ms-09

MS-9 1.

Given Given the the profit profit func functio tion n of a firm firm in the the form form of tabl table, e, calcu calculat late e total total profi profit, t, avera average ge profi profitt and marginal profit and differentiate between incrementalism and marginalism.

Unit of output Total revenue Total cost Total profit 1 10 5 2 30 18 3 50 29 4 70 38 Ans: Ans: Tota Totall prof profit it = Tota Totall reve revenu nue e – Tot Total al cos costt

Average profit

Marginal profit

Total profit

Average profit

Marginal profit

5 12 21 32

5.0 6.0 7.0 8.0

-7 9 11

Average profit = Total profit/unit of output Marginal profit = Difference of successive successive total profit Unit of output 1 2 3 4

Total revenue 10 30 50 70

Total cost 5 18 29 38

Incrementalism: Incremental reasoning involves estimating the impact of decision alternatives. The two basic concepts in the incremental analysis are: (i) Incremental Cost (IC) (ii) Incremental Re Revenue (I (IR) Incremental cost is defined as the change in total cost as a result of change in the level of output, investment etc. Incremental revenue is defined as the change in total revenue resulting from a change in the level of output, prices etc. A manager always determines the worth of a decision on the basis of the criterion that IR > IC. A decision is profitable if (i) it in inc crea eas ses re rev ven enue ue mor ore e tha than n itit inc incre rea ase ses s cos costt (ii) (i i) it re redu duce ces s som some e cos costs ts mo more re th than an it in incr crea ease ses s oth other ers s (iii) (i ii) it inc incre reas ases es so some me re reso sour urce ces s mor more e tha than n itit dec decre reas ases es ot othe hers rs (iv) (i v) it de decr crea ease ses s co cost sts s mo more re th than an it de decr crea ease ses s re reve venu nues es.. Marginalism: Marginalism: According to this principle, different courses of action should be pursued upto the point where all the courses provide equal marginal benefit per unit of cost. It states that a rational decision-maker would allocate or hire his resources in such a way that the ratio of marginal returns and marginal costs of various uses of a given resource or of various resources in a given use is the same. For example, a consumer seeking maximum utility (satisfaction) from his consumption basket, will allocate his consumption budget on goods and services such that MU1/MC1 = MU2 / MC2 =……..= MUn / MCn, Where MU1 = marginal utility from good one, MC1 = marginal cost of good one and so on. Similarly, a producer seeking maximum profit would use the technique of production (inputmix.) which would ensure

MRP1/MC1 = MRP2/MC2 =………….=MRPn/MCn Where MRP1=Marginal revenue product of input one (e.g. Labour), MC1= Marginal cost of input one and so on. It is easy to see that if the above equation was not satisfied, the decision mak aker ers s co coul uld d ad add d to hi his s ut util ilit ity/ y/pr prof ofit it by re resh shuf uffl flin ing g hi his s re reso sour urce ces/ s/in inpu putt e. e.g. g. if MU1/MC1>MU2/MC2 the consumer would add to his utility by buying more of good one and less of good two.

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Defi Define ne Pric Price e Ela Elast stic icit ity. y. Expl Explai ain n the the dete determ rmin inan ants ts of Pric Price e Ela Elast stic icit ity. y.

Ans:

Price Elasticity: Elasticity: Price elasticity of demand measures the responsiveness of the quantity sold to changes in the product’s price, ceteris paribus. It is the percentage change in sales divided by a percentage change in price. The notation Ep will be used for the arc price elasticity of demand, and ep will be used for the point price elasticity of demand. If the absolute value of Ep (or ep ) is greater than one, a given percentage decrease (increase) in price will result in an even greater percentage increase (decrease) in sales.1 In such a case, the demand for the product produ ct is cons considered idered elastic ; tha thatt is, sal sales es are relativel relatively y res respon ponsiv sive e to pri price ce cha change nges. s. Therefore, There fore, the perc percentage entage change in quanti quantity ty demanded will be greater than the percentage percentage change in the price. When the absolute value of the price elasticity of demand is less than one, the percentage change in sales is less than a given percentage change in price. Demand is then said to be inelastic with respect to price. Unitary price elasticity results when a given percentage changes in price results in an equal percentage change in sales. The absolute value of the coefficient of price elasticity is equal to one in such cases. These relationships are summarized as follows: If |ep| or |Ep |> 1, demand is elastic If |ep| or |Ep| < 1, demand is inelastic If |ep| or |Ep| = 1, demand is unitarily elastic Determinants of Price Elasticity: Elasticity: Price elasticities can be estimated for many goods and services; the short-run elasticities reflect periods of time that are not long enough for the consumer to adjust completely to changes in prices. The long-run values refer to situations where consumers have had more time to adjust. The long-run demand for foreign travel by U.S. residents is elastic (i.e., ep = |4.10|). In contrast, the long-run demand for water is highly inelastic (i.e., ep = |0.14|). Demand for is inelastic in the short run, but elastic in the long run. In general, three factors determine the price elasticity of demand. They are: (1) availability of substitutes, (2) proportion of income spent on good or service, and (3) length of time. Availability of Substitutes: The main determinant of elasticity is the availability of substitutes. Products Produ cts for which there are good subst substitutes itutes tend to have higher price elasticity elasticity of deman demand d than products for which there are few adequate substitutes. Movies are a good example. Movies Mov ies are a form of recr recreation eation,, but there are many altern alternative ative recreationa recreationall activ activities ities.. When ticket prices at the movie theatre increase, these substitute activities replace movies. Thus, the demand for motion pictures is relatively elastic, as shown in Table. Other examples of products with wit h clo close se sub substi stitut tutes es and the theref refore ore ela elasti stic c dem demand and wou would ld be dem demand and for Mar Maruti uti car cars, s, subscription to cellular services, demand for air-travel etc. Estimates of Price Elasticity Good or Service

