UPPSC GOVERNMENT DEGREE COLLEGE COMMERCE NOTE UNIT-I

MANAGERIAL ECONOMICS UNIT-1 Business economics, Concept, nature and significance of business economics, Principles of Business economics, Demand analysis, Production analysis, Pricing analysis, Business cycles and inflation. Mansfield, "Managerial Economics is concerned with the application of economic concepts and economic analysis to the problems of formulating rational managerial decisions." According to McNair and Meriam, "Managerial economics is the use of economic modes of thought to analyse business situations." According to Hailstones and Rothwel, "Managerial economics is the application of economic theory and analysis to practice of business firms and other institutions." Spencer and Siegelman define it as "The integration of economic theory with business practice for the purpose of facilitating decision making and forward planning by management." The four distinctively macroeconomic problems are: 1. Recessions 2. Unemployment 3. Inflation 4. Economic Growth or Stagnation In positive economic analysis, the problem is analysed in objective terms based on principles and theories. In normative economic analysis, the problem is analysed based on value judgement. Virtuous Circles in Economic Growth: For Smith, a major consequence of division of labor and resulting increasing productivity was a “virtuous circle” of continuing growth. Equimarginal Principle-This is the diagnostic principle for economic efficiency. Cobweb Adjustment: This might give the explanations when the market does not move smoothly to equilibrium, but overshoots. Non-cooperative equilibrium (a) Prisoners’ Dilemma (dominant strategy) equilibrium (b) Nash (best response) equilibrium, (but not all Nash equilibrium are dominant strategy equilibrium), Programme code named MOST (Maynards Operation Sequence Technique). The event that created modern macroeconomics was called "the Great Depression," A recession is defined as a period of two or more successive quarters of decreasing production. Stagnation is a period of many years of slow growth of gross domestic product, in which the growth is, on the average, slower than the potential growth in the economy. Causes of Stagnation 1. Population growth might high. 2. Fewer people might choose to work. 3. The growth of labor productivity might slow Demand Function: A comprehensive formulation which specifies the factors that influence the demand for the product. The law of diminishing marginal utility says that with the increase in the consumption of a good there is a decrease in the marginal utility that person derives from consuming each additional unit of that product. The Law of Equi-Marginal Utility is an extension to the law of diminishing marginal utility. The principle of equi-marginal utility explains the behavior of a consumer in distributing his limited income among various goods and services. This law states that how a consumer allocates his money income between various goods so as to obtain maximum satisfaction. The consumer is in equilibrium position when marginal utility of money expenditure on each good is the same. MU of good A/ Price of A = MU of good B/ Price of B An indifference curve may be defined as the locus of points. Each point represents a different combination of two substitute goods, which yields the same utility or level of satisfaction to the consumer. Assumptions The following assumptions about the consumer psychology are implicit in indifference curve analysis: 1. Transitivity: If a consumer is indifferent to two combinations of two goods, then he is unaware of the third combination also. 2. Diminishing marginal rate of substitution: The rarer the availability of a good, the greater is its substitution value. For example, water has a high substitution value as it is a scarce resource. 3. Rationality: The consumer aims to maximise his total satisfaction and has got complete market information. 4. Ordinal utility: Utility in this approach is not measurable. A consumer can only specify his preference for a particular combination of two goods, he cannot specify how much. Indifference Curves have a Negative Slope In the words of Hicks, “so long as each commodity has a positive marginal utility, the indifference curve must slope downward to the right”. The negative slope of indifference curve implies- 1. that the two commodities can be substituted for each other 2. that if the quantity of one commodity decreases, quantity of the other commodity must increase so that the consumer stays at the same level of satisfaction. • Indifference Curves are Convex to Origin • Indifference Curves can neither Intersect nor be Tangent to one Another • Upper Indifference Curves represent a Higher Level of Satisfaction Budget Line The budget line is also known as the price line, the consumption possibility line or the price opportunity line. It represents different combinations of two goods X and Y which the consumer can buy by spending all his income. Law of Equi-marginal Utility or the principle of Equi-marginal utility says that the consumer would maximise his utility if he allocates his expenditure on various goods he consumes such that the utility of the last rupee spent on each good is equal. Price Effect (KM) = Substitution Effect (KL) + Income Effect (LM). Consumer Surplus-Consumer surplus is the satisfaction that a consumer obtains from a good over and above the price paid. This is the difference between the maximum demand price that buyers are willing to pay and the price that they