Scdl - Pgdba - Finance - Sem 1 - Managerial Economics

Managerial Economics

Managerial Economics

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Managerial Economics

Q1. What is a Joint Stock Company? Explain the merits and demerits of a Joint Stock Company. Ans. The form of a joint stock company enables it to centralize free money and/or the savings of public. Due to this it is suitable for activities demanding business capital. In highly developed countries it is one of the most frequent forms of doing business. It is one of the oldest kinds of capital association. Joint Stock Company is suited for cases where the number of shareholders is large or when its shares are to be traded on the Stock Exchange. A joint-stock company is a company the basic capital of which is divided into certain number of shares, which are securities with nominal value. The company is liable for the breach of its obligations up to the extent of the entire property. Doing business with the aim of making a profit does not have to represent its only business activity. Its goal may also be accumulation of certain basic capital. A share represents a security connected with which are rights of a shareholder to act as a partner and to participate in the management of the company, in profit and in the liquidation balance at the dissolution of the company. The law does not specify the external form of the share but it must always be in a written form. The shares may be bearer shares and inscribed shares. They may be employee shares, preference shares, capital stock, normal shares, etc. Issuing of shares connected with a right for certain interest regardless of the economic results of the company is not permitted. According to the last amendment of the Civil Code a share may be issued as a materialized or listed security. Bearer shares may be issued only as listed securities. The removal of the anonymity of the bearer shareowner should mostly contribute to better transparency of ownership relations in the process of privatization. The company statutes must determine the value of all kinds of shares, which are to be issued. The total sum of pars of these shares must correspond to the amount of the basic capital. The par of a share must be expressed by a positive integer. Merits of Joint stock Company  Personal assets are protected from business debt and liability.  Joint Stock Company is perpetual (life extending beyond the illness or death of the owners).  The ownership of the corporation is easily transferable.  Ownership will not affect current management.  Unlimited number of shareholders.  Raising capital through the sale of stocks and bonds is simplified.

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Managerial Economics Demerits of Joint stock Company  More Expensive to form than Limited Liability Company.  Legal formality. Q2. State and Explain the Law of Demand. What are its exceptions? Ans. The law of demand states that if price declines, then the quantity demanded of the product will increase. The inverse relationship between price and quantity leads to the downward sloping demand curve. This section provides a graphical derivation of the law of demand. The law of demand and it's application to fundamental analysis of commodities rests upon an understanding of consumer behavior. The factors which characterize consumer choice, and how individual consumer responses are reflected in the market place are key components of this economic theory. Understanding what factors have affected demand in the past will help to develop expectations about demand in the future and the impact on market price. Demand for a particular product or service represents how much people are willing to purchase at various prices. Thus, demand is a relationship between price and quantity, with all other factors remaining constant. Demand is represented graphically as a downward sloping curve with price on the vertical axis and quantity on the horizontal axis (figure above) Market Demand Curve

Demand for a particular product or service represents how much people are willing to purchase at various prices. Thus, demand is a relationship between price and quantity, with all other factors remaining constant. Demand is represented graphically as a downward Page 3

Managerial Economics sloping curve with price on the vertical axis and quantity on the horizontal axis (figure above) Generally the relationship between price and quantity is negative. This means that the higher is the price level the lower will be the quantity demanded and, conversely, the lower the price the higher will be the quantity demanded. Market demand is the sum of the demands of all individuals within the marketplace. Market demand will be affected by other variables in addition to price, such as various value added services including handling, packaging, location, quality control, and financing. Thus the demand for an agricultural commodity is typically derived from the demand for a finished product. It is important for you to understand that a free market economy is driven not by producers but by consumers. Ultimately the market value for any good or service is determined by its value to the consumer. Higher prices mean higher profits and higher profits provide you with the incentive and the means to expand production of those goods and services that consumers value the most. So profit driven expansion is the market’s response to stronger buyer demand. On the other hand, when consumers are unwilling to buy what is offered at the current price, the seller will have to lower the price ultimately resulting in lower profits or losses to you the producer. Losses reduce the producer’s incentive to produce things that have weak demand, which will ultimately force production cuts as farmers lose more and more money. This is the discipline of the marketplace. Those who produce things that consumers are willing and able to buy are rewarded. Those who produce things that consumers don’t want or can’t buy are penalized. Farmers must produce for the markets. They cannot expect to find or create a profitable market for whatever they choose to produce. Exceptions to the Law of Demand Economists, as is their wont, have struggled to think of exceptions to the law of demand. Marketers have found them. One of the best examples was a new car wax. Economist Thomas Nagle points out that when one particular car wax was introduced, it faced strong resistance until its price was raised from Rs..69 to Rs.1.69. The reason, according to Nagle, was that buyers could not judge the wax's quality before purchasing it. Because the quality of this particular product was so important—a bad product could ruin a car's finish—consumers "played it safe by avoiding cheap products that they believed were more likely to be inferior." While the law of demand seems is a well-documented, extensively tested economic principle, it is not without exception. That exception is termed a Giffen good. A Giffen good is one in which a change in price causes quantity to change in the same direction. An increase in price

