this period, the level of economic activity

is extremely low.It is characterized by a low level of economic activity. This phase is

known as high un-employment, falling prices, wages, interest, and profit. While all

sectors in the economy suffer, some suffer more than others.

This period is characterized by:

A fall in the price.

A fall in interest rates.

Fall in the marginal efficiency of capital and hence the level of investment.

Contraction in bank credit.

A high rate of business failures.

A reduction in the volume of output, trade and transactions.

An increase in the level of unemployment.

A reduction in aggregate income of the community especially wages and profits.

There is a lot of excess capacity as industries producing capital and consumer

goods work capacity due to lack of demand.

2. Recovery:

Recovery refers to the lower turning point at which an economy undergoes changes

from depression to prosperity. With improvement in demand for capital goods,

recovery sets in when the demand for consumption goods rises, prices start rising

and so on.

The recovery may be initiated by the following factors:

Government expenditure.

Changes in production techniques.

Investment in new regions.

Exploitation in new sources of energy etc.

New innovations.

Low production costs.

As a result of these factors, business people take more risks, invest more. Low

wages, interest rates, cost of production, recovery in marginal efficiency of capital

etc induce the business people to take new ventures.

3. Expansion or Prosperity or full employment level:

It is characterized by a very high marginal efficiency of capital, resultant increased

investment, higher level of income, employment, expansion of book credit and

higher margin of profits causes, accelerated economic development.

During the period of prosperity, an economy experiences:

A high level of output and trade.

A high level of effective demand.

A high level of employment and income.

A high level of marginal efficiency of capital.

Price inflation.

A rise in interest rate.

A large expansion in bank credit.

Firms operate almost at full capacity along with its production possibility frontier.

Spread of optimistic environment through the economy.

4. over full employment level or Boom:

The prosperity phase does not stop at full employment. It gives way to the

emergence of a boom.

This is the situation where all the resources including natural and human resources

are optimally used.

During this phase:

The prices, wages, interest, profit, move in the upward direction.

Marginal Efficiency of Capital raises leading to business expansion.

Business people borrow more and invest. This adds fuel to the fire.

There is higher purchasing power and the level of effective demand will reach

new heights.

There is an atmosphere of “over optimism” all round which results in over

investment.

It is a symptom of the end of prosperity phase and the beginning of recession.

5. Recession:

The period of recession begins when the phase of prosperity ends. Recession exits

for a short period of time. Business pessimism during this period is characterized by

feelings of hesitation, doubt and fear.

Recession refers to decline in economic activity and a persistent fall in the

production caused by the inefficiency of income. It is also associated with a sharp

drop in the price level. Recession relates to turning point rather a phase.

Q5. What is inflation? Explain the causes of inflation.

Ans: Demand-pull inflation

Remember that Keynesians assume that the long run aggregate supply (LRAS) curve is horizontal, upward sloping and then vertical. Assume that the current level of aggregate demand is AD1. The price level is P1 and the level of real output is Y1. There is a lot of spare capacity in the economy. The level of output is nowhere near the full employment level YFE. An increase in aggregate demand (AD from now on) to AD2 in this situation, due to a rise in government spending, for example, will cause in increase in real output (to Y2) with no penalty in terms of rising prices.

Further increases in government spending would start to be inflationary. A shift in the AD curve from AD2 to AD3will increase real output (from Y2 to Y3) but the price level will also rise (from P1 to P2). The result is similar if AD rises to AD4. At this stage, the economy is approaching the full employment level of real output, so some industries still have some spare capacity but others will be at full capacity, resulting in price rises in some industries, and so a rise in the average price level when AD rises.

A further increase in AD when the economy is at full employment (AD level AD4) will simply result in a price rise with no increase in the level of real output.

The diagram shows that increases in the level of demand in an economy cause inflation. The rising level of demand is 'pulling' the price level up, hence the name 'demand-pull' inflation.

This effect can also be shown on the 45-degree diagram, where a level of demand above that which gives full employment equilibrium results in an inflationary gap.

The best example of this happening in the UK economy was the consumer boom of the late 80s. Excessive demand in the economy forced the inflation rate up to 10%.

Cost-push inflation

This cause of inflation is associated with rises in the costs of an industry, or the economy generally. The main reasons why costs might rise are (i) increases in wages and salaries (the biggest cost of production economy wide); (ii) increases in the cost of raw materials; (iii) increases in the price of imported goods (either as finished goods, semi-finished manufactures or raw materials) due to a fall in the value of the £ or price rises in the country of origin; (iv) increases in indirect taxes (or reductions in government subsidies). Any of these factors will have the following effect:

Short run aggregate supply (SRAS) curves have been used, but the analysis could be applied to LRAS curves. Quite simply, an increase in the costs of an economy will shift the SRAS curve to the left (from SRAS1 to SRAS2) causing the price level to rise to P2 and the level of real output to fall to Y2.

