Ignou Sovled Assignment Ms09

7/30/2019 Ignou Sovled Assignment Ms09

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Q1. “The Opportunity Cost of a product is the return that can be had from the next best alterative use.” Explain this statement using Production Possibility Curve.

Answer

Decisions have opportunity costs because choosing one thing in a world of scarcity means

giving up something else. The opportunity cost is the value of the most valuable good orservices.

In another way, the opportunity cost of anything is the return that can be had from the next best alternative use. A farmer who is producing wheat can also produce potatoes with thesame factors. Therefore, the opportunity cost of a quintal of wheat is the amount of theoutput of potatoes given up. The opportunity costs are the ‘costs of sacrificed alternatives.’

Business decisions have opportunity costs, too. Do all opportunity costs show up on theprofit and loss statement? Not necessarily. In general, business accounts include onlytransactions in which money actually changes hands. By contrast, the economist always

tries to “pierce the veil of money” costs of an activity. Economist therefore includes all costswhether they reflect monetary transaction or not.

Let’s illustrate the concept of opportunity cost by considering the owner of hot dog venturethe owner puts in 60 hours a week but earns no “wages”. At the end of year, the firms earna profit of 310000 pretty good for a neophyte firm.

Or is it? The economist would insist that we should consider the value of a factor of production regardless of how the factor happens to be owned. We should count theowner’s own labor as a cost even though the owner doesn’t get paid directly but insteadreceives compensation in the form of in terms of the lost opportunities.

A careful examination might show that Hotdog ventures’ owner could find a similar andequally interesting job working for someone else and earning 60000. This represents theopportunity cost or earning forgone because the owner decided to become the unpaidowner of a small business rather than the paid employee of another firm.

Therefore, the economist continues, let us calculate the true economic profits of the hot dog firm. If we take the measured profits of 37000 and subtract the 60000 opportunity cost of the owner’s labor, we find a net loss of 23000. Hence, although the accountant might conclude that a hot dog venture is economically viable, the economist would pronouncethat the firm is an unprofitable loser.

Production possibility curve

Definition – A curve that outlines all possible combinations of total output that could beproduced assuming

1. The utilization of a fixed amount of productive resources2. Full and efficient use of those resources3. A specific state of technical knowledge



The slope of the curve indicates the rate at which one product can be traded off to producemore of the other. There are three places that we can be on the graph (not the curve but theentire graph)

A. Efficiency – these are points that lie on the curveB. Inefficiency – these are points that lie inside the curveC. Impossibility – these are points that lie beyond the curve (unless we shift the curve)

Production Possibilities Curve

This is a production possibilities curve for any two goods. Point D is beyond the range of this production possibility curve. Points B, C, and A are all possible and efficient pointsalong the production possibility curve. These three points just represent different amountsof good 1 and good 2, for which the economy is indifferent to.

Point X represents a point inside the production possibility curve. Although this point isattainable using the given resources of the economy, the economy could be better off if it used those resources fully to actually reach the production possibilities curve.

The slope of the production possibilities curve indicates the rate at which one product canbe traded off to produce more of the other. Note that point A can be reached if we shift theproduction possibilities curve outward

We can shift away from other goods that we no longer wish to consume to attempt toproduce goods that we now want (for example we can shift away from making horse andbuggies as people no longer desire them in order to make cars which allow for fastertransportation, increasing the amount of time we can spend in other endeavors

Let us take the example that the economy can produce only two goods, butter and guns.The economy can produce only guns, only butter or a combination of the two, illustrating



the tradeoffs or choice inherent in such a decision. The opportunity cost of choosing gunsover butter increases as the production of guns is increased. The reason is that someresources are relatively better suited to producing guns. The quantity of butter, which hasto be sacrificed to produce an additional unit of guns, is called the opportunity cost of guns(in terms of butter). Due to the increasing opportunity cost of guns, the PPC curve will be

concave to the origin. Increasing opportunity cost of guns means that to produce eachadditional unit of guns, more and more units of butter have to be sacrificed. The basis forincreasing opportunity costs is the following assumptions:

i) Some factors of production are more efficient in the production of butter and some moreefficient in production of guns. This property of factors is called specificity. Thus specificityof factors of production causes increasing opportunity costs.

ii) The production of the goods requires more of one factor than the other. For example, theproduction of guns may require more capital than that of butter. Hence, as more and more

of capital is used in the manufacture of guns, the opportunity cost of guns is likely toincrease.

Let us assume that an economy is at point A where it uses all its resources in theproduction of butter. Starting from A, the production of 1 unit of guns requires that ACunits of butter be given up. The production of a second unit of guns requires that additionalCD units of butter be given up. A third requires that DE be given up, and so on. SinceDE>CD>AC, and so on, it means that for every additional unit of guns more and more unitsof butter will have to be sacrificed, or in other words, the opportunity cost keeps onincreasing.

The opportunity cost of the first few units of guns would initially be low and thoseresources, which are more efficient in the production of guns move from, butter productionto gun production. As more and more units of guns are produced, however, it becomesnecessary to move into gun production, even for those factors, which are more efficient inthe production of butter. As this happens, the opportunity cost of guns gets larger andlarger. Thus, due to increasing opportunity costs the PPC is concave.



If the PPC curve were to be a straight line, the opportunity cost of guns would always beconstant. This would mean equal (and not increasing amounts of butter) would have to beforgone to produce an additional unit of guns. The assumption of constant opportunitycosts is very unrealistic. It implies that all the factors of production are equally efficient either in the production of butter or in the production of guns.

