Name Roll No Learning Centre Subject Assignment No

: : : : : MANAGERIAL ECONOMICS TWO

Date of Submission at the learning centre:

1. curve.

The supply of a product depends on the price of the product. This determines

the supply curve. What are the factors other than price that cause shifts in the supply

Ans. In the same way that price has a significant effect on the quantity of goods demanded by consumers; it also has a significant effect on the quantity of goods supplied by producers. This is because, as the market price of any good increases, the market becomes more valuable and attractive to producers, leading to new customers entering the market and existing producers increasing their production volumes. In contrast, as the price of a good falls, so the quantity suppliers are willing to produce falls as they attempt to keep the price high and avoid making any losses. This can be seen most clearly in the price for commodities such as oil. As the oil price rises, so it becomes more economical to extract oil from deeper sources which are harder to reach. Existing oil fields also increase production to take advantage of the price increase. However, as the price falls oil fields and companies will reduce production to conserve their reserves for the future. Some oil fields will also stop production altogether, as they can no longer make a profit from buying and selling oil. As a result, for most goods, when all other factors are held constant, the quantity supplied will rise as the market price rises. This allows for the construction of a supply schedule and a supply curve. Supply Schedule Quanti ty 0 10 20 30 40 50

Price 10 20 30 40 50 60

Again, as with the demand curve, price is displayed on the y axis, whilst quantity is on the x axis. This is the accepted convention, because the price is set by the market: individual firms generally only have the ability to set their own production levels: they cannot fix the market price. As such, whilst the market price will determine the quantity produced by an individual firm, the quantity produced by all firms will determine the ultimate price, hence the price is shown as the dependent variable. 2

Similar to the law of demand, the law of supply states that as prices rise, so the quantity of goods supplied by all producers will rise, hence the supply curve has an upward slope. In addition, as with the demand curve the supply curve is often shown as a straight line to make analysis simple. However, in practice the slope of the supply curve will be determined by factors such as the minimum efficient size of factories and the economies of scale of the industry, and hence will not be a perfect straight line. Whilst the supply curve demonstrates how price changes with respect to quantity, with all other factors held constant, any changes in the other economic or social factors can cause the supply curve to shift. These shifts are referred to as either being to the left or to the right. A shift to the left indicates that producers will reduce the quantity they produce at a certain price, whilst a shift to the right indicates they will increase the quantity they will supply for each price. The factors that can cause this are: The prices of and demand for other goods: if the price of computers suddenly rises, many TV producers may switch to making computers. This would cause the supply curve for TVs to move to the left as less producers are making TVs. The number of producers in the market: more sellers will produce more goods, and engage in price wars. This will move the supply curve to the right, as the quantity increases for a set price The prices of input materials: if the materials used to produce a good increase in price, it will cost producers more to make a good. Hence the supply will move to the left as producers require higher prices to continue production. Production efficiency: as production processes become more efficient, producers can make goods for a lower cost, hence the supply curve moves to the right Price expectations: if prices are expected to increase, sellers may decrease the quantity they currently supply, stockpiling materials and finished goods to enable them to sell more when the price increases

2.

Explain with examples the following types of costs:

a) Fixed costs In economics, fixed costs are business expenses that are not dependent on the level of goods or services produced by the business. They tend to be time-related, such as salaries or rents being paid per month, and are often referred to as overhead costs. This is in 3

contrast to variable costs, which are volume-related (and are paid per quantity produced). In
management accounting, fixed costs are defined as expenses that do not change as a

function of the activity of a business, within the relevant period. For example, a retailer must pay rent and utility bills irrespective of sales. Along with variable costs, fixed costs make up one of the two components of total cost: total cost is equal to fixed costs plus variable costs Fixed costs should not be confused with sunk costs. From a pure economics perspective, fixed costs are not permanently fixed; they will change over time, but are fixed in relation to the quantity of production for the relevant period. For example, a company may have unexpected and unpredictable expenses unrelated to production; and warehouse costs and the like are fixed only over the time period of the lease.

