2014
COMMERCE
Paper: 105
(Managerial Economics)
Full Marks – 80
Time – Three Hours
The figures in the margin indicate full marks for the questions.
1(a)(i) Define managerial economics. Explain how the concepts and theories of economics are used in making managerial decision.
-> Managerial economics is a stream of management studies which emphasizes solving business problems and decision-making by applying the theories and principles of microeconomics and macroeconomics. It is a specialized stream dealing with the organization’s internal issues by using various economic theories.
Economics is an inevitable part of any business. All the business assumptions, forecasting and investments are based on this one single concept.
Nature of Managerial Economics:-
Art and Science : Managerial economics requires a lot of logical thinking and creative skills for decision making or problem-solving. It is also considered to be a stream of science by some economist claiming that it involves the application of different economic principles, techniques and methods, to solve business problems.
Micro Economics : In managerial economics, managers generally deal with the problems related to a particular organization instead of the whole economy. Therefore it is considered to be a part of microeconomics.
Macro Economics : A business functions in an external environment, i.e. it serves the market, which is a part of the economy as a whole.
Therefore, it is essential for managers to analyze the different factors of macroeconomics such as market conditions, economic reforms, government policies, etc. and their impact on the organization.
Multi-disciplinary : It uses many tools and principles belonging to various disciplines such as accounting, finance, statistics, mathematics, production, operation research, human resource, marketing, etc.
Prescriptive / Normative Discipline : It aims at goal achievement and deals with practical situations or problems by implementing corrective measures.
Management Oriented : It acts as a tool in the hands of managers to deal with business-related problems and uncertainties appropriately. It also provides for goal establishment, policy formulation and effective decision making.
Pragmatic : It is a practical and logical approach towards the day to day business problems.
Concepts and theories of economics are used in making managerial decision:-
1. The Incremental Concept:
The incremental concept is probably the most important concept in economics and is certainly the most frequently used in Managerial Economics. Incremental concept is closely related to the managerial cost and marginal revenues of economic theory. The two major concepts in this analysis are incremental cost and incremental revenue. Incremental cost denotes change in total cost, whereas incremental revenue means change in total revenue resulting from a decision of the firm.
The incremental principle may be stated as follows:
A decision is clearly a profitable one if
(i) It increases revenue more than costs.
(ii) It decreases some cost to a greater extent than it increases others.
(iii) It increases some revenues more than it decreases others.
(iv) It reduces costs more than revenues.
Illustration:
Some businessmen hold the view that to make an overall profit; they must make a profit on every job. The result is that they refuse orders that do not cover full costs plus a provision of profit. This will lead to rejection of an order which prevents short run profit. A simple problem will illustrate this point. Suppose a new order is estimated to bring in additional revenue of Rs. 10,000. The costs are estimated as under:
Labor Rs. 3,000
Materials Rs. 4,000
Overhead charges Rs. 3,600
Selling and administrative expenses Rs. 1,400
Full Cost Rs.12, 000
The order appears to be unprofitable. For it results in a loss of Rs. 2,000. However, suppose there is idle capacity which can be utilized to execute this order. If order adds only Rs. 1,000 to overhead charges and Rs. 2000 by way of labor cost because some of the idle workers already on the pay roll will be deployed without added pay and no extra selling and administrative costs, then the actual incremental cost is as follows:
Labor Rs. 2,000
Materials’ Rs. 4,000
Overhead charges Rs. 1,000
Total Incremental Cost Rs. 7,000
Thus there is a profit of Rs. 3,000. The order can be accepted on the basis of incremental reasoning. Incremental reasoning does not mean that the firm should accept all orders at prices which cover merely their incremental costs.
The concept is mainly used by the progressive concerns. Even though it is widely followed concept, it has certain limitations:
a) The concept cannot be generalized because observed behavior of the firm is always variable.
b) The concept can be applied only when there is excess capacity is the concern.
c) The concept is applicable only during the short period.
2. Concept of Time Perspective:
The time perspective concept states that the decision maker must give due consideration both to the short run and long run effects of his decisions. He must give due emphasis to the various time periods. It was Marshall who introduced time element in economic theory.
The economic concepts of the long run and the short run have become part of everyday language. Managerial economists are also concerned with the short run and long run effects of decisions on revenues as well as costs. The main problem in decision making is to establish the right balance between long run and short run.
In the short period, the firm can change its output without changing its size. In the long period, the firm can change its output by changing its size. In the short period, the output of the industry is fixed because the firms cannot change their size of operation and they can vary only variable factors. In the long period, the output of the industry is likely to be more because the firms have enough time to increase their sizes and also use both variable and fixed factors.
In the short period, the average cost of a firm may be either more or less than its average revenue. In the long period, the average cost of the firm will be equal to its average revenue. A decision may be made on the basis of short run considerations, but may as time elapses have long run repercussions which make it more or less profitable than it at first appeared.
Illustration:
The firm which ignores the short run and long run considerations will meet with failure can be explained with the help of the following illustration. Suppose, a firm having a temporary idle capacity, received an order for 10,000 units of its product. The customer is willing to pay only Rs. 4.00 per unit or Rs. 40,000 for the whole lot but no more.
The short run incremental cost (ignoring the fixed cost) is only Rs. 3.00. Therefore, the contribution to overhead and profit is Rs. 1.00 per unit (or Rs. 10, 000 for the lot). If the firm executes this order, it will have to face the following repercussion in the long run:
(a) It may not be able to take up business with higher contributions in the long run.
(b) The other customers may also demand a similar low price.
(c) The image of the firm may be spoilt in the business community.
(d) The long run effects of pricing below full cost may be more than offset any short run gain.
Haynes, Mote and Paul refer to the example of a printing company which never quotes prices below full cost due to the following reasons:
(1) The management realized that the long run repercussions of pricing below full cost would more than offset any short run gain.
(2) Reduction in rates for some customers will bring undesirable effect on customer goodwill. Therefore, the managerial economist should take into account both the short run and long run effects as revenues and costs, giving appropriate weight to most relevant time periods.
3. The Opportunity Cost Concept:
Both micro and macro economics make abundant use of the fundamental concept of opportunity cost. In everyday life, we apply the notion of opportunity cost even if we are unable to articulate its significance. In Managerial Economics, the opportunity cost concept is useful in decision involving a choice between different alternative courses of action.
Resources are scarce; we cannot produce all the commodities. For the production of one commodity, we have to forego the production of another commodity. We cannot have everything we want. We are, therefore, forced to make a choice.
Opportunity cost of a decision is the sacrifice of alternatives required by that decision. Sacrifice of alternatives is involved when carrying out a decision requires using a resource that is limited in supply with the firm. Opportunity cost, therefore, represents the benefits or revenue forgone by pursuing one course of action rather than another.
The concept of opportunity cost implies three things:
1. The calculation of opportunity cost involves the measurement of sacrifices.
2. Sacrifices may be monetary or real.
3. The opportunity cost is termed as the cost of sacrificed alternatives.
Opportunity cost is just a notional idea which does not appear in the books of account of the company. If resource has no alternative use, then its opportunity cost is nil.
In managerial decision making, the concept of opportunity cost occupies an important place. The economic significance of opportunity cost is as follows:
1. It helps in determining relative prices of different goods.
2. It helps in determining normal remuneration to a factor of production.
3. It helps in proper allocation of factor resources.
4. Equi-Marginal Concept:
One of the widest known principles of economics is the equi-marginal principle. The principle states that an input should be allocated so that value added by the last unit is the same in all cases. This generalization is popularly called the equi-marginal.
Let us assume a case in which the firm has 100 unit of labor at its disposal. And the firm is involved in five activities viz., А, В, C, D and E. The firm can increase any one of these activities by employing more labor but only at the cost i.e., sacrifice of other activities.
An optimum allocation cannot be achieved if the value of the marginal product is greater in one activity than in another. It would be, therefore, profitable to shift labor from low marginal value activity to high marginal value activity, thus increasing the total value of all products taken together.
If, for example, the value of the marginal product of labor in activity A is Rs. 50 while that in activity В is Rs. 70 then it is possible and profitable to shift labor from activity A to activity B. The optimum is reached when the values of the marginal product is equal to all activities. This can be expressed symbolically as follows:
VMPLA = VMPLB = VMPLC = VMPLD = VMPLE
Where VMP = Value of Marginal Product.
L = Labor
ABCDE = Activities i.e., the value of the marginal product of labor employed in A is equal to the value of the marginal product of the labor employed in В and so on. The equimarginal principle is an extremely practical notion.
It is behind any rational budgetary procedure. The principle is also applied in investment decisions and allocation of research expenditures. For a consumer, this concept implies that money may be allocated over various commodities such that marginal utility derived from the use of each commodity is the same. Similarly, for a producer this concept implies that resources be allocated in such a manner that the marginal product of the inputs is the same in all uses.
