Management Consulting/managerial eoconomc


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1.  "The opportunity cost of anything is the return that can be had from the next best 20 alternative use". Elucidate the statement with reference to the opportunity cost principle applied in agricultural sector.  
2.  The demand function is written as Qd= F (Po, Pc, Ps, Yd, T, A, CR, R, E, N, 0) Describe 20 each of this variables separately giving examples.  
3.  What do you understand by 'Price discrimination' and the various types of price 20 discrimination ? I-low is the optimal quantity to be supplied in different markets determined ? Elucidate your answer with suitable examples.

4. Define elasticity of demand. How are the price, income, cross elasticities measured ?

1.   "The opportunity cost of anything is the return that can be had from the next best  alternative use". Elucidate the statement with reference to the opportunity cost principle applied in agricultural sector.  
2.   The cost of passing up the next best choice when making a decision. For example, if an asset such as capital is used for one purpose, the opportunity cost is the value of the next best purpose the asset could have been used for. Opportunity cost analysis is an important part of a company's decision-making processes, but is not treated as an actual cost in any financial statement.

The cost of an alternative that must be forgone in order to pursue a certain action. Put another way, the benefits you could have received by taking an alternative action.

The difference in return between a chosen investment and one that is necessarily passed up. Say you invest in a stock and it returns a paltry 2% over the year. In placing your money in the stock, you gave up the opportunity of another investment - say, a risk-free government bond yielding 6%. In this situation, your opportunity costs are 4% (6% - 2%).

  The opportunity cost of going to college is the money you would have earned if you worked instead. On the one hand, you lose four years of salary while getting your degree; on the other hand, you hope to earn more during your career, thanks to your education, to offset the lost wages.

Here's another example: if a gardener decides to grow carrots, his or her opportunity cost is the alternative crop that might have been grown instead (potatoes, tomatoes, pumpkins, etc.).

In both cases, a choice between two options must be made. It would be an easy decision if you knew the end outcome; however, the risk that you could achieve greater "benefits" (be they monetary or otherwise) with another option is the opportunity cost.

Opportunity cost is a useful concept when considering alternative places for using your resources and assets.  In situations where the owner’s resources and assets are used in the business, it is the concept used in determining if the business is making a return over and above the cost of contributed resources.

The definition of opportunity cost is the income foregone by not using the resource or asset in its next best alternative.  The opportunity cost concept is frequently associated with resources and assets that an individual or business owns.  For example, if an individual owns 100 acres of farmland, he/she has the decision of either farming the land or renting it to a neighbor.  If he/she farms the land, the opportunity cost is the income foregone by not renting it to a neighbor.  If the cash rental rate is $150 per acre, the opportunity cost (income foregone) by farming the land and not renting it to the neighbor is $15,000 ($150 X 100 acres.)  So, unless the individual can generate net returns of more than $15,000 from farming the land, he/she is financially better off renting the land to the neighbor.

This example can be taken a step further.  The land could be sold and the proceeds invested elsewhere.  For example, if the farmland can be sold for $3,000 per acre and the proceeds put in an alternative investment that returns 10 percent, the income forgone (opportunity cost) for either farming the land or renting it to a neighbor is $30,000 ($3,000 X 100 acres X 10%).

If you are contributing your labor to a value-added business, the opportunity cost is the income foregone by not employing the labor elsewhere.  For example, if you are working full-time in a value-added business and the value of your labor is $40,000 in the job market, the opportunity cost is the $40,000 foregone by not being employed.
2.  The demand function is written as Qd= F (Po, Pc, Ps, Yd, T, A, CR, R, E, N, 0) Describe  each of this variables separately giving examples.  

Demand Demand refers to the quantity of goods that consumers are willing & able to purchase at various prices during a give period of time. Person’s demand for a product means the demand over some appropriate time period

The demand function:
The demand function The demand function sets out the variables which are believed to have an influence on the demand for a particular product. Qd =f (Po, Pc, Ps, Yd, T, A, CR, R, E, O)

Po- price of the own product Pc- price of the complementary product Ps- price of the substitute product Yd- disposable income T- taste A- advertising CR- availability of the credit R- rate of interest E- expectation ( of income & price) N- no. of potential consumers 0- miscellaneous factors

The law of demand:
The law of demand Other things being equal, a fall in price leads to expansion in demand & a rise in price leads contraction in demand. The inverse relationship between price & quantity demanded is called law of demand.