Estimated Price Elasticity

Electricity Electricity Water Motion pictures Gasoline Gasoline Foreign travel

– 0.13 Short run – 1.89 Long run – 0.14 Long run – 3.69 Long run – 0.15 Short run – 0.78 Long run – 4.10 Long run

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At the other extreme, consider the short-run demand for electricity. When your local supplier increases prices, consumers have few options. There are not many short-run alternatives to using electricity for cooling and lighting. Hence the short run demand for electricity is relatively inelastic. In the days of the license raj in India, when government was the monopoly provider, demand for telecom services was relatively inelastic since there was no other service provider in the market. Thus, a product with close substitutes substitutes tends to have elastic demand; one with no close substitutes tends to have inelastic demand. An important mission for most advertising is to mak make e the con consum sumer er per percei ceive ve tha thatt no clo close se sub substi stitut tute e exi exists sts for the product product bei being ng advertised, thereby rendering the consumers demand relatively inelastic. Proportion of Income Spent: Demand tends to be inelastic for goods and services that account for only a small proportion of total expenditures. Consider the demand for salt. 250 grams of salt will meet the needs of the typical household for months and costs only a few rupees. If the price of salt were to double, this change would not have a significant impact on the family’s purchasing power. As a result, price changes have little effect on the household demand for salt. In contrast, demand will tend to be more elastic for goods and services that require a substantial portion of total expenditures. Thus demand for holiday travel and luxury cars take up a considerable portion of the family’s budget and therefore tend to have higher elasticiti elast icities. es. The relat relative ive necessity of a good also influe influences nces elasticity. elasticity. For exam example, ple, the demand for insulin is probably very inelastic because it is necessary for diabetics who rely on this drug. Time Period: Demand is usually more elastic in the long run than in the short run. The explanation is that, given more time, the consumer has more opportunities to adjust to changes in prices. In the above table indicates that the long-run elasticity for electricity is more than ten times the short-run value. Price Elasticity and Decision Making: Information about price elasticities can be extremely useful to managers as they contemplate pricing decisions, if demand is inelastic at the current price, a price decrease will result in a decrease in total revenue. Alternatively, reducing the price of a product with elastic demand would cause revenue to increase. The effect on total revenue would be the reverse for a price increase. However, if demand is unitary elastic, price changes will not change total revenues. However, a price reduction is not always the correct strategy when demand is elastic. The decision must also take into account the impact on the firm’s costs and profits. As another example of how knowledge of price elasticity may be useful, let’s consider the demand for cigarettes. The price elasticity for cigarettes by age groups has been found to be: Age Group 12-17 years 20-25 years 26-35 years 36-74 years

Price Elasticity – 1.40 – 0.89 – 0.47 – 0.45

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

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3.

‘To ‘T o an eco econo nomi mist st the the fix fixed ed cos costs ts are are ove overh rhea ead d cost costs s and and to an an acco accoun unta tant nt the these se are are ind indir irec ectt costs’. Substantiate this statement with the help of an example.

