Managerial Eco 2

7/30/2019 Managerial Eco 2

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ELASTICITY OF SUPPLY


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The Price Elasticity of Supply

The law of supply states that higherprices raise the quantity supplied.

The price elasticity of supplymeasures how much the quantitysupplied responds to changes in theprice.

The price elasticity of supply dependson the flexibility of sellers to changethe amount of the good they produce.


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In most markets, a key determinantof the price elasticity of supply is thetime period being considered.

Supply is usually more elastic in thelong run than in the short run.

In the short run, the quantity

supplied is not very responsive to theprice.


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Computing the Price Elasticity ofSupply


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Problems- Applications of Supply,Demand & Elasticity

1.Can Good News for Farming (wheatproducers) be Bad News for Farmers?

Why Did OPEC Fail to Keep the Priceof Oil High?

Drug Interdiction Increase orDecrease Drug-Related Crime?


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When the supply of oil falls, the responsedepends on the time horizon. In the shortrun, supply & demand are relatively

inelastic. The supply curve shifts from S1 toS2, the price rises substantially.

In the long run, supply and demand arerelatively elastic, In this case, the samesize shift in the supply curve S1, to S2

causes a smaller increase in the price. Hence, OPEC could not sustain the price

hike


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An Increase In Supply in theMarket for Wheat

With an advance in farm technologyincreases the supply wheat from S1,to S2, the price of wheat falls.Because the demand for wheat isinelastic, the increase in the quantitysold is proportionately smaller than

the decrease in the price Hence Bad for farmers.


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Policies to Reduce the Use of illegalDrugs

Drug interdiction reduces the supply ofdrugs from S1, to S2 . If the demand drugsis inelastic, then the total amount paid drug

users rises, even as the amount of druguse falls By contrast, drug educationreduces the demand for drugs from D1, toD2, Because both price and quantity fall,

the amount paid by drug users falls Drug education is better than drug

interdiction


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Managerial significance of theconcept of ED- 1. Pricing decisions

If ed>1,larger qty can be sold through a smallreduction in price

If ed=0, monopoly like situation-can charge higherprice

In case of substitutes demand is elastic i.e. a rise inthe price of X will increase in demand for Y.

Complements (Jointly supplied )-Can take advantageof the inelastic demand for one good

Habituated goods: -Inelastic demand

urgent goods/Necessaries-inelastic demand Price in different markets-depends upon elasticity


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practice price discrimination.

monopolist will try to practice pricediscrimination. He would charge ahigher price in a market where thedemand is relatively inelastic andlower price in a market where thedemand is relatively elastic and

thereby maximize his profit.


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2. Factor pricing

The price paid to a factor of pdn

depends upon its elasticity Higher prices are paid to factors

which has inelastic demand and vice-versa.


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3.IMPORTANCE TO TRADE UNIONS

The concept of elasticity of demand isuseful to trade union leaders intackling wage bargaining and avoidthe exploitation of labour.

Workers producing products havinginelastic demand can easily get their

wages raised.


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INTERNATIONAL TRADE

It is useful in formulating export-import policies and determining theterms of trade

when the demand for a countrysexports is inelastic, the country willhave favorable BOP and vice versa.


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USEFUL TO POLICY MAKERS

U is useful in determining

the prices of agricultural commodities

Policy of devaluation, policy of nationalization

Fiscal and monetary policies

Forecasting economic effects.


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USEFUL TO GOVERNMENT

It is useful to the government informulating an appropriate taxpolicy.

The government must impose lowtaxes on goods whose demand iselastic and

High taxes on goods whose demandis Inelastic, in order to get morerevenue.


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Public Utility Pricing :

In case of public utilities pricediscrimination is generally practiced.

A higher price is charged fromconsumers with inelastic demand &lower price in case of elastic demand.


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Shifting the tax burden:

It is possible for a businessman toshift commodity tax in case ofinelastic demand to his customers

1f Demand is elastic he will have tobear the tax burden himself.


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Production Theory and Estimation

Production refers to the transformation of inputs into

outputs of goods and services.

Inputs are broadly classified into labor (including

entrepreneurial talent), capital, and land or naturalresources.

can also be classified as fixed (if they cannot be readily

changed during the time period under consideration)

and variable (if they can be varied easily and on veryshort notice). If all inputs are variable, We are in the

long run.


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Production function

Production is the transformation of resourcesinto commodities over time.

Production is the act of transforming inputs into

outputs.

PF refers to the functional relationship betweenphysical factor inputs and output of a firm per

unit of time, Q= f ( L, K)Short period production function

Q= f ( L, K)Long period production function


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Short run production function

In the short run, the production function

includes fixed and variable factors. . The output

can be increased or decreased by varying the

variable factors

Q=f (L, K)


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Long-run production function:

In the long-run, all factors arevariable

Q= f ( L, K)


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LAW OF VARIABLE PROPORTIONS

In the short run, as the amount a variable factorincreases, other things remaining equal, theoutput will increase more than proportionately

in the beginning, then it may increase in thesame proportion& ultimately it will increaseless than proportionately

This is because the marginal product of the

variable factors rise in the beginning buteventually tends to diminish,


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Production schedule

V. Factor TP AP MP Stage

1 20

2 50

3 904 120

5 135

6 1447 147

8 148

9 148

10 145


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Total, Average, and Marginal Product

Total Product (TP) refers to the total amount of acommodity produced during period of time, by usingcertain amounts of inputs.

