AIMA PGDM GMO4 Managerial Economics Assignment Solutions including Case Study
GM 04 Managerial economics assignment AIMA PGDM
1. What are the key points in short run production functions that delineate the three stages of production? Explain the relationship between the law of diminishing return and three stages of production.
Short run production function studies the effect on output due to change in variable input, assuming no change in other factors. As there is change in variable input only, the ratio between different inputs tends to change at different levels of output. This relationship is explained by the slopes, shapes, and interrelationships of the total, marginal, and average product curves. It shows the nature of rate of change in output due to a change in only one variable factor of production
Key points in short run production functions that delineate the three stages of production
The key points in short run production functions that delineate the three stages of production are slopes, shapes, and interrelationships of the total, marginal, and average product curves.
The total product curve is a reflection of the firm’s overall production and is the basis of the two other curves. The average product curve is the quantity of the total output produced per unit of a "variable input," such as hours of labor. The marginal product curve is slightly different: It measures the change in product output per unit of variable input. For example, if the average curve depicts the number of units produced based on an overall number of employees, the marginal curve would show the number of additional units produced if one more employee is added.
Since both average and marginal products are derived from total product, the average and marginal product curves are closely related to the total product curve. The input-output relationship showing total, average and marginal productivity can be divided into three stages of production and a set of product curves is presented in the diagram. The variable input in this example is labor and the fixed factor is capital.
[RBL Academy provides coaching, home tuition and online tuition for XI & XII all subjects such as Accountancy, Business Studies, Economics, English, sociology, psychology and other specific subjects as per the requirements of coaching, Home tuition continuously provide them study materials and other course specific materials for their best results in their subjects. ]
Stage I
The total product curve has a positive slope.
TP increases at increasing rate increasing and MP also increases.
Marginal product is greater than average product. Marginal product initially increases then decreases until it is equal to average product at the end of Stage I.
Average product is positive and the average product curve has a positive slope.
Stage II
The three product curves reveal the following patterns in Stage II.
The total product curve has a decreasing positive slope. In other words, the slope becomes flatter with each additional unit of variable input.
Marginal product is positive and the marginal product curve has a negative slope. The marginal product curve intersects the horizontal quantity axis at the end of Stage II.
Average product is positive and the average product curve has a negative slope. The average product curve is at its a peak at the onset of Stage II. At this peak, average product is equal to marginal product.
TP increases at decreasing rate and MP falls. This phase ends when MP becomes zero and TP reaches its maximum point:
Stage III
The total product curve has a negative slope. It has passed its peak and is heading down.
Marginal product is negative and the marginal product curve has a negative slope. The marginal product curve has intersected the horizontal axis and is moving down.
Average product remains positive but the average product curve has a negative slope.
TP starts decreasing and MP not only falls, but also becomes negative.
Relationship between the law of diminishing return and three stages of production.
Law of diminishing returns states that as more and more of the factor input is employed, all other input quantities remaining constant, a point will finally be reached where additional quantities of varying input will produce diminishing marginal contributions to total product. It states that marginal product diminishes when proportion between variable and fixed factors increase beyond a point.
Three stages of production in short run is an extension to Law of Diminishing Returns as it also considers the phase of rising MP in addition to falling MP. The common element between both is that MP is bound to decrease sooner or later with increase in units of variable factor.
Short-run production Stage I arise due to increasing average product. As more of the variable input is added to the fixed input, the marginal product of the variable input increases. Most importantly, marginal product is greater than average product, which causes average product to increase. This is directly illustrated by the slope of the average product curve.
In Stage II, short-run production is characterized by decreasing, but positive marginal returns. As more of the variable input is added to the fixed input, the marginal product of the variable input decreases. Stage two is the period where marginal returns start to decrease. Each additional variable input will still produce additional units but at a decreasing rate. This is because of the law of diminishing returns: Output steadily decreases on each additional unit of variable input, holding all other inputs fixed.
Stage III of production function results due to negative marginal returns. In this stage of short-run production, the law of diminishing marginal returns causes marginal product to decrease so much that it becomes negative. Stage III production is most obvious for the marginal product curve, but is also indicated by the total product curve. Adding more variable inputs becomes counterproductive; an additional source of labor will lessen overall production.
Diminishing returns to a factor can be understood with the help of total and marginal product curves. Total Product rises first to an increasing rate in stage I and later at a diminishing rate in stage II. At stage II, Total Product remains constant. Correspondingly when TP is rising at an increasing rate, MP and AP curves are rising; and when total product is rising at a diminishing rate, the MP and AP curves are declining. When TP becomes constant, the MP becomes zero, and additional labour beyond this level makes MP negative.
No firm will choose to operate either in Stage I or Stage III. In Stage I the marginal physical product is rising, i.e., each additional unit of the variable factor is contributing to output more than the earlier units of the factor; it is therefore profitable for the firm to keep on increasing the use of labour. In Stage III, marginal contribution to output of each additional unit of labour is negative; it is therefore, not advisable to use any additional labour. Even if cost of labour used is zero, it is still unprofitable to move into Stage III. Thus, Stage II i.e. law of diminishing return is the only important range for a rational firm in a competitive situation to operate in.
[RBL Academy provides coaching, home tuition, online tuition, project and assignment solution to XI, XII, BBA, B.COM (H), MBA & CA students from various schools, institutes and universities such as Amity University, IGNOU, CCSU, MDU, ROHTAK UNIVERSITY, D.U., G.B.T.U., M.T.U., S.M.U., P.T.U., Annamalai, Jamia, Jaypee, IILM, NIILM, U.P.T.U., Manav Rachna University, Sharda University, Lovely Professional University etc.]
RBL Academy provides BBA online tuition, B.Com Online tuition, MBA online tuition, MBA projects and assignments solution
Yes, I agree with the statement Because of economics of scale, it is sometimes more cost effective for a firm to operate a large plant at less than maximum efficiency than a small plant at maximum efficiency. Economies of scale refer to the cost savings made possible as plant size increases. A firm is said to achieve economies of scale if its long-run average costs decline as it increases the size of its plant. All costs are variable in the long run and they give rise to a long run cost curve which is roughly L-shaped. In the beginning, the LAC curve rapidly falls but after a point, the curve remains flat, or may slope gently downwards due to benefits of economies of scale are neutralized after achieving a certain level of production without reaching to its maximum production capacity.
Various reasons attributed to LAC curve to be L shaped due to which it is cost effective to produce less than maximum efficiency in a large plant than producing at maximum efficiency in a small plant include-
1. Production and Managerial costs:
In the long-run, all costs being variable, production costs and managerial costs of a firm are taken into account when considering the effect of expansion of output on average costs. As output increases, production costs fall continuously while managerial cost may rise at very large scales of output. But the fall in production costs outweighs the increase in managerial costs so that the LAC curve falls with increases in output. We analyze the behaviour of production and managerial costs in explaining the L-Shaped of the LAC Curve.
As a firm increases its scale of production, cost fell steeply in the beginning and then gradually. This is due to the technical economies of large scale production enjoyed by the firm. Initially, these economies are substantial, but after a certain level of output, when all or most of these economies have been achieved, the firm reaches the minimaloptimal scale or minimum efficient scale (MES). Given the technology of the industry, the firm can continue to enjoy some technical economies at outputs larger than the MES for the following reasons.
(a) From further decentralization and improvement in skills and productivity of labour.
(b) From lower repair costs after the firm reaches a certain size; and
(c) By itself producing some of the materials and equipment cheaply which the firm needs instead of buying them from other firms.
In modern firms, for each plant there is a corresponding managerial set-up for its smooth operation. There are various levels of management, each having a separate management technique applicable to a certain range of output. Thus, given a managerial setup for a plant, its managerial costs first fall with the expansion of output and it is only at a very large scale of output, they rise very slowly.
In summary, production costs fall smoothly at very large scales, while managerial costs may rise slowly at very large scales of output. But the fall in production costs more than offsets the rise in managerial costs so that the LAC curve falls smoothly or becomes flat at very large scales of output, thereby giving rise to the L-shape of the LAC curve
Each SAC curve includes production costs, managerial costs, other fixed costs and a margin for normal profits. Each scale of plant is subject to a typical load factor capacity so that points A, B and C represent the minimal optimal scale of output of each plant. By joining all such points as A, B and C of a large number of SACs, we trace out a smooth and continuous LAC curve.
