ASSIGNMENTS

Subject code – MB0026

(4 credits)
Set 1
Marks 60

SUBJECT NAME- MANAGERIAL ECONOMICS

Note: Each Question carries 10 marks.

1. The demand function of a good is as follows:

Q1=100-6P1-4P2+2P3+0.003Y
WHERE P1 and Q1 are the price and quantity values of good 1
P2 and P3 are the prices of good 2 and good 3 and Y is
the income of the consumer. The initial values are given:
P1 =7
P2 =15
P3 =4
Y=8000
Q1 =30

You are required to:

a) Using the concept of cross elasticity determine the
relationship between good 1 and others
b) Determine the effect on Q1 due to a 10 % increase in the price
of good 2 and good 3.
Answer

Q1=100-6P1-4P2+2P3+0.003Y
Where initial values are
P1 =7
P2 =15
P3 =4
Y=8000
Q1 = 30

a)
Relation between good 1 & 2
Increase in price of good 2 by 10% ie new price is Rs 16.5
Q1 = 100 – 6x7-4x16.5 + 2x4 + 0.003 x 8000
Q1= 24
Ec = -2
Good 2 & 1are complementary.
Relation between good 1 &3
Increase in price of good 3 by 10% ie new price is Rs 4.4
Q1 = 100 – 6x7-4x15 + 2x4.4 + 0.003 x 8000
Q1= 30.8
Ec = 0.26
Good 3 is a good substitute of Good 1.
b)
Q1=100-6P1-4P2+2P3+0.003Y
Where initial values are
P1 =7
 P2 =15
P3 =4
Y=8000
Q1 = 30

New price of Goods 2 & 3 due to 10% increase are Rs 16.5 and
Rs 4.4 respectively.

Q1 = 100 – 6x7-4x16.5 + 2x4.4 + 0.003 x 8000

Q1 = 24.8, Decrease in demand of Good 1.

2. What are the factors that determine the Demand curve? Explain.

It is to be clearly understood that if demand charges only because of change

in the prices of given commodity, in that case there would be either
expansions or contraction in demand. Both of them can be explained with
the help of only one demand curve. If demand changes not because of
price change but because of other factors or forces , then in that case
there would be either increase or decrease in demand.

Determinants of Demand

Demand for a commodity or a service is determined by a number of factors.

All such factors are called ‘Demand determinants’.

Price of the given commodity, prices of other substitutes and/or

complements, further expected trend in prices etc.
General price level existing in the country inflation or deflation.
Level of income and living standards of the people.
Size, rate of growth and composition of population.
Tastes, preference, customers, habits, fashion and styles.
Publicity, propaganda and advertisements.
Quality of product.
Profit margin kept by the sellers.
Weather and climatic conditions
Condition of trade-boom or prosperity in the economy.
Terms & condition of trade.
Government’s policy taxation, liberal or restrictive measures.
Level of savings & patterns of consumer expenditure.
Total supply of money circulation and liquidity preference of the people.
Improvements in educational standards etc.

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

Answer:

Elasticity of Supply (ES) = % change in supply/% change in Price

From the above problem,

% change in supply=(5000-3000)/3000

=2000/3000=2/3

=66.66%

% change in price =(22-10)/10=1.2

= 120%

Hence, ES=66.66/120=0.55

4. Briefly explain the profit-maximization model.

Answer: Profit maximization Model

In economics, profit maximization is the process by which a firm determines the price and
output level that returns the greatest profit. There are several approaches to this problem. The
total revenue–total cost method relies on the fact that profit equals revenue minus cost, and the
marginal revenue–marginal cost method is based on the fact that total profit in a perfectly
competitive market reaches its maximum point where marginal revenue equals marginal cost.
Any costs incurred by a firm may be classed into two groups: fixed cost and variable cost. Fixed
costs are incurred by the business at any level of output, including zero output. These may
include equipment maintenance, rent, wages, and general upkeep. Variable costs change with the
level of output, increasing as more product is generated. Materials consumed during production
often have the largest impact on this category. Fixed cost and variable cost, combined, equal total
cost.

TC-Total cost-total revenue method

Profit Maximization - The Totals Approach

To obtain the profit maximizing output quantity, we start by recognizing that profit is equal to
total revenue (TR) minus total cost (TC). Given a table of costs and revenues at each quantity,
we can either compute equations or plot the data directly on a graph. Finding the profit-
maximizing output is as simple as finding the output at which profit reaches its maximum. That
is represented by output Q in the diagram.