actually pay. A related notion from the supply side of the market is producer surplus. Marginal utility means the utility derived by consuming every next unit of same thing. According to the law of diminishing marginal utility when a person consumes more and more units of a good his total utility increases while the extra utility derived from consuming successive units of the good diminishes. Law of Equi-marginal Utility or the principle of Equi-marginal utility says that the consumer would maximise his utility if he allocates his expenditure on various goods he consumes such that the utility of the last rupee spent on each good is equal. Independent curve shows all combinations of two goods which yield the same level of satisfaction to the consumer. The consumer is indifferent about any two points lying on this curve. Budget line represents different combinations of two goods X and Y which the consumer can buy by spending all his income. The indifference curve analysis considers the income effect. Change in the price of commodity will change the real income position. Indifference curve also considers the effect of substitution goods. Consumer surplus- When the demand price is generally greater than the price actually paid, most consumers under most circumstances receive some surplus of satisfaction. It is known as consumer surplus. Producer surplus-When the supply price is less than the price actually received, most producers under most circumstances receive some surplus of revenue. It is known as producer surplus. Budget line: It represents different combination of two goods which the consumer can buy by spending all his incomes Cardinal measure of utility: Utility is a measurable and quantifiable Marginal utility: Utility derived from every next unit Price consumption curve: The line connecting such (drawn because of change in price) successive equilibrium points is called PCC or price consumption curve The indifference curve: The curve at which satisfaction is equal at each point. Elasticity is the measure of responsiveness. It is the ratio of the percent change in one variable to the percent change in another variable. Computation of Elasticity Coefficients We may use two measures of elasticity: 1. Arc elasticity, if the data is discrete and therefore incremental changes are measurable. 2. Point elasticity, if the demand function is continuous and therefore only marginal changes are calculable. The measurement of elasticity is done by two methods, namely, Geometrical Method and Arithmetical Method. A geometrical way of measuring the elasticity at any point on a demand curve is now in order. Arc Elasticity-The geometrical method of measurement of price elasticity of demand is applicable only for infinitesimal changes in price. If price changes appreciably then we use the arc elasticity of demand. A normal good is one where a percentage increase in income ceteris paribus causes a percentage increase in quantity demanded and vice-versa. An inferior good is one where a percentage increase in income ceteris paribus, causes a percentage decrease in quantity demanded and vice-versa. The cross elasticity of demand (ec) is a numerical measure of the degree to which quantity demanded of a good responds to changes in the prices of other commodities. The higher the numerical magnitude of cross elasticity, the greater is the degree of complementarity/substitution between the two goods. Thus, theoretically the value of cross elasticity ranges from minus infinity (- ) for perfect complements to plus infinity (+ ) for perfect substitutes. If X and Y (say butter and bread) are complements, ec will be negative. If X and Y (say tea and coffee) are substitutes, ec will be positive. “Some of the preliminary information we have in the last few weeks indicates that gasoline demand appears to be down a little bit,” Felmy said. Elasticity of demand tells the degree of responsiveness of consumer to a price change. The arc elasticity is a measure of average elasticity, that is, the elasticity at the midpoint of the chord that connects the two points (A and B) on the demand curve defined by the initial and new price levels. The income elasticity of demand is a numerical measure of the degree to which quantity demanded responds to a change in income, other determinants of demand being kept constant. Arc elasticity: It computed if the data is discrete and therefore incremental change is measurable. Point elasticity: It computed if demand function is continuous and therefore only marginal changes are calculable. Cobb-Douglas production function, Q = AKaLb Isoquants-Isoquants are a geometric representation of the production function. The same level of output can be produced by various combinations of factor inputs. Imagining continuous variation in the possible combination of labour and capital, we can draw a curve by plotting all these alternative combinations for a given level of output. This curve which is the locus of all possible combination is called the ‘isoquant’. Any quantity of a good can be produced by using many different combinations of labour and capital (assuming both can be substituted for each other). An isoquant or an iso-product curve is the line which joins together different combinations of the factors of production (L, K) that are physically able to produce a given amount of output. Types of Isoquants Linear Isoquants- This type assumes perfect substitutability of factors of production. A given commodity may be produced by using only capital, or only labour, or by an