2. Technical progress:
The L-shape of the LAC curve due to technical progress can be explained using below figure:
Suppose the firm is producing 0Q1 output on LAC1 curve at per unit cost of 0C1 output on LAC1 curve at a per unit cost of 0C1. If there is an increase in demand for the firm's product to 0Q2, with no change in technology, the firm will produce 0Q2 output along the LAC1 curve at per unit cost of 0C'. If, however, there is technical progress in the firm, it will install a new plant having LAC2 as the long-run average cost curve. On this plant, it produces 0Q2 output at a lower cost 0C2 per unit. Similarly, if the firm decides to increase its output to 0Q3 to meet further rise in demand, technical progress may have advanced to such a level that it installs the plant with the LAC3 curve. Now it produces 0Q3 output at a still lower cost 0C3 per unit. If the minimum points, L, M and N of these U-shaped long-run average cost curves LAC1, LAC2 and LAC3 are joined by a line, it forms an L-shaped gently sloping downward curve LAC.
3. Learning:
Yet another reason for the L-shaped long-run average cost curve is the learning process. Learning is the product of experience. If experience in this context can be measured by the amount of a commodity produced, then higher the production is, the lower it is per unit cost. The consequences of learning are similar to increasing returns. First, the knowledge gained from working on a large scale cannot be forgotten. Second, learning increases the rate of productivity. Third, experience is measured by the aggregate output produced since the firm first started to produce the product. Learning by doing has been observed when firm starts producing new products. After they have produced the first unit, they are able to reduce the time required for production and thus reduce per unit cost. Growing experience with making the product leads to falling costs as more and more of it is produced. When the firm has exploited all learning possibilities, costs reach a minimum level.
Thus the LAC curve is L-shaped due to learning by doing.
The planning of the plant (or the firm) consists of deciding the size of the fixed and indirect factors which determine the size of the plant, because they set limits to its production capacity. Direct factors such as labour and raw materials are assumed not to set limit on size; the firm can acquire them easily from the market without any time lag. The business man will start his planning with a figure for the level of output which he anticipates selling, and he will choose the size of plant which allows him to produce this level of output more efficiently, and with the maximum flexibility, the business man will want to be able to meet seasonal and cyclical fluctuations in his demand. Reserve capacity will give the business man greater flexibility for repairs of broken down machinery without disrupting the smooth flow of the production process.
The entrepreneur will want to have more freedom to increase his output if demand increases. All businessmen hope for growth. In view of anticipated increase in demand, the entrepreneur builds some reserve capacity because he would not like to let all new demand go to his rivals as this may endanger his future hold in the market. It also gives him some flexibility for minor alterations of his product, in view of changing tastes of customers.
Technology usually makes it necessary to build into the plant some reserve capacity. Some basic types of machinery (e.g. a turbine) may not be technically fully employed when combined with other small types of machines in certain numbers. More of which may not be required, given the specific size of the chosen plant. Furthermore, some machinery may be so specialized as to be available only on order, which takes time. In this case, such machinery will be bought in excess of the minimum requirement at present numbers, as a reserve.
Some reserve capacity will always be allowed in the land and buildings, since expansion of operations may be seriously limited if new land or new buildings have to be acquired. Finally, there will be some reserve capacity on the organizational and administrative level. The administrative staff will be hired at such numbers as to allow some increase in the operations of the firm.
In summary, the businessman will not necessarily choose the plant which will give him the lowest cost, but rather, that equipment which will allow him the greatest possible flexibility for minor alterations of his product or his technique of production.
Contact RBL Academy for BBA online tuition, B.Com Online tuition, MBA online tuition, MBA projects and assignments solution
3. Explain the following concepts with suitable example.
Opportunity cost refers to highest valued alternative forgone whenever a choice is made. It is the loss of potential gain from other alternatives when one particular alternative is chosen over the others.
As a representation of the relationship between scarcity and choice, the objective of opportunity cost is to ensure efficient use of scarce resources. It incorporates all associated costs of a decision, both explicit and implicit. Opportunity cost also includes the utility or economic benefit an individual lost; it is indeed more than the monetary payment or actions taken. As an example, to go for a walk may not have any financial costs imbedded to it. Yet, the opportunity forgone is the time spent walking which could have been used instead for other purposes such as earning an income. Concept of opportunity cost can be well understood with the help of following example-
Mr. X is the owner of a small grocery store in a busy section of Mumbai. Adam’s annual revenue is Rs. 20, 00,000 and his total explicit cost (Adam pays himself an annual salary of $3, 00,000) is Rs.15,00,000 per year. A supermarket chain wants to hire Adam as its general manager for Rs. 6, 00,000 per year. In this case, the opportunity cost to Mr. X of owning and managing the grocery store is the Rs.6,00,000 in forgone salary that he might have earned had he decided to work as general manager for the supermarket chain.
Opportunity cost can be of two types-
Sometimes referred to as out-of-pocket expenses, explicit costs are “visible” in the sense that they are direct payments for factors of production. Explicit costs are visible expenditures associated with the procurement of the services of a factor of production Operation and maintenance costs such as Wages paid to workers, overhead, materials and rental payments, Land and infrastructure costs are examples of explicit costs.
For instance, if a person leaves work for an hour and spends Rs. 200 on office supplies, then the explicit costs for the individual equates to the total expenses for the office supplies of Rs. 200. If a printer of a company malfunctions, then the explicit costs for the company equates to the total amount to be paid to the repair technician.
Implicit costs are “invisible” in the sense that no direct monetary payments are involved. They are the value of any forgone opportunities. Implicit costs, however, may be made explicit. Implicit costs represent the value of resources used in the production process for which no direct payment is made. This value is generally taken to be the money earnings of resources in their next best alternative employment. When a computer software programmer quits his or her job to open a consulting firm, the forgone salary is an example of an implicit cost. When the owner of an office building decides to open a hobby shop, the forgone rental income from that store is an example of an implicit cost. When a housewife decides to redeem a certificate of deposit to establish a day-care center for children, the forgone interest earnings represent an implicit cost. Examples of implicit costs regarding production are mainly resources contributed by a business owner which includes human labour, Infrastructure and time
Significance of Opportunity Cost
Opportunity cost is an inevitable part of any business activity since it triggers the process of decision making. Major reasons for which any business needs to determine the opportunity cost are as follows:
Opportunity cost provides support for making an appropriate choice while selecting one out of many available alternatives.
Based on the expenses incurred in the procurement of any goods or services along with the cost which may have been committed to acquiring alternative options, the price of the products or services is determined.
· Efficient Resource Allocation
It helps in investing the resources in the right opportunity by analysing the opportunity cost of all the alternatives.
In organisations, it played a crucial role in determining the expected value an employee would create for the organisation. It is acquired after his/her comparison to the other alternatives available, and thus, personnel remuneration is considered accordingly.
According to this principle, if a decision affects costs and revenues in long-run, all those costs and revenues must be discounted to present values before valid comparison of alternatives is possible. This is essential because a rupee worth of money at a future date is not worth a rupee today. Money actually has time value. Discounting can be defined as a process used to transform future dollars into an equivalent number of present dollars.
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, we are offered a choice of Rs. 1,000 today or Rs. 1,000 next year. Naturally, we will select Rs. 1,000 today. That is true because future is uncertain. Let us assume we can earn 10 per cent interest during a year. We 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. Discount rates are used to compress a stream of future benefits and costs into a single present value amount. Thus, present value is the value today of a stream of payments, receipts, or costs occurring over time, as discounted through the use of an interest rate. Present value calculations of benefits and costs are then compared to determine benefit-cost ratios. For example, if the present value of all discounted future benefits of a restoration project is equal to $30 million and the discounted present value of project costs totals $20 million, the benefit-cost ratio would be 1.5 ($30 million / $20 million), and the net benefit would be $10 million ($30 million — $20million). Any benefit-cost ratio in excess of 1.0 or net benefit above 0.0 demonstrates positive economic returns to society. Note that values used for benefit-cost analysis are often amortized over the project time horizon, yielding annualized benefits and costs. This practice allows for comparison of projects with different timeframes. The formula of computing the present value is given below:
V = A/1+i
where:
V = Present value
A = Amount invested suppose Rs. 100
i = Rate of interest supposed to be 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
= 100/ 1.052 = Rs. 90.70
For n years V = A/ (1+i) n
Discounting reflects how individuals value economic resources. Empirical evidence suggests that humans’ value immediate or near-term resources at higher levels than those acquired in the distant future. Thus, discounting has been introduced to address the issues raised by the existence of this phenomenon, which is known as time preference. Time preference is of significant interest to economists but the weight it is given depends on the discount rates used to perform present-value calculations.