5. Discounting Concept:
This concept is an extension of the concept of time perspective. Since future is unknown and incalculable, there is lot of risk and uncertainty in future. Everyone knows that a rupee today is worth more than a rupee will be two years from now. This appears similar to the saying that “a bird in hand is more worth than two in the bush.” This judgment is made not on account of the uncertainty surrounding the future or the risk of inflation.
It is simply that in the intervening period a sum of money can earn a return which is ruled out if the same sum is available only at the end of the period. In technical parlance, it is said that the present value of one rupee available at the end of two years is the present value of one rupee available today. The mathematical technique for adjusting for the time value of money and computing present value is called ‘discounting’.
The following example would make this point clear. Suppose, you are offered a choice of Rs. 1,000 today or Rs. 1,000 next year. Naturally, you will select Rs. 1,000 today. That is true because future is uncertain. Let us assume you can earn 10 per cent interest during a year.
You may say that I would be indifferent between Rs. 1,000 today and Rs. 1,100 next year i.e., Rs. 1,100 has the present worth of Rs. 1,000. Therefore, for making a decision in regard to any investment which will yield a return over a period of time, it is advisable to find out its ‘net present worth’. Unless these returns are discounted and the present value of returns calculated, it is not possible to judge whether or not the cost of undertaking the investment today is worth.
The concept of discounting is found most useful in managerial economics in decision problems pertaining to investment planning or capital budgeting.
The formula of computing the present value is given below:
V = A/1+i
where:
V = Present value
A = Amount invested Rs. 100
i = Rate of interest 5 per cent
V = 100/1+.05 = 100/1.05 =Rs. 95.24
Similarly, the present value of Rs. 100 which will be discounted at the end of 2 years: A 2 years V = A/ (1+i) 2
For n years V = A/ (1+i) n
6. Risk and Uncertainty
Managerial decisions are actions of today which bear fruits in future which is unforeseen. Future is uncertain and involves risk. The uncertainty is due to unpredictable changes in the business cycle, structure of the economy and government policies.
This means that the management must assume the risk of making decisions for their institution in uncertain and unknown economic conditions in the future. Firms may be uncertain about production, market prices, strategies of rivals, etc. Under uncertainty, the consequences of an action are not known immediately for certain.
Economic theory generally assumes that the firm has perfect knowledge of its costs and demand relationships and of its environment. Uncertainty is not allowed to affect the decisions. Uncertainty arises because producers simply cannot foresee the dynamic changes in the economy and hence, cost and revenue data of their firms with reasonable accuracy.
Also dynamic changes are external to the firm; they are beyond the control of the firm. The result is that the risks from unexpected changes in a firm’s cost and revenue data cannot be estimated and therefore the risks from such changes cannot be insured. But products must attempt to predict the future cost and revenue data of their firms and determine the output and price policies.
The managerial economists have tried to take account of uncertainty with the help of subjective probability. The probabilistic treatment of uncertainty requires formulation of definite subjective expectations about cost, revenue and the environment. The probabilities of future events are influenced by the time horizon, the risk attitude and the rate of change of the environment.
(ii) What is meant by opportunity cost? Justify the relevance of the opportunity cost principle in business decision making process with example.
-> Opportunity costs represent the benefits an individual, investor or business misses out on when choosing one alternative over another. While financial reports do not show opportunity cost, business owners can use it to make educated decisions when they have multiple options before them. Bottlenecks are often a cause of opportunity costs. Because by definition they are unseen, opportunity costs can be easily overlooked if one is not careful. Understanding the potential missed opportunities foregone by choosing one investment over another allows for better decision-making. Opportunity cost of a decision is the scarifies of alternatives required by that decision. “Sacrifice of alternatives is involved when carrying out a decision requires using a resource that is limited in supply with the firm. Thus it represents the benefits or revenue foregone by pursuing on course of action rather than another.”
The opportunity cost concept is a notional idea which does not appear in the books of account of a firm. Although it has economic impact upon firm the accountants does not recognize it as a cost. Some of the illustrations of opportunity costs are:
a) The opportunity cost of the funds employed in one’s own business is the amount of interest which could have been earned by investing in the next best channel of investment.
b) When product ‘X’ is produced rather than Y by using a machine which can be used to produce both, the opportunity cost of pricing ‘X’ is the amount of Y sacrificed.
c) The opportunity cost of using an idle machine is nil as there is no sacrifice.
The significance of opportunity cost in managerial decision making can be stated as follows:
a) It helps in determining relative prices of different goods and services.
b) It helps to pay compensation to the factors of production.
c) It is also useful in allocation of available resources.
The opportunity cost concept includes both implicit and explicit cost as a result the cost from economist’s point of view may be higher than the cost as recognized by accountants.
The opportunity cost principle in business decision making process with example: It is vital to discourse prudently the opportunity cost and its importance in the practical life by discussing in detail the concept of opportunity cost in the light of different economists and authors and its value in the decision making of everyday life. In this discussion, a broader meaning of the opportunity cost will be given and its relevance with scarcity and choice. Moreover, the significance of opportunity cost will be shown in the context of decision making pitfall, exchange and opportunity cost, the relation of opportunity cost and specialization with respect to the principle of comparative advantage and it relevance to trade. Furthermore, its importance in the business decision making, objective of maximizing the profit, its relevance to the cost of capital, difference in economists and accounting point of view regarding opportunity cost will be considered with relevant explanation. In addition to this, the affiliation of opportunity cost and markets, opportunity cost of political decisions, opportunity cost for society and the opportunity cost of holding money will be analyzed to manifest the meaning and significance of opportunity cost.
Opportunity cost is a simple and one of the most significant concepts of microeconomics (Frank: 2003). McDowell et al. (2009) describes, opportunity cost of engaging in an activity is the cost of the next most desirable alternative activity that a person have to give up in order to engage in that activity. Giving a simple example of opportunity cost, McDowell et al. (2009) suppose that a person is indifferent in choosing the amount of time to spend on either studying for a very important test or watching a favorite programmed on television. In this case the opportunity cost of watching the television is the value of the study for the test that must be sacrificed, which is very high, and the person is very highly unlikely to watch television and is more likely to decide against watching television. Sloman (2006) illustrate that as there are scarce resources in the world, so people have to make choices among scarce resources, which involves sacrifice of alternative goods or services. Spending more money on food involves sacrifice of other goods and services. This sacrifice of other goods and services is known as its opportunity cost. Sloman (2006) called opportunity cost as a ‘threshold concept’. Once people become aware of its vitality, they start thinking like economists and it affects the way of dealing with economic problems. However, the way of thinking like economists and dealing with economic problems is different from accountants thinking and dealing, which will be discussed later in detail. Sloman (2006) claim that people start recognizing that they face trade-offs, when they begin looking at the opportunity cost. That means engaging more in one action involves doing less of other activities. Nations face trade-offs and is widely known as ‘Gun versus butter’ trade-off. The more a country will spend on its defense, the less it will be left to spend on the welfare of its people and basic consumer necessities.
Example:-
For example, Bill Gates dropped out of college. Yet, he ended up creating one of the most successful software businesses in Microsoft . His opportunity cost was the benefit of a college education at Harvard and a stable, successful career working for someone else. However, his entrepreneurial drive led him to choosing the route of becoming a self-starter and entrepreneur . While most people who drop out of college do not become billionaires, it was different for Bill Gates. The opportunity cost of staying in college and working for someone else didn’t have enough value compared to his dream of becoming an entrepreneur .
Life decisions require the two following things:
- Personal self-reflection regarding the benefits of the first choice
- The opportunity costs of the next best choice
Your opportunity costs are not the same as the person sitting next to you. The true cost of one choice is the cost of what you give up to get it. The more choices we have in society, the more you have to give up by choosing one thing over another. As long as you are content with the result of your decision, whether you think about what you gain or lose, you can live a successful life.
(b) Spell out the objectives of firms. In the context of Baumol’s theory, explain the equilibrium of a sales revenue maximizing firm.
-> The objectives of the firm are:-
1. Profit Maximization:
In the conventional theory of the firm, the principal objective of a business firm is profit maximization. Under the assumptions of given tastes and technology, price and output of a given product under perfect competition are determined with the sole objective of maximizing profits.
2. Multiple Objectives:
The basis of the difference between the objectives of the neo-classical firm and the modern corporation arises from the fact that the profit maximization objective relates to the entrepreneurial behavior while modem corporations are motivated by different objectives because of the separate roles of shareholders and managers.
