Managerial Economics Set1 MB 0042

8/2/2019 Managerial Economics Set1 MB 0042

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Q1. What is a business cycle? Describe the different phases of abusiness cycle.

The business cycle phases define long-term pattern of changes in GrossDomestic Product (GDP) that follows four basic stages: expansion,

prosperity, contraction, and recession. After a recessionary phase, theexpansionary phase starts again.

The business cycle phases are characterized by changing employment,industrial productivity, and interest rates. Stock analysts believe thatstock prices lead the business cycle phases. This economic cycle providesthe strategic framework for business activity and investing. Moreover, thebusiness cycle phases affect employees, employers and investors.

A business cycle is identified as a sequence of four phases:

Expansion Phase: The economy is strong, people are employed andmaking money. Demand for goods -- food, consumer appliances,electronics, services -- increases to the point where it outstripssupply. This demand fuels a rise in prices, or inflation.

Prosperity Phase: As prices increase, people ask for higher wages.Higher employment costs translate into higher prices for goods,fueling an upward spiral effect.

Contraction Phase: When prices get too high, consumers andcompanies curtail their spending, as goods and services are tooexpensive. This decreases demand. When demand decreases,companies cut expenses that includes laying off workers, since theydo not need to make as many goods or provide as much service.

Recession Phase: Decreasing demand fuels declining prices,declining GDP, and rising unemployment. This means the economyis in a recession.

Expansion Phase begins again: Lower prices eventually spursdemand. As demand picks up, people begin buying again, fuelingthe need for greater supply, expansion of credit, new jobs and agrowing economy.

When the business cycle doesn't run as expected, it can have

consequences that can be as disastrous as the Great Depression. That'swhy governments intervene to try to manage the economy. If it appearsthat inflation is rising too quickly, the Federal Reserve (the central bank ofthe U.S. charged with handling monetary policy) may decide to raiseinterest rates to curtail price increases. On the other hand, if the economyis performing poorly, the government may lower taxes to spurconsumption and investment and the Federal Reserve may lower interestrates to reduce the cost of borrowing.

Interest rates and the yield curve play a very important role indetermining economic activity, the phases of the business cycle and the

performance of the stock market. Higher interest rates increase the coststo businesses and individuals. Companies must pay more to borrow
http://www.smartmoney.com/onebond/index.cfm?story=yieldcurvehttp://www.smartmoney.com/onebond/index.cfm?story=yieldcurve


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money for capital investments or to fund daily business operations.Individuals pay more for mortgages, as well as other loans they may takeout to purchase products. Higher interest rates also increase the demandfor money to invest in bonds, competing for money to invest in the stockmarket.

The phases of the business cycle have implications for markets andinvestors. Broadly, a recession often corresponds with a sustained periodof weak stock prices, or a bear market. And a healthy, expandingeconomy that keeps inflation from rising too quickly often correspondswith a bull market, or period of sustained market growth.

Sector Rotation

Fortunately, there are investment strategies for each phase of thebusiness cycle. Sam Stovall's Sector Investing, 1996 states that differentsectors are stronger at different business cycle phases. The table below

describes this theoretical model showing the phases of the business cycle.

Phase:ConsumerExpectations:IndustrialProduction:Interest Rates:Yield Curve:

Full RecessionRevivingBottoming OutFallingNormal

Early RecoveryRisingRisingBottoming OutNormal (Steep)

Full RecoveryDecliningFlatRising Rapidly(Fed)Flattening Out

Early RecessionFalling SharplyFallingPeakingFlat/Inverted

The graph below, courtesy ofStockCharts.com, shows these relationshipsand the alignment of the key sectors as they respond to the businesscycle. The stock market cycle tends to precede the business cycle by sixmonths on average, as investors try to anticipate when the market willrespond to changes in the economy. This means investors are more likelyto beat the market, if they invest in the sectors that line up with thecurrent and next phase of the business cycle.

Sector Rotation Model:
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Legend: Market CycleEconomic Cycle

As shown above the stock market is a leading indicator of the economic orphases of the business cycle. Since the market leads the economy,

investors need to pay particular attention to the early signs of a change ineach phase of the business cycle.

Many people believe that GDP is the primary indicator of the businesscycle. The National Bureau of Economic Research (NBER) gives relativelylow weight to GDP as a primary business cycle indicator, since the GDP issubject to frequent revisions after the fact. In addition, it is only reportedon a quarterly basis. The NBER is the official organization that defineswhen the U.S. is in a recession and when it comes out of one.

