Master of Business Administration- MBA Semester 1 (Book ID: 1131) MB0042 Managerial Economics - 4 Credits

Assignment Set- 2 (60 Marks) Note: Each question carries 10 Marks. Answer all the questions. 1. Under perfect competition how is equilibrium price determined in the short and long run? Solution: The Long Run Adjustment Process If most firms are making abnormal profits in the short run there will be an expansion of the output of existing firms and we expect to see the entry of new firms into the industry. Firms are responding to the profit motive and supernormal profits act as a signal for a reallocation of resources within the market. The addition of new suppliers causes an outward shift in the market supply curve. This is shown in the diagram below.

Making the assumption that the market demand curve remains unchanged, higher market supply will reduce the equilibrium market price until the price = long run average cost. At this point each firm is making normal profits only. There is no further incentive for movement of firms in and out of the industry and a long-run equilibrium has been established. The entry of new firms shifts the market supply curve to MS2 and drives down the market price to P2. At the profit-maximizing output level Q3 only normal profits are being made. There is no incentive for firms to enter or leave the industry. Thus a long-run equilibrium is established.

Does perfect competition lead to economic efficiency? Perfect competition is used as a yardstick to compare with other market structures (such a monopoly and oligopoly) because it displays high levels of economic efficiency. In both the short and long run, price is equal to marginal cost (P=MC) and therefore allocative efficiency is achieved the price that consumers are paying in the market reflects the factor cost of resources used up in producing / providing the good or service. Productive efficiency occurs when price is equal to average cost at its minimum point. This is not achieved in the short run firms can be operating at any point on their short run average total cost curve, but productive efficiency is attained in the long run because the profit maximizing output is achieved at a level where average (and marginal) revenue is tangential to the average total cost curve. The long run of perfect competition, therefore, exhibits optimal levels of static economic efficiency. There is of course another form of economic efficiency dynamic efficiency which relates to aspects of market competition such as the rate of innovation in a market, the quality of output provided over time. 2. Under what conditions is price discrimination possible? Solution: Pre-Requisite conditions for Price Discrimination (when price discrimination is possible) 1. Existence of imperfect market 2. Existence of different degrees of elasticity of demand in different markets 3. Existence of different markets for the same commodity 4. No contact among buyers 5. No possibility of resale 6. Legal sanction 7. Buyers illusion 8. Ignorance and lethargy 9. Preferences and Prejudices of buyers 10. Non-transferability features

11. Purpose of service 12. Geographical distance and tariff barriers 1. Existence of imperfect market: Under perfect competition there is no scope for price discrimination because all the buyers and sellers will have perfect knowledge of market. Under monopoly, there will be place for price discrimination as there are buyers with incomplete knowledge and information about the market. 2. Existence of different degree of elasticity of demand in different markets: A Monopolist will succeed in charging higher price in inelastic market and lower price in the elastic market. 3. Existence of different markets for the same commodity: This will facilitate price discrimination because buyers in one market will not be knowing the prices charged for the same commodity in other markets. 4. No contract among buyers: If there is possibility of contact and communication among buyers, they will come to know that discriminatory practices are followed by buyers. 5. No possibility of resale: Monopoly product purchased by consumers in the low priced market should not be resold in the high priced market. Prevention of re exchange of goods is a must for price discrimination. 6. Legal sanction: In some cases, price discrimination is legally allowed. For eg The electricity department will charge different rates per unit of electricity for different purposes. Similarly charges on trunk calls; book post, registered posts, insured parcel and courier parcel are different. 7. Buyers

Price Discrimination Most businesses charge different prices to different groups of consumers for what is more or less the same good or service! This is price discrimination and it has become widespread in nearly every market. This note looks at variations of price discrimination and evaluates who gains and who loses? What is price discrimination? Price discrimination or yield management occurs when a firm charges a different price to different groups of consumers for an identical good or service, for reasons not associated with costs. It is important to stress that charging different prices for similar goods is not pure price discrimination. We must be careful to distinguish between price discrimination and product differentiation Differentiation of the product gives the supplier greater control over price and the potential to charge consumers a premium price because of actual or perceived differences in the quality / performance of a good or service. Conditions necessary for price discrimination to work