3. Marris Growth Maximization:
The managers aim at the maximization of the growth rate of the firm and the shareholders aim at the maximization of their dividends and share prices. To establish a link between such a growth rate and the share prices of the firm, Marris develops a balanced growth model in which the manager chooses a constant growth rate at which the firm’s sales, profits, assets, etc., grow.
4. Baumol’s Sales Maximization:
Being a consultant to a number of firms, Baumol observes that when asked how their business went last year, the business managers often respond, “Our sales were up to three million dollars”. Thus, according to Baumol, revenue or sales maximization rather than profit maximization is consistent with the actual behavior of firms.
5. Output Maximization:
Ilton Kafolgis suggests output maximization as the objective of a business firm. According to him, “The performance of firms frequently is measured directly in terms of physical output with revenue occupying a secondary position.” Thus Kafolgis prefers output maximization both to profit maximization and revenue maximization as the objective of a firm.
6. Security Profits:
Rothschild has put forward the view that the firm is motivated not by profit maximization but by the desire for security profits. In his words, “There is another motive which is probably of a similar order of magnitude as the desire for maximum profits, the desire for security profits.”
7. Satisfaction Maximization:
Scitovsky is concerned with managerial effort and the distaste that managers have for work. According to him an entrepreneur would maximize profits only if his choice between more income and more leisure is independent of his income. In other words, the supply of entrepreneurship should have zero income elasticity.
Baumol’s theory of sales revenue maximization was created by American economist William Jack Baumol. It’s based on the theory that, once a company has reached an acceptable level of profit for a good or service, the aim should shift away from increasing profit to focus on increasing revenue from sales. In the words of Baumoul, ‘The sales maximization goal says that managers of firms seek to maximize their sales revenue subject to the constraint of earning satisfactory profits. “According to the theory, companies should do so by producing more, keeping prices low, and investing in advertising to increase product demand.
The idea is that applying this sales revenue maximization model will improve the overall reputation of the company and, in turn, lead to higher long term profits. The theory is said to touch every aspects of a business, even employee morale. After all when employees feel like they are working for a successful company due to increased revenue, they are likely to provide products and services at a higher quantity and quality. Baumol raised serious questions on the validity of profit maximization as an objective of the firm. He stressed that in competitive markets, firms would rather aim at maximizing revenue, through maximization of sales. According to him, sales volumes, and not profit volumes, determine market leadership in competition. He further stressed that in large organizations, management is separate from owners. Hence there would always be a dichotomy of managers’ goals and owners’ goals. Manager’s salary and other benefits are largely linked with sales volumes, rather than profits.
2(a)(i) What is meant by demand? Explain the determinants of demand.
-> Demand is an economic term that refers to the amount of products or services that consumers wish to purchase at any given price level. The mere desire of a consumer for a product is not demand. Demand includes the purchasing power of the consumer to acquire a given product at a given period. In other words, it’s the amount of products or services that consumers are willing and able to purchase. Consumer purchasing behavior is related to consumer income and the prices of goods and services. Different income levels determine diverse quantities demanded of the same product or service, reflecting the purchasing power of consumers and the apprehended utility.
Demand means the quantity of a commodity which an individual consumer or a household or a market willing to purchase at a given time and price. Basically it implies three things:
a) Willingness to buy the product,
b) Desire of the consumer or the household to buy the product, and
c) The buyer has sufficient purchasing power to purchase the commodity.
The following are the factors which determine demand for goods:-
1. Tastes and Preferences of the Consumers:
An important factor which determines demand for a good is the tastes and preferences of the consumers for it. A good for which consumers’ tastes and preferences are greater, its demand would be large and its demand curve will lie at a higher level. People’s tastes and preferences for various goods often change and as a result there is change in demand for them
2. Incomes of the People:
The demand for goods also depends upon incomes of the people. The greater the incomes of the people the greater will be their demand for goods. The greater income means the greater purchasing power. Therefore, when incomes of the people increase, they can afford to buy more.
3. Changes in the Prices of the Related Goods:
The demand for a good is also affected by the prices of other goods, especially those which are related to it as substitutes or complements. Therefore, when the prices of the related goods, substitutes or complements, change the whole demand curve would change its position; it will shift upward or downward as the case may be.
4. The Number of Consumers in the Market:
We have already explained that the market demand for a good is obtained by adding up the individual demands of the present as well as prospective consumers or buyers of a good at various possible prices. The greater the number of consumers of a good, the greater the market demand for it.
5. Changes in Propensity to Consume:
People’s propensity to consume also affects the demand for them. The income of the people remaining constant, if their propensity to consume rises, then out of the given income they would spend a greater part of it with the result that the demand for goods will increase.
6. Consumers’ Expectations with regard to Future Prices:
Another factor which influences the demand for goods is consumers’ expectations with regard to future prices of the goods. If due to some reason, consumers expect that in the near future prices of the goods would rise, then in the present they would demand greater quantities of the goods so that in the future they should not have to pay higher prices.
7. Income Distribution:
Distribution of income in a society also affects the demand for goods. If distribution of income is more equal, then the propensity to consume of the society as a whole will be relatively high which means greater demand for goods.
(ii) Distinguish between price elasticity of demand and cross elasticity of demand. What is the significance of cross elasticity of demand in making business decisions?
-> Distinguish between price elasticity of demand and cross elasticity of demand are:-
1. The proportionate (percentage) change in quantity demanded of a product due to proportionate (percentage) change in its price is measured by the price elasticity of demand.
The proportionate change in quantity demanded of a commodity due to change in price of another commodity (like the substitute or the complementary good) is called as cross elasticity of demand.
2. The coefficient of Price Elasticity of demand is always negative due to inverse relation between price and quantities demanded (Though it is stated as a positive number).
The positive coefficient of cross elasticity shows that the given commodities are substitutes. Negative cross elasticity shows that the given commodities are complementary to each other, and when it is zero then the given commodities are unrelated to each other.
3. The coefficient of price elasticity shows different degrees of price elasticity like elastic, inelastic and unitary demand.
The coefficient of cross elasticity shows the relation between the given set of goods.
4. The formula for price elasticity of demand is:
% change in quantity demanded by % change in price
The formula for cross Elasticity of demand is as stated below:
% change in quantity demanded of commodity A by % change in price of commodity B.
Significance of cross elasticity of demand in making business decisions:-
1) A change in quantity demanded refers to the movement along a particular demand curve caused by a change in the price of the goods.
2) A change in demand refers to a shift in demand curve resulting from a change in consumer preferences, income or/and price of the goods.
3) When price of one good increase or decrease but the demand for the other goods does not change.
4) The market demand is sum total of individual demand and its price.
5) Demand for consumer durables occurs at irregular intervals and depends upon the need and performances of the family.
6) Price elasticity is defined as the percentage change in quantity demanded that results from a 1 percent change in own price.
7) Cross elasticity of substitute goods is positive and for complement goods it is negative.
(b) State the law of demand. Explain with appropriate illustration the law of demand for a normal goods and giffin goods. Analyze the situations under which the law of demand will not hold true.
-> The law of demand is one of the most fundamental concepts in economics. It works with the law of supply to explain how market economies allocate resources and determine the prices of goods and services that we observe in everyday transactions. The law of demand states that quantity purchased varies inversely with price. In other words, the higher the price, the lower the quantity demanded. This occurs because of diminishing marginal utility . That is, consumers use the first units of an economic good they purchase to serve their most urgent needs first, and use each additional unit of the good to serve successively lower valued ends.
Normal goods are a type of goods whose demand shows a direct relationship with a consumer’s income . It means that the demand for normal goods increases with an increase in the consumer’s income or expansion of the economy . Demand for normal goods is determined by patterns in the behavior of consumers . Larger income leads to changes in consumers’ behavior. As income increases, consumers may be able to afford goods that were not previously available to them.
In such a case, the demand for the goods increases due to their attractiveness to consumers. It may be explained by the higher quality of the goods, higher functionality, or more prestigious socio-economic value think about many luxury goods.
A Giffen good is a low income, non-luxury product for which demand increases as the price increases and vice versa. A Giffen good has an upward-sloping demand curve which is contrary to the fundamental laws of demand which are based on a downward sloping demand curve. Since there are few substitutes for Giffen goods, consumers continue to remain willing to buy a Giffen good when the price rises.
The situations under which law of demand wil not hold true are :-
1. Expected change in the price of goods- Quantity demanded of a product increases if it is expected that there will be a rise in the price of the product. Consumers postpone their purchases when fall in price is expected.
2. Type of Goods-Inferior Goods- Generally low-quality goods are consumed by the poorer sections of society. Inferior goods are consumed by poor consumers for their survival. Consumers move to better quality goods with an increase in income.
3. Change in Fashion- Change in fashion and taste affects the demand for a commodity. When he considers that goods are out of fashion, the law of demand becomes ineffective. Once the commodity goes out of fashion, consumers resist buying more even if the price falls.