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Managerial Economics causes and increase in quantity and a decrease in price causes a decrease in quantity. A Giffen good exists because the good in question is an inferior good (an increase in income causes a decrease in demand) and the income effect overwhelms the substitution effect. Giffen goods are extremely rare and generally only surface if buyers spend a substantial portion of their income on an inferior good.

Q3. Explain Lord J.M. Keynes’ view of equilibrium attained at less than full employment level. Ans. Essential features of Keynesian Theory: 1. Employment & Income depend on effective demand 2. Effective demand is governed by aggregate demand & aggregate supply – Keynes assumes aggregate supply as fixed in the short period and concentrates wholly upon aggregate demand 3. Aggregate demand is determined by consumption expenditure & investment expenditure 4. Consumption expenditure is determined by (i) Size of the income (ii) Propensity to consume 5. Propensity to consume is relatively stable 6. Employment depends on the volume of investment if the propensity to consume remains unchanged 7. Investment depends on the role of interest & the marginal efficiency of capital 8. Marginal efficiency of capital, in its turn, is determined by the supply price of capital asset and the propensity yield of capital asset 9. Rate of interest depends on the liquidity preference & the supply of money 10.Liquidity preference is determined by 3 motives (i) Transitions motive, (ii) (ii) Precautionary motive (iii) (iii) Speculative motive. The Government controls the supply of money. Effective Demand The concept of effective may be regarded as a logical starting point of Keyne’s theory of Income & Employment. It refers to that level of demand in the economy, which is fully met by the corresponding supply so that there is no tendency on the part of the entrepreneurs to either expand or contract production. Page 5

Managerial Economics Effective demand, thus, is equal to the national income or the receipts of all members of the community in the form of rent, wages, interest and profit. These receipts are in turn spent on the purchase of products produced in an economy. It is also equal to the value of total output of the community. It also equals the national expenditure on consumption goods & capital goods because all goods are either consumption goods or investment goods. Determinants of Effective Demand 1> Aggregate Demand Function 2> Aggregate Supply Function Aggregate Demand Function: It refers to the total demand for all goods & services in the economic system as a whole. Goods & services are demanded for two purposes viz. (i) consumption (ii) investment The household demand consumption goods like wheat, bread etc & services like transport and entertainment etc. The demand for consumption goods originating from the private households is known as private consumption & similarly Govt may also demand consumption goods. This type of demand is known as public consumption. Total Consumption Consumption

=

Public

Consumption

+

Private

The second important constituent of total consumption demand for goods 7 services is the demand for investment i.e.; demand for capital goods. Again demand originated from the private entrepreneurs is called private investment & similarly demand from the Government is called public investment. These two taken together constitute total investment demand by the community. Aggregate Demand = Consumption Demand + Investment Demand Aggregate demand is a sum of total expenditure in the economy. Wherever the households, firms & the government demand any goods & services, they incur expenditure on the same. We can, therefore, also look at the aggregate demand of the community as the aggregate expenditure by the community incurred on the purchase of goods & services. Aggregate = Aggregate = Consumption + Investment Demand Expenditure Expenditure Expenditure Page 6

Managerial Economics

Relation between Aggregate Expenditure and the level of Employment The aggregate expenditure depends upon the level of employment in the economy. There will, more generally, be a direct positive relationship between the level of employment & the level of expenditure in the economy. The shape of the aggregate demand curve depends on a basic economic principle which says that when income increases, people tend to spend a smaller portion of income. In other words, as the level of employment increases, aggregate demand rises but at a diminishing rate, & thus the slope of the curve diminishes. Aggregate Supply Function: This in an economy refers to the total volume of all goods & services available for consumption & investment. The minimum expected sale proceeds which are necessary to induce firms to produce an output and to provide employment to a certain number of workers are the aggregate supply price of that output. Relation between aggregate supply & the level of the employment Aggregate supply is positively related to the level of employment. It increases with increase in level of employment & vice versa. Thus symbolically: AS = f (N) AS= Aggregate supply price of the output and N= Number of workers employed Since marginal costs are bound to be positive, the aggregate supply curve will slope upwards as employment increases. As level of employment & output increases, less efficient factors of production are bound to be employed. Consequently, diminishing returns set in & the aggregate supply curve will start to rise more steeply. At full employment level any increase in costs cannot result in extra employment & so the aggregate supply curve becomes vertical. Determination of Equilibrium We have defined aggregate demand price as the amount of receipts which all the firms taken together expect to receive from the sale of their products. We have also defined aggregate supply price as the amount of receipts which all firms taken together must get.

