Ms 09

MS-9
1. Given the profit function of a firm in the form of table, calculate total profit, average profit and
marginal profit and differentiate between incrementalism and marginalism.
Unit of output Total revenue Total cost Total profit Average profit Marginal profit
1 10 5
2 30 18
3 50 29
4 70 38
Ans: Total profit = Total revenue – Total cost
Average profit = Total profit/unit of output
Marginal profit = Difference of successive total profit
Unit Total revenue Total cost Total profit Average profit Marginal profit
of output
1 10 5 5 5.0 --
2 30 18 12 6.0 7
3 50 29 21 7.0 9
4 70 38 32 8.0 11
Incrementalism: Incremental reasoning involves estimating the impact of decision alternatives.

The two basic concepts in the incremental analysis are:
(i) Incremental Cost (IC)
(ii) Incremental Revenue (IR)
Incremental cost is defined as the change in total cost as a result of change in the level of
output, investment etc. Incremental revenue is defined as the change in total revenue resulting
from a change in the level of output, prices etc. A manager always determines the worth of a
decision on the basis of the criterion that IR > IC.
A decision is profitable if
(i) it increases revenue more than it increases cost
(ii) it reduces some costs more than it increases others
(iii) it increases some resources more than it decreases others
(iv) it decreases costs more than it decreases revenues.
Marginalism: According to this principle, different courses of action should be pursued upto
the point where all the courses provide equal marginal benefit per unit of cost. It states that a
rational decision-maker would allocate or hire his resources in such a way that the ratio of
marginal returns and marginal costs of various uses of a given resource or of various resources
in a given use is the same. For example, a consumer seeking maximum utility (satisfaction)
from his consumption basket, will allocate his consumption budget on goods and services such
that
MU1/MC1 = MU2 / MC2 =……..= MUn / MCn,

Where MU1 = marginal utility from good one,
MC1 = marginal cost of good one and so on.
Similarly, a producer seeking maximum profit would use the technique of production (input-
mix.) which would ensure
MRP1/MC1 = MRP2/MC2 =………….=MRPn/MCn

Where MRP1=Marginal revenue product of input one (e.g. Labour), MC1= Marginal cost of input
one and so on. It is easy to see that if the above equation was not satisfied, the decision
makers could add to his utility/profit by reshuffling his resources/input e.g. if
MU1/MC1>MU2/MC2 the consumer would add to his utility by buying more of good one and less
of good two.
1
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2. Define Price Elasticity. Explain the determinants of Price Elasticity.
Ans: Price Elasticity: Price elasticity of demand measures the responsiveness of the quantity sold
to changes in the product’s price, ceteris paribus. It is the percentage change in sales divided
by a percentage change in price. The notation Ep will be used for the arc price elasticity of
demand, and ep will be used for the point price elasticity of demand. If the absolute value of E p
(or ep ) is greater than one, a given percentage decrease (increase) in price will result in an
even greater percentage increase (decrease) in sales.1 In such a case, the demand for the
product is considered elastic; that is, sales are relatively responsive to price changes.
Therefore, the percentage change in quantity demanded will be greater than the percentage
change in the price. When the absolute value of the price elasticity of demand is less than one,
the percentage change in sales is less than a given percentage change in price. Demand is
then said to be inelastic with respect to price. Unitary price elasticity results when a given
percentage changes in price results in an equal percentage change in sales. The absolute
value of the coefficient of price elasticity is equal to one in such cases. These relationships are
summarized as follows:
If |ep| or |Ep |> 1, demand is elastic

If |ep| or |Ep| < 1, demand is inelastic
If |ep| or |Ep| = 1, demand is unitarily elastic
Determinants of Price Elasticity: Price elasticities can be estimated for many goods and
services; the short-run elasticities reflect periods of time that are not long enough for the
consumer to adjust completely to changes in prices. The long-run values refer to situations
where consumers have had more time to adjust. The long-run demand for foreign travel by
U.S. residents is elastic (i.e., ep = |4.10|). In contrast, the long-run demand for water is highly
inelastic (i.e., ep = |0.14|). Demand for is inelastic in the short run, but elastic in the long run. In
general, three factors determine the price elasticity of demand. They are: (1) availability of
substitutes, (2) proportion of income spent on good or service, and (3) length of time.
Availability of Substitutes: The main determinant of elasticity is the availability of substitutes.

