Managerial Economics (Set 1)

Q1) The demand function of a goods is as follows:

Q1= 100-6p1-4p2+2p3+0.0037
Where P1 and Q1 are the price and quantity values of good 1, P2&P3 are the prices of good 2
and good 3 & y is the income of the consumer. The initial values are given:
P1=7, P2=15, P3= 4, y=8000, Q1=30
You are required to:
• Using the concept of cross elasticity determine the relationship between good 1 &
others.
• Determine the effect on Q1 due to a 10% increase in the price of good 2& good 3.

Ans:a) Q1=100-6p-4p+2p3+0.003y
According to question the initial values are.
P1=7, P2=15,P3=4, y=8000, Q1=30
Now putting the values:
Q1=100-6(7)-4(15)+2(4)+0.003(8000)
Or Q1=100-42-60+8+24
Q1=30.
From the above information, we can find the elasticity of the demand for good 1 with respect
to its price, means the prices of good 2. Good 3 & the y(means income)
EP1=-6(7/7)= -6
Ep2=-4(15/7)= -8.57
Ep3=2(4/7)= 1.14
Ey= 0.003(8000/7)= 3.43
According to the concept of cross- price elasticity-
Ec= ∆ >0= Substitute goods.

Ec=∆ <0= Complementary goods.

Ep2<0 = good 2 is complementary goods

Ep3>0= good 3 is substitute goods.

1b) Now Q1=?. When 10% increase in price of good 2 & good 3.
Q1=100-6(7)-4(16.5)+2(4.4)+0.003(8000)
Or Q1=100-42-66+8.8+24.
Q1=24.8
Demand of good 1 or the quality value of good 1 decrease with the increase in the price of
good 2 & good 3. Demand of good 1 falls by 17.33%.

2. What are the factors that determine the Demand curve? Explain.
Ans. The factors that determine the Demand curve are mention below:-
 i) Price of the given commodity, price of other substitutes and complements, future expected trend in
price etc.
ii) General Price level existing in the country-inflation or deflation.
iii) Level of income and living standards of the people.
iv) Size, rate of growth and composition of population.
v) Tastes, preferences, customs, habits, fashion and styles.
vi) Publicity, propaganda and advertisements.
vii) Quality of the product.
viii) Profit margin kept by the sellers.
ix) Weather and climatic conditions.
x) Conditions of trade-boom or prosperity in the economy.
xi) Terms & conditions of trade.
xii) Government’s policy-taxation, liberal or restrictive measures.
xiii) Level of savings & pattern of consumer expenditure.
xiv) Total supply of money circulation and liquidity preference of the people.
xv) Improvements in educational standards etc.

Thus, several factors are responsible for bringing changes in the demand for a product in the market.

Q3) A firm supplied 3000 pens at the rate of Rs.10. Next month, due to a rise of in the price to
22 rs per pen the supply of the firm increases to 5000 pens. Find the elasticity of supply of the
pens.
Ans:> Now,
S1=3000 S2=5000
P1=10 p2=22
We know:

Or,

Or,

..Es= 0.56. ans.

4. Briefly explain the profit-maximization model.

Ans: Profit maximization model helps to predict the price-output behavior of a firm under changing market
conditions like tax rates, wages and salaries, bonus, the degree of availability of resources, technology, fashions,
tastes and preferences of consumers etc. It is a very simple and unambiguous model. It is the single most ideal
model that can explain the normal behavior of a firm.
Main proposition of the profit-maximization model:
The model is based on the assumption that each firm seeks to maximize its profit given certain technical and
market constraints. The following are the main propositions of the model.
 • A firm is a producing unit and as such it converts various inputs into outputs of higher value under a
given technique of production.
• The basic objective of each firm is to earn maximum profit.
• A firm operates under a given market condition.
• A firm will select that alternative course of action which helps to maximize consistent profits.
• A firm makes an attempt to change its prices, input and output quantity to maximize its profit.
Profit-maximization implies earning highest possible amount of profits during a given period of time. A firm has
to generate largest amount of profits by building optimum productive capacity both in the short run and long run
depending upon various internal and external factors and forces.
It is to be noted with great care that a firm has maximize its profits after taking in to consideration of
various factors in to account. They are as follows:
• Pricing and business strategies of rival firms and impact on the working of the given firm.
• Aggressive sales promotion policies adopted by rival firms in the market.
• Without inducing the workers to demand higher wages and salaries leading to rise in operation costs.
• Without resorting to monopolistic and exploitative practices inviting government controls and
takeovers.
• Maintaining the quality of the product and services to the customers.