b) Variable costs Variable costs are expenses that change in proportion to the activity of a business. Variable cost is the sum of marginal costs over all units produced. It can also be considered normal costs. Fixed costs and variable costs make up the two components of total cost. Direct Costs, however, are costs that can easily be associated with a particular cost object. However, not all variable costs are direct costs. For example, variable manufacturing
overhead costs are variable costs that are indirect costs, not direct costs. Variable costs are

sometimes called unit-level costs as they vary with the number of units produced. Direct labor and overhead are often called conversion cost, while direct material and direct labor are often referred to as prime cost For example, a manufacturing firm pays for raw materials. When activity is decreased, less raw material is used, and so the spending for raw materials falls. When activity is increased, rawer materials is used and spending therefore rises. Note that the changes in expenses happen with little or no need for managerial intervention. These costs are variable costs. A company will pay for line rental and maintenance fees each period regardless of how much power gets used. And some electrical equipment (air conditioning or lighting) may be kept running even in periods of low activity. These expenses can be regarded as fixed. But beyond this, the company will use electricity to run plant and machinery as required. The busier the company, the more the plant will be run, and so the more electricity gets used. This extra spending can therefore be regarded as variable. In retail the cost of goods is almost entirely a variable cost; this is not true of manufacturing where many fixed costs, such as depreciation, are included in the cost of goods. Although 4

taxation usually varies with profit, which in turn varies with sales volume, it is not normally considered a variable cost. For some employees, salary is paid on monthly rates, independent of how many hours the employees work. This is a fixed cost. On the other hand, the hours of hourly employees can often be varied, so this type of labour cost is a variable cost.

c) Marginal costs In economics and finance, marginal cost is the change in total cost that arises when the quantity produced changes by one unit. That is, it is the cost of producing one more unit of a good.[1] Mathematically, assuming the cost function is differentiable, the marginal cost (MC) function is expressed as the first (order) derivative of the total cost (TC) function with respect to quantity (Q). Note that the marginal cost will change with volume, as a non-linear and non-proportional cost function includes variable terms dependent to volume, constant terms independent to volume and occurring with the respective lot size, jump fix cost increase or decrease dependent to steps of volume increase. In general terms, marginal cost at each level of production includes any additional costs required to produce the next unit. If producing additional vehicles requires, for example, building a new factory, the marginal cost of those extra vehicles includes the cost of the new factory. In practice, the analysis is segregated into short and long-run cases, and over the longest run, all costs are marginal. At each level of production and time period being considered, marginal costs include all costs which vary with the level of production, and other costs are considered fixed costs. If the cost function is differentiable, the marginal cost is the cost of the next unit produced referring to the basic volume.

A number of other factors can affect marginal cost and its applicability to real world problems. Some of these may be considered market failures. These may include information
asymmetries, the presence of negative or positive externalities, transaction costs, price discrimination and others.

d) Average costs 5

The average cost of a unit of product is made up of its fixed costs / # units produced, and the variable cost per unit. With digital products, where the variable costs are very small (and in some instances zero), the average cost of the product declines as more units are produced and sold. Thus the market leader for a product typically has the lowest average cost per unit. This allows the leader to have increased margins, and increased flexibility to lower price. This is one of the reasons why first-mover advantage can be so important. Imagine that your factory has an annual fixed cost of $1 million ($1,000,000), for interest, utilities, taxes, etc. Your factory makes plastic toys. Suppose the marginal cost of producing one toy is $1. Enable Java on your computer to use this applet. What is the average cost per toy if you make just 1 toy a year? Enable Java on your computer to use this applet. Once you have that one right, try this one: For that same factory, what is the average cost of producing 2 toys per year? Enable Java on your computer to use this applet. It's easy to confuse average cost with marginal cost. Marginal cost is the cost of adding or subtracting one unit of output.