Products for which there are good substitutes tend to have higher price elasticity of demand
than products for which there are few adequate substitutes. Movies are a good example.
Movies are a form of recreation, but there are many alternative recreational activities. When
ticket prices at the movie theatre increase, these substitute activities replace movies. Thus, the
demand for motion pictures is relatively elastic, as shown in Table. Other examples of products
with close substitutes and therefore elastic demand would be demand for Maruti cars,
subscription to cellular services, demand for air-travel etc.
Estimates of Price Elasticity
Good or Service Estimated Price Elasticity
Electricity – 0.13 Short run

Electricity – 1.89 Long run
Water – 0.14 Long run
Motion pictures – 3.69 Long run
Gasoline – 0.15 Short run
Gasoline – 0.78 Long run
Foreign travel – 4.10 Long run

At the other extreme, consider the short-run demand for electricity. When your local supplier
increases prices, consumers have few options. There are not many short-run alternatives to
using electricity for cooling and lighting. Hence the short run demand for electricity is relatively
inelastic. In the days of the license raj in India, when government was the monopoly provider,
demand for telecom services was relatively inelastic since there was no other service provider
in the market. Thus, a product with close substitutes tends to have elastic demand; one with
no close substitutes tends to have inelastic demand. An important mission for most advertising
is to make the consumer perceive that no close substitute exists for the product being
advertised, thereby rendering the consumers demand relatively inelastic.
Proportion of Income Spent: Demand tends to be inelastic for goods and services that
account for only a small proportion of total expenditures. Consider the demand for salt. 250
grams of salt will meet the needs of the typical household for months and costs only a few
rupees. If the price of salt were to double, this change would not have a significant impact on
the family’s purchasing power. As a result, price changes have little effect on the household
demand for salt. In contrast, demand will tend to be more elastic for goods and services that
require a substantial portion of total expenditures. Thus demand for holiday travel and luxury
cars take up a considerable portion of the family’s budget and therefore tend to have higher
elasticities. The relative necessity of a good also influences elasticity. For example, the
demand for insulin is probably very inelastic because it is necessary for diabetics who rely on
this drug.
Time Period: Demand is usually more elastic in the long run than in the short run. The
explanation is that, given more time, the consumer has more opportunities to adjust to changes
in prices. In the above table indicates that the long-run elasticity for electricity is more than ten
times the short-run value.
Price Elasticity and Decision Making: Information about price elasticities can be extremely
useful to managers as they contemplate pricing decisions, if demand is inelastic at the current
price, a price decrease will result in a decrease in total revenue. Alternatively, reducing the
price of a product with elastic demand would cause revenue to increase. The effect on total
revenue would be the reverse for a price increase. However, if demand is unitary elastic, price
changes will not change total revenues. However, a price reduction is not always the correct
strategy when demand is elastic. The decision must also take into account the impact on the
firm’s costs and profits. As another example of how knowledge of price elasticity may be useful,
let’s consider the demand for cigarettes. The price elasticity for cigarettes by age groups has
been found to be:
Age Group Price Elasticity

12-17 years – 1.40
20-25 years – 0.89
26-35 years – 0.47
36-74 years – 0.45
These elasticities indicate that young smokers are much more responsive to price than are
older smokers. This may be in part related to the fraction of income that goes towards the
purchase of cigarettes. It may also reflect the degree to which physical/psychological addiction
influences consumption. From the perspective of cigarette sellers, these results suggest that if
all sellers increased prices proportionately, the total expenditure on cigarettes by adult smokers
would increase. (Recall that when demand is inelastic, price and total revenue move in the
same direction). Individual brands would be more price elastic than for the entire product class
because each brand has other brands that represent potential substitutes; however, for the
product class, there may be few good substitutes.

