Master of Business Administration- MBA Semester 1

MB0042 – Managerial Economics - 4 Credits

(Book ID : B1131) Assignment Set- 1

Ques1. What is Price Discrimination? Explain the basis of Price Discrimination.(5+5)

Ans.

The policy of price discrimination refers to the practice of a seller to charge different prices for different
customers for the same commodity, produced under a single control without corresponding differences
in cost.

Price Discrimination May Take The Following Forms: (Basis Of Price Discrimination)

1. Personal differences: This is nothing but charging different prices for the same commodity because of
personal differences arising out of ignorance and irrationality of consumers, preferences, prejudices and
needs.

2. Place: Markets may be divided on the basis of entry barriers, for e.g. price of goods will be high in the
place where taxes are imposed. Price will be low in the place where there are no taxes or low taxes.

3. Different uses of the same commodity: When a particular commodity or service is meant for different
purposes, different rates may be charged depending upon the nature of consumption. For e.g. different
rates may be charged for the consumption of electricity for lighting, heating and productive purposes in
industry and agriculture.

4. Time: Special concessions or rebates may be given during festival seasons or on important occasions.

5. Distance: Railway companies and other transporters, for e.g., charge lower rates per KM if the
distance is long and higher rates if the distance is short.

6. Special orders: When the goods are made to order it is easy to charge different prices to different
customers. In this case, particular consumer will not know the price charged by the firm for other
consumers.

7. Nature of the product: Prices charged also depends on nature of products e.g., railway department
charge higher prices for carrying coal and luxuries and less prices for cotton, necessaries of life etc.

8. Quantity of purchase: When customers buy large quantities, discount will be allowed by the sellers.
When small quantities are purchased, discount may not be offered.

9. Geographical area: Business enterprises may charge different prices at the national and international
markets. For example, dumping – charging lower price in the competitive foreign market and higher
price in protected home market.
10. Discrimination on the basis of income and wealth: For e.g., A doctor may charge higher fees for rich
patients and lower fees for poor patients.

11. Special classification of consumers: For E.g., Transport authorities such as Railway and Roadways
show concessions to students and daily travelers. Different charges for I class and II class traveling,
ordinary coach and air conditioned coaches, special rooms and ordinary rooms in hotels etc.

12. Age: Cinema houses in rural areas and transport authorities charge different rates for adults and
children.

13. Preference or brands: Certain goods will be sold under different brand names or trade marks in
order to attract customers. Different brands will be sold at different prices even though there is not
much difference in terms of costs.

14. Social and or professional status of the buyer: A seller may charge a higher price for those customers
who occupy higher positions and have higher social status and less price to common man on the street.

15. Convenience of the buyer: If a customer is in a hurry, higher price would be charged. Otherwise
normal price would be charged.

16. Discrimination on the basis of sex: In selling certain goods, producers may discriminate between
male and female buyers by charging low prices to females.

17. If price differences are minor, customers do not bother about such discrimination.

18. Peak season and off peak season services.

Ques2. Explain the price output determination under monopoly and oligopoly.

Ans:

Price – Output determination under Monopoly

Assumptions
a. The monopoly firm aims at maximizing its total profit.
b. It is completely free from Govt. controls.
c. It charges a single & uniform high price to all customers.
It is necessary to note that the price output analysis and equilibrium of the firm and industry is one and
the same under monopoly.
As output and supply are under the effective control of the monopolist, the market forces of demand
and supply do not work freely in the determination of equilibrium price and output in case of the
monopoly market. While fixing the price and output, the monopoly firm generally considers the
following important aspects.
1. The monopolist can either fix the price of his product or its supply. He cannot fix the price and control
the supply simultaneously. He may fix the price of his product and allow supply to be determined by the
demand conditions or he may fix the output and leave the price to be determined by the demand
conditions.
2. It would be more beneficial to the monopolist to fix the price of the product rather than fixing the
supply because it would be difficult to estimate the accurate demand and elasticity of demand for the
products.
3. While determining the price, the monopolist has to consider the conditions of demand, cost of the
product, possibility of the emergence of substitutes, potential competition, import possibilities,
government control policies etc.
4. If the demand for his product is inelastic, he can charge a relatively higher price and if the demand is
elastic, he has to charge a relatively lower price.
5. He can sell larger quantities at lower price or smaller quantities at a higher price.
6. He should charge the most reasonable price which is neither too high nor too low.
7. The most ideal price is that under which the total profit of the monopolist is the highest.
Price – Output Determination under Oligopoly
It is necessary to note that there is no one system of pricing under oligopoly market. Pricing policy
followed by a firm depends on the nature of oligopoly and rivals reactions. However, we can think of
three popular types of pricing under oligopoly. They are as follows:
Independent pricing: (non-collusive oligopoly)
When goods produced by different oligopolists are more or less similar or homogeneous in nature, there
will be a tendency for the firms to fix a common pricing. A firm generally accepts the “Going price” and
adjusts itself to this price. So long as the firm earns adequate profits at this price, it may not endeavor to
change this price, as any effort to do so may create uncertainty. Hence, a firm follows what is called is
“Acceptance pricing” in the market.
When goods produced by different firms are different in nature (differentiated oligopoly), each firm will
be following an independent pricing policy as in the case of monopoly. In this case, each firm is aware of
the fact that what it does would be closely watched by other oligopolists in the industry. However, due
to product differentiation, each firm has some monopoly power. It is referred, to as monopoly behavior
of the Oligopolist. On the contrary, it may lead to Price-wars between different firms and each firm may
fix price at the competitive level. A firm tends to charge prices even below their variable costs. They
occur as a result of one firm cutting the prices and others following the same. It is due to cut-throat
competition in oligopoly. The actual price fixed by a firm may fall in between the upper limit laid down
by the monopoly price and the lower limit fixed by the competitive price. It may be similar to that of the
pricing under monopolistic competition.
However, independent pricing in reality leads to antagonism, friction, rivalry, infighting, price-wars etc.,
which may bring undesirable changes in the market. The Oligopolist may realize the harmful effects of
competition and may decide to avoid all kinds of wastes. It encourages a tendency to come together.
This leads to pricing under collusion. In other words independent pricing can be followed only for a short
period and it cannot last for a long period of time.

Ques3. Give a brif description of (5+5)

(a) Total Revenue and Marginal Revenue
(b) Implicit and Explicit Cost

Ans:

(a) Total Revenue and Marginal Revenue

Total revenue is the total money received from the sale of any given quantity of output.
The total revenue is calculated as the selling price of the firm's product times the quantity sold, i.e.
total revenue = price × quantity;
or
letting TR be the total revenue function,
 TR(Q) = P(Q) × Q
where Q is the quantity of output sold, and P(Q) is the inverse demand function (the demand function
solved out for price in terms of quantity demanded).

Numerical Example
A promoter has properly estimated the demand curve for seats at an event to be
Q = 40,000 − 2000P
where P is the price of a seat. The inverse demand curve, which determines price as a function of
quantity, is therefore represented by
P(Q) = 20 − Q / 2000.
We therefore have
TR(Q) = 20Q − Q2 / 2000

Marginal revenue : is the revenue associated with one additional unit of production. Whether this is
higher, lower or the same as the revenue from the previous unit of production depends on the demand
for the producer's product. In the case of a producer who supplies a very small percentage of the
market, an extra unit of production is unlikely to have an effect on market prices. In this case, increased
production will not affect marginal revenue. On the other hand, if the producers supplies most or all of
the market (such as in a monopoly or near-monopoly), then increased production is likely to reduce
marginal revenue.
Marginal revenue is the increase in revenue from selling one more unit of a product. It differs from the
price of the product because it takes into account the effect of changes in price.
For example if you can sell 10 units at £20 each or 11 units at £19 each, then your marginal revenue
from the eleventh unit is (10 × 20) - (11 × 19) = £9.
The concept is important in microeconomics because a firm's optimal output (most profitable) is where
its marginal revenue equals its marginal cost: i.e. as long as the extra revenue from selling one more unit
is greater than the extra cost of making it, it is profitable to do so.It is usual for marginal revenue to fall
as output goes up both at the level of a firm and that of a market, because lower prices are needed to
achieve higher sales or demand respectively.

(b) Implicit and Explicit Cost

Explicit cost
An Explicit cost is a business expense accounted cost that can be easily identified such as wage, rent and
materials. Explicit costs gives clear and evident cash outflows from business that decreases its end result
profitability. This cost directly effect the revenue. Intangible expenses such as goodwill and amortization
are not explicit expense because these expenses don't show clear effects on a business's revenue and
expenses.

Implicit cost
An implicit cost results if the person who at first foregoes the satisfaction in the search of an activity and
is not rewarded by money or another form of payment. The implicit cost begins and ends with foregoing
the benefits and satisfaction. When an organization or owner uses its own equity for company's well-air
then that cost is considered as implicit cost. Goodwill is a good example of implicit cost.

Explicit Cost vs. Implicit Cost

Explicit cost can be counted in terms of money whereas implicit cost can not be traded and therefore
can not be counted in terms of money.
Explicit cost is a direct tangible cost whereas implicit cost is indirect intangible cost.
Ques4. Explain the Law of Variable Propotion.