P1 P0 Q1 Q0 Quantity demanded Price A* B* DEMAND CURVE

Exception to law of Demand:
Exception to law of Demand It states that with a fall in price, demand also falls & with a rise in price demand also rises.

Determinants of exception of law of demand:
Determinants of exception of law of demand Giffen’s paradox Veblen’s effect Fear of shortage Fear of future rise in price Speculation Conspicuous necessaries Emergencies Ignorance Necessaries

Changes /shifts in demand curve:
Changes /shifts in demand curve If demand changes not because of price changes but because of other factors, then in that case there would either increase or decrease in demand. Eg: At a price Rs.15,the initial demand of the cold-drink is 10000 units. If demand increases reaches 12000 units with same price , it will be known as increase in demand curve.

price Qty dd D1 D2 D1 D2 D3 D3 P1 Q3 Q1 Q2 Increase and decrease in demand curve

Elasticity of demand :
Elasticity of demand It is defined as the responsiveness or sensitiveness of demand to a given change in the price of a commodity. It shows the reaction of one variable with respect to a change in other variables on which it is dependent. It is an index of reaction.

Kind of elasticity of demand:
Kind of elasticity of demand Price elasticity of demand Income elasticity of demand Cross elasticity of demand

Price Elasticity of Demand:
Price Elasticity of Demand Price elasticity of demand measures the responsiveness of the sold to changes in the product’s price, ceteris paribus. Ep = %age change in qty demanded %age change in price

Different degree of price elasticity of demand :
Different degree of price elasticity of demand n = 0 Perfectly inelastic. 0 > n > -1 Relatively inelastic. n = 1 Unitary elastic. -1 > n > -∞ Relatively elastic. n = -∞ Perfectly elastic.

Perfectly elastic of demand

P1 P0 Q1 Q0 Quantity demanded Price A* B* RELATIVELY ELASTIC DEMAND

P1 P0 Q1 Q0 Quantity demanded Price A* B* UNITARY ELASTIC DEMAND

P1 P0 Q1 Q0 Quantity demanded Price A* B* RELATIVE INELASTIC DEMAND

Perfectly Inelastic demand

Determinants of price elasticity of demand :
Determinants of price elasticity of demand Nature of the demand Existence of substitutes Number of user of the commodity Durability & reparability of the commodity Possibility of postponing the use of a commodity. Level of income of the people Range of the price Habits Existence of complementary goods

Measurement of price elasticity of demand:
Measurement of price elasticity of demand Arc price elasticity Point elasticity advertising

Point price elasticity:
Point price elasticity Prof. Marshall advocated this method The point method measures price elasticity of demand at different points on a demand curve. Ep= %age change in demand % change in price or Ep= dq * p dp q

Arc Price Elasticity :
Arc Price Elasticity When elasticity is measured over an interval of a demand curve, the elasticity is called as an interval or Arc elasticity Arc elasticity= Q2-Q1 * P2+P1 P2-P1 * Q2-Q1

Income Elasticity Of Demand:
Income Elasticity Of Demand Income Elasticity Of Demand may be defined as the ratio or proportionate change in the quantity demanded of a commodity to a given proportionate change in the income. Ey= % change in demand % change in income

Ey can be positive, negative or zero. When Ey is positive, the commodity is normal(used in day to day life) When Ey is negative, the commodity is inferior(jowar, beedi) When Ey is positive & greater than one, the commodity is luxury When Ey is positive , but less than one, the commodity is essential When Ey is Zero, the commodity is neutral(salt, match box)

Cross Price Elasticity:
Cross Price Elasticity It may be defined as the proportionate change in the quantity demanded of a particular commodity in response to a change in the price of another related commodity Ec =% change in Qty dd of commodity X %age change in the price of Y

Advertising /promotional elasticity of demand:
Advertising /promotional elasticity of demand Advertising elasticity refers to the responsiveness of demand or sales to change in advertising or other promotional expenses. Ea= % change in demand or sales %age change in adv expenditure

3.   What do you understand by 'Price discrimination' and the various types of price  discrimination ? I-low is the optimal quantity to be supplied in different markets determined ? Elucidate your answer with suitable examples.