Inflation is a primary reason for discounting; however, independent of inflation, discounting is an important tool for assessing environmental benefit streams. Discount rates also reflect the opportunity cost of capital. The opportunity cost of capital is the expected financial return forgone by investing in a project rather than in comparable financial securities. For example, if Rs.10 is invested today in the private capital markets and earns an annual real rate of return of 10 percent, the initial Rs.10 investment would be valued at Rs. 25.94 at the end of 10 years. Therefore, discount rates reflect the forgone interest earning potential of the capital invested in the public project.
Humans prefer near-term to future benefits. The inability to defer gratification results in decisions that are slanted toward obtaining near-term benefits, often at the cost of those available in the long-term. Regardless of whether this represents a sound policy, economic value is established based on human preferences, and humans prefer near-term benefits to those that accrue in the distant future
[RBL Academy provides coaching, home tutor, online tuition, project and assignment solutions for XI, XII, BBA, B.COM, MBA, CA CPT, IPCC, Final, CS Foundation, Executive, CMA Foundation, Inter and Final]
GM 04 MANAGERIAL ECONOMICS assignment AIMA PGDM
Managerial Economics can be defined as amalgamation of economic theory with business practices so as to ease decision-making and future planning by management. Managerial Economics assists the managers of a firm in a rational solution of obstacles faced in the firm’s activities. It makes use of economic theory and concepts. It helps in formulating logical managerial decisions. The key of
Managerial Economics is the micro-economic theory of the firm. It lessens the gap between economics in theory and economics in practice. Managerial Economics is a science dealing with effective use of scarce resources. It guides the managers in taking decisions relating to the firm’s customers, competitors, suppliers as well as relating to the internal functioning of a firm. It makes use of statistical and analytical tools to assess economic theories in solving practical business problems.
Study of Managerial Economics helps in enhancement of analytical skills, assists in rational configuration as well as solution of problems. While microeconomics is the study of decisions made regarding the allocation of resources and prices of goods and services, macroeconomics is the field of economics that studies the behavior of the economy as a whole (i.e. entire industries and economies). Managerial Economics applies micro-economic tools to make business decisions. It deals with a firm.
The use of Managerial Economics is not limited to profit-making firms and organizations. But it can also be used to help in decision-making process of non-profit organizations (hospitals, educational institutions, etc). It enables optimum utilization of scarce resources in such organizations as well as helps in achieving the goals in most efficient manner. Managerial Economics is of great help in price analysis, production analysis, capital budgeting, risk analysis and determination of demand.
Managerial economics uses both Economic theory as well as Econometrics for rational managerial decision making. Econometrics is defined as use of statistical tools for assessing economic theories by empirically measuring relationship between economic variables. It uses factual data for solution of economic problems.
Managerial Economics is associated with the economic theory which constitutes “Theory of Firm”. Theory of firm states that the primary aim of the firm is to maximize wealth. Decision making in managerial economics generally involves establishment of firm’s objectives, identification of problems involved in achievement of those objectives, development of various alternative solutions, and selection of best alternative and finally implementation of the decision.
The following figure tells the primary ways in which Managerial Economics correlates to managerial decision-making.
All the economic theories, tools, and concepts are covered under the scope of managerial economics to analyze the business environment and make managerial decisions while utilizing scarce resources efficiently and effectively. Following are the major applications of managerial economics in sound business decision making process involving the best use of a firm’s scarce resources -
Demand analysis and forecasting
When a business manager decides to venture into a business, the very first thing he needs to find out is the nature and amount of demand for the product, both at present and in the future. A firm's performance and profitability depends upon accurate estimates of demand. The firm will prepare its production schedule on the basis of demand forecast. Demand analysis helps to identify the factors influencing the demand for a firm's product and thus helps a manager in business planning.
Demand analysis and forecasting thus help him in the choice of the product and in planning output levels. The main topics covered under demand analysis and forecasting are the concepts of demand, demand determinants, law of demand, its assumptions, elasticity of demand (price, income and cross elasticity), demand forecasting, etc.
Cost and production analysis
Estimation of the cost in production.
Recognizing the factors, which are causing cost to firm.
Suggests cost should be reduced for making good profits.
Production analysis deals with, Minimum cost should be spend on raw materials and maximum production should be obtained
Pricing decisions, policies and practices
Once a particular quantity of output is ready for sale, the firm has to fix its price given the conditions in the market. Pricing is a very important aspect of Managerial Economics as a firm's revenue earnings largely depend on its pricing policy. A correct pricing policy makes a firm successful, while incorrect pricing may lead to its elimination. The topics covered under this area are: price determination in various market forms such as perfect market, monopoly, oligopoly, etc., pricing methods such as differential pricing and product-line pricing, and price forecasting.
Business firms are established with the objective of making profits and it is thus the chief measure of success. For maximizing profits the firm needs to take care of pricing, cost aspects and long-range decisions, i.e., it has to evaluate its investment decisions and carry out the best policy of capital budgeting for the firm under a given set of conditions. If we know the future, profit analysis would be an easy task. However, in a world of uncertainty our expectations are not always realized, so that profit planning and measurement constitute a difficult area of Managerial Economics. The important aspects covered under this area are: nature and measurement of profit, profit policies, and techniques of profit planning like break-even analysis, cost-volume-profit analysis, etc.
Large amount of capital / money is invested in to the business and that money should be managed efficiently. Capital management involves planning and controlling of expenses. There are many problems related to capital investments which involve considerable amount of time and labor. Cost of capital and rate of return are important factors of capital management.
Study of markets is one of the important aspects of the work of a managerial economist. A manager should have clear knowledge of different markets existing in the environment. The environment is not constant and goes on changing. Thus, the manager should know clearly about perfect and imperfect markets so as to introduce the product in such markets where he can increase the sales revenue. The main aspects are perfect market, monopoly market, monopolistic market, oligopoly market, and price fixation under different market conditions.
Role of managerial economics in business decision making process
Tools of managerial economics can be used to achieve all the goals of a business organization in an cost effective and efficient manner with the motive to optimal utilization of scarce. Typical managerial decision making may involve one of the following issues:
Managerial economics assists businesses in determining pricing strategies and appropriate pricing levels for their products and services. Some common analysis methods are price discrimination, value-based pricing and cost-plus pricing.
Economists can determine price sensitivity of products through a price elasticity analysis. Some products, such as milk, are consider a necessity rather than a luxury and will purchase at most price points. This type of product is considered inelastic. When a business knows they are selling an inelastic good, they can make marketing and pricing decisions easier.
Managerial economics uses quantitative methods to analyze production and operational efficiency through schedule optimization, economies of scale and resource analyses. Additional analysis methods include marginal cost, marginal revenue and operating leverage. Through tweaking the operations and production of a company, profits rise as costs decline.
Many managerial economic tools and analysis models are used to help make investing decisions both for corporations and savvy individual investors. These tools are use to make stock market investing decisions and decisions on capital investments for a business. For example, managerial economic theory can be used to help a company decide between purchasing, building or leasing operational equipment.
Uncertainty exits in every business and managerial economics can help reduce risk through uncertainty model analysis and decision-theory analysis. Heavy use of statistical probability theory helps provide potential scenarios for businesses to use when making decisions.
[RBL Academy provides Best coaching, home tutor home tuition, online coaching classes, Project and assignment solutions for all subjects of Class 11 and 12 Accounts, Business Studies and economics. Home tuition for BBA, B.Com, MBA, CA, CS and CMA all subjects Financial management, Cost Accounting, Management Accounting, Corporate Finance, Business Statistics, Economics, Income Tax, Financial Accounting, Operation Research, Operation Management, Business Statistics, Investment Management, Security analysis and Portfolio Management, Corporate Accounting, Research methodology, Corporate tax Planning, Strategic Financial Management, Advance Cost Accounting, Financial Derivatives and all other subjects as per requirement of students are also offered.]
GM 05 Managerial economics AIMA PGDM assignment
Monopolistic competition is a market situation in which there are many sellers of a particular product but the product of each seller is in some way differentiated in the minds of consumers from the product of every other seller.
Features of a Monopolistic Competition
In Monopolistic Competition, a buyer can get a specific type of product only from one producer. In other words, there is product differentiation.
The firms have to incur selling expenses since there is product differentiation.
There is a large number of sellers with inter-dependent demand and supply conditions. Sellers are price-makers and the demand curve for the product of an individual seller is downward sloping. The demand is not perfectly elastic.