3. ‘To an economist the fixed costs are overhead costs and to an accountant these are indirect
costs’. Substantiate this statement with the help of an example.
Ans: There are some costs, which can be directly attributed to production of a given product. The
use of raw material, labour input, and machine time involved in the production of each unit can
usually be determined. On the other hand, there are certain costs like stationery and other
office and administrative expenses, electricity charges, depreciation of plant and buildings, and
other such expenses that cannot easily and accurately be separated and attributed to individual
units of production, except on arbitrary basis. When referring to the separable costs of first
category accountants call them the direct, or prime costs per unit. The accountants refer to the
joint costs of the second category as indirect or overhead costs. Direct and indirect costs are
not exactly synonymous to what economists refer to as variable costs and fixed costs. The
criterion used by the economist to divide cost into either fixed or variable is whether or not the
cost varies with the level of output, whereas the accountant divides the cost on the basis of
whether or not the cost is separable with respect to the production of individual output units.
The accounting statements often divide overhead expenses into ‘variable overhead’ and ‘fixed
overhead’ categories. If the variable overhead expenses per unit are added to the direct cost
per unit, we arrive at what economists call as average variable cost.
Fixed costs are that part of the total cost of the firm which does not change with output.
Expenditures on depreciation, rent of land and buildings, property taxes, and interest payment
on bonds are examples of fixed costs. Given a capacity, fixed costs remain the same
irrespective of actual output. To an economist the fixed costs are overhead costs and to an
accountant these are indirect costs. When the output goes up, the fixed cost per unit of output
comes down, as the total fixed cost is divided between larger units of output.

4. What effect does change in demand have on price and quantity? Discuss with reference to
pricing analysis of markets by giving illustrations.
Ans: Pricing is an important function of all firms. Every firm is engaged in the production of
some goods and/or services, incurring some expenditure to sell them in the market. It must,
therefore, set a price for its product. It is only in extreme cases that the firm has no say in
pricing its product because there prevails perfect competition in the market or the good has so
much public significance that its price is decided by the government. Otherwise, in large
number of cases, the individual producer plays the role in pricing his/her product.
Demand-Supply Schedule
Price Demand Supply

5 100 200
4 120 180
3 150 150
2 200 110
1 300 50
Setting the right price for its product is crucial for any firm in the market. This is because the
price is such a parameter that it exerts a direct influence on the demand for and supply of the

product and thereby on its sales and profit – the important yardsticks for the success or failure
of the firm. If the price is set too high, the seller may not find enough customers to buy his/her
product. On the other hand, if the price is set too low, the seller may not be able to recover
his/her costs. Further, demand and supply conditions vary over time and the managers must
therefore review and reformulate their pricing decisions from time to time.
It is clear that the price of a product is determined by the demand for and supply of that
product.
Demand – supply curve
3 ---------------------------------
Price
0 100 150 200 250 300
Quantity
In the above example the market price, P = 3 and no other price prevails in the market.
Because if P = 5, supply exceeds demand and the producers may not be able to find enough
customers for their product. This would result into competition among the producers forcing
them to bring down the price to 3. On the other hand, if P = 1, the demand exceeds supply
which would give rise to competition among the buyers of the product, pushing the price up to
3. Therefore, at P = 3, demand equals supply, which is called equilibrium price. The equilibrium
price is thus determined by the interaction of demand and supply. Therefore, the factors which
affect either demand or supply are also determinants of price. A change in demand and/or
supply would bring in a change in price.
If the supply of a good is fixed, the level of demand appears to determine the equilibrium price.
In this case, the price is determined by the ‘other factors’ influencing the level of demand curve.
An increase in demand from D1 to D2, leads to an increase in equilibrium price from P1 to P2 and
an increase in quantity from Q1 to Q2. Which is shown in the following graph.
Effect of a change in demand on price and quantity
Increase in Demand