1st, 2nd and 3rd Price discrimination
•   Price Discrimination according  is, "Charging a different price for a different product or to a different buyer without any true cost differential to justify the different price" .
•   1st Degree Price Discrimination follows the definition above but is charging a different price based on the customer.
•   2nd Degree Price Discrimination is charging a different price based on quantity sold.
•   3rd Degree Price Discrimination is charging a different price based on location of customer segment.

1st Degree Price Discrimination
This type of discrimination, also known as perfect price discrimination, essentially states the company charges the consumer the maximum price that individual is willing to pay for that product. This extracts all the consumer surplus and earns the firms the highest possible profits. This method of discrimintation is also one of the most difficult to adopt because it requires the company knows each of its customers perfectly at each level of consumption . This can best be seen in car dealers, where the price on the car is negotiable, and the dealers job is to get the most out of the consumer as possible, the consumer surplus will be 0. In some cultures, bargaining for goods and services, i.e., first degree price discrimination is the norm. In others, first degree discrimination is much less prevalent and consumers are more used to prices which are not negotiable. The aim of first degree price discrimination is for the firm to appropriate the entire consumer surplus (see fig. 1,2, and 3).

Figure 1

Figure 2

Figure 3

Examples of 1st degree price discriminators:
Car dealerships mechanics, doctors, and lawyers (service related business).

2nd Degree Price Discrimination
In this type of discrimination the companies are actually not able to differentiate between the different types of consumers. This practice creates a schedule of declining prices for different quantities. Using this strategy the company can extract some of the consumer surplus without knowing much about the individual consumer. The consumer chooses the amount of product they wish to consume with the posted prices, and this allows consumers to differentiate themselves according to preference. This type of discrimination can easily be seen in the bulk purchases of large consumers like Walmart, who in turn pass the savings onto the eventual consumer. This can also be seen in quantity discounts, the more you purchase the more you save. A family pack of soap powder or biscuits tends to cost less per kg than smaller packs. This of course discriminates against people living alone, often pensioners and students. In some supermarkets the price per kg of product is listed, which helps the customer by providing information on which to base decisions on.

Figure 4

Examples of 2nd degree price discriminators:
Electric utilities, cable companies, water & sewage companies, trash collection.

3rd Degree Price Discrimination
This type of price discimination, is based around the idea that the firm sets prices that will accomodate the consumer. The firms know broad demographics about the particular types of consumers they will supply, and charge prices such that everyone will be able to consume the product. In order for this form of discrimination to work the firm must be able to predict the elasticity of demand in various consumers. This type of discrimination can be seen in the movie theater business. Student and senior discounts are given because these groups of consumers have more elastic price elasticity of demand. It is because of this discrimination that the firm is able to extract the consumer surplus of those who might not otherwise pay the standard rate. Third degree price discrimination relies on the firm being able to separate the segments. If separation of segments is not possible then the product can be transferred.

The example below shows the total market for public transport journeys before 9.00am. The total market demand (Dm) is the sum of the demand of two segments, adults (Da) and students (Ds). For adults the price of a bus ticket is only a small part of their income and this means that their demand (Da) is more inelastic than that of students for whom a bus ticket is a larger part of their income, (see the determinants of elasticity).

In fig. 3 the firm we once again decides on their output by equating MC with MR. However there is not just one price. By drawing a horizontal line through the MC=MR point until it intersects with the MR curves for adults and students and then reading the price off the respective demand curves Da and Dr the price in each segment is determined, Pa and Pr. Not surprisingly the price in the adult market is higher.

Figure 5

This discrimination allows the firm to appropriate more, but not all, of the consumer surplus, fig. 6.

Figure 6

Firms can often segment the market by charging different amounts for providing the product or service at different times, e.g. Weekend rail fares. The firm can also change the basic product in some way, for example offering faster check-in for flights, slightly more legroom and complimentary drinks. These firms can also segment markets by location, selling in different places at different prices, car sales are an example of this. Car prices tend to be different in different countries and these differences in prices cannot always be explained away.

Examples of 3rd degree price discriminators:
Wall street journal (student pricing), movie theaters (student & senior discounts), hotels (senior discounts).