The firm can improve or deteriorate the quality of its products too. Improving the quality helps in increasing the demand and price of the product. On the other hand, deteriorating the quality helps reduce the average cost of production.
The firms compete for inputs too. Also, they need to operate within a given technological range. Therefore, no firm can produce a better quality product at a lower average cost.
Firms are expected to know its demand and cost conditions. Further, they must use this knowledge to maximize its expected profit income.
Any firm can leave the group of firms belonging to a specific product group. Also, new firms can enter the group and produce close substitutes of the existing products in the group. This ensures that no firm incurs losses or earns super-normal profits.
In Monopolistic Competition, every firm must pursue the goal of profit maximization.
It is assumed that all firms in this market structure have identical cost and demand conditions.
Monopolistic competition and Product differentiation
Yes, Product differentiation is an outcome of monopolistic competition or vice-versa as monopolistic competition is the market structure which combines typical features of monopoly and perfect competition. Similar to perfect competition there are many small firms in the market. Their decisions are assumed to be not interdependent. There is free entry of firms to the market with monopolistic competition. But due to product differentiation each firm behaves like a monopolist at its narrow segment of an aggregate market of close substitutes. Each firm has market power to influence the price for its product choosing the volume of output. The distinguishing feature of monopolistic competition which makes it as a blending of competition and monopoly is the differentiation of the product. This means that the products of various firms are not homogeneous but differentiated though they are closely related to each other. Product differentiation does not mean that the products of various firms are altogether different.
They are only slightly different so that they are quite similar and serve as close substitutes of each other. When there is any degree of differentiation of products, monopoly element enters the situation. And. the greater the differentiation, the greater the element of monopoly involved in the market situation.
When there are a large number of firms producing differentiated products, each one has a monopoly of its own product but is subject to the competition of close substitutes. Since each is a monopolist and yet has competitors, there is a market situation which can be aptly described as “monopolistic competition.”
With differentiation appears monopoly and as it proceeds further, the element of monopoly becomes greater. Where there is any degree of differentiation whatever, each seller has an absolute monopoly of his own product, but is subject to the competition of more or less imperfect substitutes. Since each is a monopolist and yet has competitors we may speak of them as ‘competing monopolists’ and with peculiar appropriateness, of the forces at work as those of monopolistic competition.”
Many examples of product differentiation can be taken from market such as there are various manufacturers of toothpaste which produce different brands such as Colgate. Patanjali Dant kanti, Binaca, Forhans, Pepsodent, Signals, Neem etc. Thus, the manufacturer of ‘Colgate’ has a monopoly of producing it (nobody else can produce and sell the toothpaste with the name ‘Colgate’) but it faces competition from the manufacturers of Patanjali, Forhans, Binaca, Pepsodent etc. which are close substitutes of Colgate. A general class of product is differentiated if a basis exists for preferring goods of one seller to those of others. Such a basis for preference may be real or fancied; it will cause differentiation of the product. When such differentiation of the product exists, even if it is slight, buyers will be paired with sellers not in a random fashion (as in perfect competition) but according to their preferences.
Monopolistic competition corresponds more to the real world economic situation than perfect competition or monopoly and product differentiation pops out to keep market monopolistic as well as competitive. Thus, it can be said that product differentiation an outcome of monopolistic competition or vice-versa.
Behavior of the firm under monopolistic competition
In monopolistic competition, a firm takes the prices charged by its rivals as given and ignores the impact of its own prices on the prices of other firms.
Unlike in perfect competition, firms that are monopolistically competitive maintain spare capacity. Models of monopolistic competition are often used to model industries.
Firm’s behaviour in short run under Monopolistic competition
Like monopolies, the suppliers in monopolistic competitive markets are price makers and will behave similarly in the short-run. Also like a monopoly, a monopolistic competitive firm will maximize its profits by producing goods to the point where its marginal revenues equals its marginal costs. The profit maximizing price of the good will be determined based on where the profit-maximizing quantity amount falls on the average revenue curve. The profit the firm makes is the amount of the good produced multiplied by the difference between the price minus the average cost of producing the good.
Since monopolistically competitive firms have market power, they will produce less and charge more than a firm would under perfect competition. This causes deadweight loss for society, but, from the producer’s point of view, is desirable because it allows them to earn a profit and increase their producer surplus. Because of the possibility of large profits in the short-run and relatively low barriers of entry in comparison to perfect markets, markets with monopolistic competition are very attractive to future entrants.
Short Run Equilibrium under Monopolistic Competition:
As seen from the chart, the firm will produce the quantity (Qs) where the marginal cost (MC) curve intersects with the marginal revenue (MR) curve. The price is set based on where the Qs falls on the average revenue (AR) curve. The profit the firm makes in the short term is represented by the grey rectangle, or the quantity produced multiplied by the difference between the price and the average cost of producing the good.
Firm’s behaviour in long run under Monopolistic competition
Like monopolies, the suppliers in monopolistic competitive markets are price makers and will behave similarly in the long-run. Also like a monopoly, a monopolistic competitive firm will maximize its profits by producing goods to the point where its marginal revenues equals its marginal costs. The profit maximizing price of the good will be determined based on where the profit-maximizing quantity amount falls on the average revenue curve.
While a monopolistic competitive firm can make a profit in the short-run, the effect of its monopoly-like pricing will cause a decrease in demand in the long-run. This increases the need for firms to differentiate their products, leading to an increase in average total cost. The decrease in demand and increase in cost causes the long run average cost curve to become tangent to the demand curve at the good’s profit maximizing price. This means two things. First, that the firms in a monopolistic competitive market produce a surplus in the long run. Second, the firm is only able to break even in the long-run; it will not be able to earn an economic profit.
Long Run Equilibrium of Monopolistic Competition:
In the long run, firms in a monopolistic competitive market will produce the amount of goods where the long run marginal cost (LRMC) curve intersects marginal revenue (MR). The price is set where the quantity produced falls on the average revenue (AR) curve. The result is that in the long-term the firm will break even.
[RBL Academy provides coaching, home tuition and home tuition for XI & XII all subjects such as Accountancy, Business Studies, Economics, English, sociology, psychology and other specific subjects as per the requirements of coaching, Home tuition continuously provide them study materials and other course specific materials for their best results in their subjects.]
6. What is Oligopoly? Explain how price & output decisions are taken under the conditions of collusive.
Oligopoly is that market situation in which the number of firms is small but each firm in the industry takes into consideration the reaction of the rival firms in the formulation of price policy. The number of firms in the industry may be two or more than two but not more than 20. Oligopoly differs from monopoly and monopolistic competition in this that in monopoly, there is a single seller; in monopolistic competition, there is quite a larger number of them; and in oligopoly, there are only a small number of sellers.
1. Every seller can exercise an important influence on the price-output policies of his rivals. Every seller is so influential that his rivals cannot ignore the likely adverse effect on them of a given change in the price-output policy of any single manufacturer. The rival consciousness or the recognition on the part of the seller is because of the fact of interdependence.
2. The demand curve under oligopoly is indeterminate because any step taken by rivals may change the demand curve. It is more elastic than under simple monopoly and not perfectly elastic as under perfect competition.
3. It is often noticed that there is stability in price under oligopoly. This is because the oligopolist avoids experimenting with price changes. They know that if they raise the price, they will lose customers and if they lower it they will invite rivals to price war.
Price and Output Determination under Collusive Oligopoly:
The term 'collusion' implies to 'play together'. When firms under oligopoly agree formally not to compete with each other about price or output, it is called collusive oligopoly. The collusions can be classified into:
(A) Cartels- In cartels firms jointly fix the price and output through a process of agreement.
(B) Price leadership- In this form Collusive Oligopoly, one firm sets the price and others follow it. There is a price leader who is followed by the followers.
The firms may agree on setting output quota, or fix prices or limit product promotion or agree not to 'poach' in each other's market. The competing firms thus from a 'cartel'. The members of firms behave as if they are a single firm.
There are two forms of cartel:
1. Cartel aiming at joint profit maximization
2. Cartel aiming at sharing of the market
Each of the form of the model is discussed below:
1. Cartel aiming at joint profit maximization:
In this form of cartel the aim is to maximize joint industry profits. A central administrative agency decides total quantity to be produced, price, and allocation of output among each firm and distribution of profit among each firm.
In order to maximize joint profits central agency will apply marginal list rule i.e. equate industry marginal cost and industry marginal revenue curve.