S1
P2
P1
D2
D1
0 Q1 Q2
Decrease in Demand
S1
P1
P2
D1
D2
0 Q2 Q1
Quite the opposite holds true in the event of a decrease in demand which is shown in above
graph.
If the demand for a commodity is fixed, the level of the supply curve determines the equilibrium
price of the commodity. The equilibrium price would, therefore depend on the ‘other factors’
underlying the supply curve of the commodity. The following graph shows that an increase in
supply from S1 to S2 causes price to fall from P1 to P2 and the quantity to increase from Q1 to Q2.

Effects of change in supply on price and quantity
Increase in Supply
S1
S2
P1
P2
D1
0 Q1 Q2
So far we have discussed the general equilibrium price which is determined by the interaction
of demand and supply. However, the actual shapes of the demand and supply schedules
depend on the structure of the product, market and the objectives of the firm. Thus market
structure and firms’ objectives also have a bearing on price. Since market structure influences
price and different product group’s fall under different market structures, pricing decisions
depend upon market structure. For instance, automobile prices are set quite differently from
prices of soap because the two products are produced by firms in different market structures.
A large firm may produce a number of products, which are sold in variety of markets catering to
the needs of different sections of the society. Let us take the example of HLL, which produces
products ranging from cosmetics to food products. Here comes the real task to be performed.
At times it happens that price set for one of such products may affect the demand for the other
product sold by the same firm. For example, the introduction of Alto from MUL had an effect on
the price of Zen’s sold in the market.

5. Write short notes on the following:-
(a) Market experiments
(b) Bundling of services
(c) Product differentiations
Ans: (a) Market experiments: The various types of markets existing. Experiments on market is
necessary for the economic point of view.
(i) Primary target market-large and low-income families

(ii) Secondary target market-other childbearing families
(iii) Tertiary target market-sources of funds and additional volunteer efforts
(iv) Miscellaneous target market-politicians and religious groups
You should, however, remember that a marketing planning approach does not necessarily
mean or guarantee that the social objectives will be achieved but it offers a useful framework
for effective social planning.
(b) Bundling of services: Bundling is the practice of selling two or more separate products
together for a single price i.e. bundling takes place when goods or services which could be sold
separately are sold as a package.
A codification of bundling practices and definitions of selling strategies is:

(i) Pure bundling: products are sold only as bundles. Pure bundling involves selling
two products only as a package and not separately.
For example, Reliance WLL -cellphone instrument (handset) and connection are only available
together and not available separately. Microsoft’s bundle of Windows and Internet Explorer
could be considered a pure bundle. Also Cable TV Channels are an example of pure bundling.
In North America it is not possible to get only Disney Channel has it is always bundled with
other premium channels. In India, the prospective CAS(Conditional Access System) also has
similar channel packages where some of the channels can’t be purchased separately like Zee
TV, would only be available with other, Zee Channels.
(ii) Mixed-bundling: products are sold both separately and as a bundle.
McDonald’s Value Meals and Microsoft Office are examples of Mixed Bundling. In a recently
introduced offer, The Times of India and The Economic Times can be purchased together for
weekdays for a price much less than if purchased separately. This is also an example of mixed
bundling. In most cases mixed bundling provides price savings for consumers.
(iii) Tying: The purchase of the main product (tying product) requires the purchase of
another product (tied product) which is generally an additional complementary product. Tying
involves purchase of the main product (tying product) along with purchase of another product
(tied product) which is generally an additional complementary product.
Financial bundling has become widespread. It has been suggested that manufacturers such as
GE, General Motors and Lucent grow ever more involved in providing finance, so
“manufacturing is becoming the loss-leader of the profit chain for many companies.” In other
words, give away the product; make money on the lending that is bundled with it. In India too, a
number of automobile companies are providing finance and bundling the automobile with
financing. Bundling can be good for consumers. It can reduce “search costs” (the bundled
goods are in the same place), as well as the producer’s distribution costs. There are lower
“transaction costs” (because a single purchase is cheaper to carry out than multiple ones). And
the producer may be a more efficient bundler than the customer: few of us choose, after all, to
buy the individual parts of a computer to assemble them ourselves.
In perfectly competitive markets, bundling should happen only if it is more efficient than selling
the products separately. Where there is less than perfect competition - that is, most markets -
9