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Managerial Economics Firms will expand the level of employment & output as long as the receipts they expect to get are more than the receipts they must get. In other words, as long as the demand curve lies above the supply curve the firms will expand the level of employment & output conversely, if the aggregate demand curve lies below the aggregate supply curve, the firm is compelled to reduce the level of employment & output. The equilibrium will be established at the point where the aggregate supply function interests the aggregate demand further. It can be observed that level of employment is determined at a point where aggregate supply function intersects aggregate demand function. At this point of equilibrium the firms do not have tendency either to increase or decrease employment but this need not necessarily be point of full employment equilibrium.

Q4 . Explain how price is determined under monopoly MONOPOLY While classifying the market we had discussed perfect competition as a case of extreme competition. The other extreme case would be a total absence of competition. There is no competition when only one producer is present. This is the state of Monopoly. Monopoly Price during Short-Run During short-run monopolist cannot expand or contract the size of his plant nor can he change the structure of the fixed costs. In order to be in equilibrium, a monopoly firm would like to produce that level of output at which its marginal revenue equals to marginal cost. In the short-run, the monopoly firm may get a normal profit & may suffer loss also. Monopoly Price during Long-Run The long run equilibrium of the monopoly firm is attained at that level of output where its marginal cost equals the marginal revenue. Monopoly firm in the long-run gets abnormal profit. It is so because the new firms are not allowed to enter the market. Monopoly firm does not suffer loss in the long run, as all the costs in the long-run are variable & these must be recovered. In case a monopoly firm fails to recover the variable costs in the long run, it would better stop production & quit the market.

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Managerial Economics Distinction between Price Level under perfect competition & Monopoly Under perfect competition the price is determined at the point where MC=MR, or the price is equal to the Marginal Revenue (P=MR). In monopoly equilibrium, Marginal Cost equates Marginal Revenue, but the price is not equal to the Marginal Revenue i.e. P # MR. The obvious reason is that under perfect competition, the demand curve is perfectly elastic (E  but the demand curve of a monopoly firm is not perfectly elastic. It is only for this reason that the monopoly price is always higher than the marginal revenue. Distinction between level of output under Perfect Competition & Monopoly Under perfect competition, a firm increases production until the marginal cost becomes equal to the marginal revenue. In other words, the output is raised upto the limit where price equates the marginal cost. Monopoly firm will restrict its output at the point where Marginal Cost equates Marginal Revenue, but the price is higher than the marginal cost (P > MC). The difference of output between the competitive firm & monopoly firm can be explained with the help of a diagram as below:

AR = Average Revenue Curve of the monopolist

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Managerial Economics MR = Marginal Revenue Curve of the monopolist AR & MR are the average revenue & marginal revenue of the competitive firm. Equilibrium of the monopoly firm is attained at point P, where the equilibrium level of output OQM is sold at price RQ per unit. Equilibrium of the competitive firm is attained at point S, where equilibrium level of output OQ is sold at price SQ. Two important observations can be made from the above figure. Monopoly price RQ is higher than the competitive price SM. Monopoly output OQ is less than the competitive output OQ. The reason for the large size of output under competitive conditions is that a horizontal demand curve (AR) of the firm can be tangent to the average cost curve at its minimum point. The optimum level of output is attained where the average cost is minimum. In case of monopoly level of output is always less than optimum because a downward sloping demand curve (AR) of the firm can never be tangent to AC curve at its minimum point.