The profit maximization model is based on three important assumptions. They are as follows-
i) Profit maximization is the main goal of the firm.
ii) Rational behavior on the part of firm to achieve its goal of profit maximization.
iii) The firm is managed by owner-entrepreneur.
Profit maximization of a firm can be explained in two different ways.
α ) Total revenue and total cost approach: – excess of revenue over costs is the profits. Profit = Total
revenue – Total cost. If Total revenue is equal to Total cost in that case, there will be break even point. If
Total revenue is less than Total cost, in that case, a firm will be incurring losses.

b) Marginal revenue and marginal cost approach: - In this case, we take in to account of revenue earned from
one and cost incurred to produce only one unit of out put. A firm will be maximizing its profits when Marginal
revenue = Marginal cost and Marginal cost curve cuts Marginal revenue curve from below.
5. What is Cyert and March’s behavior theory? What are the demerits?
Ans:- Cyert and March’s behavior theory explains the usual and normal behavior of different group of people who
work in an organization having mutually opposite goals. Cyert and March explain how complicated decisions are
taken in big industrial houses under various kinds of risks and uncertainties in an imperfect market in the
background of limited data and information.
Cyert and March consider that a modern firm is a multi-product, multi-goal and multi-decision making
coalition business unit. Like a coalition government, it is managed by a number of groups. The group consists of
share holders, managers, workers, customers, suppliers, distributors, financiers, legal experts and so on. Each
group is independent by itself and has it own set of objectives and they try to maximize their individual benefits.
For example, shareholders expect faster growth of the company and higher dividends, workers expect maximum
wages and minimum work.
Cyert and March point out the goals of a business organization would depend upon the multiple objectives
of each group and their collective demands. Each one of the group out of their past experience and success
availability of limited resources at the disposal of a firm, would arrange their demand on the basis of priorities.
Most urgent demands are highlighted and low-priority demands are postponed to latter period. The management
may honor a few demands of a few groups and postpone the demands of other groups in view of financial
constraints. This may create heart-burns and conflict between different groups in the same organization.
If actual performance and achievements of the organization is much better than expected aspirations and
target level, in that case, there will be upward revision in their demands and vice-versa. Thus, there is a strong
linkage between the expected and actual demand of each group in the organization, past success and future
environment.
Cyert and March suggest the following methods to overcome the conflicts of different groups and smooth
working of the organization. They are as follows. Demand of each group may be separated from that of the other
and separate attempts are made to fulfill them so that their impact on the whole organization may be avoided.
They may also grant side payments to different departments to carryon their work smoothly. Share holders may be
granted higher dividends; managers are given more power, more autonomy, higher salaries, lavish and luxurious
air-conditioned offices, vehicles, and various kinds of facilities to keep them happy. These additional benefits may
be flexible to suit to the profit and loss conditions of a firm. On the basis of the priority and importance of each
demand, the management may fulfill most urgent demand first and then postpone the remaining less-urgent ones.
The management may also tackle the problem by decentralizing the decision making process.
Cyert and March are of the opinion that out of several objectives a firm has five important goals. They are-
i) Production goal. Neither there should be over production nor under production but just that
much to meet the required demand in the market.
ii) Inventory goal. Neither there should be surplus stock or shortage of different inputs. Proper
balance between demand and supply is to be maintained.
iii) Sales goal. There should be adequate sales in any organization to earn reasonable amounts
of profits. In order to create demand sales promotion policies may be adopted from time to
time.
iv) Market-share goal. Each firm has to make consistent effort to increase its market share to
compete successfully with other firms and make sufficient profits.
v) Profit goal. This is one of the basic objectives of any firm. The very survival and success of
the firm would depend upon the volume of profit earned by it.
The management has to accommodate as many as possible demands of different groups with out jeopardizing its
own basic goal of making profit. The model highlights on satisfactory levels of performance and achievements of
its multiple objectives as maximization of different goals may not be possible in the context of complex business
world. Hence, making satisfactory levels of profits rather than maximum profits has become the order of the day.

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

6. What is Boumal’s Static and Dynamic?

Ans: Sales maximization model is an alternative model for profit maximization. The model is developed by
Prof. W. J. Boumal, an American economist. The model highlights that the primary objective of a firm is to
maximize its sales rather than profit maximization. It states that the goal of the firm is maximization of sales
revenue subject to a minimum profit constraint.

The Static Model

This model is based on the following assumptions.

i) The model is applicable to a particular time period and the model does not operate at different
periods of time.
ii) The firm aims at maximizing its sales revenue subject to a minimum profit constraint.
iii) The demand curve of the firm slope downwards from left to right.
iv) The average cost curve of the firm is U-shaped one.

With the help of the following diagram, we can explain sales maximization model subject to a minimum
profit constraint.
 At OX1 level of output profit is maximum; TR is much in excess of TC. If the firm chooses to produce OX3
output, profit will fall to X3K though the TR is still in excess of TC. Profit constraint is less at OX2 level of
output as the firm earns X2 N profit, depending upon the market conditions a firm can determine the level of
output with minimum profit constraint.

Sales maximization [Dynamic model]

In the real world many changes takes place which affects business decisions of a firm. In order to include
such changes, Boumal has developed another dynamic model. This model explains how changes in advertisement
expenditure, a major determinant of demand, would affect the sales revenue of a firm under severe competitions.
Assumptions:
i) Higher advertisement expenditure would certainly increase sales revenue of a firm.
ii) Market price remains constant.
iii) Demand and cost curves of the firm are conventional in nature.
A price cut may increases sales in general. But increase in sales mainly depends on whether the demand for a
product is elastic or inelastic. A price reduction policy may increase its sales only when the demand is elastic and
if the demand is inelastic; such a policy would have adverse effects on sales. Hence, to promote sales,
advertisements become an effective instrument today. It is the experience of most of the firms that with an
increase in advertisement expenditure, sales of the company would also go up. However, it is to be remembered
that amount allotted for sales promotion should bring more than proportionate increase in sales and total profits of
a firm. Otherwise, it will have a negative effect on business decisions.