4. Complementary Goods- Complementary goods are another exception to the law of demand. For Example: – Demand of DVD player increases due to falling in its prices; demand for DVD’s will also increase irrespective of its high price.
3(a) Distinguish between demand estimation and demand forecasting. Why is demand forecasting essential? Analyze the steps involved in demand forecasting .
-> 1 . Demand estimation attempts to quantify the links between the level of demand and the variables which determine it. Forecasting, on the other hand, attempts to predict the overall level of future demand rather than looking at specific linkages.
2. An estimation technique can be used to forecast demand but a forecasting technique cannot be used to estimate demand.
3. A manager who wishes to know how high demand is likely to be in two years’ time might use a forecasting technique. A manager who wishes to know how the firm’s pricing policy could be used to generate a given increase in demand would use an estimation technique.
Demand forecasting is a technique for estimation of probable demand for a product or services in the future. It is based on the analysis of past demand for that product or service in the present market condition. Demand forecasting should be done on a scientific basis and facts and events related to forecasting should be considered.
Demand forecasting is essential because,
1. It is the most important aspect for business for achieving its objectives. Many decisions of business depend on demand like production, sales, staff requirement, etc. Forecasting is the necessity of business at an international level as well as domestic level. 2. Demand forecasting reduces risk related to business activities and helps it to take efficient decisions. For firms having production at the mass level, the importance of forecasting had increased more. A good forecasting helps a firm in better planning related to business goals. 3. There is a huge role of forecasting in functional areas of accounting . Good forecast helps in appropriate production planning, process selection, capacity planning, facility layout planning, and inventory management , etc.
4. Demand forecasting provides reasonable data for the organization’s capital investment and expansion decision. It also provides a way for the formulation of suitable pricing and advertisement strategies.
The steps involved in demand forecasting are:-
1. Determining the objectives-
The first step in this regard is to consider the objectives of sales forecasting carefully.
2. Period of forecasting
Before taking up forecasting, the company has to decide the period of forecasting — Whether it is a short-term forecast or long-term research.
3. Scope of forecast The next step is to decide the scope of forecasting— Whether it is for the products, or for a particular area or total industry or at the national/international level. 4. Sub-dividing the task Sub-dividing the task into homogeneous groups, according to product, area, activities or consumers. The figure of sales forecasting shall be the sum total of the sales forecasts of all the groups. 5. Identify the variables The different variables or factors affecting the sales should be identified so that due weight age may be given to those different factors. 6. Selecting the method Appropriate method of sales forecasting is selected by the company taking into account all the relevant information, purpose of forecasting and the degree of accuracy required. 7. Collection and analysis of data Necessary data for the forecast are collected, tabulated, analyzed and cross-checked. The data are interpreted by applying the statistical or graphical techniques, and then to draw necessary deductions there from. 8. Study of correlation between sales forecasts and sales promotion plans Making the forecast reliable, the sales promotion plans such as advertising , personal selling and other sales programmers should be reviewed. 9. Competitors activities Volume of sales of a company is largely affected by the activities of competitors and, therefore, the forecaster must also study the competitors’ activities, policies, programmers and strategies. 10. Preparing final sales forecasts The preliminary sales forecasts figure should be reviewed and final sales forecast figures should be arrived at after making all adjustments. 11. Evaluation and adjustments The figures of final sales forecasts form the basis for the operations of the company in the next period. The actual sales performance in the forthcoming period should be reviewed and evaluated from time to time via, monthly, quarterly, half-yearly or yearly and so on.
(b) Critically evaluate different consumer survey methods of demand forecasting.
-> Consumer Survey Method is one of the techniques of demand forecasting that involves direct interview of the potential consumers.
1. Survey of Buyer’s-Intentions: This is a short-term method of knowing and estimating customer’s demand. This is direct method of estimating demand of customers as to what they intend to buy for the forthcoming time—usually a year. By this the burden of forecasting goes to the buyer. This method is useful for the producers who produce goods in bulk. Still their estimates should not entirely depend upon it. This method does not hold good for household consumers because of their inability to foresee their choice when they see the alternatives. Besides the household consumers there are many which make this method costly and impracticable. It does not expose and measure the variables under management control.
2. Collective Opinion or Sales Force Competitive Method:
Under this method, the salesman is nearest persons to the customers and is able to judge, their minds and market. They better understand the reactions of the customers to the firm’s products and their sales trends. The estimates of the different salesmen are collected and estimates sales are predicted.
These estimates are revised from time to time with changes in sales price, product, designs, and publicity programmers, expected changes in competition, purchasing power, income distribution, employment and population. It makes use of collective wisdom of salesmen, departmental heads and top executives.
Advantages:
(1) It is simple, common sense method involving no mathematical calculations.
(2) It is based on the first-hand knowledge of salesman and the persons directly connected with sales.
(3) This method is particularly useful for sales of new product. It has the salesman’s judgment.
Dis-advantages:
(1) It is a subjective approach.
(2) This method can be used only for short-term forecasting.
For long-term planning it is not useful.
3. Trend Projection or Time Trend of the Time Series:
This is the most popular method of analyzing time series and is generally used to project the time trend of the time series. A trend line can be filled through the series in visual or statistical way by the method of least squares.
The analyst can make a plausible algebraic relation—may it be linear, a quadratic or logarithmic between sales on one hand and independent variable time on the other. The trend line is then projected into the future for purpose of extrapolation.
Advantages:
This method is most popular as it is simple and in-extensive and because of time series data often exhibits a persistent growth trend.
Assumptions:
The basic assumption of this method is that the past rate of change of the variable under study will be continuing in future. This assumption gives good safe results till the time series exhibits a persistent tendency to move in the same direction.
When the burning point comes, the trend projection breaks down. Even though a forecaster could hope normally to be correct in most forecasts when the turning points are few and spaced at long intervals from each other.
In fact, the actual challenge of forecasting is in the prediction of turning points rather than in the trend projection. At such turning points the management will have to change and revise its sales and projection strategies most drastically.
There are four factors responsible for the characterization of time series.
They are:
1. Fluctuations and turning points.
2. Trend seasonal variations.
3. Cyclical fluctuations, and
4. Irregular or random forces.
The problem in forecasting is to separate and measure each of these factors.
This time series is expressed by the following equation:
O = TSCI
where, O = observed data
T = a secular tend
S = a seasonal factor
C = cyclical element
I = an irregular movement.
The usual practice is to calculate the trend first from the basic data. The trend values are then taken out from the observed data (TSCI /T). The next step is to reckon the seasonal index that is utilized to remove the seasonal effect (SCI/S).
It is fitted through chain to the remainder that also gives the irregular effect. This approach to the breaking up of time series data is an analytical device of usefulness for the knowledge of the nature of business fluctuations.
Assumptions:
(a) Analysis of movements would be in the order of trend, seasonal variations and cyclical changes.
(b) The effects of every component are not dependent on any other components.
4. Executive Judgment Method:
Under this method opinions are sought from the executives of different discipline i.e., marketing, finance, production etc. and estimates for future demands are made. Thus, this is a process of combining, averaging or evaluating in some other way the opinions and views of the top executives.
Advantages:
The main advantages of this method are:
1. The forecasts can be made speedily by analyzing the opinions and views of top executives. The techniques are quite easy and simple.
2. No need of elaborate statistics:
There is no need of collecting elaborate. Statistics for the forecasts hence it is not much expensive.
3. Only feasible method to follow:
In the absence of adequate data is it the only feasible method to be followed.
Dis-advantages:
The chief dis-advantages of the of this method are:
(1) No factual basis of such forecast:
There is no factual basis of such forecasts, so the method is inferior to others.
(2) No accuracy:
Accuracy cannot be claimed under this method.
(3) Responsibility for the accuracy of data cannot be fixed on any one.
5. Economic Indicators:
This method has its base for demand forecasting on few economic indicators.
(a) Construction contracts:
For demand towards building materials sanctioned for Cement.
(b) Personal Income:
Towards demand of consumer goods.
(c) Agricultural Income:
Towards demand of agricultural imports instruments, fertilizers, manner etc.
(d) Automobiles Registration:
Towards demand of car parts and petrol. These and other economic indicators are given by specialized organization. The analyst should establish relationship between the sale of the product and the economic indicators to project the correct sales and to measure as to what extent these indicators affect the sales. To establish relationship is not an easy task especially in case of New Product where there are no past records.
Steps:
Following steps may be remembered:
(a) If there is any relationship between the demand for a product and certain economic indicator.
(b) Make the relationship by the method of least squares and derive the regression equation. Supposing the relationship is Linear the equation will be of the form y = α + bx. There can be curvilinear relationship also.
(c) Once the regression equation is obtained any value of X (economic indicator) can be applied to forecast the value of Y (demand).