The average cost includes a portion of the fixed cost, as well as variable cost. The marginal cost includes only variable cost

e) Short Run Costs "The short run is a period of time in which the quantity of at least one input is fixed and the quantities of the other inputs can be varied A simple numerical example of short run costs is shown in the table below. Fixed costs are assumed to be constant at 200. Variable costs increase as more output is produced. Total FixedTotal VariableTotal Cost Average CostMarginal Cost Costs (TFC) Costs (TVC) Per Unit (the change in total (TC= TFC +(AC = TC/Q) cost from a one unit change in output) TVC) 200 0 200 200 100 300 6 2 200 180 400 4 2 6

Output (Q) 0 50 100

150 200 230 450 3 200 200 260 460 2.3 250 200 280 465 1.86 300 200 290 480 1.6 350 200 325 525 1.5 400 200 400 600 1.5 450 200 610 810 1.8 500 200 750 1050 2.1 In our example, average cost per unit is minimised at a range

1 0.2 0.1 0.3 0.9 1.5 4.2 4.8 of output between 350 and

400 units. Thereafter, because the marginal cost of production exceeds the previous average, so the average cost rises (for example the marginal cost of each extra unit between 450 and 500 is 4.8 and this increase in output has the effect of raising the cost per unit from 1.8 to 2.1).

Short Run Cost Curves When diminishing returns set in (beyond output Q1) the marginal cost curve starts to rise. Average total cost continues to fall until output Q2 where the rise in average variable cost equates with the fall in average fixed cost. Output Q2 is the lowest point of the ATC curve for this business in the short run. This is known as the output of productive efficiency.

3.

Indian railways is an example of monopoly in India. Discuss the factors that

determine price in the different categories of travel in railways. Ans. To remain financially solvent, Indian Railways must earn sufficient revenue to meet the cost of administration, maintenance of assets, operation, the requirement of depreciation and pensioners benefits and liability for payment of dividend as also leave a margin of profit compatible with the nature of the undertaking and sufficient to meet the needs of developmental expenditure. The pricing policy has, therefore, an important bearing on the Railways' financial well-being. At the same time, the Railways cannot be unmindful of their role as a premier public utility concern and the effect that their pricing policy will have en the rail user and the general economic development of the country. Railway Freight Structure Enquiry Committee to review the then existing railway freight structure and to suggest, among other things, modifications bearing in mind the needs of the developing economy and the necessity for maintaining the financial stability of the Railways. The main recommendations of the Committee consisted of 7

(a) (b)

Radical revision of the pattern of the legs of the telescopic freight structure. Laying down a wagon-load classification and a " smalls" classification for all

commodities. (c) Abolition of terminal charges by taking these into consideration in evolving the

revised freight structure. (d) (e) Discontinuance of the separate levy of transshipment/ghat charges ; and Evolution of a percentage system of rates from the lowest class to the highest

class to form an integrated scale of rates covering both class rates and wagon-load rates. For this purpose, the Committee recommended a norm or "standard "rate to be called the Class 100 rate, expressing the rates above and below this Class as per percentage of the new Class 100. Based on the recommendations of this Committee, a revised freight structure was introduced in 1958. Over the years, there were changes in the freight structure with a view to raising additional revenues for meeting the escalation in costs. Similarly, there were changes in the passenger fares and parcel structures. The Public Accounts Committee as well as the Railway Convention Committee had examined the tariffs and had emphasized the need for rationalizing the fare and freight structure having due regard to cost of service. One such principle is commonly referred to as charging "what the traffic will bear", i. e. fixing the charge for each variety of goods according to its ability to pay for transportation. This is also called the 'value of service' principle. industrial raw products, may be carried at lower rates. In this way, goods of high value are This is eminently equitable and it made to pay more, so that commodities and articles of low value, including foodstuffs and is from this principle of charging "what the traffic will bear" that the Railways derive sanction for the practice of classifying commodities into different groups, within each of which a sufficient degree of affinity of transportation and economic characteristics can be found to justify the application, to each group, of a different scale of basic rates. Another basic principle of rating which is receiving increasingly greater attention is that of the 'Cost of Service'. Thus, Caking the two principles together, each variety of For applying this criterion, duo cognizance goods should be charged no more than it can ordinarily afford to pay for transportation and, by and large, no less than it costs to move it. has to be taken of the factors affecting the ability of commodity to pay for transport viz. (a) Value in relation to weight, 8