Benefits and costs of price discrimination

These of course depend on whether you are the firm or the consumer. Price discrimination means that consumer surplus can be appropriated, and as long as the cost of the marketing scheme (adverts, identity cards, ticket inspectors etc.) is less than the extra revenue the scheme brings in then it is advantageous to the firm. At first sight it would seem the loser is the consumer. But a second examination reveals that students are gaining, they pay less than if there was a single market price. But an even deeper examination shows how adults might gain. If by price discriminating the firm can increase output substantially, the average costs may fall because of economies of scale. These economies may even outweigh the price difference between adults and students. In conclusion, it is necessary to look at price discrimination on a case-by-case basis.

1) Suppose a profit maximizing monopolist is able to engage in perfect price discrimination (meaning that each unit is sold at a price equal to it marginal value) and faces a demand curve for its products given by Q=20-0.05P. This monopolis has a total cost function of TC=24+4Q. How much will this monopolist's profits be?

a.) $138
b.) $106
c.) $276
d.) $300
e.) $324
Solution: A firm able to engage in perfect price discrimination will attempt to capture all available surplus, so it will set Q to where P=MC. The producer surplus is equal to the area between the demand curve and MC curve from Q=0 to 18, this area is 324. Profit is Producer surplus - FC (fixed costs are 24), so the profit is $300. Answer: d.

2) Perfect price discrimination means that a firm charge:
a) The maximum amount that buyers are willing to pay for each unit.
b) Different prices to people of different racial or ethnic backgrounds.
c) Different prices to different groups of buyers.
d) One single price—the maximum possible—to all of its buyers.
Solution: Perfect price discrimination occurs when a firm charges the maximum amount that buyers are willing to pay for each unit. (a)

3) If an economist says that firm practices price discrimination, that firm is:
a) Exploiting the poor.
b) Charging different prices for the same good or service.
c) Making great efforts to keep its costs as low as possible.
d) Producing two products, one with decreasing returns to scale and the other with increasing returns
Solution: b.

4) If a firm charges customers $ 200 per unit of the first unit purchased, and $160 per unit for each additional unit purchased in excess of one unit. Then, what is the economic term of this strategy?
a) First-degree price discrimination
b) Profit maximization pricing
c) Second-degree price discrimination
d) Third -degree price discrimination
Solution: Second degree price discrimination (c) because second-degree price discrimination involves charging different prices for different quantities.


4. Define elasticity of demand. How are the price, income, cross elasticities measured
The degree to which demand for a good or service varies with its price. Normally, sales increase with drop in prices and decrease with rise in prices. As a general rule, appliances, cars, confectionary and other non-essentials show elasticity of demand whereas most necessities (food, medicine, basic clothing) show inelasticity of demand (do not sell significantly more or less with changes in price). Also called price demand elasticity.

elasticity of demand= %change in quantity/%change in price. Elasticity>1 is elastic,<1 is inelastic and=1 is unit elastic.For example, Cigarette in the US has price elasticity = - 0.3, inelastic. Total revenue will be maximized when elasticity=1.
When the demand for a product or service increases or decreases with the price for same. i.e., if the price for an automobile went from $28,000.00 to $14,000, the sales or demand for the car would probably at least double or triple all other things being equal as in the car being initially worth $28,000.00. The reverse would be true if the price went from $14,000.00 to $28,000.00, the demand would drop off to practically nothing. The price is therefore elastic or dependent on price. Items like water is normally considered an inelastic product as you always need it and will buy it to stay alive regardless of price. The elasticity or in- elasticity depends on the type of product or service. To maintain your health, (or life) you would probably sacrifice nearly all your money to stay alive as in necessary open heart surgery.
The degree to which a demand or supply curve reacts to a change in price is the curve's elasticity. Elasticity varies among products because some products may be more essential to the consumer. Products that are necessities are more insensitive to price changes because consumers would continue buying these products despite price increases. Conversely, a price increase of a good or service that is considered less of a necessity will deter more consumers because the opportunity cost of buying the product will become too high.