(d) Past relationship may not recur. Therefore, need for value judgments are felt. Other new factors may also have to be taken into consideration.
Limitations:
The limitations of economic indicators are as follows:
(1) It is difficult to find out an appropriate economic indicator.
(2) For few products it is not good, as no past data are available.
(3) This method of forecasting is best suited where relationship of demand with a particular indicator is characterised by a Time Lag, such as construction contracts will give consequence to demand for building materials with some amount of Time Lag.
But where the demand does not Lag behind the particular economic index, the utility is restricted because forecast may have to be based on projected economic index itself that may not result true.
6. Controlled Experiments:
Under this method, an effort is made to ascertain separately certain determinants of demand which can be maintained, e.g., price, advertising etc. and conducting the experiment, assuming etc., and conducting the experiment, assuming that the other factors remain constant.
Thus, the effect of demand determinants like price, advertisement packing etc., on sales can be assessed by either varying them over different markets or by varying them over different time periods in the same market.
For example:
Different prices would be associated with different sales on that basis the price, quantity relationship is estimated in the form of regression equation and used for forecasting purposes. It must be noted that the market divisions here must be homogeneous with regard to income, tastes etc.
Such experiments have been conducted widely in the USA and were successful. This is a new experiment. This is quite new and less applied.
The main reasons for non-application of this method so far as follows:
1. The method is expensive and time consuming.
2. It is risky because it may lead to un-favorable reactions on dealers, consumers and competitors.
3. It is not always easy to determine what conditions should be taken to be constant and what factors should be regarded as variable, so as to separate and measures their influence on demand.
4. It is hard to satisfy the homogeneity of market conditions. In-spite of these drawbacks, controlled experiments has sufficient potentialities to become a useful method for business research and analysis in future.
7. Expert’s Opinions:
Under this method expert’s opinions are sought from specialists in the field, outside the organizations or the organization collects opinions from such specialists; views of expert’s published in the newspaper and journals for the trade, wholesalers and distributors for the company’s products, agencies and professional experts.
These opinions and views are analyzed and deductions are made there from to arrive at the figure of demand forecasts.
Advantages:
The advantages of this method are:
(1) Forecasts can be done easily and speedily.
(2) It is based on expert’s views and opinions hence estimates are nearly accurate.
(3) The method is suitable where past records of sales are not available.
(4) The method is economical because survey is done to collect the data. The expenses of seeking the opinions and views of experts are much less than the expenses of actual survey.
Dis-advantages:
The important dis-advantages of this method are:
(1) Estimates for a market segment cannot be possible.
(2) The reliability of forecasting is always subjective because forecasting is not based on facts.
4(a) What is third-degree price discrimination? Explain the conditions that a firm must meet to be able to practice third-degree price discrimination.
-> Third-degree price discrimination occurs when companies price products and services differently based on the unique demographics of subsets of its consumer base, such as students, military personnel, or seniors.
Companies can understand the broad characteristics of consumers more easily than the buying preferences of individual buyers. Third-degree price discrimination provides a way to reduce consumer surplus by catering to the price elasticity of demand of specific consumer subsets. This type of pricing strategy is often seen in movie theater ticket sales, admission prices to amusement parks, or restaurant offers. Consumer groups that may otherwise not be able or willing to purchase a product due to their lower income are captured by this pricing strategy, increasing company profits.
In the real world, third-degree price discrimination is quite common. For a firm to practice price discrimination it requires:
· Ability to set prices. Some market power.
· Ability to segment different classes of consumers (e.g. rail card to prove you are a senior citizen)
· Ability to prevent resale. E.g. stop adults using student tickets.
Third degree price-discrimination is sometimes known as direct price discrimination. Because a firm directly sets different prices depending on distinct groups of consumers (e.g. age)
The alternative is indirect price discrimination where consumers can choose depending on their behavior, e.g. bulk buying gets lower average cost.
(b)(i) What is transfer pricing? Explain how transfer price is determined if there is no external market for the product.
-> Transfer pricing refers to the rules and methods for pricing transactions within and between enterprises under common ownership or control. Because of the potential for cross-border controlled transactions to distort taxable income, tax authorities in many countries can adjust intergroup transfer prices that differ from what would have been charged by unrelated enterprises dealing at arm’s length.
Aims & Objective of Transfer Pricing:
1. Transfer pricing minimizes the tax burden or arranging direction of cash flow:
Transfer price, as aforesaid, refers to the value attached to transfer of goods, services, and technology between related entities such as parent and subsidiary corporations and also between the parties which are controlled by a common entity. Its essence being that the pricing is not set by an independent transferor and transferee in an arm’s length transaction. Transaction between them is not governed by open market considerations.
2. Transfer pricing results in shifting profits:
Whatever the reason for fixing a transfer price which is not arm’s length, the result is the shift of profit. The effect is that the profit appropriately attributable to one jurisdiction is shifted to another jurisdiction. The main object is to avoid tax as also to withdraw profits leaving very little for the local participation to share. Other object is avoidance of foreign exchange restrictions.
3. Shifting of Profits- Tax avoiding not the only object:
Transfer between the enterprises under the same control and management, of goods, commodities, merchandise, raw material, stock, or services is made at a price which is not dictated by the market but controlled by such considerations such as:
• To reduce profits artificially so that tax effect is reduced in a specific country;
• To facilitate decentralization of production so that efforts are directed to concentrate profits in the State of production where there is no or least competition;
• To remit profits more than the ceilings imposed for repatriation;
• To use it as an effective tool to exploit the fluctuation in foreign exchange to advantage.
In financial sector, transfer pricing is the value placed on transfers within an organization, used as a means of allocating costs to various profit centers. Transfer pricing is used widely in multi-office banks and bank holding companies, serving these important functions: (i) price setting for services performed by business units; (ii) a means of evaluating financial performance by business units; and (iii) determining the contribution to net income by profit centers in the organization. The large size firms divide their operation very often into product divisions or subsidiaries. Growing firms add new divisions or departments to the existing ones. The firms then transfer some of their activities to other divisions. The goods and services produced by the new division are used by the parent organization. In other words, the parent division buys the product of its subsidiaries. Such firms face the problem of determining an appropriate price for the product transferred from one division or subsidiary to the other. Specifically, the problem is of determining the price of a product produced by one division of the same firm. This problem becomes much more difficult when each division has a separate profit function to maximize. Pricing of infra-firm ‘transfer product’ is referred to as ‘transfer pricing’. One of the most systematic treatments of the transfer pricing technique has been provided by Hirshleifer.
We will discuss here briefly his technique of transfer pricing.
(1) Market Prices
(2) Cost-Based Prices
(3) Negotiated Prices
(4) Dual Prices
(1) Market-Based Prices:
Market price refers to a price in an intermediate market between independent buyers and sellers. When there is a competitive external market for the transferred product, market prices work well as transfer prices. When transferred goods are recorded at market prices, divisional performance is more likely to represent the real economic contribution of the division to total company profits. If the goods cannot be bought from a division within the company, the intermediate product would have to be purchased at the current market price from the outside market. Divisional profits are therefore likely to be similar to the profits that would be calculated if the divisions were separate organizations.
Consequently, divisional profitability can be compared directly with the profitability of-similar companies operating in the same type of business. Managers of both buying and selling divisions are indifferent between trading with each other or with outsiders. No division can benefit at the expense of another division. In the market price situation, top management will not be tempted to intervene.
Market-based prices are based on opportunity costs concepts. The opportunity cost approach signals that the correct transfer price is the market price. Since the selling division can sell all that it produces at the market price, transferring internally at a lower price would make the division worse off.
Similarly the buying division can always acquire the intermediate goods at the market price, so it would be unwilling to pay more for internally transferred goods. Since the minimum transfer price for the selling division is the market price and the maximum price for the buying division is also the market price, the only possible transfer price is the market price.
The market price can be used to resolve conflicts among the buying and selling divisions. From the company viewpoint, market price is the optimal so long as the selling division is operating at full capacity. The market price does not allow any gains or losses in efficiency of the selling division. It saves administrative costs as the use of competitive market prices is free from any dispute, argument and bias.
Further, transfer prices based on market prices are consistent with the responsibility accounting concepts of profit centers and investment centers. In addition to encouraging division managers to focus on divisional profitability, market based transfer prices help to show the contribution of each division to overall company profit.
However, there are some problems using the market price approach:
Another problem with market prices can occur when a selling division is not operating at full capacity and cannot sell all its products. To illustrate this point, assume that material used by Division A in a company is being purchased from outside market at Rs 200 per unit.