Essentially there are two main conditions required for discriminatory pricing Differences in price elasticity of demand between markets: There must be a different price elasticity of demand from each group of consumers. The firm is then able to charge a higher price to the group with a more price inelastic demand and a relatively lower price to the group with a more elastic demand. By adopting such a strategy, the firm can increase its total revenue and profits (i.e. achieve a higher level of producer surplus). To profit maximise, the firm will seek to set marginal revenue = to marginal cost in each separate (segmented) market. Barriers to prevent consumers switching from one supplier to another: The firm must be able to prevent market seepage or consumer switching defined as a process whereby consumers who have purchased a good or service at a lower price are able to re-sell it to those consumers who would have normally paid the expensive price. This can be done in a number of ways, and is probably easier to achieve with the provision of a unique service such as a haircut rather than with the exchange of tangible goods. Seepage might be prevented by selling a product to consumers at unique and different points in time for example with the use of time specific airline tickets that cannot be resold under any circumstances. Examples of price discrimination Price discrimination is an extremely common type of pricing strategy operated by virtually every business with some discretionary pricing power. It is a classic part of price competition between firms seeking a market advantage or to protect an established market position. (a) Perfect Price Discrimination charging whatever the market will bear Sometimes known as optimal pricing, with perfect price discrimination, the firm separates the whole market into each individual consumer and charges them the price they are willing and able to pay. If successful, the firm can extract all consumer surplus that lies beneath the demand curve and turn it into extra producer revenue (or producer surplus). This is impossible to achieve unless the firm knows every consumers preferences and, as a result, is unlikely to occur in the real world. The transactions costs involved in finding out through market research what each buyer is prepared to pay is the main block or barrier to a businesss engaging in this form of price discrimination. If the monopolist is able to perfectly segment the market, then the average revenue curve effectively becomes the marginal revenue curve for the firm. The monopolist will continue to see extra units as long as the extra revenue exceeds the marginal cost of production. The reality is that, although optimal pricing can and does take place in the real world, most suppliers and consumers prefer to work with price lists and price menus from which trade can take place rather than having to negotiate a price for each unit of a product bought and sold.

Second Degree Price Discrimination This type of price discrimination involves businesses selling off packages of a product deemed to be surplus capacity at lower prices than the previously published/advertised price. Examples of this can often be found in the hotel and airline industries where spare rooms and seats are sold on a last minute standby basis. In these types of industry, the fixed costs of production are high. At the same time the marginal or variable costs are small and predictable. If there are unsold airline tickets or hotel rooms, it is often in the businesses best interest to offload any spare capacity at a discount prices, always providing that the cheaper price that adds to revenue at least covers the marginal cost of each unit.

There is nearly always some supplementary profit to be made from this strategy. And, it can also be an effective way of securing additional market share within an oligopoly as the main suppliers battle for market dominance. Firms may be quite happy to accept a smaller profit margin if it means that they manage to steal an advantage on their rival firms. The expansion of e-commerce by both well established businesses and new entrants to online retailing has seen a further growth in second degree price discrimination. Early-bird discounts extra cash-flow The low cost airlines follow a different pricing strategy to the one outlined above. Customers booking early with carriers such as Easy Jet will normally find lower prices if they are prepared to commit themselves to a flight by booking early. This gives the airline the advantage of knowing how full their flights are likely to be and a source of cash-flow in the weeks and months prior to the service being provided. Closer to the date and time of the scheduled service, the price rises, on the simple justification that consumers demand for a flight becomes more inelastic the nearer to the time of the service. People who book late often regard travel to their intended destination as a necessity and they are therefore likely to be willing and able to pay a much higher price very close to departure. Airlines call this price discrimination yield management but despite the fancy name, at the heart of this pricing strategy is the simple but important concept price elasticity of demand! Peak and Off-Peak Pricing Peak and off-peak pricing and is common in the telecommunications industry, leisure retailing and in the travel sector. Telephone and electricity companies separate markets by time: There are three rates for telephone calls: a daytime peak rate, and an off peak evening rate and a cheaper weekend rate. Electricity suppliers also offer cheaper off-peak electricity during the night. At off-peak times, there is plenty of spare capacity and marginal costs of production are low (the supply curve is elastic) whereas at peak times when demand is high, we expect that short run supply becomes relatively inelastic as the supplier reaches capacity constraints. A combination of higher demand and rising costs forces up the profit maximizing price.