TP = f (q vf)

Average Product (AP) refers to total product per unit ofa given variable factor.

AP=TP/q vf

Marginal Product (MP) refers to the addition made to

the total product by employing an additional unit of afactor, other factors remaining constant.

MPn = TPn-TPn-I


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LAW OF VARIABLE PROPORTIONS

In the short run, as the amount of a variablefactor increases, other things remaining equal,

the output will increase more than

proportionately in the beginning,

then it may increase in the same proportion

And ultimately it will increase less than

proportionately.


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Stage I: Increasing returns.

Initially the total product increases at an

increasing rate i.e at the rate of marginal

product.

The average product and the marginal product

also rise.

This is the stage of increasing returns.


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Causes of increasing returns:

Indivisibility of fixed factors:

Better utilization of Fixed factors

Better utilization of variable factors specialization and Economies of Scale:


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Stage II: Diminishing returns

After a certain point, the marginal product

begins to diminish Hence the total product

increases at a diminishing rate.

As the marginal product tends to diminish, it

ultimately becomes zero and negative

thereafter.


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Causes of diminishing returns:

Changing, the proportion between the fixedand variable factors

Fixed factors are used in a wrong proportion

after the optimum combination.

Fixed factors cannot be increased.

Imperfect substitution between factors


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Stage III: negative Returns:

When the amount of the variable factors

becomes extremely excessive in relation to

fixed factors, the returns become negative.


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Causes of negative Returns:

variable factors becomes extremely excessive

in relation to fixed factors,

The efficiency of the fixed factors is reduced

when excessive amount of variable factors are

used

Stage III of negative returns is irrational.


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Significance of the law:

The law of diminishing returns operates inPrimary sector

Enables the producer to plan the optimum

combination of factors at minimum cost. It helps a rational producer to avoid the third

stage of negative returns.

Under given stage of technology, if the stage ofdiminishing returns takes place. It is essential tochange the technology


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Long run production function

LAW OF RETURNS TO SCALE

Used to describe the output behavior in the long-run

As the firm increases the quantities of all factors the

output may rise initially at a rapid rate than increase in

inputs , then the output may rise in same proportion toincrease in input and ultimately, output increases less

proportionately

If the input increases by 10%, output increases more

than proportionately i.e. by20%.


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Causes of Increasing Returns to Scale:

due to the realization of internal economies of

scale

Improved efficiency of labour and capital.

Economy of organization.

Improvements in large-scale operation.

Specialization and division of labour.

Better technology and use of sophisticated

machinery.


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The law of constant returns :

when a given percentage increase in inputleads to the same percentage increase in output.

If the input increases by 10%, output increases

proportionately i.e. by 10%.


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Causes of Decreasing Returns to scale:

due to the realization of internal economies of

scale

Improved efficiency of labour and capital.

Economy of organization.

Improvements in large-scale operation.

Specialization and division of labour.

Better technology and use of sophisticated

machinery.


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ECONOMIES OF SCALE

Refers to the advantages of large scale production.

Economics of scale refer to the factors Which

contribute to minimize the average cost of production

in the long run, when scale of production is increased.

Also indicated by an increase in the average physical

productivity due to large scale production of a

commodity.


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Diseconomies of scale

They refer to the factors which maximize the

average total cost

Refers to the factors which maximize the

average total cost of production in the long run

Economies of scale arises due to two types of

factors-Internal and External economies


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Internal Economies :

Refer to the advantages which are enjoyed by a firm

when it increases its scale of production or size of its

output.

They are enjoyed by the firm alone due to itsexpansion, independent of the actions of other firms.

Enjoyed by the firm alone due to its expansion,

independent of the actions of other firms.

They emerge within the firm itself as scale of

production increases.


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External economies

Refer to the advantages which are shared by all

the firms in an industry

Also called external advantages of large scale

production


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Types of Internal Economies:

Labour economies:- When complex divisionof labor is introduced

Managerial economies:

Marketing economies :

Financial economies

Riskbearing economies:

Technological Economies:- Economies inpower : Economies of byproducts : Economiesof continuation :


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Forms of Internal Diseconomies:

Are the disadvantages experienced by a firmwhen its scale of production goes beyond theoptimum. Diseconomies of scale lead to rise in

average cost of production. Labour diseconomies :

Managerial diseconomies:

Administration diseconomies :

Financial difficulties :

Risk


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Forms of External Economies:

Economies of localization:

Economies of information, technical and

market intelligence

Economies of vertical disintegration :

Economies of subsidiary and ancillary

industries:

Economies due to Trade Association:


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Forms of External Diseconomies:

Overcrowding.

