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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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

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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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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.

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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 = Public Consumption + Private

Consumption

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

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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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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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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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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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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

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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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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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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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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

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the number of units sold. Total opportunity cost includes both the costs
of all inputs into the production process plus the value of the highest-
valued 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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