Third Degree (Multi-Market) Price Discrimination This is the most frequently found form of price discrimination and involves charging different prices for the same product in different segments of the market. The key is that third degree discrimination is linked directly to consumers willingness and ability to pay for a good or service. It means that the prices charged may bear little or no relation to the cost of production. The market is usually separated in two ways: by time or by geography. For example, exporters may charge a higher price in overseas markets if demand is estimated to be more inelastic than it is in home markets. MC=AC

Suppose that a firm has separated a market by time into a peak market with inelastic demand, and

an off-peak market with elastic demand. The demand and marginal revenue curves for the peak market and off peak markets are labelled A and B respectively. This is illustrated in the diagram above. Assuming a constant marginal cost for supplying to each group of consumers, the firm aims to charge a profit maximizing price to each group. In the peak market the firm will produce where MRa = MC and charge price Pa, and in the off-peak market the firm will produce where MRb = MC and charge price Pb. Consumers with an inelastic demand for the product will pay a higher price (Pa) than those with an elastic demand who will be charged Pb. The internet and price discrimination A number of recent research papers have argued that the rapid expansion of e-commerce using the internet is giving manufacturers unprecedented opportunities to experiment with different forms of price discrimination. Consumers on the net often provide suppliers with a huge amount of information about themselves and their buying habits that then give sellers scope for discriminatory pricing. For example Dell Computer charges different prices for the same computer on its web pages, depending on whether the buyer is a state or local government, or a small business. Two Part Pricing Tariffs Another pricing policy common to industries with pricing power is to set a two-part tariff for consumers. A fixed fee is charged (often with the justification of it contributing to the fixed costs of supply) and then a supplementary variable charge based on the number of units consumed. There are plenty of examples of this including taxi fares, amusement park entrance charges and the fixed charges set by the utilities (gas, water and electricity). Price discrimination can come from varying the fixed charge to different segments of the market and in varying the charges on marginal units consumed (e.g. discrimination by time). Product-line pricing Product line pricing is also becoming an increasingly common feature of many markets, particularly manufactured products where there are many closely connected complementary products that consumers may be enticed to buy. It is frequently observed that a producer may manufacture many related products. They may choose to charge one low price for the core product (accepting a lower mark-up or profit on cost) as a means of attracting customers to the components / accessories that have a much higher mark-up or profit margin. Good examples include manufacturers of cars, cameras, razors and games consoles. Indeed discriminatory pricing techniques may take the form of offering the core product as a loss-leader (i.e. priced below average cost) to induce consumers to then buy the complementary products once they have been captured. Consider the cost of computer games consoles or Mach3 Razors contrasted with the prices of the games software and the replacement blades! The Consequences of Price Discrimination - Welfare and Efficiency Arguments To what extent does price discrimination help to achieve a more efficient allocation of resources? There are arguments on both sides of the coin indeed the impact of price discrimination on welfare seems bound to be ambiguous. The impact on consumer welfare Consumer surplus is reduced in most cases - representing a loss of consumer welfare. For the majority of consumers, the price charged is significantly above marginal cost of production. Those consumers in segments of the market where demand is inelastic would probably prefer a return to uniform pricing by firms with monopoly power! Their welfare is reduced and monopoly pricing power

is being exploited. However some consumers who can buy the product at a lower price may benefit. Previously they may have been excluded from consuming it. Low-income consumers may be priced into the market if the supplier is willing and able to charge them a lower price. Good examples to use here might include legal and medical services where charges are dependent on income levels. Greater access to these services may yield external benefits (positive externalities) which then have implications for the overall level of social welfare and the equity with which scarce resources are allocated. Producer surplus and the use of profit Price discrimination is clearly in the interests of businesses who achieve higher profits. A discriminating monopoly is extracting consumer surplus and turning it into extra supernormal profit. Of course businesses may not be driven solely by the aim of maximizing profit. A company will maximize its revenues if it can extract from each customer the maximum amount that person is willing to pay. Price discrimination also might be used as a predatory pricing tactic i.e. setting prices below cost to certain customers in order to harm competition at the suppliers level and thereby increase a firms market power. This type of anti-competitive practice is difficult to prove, but would certainly come under the scrutiny of the UK and European Union competition authorities. A converse argument to this is that price discrimination may be a way of making a market more contestable in the long run. The low cost airlines have been hugely successful partly on the back of extensive use of price discrimination among consumers. The profits made in one market may allow firms to cross-subsidise loss-making activities/services that have important social benefits. For example profits made on commuter rail or bus services may allow transport companies to support loss making rural or night-time services. Without the ability to price discriminate these services may have to be withdrawn and employment might suffer. In many cases, aggressive price discrimination is seen as inimical to business survival during a recession or sudden market downturn. An increase in total output resulting from selling extra units at a lower price might help a monopoly supplier to exploit economies of scale thereby reducing long run average costs.

