Managerial economics

1. If a firm raises its price for Product X, TR will increase. Uncertain, Total revenue = Price × Quantity Sold. The price elasticity of demand tells us there are two effects, first is price effect. If price increase, each unit sold sells for a higher price, which tends to raise revenue. Second is quantity effect. If price increase, fewer units are sold, which tends to lower revenue. This is determines by which price effect or the quantity effect is stronger

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2. When MR > MC, MP (marginal profit) will be positive. True, for each unit sold, marginal profit equals marginal revenue (MR) minus marginal cost (MC). Then, if MR is greater than MC at some level of output, marginal profit is positive and thus a greater quantity should be produced.

3. If a 10% increase in price leads to a 5% increase in TR, demand must be elastic. False, if an increase in price causes an increase in total revenue, then demand can be said to be inelastic, since the increase in price does not have a large impact on quantity demanded.

4. If the cross price elasticity is positive for two goods X and Y, X and Y must be complements. False, if the goods are complements, the value will be negative because quantity demanded increases when the price of complement falls. Example, if the price of petrol decreases to RM2 a litre, sales of cars would increase.

5. Maximizing TR is never a desirable goal for a firm. True, profit is the difference between a firm’s total revenue and its total opportunity cost. Total revenue is the amount of income earned by selling products. But it does not include the total opportunity costs of all inputs into the production process. Hence, it is never a desirable goal for a firm. Firm should consider maximizing Profit instead of TR.

6. The more inelastic the demand, the more likely it is that a firm can have regular price increases. True, if firm have regular increase in price (refer to Appendix 1) from P4 to P5, the decrease in the quantity demanded is relatively small (from Q4 to Q5). It means that, the more inelastic the demand, the percentage change in quantity demanded is less than percentage change price. Hence, firm can have regular price increases.

7. If EP = -1.25 for Group A, and EP = -.375 for Group B, and a firm uses price discrimination, Group A should pay a higher price than Group B. False, Group A is elastic and Group B is inelastic. The consumers in the inelastic sub-market will be charged the higher price, and those in the elastic sub market will be charged the lower price. So Group B should pay higher price. Please refer to Appendix 2 for illustration.

8. A consumer spends 1% of her income on Good A and 25% on Good B. Price Elasticity of Demand should be greater for Good B. True, if the consumer spends less of her income, means that Good A is a necessity good and spends more of her income means that Good B is a luxury good. Luxuries tend to more elastic than necessities as there are more options for consumer.

9. Income elasticity for an inferior good is always negative. True, because quantity demand falls as income rises. Quantity demanded and income move opposite directions, inferior goods have negative elasticity.

10. The more inelastic the demand, the flatter the demand curve. False, inelastic demand have steeper curve because quantity demanded does not respond strongly to price changes. Please refer to Appendix 3 for illustration. For a inelastic demand product such as cigarettes, when price increase by 10%, the quantity demanded will fall by 3.8%. 11. If demand goes from P = 1850 – .05Q to P = 1700 – .05Q, Demand has increased. False. If P = 1850 – .05Q then Qd= 37000-20P and if P = 1700 – .05Q, then Qd= 34000-20P. The demand curve shift to left and hence, the demand decreases. Please refer to Appendix 4 for illustration 12. If TC goes from TC = 1250 + .5Q to TC = 1200 + .6Q, FC have gone up and VC have gone down. False, because TC=TFC+TVC. From the equation above shows that, the FC decreases leads TFC to fall from 1250 to 1200 and the VC increases leads TVC to gone up from 0.5 to 0.6. Part B (Explain in a short Essay (not more than 1 page each))

1) Define demand, discuss various determinants of demand.
Demand is the quantities of good or service that consumers are willing to buy at various prices within some given period of time. Holding all other factors constant, the price of a good or service increases as its demand increases and vice versa. When factors other than price changes, demand curve will shift. There are 5 determinants of the demand curve. First factor is price of related goods. A good or service can be related to another by being a substitute or complement. If price of a substitute changes, we expect the demand for the good under consideration to change in the same direction as the change in the substitute’s price. For instance, if the price of coffee rises, the demand for tea should increase. The complement goods are the goods that can be used together.

Price of complement and demand for the other good are negatively related. Example, if the price of sugar increases, the demand for coffee will fall. Second factor is income, as people’s income rises, it is reasonable to expect their demand for a good to increase and vice versa, the demand curve will shift right. A fall in income will lead to a decrease in demand for normal goods. Goods whose demand varies inversely with income are called inferior goods. Third determinant is future expectation. If enough, buyers expect the price of a good rises in future, the current demand will increase. Also, if consumers’ current demand will increase, they expect higher future income. For example, in 2005 housing prices rose, but people bought more because they expected the price to continue to go up. This drove prices even further, until the bubble burst in 2006 ( n.d.).