infinite combination of K and L. Input-output Isoquants- This assumes strict complementarity, that is, zero substitutability of the factors of production. There is only one method of production for any one commodity.The isoquant takes the shape of a right angle. This type of isoquant is called "Leontief isoquant." Kinked Isoquants- This assumes limited substitutability of K and L. There are only a few processes for producing any one commodity. Substitutability of factors is possible only at the kinks. It is also called "activity analysis isoquant" or "linear-programming isoquant" because it is basically used in linear programming. Smooth, Convex Isoquants- This form assumes continuous substitutability of K and L only over a certain range, beyond which factors cannot substitute each other. This isoquant appears as a smooth curve convex to the origin. Isocost Line If a firm uses only labour and capital, the total cost or expenditure of the firm can be represented by: C = wL + rK Where C = total cost w = wage rate of labour L = quantity of labour used r = rental price of capital K = quantity of capital used The equation shows that the total cost of the firm (C) is equal to the sum of its expenditures on labour (wL) and capital (rK). This equation is a general one of the firm's isocost line or equal-cost line. It shows the various combinations of labour and capital that the firm can hire or rent at a given total cost. Producer’s Equilibrium A firm may decide to produce a particular level of output and then attempt to minimise the cost of total inputs or it may attempt to maximise its output subject to a cost constraint. A firm spends money on two inputs only, X and Y. It decides its budget and knows the price of each of the inputs which remains constant. An expansion path is formally defined as the set of combinations of capital and labour that meet the efficiency condition . Isoquants are a geometric representation of the production function. Various combinations of factor inputs can produce the same level of output. The marginal rate of technical substitution of L for K (denoted by MRTSL,K) is defined as the number of units of input K that a producer is willing to sacrifice for an additional unit for L so as to maintain the same level of output. Returns to scale are classified as follows: 1. Increasing Returns to Scale (IRS): If output increases more than proportionate to the increase in all inputs. 2. Constant Returns to Scale (CRS): If all inputs are increased by some proportion, output will also increase by the same proportion. 3. Decreasing Returns to Scale (DRS): If increase in output is less than proportionate to the increase in all inputs. Explicit costs are those expenses which are actually paid by the firm (paid-out-costs). These costs appear in the accounting records of the firm. Implicit costs are theoretical costs in the sense that they go unrecognised by the accounting system. Economies of scope are reductions in average costs attributable to an increase in the number of goods produced. In theory, perfect competition implies no rivalry among firms. In the short run the best level of output of the firm is the one at which the firm maximizes profits or minimises losses. This is possible at P = MR = MC. The point at which the firm covers its variable costs is called "the closing down point". Short Run Equilibrium In the short run the monopolist maximises his short run profits or minimises his short run losses if the following two conditions are satisfied: 1. MC = MR and 2. The slope of MC is greater than the slope of MR at the point of their intersection (i.e., MC cuts the MR curve from below). When firms are competing only through price changes, there are three cases of long run equilibrium of a typical firm under monopolistic competition. The long run equilibrium can be seen under three situations: when competition takes place only through the entry of new firms, when competition takes place only through price variations and when competition arises through price variation and new entry. Collusive Oligopoly Models There can be two types of collusion (a) Cartels where firms jointly fix a price and output policy through agreement, and (b) Price Leadership where one firm sets the price and others follow it. Cartel A cartel is a formal collusive organisation of the oligopoly firms in an industry. There may either be an open or secret collusion. A perfect cartel is an extreme form of collusion in which member firms agree to abide by the instructions from a central agency in order to maximize joint profits. The profits are distributed among the member firms in a way jointly decided by the firms in advance and may not be in proportion to its share in total output or the costs it incurs. Price Leadership This is an example of imperfect collusion among duopoly firms. It may result through tacit or formal agreement as one firm sets the price and others follow it. Price leadership has two forms. Price Leadership by a Low Cost Firm Sweezy's Model of Kinked Demand Curve According to Sweezy, the most distinguishing feature of oligopoly is that an individual firm does not know (and cannot determine) the exact nature (functional form) of its actual demand curve because of the uncertainty and indeterminacy of rivals' reactions to its own actions. An oligopolistic firm is therefore guided in its decisions by the 'imagined' demand curve which is based on what it expects to be the most likely (probable) reaction of its rivals. Monopoly Power To measure the amount of monopoly power possessed by a firm, economists often use the Lerner index, which equals L= P- MC/P Where P is the firm's price and MC is its marginal cost. This index varies between 0 and I. For a perfectly competitive firm, price equals marginal cost, so L=0. Seller’s monopoly power =0 P = 0. The higher the L is, the higher the degree of monopoly power is. What factors influence the price elasticity of demand for a firm's product and hence influence this firm's degree of monopoly power, as measured by the Lerner index? 