3. Explain the average and marginal propensity to consume. Solution: Sl. No Average Propensity to Consume The relationship between income and consumption is measured by the average and marginal propensity to consume. The APC explains the relationship between total consumption and total income. At a certain period of time, it indicates the ratio of aggregate consumption expenditure to aggregate income. Thus, it is the ration of Marginal Propensity to consume Marginal Propensity to consume may be defined as the incremental change in consumption as a result of a given increment in income. It refers to the ratio of the change in aggregate consumption to the change in the level of aggregate income. It may be derived by dividing an increment in consumption by an increment in income.

consumption to income and is expressed as C/Y. Thus, APC=Total consumption / Total Income Symbolically MPC = AC / AY. Suppose total income increases from Rs.10000 crore to Rs.20000 crore and total APC = C/Y, APC = 8000 / 10000 = 0.8 or 80% consumption increases from Rs. 8000 crore to Rs. 15000 crore then, MPC = 7000 / 10000 = 0.7 of 70%.

4. What is monetary policy? What are the objectives of such policy? Solution:

(4+6)

Monetary policy is a part overall economic policy of a country. It is employed by the government as an effective tool to promote economic stability and achieve certain predetermined objectives. Monetary Policy can be explained in two different ways. In a narrow sense, it is concerned with administering and controlling a countrys money supply including currency notes and coins, credit money, level of interest rates and managing the exchange rates. In a border sense, monetary policy deals with all those monetary and non-monetary measures and decisions that affect the total money supply and its circulation in a economy. It also includes several nonmonetary measures like wages and price control, income policy, budgetary operations taken by the government which indirectly influence the monetary situations in an economy. According to RP Kent, Monetary policy is the management of the expansion and contraction of the volume of money in circulation for the explicit purpose of attaining a specific objective such as full employment. In the words of D.C Rowan, The monetary policy is defined as discretionary act undertaken by the authorities designed to influence the supply of money, cost of money or interest rate and the availability of money. Objectives of Monetary Policy Objectives of monetary policy must be regarded as a part of overall economic objectives of the government. It should be designed and directed to achieve different macroeconomic goals. The objectives may be manifold in relation to the general economic policy of a nation. The various objectives may be inter related, inter dependent and mutually complementary to each other. They may also be mutually inconsistent and clash with each other. Hence, very often the monetary authorities are concerned with a careful choice between alternative ends. The priorities of the objectives depend on the nature of economic problems, its magnitude and economic policy of a nation. The various objectives also change over a time period. Economists have conflicting and divergent views with regard to the objectives of monetary policy in a developing and developed economy. There are certain general objectives for which there is common consent and certain other objectives are laid down to suit to the special conditions of a developing economy. The main objective in a developed economy is to ensure economic stability and help in maintaining equilibrium in different sectors of the economy where as in a developing economy it has to give a big push to a slowly developing economy and accelerate the rate of economic growth.

General objectives of monetary policy 1. 2. 3. 4. 5. 6. 7. Neutral money policy Price stability Exchange rate stability Control of trade cycles Full employment Equilibrium in the balance of payments Rapid economic growth