In above figure the industry demand curve DD is consisting of two firms. Marginal cost curve (MC) is obtained by the horizontal summation of MCA and MCB. So the MR curve and MC curve which are identical. The cartel's MR curve intersects the MC curve at point E. Profits are maximized at output OQ, where MC = MR. The cartel will set a price OP, at which OQ, output will be produced and demanded. Once the allocation is done in such a way that the marginal cost of each firm is equal, i.e. MCA = MCB = MR.
The total output produced by firm A and B would be determined points EA and EB respectively. Thus firm A produce OQA and firm B produce OQB level of output.
Therefore total output is the sum of individual output of A and B i.e. OQ = OQA + OQB.
It is considered that firm A is low cost firm then firm A makes profits equal to PNML while firm B makes profit PRST. The maximum joint profit is obtained by summing the individual profit of the firm.
2. Cartel aiming at sharing of the market:
In this form of cartel members firms agree not only to a common price but also agree on the quantity which they can sell in the market. If there is are only two firms in the cartel each firm will sell half of the total market demand at that price. The quotas of market share are decided by bargaining between the firms. This is graphically shown below.
Consider two firms A and B form a cartel in industry. DD is the market demand curve and MR is the corresponding marginal revenue curve. MC curve obtained by the horizontal summation of MCA and MCB at the equilibrium point E, where MC=MR, the cartel will achieve maximum profits. The total equilibrium output will be OQ and price OP. The total output of firm A will be OQA and of firm B will be OQB.
Thus total output in the industry will be, OQ = OQA + OQB
The total output OQ is obtained by drawing a line parallel to X- axis from point E that intersect MCA at point EA and MCB at point EB. Thus each firm sells output at monopoly price OP. This is called as market sharing cartel.
Price leadership is a form of collusion in which one firm sets the price and other firms in the market follow it. Hence it is called as price leadership.
Key Assumptions:
(a) There are two firms A and B in the market.
(b) The output produced by the two firms is homogeneous.
(c) The firm 'A being the low cost firm or a dominant firm acts as a leader firm.
(d) Both of the firms face the same demand curve.
(e) Each of the two firms has an equal share in the market.
The price and output determination under price leadership is now explained with the help of the diagram below.
In above figure DD1 is the demand curve which is faced by each of the two firms. MR is the marginal revenue curve of each firm. MCA is the marginal cost of firm A and MCB is the marginal cost of firm B. It is assumed that the firm A is a low cost firm than firm B. As such the MCA lies below MCB. The leader firm using the marginalistic rule of MC = MR is in equilibrium at point E.
The firm A maximizes profits by selling output OM and setting price MP. The firm B is in equilibrium at point F where MCB = MR. The firm B maximizes profits by producing ON output and selling it at NK price. The firm B has to compete firm A in the market, if the firm B fixes the price NK per unit, it will not be able to compete with firm A which is selling goods at MP price per unit. Hence, the firm B will be compelled to follow the leader firm A. The firm B will also charge MP price per unit as set by the firm A. The firm B will also produce QM output like
Different forms of Price leadership
(1) Price Leadership by a Low-Cost Firm:
The low-cost firm in the industry in order to maximize profits sets a lower price than the profit-maximizing price of the high-cost firms. As a result, the high-cost firms will not be able to sell their product at the higher price; these high cost firms will therefore be forced to agree to fix the low price set by the low-cost firm. The low -cost firm becomes the price leader. However, the price leader i.e., the low-cost firm has to make sure that the price which it sets must yield some amount of profits to the followers.
(2) Price Leadership of the Dominant Firm:
In this form of leadership it is observed that there is one firm among the few firms in the industry which contributes a very huge proportion of the total production of the industry. This firm owing to its market share dominates the market for the product. This dominant firm which acquires the leadership exercises a profound influence over the market for that product. The other small firms are normally don’t have such influence on the market.
Attaining the leadership status, the dominant firm estimates its own demand curve and fixes a price which maximizes its own profits. The small firm who turns out to be the followers has no individual effects on the price of the product in the market. They therefore follow the dominant firm and accepting the price set by the price leader will adjust their output accordingly.
(3) Price Leadership by a Barometric Firm:
As the name suggest in this form of price leadership there is a firm which is an old, matured, experienced, largest or most prestigious firm. This firm becomes the price leader and undertakes the responsibility of a guardian to protect the interests of the other firms.
The barometric price leader assesses the changes in the market conditions with regard to the change in demand, change in production cost, competition from the related products and other similar changes and accordingly takes initiatives to meet the challenges keeping in view interest and welfare of all the firms in the industry. The followers in this from follow the barometric price leadership.
(4) Price Leadership by an Exploitative Firm (Also Termed as Aggressive PriceLeadership):
In this form of price leadership there is usually a very large or dominant firm. This particular firm takes the help of aggressive price policies in order to assume the status of the Price leader. The aggressive price leader forces the other firms in the industry accept its leadership. An exploitative firm often threatens to compete with the others firms to throw them out of market if they do not follow its leadership.
[RBL Academy provides Best coaching, home tutor home tuition, online coaching classes, Project and assignment solutions for all subjects of Class 11 and 12 Accounts, Business Studies and economics. Home tuition for BBA, B.Com, MBA, CA, CS and CMA all subjects Financial management, Cost Accounting, Management Accounting, Corporate Finance, Business Statistics, Economics, Income Tax, Financial Accounting, Operation Research, Operation Management, Business Statistics, Investment Management, Security analysis and Portfolio Management, Corporate Accounting, Research methodology, Corporate tax Planning, Strategic Financial Management, Advance Cost Accounting, Financial Derivatives and all other subjects as per requirement of students are also offered. ]
7. Explain why the demand curve facing a perfectly competitive firm is assumed to be perfectly elastic.
In a perfectly competitive market, it is assumed a firm would have a perfectly elastic demand. This is because if they increased the price, the consumers with perfect information would switch to other firms who offer the identical product. In perfect competition, we say a firm is a price taker. This means its demand curve is perfectly elastic; it has to accept the market price. A perfectly competitive industry is comprised of a large number of relatively small firms that sell identical products. Each perfectly competitive firm is so small relative to the size of the market that it has no market control; it has no ability to control the price. In other words, it can sell any quantity of output it wants at the going market price. This translates into a horizontal or perfectly elastic demand curve. It also translates in equality between price, average revenue, and marginal revenue.
The market price in a perfectly competitive market is determined by the market supply and demand curves. An individual firm in that market cannot charge more than the market price and will not charge less. So, the demand curve facing an individual firm is horizontal at the market price, that is, it is perfectly elastic.
The demand and supply curves for a perfectly competitive market are illustrated in Figure (a); the demand curve for the output of an individual firm operating in this perfectly competitive market is illustrated in Figure (b).
In a perfectly competitive market, the market demand curve is a downward sloping line, reflecting the fact that as the price of ordinary good increases, the quantity demanded of that good decrease. Price is determined by the intersection of market demand and market supply; individual firms do not have any influence on the market price in perfect competition.
Once the market price has been determined by market supply and demand forces, individual firms become price takers. Individual firms are forced to charge the equilibrium price of the market or consumers will purchase the product from the numerous other firms in the market charging a lower price.
The demand curve for an individual firm is thus equal to the equilibrium price of the market. Individual firm's equilibrium quantity of output will be completely determined by the amount of output the individual firm chooses to supply. The difference in the slopes of the market demand curve and the individual firm's demand curve is due to the assumption that each firm is small in size.
A perfectly competitive firm faces a perfectly elastic demand curve at the market price. Profits are maximized by producing the quantity at which marginal revenue equals marginal cost.
Since price equals marginal revenue for a perfect competitor, profits are maximized at the quantity of output at where price equals marginal cost. This occurs where the marginal cost curve intersects the demand curve.
The profit maximizing quantity is 15 units of output. The price is the market price of $10. The firm's average cost is $6 per unit of output. So, the firm makes a profit of $10 - $6 = $4 per unit of output. Total profits are 15 x $4 = $60.
[RBL Academy provides coaching classes, home tuition, home tutor, project and assignment solutions to XI, XII, BBA, B.COM (H), MBA & CA students from various schools, institutes and universities such as Amity University, IGNOU, CCSU, MDU, ROHTAK UNIVERSITY, D.U., G.B.T.U., M.T.U., S.M.U., P.T.U., Annamalai, Jamia, Jaypee, IILM, NIILM, U.P.T.U., Manav Rachna University, Sharda University, Lovely Professional University etc.]