The same materials are produced by Division B. If Division B is operating at full capacity, say of 50,000 units and can sell all its products to either Division A or to outside buyers, then the use of transfer price of Rs 200 per unit (market price) has no effect on Division B’s income or total company profit. Division B will earn revenue of Rs 200 per unit on all its production and sales, regardless of who buys its product and Division A will pay Rs 200 per unit, regardless of whether it purchases the materials from Division B or from an outside supplier. In this situation, the use of market price as the transfer price is appropriate.
However, if Division B is not operating at full capacity and unused capacity exists in that division, the use of market price may not lead to maximization of total company profit. To illustrate this point, assume that Division B has unused capacity of 30,000 units and it can continue to sell only 50,000 units to outside buyers.
In this situation, the transfer price should be set to motivate the manager of Division A to purchase from Division B if the variable cost per unit of product of Division B is less than the market price. If the variable costs are less than Rs 200 per unit but the transfer price is set equal to the market price of Rs 200, then the manager of Division A is indifferent as to whether materials are purchased from Division B or from outside suppliers, since the cost per unit to Division B would be the same, Rs 200.
Hilton sums up difficulty associated with general rule of transfer pricing in the following words:
(i) Difficulting in Measuring Opportunity Costs:
The general transfer-pricing rule will always promote goal-congruent decision making if the rule can be implemented. However, the rule is often difficult or impossible to implement due to the difficulty of measuring opportunity costs. Such a cost-measurement problem can arise for a number of reasons. One reason is that the external market may not be perfectly competitive. Under perfect competition, the market price does not depend on the quantity sold by anyone producer.
Under imperfect competition, a single producer or group of producers can affect the market price by varying the amount of product available in the market. In such cases, the external market price depends on the production decisions of the producer. This in turn means that the opportunity cost incurred by the company as a result of internal transfers depends on the quantity sold externally. These interactions may make it impossible to measure accurately the opportunity cost caused by a product transfer.
(ii) Nature of Transferred Goods:
Other reasons for difficulty in measuring the opportunity cost associated with a product transfer include uniqueness of the transferred goods or services, a need for the producing division to invest in special equipment in order to produce the transferred goods, and interdependencies among several transferred products or services. For example, the producing division may provide design services as well as production of the goods for a buying division. What is the opportunity cost associated with each of these related outputs of the producing division? In many such cases it is difficult to sort out the opportunity costs.
(iii) Distress Market Prices:
Occasionally an industry will experience a period of significant excess capacity and extremely low prices. For example, when gasoline prices soared due to a foreign oil embargo, the market prices for recreational vehicles and power boats fell temporarily to very low levels.
Under such extreme conditions, basing transfer prices on market prices can lead to decisions that are not in the best interests of the overall company. Basing transfer prices on artificially low distress market prices could lead the producing division to sell or close the productive resources devoted to producing the product for transfer. Under distress market prices, the producing division manager might prefer to move the division into a more profitable product line.
While such a decision might improve the division’s profit in the short run, it could be contrary to the best interests of the company overall. It might be better for the company as a whole to avoid divesting itself of any productive resources and to ride out the period of market distress. To encourage an autonomous division manager to act in this fashion, some companies set the transfer price equal to the long-run average external market price, rather than the current (possibly depressed) market price.
(2) Cost Based Prices:
When external markets do not exist or are not available to the company or when information about external market prices is not readily available, companies may decide to use some forms of cost-based transfer pricing system.
Cost-based transfer prices may be in different forms such as variable cost, actual full cost, full cost plus profit margin, standard full cost.
(a) Variable Cost:
Variable cost-based pricing approach is useful when the selling division is operating below capacity. The manager of the selling division will generally not like this transfer price because it yields no profit to that division. In this pricing system, only variable production costs are transferred. These costs are direct materials, direct labour and variable factory overhead.
Variable cost has the major advantage of encouraging maximum profits for the entire firm. By passing only variable costs alone to the next division, production and pricing decisions are based on cost- volume-profit relationships for the firm as a whole. The obvious problem is that selling division is left holding all its fixed costs and operating expenses. That division is now a loss division, nowhere near a profit centre.
(b) Actual Full Cost:
In actual full cost approach, transfer price is based on the total product cost per unit which will include direct materials, direct labor and factory overhead. When full cost is used for transfer pricing, the selling division cannot realize a profit on the goods transferred. This may be disincentive to the selling division. Further, full cost transfer pricing can provide perverse incentives and distort performance measures. A full cost transfer price would have shutdown the chances of any negotiation between divisions about selling at transfer prices.
(c) Full Cost plus Profit Margin:
Full cost plus mark up (or profit margin) overcomes the weaknesses of full cost basis transfer pricing system. The full cost plus price include the allowed cost of the item plus a mark up or other profit allowance. With such a system, the selling division obtains a profit contribution on units transferred and hence, benefits if performance is measured on the basis of divisional operating profits. However, the manager of the buying division would naturally object that his costs (and hence reported performance) are adversely affected.
The basic question in full cost plus mark up is ‘what should be the percentage of mark up.’ It can be suggested that the mark up percentage should cover operating expenses and provide a target return on sales or assets.
(d) Standard Costs:
In actual cost approaches, there is a problem of measuring cost. Actual cost does not provide any incentive to the selling division to control cost. All product costs are transferred to the buying division. While transferring actual costs any variances or inefficiencies in the selling division are passed along to the buying division.
The problem of isolating the variances that have been transferred to subsequent buyer division becomes extremely complex. To promote responsibility in the selling division and to isolate variances within divisions, standard costs are usually used as a basis for transfer pricing in cost-based systems.
Whether transferring at differential costs or full costs, standard costs, where available, are often used as the basis for the transfer. This encourages efficiency in the selling division because inefficiencies are not passed onto the buying division. Otherwise, the selling division can transfer cost inefficiencies to the buying division. Use of standard cost reduces risk to the buyer. The buyer knows that standard costs will be transferred and avoids being charged with suppliers’ cost overruns.
(3) Negotiated Prices:
Negotiated prices are generally preferred as a middle solution between market prices and cost- based prices. Under negotiated prices, the managers involved act much the same as the managers of independent companies. Negotiation strategies may be similar to those employed when trading with outside markets. If both divisions are free to deal either with each other or in the external market, the negotiated price will likely be close to the external market price. If all of a selling division’s output cannot be sold in the external market (that is, a portion must be sold to the buying division), the negotiated price will likely be less than the market price and the total margin will be shared by the divisions.
The conditions under which a negotiated transfer price will be successful include:
1. Some Form of Outside Market for the Intermediate Product:
This avoids a bilateral monopoly situation in which the final price could vary over too large a range, depending on the strength and skill of each negotiator.
2. Sharing of all Market Information Among the Negotiators:
This should enable the negotiated price to be close to the opportunity cost of one or preferably both divisions.
3. Freedom to Buy or Sell Outside:
This provides the necessary discipline to the bargaining process.
4. Support and Occasional Involvement of Top Management:
The parties must be urged to settle most disputes By themselves, otherwise the benefits of decentralization will be lost. Top management must be available to mediate the occasional unresolvable dispute or to intervene when it sees that the bargaining process is clearly leading to suboptimal decisions. But such involvement must be done with restraint and tact if it is not to undermine the negotiating process.
Negotiated price avoids mistrusts, bad feelings and undesirable bargaining interests among divisional managers. Also, it provides an opportunity to achieve the objectives of goal congruence, autonomy and accurate performance evaluation. The overall company is beneficiary if selling and buying divisions can agree upon some mutually transfer prices. Negotiated transfer price is considered as a vital integrating tool among divisions of a company which is necessary to achieve goal congruence.
If negotiations help ensure goal congruence, top management has little temptation to intervene between divisions. The agreed prices also can be used for performance measurement without creating any friction. The use of negotiated prices is consistent with the concept of decentralized decision-making in the divisionalised firms.
However, negotiated prices have the following disadvantages:
(1) A great deal of management effort, time and resources can be consumed in the negotiating process.
(2) The final emerging negotiated price may depend more on the divisional manager’s ability and skill to negotiate than on the other factors. Thus, performance measures will be distorted leading to incorrect evaluation of divisional performance.
(3) One divisional manager having some private information may take advantage of another divisional manager.
(4) It is time-consuming for the managers involved.
(5) It leads to conflicts between divisions.
(6) It may lead to a suboptimal level of output if the negotiated price is above the opportunity cost of supplying the transferred goods.
(4) Dual Prices:
Under dual prices of transfer pricing, selling division sells the transferred goods at a (i) market or negotiated market price or (ii) cost plus some profit margin. But the transfer price for the buying division is a cost-based amount (preferably the variable costs of the selling division). The difference in transfer prices for the two divisions could be accounted for by special centralized account. This system would preserve cost data for subsequent buyer departments, and would encourage internal transfers by providing a profit on such transfers for the selling divisions.