1. The higher the price elasticity of demand for any individual firm's product, lower is the degree of monopoly power. 2. The larger the number of firms in the industry and the more strongly they compete, the higher the price elasticity of demand is likely to be for any individual firm's product (and the lower the degree of monopoly power). The national income accounts give us regular estimates of GNP — the basic measure of the economy's performance in producing goods and services. Paul Studenski, writes: "National income is both a flow of goods and services and a flow of money incomes. It is therefore called national product as often as national income". The flow of national income begins when production units combine capital and labour and turn out goods and services. It may be noted from above that 1. National income is an aggregative value concept: It makes use of the value determined by the money as the common denominator. 2. National income is a flow concept: It represents a given amount of aggregate production per unit of time, conventionally represented by one year and relates to a particular year. 3. National income represents the aggregate value of final products rather than the total value of all kinds of products produced in the economy. Personal Income National income is the total income accruing to the factors of production for their contribution to current production. It does not represent the total income that individuals actually receive. Personal Income = NNP at factor cost – Undistributed profits – Corporate taxes + Transfer payments NNP at Factor Cost (or National Income) Goods and services are produced with the help of factors of production. National income or NNP at factor cost is the sum of all the income payments received by these factors of production. NI = GNP – Depreciation – Indirect taxes + Subsidies NNP at factor cost = NNP at market prices – Indirect taxes + Subsidies Disposable Income Disposable income is the total income that actually remains with individuals to dispose off as they wish. It differs from personal income by the amount of direct taxes paid by individuals. Disposable Income = Personal Income – Personal taxes Real GDP: It is calculated by evaluating current production using prices that are fixed at past levels, it shows the economy's overall production which changes over time. Nominal GDP: It is calculated by using the current prices to place value on the economy's production of goods and services. The Following are the three different methods of measuring national income. 1. Product Approach 2. Income Approach 3. Expenditure Approach Product Approach Notes According to this method, the sum of net value of goods and services produced at market prices is found. Income Approach This approach is also known as the income-distributed method. According to this method, the incomes received by all the basic factors of production used in the production process are summed up. The basic factors for the purposes of national income are categorised as labour and capital. We have three incomes. 1. Labour income which includes wages, salaries, bonus, social security and welfare contributions. 2. Capital income which includes dividends, pre-tax retained earnings, interest on saving and bonus, rent, royalties and profits of government enterprises. 3. Mixed income, i.e., earnings from professions, farming enterprises, etc. Expenditure Approach This method is known as the final product method. According to this method, the total national expenditure is the sum of the expenditure incurred by the society in a particular year. The expenditures are classified as personal consumption expenditure, net domestic investment, government expenditure on goods and services and net foreign investment (imports-exports). Circular Flow of Income Circular flow of income model shows the flow of income between the producers and the households who buy their goods or services. Circular Flow of Income in a 2 Sector Model 1. The economy consists of two sectors: households and firms. 2. Households spend all of their income (Y) on goods and services or consumption (C). There is no saving (S). 3. All output (O) produced by firms is purchased by households through their Notes expenditure (E). 4. There is no financial sector. 5. There is no government sector. 6. There is no overseas sector. Circular Flow of Income in a 3 Sector Model In this model, we introduce the government sector as well that purchases goods from firms and factors services from households. Between households and the government money flows from government to the household when the government makes transfer payments. Circular Flow of Income in a 4 Sector Model In a 4 sector model, an economy moves from being a closed economy to an open economy. In an open economy imports and exports are made. In a 4 sector model, we have, Y = C + I + G + (X-M) Where, Y = Income or Output C = Household consumption expenditure I = Investment expenditure G = Government expenditure X – M = Exports minus Imports