Managerial Economic Assignment

QUESTION 1


How does the theory of the firm provide an integrated framework for the analysis of managerial decision making across the functional areas of business? Discuss.

[10 marks]

Theory of firms says that the objective of any firm is to maximize the shareholders wealth. Hence when any managerial decision comes into question this framework is used to make the final call. If the decision is going to increase firms wealth then the decision is taken for the work, otherwise the call is rejected.(Answered)

QUESTION 2

Profit rates differ among firms in a given industry and even more widely among firms in different industries. Please explain the factorswhich contribute to different profit rates.

10 marks]

Profit rates differ across industries and also inside a particular industry. The main reason is the margin that is available to all the firms. All industries don’t enjoy the same macro factors and hence are different on margins they can make. Finally in a particular industry the option to command margins is not same for all firms. This is because of cost structure and pricing differ for all firms.(Answered)

QUESTION 3


What is price discrimination? What are the conditions to make price discrimination effective? Discuss some examples from the Airline Industry.

[10 Marks]

Price discrimination or price differentiation exists when sales of identical goods or services are transacted at different prices from the same provider. In a theoretical market with perfect information, perfect substitutes, and no transaction costs or prohibition on secondary exchange (or re-selling) to prevent arbitrage, price discrimination can only be a feature of monopolistic and oligopolistic markets, where market power can be exercised. Otherwise, the moment the seller tries to sell the same good at different prices, the buyer at the lower price can arbitrage by selling to the consumer buying at the higher price but with a tiny discount. However, product heterogeneity, market frictions or high fixed costs (which make marginal-cost pricing unsustainable in the long run) can allow for some degree of differential pricing to different consumers, even in fully competitive retail or industrial markets. Price discrimination also occurs when the same price is charged to customers which have different supply costs.

The effects of price discrimination on social efficiency are unclear; typically such behavior leads to lower prices for some consumers and higher prices for others. Output can be expanded when price discrimination is very efficient, but output can also decline when discrimination is more effective at extracting surplus from high-valued users than expanding sales to low valued users. Even if output remains constant, price discrimination can reduce efficiency by misallocating output among consumers.

Price discrimination requires market segmentation and some means to discourage discount customers from becoming resellers and, by extension, competitors. This usually entails using one or more means of preventing any resale, keeping the different price groups separate, making price comparisons difficult, or restricting pricing information. The boundary set up by the marketer to keep segments separate are referred to as a rate fence. Price discrimination is thus very common in services, where resale is not possible. Price discrimination can also be seen where the requirement that goods be identical is relaxed

Airlines and other travel companies use differentiated pricing regularly, as they sell travel products and services simultaneously to different market segments. This is often done by assigning capacity to various booking classes, which sell for different prices and which may be linked to fare restrictions. The restrictions or "fences" help ensure that market segments buy in the booking class range that has been established for them. For example, schedule-sensitive business passengers who are willing to pay $300 for a seat from city A to city B cannot purchase a $150 ticket because the $150 booking class contains a requirement for a Saturday night stay, or a 15-day advance purchase, or another fare rule that discourages, minimizes, or effectively prevents a sale to business passengers.

Notice however that in this example "the seat" is not really always the same product. That is, the business person who purchases the $300 ticket may be willing to do so in return for a seat on a high-demand morning flight, for full refundability if the ticket is not used, and for the ability to upgrade to first class if space is available for a nominal fee. On the same flight are price-sensitive passengers who are not willing to pay $300, but who are willing to fly on a lower-demand flight (say one leaving an hour earlier), or via a connection city (not a non-stop flight), and who are willing to forgo refundability.

On the other hand, an airline may also apply differential pricing to "the same seat" over time, e.g. by discounting the price for an early or late booking (without changing any other fare condition). This could present an arbitrage opportunity in the absence of any restriction on reselling. However, passenger name changes are typically prevented or financially penalized by contract.

Since airlines often fly multi-leg flights, and since no-show rates vary by segment, competition for the seat has to take in the spatial dynamics of the product. Someone trying to fly A-B is competing with people trying to fly A-C through city B on the same aircraft. This is one reason airlines use yield management technology to determine how many seats to allot for A-B passengers, B-C passengers, and A-B-C passengers, at their varying fares and with varying demands and no-show rates.

With the rise of the Internet and the growth of low fare airlines, airfare pricing transparency has become far more pronounced. Passengers discovered it is quite easy to compare fares across different flights or different airlines. This helped put pressure on airlines to lower fares. Meanwhile, in the recession following the September 11, 2001, attacks on the U.S., business travelers and corporate buyers made it clear to airlines that they were not going to be buying air travel at rates high enough to subsidize lower fares for non-business travelers. This prediction has come true, as vast numbers of business travelers are buying airfares only in economy class for business travel.