The NBER relies on indicators that are reported monthly to identify the

business cycle phases including:

Employment, especially new unemployment claims; Personal income; Industrial production; Sales in key sectors such as housing, autos, durable goods and

retail sales; Interest rates and the yield curve; and Commodity prices.

By following these indicators carefully, investors can anticipate when toexpect changes in the business cycle. These indicators tend to changetheir trajectory over several months, giving investors ample time toidentify a change in the trend. If you believe a change in the phase of thebusiness cycle is underway then it is time to close out sectors that will goout of favor and start new positions in sectors that will come into favour.This strategy will position you to beat the market using the phases of thebusiness cycle as a guide.

Our stock market strategy begins with an understanding of where we arein the the business cycle. Assessing the business cycle phases is the first

of five steps in our stock market strategy that we use to beat the market.

Q2. What is monetary policy? Explain the general objectives andinstruments of monetary policy

Monetary policy is the process by which the monetary authority of acountry controls the supply of money, often targeting a rate of interest forthe purpose of promoting economic growth and stability.[1] [2] The officialgoals usually include relatively stable prices and low unemployment.

Monetary theory provides insight into how to craft optimal monetarypolicy. It is referred to as either being expansionary or contractionary,
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where an expansionary policy increases the total supply of money in theeconomy more rapidly than usual, and contractionary policy expands themoney supply more slowly than usual or even shrinks it. Expansionarypolicy is traditionally used to try to combat unemployment in a recessionby lowering interest rates in the hope that easy credit will enticebusinesses into expanding. Contractionary policy is intended to slow

inflation in hopes of avoiding the resulting distortions and deterioration ofasset values.

Goals of Monetary policy

The goals of monetary policy have developed with the evolution centralbanking thought and the changes in both the behaviour and performanceof different economies. There is worldwide agreement that the ultimategoals of monetary policy at present in both the developed and developingcountries are price stability and high employment rates, enhancingeconomic growth rates and controlling imbalances in external payments,

including the protection of the external purchasing power of the currencythrough maintaining relatively stable levels of exchange rates. Thesegoals, though interrelated by their nature, may be contradictory. Thisexplains the importance of co-ordination among different economicpolicies on the one hand, and the importance of diagnosing the economicproblem before taking appropriate treatment measures on the other. Thesignificance of this issue becomes evident when we stress the need toapply rational monetary policies, particularly with regard to thepracticality of goals pursed by the monetary authorities and the possibilityof achieving these goals without economic consequences that might

aggravate economic problems.

Besides the above goals, some people believe that monetary policyshould have other important goals, such as high and stable share prices,while others would include the maintenance of low interest rates as amajor goal. Others stress increasing the efficiency of the financial systemand maintaining the soundness of the banking system. In fact, each ofthese goals has special significance and directly relates either to themonetary policy goals discussed above or to the intermediate objectivesof monetary policy, which represent the link between monetaryprocedures and the influence of these procedures on the path of economic

activity. I believe, however, that despite the differences in viewpointstowards the goals of monetary policy, the goal of increasing the efficiencyof the financial system and maintaining the soundness and stability of thebanking system should rank first. This conviction may be supported by thefact that the effects of monetary policy measures on the economy occurthrough the banking and financial systems, which makes the systemsresponse to monetary variables a very important issue. Furthermore, theincreased relative importance of deposit money makes the protection ofthe banking system and enhancing confidence in it one of the major goalsof central banks, as it means protecting the mechanism of the paymentssystem in the economy.


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Talking about the monetary policy goals as shown above should notmitigate the important role central banks may play in other economicareas, especially in the area of developing money and capital markets incountries where these markets are lacking. The development of suchmarkets will enable central banks to use one of the important instrumentsof monetary policy, i.e. open market operations.

Monetary Policy Instruments

The set of instruments available to monetary authorities may differ fromone country to another, according to differences in political systems,economic structures, statutory and institutional procedures, developmentof money and capital markets and other considerations. In most advancedcapitalist countries, monetary authorities use one or more of the followingkey instruments: changes in the legal reserve ratio, changes in thediscount rate or the official key bank rate, exchange rates and openmarket operations. In many instances, supplementary instruments are

used, known as instruments of direct supervision or qualitativeinstruments. Although the developing countries use one or more of theseinstruments, taking into consideration the difference in their economicgrowth levels, the dissimilarity in the patterns of their productionstructures and the degree of their of their link with the outside world,many resort to the method of qualitative supervision, particularly thosecountries which face problems arising from the nature of their economicstructures. Although the effectiveness of monetary policy does notnecessarily depend on using a wide range of instruments, coordinated useof various instruments is essential to the application of a rational

monetary policy.