(b) (c) (d) (i) (ii) (iii) (iv)

Uses, Stage of manufacture, Volume of traffic, Bulk in proportion to weight, Risk of damage, wastage, or deterioration in transit, Speed of transit, and; Volume of traffic.

and also the factors affecting the costs of transportation viz.

4. In the case of consumer durables, we find that when the product is introduced, the prices are high, but over time the prices reduce. What is the pricing policy followed? Ans. Basically the pricing policy of a new product is the same as that for an established product. The price must cover the full costs in the long run and direct costs or prime costs in the short run. In case of new products the degree of uncertainty would be more as the firm is generally ignorant about the cost and the market conditions. There are two alternative price strategies which a firm introducing a new product can adopt, viz., skimming price policy and penetration pricing policy. In this case price skimming is the pricing strategy followed. Price skimming is a pricing strategy in which a marketer sets a relatively high price for a product or service at first, then lowers the price over time. It is a temporal version of price discrimination/yield management. It allows the firm to recover its sunk costs quickly before competition steps in and lowers the market price. Price skimming is sometimes referred to as riding down the demand curve. The objective of a price skimming strategy is to capture the consumer surplus. If this is done successfully, then theoretically no customer will pay less for the product than the maximum they are willing to pay. In practice, it is almost impossible for a firm to capture all of this surplus. Limitations of Price Skimming There are several potential problems with this strategy. It is effective only when the firm is facing an inelastic demand curve. If the long run demand schedule is elastic (as in the diagram to the right), market equilibrium will be achieved by quantity changes rather than price changes. Penetration pricing is a more suitable strategy in this case. Price changes by 9

any one firm will be matched by other firms resulting in a rapid growth in industry volume. Dominant market share will typically be obtained by a low cost producer that pursues a penetration strategy. A price skimmer must be careful with the law. Price discrimination is illegal in many jurisdictions, but yield management is not. Price skimming can be considered either a form of price discrimination or a form of yield management. Price discrimination uses market characteristics (such as price elasticity) to adjust prices, whereas yield management uses product characteristics. Marketers see this legal distinction as quaint since in almost all cases market characteristics correlate highly with product characteristics. If using a skimming strategy, a marketer must speak and think in terms of product characteristics in order to stay on the right side of the law. The inventory turn rate can be very low for skimmed products. This could cause problems for the manufacturer's distribution chain. It may be necessary to give retailers higher margins to convince them to handle enthusiastically the product. Skimming encourages the entry of
competitors. When other firms see the high margins available in the industry, they will quickly

enter. Skimming results in a slow rate of stuff diffusion and adaptation. This results in a high level of untapped demand. This gives competitors time to either imitate the product or leap frog it with a new innovation. If competitors do this, the window of opportunity will have been lost. The manufacturer could develop negative publicity if they lower the price too fast and without significant product changes. Some early purchasers will feel they have been ripped off. They will feel it would have been better to wait and purchase the product at a much lower price. This negative sentiment will be transferred to the brand and the company as a whole. High margins may make the firm inefficient. There will be less incentive to keep costs under control. Inefficient practices will become established making it difficult to compete on value or price. Examples of price skimming. Price skimming has been used for certain high-end electronics. For instance, the Sony
PlayStation 3 was initially sold at $599, but the price has gradually reduced to $299.

Reasons for price skimming Price skimming occurs in mostly technological markets as firms set a high price during the first stage of the product life cycle. The top segment of the market which are willing to pay the highest price are skimmed of first. When the product enters maturity the price is 10

lowered.