Problem of transport, communication.

Rise in the cost of factors.

Rise in rent and wages of labor. Powershortages. Delays in getting messages orOrders. Pollution and unhygienic conditions

When external diseconomies outweighexternal economies the results arenegative.


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ECONOMIES OF SCOPE

Traditional economic theories states thatlong run average cost curve tents to be Ushaped due to economies of scale

However in practice, the long run AC tendsto be downward sloping due to theoperation of Economies of scope

Economics of Scope can be defined as the

reduction of a firms average unit cost byproducing two or more goods or servicesjointly rather than separately.


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According the concept of economics of scale, cost

advantages follow from the increase in the volume of

production or what is called the scale of output.

According to the concept of economics of scope, suchcost advantages may follow from a variety of output or

production diversification

If the same plant can produce multiple products, there

is scope for lot of savings in cost due to the joint use ofinputs.


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CAPITAL BUDGETING

: Capital Budgeting implies a process of conceiving,

generating, evaluating & selecting the most profitable

investment proposal or project.

It is the process of planning capital projects, raisingfunds & efficiently allocating resources to those capital

projects.

Capital Budgeting is also referred to as project

planning. It is concerned with designing and carryingthrough a systematic investment programme.


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Significance of Capital Budgeting

Expansion of production facilities.

Entering new product lines.

Replacement of worn-out capital & equipment.

Planning major advertising campaigns.

Employee training Programmes.

Research and development

Decision to purchase or rent equipments. Undertake any other investment which would result in

costs and revenues over a long period


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Managerial significance of capital budgeting

Long-term investment involves commitment of funds

and it would be difficult to reverse

The finances involved is quite large which would

affect the profitability of the firm. Since projects are of long period, the impact of capital

budgeting on profitability has great relevance.

Helps to reduce uncertainties and improve profitability.

Vital for the reputation of the management.


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STAGES OF CAPITAL BUDGETING

Search for new investment proposals:

Project classification :

Analysis of costs and benefits

Measurement of investment worth

Feasibility Study

Decision making:

Implementation :

Performance Review :


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INVESTMENT CRITERIA

The measurement of investment worth is a very

important aspect of project planning. The most

commonly adopted investment criteria are :

Payback Period method.

Discounted Present Value method.

Internal Rate of Return Method.


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Payback Period method :

PBP measures the time required to recover the

original investment outlay from the annual cash

inflow expected from the investment project.

example, if an investment project requires an

outlay of Rs. 1,00,000 results in the cash

inflow of Rs.20,000 per annum, its pay-back

period is 1,00,000 / 20,000 = 5 years.


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Find out the most desirable project on the

basis of pay-back method.

Project investment Annual cashflow

A 4 0.5

B 6 1.5

C 7 0.7

D 6 2.0

E 5 1.0

F 6 1.0


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Year Investment Net cash flaws Cum cash flaws

1 25.000 8,000

2 7,000

3 7,000

4 3,000

5 5,000


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Cash outlay of projects X&Y=5.00.000

Year Proj: X CumulativeCash flows

Proje:Y Cumulativecash flows

1 1.0 1.4

2 1.2 1.6

3 1.5 2.0

4 1.8 1.7

5 2.0 1.5


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Advantages of PBP method

It is simple and easy to calculate.

It enables quick recovery and hence eases the problemof liquidity

PBP method takes care of the fact that investmentdecisions are made under Conditions of highuncertainty.

Useful in investments subject to rapid technologicaladvances.

This method favors the short-term project to long termones.


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Limitations:

This method ignores changes in cash flows.

It does not consider profitability of the project.

It disregards time value of money.

It overemphasis the liquidity aspect

It does not pay attention to cash inflows after the

payback period,

It ignores the long term prospects of growth.

It does little justice to a project with long gestation

period.


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Net Present Value (NPV)

One method of deciding whether or not a firm should

accept an investment project is to determine the net

present value of the project.

The net present value (NPV) of a project is equal to thepresent value of the expected stream of net cash flows

from the project, discounted at the firms cost of

capital, minus the initial cost of the project.

Go ahead If the NPV of the project is positive, declineif the NPV of the project is negative & If NPV is zero,

there is indifference position in the choice.


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Net Present Value Index

When there are a number of proposals under

consideration, we can compute the present

value of cash flows of all proposals under

consideration.

Net Present Value Index (NPVI) of each

proposal by the following method.

NPV Index = Total PV /Initial investment


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Find the PV of the following cash flows The

discount rate is 12 %. ,Investment=20,000

Year Cash streams PV of cashstreams

1 2,000

2 6,000

3 7,000

4 9,000

ABC. Ltd. Is considering to investment requiring a capital


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outflow of3,50,000 . Depreciation is charged on SLM basis.

Forecast for annual income after tax is .Give your opinion:

Year 1 2 3 4 5

Profit aftertax

75,000 90,000 95,000 50,000 70,000


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Managerial Eco 2