The oil price shocks of the mid 70s and early 80s are good examples of large increases in costs causing inflation. The militant trade unions made things worse by insisting on above inflation pay rises to make up for the price rises plus any unpredictable future rises in the price level.

This brings us onto an important subsequent effect of cost-push inflation, namely, wage-price spirals. During the price rises of the mid 70s, caused by the initial supply side shock of the huge rise in the price of oil, trade unions would press for higher wages. They were powerful bodies in those days and usually got what they wanted. Firms were forced to raise their prices to maintain profit levels. The loss in international competitiveness may well cause the £ to fall in value, increasing the price of imported goods. These further increases in the price level

caused more demands for higher wages from the trade unions. If successful, firms would raise their prices again, and so on. The price level would spiral out of control.

The unions may well have been aware that continual increases in their wage were self defeating because the real value of these increases was quickly eroded by the subsequent rises in the price level, but which union was going to act sensibly first? Only if all unions stopped asking for more money would the spiral be broken.

The effect was made worse by the 'leap-frogging' that took place. If the car workers got 15%, the miners wanted 17% and the steel workers wanted 20%. The car workers would then go back to their employers and say, "the steel workers got 20%, so we want at least 20%."

The Quantity Theory of Money

The last two causes of inflation were Keynesian explanations. As was said earlier, monetarists believed that sustained inflation would only occur if there was an increase in the money supply. The 'Quantity Theory of Money' can be used to explain the monetarists' point of view.

The money supply (M) is the amount of money in the economy. There are lots of definitions as to what exactly constitutes money, but for the time being, let us assume that it includes only notes and coins.

The velocity of circulation (V) refers to how quickly this money 'circulates' around the economy. One ten pound note may get spent three times in one week. So M times V is, effectively, equal to the 'money spent' in an economy.

P is the price level and y is the level of real output, or real income (some textbooks will use 'T' for transactions), which ever you prefer. P times y, therefore, represents the value of everything on which money is spent.

It has to be true that MV = Py. Money spent = what the money is spent on. That is why there are three horizontal lines instead of the usual two (the equals sign). This means that, rather than being an equation, this is an identity. Whatever is on the left (MV) always equals whatever is on the right (Py).

So far, this identity does not help us much. If, as the monetarists have done, one makes assumptions about certain variables in the identity, then things start to get interesting. Monetarists believe that V is fairly constant in the long run.

They also claim that, whilst y is not constant, it does tend to grow at a predictable rate. The 'trend' growth rate in the UK is currently 2.5%. More particularly, monetarists believe that the long term 'trend' growth rate is determined by the position of the vertical long run aggregate supply curve which, in turn, is determined by supply side polices. They believe that y is exogenous, or determined outside this particular model.

Now the identity becomes a meaningful equation. If V is constant and y is at least predictable, then any significant change in M will cause a similar change in P. So large rises in the money supply (M) cause large rises in the price level (P).

A fairly simple theory really. Of course, the Keynesians highlight many pitfalls. What if V is not constant? Good question. Many economists think this may be why the Thatcher experiment of the early 80s did not work. She was very keen on this theory. She tried to control the money supply through high interest rates and attempted control of government borrowing. Not only did she have problems in controlling the money supply, but the theory just didn't seem to work. When the money supply grew faster than she had planned, inflation still fell and when the money supply was finally under control, inflation started to rise again!

When the percentage changes in M and P are relatively small (as they are in the UK), then any significant change in V will totally muck up this simple looking theory. This theory works very well in countries that keep printing money in a desperate attempt to save the economy (like Russia). If M is growing at, say, 100%, then changes in V and y will be so small in comparison that P is bound to rise substantially.

Q6. Write short notes on the following:

a. Monopoly

Ans: The word monopoly is made up of two syllables – “MONO” means single and “POLY” means to sell. Thus, monopoly means existence of a single seller in the

market. Monopoly is that market form in which a single producer controls the whole supply of a single commodity which has no close substitutes. Monopoly may be defined as a condition of production in which a person or a number of persons acting in combination have the power to fix the price of the commodity or the output of the commodity. It is a situation where there exists a single control over the market producing a commodity having no substitutes and no possibilities for anyone to enter the industry to compete.

b. Oligopoly

Ans: The term oligopoly is derived from two Greek words “Oligoi” means a few and “Poly” means to sell. Under oligopoly, we come across a few producers specializing in the production of identical goods or differentiated goods competing with one another. The products traded by the oligopolists may be differentiated or homogeneous. In the case of former, we can give the e.g., of automobile industry where different model of cars, ambassador, fiat etc., are manufactured. Other examples are cigarettes, refrigerators, T.V. sets etc., pure or homogeneous oligopoly includes such industries as cooking and commercial gas cement, food, vegetable oils, cable wires, dry batteries, petroleum etc., in the modern industrial set up there is a strong tendency towards oligopoly market situation. To avoid the wastes of competition in case of competitive industries and to face the emergence of new substitutes in case of monopoly industries, oligopoly market is developed. e.g., an electric refrigerator, automatic washing machines, radios etc.