Tuesday, May 13, 2008

Managerial Economics(For Batch 2003 and Earlier) - 1

Q1. What is Managerial Economics? Explain the nature and scope of Managerial Economics.
Managerial Economics generally refers to the integration of economic theory with business practice. While economics provides the tools which explain various concepts such as Demand, Supply, Price, Competition etc. Managerial Economics applies these tools to the management of business. Managerial Economics is also understood to refer to business economics or applied economics.

“Managerial Economics lies on the border line of management & economics. It is a hybrid of two disciplines and it is primarily an applied branch of knowledge.”

According to Prof. Spencer Sigelman,”Managerial Economics deals with integration of economics theory with business practice for the purpose of facilitating decision making and forward planning by management”.

According to Prof. Joel Dean,” The purpose of Managerial Economics is to show how economic analysis can be used in formulating business policies”.

Nature of Managerial Economics:

It is true that managerial economics aims at providing help in decision-making by firms. For this purpose, it draws heavily on the propositions of microeconomic theory. Note that microeconomics studies the phenomenon at the individual’s level: behavior of individual consumers, firms. The concepts of microeconomics used frequently in managerial economics are: (i) elasticity of demand ii) marginal cost (iii) marginal revenue (iv) market structures and their significance in pricing policies, etc. Some of these concepts however provide only the logical base and have to be modified in practice.

Microeconomics assists firms in forecasting. Note that macroeconomic theory studies the economy at the aggregative level and ignores the distinguishing features of individual observations. For example, macroeconomics indicates the relationship between (i) the magnitude of investment and the level of national income, (ii) the level of national income and the level of employment (iii) the level of consumption and the national income, etc. Therefore, the postulates of macroeconomics can be used to identify the level of demand at some future point in time, based on the relationship between the level of national income and the demand for a particular product. For example, there is a relationship between the level of national income and demand for electric motors. Also, the demand for durable goods such as refrigerators, air-conditioners, and motorcars depends upon the level of national income.

Managerial Economics is decidedly applied branch of knowledge. Therefore, the emphasis is laid on those propositions, which are likely to be useful to the management. The precision of a scientist is not motivating factor in research activity. Improvement in the quality of results is attempted provided the additional cost is not very high and the decision maker can wait. For example it may be possible to have more accurate data on the demand for the firm’s product by taking into consideration additional factors (explanatory variables). But this may not be attempted because the decision has to be made without delay. Besides, more accurate forecasts may not be justified on cost considerations.

Managerial Economics is prescriptive in nature and character. It recommends that it should be done under alternative conditions. For example, if the price of the synthetic yarn falls by 50 %, it may be desirable to increase its use in producing different types of textiles. Thus, managerial economics is one of the normative sciences and reflects upon the desirability or otherwise of the propositions. For example if the analysis suggests that the benefit-cost ratio of a large plant is less than that for a smaller plant and the benefit-cost ratio is used as the criterion for project appraisal it is recommended that the firm should not install a large plant. Contrast this with the positive sciences, which state the propositions without commenting upon what should be done. For example, if the distribution of income has become more uneven, it is stated without indicating what should be done to correct this phenomenon.

Managerial economics, to the extent that it uses economic thought, is a science, but it is an applied science, Economic thought uses deductive logic (if X is true, then Y is true). For example, if the triangles are congruent, their angles are equal. To have confidence in the findings, the propositions deduced are subjected to empirical verification. For example, empirical studies try to verify whether cost curves faced by a firm are really U-shaped as suggested by the theory. Furthermore, there is an attempt to generalize the propositions, which provide a predictive character. For example, empirical studies may suggest that for every 1% rise in expenditure on advertising, the demand for the product shall increase by 0.5%.

Scope of Managerial Economics:

The scope of Managerial Economics is so wide that it embraces almost all the problems & areas of the manager and the firm. It deals with demand analysis and forecasting, production function, cost analysis, inventory management advertising price system, resource allocation, capital budgeting etc.