Dual prices give motivation and incentive to selling divisions as goods are transferred at market price and this arrangement provides a minimal cost to the buying division as well. Market price can be considered as the most appropriate base for the selling division. Thus dual pricing-system has the function of motivating both the selling division and buying division to make decisions that are consistent with the overall goals of decentralization—goal congruence, accurate performance measurement, autonomy, adequate motivation to divisional manager.
(ii) Can a perfectly competitive firm practice price discrimination? Justify your answer.
-> When a firm charges different prices for the same good or service to different consumers, even though there is no difference in the cost to the firm of supplying these consumers, the firm is engaging in price discrimination. Except for a few situations of price discrimination that have been declared illegal, such as manufacturers selling their goods to distributors at different prices when there are no differences in cost, price discrimination is generally legal.
The potential for price discrimination exists in all market structures except perfect competition. As long as a firm faces a downward-sloping demand curve and thus has some degree of monopoly power, it may be able to engage in price discrimination. But monopoly power alone is not enough to allow a firm to price discriminates. Monopoly power is one of three conditions that must be met:
1. A Price-Setting Firm The firm must have some degree of monopoly power—it must be a price setter. A price-taking firm can only take the market price as given—it is not in a position to make price choices of any kind. Thus, firms in perfectly competitive markets will not engage in price discrimination. Firms in monopoly, monopolistically competitive, or oligopolistic markets may engage in price discrimination.
2. Distinguishable Customers The market must be capable of being fairly easily segmented—separated so that customers with different elasticity’s of demand can be identified and treated differently.
3. Prevention of Resale The various market segments must be isolated in some way from one another to prevent customers who are offered a lower price from selling to customers who are charged a higher price. If consumers can easily resell a product, then discrimination is unlikely to be successful. Resale may be particularly difficult for certain services, such as dental checkups.
Examples of Price Discrimination
Examples of price discrimination abound. Senior citizens and students are often offered discount fares on city buses. Children receive discount prices for movie theater tickets and entrance fees at zoos and theme parks. Faculty and staff at colleges and universities might receive discounts at the campus bookstore. Airlines give discount prices to customers who are willing to stay over a Saturday night. Physicians might charge wealthy patients more than poor ones. People who save coupons are able to get discounts on many items. In all these cases a firm charges different prices to different customers for what is essentially the same product.
Not every instance of firms charging different prices to different customers constitutes price discrimination. Differences in prices may reflect different costs associated with providing the product. One buyer might require special billing practices, another might require delivery on a particular day of the week, and yet another might require special packaging. Price differentials based on differences in production costs are not examples of price discrimination.
Suppose an airline has found that its long-run profit-maximizing solution for a round-trip flight between Minneapolis and Cleveland, when it charges the same price to all passengers, is to carry 300 passengers at $200 per ticket. The airline has a degree of monopoly power, so it faces a downward-sloping demand curve. The airline has noticed that there are essentially two groups of customers on each flight: people who are traveling for business reasons and people who are traveling for personal reasons (visiting family or friends or taking a vacation). We will call this latter group “tourists.” Of the 300 passengers, 200 are business travelers and 100 are tourists. The airline’s revenue from business travelers is therefore currently $40,000 ($200 times 200 business travelers) and from tourists is currently $20,000 ($200 times 100 tourists).
It seems likely that the price elasticity’s of demand of these two groups for a particular flight will differ. Tourists may have a wide range of substitutes: They could take their trips at a different time, they could vacation in a different area, or they could easily choose not to go at all. Business travelers, however, might be attending meetings or conferences at a particular time and in a particular city. They have options, of course, but the range of options is likely to be more limited than the range of options facing tourists. Given all this, tourists are likely to have relatively more price elastic demand than business travelers for a particular flight.
The difference in price elasticity’s suggests the airline could increase its profit by adjusting its pricing. To simplify, suppose that at a price of about $200 per ticket, demand by tourists is relatively price elastic and by business travelers is relatively less price elastic. It is plausible that the marginal cost of additional passengers is likely to be quite low, since the number of crew members will not vary and no food is served on short flights. Thus, if the airline can increase its revenue, its profits will increase. Suppose the airline lowers the price for tourists to $190. Suppose that the lower price encourages 10 more tourists to take the flight. Of course, the airline cannot charge different prices to different tourists; rather it charges $190 to all, now 110, tourists. Still, the airline’s revenue from tourist passengers increases from $20,000 to $20,900 ($190 times 110 tourists). Suppose it charges $250 to its business travelers. As a result, only 195 business travelers take the flight. The airline’s revenue from business travelers still rises from $40,000 to $48,750 ($250 times 195 business travelers). The airline will continue to change the mix of passengers, and increase the number of passengers, so long as doing so increases its profit. Because tourist demand is relatively price elastic, relatively small reductions in price will attract relatively large numbers of additional tourists. Because business demand is relatively less elastic, relatively large increases in price will discourage relatively small numbers of business travelers from making the trip. The airline will continue to reduce its price to tourists and raise its price to business travelers as long as it gains profit from doing so.
Of course, the airline can impose a discriminatory fare structure only if it can distinguish tourists from business travelers. Airlines typically do this by looking at the travel plans of their customers. Trips that involve a stay over a weekend, for example, are more likely to be tourist related, whereas trips that begin and end during the workweek are likely to be business trips. Thus, airlines charge much lower fares for trips that extend through a weekend than for trips that begin and end on weekdays.
In general, price-discrimination strategies are based on differences in price elasticity of demand among groups of customers and the differences in marginal revenue that result. A firm will seek a price structure that offers customers with more elastic demand a lower price and offers customers with relatively less elastic demand a higher price.
It is always in the interest of a firm to discriminate. Yet most of the goods and services that we buy are not offered on a discriminatory basis. A grocery store does not charge a higher price for vegetables to vegetarians, whose demand is likely to be less elastic than that of its omnivorous customers. An audio store does not charge a different price for Pearl Jam’s compact disks to collectors seeking a complete collection than it charges to casual fans who could easily substitute a disk from another performer. In these cases, firms lack a mechanism for knowing the different demands of their customers and for preventing resale.
Monopolies are usually considered to be inefficient, but if allowed to price discriminate they can (in a perfect world) be very efficient. Of course, unregulated monopolies are illegal in the U.S. and regulated monopolies generally are not allowed to price discriminate. For this reason, price discrimination is really a practice of imperfectly competitive firms (oligopolies and monopolistically competitive firms).
5(a) Elucidate the meaning of business cycle. Explain the salient features of different phases of business cycle. In which phase a business firm will prefer to operate and why?
-> The period of high income, output and employment has been called the period of expansion, upswing or prosperity, and the period of low income, output and employment has been described as contraction, recession, downswing or depression.
The economic history of the free market capitalist countries has shown that the period of economic prosperity or expansion alternates with the period of contraction or recession.
These alternating periods of expansion and contraction in economic activity has been called business cycles. They are also known as trade cycles. J.M. Keynes writes, “A trade cycle is composed of periods of good trade characterized by rising prices and low unemployment percentages with periods of bad trade characterized by falling prices and high unemployment percentages.”
A noteworthy feature about these fluctuations in economic activity is that they are recurrent and have been occurring periodically in a more or less regular fashion. Therefore, these fluctuations have been called business cycles. It may be noted that calling these fluctuations as ‘cycles’ means they are periodic and occur regularly, though perfect regularity has not been observed.
The duration of a business cycle has not been of the same length; it has varied from a minimum of two years to a maximum of ten to twelve years, though in the past it was often assumed that fluctuations of output and other economic indicators around the trend showed repetitive and regular pattern of alternating periods of expansion and contraction.
However, actually there has been no clear evidence of very regular cycles of the same definite duration. Some business cycles have been very short lasting for only two to three years, while others have lasted for several years. Further, in some cycles there have been large swings away from trend and in others these swings have been of moderate nature.
A significant point worth noting about business cycles is that they have been very costly in the economic sense of the word. During a period of recession or depression many workers lose their jobs and as a result large-scale unemployment, which causes loss of output that could have been produced with full employment of resources, come to prevail in the economy.
Besides, during depression many businessmen go bankrupt and suffer huge losses. Depression causes a lot of human sufferings and lowers the levels of living of the people. Fluctuations in economic activity create a lot of uncertainty in the economy which causes anxiety to the individuals about their future income and employment opportunities and involve a great risk for long-run investment in projects. Even boom when it is accompanied by inflation has its social costs. Inflation erodes the real incomes of the people and makes life miserable for the poor people. Inflation distorts allocation of resources by drawing away scarce resources from productive uses to unproductive ones. Inflation redistributes income in favor of the richer sections and also when inflation rate is high, it impedes economic growth.