5. In the long run, the long run average cost curve is an envelope of the short run cost curves. Discuss the concept behind the same. Ans. The long-run average cost curve depicts the cost per unit of output in the long run that is, when all productive inputs' usage levels can be varied. All points on the line represent least-cost factor combinations; points above the line are attainable but unwise, while points below are unattainable given present factors of production. The behavioral assumption underlying the curve is that the producer will select the combination of inputs that will produce a given output at the lowest possible cost. Given that LRAC is an average quantity, one must not confuse it with the long-run marginal cost curve, which is the cost of one more unit. The LRAC curve is created as an envelope of an infinite number of short-run average total cost curves, each based on a particular fixed level of capital usage. The typical LRAC curve is U-shaped, reflecting increasing returns of scale where negativelysloped, constant returns to scale where horizontal and decreasing returns (due to increases in factor prices) where positively sloped. Contrary to Viner, the envelope is not created by the minimum point of each short-run average cost curve. This mistake is recognized as Viner's Error. In a long-run perfectly competitive environment, the equilibrium level of output corresponds to the minimum efficient scale, marked as Q2 in the diagram. This is due to the zero-profit requirement of a perfectly competitive equilibrium. This result, which implies production is at a level corresponding to the lowest possible average cost, does not imply that production levels other than that at the minimum point are not efficient. All points along the LRAC are productively efficient, by definition, but not all are equilibrium points in a longrun perfectly competitive environment. In some industries, the bottom of the LRAC curve is large in comparison to market size (that is to say, for all intents and purposes, it is always declining and economies of scale exist indefinitely). This means that the largest firm tends to have a cost advantage, and the industry tends naturally to become a monopoly, and hence is called a natural
monopoly. Natural monopolies tend to exist in industries with high capital costs in relation to

variable costs, such as water supply and electricity supply.

6. A company wishes to introduce a new flavour of tea in the market. Discuss how 11

the company can forecast demand for the new flavour of tea. Ans. No demand forecasting method is 100% accurate. Combined forecasts improve accuracy and reduce the likelihood of large errors. Reference class forecasting was developed to reduce error and increase accuracy in forecasting, including in demand forecasting. Broadly speaking, there are two approaches to demand forecasting- one is to obtain information about the likely purchase behavior of the buyer through collecting experts opinion or by conducting interviews with consumers, the other is to use past experience as a guide through a set of statistical techniques. Both these methods rely on varying degrees of judgment. The first method is usually found suitable for short-term forecasting, the latter for long-term forecasting. There are specific techniques which fall under each of these broad methods. Simple Survey Method: For forecasting the demand for existing product, such survey methods are often employed. In this set of methods, we may undertake the following exercise. 1) Experts Opinion Poll: In this method, the experts on the particular product whose demand is under study are requested to give their opinion or feel about the product. These experts, dealing in the same or similar product, are able to predict the likely sales of a given product in future periods under different conditions based on their experience. If the number of such experts is large and their experience-based reactions are different, then an average-simple or weighted is found to lead to unique forecasts. Sometimes this method is also called the hunch method but it replaces analysis by opinions and it can thus turn out to be highly subjective in nature.

2) Reasoned Opinion-Delphi Technique: This is a variant of the opinion poll method. Here is an attempt to arrive at a consensus in an uncertain area by questioning a group of experts repeatedly until the responses appear to converge along a single line. The participants are supplied with responses to previous questions (including seasonings from others in the group by a coordinator or a leader or operator of some sort). Such feedback may result in an expert revising his earlier opinion. This may lead to a narrowing down of the divergent views (of the experts) expressed earlier. The Delphi Techniques, followed by the Greeks earlier, thus generates reasoned opinion in place of unstructured opinion; but this is still a poor proxy for market behavior of economic variables. 3) Consumers Survey- Complete Enumeration Method: Under this, the forecaster 12