Intermediate Objectives of Monetary Policy

The intermediate objectives of monetary policy are defined as a numberof variables linking the instruments of monetary policy with their ultimategoals. These variables are money supply, interest rates, disposable credit,the monetary base or any other variable deemed by the monetaryauthorities as an appropriate intermediate objective for monetary policy.In many instances, these objectives can be used as indicators of theeffects of the applied monetary policy. This issue, thought it is a major

pivot of the monetary policy framework, is still a subject of majorviewpoint differences among economists. While monetarists believe thatmonetary authorities must select quantitative targets for their monetarypolicy through controlling growth levels in money supply and therebyadopting mostly the monetary base approach, non-monetarists, despitetheir recognition of the importance of money, see that changes indifferent components of aggregate demand have significant impact on thelevel of economic activity and, therefore, they give basic consideration tothe adoption of price objectives through the selection of the interest rateas an intermediate objective representing a link between money andproduction.


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The monetarists choice of money supply as a target is based on a numberof hypotheses or principles. For instance, they believe that money supplyis an exogenous variable that is controllable in the long run, and that thedirection of causal relations in the exchange equation moves from moneyto prices and production. Furthermore, the strongest final effect will berepresented by high prices, given the stability in the function of demand

for money and a time lag for the effect of monetary policy, thus avoidingthe adoption of fiscal policies as a stimulus. This is a lengthy issue, and itwould not be appropriate to discuss it in detail here. We can sum up ourpoint of view as follows:

a. The selection of intermediate objectives for monetary policy shouldbe made according to the structural characteristics of the concernedeconomies and according to analytical studies on economicbehaviour, including the demand function for money and thedirections of the general economic policy. The dispute arisingbetween monetarists and non-monetarists relates to other issues

than simply the behaviour of the monetary policy to be applied.These issues may affect the nature of the role to be played by thestate in the economy.

b. The choice of a certain intermediate objective by the monetaryauthorities does not necessarily mean that these authorities shouldadhere to that objective all the time. The objective should be reviewed inthe light of structural and behavioural changes in the economy. Further,both the prevailing economic situation and the change in the priorities ofmonetary policy objectives may provide the monetary authorities with

sufficient justification to shift from one objective to another.

c. Central banking is an art, which gives a strong reason to believe thatthe effects of monetary procedures may be transferred through severalchannels, such as the volume of disposable credit, interest rates, moneysupply and the general liquidity position in the economy. We believe thatthe estimation based on all relevant data is still the best approach forformulating monetary policy.

Q3. A firm supplied 3000 pens at the rate of Rs 10. Next month,due to a rise of in the price to 22 rs per pen the supply of the firm

increases to 5000 pens. Find the elasticity of supply of the pens.

Price elasticity of demand is a ratio of two pure numbers, the numerator isthe percentage change in the quantity demanded and the denominator isthe percentage change in price of the commodity. It is measured by thefollowing formula:

Ep = Percentage change in quantity demanded/ Percentage changed inprice

Applying the provided data in the equation: Percentage change in quantity

demanded = (5000 3000)/3000Percentage changed in price = (22 10) / 10 Ep = ((5000 3000)/3000) / ((22 10)/10) = 1.2


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Q4. Give a brief description of

a. Implicit and explicit cost

b. Actual and opportunity cost

Implicit and Explicit cost

Explicit costs

are those costs which are in the nature of contractual payments and arepaid by an entrepreneur to the factors of production [excluding himself]inthe form of rent, wages, interest and profits, utility expenses, andpayments for raw materials etc. They can be estimated and calculatedexactly and recorded in the books of accounts.

Implicit or imputed costs

are implied costs. They do not take the form of cash outlays and as suchdo not appear in the books of accounts. They are the earnings of owneremployed resources. For example, the factor inputs owned by theentrepreneur himself like capital can be utilized by him or can be suppliedto others for a contractual sum if he himself does not utilize them in thebusiness. It is to be remembered that the total cost is a sum of bothimplicit and explicit costs.

(b) Actual and opportunity cost

Actual costs

are also called as outlay costs, absolute costs and acquisition costs. Theyare those costs that involve financial expenditures at some time andhence are recorded in the books of accounts. They are the actualexpenses incurred for producing or acquiring a commodity or service by afirm. For example, wages paid to workers, expenses on raw materials,power, fuel and other types of inputs. They can be exactly calculated andaccounted without any difficulty.