Objectives of monetary policy in developing countries 1. Development role 2. Effective central banking 3. Inducement to savings 4. Investment of savings 5. Developing banking habits 6. Magnetization of the economy 7. Monetary equilibrium 8. Maintaining equilibrium in the balance of payments 9. Creation and expansion of financial institutions 10. Integration of organized and unorganized money markets 11. Integrated interest rate structure 12. Debt management 13. Long term loan for industrial development 14. Reforming rural credit system 15. To create a broad and continuous market for government securities 1. Neutral money policy: Prof Wicksteed, Hayak Robertson and others have advocated this policy. This objective was in vogue during the days of gold standard. According to this policy, money is only a technical devise having no other role to play. It should be a passive factor having only a technical devise having no other role to play. It should be a passive factor having only one function, namely to facilitate exchange. It should not inject any disturbances. It should be neutral in its effects on prices, income, output and employment. They considered that changes in total money supply are the root cause for all kinds of economic fluctuations and as such if money supply is stabilized and money becomes neutral, the price level will vary inversely with the productive power of the economy. If productivity increases, cost per unit of output declines and prices fall and vice-versa. According to this policy, money supply is not rigidly fixed. It will change whenever there are changes in productivity, population, improvements in technology etc to neutralize fundamental changes in the economy. Under these conditions, increase or decrease in money supply is allowed to result in either fall or raise in general price level. In a dynamic economy, this policy cannot be continued and it is highly impracticable in the present day economy. 2. Price Stability: With the suspension of the gold standard, maintenance of domestic price level has become an important aim monetary policy all over the world. The bitter experience of 1920s and 1930s has made all most all economies to go for price stability. Both inflation and deflation are dangerous and detrimental to smooth economic growth. They distort and disturb the working of economic system and create chaos. Both of them are bad as they bring unnecessary loss to some groups where as undue advantage to some others. They have potential power to create economic inequality, political upheavals and social unrest in any economy. In view of this, price stability is considered as one of the main objectives of monetary policy in recent years. It is to be remembered that price stability does not mean that prices of all commodities are kept constant

or fixed over a period of time. It refers to the absence of sharp variations or fluctuations in the average price level in the country. A hundred percent price stability is neither possible nor desirable in any economy. It simply implies relative price stability. A policy of price stability checks cyclical fluctuations and smoothen production and distribution, keeps the value of money stable, prevent artificial scarcity or prosperity makes economic calculations possible, introduces and element of certainty, eliminate socio-economic disturbances, ensure equitable distribution of income and wealth, secure social justice and promote economic welfare. 3. Exchange rate stability: Maintenance of stable or fixed exchange rate was one of the major objects of monetary policy for a long time under the gold standard. The stability of national output and internal price level was considered secondary and subservient to the former. It was through free and automatic imports and exports of gold that the country was able to remove the disequilibrium in the balance of payments and ensure stability of exchange rates with other countries. However, in order to have smooth and unhindered international trade and free flow of foreign capital in to a country, it becomes imperative for a country to maintain exchange rate stability. 4. Control of trade cycles: Operation of trade cycles has become very common in modern economies. A very high degree of fluctuations in overall economic activities is detrimental to the smooth growth of any economy. Hence it has become one of the major objectives of monetary authorities to control the operations of trade cycles and ensure economic stability by regulating total money supply effectively. 5. Full Employment: In recent years it has become another major goal of monetary policy all over the world especially with the publication of general theory by Lord Keynes. Deliberate efforts are to be made by the monetary authorities to ensure adequate supply of financial resources to exploit and utilize resources in the best possible manner so as to raise the level of aggregate effective demand in economy. 6. Equilibrium in the balance of payments: This objective has assumed greater importance in the context of expanding international trade globalization. Hence, monetary authorities have to take appropriate monetary measures like deflation, exchange depreciation, devaluation, exchange control, current account and capital account convertibility, regulate credit facilities and interest rate structures and exchange rates etc. 7. Rapid economic growth: This is comparatively a recent objective of monetary policy. Achieving a higher rate of per capita output and income over a long period of time has become one of the supreme goals of monetary policy in recent years. A higher rate of economic growth would ensure full employment condition, higher output, income and better living standards to the people. 5. Explain briefly the phases of business cycle. Through what phase did the world pass in 09-09. (7+3) Solution: A business cycle has only two parts-expansion and contraction or prosperity and depression. Burns and Mitchell observe that peaks and troughs are the two main mark-off points of a business cycle. The expansion phase starts from revival and includes prosperity and boom. Contraction phase includes recession, depression and trough. In between these two main parts, we came across a few other interrelated transitional phases. In broader perspective, a business cycle has five phases. They are as follows.