Q5. Write short notes on. (Any four) Ans.  Pricing methods There are two main types of pricing methods, these are: cost based pricing methods and market orientated pricing methods. With cost based pricing methods, no account is taken of market requirements but a set amount is added to the costs. The disadvantage is that if costs increase, the price of the product must also increase. The following are examples of cost based pricing methods: Absorption cost pricing: Used mainly in large department stores. The price of each product is dependant on how many costs it creates. Target pricing: A target price is made and then costs are adjusted so that that price can be achieved. Market based pricing methods depend on accurate analysis of the market and consumer requirements. The following are examples of market based pricing methods:

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Managerial Economics Penetration pricing: Used for new products wanting to gain market share. The product is priced low so that it is able to get a hold in the market. Market skimming: When a new innovative product is bought out during the first few months high prices can be charged as there is little competition and the product is popular because it is new. Loss leader pricing: Charging below cost price to try and attract customers to other products (normally in supermarkets). Psychological pricing: Hitting price points that are significant e.g. Rs.99.99 sounds better than Rs.100.00 Price discrimination: Charging different people different prices for effectively the same product. Normally time based (charging different prices at different times of the day / week / year) Discount pricing: Offering lower prices for a set time period to try and boost sales and sell off unwanted stock. There are two types of competition based pricing methods: Going rate or market pricing: Charging the same as competitors or the market leader. Destroyer or destructor pricing: Charging a price below average to drive out competition.  Differences between shares and debentures Debentures A debenture ‘includes debenture stock, bonds and any other securities of a company, whether constituting a charge on the assets of the company or not’. A company may issue debentures which are payable to the registered holder, and also debentures which are payable to bearer. In the latter case, the debenture is transferable by delivery. It is possible for the company to issue irredeemable debentures or debentures which carry rights of conversion to fully paid ordinary shares at a later date. If the debenture does not create any charge on particular assets, the holders will rank with general creditors for repayment of their loan in the event of the winding-up of the company. If the debenture is not charged on any of the company's assets, the holder has only contractual rights thereunder. An alternative form of borrowing is by debenture stock. In such a case, the sum borrowed is secured under one document, and each stock holder is entitled to repayment of a fraction of that loan. Shares A shareholder's liability to contribute to the company's capital is restricted to the issue value of his shares. A shareholder will also be entitled to receive dividends paid out of the company's profits on a pro Page 11

Managerial Economics rata basis, based on the class rights of his shares and the size of his shareholding. Further control of the company's affairs rests ultimately with the shareholders, who exercise votes in accordance with the class rights and number of shares held. Finally, entitlements on distribution of surplus assets in the event of the winding up of a company are determined by the class rights and size of shareholdings. Legal nature of a share A share is a ‘chose in action’, in that it is assignable, and the assignee would be entitled to sue upon it to obtain his appropriate share of the net profits. This means ownership of a share carries rights which can be legally enforced, but does not confer ownership in tangible property. The Companies Act expressly provides that shares in a company are personal estate and not real estate. This ensures ease of transferability, subject to any rules contained in the articles of association particular to that company. Authorised capital This is the maximum amount a company is permitted to raise by way of share capital. That amount may be increased by a procedure set out in statute or the company's articles. Paid up capital The ‘paid up’ share capital is the amount of issued share capital that has actually been paid up to the company by its shareholders. Called up capital The ‘called up’ share capital is the total sum the company has requested from members, and will be a greater sum than the paid up share capital in the event that subscribers still owe the company moneys for their shares. Similar aspects: • Transfer procedures • Issue to the public Differences: • Holders of debentures are company creditors where shareholders are members • Debentures can be purchased by the company itself but the same situation does not apply for shares • Debentures can be issued at discount where shares cannot  Production Function

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Managerial Economics When most people think of fundamental tasks of a firm, they think first of production. Economists describe this task with the production function, an abstract way of discussing how the firm gets output from its inputs. It describes, in mathematical terms, the technology available to the firm. A production function can be represented in a table such as the one below. In this table five units of labor and two of capital can produce 34 units of output. It is, of course, always possible to waste resources and to produce fewer than 34 units with five units of labor and two of capital, but the table indicates that no more than 34 can be produced with the technology available. The production function thus contains the limitations that technology places on the firm.

A Production Function Labor 5

30

34

37

4

26

30

33

3

21

25

28

2

16

20

23

1

10

13

15

1

2

3 Capital

There is one rule that seems to hold for all production functions, and because it always seems to hold, it is called a law. The law of diminishing returns says that adding more of one input while holding other inputs constant results eventually in smaller and smaller increases in added output. To see the law in the table above, one must follow a column or row. If capital is held constant at two, the marginal output of labor (which economists usually call marginal product of labor) is shown in the table below. The first unit of labor increases production by 13, and as more labor is added, the increases in production gradually fall.