economic models suggest that bundling sometimes benefits consumers and sometimes
producers. When firms have a measure of market power, they can engage in price
discrimination, charging different prices to different customers. Bundling can play a part in price
discrimination, as different bundles of goods and prices may appeal to different customers. In a
celebrated case that caught much media attention, Microsoft was accused of anti-competitive
conduct in ‘bundling’ Internet Explorer and Windows as a pure bundle. Microsoft claimed they
are not a bundle at all, rather a single product incapable of being broken into parts. It is of
course difficult to settle such arguments and these go beyond the economic domain to the
judicial domain, and are settled in courts. But the interesting aspect is that the company does
not consider its product (Windows and Internet Explorer) as being capable of being broken into
parts.
(c) Product differentiations: If the products competing in the market are not identical or
homogeneous, they are said to be differentiated and hence ‘product differentiation’ exists in the
market. Product differentiation is a fact of life and there is some amount of differentiation for
almost all products that we buy in markets. For example, ingredients in different soaps could be
different as can be the packaging, advertising etc. Even seemingly homogeneous goods such
as apples and bananas are at present differentiated on the basis of the orchards where they
have been grown and the way these are marketed. Wheat is a good example of a product that
can be considered undifferentiated. The degree of substitutability or product differentiation is
measured by cross-elasticity of demand between two competing products. This feature was
explained in unit 5. Products can be classified into perfect substitutes or homogeneous
products, close substitutes like soaps of different brands, remote substitutes like radio and
television and no substitutes like cereals and soaps. Further, perfect substitutes for one
consumer may not be so for another. For example, Rahul may feel that Coke and Pepsi are
perfect substitutes while Sachin may have a strong brand preference for Pepsi. Product
differentiation is a basis for a lot of advertising that is seen in the media where the focus is to
create a strong brand preference for the product being advertised.
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MS-9

Average profit = Total profit/unit of output

Marginal profit = Difference of successive total profit

Incrementalism: Incremental reasoning involves estimating the impact of decision alternatives.

MU1/MC1 = MU2 / MC2 =……..= MUn / MCn,

MRP1/MC1 = MRP2/MC2 =………….=MRPn/MCn

Please send your documents/contribution at kvrajan6@gmail.com .

If |ep| or |Ep |> 1, demand is elastic

Availability of Substitutes: The main determinant of elasticity is the availability of substitutes.

Estimates of Price Elasticity

Good or Service Estimated Price Elasticity

Electricity – 0.13 Short run

Please send your documents/contribution at kvrajan6@gmail.com .

Age Group Price Elasticity

Please send your documents/contribution at kvrajan6@gmail.com .

Please send your documents/contribution at kvrajan6@gmail.com .

Price Demand Supply

Please send your documents/contribution at kvrajan6@gmail.com .

Demand – supply curve

0 100 150 200 250 300

Effect of a change in demand on price and quantity

Please send your documents/contribution at kvrajan6@gmail.com .

Please send your documents/contribution at kvrajan6@gmail.com .

Please send your documents/contribution at kvrajan6@gmail.com .

(i) Primary target market-large and low-income families

A codification of bundling practices and definitions of selling strategies is:

(ii) Mixed-bundling: products are sold both separately and as a bundle.

Please send your documents/contribution at kvrajan6@gmail.com .

Please send your documents/contribution at kvrajan6@gmail.com .

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