A good or service is considered to be highly elastic if a slight change in price leads to a sharp change in the quantity demanded or supplied. Usually these kinds of products are readily available in the market and a person may not necessarily need them in his or her daily life. On the other hand, an inelastic good or service is one in which changes in price witness only modest changes in the quantity demanded or supplied, if any at all. These goods tend to be things that are more of a necessity to the consumer in his or her daily life.

To determine the elasticity of the supply or demand curves, we can use this simple equation:
Elasticity = (% change in quantity / % change in price)

If elasticity is greater than or equal to one, the curve is considered to be elastic. If it is less than one, the curve is said to be inelastic.

As we mentioned previously, the demand curve is a negative slope, and if there is a large decrease in the quantity demanded with a small increase in price, the demand curve looks flatter, or more horizontal. This flatter curve means that the good or service in question is elastic.

Meanwhile, inelastic demand is represented with a much more upright curve as quantity changes little with a large movement in price.

Elasticity of supply works similarly. If a change in price results in a big change in the amount supplied, the supply curve appears flatter and is considered elastic. Elasticity in this case would be greater than or equal to one.

On the other hand, if a big change in price only results in a minor change in the quantity supplied, the supply curve is steeper and its elasticity would be less than one.

A. Factors Affecting Demand Elasticity
There are three main factors that influence a demand's price elasticity:
1. The availability of substitutes - This is probably the most important factor influencing the elasticity of a good or service. In general, the more substitutes, the more elastic the demand will be. For example, if the price of a cup of coffee went up by $0.25, consumers could replace their morning caffeine with a cup of tea. This means that coffee is an elastic good because a raise in price will cause a large decrease in demand as consumers start buying more tea instead of coffee.

However, if the price of caffeine were to go up as a whole, we would probably see little change in the consumption of coffee or tea because there are few substitutes for caffeine. Most people are not willing to give up their morning cup of caffeine no matter what the price. We would say, therefore, that caffeine is an inelastic product because of its lack of substitutes. Thus, while a product within an industry is elastic due to the availability of substitutes, the industry itself tends to be inelastic. Usually, unique goods such as diamonds are inelastic because they have few if any substitutes.

2. Amount of income available to spend on the good - This factor affecting demand elasticity refers to the total a person can spend on a particular good or service. Thus, if the price of a can of Coke goes up from $0.50 to $1 and income stays the same, the income that is available to spend on coke, which is $2, is now enough for only two rather than four cans of Coke. In other words, the consumer is forced to reduce his or her demand of Coke. Thus if there is an increase in price and no change in the amount of income available to spend on the good, there will be an elastic reaction in demand; demand will be sensitive to a change in price if there is no change in income.

3. Time - The third influential factor is time. If the price of cigarettes goes up $2 per pack, a smoker with very few available substitutes will most likely continue buying his or her daily cigarettes. This means that tobacco is inelastic because the change in price will not have a significant influence on the quantity demanded. However, if that smoker finds that he or she cannot afford to spend the extra $2 per day and begins to kick the habit over a period of time, the price elasticity of cigarettes for that consumer becomes elastic in the long run.

B. Income Elasticity of Demand
In the second factor outlined above, we saw that if price increases while income stays the same, demand will decrease. It follows, then, that if there is an increase in income, demand tends to increase as well. The degree to which an increase in income will cause an increase in demand is called income elasticity of demand, which can be expressed in the following equation:

If EDy is greater than one, demand for the item is considered to have a high income elasticity. If however EDy is less than one, demand is considered to be income inelastic. Luxury items usually have higher income elasticity because when people have a higher income, they don't have to forfeit as much to buy these luxury items. Let's look at an example of a luxury good: air travel.

Bob has just received a $10,000 increase in his salary, giving him a total of $80,000 per annum. With this higher purchasing power, he decides that he can now afford air travel twice a year instead of his previous once a year. With the following equation we can calculate income demand elasticity:

Income elasticity of demand for Bob's air travel is seven - highly elastic.

With some goods and services, we may actually notice a decrease in demand as income increases. These are considered goods and services of inferior quality that will be dropped by a consumer who receives a salary increase. An example may be the increase in the demand of DVDs as opposed to video cassettes, which are generally considered to be of lower quality. Products for which the demand decreases as income increases have an income elasticity of less than zero. Products that witness no change in demand despite a change in income usually have an income elasticity of zero - these goods and services are considered necessities.

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