Opportunity cost

Opportunity cost of a good or service is measured in terms of revenuewhich could have been earned by employing that good or service in someother alternative uses. In other words, opportunity cost of anything is thecost of displaced alternatives or costs of sacrificed alternatives. It impliesthat opportunity cost of anything is the alternative that has beenforegone. Hence, they are also called as alternative costs. Opportunitycost represents only sacrificed alternatives. Hence, they can never beexactly measured and recorded in the books of accounts. The knowledgeof opportunity cost is of great importance to management decision. They

help in taking a decision among alternatives. While taking a decision


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among several alternatives, a manager selects the best one which is moreprofitable or beneficial by sacrificing other alternatives

Q5. Explain in brief the relationship between TR, AR, and MRunder different market condition.

Revenue is the income received by the firm.There are three concepts of revenue Total revenue, Average revenueand Marginal revenue.

1. Total revenue (TR):Unit 7Total revenue refers to the total amount of money that the firmreceives from the sale of its products, i.e. .gross revenue.In other words, it is the total sales receipts earned from the sale of itstotaloutput produced over a given period of time. We may show total revenueasa function of the total quantity sold at a given price as below.

TR = f(q). It implies that higher the sales, larger would be the TR Thus, TR= PXQ. For e.g. a firm sells 5000 units of a commodity at the rate of Rs. 5per unit, then TR would beTR = P x Q = 5 x 5000 = 25,000.00.YTR0SalesX2. Average revenue (AR)Average revenue is the revenue per unit of the commodity sold. It can

be obtained by dividing the TR by the number of units sold. Then,AR = TR/Q AR = 150/15= 10.Thus average revenue means price. Since the demand curve shows therelationship between price and the quantity demanded, it also representsthe average revenue or price at which the various amounts of acommodityare sold, because the price offered by the buyer is the revenue fromseller spoint of view. Therefore, average revenue curve of the firm is the sameas demand curve of the consumer.Therefore, in economics we use AR and price as synonymous except in

the context of price discrimination by the seller. Mathematical y P = AR.


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3. Marginal Revenue (MR)Marginal revenue is the net increase in total revenue realized from sellingone more unit of a product. It is the additional revenue earned by sellingan additional unit of output by the seller.

Suppose a firm is selling 4 units of the output at the price of Rs.14 perunit.Now if it wants to sell 5 units instead of 4 units and thereby the price oftheproduct falls to Rs.12 per unit, then the marginal revenue wil not be equaltoRs.12 at which the 5th unit is sold. 4 units, which were sold at the price ofRs.14 before, wil al have to be sold at the reduced price of Rs.12 and thatwil mean the loss of 2 rupees on each of the previous 4 units. The totallosson the previous units will be equal to Rs.8. Therefore, this loss of 8 rupees

should be deducted from the price of Rs.12 of the 5th unit whilecalculatingthe marginal revenue. The marginal revenue in this case, therefore, willbeRs.12 Rs.8 =Rs.4 and not Rs.12 which is the average revenue.Marginal revenue can also be directly calculated by finding out thedifference between the total revenue before and after selling theadditionalunit of the product.Total revenue when 4 units are sold at the price of Rs.14 = 4 X 14 = Rs.56

Total revenue when 5 units are sold at the price of Rs.12 = 5 X 12 = Rs.60Therefore, Marginal revenue or the net revenue earned by the 5th unit =60-56 = Rs.4.Thus, Marginal revenue of the nth unit = difference in total revenue inincreasing the sale from n-1 to n units orMarginal revenue = price of nth unit minus loss in revenue on previousunitsresulting from price reduction.The concept is important in micro economics because a firm's optimaloutput (most profitable) is where its marginal revenue equals its marginal

cost i.e. as long as the extra revenue from selling one more unit is greaterthan the extra cost of making it, it is profitable to do so.It is usual for marginal revenue to fall as output goes up both at the levelofa firm and that of a market, because lower prices are needed to achievehigher sales or demand respectively.

MR = TR = where TR represents change in TR Q

And Q indicates change in total quantity sold.Also MR = TRn TRn-1

Marginal revenue is equal to the change in total revenue over the changein quantity.