1. Demand analysis and forecasting:
It analyses carefully and systematically the various types of demand which enable the manager to arrive at a reasonable estimate of demand for products of his company. He takes into account such concepts as income elasticity and cross elasticity.

2. Production Function
Resources are scarce and also have alternative uses. Inputs play a vital role in the economics of production. The factors of production, otherwise called inputs, may be combined in a particular way to yield the maximum output. Alternatively, when the price of inputs shoot up, a firm is forced to work out a combination of inputs so as to ensure that this combination becomes least cost combination.

3. Cost Analysis:
Determinants of cost. Methods of estimating costs, the relationship between cost & output, the forecast of cost and profit-these are very vital to a firm.

4. Inventory Management:
An inventory refers to stock of raw materials, which a firm keeps. Now the problem is how much of the inventory is ideal stock. If it is high, capital is unproductively feed up, which might, if the stock of inventory is reduced, be used for other productive purposes. On the other hand, if level of inventory is low, production will be hampered. Therefore, managerial economics will use such methods as ABC analysis, a simple simulation exercise and some mathematical models with a view to minimize the inventory cost.

5. Advertising
Advertising is an area which managerial economics embraces. While the copy, illustration. Etc. of an advertisement are the responsibility of those who get it ready for the press, the problems of cost, The methods of determining the total advertisement costs and budge, the measuring of the economic effects of advertising-these are the problems of the manager.

6. Price System
The central function of an enterprise is not only production but pricing as well. While the cost of production has to be taken into account while pricing a commodity, a complete knowledge of the price system is quite essential to determination of price. Pricing is actually guided by considerations of cost plus pricing and the policies of public enterprises.

7. Resources Allocation:
Scarce resources obviously have alternate uses. The aim of course, is to achieve optimization. For this purpose, some advanced tools, such as linear programming are used to arrive at the best course of action for a specified end.

8. Capital Budgeting:
Capital is scarce and it costs something. Now, the problem is how to arrive at the cost of capita: how to ensure that capital becomes rational: how to face Upto budgeting problems, how to ensure that capital becomes rational; how to face Upto budgeting problems, how to arrive at investment decisions under conditions of uncertainly; how to effect a cost-benefit analysis etc. Any manager cannot ignore these areas.

Q2. State and explain the law of demand. What are its exceptions?

The law may be stated:”Other things being equal, the higher the price of a commodity, the smaller is the quantity demanded and lower the price, larger is the quantity demanded”. In other works, the demand for a commodity expands as the price falls and contracts as the price rises. Or briefly stated, the law of demand emphasizes that other things remaining unchanged, demand varies inversely with price.
The conventional law of demand, however, relates to the much simplified demand function:
D= f (P)
Where, D represents demand, P the price and f connotes a functional relationship. It, however, assumes that other determinants of demand are constant and only price is the variable and influencing factor. The relation between price and quantity of demand is usually an inverse or negative relation, indicating a larger quantity demanded at a lower price and a smaller quantity demanded at a higher price.

The law of demand is usually referred to the market demand. The law of demand can be illustrated with the help of a market demand schedule, thus, as the price of commodity decreases, the corresponding quantity demanded for that commodity increases and vice-versa.
Price of Commodity X (in Rs.) per unit Quantity Demanded per week
5 10
4 20
3 30
2 40
1 50

This table represents hypothetical demand schedule for commodity X. With a fall in priced at each stage, quantity demanded tends to rise. There is an inverse relationship between price and quantity demanded. Usually, economists draw a demand curve to give a pictorial presentation of law of demand. When the data of table are plotted graphically, a demand curve is drawn as shown in Fig.