Ans:
In the short-run the level of production can be changed by changing the factor
proportions. This law examines the production function with on factor variable,
keeping the other factors quantities fixed. In other words this law explains the short-
run production function. When the quantity of one input is varied, keeping other
inputs constant, the proportion between factors changes. When the proportion of
variable factors increases, the total output does not always increase in the same
proportion, but in varying proportion. This is why the law is named’ Law of Variable
proportions’. The law of variable proportion is the new name given to the famous
‘Laws of Diminishing Returns. ‘The law of variable proportion’ or the law of
diminishing returns has been defined by a number of economists. In the words of F.
Benham. “As the proportion of one factor in a combination of factors is increased,
after a point, first the marginal and then the average product of that factor will
diminish”. This law explains return to a factor.
Thus, the law states that if more and more units of a variable factor are applied to a
given quantity of fixed factor, the total output may initially increase at an increasing
rate but beyond a certain level the total output, the rate of increase in total output
eventually diminishes in the use of additional units of the variable factor. The
volume of goods produced can be looked at form three different angles viz. :
(i)
Total Product, (ii) Marginal Product and (iii) Average Product.
Total product refers to the total volume of goods produced during a specified period
of time. Total product can be raised only by increasing the quantity of variable
factors employed in production. For instance, more shirts will be produced when
more labour and capital are used. Total product, generally goes on increasing with
an increase in the quantity of the factor services employed. But there is a limit to
which total product can increase with increase in the quantity of variable factors of
production.
Marginal Product (MP). The rate at which total product increases is known as
marginal product. We also define marginal product as the addition to the total
product resulting from a unit increase in the quantity of the variable factor. Initially
marginal product rises, but ultimately it begins to fall down, it becomes zero and at
last becomes negative. It would be seen that the total product is maximum when
the marginal product is zero.
Average Product (AP). Average product can be known by dividing total product by
the total number of units of the variable factor.
AP=Total Product
Units of variable factor
It can be easily seen that the average product also show almost the same tendency
as does the marginal product. Initially, both the marginal product and the average
product rise but ultimately both of these fall. However, marginal product may be
zero. The output does not increase at a constant rate as more of any one input is
added to the production process. For example on a small plot of land. We can
improve the yield by increasing the fertilizer use to some extent. However,
excessive use of fertilizer beyond the optimum quantity may lead to reduction in
the output instead of any increase as per the law of Diminishing Returns (for
instance, single application of fertilizers may increase the output by 50 per cent, a
second application by another 30 per cent and the third by 20 per cent. However, if
we apply fertilizer five to six times in a year, the output may drop to zero).
The principle of diminishing marginal productivity (returns) states that as additional
units of a variable inputs are added to other inputs that are fixed in supply, the
increment to output eventually decline (for a constant technology). This
phenomenon has been widely observed and there is enough empirical evidence to
support it. For business managers, managers, marginal productivity of an input
plays an important part in determining how much of that input will be employed.

Ques5. What is Elasticity of Demand? Explain the factors determining it.

Ans:
A behavioral relationship between quantity consumed and a person's maximum willingness to pay for
incremental increases in quantity. It is usually an inverse relationship where at higher (lower) prices, less
(more) quantity is consumed. Other factors which influence willingness-to-pay are income, tastes and
preferences, and price of substitutes. Demand function specifies what the consumer would buy in each
price and wealth situation, assuming it perfectly solves the utility maximization problem. The quantity
demanded of a good usually is a storng function of its price. Suppose an experiment is run to determine
the quantity demanded of a particular product at different price levels, holding everything else constant.
Presenting the data in tabular form would result in a demand schedule.

Elasticity of demand is the economist’s way of talking about how responsive consumers are to price
changes. For some goods, like salt, even a big increase in price will not cause consumers to cut back very
much on consumption. For other goods, like vanilla ice cream cones, even a modest price increase will
cause consumers to cut back a lot on consumption. Elasticity of demand is an elasticity used to show the
responsiveness of the quantity demanded of a good or service to a change in its price. More precisely, it
gives the percentage change in demand one might expect after a one percent change in price. Elasticity
is almost always negative, although analysts tend to ignore the sign even though this can lead to
ambiguity. Only goods which do not conform to the law of demand, such as Veblen and Giffen goods,
have a positive elasticity demand. Goods with a small elasticity demand (less than one) are said to be
inelastic: changes in price do not significantly affect demand e.g. drinking water. Goods with large
elasticity demand’s (greater than one) are said to be elastic: even a slight change in price may cause a
dramatic change in demand. Revenue is maximised when price is set so as to create a ED of exactly one;
elasticity demand‘s can also be used to predict the incidence of tax. Various research methods are used
to calculate price elasticity, including test markets, analysis of historical sales data and conjoint analysis.
There is a neat way of classifying values of elasticity. When the numerical value of elasticity is less than
one, demand is said to be “inelastic”. When the numerical value of elasticity is greater than one,
demand is “elastic”. So “elastic” demand means that people are relatively responsive to price changes
(remember the vanilla ice cream cone). “Inelastic” demand means that people are relatively
unresponsive to price changes (remember salt). An important relationship exists between the elasticity
of demand for a good and the amount of money consumers want to spend on it at different prices.
Spending is price times quantity, p times Q. In general, a decrease in price leads to an increase in
quantity, so if price falls spending may either increase or decrease, depending on how much quantity
increases. If demand is elastic, then a drop in price will increase spending, because the percent increase
in quantity is larger than the percent decrease in price. On the other hand, if demand is inelastic a drop
in price will decrease spending because the percent increase in quantity is smaller than the percent
decrease in price.