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Marginal Revenue = (Change in total revenue) divided by (Change insales)There is another way to see why marginal revenue will be less than pricewhen a demand curve slopes downward. Price is average revenue. If thefirm sells 4 units for Rs.14, the average revenue for each unit is Rs.14.00.But as seller sells more, the average revenue (or price) drops, and this

can only happen if the marginal revenue is below price, pulling theaverage down.If one knows marginal revenue, one can tell what happens to totalrevenue ifsales change. If selling another unit increases total revenue, the marginalrevenue must be greater than zero. If marginal revenue is less than zero,then selling another unit takes away from total revenue. If marginalrevenueis zero, than selling another does not change total revenue. Thisrelationshipexists because marginal revenue measures the slope of the total revenue

curve.Relationship between Total revenue, Average revenue and MarginalRevenue conceptsIn order to understand the relationship between TR, AR and MR, we canprepare a hypothetical revenue schedule.Relationship between AR and MR and the nature of AR and MR curvesunder difference market conditions1. Under Perfect MarketUnder perfect competition, an individual firm by its own action cannotinfluence the market price. The market price is determined by the

interactionbetween demand and supply forces. A firm can sell any amount of goodsat the existing market prices. Hence, the TR of the firm would increaseproportionately with the output offered for sale. When the total revenueincreases in direct proportion to the sale of output, the AR would remainconstant. Since the market price of it is constant without any variation dueto changes in the units sold by the individual firm, the extra output wouldfetch proportionate increase in the revenue. Hence, MR & AR will beequalto each other and remain constant. This will be equal to price.Under perfect market condition, the AR curve wil be a horizontal straightline and parallel to OX axis. This is because a firm has to sell its product at

the constant existing market price. The MR cure also coincides with theARcurve. This is because additional units are sold at the same constant pricein the market.2. Under Imperfect MarketUnder all forms of imperfect markets, the relation between TR, AR, andMRis different. This can be understood with the help of the followingimaginaryrevenue schedule.


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Q6. Distinguish between a firm and an industry. Explain theequilibrium of a firm and industry under perfect competition.

Monopolistic competitionAn industry in monopolistic competition is one made up of a large numberof small firms who produce goods which are only slightly different from

that of all other sellers. It is similar to perfect competition with freedom ofentry and exit for firms and any supernormal profits earned in the short-run will be competed away in the long-run as new firms enter the industryand compete away the profits.Short Run Equilibrium

Short-run equilibrium of the firmunder monopolistic competition. The firm maximizes its profits andproduces a quantity where the firms marginal revenue (MR) is equal to itsmarginal cost (MC). The firm is able to collect a price based on theaverage revenue (AR) curve. The difference between the firms average

revenue and average cost, multiplied by the quantity sold (Qs), gives thetotal profit.Long Run Equilibrium

Long-run equilibrium of the firm under monopolistic competition. The firmstill produces where marginal cost and marginal revenue are equal;however, the demand curve (and AR) has shifted as other firms enteredthe market and increased competition. The firm no longer sells its goodsabove average cost and can no longer claim an economic profit.b) Perfect Competition is a more desirable market form than monopolisticcompetition. Discuss.
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Perfect competition is considered as the ideal or the standard againstwhich everything is judged. Perfect competition is characterised ashaving:Many buyers and sellers. Nobody has power over the market.Perfect knowledge by all parties. Customers are aware of all the productson offer and their prices.

Firms can sell as much as they want, but only at the price ruling. Thussellers have no control over market price. They are price takers, not pricemakers.All firms produce the same product, and all products are perfectsubstitutes for each other, i.e. goods produced are homogenous.There is no advertising.There is freedom of entry and exit from the market. Sunk costs are few, ifany. Firms can, and will come and go as they wish.Companies in perfect competition in the long-run are both productivelyand allocatively efficient.In perfect competition, the market is the sum of all of the individual firms.

The market is modelled by the standard market diagram (demand andsupply) and the firm is modelled by the cost model (standard average andmarginal cost curves). The firm as a price taker simply takes and chargesthe market price (P* in Figure 1 below). This price represents theiraverage and marginal revenue curve. Onto this we superimpose themarginal and average cost curves and this gives us the equilibrium of thefirm.Firms in equilibrium in perfect competition will make just normal profit.This level of profit is just enough to keep them in the industry and sinceprofits are adequate they have no incentive to leave.

Normal profitsNormal profit is the level of profit that is required for a firm to keep theresources they are using in their current use. In other words it is enoughprofit to keep them in the industry. Anything in excess of normal profits iscalled abnormal or supernormal profits.Any profit above normal profit is a bonus for the firms, as it is more thanthey need to keep them in the industry. We call this supernormal (orabnormal) profit. However, this supernormal profit will be a signal to otherfirms and will attract more firms into the industry. If firms are makingconsistently below normal profits then they will choose to leave theindustry.


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Managerial Economics Set1 MB 0042

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