1. Depression, contraction or downswing: It is the first phase of a trade cycle. It is a protracted period in which business activity is far below the normal level and is extremely low. According to Prof. Haberler depression is a state of affairs in which the real income consumed or volume of production per head and the rate of employment are falling and age sub-normal in the sense that there are idle resources and unused capacity, especially unused labor.

6. What are the causes of inflation? What were the causes that affected inflation in India during the last quarter of 2009? Solution: The causes of inflation are: 1. Demand side 2. Supply side 3. Role of Expectations 1. Increase in aggregative effective demand is responsible for inflation. In this case, aggregate demand exceeds aggregate supply of goods and services. Demand rises much faster than the supply. We can enumerate the following reasons for increase in effective demand. a) Increase in money supply: Supply of money in circulation increases on account of the following reasons deficit financing by the government, expansion in public expenditure, expansion in bank credit and repayment of past debt by the government to the people, increase in legal tender money and public borrowing. b) Increase in disposable income: Aggregate effective demand rises when disposable income of the people increases. Disposable income rises on account of the following reasons reduction in the rates of taxes, increase in national income while tax level remains constant and decline in the level of savings. c) Increase in private consumption expenditure and investment expenditure: An increase in private expenditure both on consumption and on investment leads to emergence of excess demand in an economy. When business is prosperous, business expectations are optimistic and prices are rising, more investment is made by private entrepreneurs causing an increase in factor prices. When the incomes of the factors rise, there is more expenditure on consumer goods. d) Increase in Exports: An increase in the foreign demand for a countrys exports reduces the stock of goods available for home consumption. This creates shortages in the country leading to rise in price level. e) Existence of Black Money: The existence of black money in a country due to corruption, tax evasion, black-marketing etc. increases the aggregate demand. People spend such unaccounted money extravagantly thereby creating un-necessary demand for goods and services causing inflation. f) Increase in Foreign Exchange Reserves: It may increase on account of the inflow of foreign money in to the country. Foreign Direct Investment may increase and non-resident deposits may also increase due to the policy of the government. g) Increase in population growth creates increase in demand for everything in a country.

h) High rates of indirect taxes would lead to rise in prices. i) Reduction in the level of savings creates more demand for goods and services. 2. Generally, the supply of goods and services do not keep pace with the ever-increasing demand for goods and services. Thus, supply does not match with the demand. Supply falls short of demand. Increase in supply of goods and services may be limited because of the following reasons. a) Shortage in the supply of factors of production: When there is shortage in the supply of factors of production like raw materials, labor, capital equipments etc. there will be a rise in their prices. Thus, when supply falls short of demand, a situation of excess demand emerges creating inflationary pressures in an economy. b) Operation of law of diminishing returns: When the law of diminishing returns operate, increase in production is possible only at a higher cost which de motivates the producers to invest in large amounts. Thus production will not increase proportionately to meet the increase in demand. Hence, supply falls short of demand.
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c) Hoardings by Traders and Speculators: During the period of shortage and rise in prices, hoarding of essential commodities by traders and speculators with the object of earning extra profits in future creates artificial scarcity of commodities. This creates a situation of excess demand paving the way for further inflation. d) Hoarding by Consumers: Consumers may also hoard essential goods to avoid payment of higher prices in future. This leads to increase in current demand, which in turn stimulate prices. e) Role of Trade unions: Trade union activates leading to industrial unrest in the form of strikes and lockouts also reduce production. This will lead to creation of excess demand that eventually brings a rise in the price level. f) Role of natural Calamities: Natural Calamities such as earthquake, floods and drought conditions also affect adversely the supplies of agricultural products and create shortage of food grains and raw materials, which in turn creates inflationary conditions. g) War: During the period of war, shortage of essential goods create rise in prices. h) International factors: also would cause either shortage of goods and services or rise in the prices of factor inputs leading to inflation. Eg. High prices of imports. i) Increase in prices of inputs with in the country.

3. Expectations also pay a significant role in accentuating inflation. The following points are worth mentioning: a. If people expect further rise in price, the current aggregate demand increases which in its turn causes a rise in the prices. b. Expectations about higher wages and salaries affect very much the prices of related goods. c. Expectations of wage increase often induce some business houses to increase prices even before upward wage revisions are actually made.

Thus, many prices are responsible for escalation of prices.