Y Demand Curve




Quantity Demanded of X

In this fig., DD is a downward sloping demand curve indicating an inverse relationship between price and quantity demanded.
From the given market demand-curve once can easily locate the market demand for a product at a given price. Further, the demand curve geometrically represents the mathematical demand function: Dx = f (Px)

Assumption of the law of Demand

The law of demand is based upon the following assumptions:

1. Tastes & preferences of consumer remain unchanged:
It is assured that the tastes & habits of a consumer remain unchanged. The demand curve is drawn on the basis of a particular level of tastes & preference. If it changes demand curve has to be redrawn. If the preference of a consumer changes he may demand more or less of a given commodity. For instance when a commodity becomes fashionable, consumption will increase, irrespective of price changes. In such a case the law of demand will not hold true.

2. Income remains the same:
When income changes the consumer’s scale of preference or choice usually becomes entirely different. With the increase in income, he may purchase more of a commodity at the same price. If the commodity is of inferior quality, he may replace it with a better variety at a higher price. Hence, stability of income through out the demand schedule is necessary.

3. The prices of other goods remain the same:
A change in the prices of substitutes and complementary goods may cause demand to shift. A consumer may shift from the consumption of present goods to its complementary or substitute goods due to its fall in the price. Thus the demand for tea will be affected by a fall in the price of coffee or sugar.

Exceptions to the Law of Demand

Generally, more of a commodity is demanded at a lower price & less of it is demanded at a higher price. However, under certain conditions the law of demand does not hold good. These are exceptions to the law of demand, which are as follows;

1) Conspicuous Consumption: There are certain commodities such as diamond jewellery, antique collections the possession of which is a matter of prestige. More of these commodities are purchased at a higher price & vice versa. While some goods are such the constant use of which become necessity of life. For example, in spite of the fact that the prices of television sets, refrigerator, washing machine etc. have been continuously raising their demand does not show any tendency to fall. These are the ‘supper sector’ goods.

2) Speculative markets: Households also act as speculators. In the speculative markets a rise of prices is frequently followed by large purchases & a fall of price by less purchases. Likewise, if price are expected to fall further, a reduced price may not be a sufficient incentive to buy more. For example: in the share market, a rise in the price of a specific share induces the speculators to buy large number of this share because they expect a further rise in the price of that share. Consequently, the demand for the share also rises. On the contrary, fall in the price of a specific share causes a fall in its demand.

3) Giften goods: Giften goods are special type of cheaper goods. Sir Robert Fifteen found that in the 19th century Ireland the people were so poor that they spent the major part of their income on potatoes & a small part on meat. Potato was cheap but meal was dear. When the price of potatoes rose, they had to economize on meat. To maintain the earlier level of consumption or to fill the resulting gap in food supply more potatoes had to be purchased. Thus, rise in the price of potatoes led to increased sales of potatoes. This is known as Giften effect. This effect is usually found in the case of cheap necessary foodstuffs. Bajra can also be considered as Giften good to which the law of demand does not apply.

4) The income effect: The demand curve may be affected by the income effect. If the income effect. If the income effect is positive we can expect a downward sloping curve. But, on the other hand, if the income effect is negative, particularly in case of inferior goods, the result may not be a downward sloping curve. If the total expenditure of the commodity is small, the income effect will have less implication on the demand curve & there will be an inverse relation between price and demand.

5) Emergencies: Emergencies like war, famine, floods etc. negate then operation of the law of demand, In anticipation of scarcity of goods, consumers increase their purchases & includes further price rise. Even at an increased price consumers are ready to buy more during such periods. On the other hand during depression no amount of falling price is sufficient inducement for consumers to demand more.

6) Change in fashion: A change in fashion & tastes affects demand for a commodity. When a narrow or thin metallic frame of spectacles replaces a broad plastic frame, reduction in the price of latter is not sufficient to clear the stocks. On the other hand, the demand for thin frame rises even at a higher price.

7) Ignorance: A consumer of one market may be ignorant about the prevailing prices in the other market. Thus he can end up in buying a commodity at a higher price. This is also true when the consumer is under impression that higher priced commodity is better in quality than low priced commodity which is necessarily not true. The law of demand also falls when an impulsive purchases is made without any calculation of price and usefulness of the product.

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