Phases of Business cycle:-
1. Depression or Trough:
The depression or trough is the bottom of a cycle where economic activity remains at a highly low level. Income, employment, output, price level, etc. go down. A depression is generally characterized by high unemployment of labor and capital and a low level of consumer demand in relation to the economy’s capacity to produce. This deficiency in demand forces firms to cut back production and lay-off workers.
Thus, there develops a substantial amount of unused productive capacity in the economy. Even by lowering down the interest rates, financial institutions do not find enough borrowers. Profits may even become negative. Firms become hesitant in making fresh investments. Thus, an air of pessimism engulfs the entire economy and the economy lands into the phase of depression. However, the seeds of recovery of the economy lie dormant in this phase.
2. Recovery:
After this stage, the economy comes to the stage of recovery. In this phase, there is a turnaround from the trough and the economy starts recovering from the negative growth rate. Demand starts to pick up due to the lowest prices and, consequently, supply starts reacting, too. The economy develops a positive attitude towards investment and employment and production starts increasing.
Increased production leads to an increase in demand for inputs. Employment of more labor and capital causes GNP to rise. Further, low interest rates charged by banks in the early years of recovery phase act as an incentive to producers to borrow money. Thus, investment rises. Now plants get utilized in a better way. General price level starts rising. The recovery phase, however, gets gradually cumulative and income, employment, profit, price, setc., start increasing.
3. Prosperity:
Once the forces of revival get strengthened the level of economic activity tends to reach the highest point—the peak. A peak is the top .of a cycle. The peak is characterized by an all-round optimism in the economy—income, employment, output, and price level tend to rise. Meanwhile, a rise in aggregate demand and cost leads to a rise in both investment and price level. But once the economy reaches the level of full employment, additional investment will not cause GNP to rise.
On the other hand, demand, price level, and cost of production will rise. During prosperity, existing capacity of plants is overutilised. Labor and raw material shortages develop. Scarcity of resources leads to rising cost. Aggregate demand now outstrips aggregate supply. Businessmen now come to learn that they have overstepped the limit. High optimism now gives birth to pessimism. This ultimately slows down the economic expansion and paves the way for contraction.
4. Recession:
Like depression, prosperity or pea, can never be long-lasting. Actually speaking, the bubble of prosperity gradually dies down. A recession begins when the economy reaches a peak of activity and ends when the economy reaches its trough or depression. Between trough and peak, the economy grows or expands. A recession is a significant decline in economic activity spread across the economy lasting more than a few months, normally visible in production, employment, real income and other indications.
During this phase, the demand of firms and households for goods and services start to fall. No new industries are set up. Sometimes, existing industries are wound up. Unsold goods pile up because of low household demand. Profits of business firms dwindle. Output and employment levels are reduced. Eventually, this contracting economy hits the slump again. A recession that is deep and long-lasting is called a depression and, thus, the whole process restarts.
The four-phased trade cycle has the following attributes:
(i) Depression lasts longer than prosperity,
(ii) The process of revival starts gradually,
(iii) Prosperity phase is characterized by extreme activity in the business world,
(iv) The phase of prosperity comes to an end abruptly.
(b) Distinguish between demand-pull and cost push inflation. Explain the policy measures that can be adopted to control demand-pull inflation.
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Demand-Pull Inflation | Cost-pull Inflation |
1. Demand-pull inflation arises when the aggregate demand increases at a faster rate than aggregate supply. | 1. Cost-Push Inflation is a result of an increase in the price of inputs due to the shortage of cost of production, leading to decrease in the supply of outputs. |
2. Demand-pull inflation describes how price inflation begins? | 2. Cost-push inflation explains why inflation is so difficult to stop, once started? |
3. The reason for demand-pull inflation is the increase in money supply, government spending and foreign exchange rates. | 3. Cost-push inflation is mainly caused by the monopolistic groups of the society. |
4. The policy recommendation on demand-pull inflation is associated with the monetary and fiscal measure which amounts to the high level of unemployment. | 4. Cost push inflation, where policy recommendation is related to administrative control on price rise and income policy, whose objective is to control inflation without increasing unemployment. |
5. The price level rises because of excess demand condition in the market. | 5. The price level rises because of increasing costs of production. |
6. Rise in population, rise in income etc. are the demand-pull factors. | 6. Rise in the prices of factors of production such as fuel price, wage cost etc. are the cost-pull factors. |
7. In demand-pull inflation excess of demand pushes up the prices of goods and services. | 7. In cost-pull inflation prices are “pushed up” by increase in costs of factors of production. |
The policy measures that can be adopted to control demand-pull inflation:-
1. Monetary Measures:
The government of a country takes several measures and formulates policies to control economic activities. Monetary policy is one of the most commonly used measures taken by the government to control inflation.
In monetary policy, the central bank increases rate of interest on borrowings for commercial banks. As a result, commercial banks increase their rate of interests on credit for the public. In such a situation, individuals prefer to save money instead of investing in new ventures.
This would reduce money supply in the market, which, in turn, controls inflation. Apart from this, the central bank reduces the credit creation capacity of commercial banks to control inflation.
The monetary policy of a country involves the following:
(a) Rise in Bank Rate:
Refers to one of the most widely used measure taken by the central bank to control inflation. The bank rate is the rate at which the commercial bank gets a rediscount on loans and advances by the central bank. The increase in the bank rate results in the rise of rate of interest on loans for the public. This leads to the reduction in total spending of individuals.
The main reasons for reduction in total expenditure of individuals are as follows;
(i) Making the borrowing of money costlier:
Refers to the fact that with the rise in the bank rate by the central bank increases the interest rate on loans and advances by commercial banks. This makes the borrowing of money expensive for general public.
Consequently, individuals postpone their investment plans and wait for fall in interest rates in future. The reduction in investments results in the decreases in the total spending and helps in controlling inflation.
(ii) Creating adverse situations for businesses:
Implies that increase in bank rate has a psychological impact on some of the businesspersons. They consider this situation adverse for carrying out their business activities. Therefore, they reduce their spending and investment.
(iii) Increasing the propensity to save:
Refers to one of the most important reason for reduction in total expenditure of individuals. It is a well-known fact that individuals generally prefer to save money in inflationary conditions. As a result, the total expenditure of individuals on consumption and investment decreases.
(b) Direct Control on Credit Creation:
Constitutes the major part of monetary policy.
The central bank directly reduces the credit control capacity of commercial banks by using the following methods:
(i) Performing Open Market Operations (OMO):
Refers to one of the important method used by the central bank to reduce the credit creation capacity of commercial banks. The central bank issues government securities to commercial banks and certain private businesses.
In this way, the cash with commercial banks would be spent on purchasing government securities. As a result, commercial bank would reduce credit supply for the general public.
(ii) Changing Reserve Ratios:
Involves increase or decrease in reserve ratios by the central bank to reduce the credit creation capacity of commercial banks. For example, when the central bank needs to reduce the credit creation capacity of commercial banks, it increases Cash Reserve Ratio (CRR). As a result, commercial banks need to keep a large amount of cash as reserve from their total deposits with the central bank. This would further reduce the lending capacity of commercial banks. Consequently, the investment by individuals in an economy would also reduce.
2. Fiscal Measures:
Apart from monetary policy, the government also uses fiscal measures to control inflation. The two main components of fiscal policy are government revenue and government expenditure. In fiscal policy, the government controls inflation either by reducing private spending or by decreasing government expenditure, or by using both.
It reduces private spending by increasing taxes on private businesses. When private spending is more, the government reduces its expenditure to control inflation. However, in present scenario, reducing government expenditure is not possible because there may be certain on-going projects for social welfare that cannot be postponed.
Besides this, the government expenditures are essential for other areas, such as defense, health, education, and law and order. In such a case, reducing private spending is more preferable rather than decreasing government expenditure. When the government reduces private spending by increasing taxes, individuals decrease their total expenditure.
For example, if direct taxes on profits increase, the total disposable income would reduce. As a result, the total spending of individuals decreases, which, in turn, reduces money supply in the market. Therefore, at the time of inflation, the government reduces its expenditure and increases taxes for dropping private spending.
3. Price Control:
Another method for ceasing inflation is preventing any further rise in the prices of goods and services. In this method, inflation is suppressed by price control, but cannot be controlled for the long term. In such a case, the basic inflationary pressure in the economy is not exhibited in the form of rise in prices for a short time. Such inflation is termed as suppressed inflation.
The historical evidences have shown that price control alone cannot control inflation, but only reduces the extent of inflation. For example, at the time of wars, the government of different countries imposed price controls to prevent any further rise in the prices. However, prices remain at peak in different economies. This was because of the reason that inflation was persistent in different economies, which caused sharp rise in prices. Therefore, it can be said inflation cannot be ceased unless its cause is determined.