Various models of managerial and behaviour theories are discussed below:
Managerial Theories of Firm Behaviour
During the mid-20th century it became common-place in the modern world for companies to be owned by a large number of individual (and institutional) shareholders. The Joint Stock Company was (and still is) the normal method for business ownership of large-scale firms. This type of ownership introduces a problem that is not relevant to owner-managed firms, namely separation of ownership from control or principals from agents. Under this type of business structure the owners (shareholders) are not the decision makers. Instead, professional managers (agents) are employed to make business decisions on behalf of the shareholders, who as a collective body have the right to replace the management but are not otherwise involved in the management of the firm.
There have been a number of managerial theories of the firm advanced to explain the nature of business objectives:
The revenue maximization hypothesis (Baumol, 1959)
The managerial discretion model (Williamson, 1964) and
The growth maximization model (Marris, 1964).
The revenue maximization hypothesis(Baumol, 1959)
Baumol (1959) developed the “Revenue Maximization Hypothesis”. This theory stated that after a minimum amount of profits have been reached firms that operate in an oligopolistic market will aim for sales revenue maximization and not profit maximization. This means that the firm will produce beyond the profit maximizing level of output. This can be tested by looking at the number of firms which have a minimum profit constraint. Baumol suggested that firms are more interested in sales for various reasons. Falling sales may make it difficult to raise finance and may offer a negative impression of the firm to potential buyers and distributors. Executive pay is often linked more closely to sales than to profits. Baumol was not suggesting that firms attempted to maximize sales because it may lead to greater market share and profits in the long run. In this model sales maximization was the ultimate objective.
The most apparent weakness of the model is that it does not address the period of time over which sales are to be maximized. It is possible that the managers of the firms in question may have wanted to maximize their short run sales, to gain market share in order to maximize their long run profits. This behaviour is not consistent with the model in question as Baumol stated that sales were the ultimate objective. The managers were not maximizing sales because of some other benefits that are linked to increased sales; a maximum level of sales was the aim. If mangers are interested in sales maximization it is likely to be because of the benefits that they gain from increased sales (power, salary, and prestige).
If mangers are interested in sales maximization it is likely to be because of the benefits that they gain from increased sales (power, salary, and prestige). If this is the case, as it is in model developed by Williamson (1964) then maximizing sales is not the ultimate objective, the objective is to gain salary, power etc. Sales maximizing is then a means of achieving your objectives and not an objective in its own right.
Bamoul (1959) developed his model to include advertising and his model predicts that a sales revenue maximizing firm will advertise, no less than, and most likely more than, a profit maximizing firm – as additional money spent on advertising will lead to more sales – the only constraint is one of minimum profit. Bamoul makes no attempt to test this assumption empirically and offers no support for the validity of the hypothesis.
The managerial discretion model(Williamson, 1964)
The managerial discretion model was based on the separation of ownership from control. Williamson (1964) hypothesised that managers of joint stock firms would have a different set of objectives from that of profit maximizing. The model started out as a marginal model, with both the price and output being determined in the traditional profit maximizing method (MR=MC). Williamson then developed the idea that managers will gain utility from discretionary expenditure on perks such as additional staff, special projects and other spending that increases costs without increasing profit.
The model was developed from a profit maximizing frame; price and output were determined by the intersection of the marginal revenue and marginal costs curves. Total costs increase as the mangers waste money, therefore, the profits left to be paid, as dividends to shareholders, are less than they would be under profit maximization. The managerial discretion model was a development of the classical model, and shares many of the same traits.
The model developed by Williamson is a mathematical equation that seeks to explain managerial behaviour. Two new variables (discretionary expenditure and staff expenditure) are added to the marginalist model. As it is impossible to model human behaviour in the most complex equation, it is also impossible with a simplified equation. The managerial discretion model, like profit maximization, fails if it is taken to literally tell how businesses set price and output, but it may still be valid at the level of managers’/businesses’ objectives.
The growth maximization model (Marris,1964).
Marris (1964) developed the theory of managerial capitalism. In this model the mangers of joint stock companies are concerned with maximizing the rate of growth of sales, subject to a share price/capital worth constraint. If the share price falls too low as a portion of the capital worth of the firm, then the firm may be subject to a take-over bid. The model states that a managerially controlled firm will opt for a higher rate of sales growth than an owner controlled firm, and that profits (profit rate) to the owners (shareholders) will be lower in a managerially controlled firm than it would be for an owner controlled firm, as profit will be retained to fund growth (new market development, product development etc). The model looks at the tradeoff between managers’ desire for a high rate of sales growth, that can offer them the opportunity to maximise their own utility (in a similar manor to Williamson’s model), and the need to offer dividends to shareholders. If managers do not offer a high enough dividend then they might lose their employment.
Managers are assumed to (be trying to) maximize the utility function U=U (Ċ, v), where Ċ and v represented, respectively, the satisfactions associated with power, prestige and salary and the security from take-over, plus stock–market approval. Ambiguity of the definition of Ċ and v represent the most apparent limitation of this model, it is difficult to test theories mathematically if the two main variables have not been clearly identified.
The models developed by Willaimson (1964) and Mariss (1964) both attempt to explain managerial behaviour with a mathematical equation. By using these models the researchers are trying to move away from the abstract simplification of the classical theory and construct a more realistic framework for analysing firm behaviour. But once some of the relevant factors are included then why not include all relevant factors? The end products are models that offer some intuitive insight into how separation of ownership form control may affect the objectives of a firm. The models fail to offer a general rule for a theory of the firm.
Behavioural Theories of the firm
These theories were given by a noble prize winner Herbert Simon in 1956. R.M. Cyert and J.E. Mareh Firms cannot maximise profits, sales etc. due to imperfections in data and incompatibility of interest of various constituent of an organisation. The firms should satisfy all the constituents of the firm comprising of the stock holders, management, employees, customers, suppliers and government. This objective is a multiple goal and it is very difficult to practice and achieve. Human beings want satisfaction not only in an absolute sense but in a relative sense as well. The different constituents of a business firms have diversified interest.
H.A. Simon’s Satisfying Behaviour Model
According the satisfying behaviour model given by Simon, managers in their business decision-making are constrained by the factors like incomplete information, imperfect data and uncertainty about the future. The management determines a ‗satisfactory aspiration level‘ on the basis of its past experience and judgment about the future uncertainty. They, therefore, seek a second best solution which is called the satisfying behaviour. The satisfactory behaviour holds that a manager will aim for:
(i) Satisfactory level of profit maximization.
(ii) Satisfactory level of cost rather than cost minimization.
If the satisfactory aspiration level is achieved easily, the expiration level is revised upwards. And if the satisfactory aspiration level is not achieved or upward as well as downward revisions, the management indulges in search behaviour to find the reasons for the deviations from the aspiration level. Simon suggests that if the satisfactory state is not achieved even by lowering the aspiration level and the search behaviour. The behaviour pattern of managers becomes that of apathy or aggression.
The model is positive in the following manner:
(i) The model explains certain real-world situation. For example, the firms generally use make-up pricing to generate reasonable profits rather resort to marginal cost pricing to maximize profits.
(ii) Model is consistent with the theory of motivation where human action is a function of derives and it terminates when derives are satisfied.
However, there are serious flaws with the theory of satisfying behaviour as given below:
(i) The model lacks correctness and complete information. It does not identify the types of information that are sought by a firm and nature of incompleteness, the information suffer from.
(ii) The model fails to appreciate the difference between information about conditions and information about changes in conditions. It is the information regarding changes in conditions that is vitally more important.
Cyert and March’s behavioural theory offirm
This model suggests that the firm attempts to achieve multiple goals and managers are content to achieve satisfactory levels of these multiple targets. The model considers firm as an ogranisational coalition consisting of various groups, each group having its aspiration level, the goals of the firms are arrived at by the process of continuous bargaining between groups of the coalition, wherein as many conflicting demands of the various groups as possible are accommodated.
According to Cyert and March there are five major goals of term as under:
(i) Production goal- is set by the production unit of the firm.
(ii) Inventory goals- is set by the inventory unit of the firm.
(iii) Salary of the market goals- is set by the sales unit of the firm.
(iv) Share of the market goals- is set by the sales unit of the firm.
(v) Profit goals- are set by the top management keeping in view the expectations of the shareholders bankers and other financial institution.
In the organization-coalition if there is a conflict of goals it needs to be overcome. Cyert and March suggests two ways in which the conflict can be avoided: Conflict may be phase out overtime in the sense that they are dealt with one by one, as they arise. Conflicts may be segregated to diffuse their impact on the whole organization. Each conflict may be localized into its respective department and decisions taken accordingly.