There are two graphical ways of determining that Q is optimal. Firstly, we see that the profit
curve is at its maximum at this point (A). Secondly, we see that at the point (B) that the tangent
on the total cost curve (TC) is parallel to the total revenue curve (TR), the surplus of revenue net
of costs (B,C) is the greatest. Because total revenue minus total costs is equal to profit, the line
segment C,B is equal in length to the line segment A,Q.

Computing the price at which to sell the product requires knowledge of the firm's demand curve.
The price at which quantity demanded equals profit-maximizing output is the optimum price to
sell the product.
MC-Marginal cost-marginal revenue method

Profit Maximization - The Marginal Approach

If total revenue and total cost figures are difficult to procure, this method may also be used. For
each unit sold, marginal profit equals marginal revenue minus marginal cost. Then, if marginal
revenue is greater than marginal cost, marginal profit is positive, and if marginal revenue is less
than marginal cost, marginal profit is negative. When marginal revenue equals marginal cost,
marginal profit is zero. Since total profit increases when marginal profit is positive and total
profit decreases when marginal profit is negative, it must reach a maximum where marginal
profit is zero - or where marginal cost equals marginal revenue. This is because the producer has
collected positive profit up until the intersection of MR and MC (where zero profit is collected
and any further production will result in negative marginal profit, because MC will be larger than
MR). The intersection of marginal revenue (MR) with marginal cost (MC) is shown in the next
diagram as point A. If the industry is competitive (as is assumed in the diagram), the firm faces a
demand curve (D) that is identical to its Marginal revenue curve (MR), and this is a horizontal
line at a price determined by industry supply and demand. Average total costs are represented by
curve ATC. Total economic profits are represented by area P,A,B,C. The optimum quantity (Q)
is the same as the optimum quantity (Q) in the first diagram.

If the firm is operating in a non-competitive market, minor changes would have to be made to the
diagrams. For example, the Marginal Revenue would have a negative gradient, due to the overall
market demand curve. In a non-competitive environment, more complicated profit maximization
solutions involve the use of game theory.

Maximizing revenue method

In some cases a firm's demand and cost conditions are such that marginal profits are greater than
zero for all levels of production. [1]In this case the Mπ = 0 rule has to be modified and the firm
should maximize revenue. [2]In other words the profit maximizing quantity and price can be
determined by setting marginal revenue equal to zero. Marginal revenue equals zero when the
marginal revenue curve has reached its maximum value = topped out. An example would be a
scheduled airline flight. The marginal costs of flying the route are negligible. The airline would
maximize profits by filling all the seats. The airline would determine the p-max conditions by
maximizing revenues.
Mathematical Example

A promoter decides to rent an arena for concert. The arena seats 20,000. The rental fee is 10,000.
The arena owner gets concessions and parking and pays all other expenses related to the concert.
The promoter has properly estimated his demand to be Q = 40,000 - 2000P. What is the profit
maximizing ticket price?[3]

Because the promoter’s marginal costs are zero the promoter maximizes profits by charging a
ticket price that will maximize revenue. Total revenue equals price, P, times quantity, Q or PQ =
(40,000 - 2000P)P = 40,000P - 2000(P)2. Total revenue reaches it maximum value when
marginal revenue is zero. Marginal revenue is the first derivative of the total revenue function so

MR ‘ = 40,000 - 2(2000)P = 40,000 - 4000P

MR’ = 0
40,000 - 4000P = 0
4000P = - 40,000
P = 10
Profit = TR -TC
Profit = [40,000P - 2000(P)2] - 10,000
Profit = [40,000(10) - 2000(10)2] - 10,000
Profit = 400,000 - 200,000 - 10,000
Profit = 190,000
What if the promoter had charged 12 per ticket?
Q = 40,000 - 2000P.
Q = 40,000 - 2000(12)
Q = 40,000 - 24,000 = 16,000 (tickets sold)
Profits at 12:
Q = 16,000(12) = 192,000 - 10,000 = 182,000

5. What is Cyert and March’s behavior theory? What are the demerits?
Answer: Cyert and March’s behavior theory is non-profit maximizing theory
which attemps to explain the behavior of inter group conflicts and their multiple
objectives in an organization. Prof. Simon has developed the initial behavioural
model and Prof. Cyert and March have ruther elaborated the theoriy in their book
“Behavioral theory of the Firm”, 1993.
Cyert and March explain how complicated decisions are taken in the big
industrial house under various kinds of risks and uncertainties in and
imperfect market in the background of limited data and information.The
organizational structure, goal of different departments, behavioral
pattern and intenrla working of big and multi-product firl differs from that
of small organizations. Cyert and March consider that modern firm
is a multi-product,multi-goal and multi-decision making coalition
business unit. Like a coalition government , it is managed by number of
groups. The group consists of shareholders, managers, workers
,customers, suppliers etc. In the view of several groups the most
important ones are the shareholders, workers and mangers in an
organization.