The price elasticity of demand measures how responsive the quantity demanded of a good is to a
change in its price. The value illustrates if the good is relatively elastic (PED is greater than 1) or
relatively inelastic (PED is less than 1).

A good's PED is determined by numerous factors, these include;

Number of substitutes: the larger the number of close substitutes for the good then the easier the
household can shift to alternative goods if the price increases. Generally, the larger the number of close
substitutes, the more elastic the price elasticity of demand.

Degree of necessity: If the good is a necessity item then the demand is unlikely to change for a given
change in price. This implies that necessity goods have inelastic price elasticities of demand.

Price of the good as a proportion of income: It can be argued that goods that account for a large
proportion of disposable income tend to be elastic. This is due to consumers being more aware of small
changes in price of expensive goods compared to small changes in the price of inexpensive goods.

The following example illustrates how to determine the price elasticity of demand for a good.

The price elasticity of demand for supermarket own produced strawberry jam is likely to be elastic. This
is because there are a very large number of close substitutes (both in jams and other preserves), and the
good is not a necessity item. Therefore, consumers can and will easily respond to a change in price.

Ques6 What is Marginal effeciency of Capital? Describe the factors determine MEC.(5+5)

Ans:

Marginal Efficiency of Capital

It refers to productivity of capital. It may be defined as the highest rate of return over cost
accruing from an additional unit of capital asset. Also it refers to the yield expected from a
new unit of capital. The MEC in its turn depends on two important factors.
1. Prospective yield from the capital asset and
2. The supply price of the capital asset.
The MEC is the ratio of these two factors. The prospective yield of a capital asset means the
total net returns expected from the asset over its lifetime. After deducting the variable costs
like cost of raw materials, wages, etc from the marginal revenue productivity of capital, an
investor can estimate the prospective income (expected annual returns and not the actual returns)
from the capital asset. Along with it he also has to consider the supply price or replacement cost
of the capital asset.
Determinants of MEC
Several factors that affect MEC are given below.
1. Short run factors: Expectation of increased demand, higher MEC leads to larger investment
and vice-versa.
2. Cost and Price: If the production costs are expected to decline and market prices to go up in
future, MEC will be high leading to a rise in investment and vice-versa.
3. Higher Propensity to consume leading to a rise in MEC encourages higher investment.
4. Changes in income:An increase in income will simulate investment and MEC while a decline in the
level of incomes
will discourage investment.
5. Current state of expectations:
If the current rates of returns are high, the MEC is bound to be high for new projects of
investment and vice-versa. This is because the future expectations to a very great extent depend
on the current rate of earnings.
6. State of business confidence:
During the period of optimism (boom) the MEC will be generally high and during period of
pessimism (depression), it will be generally less.
II Long run factors.
1. Rate of growth of population: In a capitalist economy, a high rate of population growth leads
to an increase in MEC because it leads to an increase in the demand for both consumption and
investment goods. On the contrary, a decline in the population growth depresses MEC.
2. Development of new areas: Development activities in the new fields like transport and
communications, generation of electricity, construction of irrigation projects, ports etc would
lead to a rise in MEC.
3. Technological progress: Technological progress would lead to the development and use of
highly sophisticated and latest machines, equipments and instruments. This will add to the
productive capacity of the economy leading to an increase in MEC.
4. Productive capacity of existing capital equipments: Under utilised existing capital assets
may be fully utilized if the demand for goods increases in the economy. In that case the MEC of
the same asset will definitely rise.
5. The rate of current investment: If the current rate of investment is already high, there would
be little scope for further investment and as such the MEC declines.
Thus, several factors both in the short run and in the long run affect the MEC of a capital asset.