The Marginal Product of Labor Labor

Marginal Output

First

13

Second

7

Third

5

Fourth

5

Fifth

4

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Managerial Economics

The law of diminishing returns does not take effect immediately in all production functions. It is possible for the first unit of labor to add only four units of output, the second to add six, and the third to add seven. If a production function had this pattern, it would have increasing returns between the first and third worker. What the law of diminishing returns says is that as one continues to add workers, eventually one will reach a point where increasing returns stop and decreasing returns set in. The law of diminishing returns is not caused because the first worker has more ability than the second worker, and the second is more able than the third. By assumption, all workers are the same. It is not ability that changes, but rather the environment into which workers (or any other variable input) are placed. As additional workers are added to a firm with a fixed amount of equipment, the equipment must be stretched over more and more workers. Eventually, the environment becomes less and less favorable to the additional worker. People's productivity depends not only on their skills and abilities, but also on the work environment they are in. The law of diminishing returns was a central piece of economic theory in the 19th century and accounted for economists' gloomy expectations of the future. They saw the amount of land as fixed, and the number of people who could work the land as variable. If the number of people expanded, eventually adding one more person would result in very little additional food production. And if population had a tendency to expand rapidly, as economists thought it did, one would predict that (in equilibrium) there would always be some people almost starving. Though history has shown the gloomy expectations wrong, the idea had an influence on the work of Charles Darwin and traces of it still float around today among environmentalists. If one increases all inputs in equal proportions, one travels out from the origin on a ray. There is no law to predict what will happen to output in this case. If a 10% increase in all inputs yields more than a 10% increase in output, the production function has increasing returns to scale. If it yields less than a 10% increase in output, the production function has decreasing returns to scale. And if it yields exactly a 10% increase in output, it has constant returns to scale. Returns to scale are important for determining how many firms will populate an industry. When increasing returns to scale exist, one large firm will produce more cheaply than two small firms. Small firms will thus have a tendency to merge to increase profits, and those that do not merge will eventually fail. On the other hand, if an industry has decreasing returns to scale, a merger of two small firms to create a large firm will cut output, raise average costs, and lower profits. In

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Managerial Economics such industries, many small firms should exist rather than a few large firms. Most products require many more than two inputs, but showing a production function with more than two inputs with graphs or tables is difficult. Products require various types of labor and capital, energy of various sorts, and raw materials. One of the key inputs, especially in larger firms, is managerial ability. Inputs do not combine by themselves to produce output. Someone must have knowledge of how to combine inputs and to coordinate the production process. If business decision-makers lack information or are incompetent, the firm will not make the best use of available resources. Or if morale is bad in a firm, people may work poorly and produce less than they could. In either case, the firm will produce below the maximum that the production function allows. Economist Harvey Liebenstein has called losses of these sorts "X-inefficiency." Although economists assume that the firm will be on the production function, a major challenge of management is to make decisions so that the firm will be on or close to the production function.  Profit Maximization Economic theory is based on the reasonable notion that people attempt to do as well as they can for themselves, given the constraints facing them. For example, consumers purchase things that they believe will make them feel more satisfied, but their purchases are limited (at least in the long run) by the amount of income they earn. A consumer can borrow to finance current purchases but must (if honest) repay the loans at a later date. Business owners also attempt to manage their businesses so as to improve their well being. Since the real world is a complicated place, a business owner may improve his well being in a number of ways. For example, if the business doesn't lack customers, the owner could respond by reducing operating hours and enjoying more leisure. Or, the business owner may seek satisfaction by earning as much profit as possible. This is the alternative we will focus on in class - for a very good reason. If a business faces tough competition, the only way the business can survive is to pay attention to revenues and costs. In many industries, profit maximization is not simply a potential goal; it's the only feasible goal, given the desire of other businesspeople to drive their competitors out of business. In economic terms, profit is the difference between a firm's total revenue and its total opportunity cost. Total revenue is the amount of income earned by selling products. In our simplified examples, total revenue equals P x Q, the (single) price of the product multiplied times Page 15

Managerial Economics the number of units sold. Total opportunity cost includes both the costs of all inputs into the production process plus the value of the highestvalued alternatives to which owned resources could be put. For example, a firm that has Rs.100,000 in cash could invest in new, more efficient, machines to reduce its unit production costs. But the firm could just as well use the Rs.100,000 to purchase bonds paying a 7% rate of interest. If the firm uses the money to buy new machinery, it must recognize that it is giving up Rs.7000 per year in forgone interest earnings. The Rs.7000 represents the opportunity cost of using the funds to buy the machinery. We will assume that the overriding goal of the managers of firms is to maximize profit: = TR - TC. The managers do this by increasing total revenue (TR) or reducing total opportunity cost (TC) so that the difference rises to a maximum.

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