There are sometimes group discounts on rail tickets and passes. This may be in view of the alternative of going by car together.

QUESTION 4


What should be the business strategy under:


a. Highly competitive market structure

Under a highly competitive market structure there are two options to work upon. One is to stay differentiated and stay competitive by this way and keep the market share intact by way of better and unique offering to customer. The other is to stay price competitive with competitors since the nature of market allows consumers to switch loyalty based on price changes.

b. Oligopoly

Under Oligopoly scenario since the market conditions are such that the demand is very high for products but providers are very less and the ones who are there are extremely powerful and dominating the market dynamics. The business strategy under this scenario is to create high barrier to switch and high barrier to entry thereby not letting other players enter the market and by not letting consumer switch brands easily, the more widely practiced strategy is of entry barriers.

c. Monopoly

In monopolistic setups also the business strategy of producers is not to allow new entrants to market by way of creating entry barriers like technological set-ups and by way of killing strategies which make the entrant lose money and do not allow him to run in long term. Since the players in these markets are minimal they are as big in every aspect that countering them becomes extremely difficult.

[10 Marks]

QUESTION 5


Write short notes on:


a. Cobb-Douglas production function

In economics, the Cobb–Douglas functional form of production functions is widely used to represent the relationship of an output to inputs. It was proposed by Knut Wicksell (1851–1926), and tested against statistical evidence by Charles Cobb and Paul Douglas in 1900–1928. It was later updated by Dick Boin who splitted productive assets from residential real estate.

For production, the function is

Y = ALαKβ,

where:

• Y = total production (the monetary value of all goods produced in a year)

• L = labor input

• K = capital input

• A = total factor productivity

• α and β are the output elasticities of labor and capital, respectively. These values are constants determined by available technology.

Output elasticity measures the responsiveness of output to a change in levels of either labor or capital used in production, ceteris paribus. For example if α = 0.15, a 1% increase in labor would lead to approximately a 0.15% increase in output.

Further, if:

α + β = 1,

the production function has constant returns to scale. That is, if L and K are each increased by 20%, Y increases by 20%. If

α + β < 1,

returns to scale are decreasing, and if

α + β > 1

returns to scale are increasing. Assuming perfect competition and α + β = 1, α and β can be shown to be labor and capital's share of output.

Cobb and Douglas were influenced by statistical evidence that appeared to show that labor and capital shares of total output were constant over time in developed countries; they explained this by statistical fitting least-squares regression of their production function. There is now doubt over whether constancy over time exists.

b. Diminishing returns to variable input

In economics, diminishing returns (also called diminishing marginal returns) refers to how the marginal production of a factor of production starts to progressively decrease as the factor is increased. According to this relationship, in a production system with fixed and variable inputs (say factory size and labor), each additional unit of the variable input (i.e., man-hours) yields smaller and smaller increases in outputs, also reducing each worker's mean productivity. Consequently, producing one more unit of output will cost increasingly more (owing to the major amount of variable inputs being used, to little effect).

This concept is also known as the law of diminishing marginal returns or the law of increasing relative cost.

c. Economies of scale and economics of scope

Economies of scope are conceptually similar to economies of scale. Whereas 'economies of scale' for a firm primarily refers to reductions in average cost (cost per unit) associated with increasing the scale of production for a single product type, 'economies of scope' refers to lowering average cost for a firm in producing two or more products. The term and concept development are due to Panzar and Willig (1977, 1981). Here, economies of scope make product diversification efficient if they are based on the common and recurrent use of proprietary knowhow or on an indivisible physical asset.

d. The Learning Curve

A learning curve is a graphical representation of the changing rate of learning (in the average person) for a given activity or tool. Typically, the increase in retention of information is sharpest after the initial attempts, and then gradually evens out, meaning that less and less new information is retained after each repetition.

The learning curve can also represent at a glance the initial difficulty of learning something and, to an extent, how much there is to learn after initial familiarity

e. Global economies of production

Economic globalization refers to increasing economic interdependence of national economies across the world through a rapid increase in cross-border movement of goods, service, technology and capital. It is the process of increasing economic integration between countries, leading to the emergence of a global marketplace or a single world market. Depending on the paradigm, globalization can be viewed as either a positive or a negative phenomenon.

Economic globalization comprises the globalization of production, markets, competition, technology, and corporations and industries. Whilst economic globalization has been occurring for the last several hundred years (since the emergence of trans-national trade), it has begun to occur at an increased rate over the last 20–30 years. This recent boom has been largely accounted by developed economies integrating with less developed economies, by means of foreign direct investment, the reduction of trade barriers, and the modernization of these developing cultures.

[10 Marks]