Forth factor is tastes and preferences. This is the desire, emotion, or preference for a good or service. If consumer preference is favorable change will leads to an increase in demand. Likewise, unfavorable change leads to a decrease in demand. Example, companies spend thousands on advertising to make you feel strongly that you want a product. Last determinant is number of buyer. If the number of buyers in market rises, the demand increases. For example, the housing bubble case. Low-cost mortgages increased the number of people who were told they could afford a house. The number of buyers actually increased, driving up the demand for housing. When they found they really couldn’t afford the mortgage, especially when housing prices started to fall, they foreclosed. This reduced the number of buyers, and demand also fell.

2) Briefly explain the concept of Law of diminishing returns? Discuss its assumption and importance? The law of diminishing marginal returns means that the productivity of a variable input declines as more is used in short-run production, holding one or more inputs fixed. This law has a direct behavior on market supply, the supply price, and the law of supply. The main reasons the marginal product (MP) of this variable input declines is the fixed input. The fixed input imposes a capacity constraint on short-run production. For example, in a sandwich production, the size of the sandwich-producing kitchen and equipment is fixed. The company employs additional workers, the kitchen becomes increasingly crowded. Only so many workers can use the sandwich-preparation counter to prepare sandwich.

While adding additional workers do increase total sandwich production, the extra production attributable to these workers is certain to fall as the capacity of the fixed input is limited. In fact, adding too many workers actually results in a negative marginal product, hence, total product falls. The law of diminishing marginal returns is reflected in the shapes and slopes of the total product, marginal product, and average product curves. The most important of these being the negative slope of the marginal product curve. Appendix 5 shows the graph three product curves. The total product (TP) curve shows that the total number of Sandwich Company produced per hour for a given amount of labor. The increasingly flatter slope of the TP is attributable to the law of diminishing marginal returns. Also, the marginal product curve indicates how the total production of Sandwich Company changes when an extra worker is hired. The negatively-sloped portion of the MP curve is a direct embodiment of the law of diminishing marginal returns.

Further, the average product curve indicates the average number of Sandwich Company produced by workers. The negatively-sloped portion of the AP curve is indirectly caused by the law of diminishing marginal returns. As marginal product declines, due to the law of diminishing marginal returns, it also causes a decrease in average product. 3) Explain the various economies and diseconomies of scale? Economies of scale are the cost advantages that a business can exploit by expanding the scale of production. The effect is to reduce the long run average (unit) costs of production. Economies of scale have brought down the unit costs of production and feeding through to lower prices for consumers (appendix 6). It could be achieved by buying new machinery, and build a bigger factory. There are two types of economy of scale and depending on the particular characteristics of an industry, some are more important than others.

Firstly, internal economies of scale are a product of how efficient a firm is at producing, that is specific to individual firm. Example, advantages are enjoyed by expansion. Next, external economies of scale occur outside of a firm but within an industry. Example, industry’s scope of operations expand due to better transportation network, will result a decrease in cost for a company working within industry, , external economies of scale have been achieved. Diseconomies of scale are the forces that cause larger firms to produce goods and services at increased per unit costs. The concept is the opposite of economies of scale to a situation which economies of scale no longer function for a firm. Rather than experiencing continued decreasing costs per increase in output, firms see an increase in marginal cost when output is increased (appendix 6).

When a firm expands its production scale beyond a certain level, it suffers certain disadvantages. These disadvantages are called internal diseconomies of scale. The result of these diseconomies of scale is a fall run average cost. There are a number of factors that might give rise to inefficiencies as the size of the firm grows. As the size of the firm grows beyond a certain level, organization, control and planning is needed. This makes the managerial responsibilities more difficult. Delegation of the management functions to lower personnel becomes very common. Since the lower personnel lack the adequate experience to undertake the task, it may result in low output at higher cost. All these lead to an increase in the long-run average cost.

Further, the external diseconomies of scale are beyond the control of a company increases its total costs, as output in the rest of the industry increases. The increase in costs can be associated with market prices increasing for some or all of the factors of production. For instance, high competition for labor, when there is more firms in industry, there will be increased demand for labor, making the best workers harder to keep (Keat and Young, 2009).

References n.d. DETERMINANTS OF DEMAND. [online] Available at: [Accessed: 28 Mar 2014]. Keat, P.G. and Young, P.K.Y., 2009 ‘Managerial Economics: 6th ed. Economic Tools for Today’s Decision Makers’. Pg. 266-268

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