[RBL Academy assist these students in almost all subjects of their curriculum such as Financial Accounting, Corporate accounting, Cost & Management Accounting, Investment Management, Economics, Operation Research, statistics, Research Methodology, Marketing Management, Customer Relationship Management, financial Management, Income Tax, Indirect Tax, Company Law, Business Law, Corporate Finance, Financial Risk Management, Human Resource Management, Operation Management etc.]
Criticism of Cyert and March behvaiouraltheory:
Cyert and March are the leading exponents of the behavioural theory. Cyert and March based their theory on four actual case studies and two experimental studies conducted with hypothetical firms. It is thus, obvious that their attempt to develop a generalized behavioural theory of firm is flawed by lack of adequate empirical evidence.
Marris’ Managerial Theory of Firm:
Growth of the firm is obviously the cornerstone of corporate strategy. The goal of the firm is the maximisation of the balanced rate of growth of the firm. Marris interprets the goal as the maximisation of the rate of growth of demand for the firm‘s products and the growth of its capital supply. Marris‘s hypothesis is that, executive actions are limited by the need for management to protect itself from dismissal or take-over raids in the event of failure. Marris tried to improve upon Baumol‘s model. He offered a variation of Baumol‘s model that stressed the maximisation of growth subject to the security of management‘s position. Marris approach is also based on the fact that ownership and control of the firm is in the hands of two different set of people. Like Williamson, Marris suggests that managers have a utility function in which salary, status power; prestige and security are important variables.
Owners of the firm (shareholders) are however, more concerned about profits, market share, output etc. In other words, goals of the managers and shareholders differ from each other.
The utility function of managers (Um) and that of the owners (Uo) may, therefore, be defined as : Um = f (salaries, power, status, job security)
UO = f (Profits, market share, output, capital, public esteem).
Robin Marris believes that most of the variables entering into the utility function of managers owners are strongly correlated with a single variable- the size of the firm. He, therefore states that the managers would be mainly concerned about the rate of growth of size. Marris takes the view that the owners being interested in the growth of the firm want maximisation of growth of the supply of capital which is assumed to maximise their utility. The utility function of owners may be depicted as follows:
UO = f (gc )
Where, UO = utility of owners,
gc = rate of growth of capital.
Managers want to maximise rate of growth of the firm rather than absolute size of the firm. They believe that growth of demand for the products of the firm is an appropriate indicator of the growth of the firm. Further, salaries, status and power of managers are strongly correlated with the growth of demand. The managerial utility function can be illustrated as under:
Um = f (gD, s)
Where, Um = utility of managers.
gD = rate of growth of demand for the products of firm
s = a measure of job security.
Marris has suggested that the decision making capacity of the managerial team sets a constraint to rate of growth of demand for the products of firm. Furthermore, he argues that job security can be measured by a weighted average of the liquidity ratio, the leverage / debt ratio and the profit retention ratio which together reflect the financial policy of the firm. Marris assumes that there is a saturation level of job security. Below the saturation level marginal utility from an increase in job security is infinity while above the saturation level it is zero. With this assumption, Marris considers job security an exogenously determined constraint. The marginal utility function thus becomes.
Um = f (gD) s
Where s is the security constraint.
In Marris model, there are two constraints:
(a)The managerial team constraint
(b) The job security constraint
(a) The managerial team constraint:
Marris is of the view that the capacity of the top management is given at any one time period. Since management is a team work, hiring new managers does not expand the managerial capacity immediately. New managers take time to get integrated in the team which is extremely essential for the efficient working of the firm. Moreover, the research and development (R & D) department also sets a limit to the growth of managerial capabilities of the firm. The managerial team constraint sets limits to both the rate growth of demand for the products of the firm (gD) and the rate of growth of capital supply (gc).
(b)TheJob Security Constraint:
Managers want job security. Their desire for security is reflected in the preference for service contracts, generous retirement benefits and their dislike for policies which may result in their dismissal. Job security is assumed to be attained by pursuing a prudent financial policy which requires that the three crucial financial ratios must be maintained at optimum levels.
To judge the prudence of a financial policy, Marris proposes the concept of financial constraint which is mainly determined by the risk attitude of the top management. A risk-loving management would prefer a high value of a, while a risk averting management would prefer a low value of Marris defines “a” as the weighted average of the following three ratios:
Liquidity Ratio (a1 ) = Liquid Assets / Total Assets
Leverage Ratio (a2) = Value of Debts / Total Assets
Retention Ratio (a3) = Retained Profit / Total Assets
The low liquidity ratio, that is, the ratio of liquid assets to total assets increases the risk of solvency. Likewise, a high leverage / debt ratio, that is, the ratio of debt to value of total assets, poses the firm to a high degree risk of bankruptcy. A high retention ratio which refers to the ratio of retained profits to total profits, contributes most to the growth of the firm‘s capital.
According to Marris, managers subjectively assign weights to financial ratios and combine them into a single parameter “a”, which is called the financial security constraint. “a” is negative lineated liquidity ratio and positively to leverage / debt ratio and retention ratio. Moreover, there is a negative relation between job security (S) and the financial security constraint “a”. Thus a Low value of “a” implies that the managers are risk averters while a high value of a means that the managers are risk takers. In Marris model, the financial security constraint “a” sets a limit to growth of the supply of capital gc. (“a” is financial security management).
The managers of corporate firm aim at maximisation of their own utility which is a function of the growth of demand for the product of the firm, given the job security constraint
Um - f (gD)
The shareholders of corporates aim at maximisation of their own utility which according to Morris, is a function of the growth of the supply of capital. The firm is considered to be in equilibrium when it attains the maximum balanced rate of growth. Thus, the condition for equilibrium of the firm may be written as follows :
gD = gC = g* maximum
In order to follow the above condition for the equilibrium of the firm, it is necessary to grasp the factors that determine gD and gC.
Marris argues that the two variables, the diversification (d) and the average profit margin (m) adequately represents the factors that determine gD and gC.
Marris suggests that the corporate first decides subjectively its financial policy. In other words the firm first determines the value of the financial constraint “a” . Subsequently, the rate of diversification (d) and profit margin (m) will be chosen.
To achieve balanced growth rate would be to identify the factors that go in to determine gD and gC. According to Marris, these determines can be expressed in terms of two variables :
a)Diversification rate (d) ; and
(b) Average profit margin (m)
Both these variables can be, however determined only after the management has decided about its financial policy “a”. The diversification rate can be chosen either by changes in style of the production cost, the average profit margin would be affected by the levels of advertising and D, Higher the expenditure on advertisement (A) as well as R and D, lower would be the average profit margin (m). Thus, the Marris gave three policy variables : a, b and m.
Marris also points out that there can be a conflict between managers’ objective of maximising growth and shareholders’ objective of maximising profits. Therefore, if the growth maximising solution does not generate sufficient profits, growth rate will have to be reduced to increase given to meet shareholders expectations.
In brief, in Marris model, the management, whose actions are limited by the motivation to protect it itself dismissed or take-over bids, takes to the following course :
(a) The management must walk on a knife-edge between a debt/asset ratio high enough to stimulate growth but not low enough to suggest financial imprudence.
(b) The management must also maintain a low liquidity ratio, i.e., liquid asset/total assets. But this ratio must not be so low that it endangers paying all obligations on time.
(c) The management must try to keep a high retention ratio, viz. retained earnings/total profits. But this ratio should not be so high that shareholder are not paid satisfactory (gd) and growth rate of capital supply (g):
Max. g = gd = gc
g = balanced growth rate
gd = growth of demand for products
gc = growth of supply of capital
By this process the managers achieve maximisation of their own utility as well as that of the share-holders. In case the management wants to expand too rapidly, it runs the risk of job security. On the other hands, if it wants to expand too slowly, it would be considered as an inefficient management, again impairing job-security.
R. Marris has made a significant contribution in the form of incorporation of financial policies into the decision making process of the corporate firm. His theory suggests that although the managers and the owners have different goals, it is possible to find a solution which maximizes utility of both. Still there are certain weaknesses of the theory as under:
(i) The assumption of given production costs and a price structure is the weakness of Marris theory.
(ii) Marris theory does not explain the determination by either costs or prices.
(iii) Oligopolistic interdependence is not satisfactorily dealt with, within Marris Model.
(iv) Marris brushes aside the mechanism by which prices are determined.
(v) Marris‘s assumption that the growth of the firm is achieved mainly via the introduction of new products which will be imitated by competitors, does not hold the ground.