Ans:: Ans

There The re are som some e costs, costs, whic which h can be dire directl ctly y attribu attributed ted to prod product uction ion of a given given produ product. ct. The The use of raw material, labour input, and machine time involved in the production of each unit can usually be determined. On the other hand, there are certain costs like stationery and other office and administrative expenses, electricity charges, depreciation of plant and buildings, and other such expenses that cannot easily and accurately be separated and attributed to individual units of production, except on arbitrary basis. When referring to the separable costs of first category accountants call them the direct, or prime costs per unit. The accountants refer to the joint costs of the second category as indirect or overhead costs. Direct and indirect costs are not exactly synonymous to what economists refer to as variable costs and fixed costs. The criterion used by the economist to divide cost into either fixed or variable is whether or not the cost varies with the level of output, whereas the accountant divides the cost on the basis of whether or not the cost is separable with respect to the production of individual output units. The accounting statements often divide overhead expenses into ‘variable overhead’ and ‘fixed overhead’ categories. If the variable overhead expenses per unit are added to the direct cost per unit, we arrive at what economists call as average variable cost. Fixed costs are that part of the total cost of the firm which does not change with output. Expenditures on depreciation, rent of land and buildings, property taxes, and interest payment on bon bonds ds are examples examples of fix fixed ed cos costs. ts. Given a cap capaci acity, ty, fixed cos costs ts rem remain ain the same irrespective of actual output. To an economist the fixed costs are overhead costs and to an accountant these are indirect costs. When the output goes up, the fixed cost per unit of output comes down, as the total fixed cost is divided between larger units of output.

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4.

What eff What effec ectt does does chan change ge in dem deman and d have have on pric price e and qua quant ntit ity? y? Dis Discu cuss ss wit with h refe refere renc nce e to pricing analysis of markets by giving illustrations. Ans: Ans: Pricin Pri cing g is an impor importan tantt functi function on of all all firms firms.. Every Every firm firm is enga engaged ged in the the produ producti ction on of some som e goods and/or services, services, incurring incurring some expenditure expenditure to sell them in the market. It must must,, therefore, set a price for its product. It is only in extreme cases that the firm has no say in pricing its product because there prevails perfect competition in the market or the good has so much muc h public significanc significance e that its price is decid decided ed by the gover government nment.. Other Otherwise wise,, in large number of cases, the individual producer plays the role in pricing his/her product.

Demand-Supply Schedule Price 5 4 3 2 1

Demand 100 120 150 200 300

Supply 200 180 150 110 50

Setting the right price for its product is crucial for any firm in the market. This is because the price is such a parameter that it exerts a direct influence on the demand for and supply of the

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product and thereby on its sales and profit – the important yardsticks for the success or failure of the firm. If the price is set too high, the seller may not find enough customers to buy his/her product. On the other hand, if the price is set too low, the seller may not be able to recover his/her costs. Further, demand and supply conditions vary over time and the managers must therefore review and reformulate their pricing decisions from time to time. It is clear that the price of a product is determined by the demand for and supply of that product.

Demand – supply curve

5

4

3

---------------------------------

Price 2

1

0

100

150

200

250

300

Quantity In the above example the market price, P = 3 and no other price prevails in the market. Because if P = 5, supply exceeds demand and the producers may not be able to find enough customers for their product. This would result into competition among the producers forcing them to bring down the price to 3. On the other hand, if P = 1, the demand exceeds supply which would give rise to competition among the buyers of the product, pushing the price up to 3. Therefore, at P = 3, demand equals supply, which is called equili brium price. The equilibrium price is thus determined by the interaction of demand and supply. Therefore, the factors which affect either demand or supply are also determinants of price. A change in demand and/or supply would bring in a change in price. If the supply of a good is fixed, the level of demand appears to determine the equilibrium price. In this case, the price is determined by the ‘other factors’ influencing the level of demand curve. An increase in demand from D1 to D2, leads to an increase in equilibrium price from P1 to P2 and an increase in quantity from Q1 to Q2. Which is shown in the following graph.

Effect of a change in demand on price and quantity Increase in Demand

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S1

P2

P1

D2 D1 0

Q1

Q2

Decrease in Demand

S1

P1

P2

D1

D2 0

Q2

Q1

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

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Effects of change in supply on price and quantity Increase in Supply

S1

S2 P1

P2

D1

0

Q1

Q2

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

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5.

Write sh short no notes on on th the fo following:(a) Market experiments (b) Bundling of services (c) Product differentiations

Ans:

(a) Market experiments: experiments: The various types of markets existing. Experiments on market is necessary for the economic point of view. (i) (i) (ii) (ii) (iii) (iii) (iv) (iv)

Prim Primar ary y targ target et mark market et-l -lar arge ge and and low low-i -inc ncom ome e fam famil ilie ies s Seco Second ndar ary y tar targe gett mar marke kett-ot othe herr chi child ldbe bear arin ing g fami famili lies es Tert Tertia iary ry targ target et mark market et-s -sou ourc rces es of fund funds s and add addit itio iona nall volun volunte teer er effo effort rts s Misc Miscel ella lane neou ous s targ target et mar marke kett-po poli liti tici cian ans s and and reli religi giou ous s grou groups ps

You should, however, remember that a marketing planning approach does not necessarily mean or guarantee that the social objectives will be achieved but it offers a useful framework for effective social planning.