According to Cyert and March , a firm has five important goals.

Production goal
Inventory Goal
Sales Goal
Market share goal
Profile goal

This model highlights on satisfactory levels of performance and

achievements of its multiple objectives as maximization of different goals
may not be possible in the context of complex business worlds. Hence,
making satisfactory levels of profits rather than maximum profits have
become the order of the day.

Demerits

The theory fails to analyze the behavior of the firm but it simply predicts the
future expected behavior of different groups.
It does not explain equilibrium of the industry as a whole
It fails to analyze the impact of the potential entry of new firms into the
industry and the behavior of the well established firms in the market.
It highlights only on short run goals rather than long run objectives of an
organization. Thus, there is certain limitation to this theory.

6. What is Boumal’s Static and Dynamic Model

Boumal’s Static and Dynamic Model

Sales maximization model is an alternative model for profit
maximization. This model is developed by Prof. W.J.Boumal, an
American economist. This alternative goal has assumed greater
significance in the context of the growth of Oligopolistic firms. The
model highlights that the primary objective of a firm is to maximize its
sales rather than profit maximization. It states that the goal of the firm
is maximization of sales revenue subject to a minimum profit
constraint. The minimum profit constraint is determined by the
expectations of the share holders. This is because no company can
displease the share holders. It is to be noted here that maximization of
sales does not mean maximization of physical sales but maximization
of total sales revenue. Hence, the managers are more interested in
maximizing sales rather than profit. The basic philosophy is that when
sales are maximized automatically profits of the company would also
go up. Hence, attention is diverted to increase the sales of the
company in recent years in the context of highly competitive markets.
In defence of this model, the following arguments are given.

1. Increase in sales and expansion in its market share is a sign of

healthy growth of a normal company.

2. It increases the competitive ability of the firm and enhances its

influence in the market.

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

4. It helps in enhancing the prestige and reputation of top

management, distribute more dividends to share holders and increase
the wages of workers and keep them happy.

5. The financial and other lending institutions always keep a watch on

the sales revenues of a firm as it is an indication of financial health of a
firm.

6. It helps the managers to pursue a policy of steady performance with

satisfactory levels of profits rather than spectacular profit
maximization over a period of time. Managers are reluctant to take up
those kinds of projects which yield high level of profits having high
degree of risks and uncertainties. The risk averting and avoiding
managers prefer to select those projects which ensure steady and
satisfactory levels of profits.

Prof, Boumal has developed two models. The first is static model and
the second one is the dynamic model.
 The Static Model

This model is based on the following assumptions. 1. The model is

applicable to a particular time period and the model does not operate
at different periods of time. 2. The firm aims at maximizing its sales
revenue subject to a minimum profit constraint.

3. The demand curve of the firm slope downwards from left to right.

4. The average cost curve of the firm is unshaped one.

Sales maximization/ dynamic model

In the real world many changes takes place which affects business decisions
of a firm. In order to include such changes, Boumal has developed
another dynamic model. This model explains how changes in
advertisement expenditure, a major determinant of demand, would affect
the sales revenue of a firm under severe competitions.

Assumptions

1. Higher advertisement expenditure would certainly increase sales

revenue of a firm.

2. Market price remains constant.

3. Demand and cost curves of the firm are conventional in nature.

Generally under competitive conditions, a firm in order to increase its

volume of sales and sales revenue would go for aggressive
advertisements. This leads to a shift in the demand curve to the right.

Forward shift in demand curve implies increased advertisement

expenditure resulting in higher sales and sales revenue. A price cut
may increase sales in general. But increase in sales mainly depends on
whether the demand for a product is elastic or inelastic.

- A price reduction policy may increase its sales only when the
demand is elastic and if the demand is inelastic; such a policy would
have adverse effects on sales. Hence, to promote sales,
advertisements become an effective instrument today. It is the
experience of most of the firms that with an increase in advertisement
expenditure, sales of the company would also go up. - A sales
maximizer would generally incur higher amounts of advertisement
expenditure than a profit maximizer. However, it is to be remembered
that amount allotted for sales promotion should bring more than
proportionate increase in sales and total profits of a firm. Otherwise, it
will have a negative effect on business decisions

-Thus, by introducing, a non-price variable in to his model, Boumal

makes a successful attempt to analyze the behaviour of a competitive
firm under oligopoly market conditions. Under oligopoly conditions as
there are only a few big firms competing with each other either
producing similar or differentiated products, would resort to heavy
advertisements as an effective means to increase their sales and sales
revenue. This appears to be more practical in the present day
situations.