Thus the maximisation of the goal of balanced growth (maximise g = gd = gs) is that by jointly maximising the rate of growth of demand and capital, managers achieve maximisation of their own utility as well as utility of the shareholders.
[Class 11, 12 accounts economics BBA b.Com, MBA & CA coaching, home tuition, home tutor, home tuition, home tutor for financial management cost statistics operation research, operation management portfolio management financial management taxation]
Govt. Moves to overhaul coal sector
The government on Wednesday moved a step closer to restructure the coal sector with a proposal that could potentially benefit the power companies that have been strained by the scarcity and poor quality of coal supplied to them.
A group of Ministers (GoM) signed off on a plan to set up a coal regulator and to create a “pass-through” mechanism that would see higher costs from imported coal being passed on as increased tariffs.
The proposal is now expected to be presented to the Union cabinet for its approval on 7 June 2013. “We have been able to achieve traction and closure, pretty much, with regard to the coal regulator Bill, in terms of the formulation of different clauses and finality of its structure,” said minister of state for power Jyotiraditya Scindia. “Similarly, with regard to the pass-through mechanism for increasing supply of coal from external sources to the power sector, we have achieved closure on that mechanism structure as well.”
The proposed coal regulator will be primarily entrusted with the task of monitoring testing, quality, supply and grading of coal, but will not regulate pricing. It will, however, have an attached appellate body that will adjudicate on disputes between coal suppliers and buyers, including some pricing issues.
Finance minister P. Chidambaram said that pricing of coal would be kept out of the ambit of the coal regulator, and that it would be empowered to resolve disputes, including those arising out of fuel supply agreements with power and other downstream producers.
“There is an agreement that pricing must be left to the producer of coal, but the regulator will have powers to adjudicate on disputes relating to price, quality, supplies. All disputes will be adjudicated with the regulator and then there will be an appellate authority,” PTI had cited Chidambaram as saying.
Scindia said the proposed appellate body would have some control over pricing.
“We certainly have given a certain amount of authority to the coal regulator in certain very specified cases,” he said in response to a question if regulation of pricing was within its ambit. Besides pricing, the new body will be entrusted with the regulation of testing, quality, supply and grading of coal, Scindia said.
“It (the proposed regulator) takes into account the interest of all stakeholders within the industry, the suppliers of coal as well as the buyers of coal,” he said. “It balances and protects the interest of all stakeholders and, at the same time, gives a very judicious balance to the regulatory authority to be able to supervise the supply and demand of coal in the country.”
Both the proposals—one on the regulator and the appellate body and the other on the price pass-through mechanism—are likely to be taken up by the cabinet on 7 June, a top coal ministry official said.
Analysts and senior coal industry executives are, however, not convinced about the effectiveness of a coal regulator, especially if pricing is kept out of its remit. For one, state-owned Coal India Ltd (CIL) is a near-monopoly producer of the fuel. “It will be a nightmare, even if it is given full pricing powers. What will you regulate? It is not just a case of CIL being a monopoly player. The cost of production of varying grades of coal from different mines is different, so imagine how many permutations and combinations there will be to regulate,” said a senior CIL official who did not want to be identified.
Chintan J. Mehta, an analyst with Mumbai-based Sunidhi Securities and Finance Ltd, said that without the authority to regulate pricing, the new body will be ineffective. “Although CIL has a monopoly over pricing, a regulator, if it had the power, could have raised an objection, thereby compelling the company into changing prices. That cannot happen now,” he said.
“Having said that, various non-pricing processes will be streamlined and become transparent, as the regulator will be an independent non-political entity,” Mehta added.
On 22 April, the cabinet had rejected a proposal to pool coal prices, which is the averaging out of cheaper domestic coal with costlier imports as a means of helping those who have to depend on supplies from overseas. Instead, it had asked a ministerial panel to set up a mechanism to pass on the incremental costs due to costlier imported coal to power producers.
CIL, the world’s largest miner of coal, supplies 85% of the domestic coal demand. It has been unable to meet growing demand, especially from the power sector, and hence has been resorting to imports to meet supply obligations.
While a pass-through price structure will increase electricity tariffs for consumers, it could potentially help restore investor interest in the power sector.
Source: Article form Live Mint published: Tue, Nov 27,2012
i. What steps have been taken by government to overhaul coal sector?
Steps taken by government to overhaul sector include setting up a coal regulator and to create a “pass-through” mechanism that would see higher costs from imported coal being passed on as increased tariffs.
The proposed coal regulator will be primarily entrusted with the task of monitoring testing, quality, supply and grading of coal, but will not regulate pricing. It will, however, have an attached appellate body that will adjudicate on disputes between coal suppliers and buyers, including some pricing issues.
Pricing of coal would be kept out of the ambit of the coal regulator, and it would be empowered to resolve disputes, including those arising out of fuel supply agreements with power and other downstream producers.
There is an agreement that pricing must be left to the producer of coal, but the regulator will have powers to adjudicate on disputes relating to price, quality, supplies. All disputes will be adjudicated with the regulator and then there will be an appellate authority.
The proposed regulator takes into account the interest of all stakeholders within the industry, the suppliers of coal as well as the buyers of coal. It balances and protects the interest of all stakeholders and, at the same time, gives a very judicious balance to the regulatory authority to be able to supervise the supply and demand of coal in the country.
Without the authority to regulate pricing, the new body will be ineffective to avoid monopoly situation in coal industry in case pricing is kept out of its remit. Although CIL has a monopoly over pricing, a regulator, if it had the power, could have raised an objection, thereby compelling the company into changing prices.
Various non-pricing processes will be streamlined and become transparent, as the regulator will be an independent non-political entity.
The cost of production of varying grades of coal from different mines is different, so there will be problem of regulating multiple pricing for coal and will be tedious and time consuming in the event of keeping pricing out of ambit of coal regulator.
The major issues in coal sector relates to monopoly situation that exists in the industry and CIL produces 85 % of coal produced domestically in India.
CIL has a monopoly in the pricing strategies of coal which is required to be regulated by an independent body and it has been authorized power to work upon pricing mechanism in the industry.
Setting up a coal regulator without regulating price in the industry and authorizing regulator to keep an eye on it will be worthless.
Coal industry is predominantly considered as a monopoly industry. Since nationalization, coal gradation and coal pricing have been controlled by the Union Ministry of Coal (MOC) and/or Coal India Ltd (CIL).
Coal Pricing Till 31 December 2011
Till 31 December 2011, non-coking coal grades used to be dependent on Useful Heat Value (UHV) expressed in kcal/kg as shown in Table 1.
UHV took into account the heat trapped in ash (A) produced by burning the coal and the heat lost in removing the moisture (M) while burning the coal. Equal importance was assigned to the heat loss arising out of ash and moisture contents.
For coal with high moisture content:
UHV = 8900 – 138 (A + M) (1)
For coal with low moisture and low volatile matter (VM) content:
UHV = 8900 – 138 (A + M) – 150 (19 – VM) (2)
The value of 8,900 kcal/kg adopted as the upper limit in Equations 1 and 2 represented the maximum heat value of Indian coal determined on pure coal basis.
Coal Pricing Till January 1, 2012
For over a decade and a half, UHV linked grade-based wide band pricing system was considered outdated. It was also felt that principally this system contributed to domestic coal being priced at 50–65 per cent cheaper than the international price till 1 January 2012.
Since then, a new grade-based pricing system has been put into effect. The new grades are dependent on heat value of coal, commonly represented by Gross Calorific Value (GCV), measured and expressed in kcal/kg. Grades are uniformly spaced at an interval of 300 kcal/kg as given in Table 2.
The new pricing was aimed at making the pricing system more scientific and rational while encouraging quality assurance. Possibly, all these three attributes brought the Indian coal prices on par with international coal prices.
Under the new system, any coal with a GCV of less than 2,201 kcal/kg is considered as ungraded coal and cannot be sold per se. Non-coking coal known in international nomenclature as thermal coal because of its intrinsic heat value is, however, priced in a rather elaborate manner in all major coal producing countries. The same has been briefly discussed hereafter.
Note: - At 5% moisture level.
** => indicates mine–head prices, excluding various duties and other charges;
(#) => Through a subsequent notification price for the GCV exceeding 7,000 kcal/kg, has been notified to increase by `150/– per tonne over and above the price applicable for GCV band exceeding 6,700 but not exceeding 7,000 kcal/kg, for increase in GCV by every 100 kcal/kg or part thereof.
Prices of all other grades were downwardly revised.