(b) Bundling of services: services: Bundling is the practice of selling two or more separate products together for a single price i.e. bundling takes place when goods or services which could be sold separately are sold as a package. A codification of bundling practices and definitions of selling strategies is: (i) bundles. Pure bundling involves selling Pure bundling: bundling: products are sold only as bundles. two products only as a package and not separately. For example, Reliance WLL -cellphone instrument (handset) and connection are only available together and not available separately. Microsoft’s bundle of Windows and Internet Explorer could be considered a pure bundle. Also Cable TV Channels are an example of pure bundling. In North America it is not possible to get only Disney Channel has it is always bundled with other premium channels. In India, the prospective CAS(Conditional Access System) also has similar channel packages where some of the channels can’t be purchased separately like Zee TV, would only be available with other, Zee Channels.

(ii)

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

McDonald’s Value Meals and Microsoft Office are examples of Mixed Bundling. In a recently introduced offer, The Times of India and The Economic Times can be purchased together for weekdays for a price much less than if purchased separately. This is also an example of mixed bundling. In most cases mixed bundling provides price savings for consumers.

(iii) Tying: The purchase of the main product (tying product) requires the purchase of another product (tied product) which is generally an additional complementary product. Tying involves purchase of the main product (tying product) along with purchase of another product (tied product) which is generally an additional complementary product. Financial bundling has become widespread. It has been suggested that manufacturers such as GE,, Ge GE Gene nera rall Mo Moto tors rs an and d Lu Luce cent nt gr grow ow ev ever er mo more re in invo volv lved ed in pr prov ovid idin ing g fi fina nanc nce, e, so “manufact “man ufacturing uring is becom becoming ing the lossloss-leader leader of the profit chain for many companies.” companies.” In other words, give away the product; make money on the lending that is bundled with it. In India too, a numberr of autom numbe automobile obile companies companies are providing finance and bundli bundling ng the automobile with financing. Bundling can be good for consumers. It can reduce “search costs” (the bundled goods are in the same place), as well as the producer’s distribution costs. There are lower “transaction costs” (because a single purchase is cheaper to carry out than multiple ones). And the producer may be a more efficient bundler than the customer: few of us choose, after all, to buy the individual parts of a computer to assemble them ourselves. In perfectly competitive markets, bundling should happen only if it is more efficient than selling the products separately. Where there is less than perfect competition - that is, most markets -

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economic model economic models s sugg suggest est that bundli bundling ng some sometimes times benefits consumers consumers and some sometimes times prod pr oduc ucer ers. s. Wh When en fi firm rms s ha have ve a me meas asur ure e of ma mark rket et po powe wer, r, th they ey ca can n en enga gage ge in pr pric ice e discrimination, charging different prices to different customers. Bundling can play a part in price discrimination, as different bundles of goods and prices may appeal to different customers. In a celebrated case that caught much media attention, Microsoft was accused of anti-competitive conduct in ‘bundling’ Internet Explorer and Windows as a pure bundle. Microsoft claimed they are not a bundle at all, rather a single product incapable of being broken into parts. It is of course difficult to settle such arguments and these go beyond the economic domain to the judicial domain, and are settled in courts. But the interesting aspect is that the company does not consider its product (Windows and Internet Explorer) as being capable of being broken into parts. (c) Product differentiations: differentiations: If the products competing in the market are not identical or homogeneous, they are said to be differentiated and hence ‘product differentiation’ exists in the market. mark et. Product differentiation differentiation is a fact of life and there is some amount amount of differentiation differentiation for almost all products that we buy in markets. For example, ingredients in different soaps could be different as can be the packaging, advertising etc. Even seemingly homogeneous goods such as apples and bananas are at present differentiated on the basis of the orchards where they have been grown and the way these are marketed. Wheat is a good example of a product that can be cons considere idered d undiff undifferent erentiated. iated. The degre degree e of subs substituta titutability bility or produ product ct differ differentiat entiation ion is measured by cross-elasticity of demand between two competing products. This feature was explai exp lained ned in uni unitt 5. Pro Produc ducts ts can be cla class ssifi ified ed int into o per perfec fectt sub substi stitut tutes es or hom homoge ogeneo neous us products, close substitutes like soaps of different brands, remote substitutes like radio and television telev ision and no subs substitute titutes s like cereals and soaps soaps.. Furth Further, er, perfect substitutes substitutes for one consumer may not be so for another. For example, Rahul may feel that Coke and Pepsi are perfect perfe ct subs substitute titutes s while Sachin may have a stron strong g brand preference preference for Peps Pepsi. i. Produ Product ct differentiation is a basis for a lot of advertising that is seen in the media where the focus is to create a strong brand preference for the product being advertised.

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