undertakes a complete survey of all consumers whose demand he intends to forecast, Once this information is collected, the sales forecasts are obtained by simply adding the probable demands of all consumers. The principle merit of this method is that the forecaster does not introduce any bias or value judgment of his own. He simply records the data and aggregates. But it is a very tedious and cumbersome process; it is not feasible where a large number of consumers are involved. Moreover if the data are wrongly recorded, this method will be totally useless. 4) Consumer Survey-Sample Survey Method: Under this method, the forecaster selects a few consuming units out of the relevant population and then collects data on their probable demands for the product during the forecast period. The total demand of sample units is finally blown up to generate the total demand forecast. Compared to the former survey, this method is less tedious and less costly, and subject to less data error; but the choice of sample is very critical. If the sample is properly chosen, then it will yield dependable results; otherwise there may be sampling error. The sampling error can decrease with every increase in sample size 5) End-user Method of Consumers Survey: Under this method, the sales of a product are projected through a survey of its end-users. A product is used for final consumption or as an intermediate product in the production of other goods in the domestic market, or it may be exported as well as imported. The demands for final consumption and exports net of imports are estimated through some other forecasting method, and its demand for intermediate use is estimated through a survey of its user industries. Complex Statistical Methods: We shall now move from simple to complex set of methods of demand forecasting. Such methods are taken usually from statistics. As such, you may be quite familiar with some the statistical tools and techniques, as a part of quantitative methods for business decisions. (1) Time series analysis or trend method: Under this method, the time series data on the under forecast are used to fit a trend line or curve either graphically or through statistical method of Least Squares. The trend line is worked out by fitting a trend equation to time series data with the aid of an estimation method. The trend equation could take either a linear or any kind of non-linear form. The trend method outlined above often yields a dependable forecast. The advantage in this method is that it does not require the formal knowledge of economic theory and the market, it only needs the time series data. The only limitation in this method is that it assumes that the past is repeated in future. Also, it is an appropriate method for long-run forecasts, but inappropriate for short-run forecasts. 13

Sometimes the time series analysis may not reveal a significant trend of any kind. In that case, the moving average method or exponentially weighted moving average method is used to smoothen the series. (2) Barometric Techniques or Lead-Lag indicators method: This consists in discovering a set of series of some variables which exhibit a close association in their movement over a period or time. 3) Correlation and Regression: These involve the use of econometric methods to determine the nature and degree of association between/among a set of variables. Econometrics, you may recall, is the use of economic theory, statistical analysis and mathematical functions to determine the relationship between a dependent variable (say, sales) and one or more independent variables (like price, income, advertisement etc.). The relationship may be expressed in the form of a demand function, as we have seen earlier. Such relationships, based on past data can be used for forecasting. The analysis can be carried with varying degrees of complexity. We are on the realm of multiple regression and multiple correlation. The form of the equation may be: DX = a + b1 A + b2PX + b3Py Given the estimated value of and bi, you may forecast the expected sales (DX), if you know the future values of explanatory variables like own price (P X), related price (Py), income (B) and advertisement (A). The principle advantage of this method is that it is prescriptive as well descriptive. That is, besides generating demand forecast, it explains why the demand is what it is. In other words, this technique has got both explanatory and predictive value. The regression method is neither mechanistic like the trend method nor subjective like the opinion poll method. In this method of forecasting, you may use not only time-series data but also cross section data. The only precaution you need to take is that data analysis should be based on the logic of economic theory. (4) Simultaneous Equations Method: Here is a very sophisticated method of forecasting. It is also known as the complete system approach or econometric model building. In your earlier units, we have made reference to such econometric models. Presently we do not intend to get into the details of this method because it is a subject by itself. Moreover, this method is normally used in macro-level forecasting for the economy as a whole; in this course, our focus is limited to micro elements only. Of course, you, as corporate managers, should know the basic elements in such an approach. 14

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