For many of the choice society make opportunity costs tend to increase as we choose moreand more of an item. Such a phenomenon about choice is so common, in fact, that it hasacquired a name: the principle of increasing marginal opportunity cost. This principlestates that in order to get more of something, one must give up ever-increasing quantitiesof something else. In other words, initially the opportunity costs of an activity are low, but they increase the more we concentrate on that activity.



Q2) Define demand function and explain the impact of price of complements and price of substitutes on demand function

Answer

The demand function sets out the variables, which are believed to have an influence on the

demand for a particular product. Various factors could determine the demand of particularproduct and they can vary for each of therm. The generic demand function which includessome of the most common variables that can affect demand can be written as:

Qd = f (Po, Pc, Ps, Yd, T, A, CR, R, E, N, 0)

The first three variables in the function relate to price.

Po= own price of the product Pc =the price of complements and

Ps =the price of substitutesYd= disposable income, that is, the amount of money available to people to spend.T= tastes of peopleA= advertisement CR= of credit R= rate of interest E= expectations.N= the number of potential customers0= any other miscellaneous factors

In the case of the own price of a good, the expected relationship would be, the higher theprice the lower the demand, and the lower the price the higher the demand.

In the case of complements, if the price of complementary goods increases, we wouldexpect demand to fall both for it and for the good that it is complementary to. This is thecase as fewer people would now wish to buy either good given that the complementarygood is now more expensive and this has the effect of reducing demand for the other goodas well. In contrast, if the price of a substitute good rises, then demand for the good that it is a substitute for would be expected to rise as people switched to buying the latter ratherthan its more expensive substitute.

The fourth variable in the demand function, Yd stands for disposable income, that is, theamount of money available to people to spend.

Higher level of disposable income = (increase) people can afford to buyThis assumption is for normal goods.

This is where the fifth variable, tastes (T), needs to be taken into account. Over a period of time, tastes may change significantly, but this may incorporate a wide range of factors. Forexample, in case of food, greater availability of alternatives may have a significant effect inchanging the national diet. Thus, in India for instance, the demand for bajra has fallen overthe past 10 years as people have switched to eating rice and wheat instead.



Social pressures may also act to alter tastes and hence demand. For example, tobaccocompanies have been forced to seek new markets as smoking has become less sociallyacceptable in the USA and Western Europe, thus reducing demand in these areas. Changesin technology may also have an impact. For example, as the demand for color televisionsincreased, the demand for black and white televisions fell as tastes changed and the latter

were deemed to be inferior goods.

Conversely, however, the higher the level of advertising of a substitute good, the lower thedemand for the good for which it is an alternative and people buy more heavily promotedgood.

The variables CR and R are also related. The former represents the availability of credit while the latter represents the rate of interest that is the price of credit. These variableswill be most important for purchases of consumer durable goods, for example cars.Someone’s ability to buy a car will depend on his or her ability to raise money to pay for it.This means that the easier credit is to obtain, the more likely they are to be able to makethe purchase. At the same time credit must be affordable, that is the rate of interest must besuch that they have the money to pay.

The letter E in the demand function stands for expectations. This may include expectationsabout price and income changes. For example, if consumers expect the price of a good torise in future then they may well bring forward their purchases of it in order to avoidpaying the higher price. This creates an increase in demand in the short term, but over themedium term, demand may fall in response to the higher price charged. The firm will needto adjust its production accordingly.

The variable N stands for the number of potential customers. Each product is likely to havea target market, the size of which will vary. The number of potential customers may be a

function of age or location. For example, the number and type of toys sold in a particularcountry will be related to its demographic spread, in this case the number of childrenwithin it and their ages.

Finally, we come to 0 which represents any other miscellaneous factors which mayinfluence the demand for a particular product. For example, it could be used to represent seasonal changes in demand for a particular product if demand is subject to suchfluctuations rather than spread evenly throughout the year.

Impact of price of complements and price of substitutes on demand function

Substitute goods are goods that are able to be interchangeable i.e. if you don't have A, you

can still use B

Teas and coffees

Imagine that at the starting place, both of these goods are sold at price P. However, due to agood harvest year, coffee price was able to decrease (since coffee bean prices decreased), toP1 lower than P.



This, in effect means that people will switch from Teas to coffee (due to cheaper price), andthus, increasing the quantity supplied and demanded of coffee while decreasing thequantity supplied and demanded of tea

Complements goods are goods that are normally used together for example, Computersand Windows.

Imagine then, what would happen if the demand of Windows increases? To run windows,people need a computer. Therefore, if the demand of Windows increase, the demand of Computers would in return, also increase. And if people demand less Windows, they wouldalso demand fewer computers (although you can argue they switch to Mac or Linux!) Muchthe same with supply, if they supply less computers, the supply level of Windows must alsogo down to not have excess software in the market. If they produce less windows, lesscomputers need to be produced for the same reason!

To illustrate the relationship, let us consider that, we observe two goods, A and B, and B is

complementary to A. If the price of B goes up, we can expect the quantity demanded for Ato be reduced. Why? Because as the price of goods B increases, its quantity demandeddecreases according to the law of demand. But now, some individuals who would havepurchased B at the lower price are no longer making those purchases. These sameindividuals now no longer have any use for A, because A was a good useful only inconjunction with B. Thus, the quantity demanded of A goes down as well. The reverse isalso true: if the price of B falls, the demand for A will rise. It should be clear why businessanalysts are concerned not only about the effect that their product’s price has on sales but also with the effect of the prices of complementary products.

Gasoline and cars are complementary goods because they are used together. Hence change

in a price of one product will affect another product’s price. If a price of gasoline increase,demand of cars will decrease.

For example during the 1970s had some effect on the demand for large versus small cars inthe United States. When the price of gasoline rose, there were at least two effects on theautomobile market. First, the higher price of as increased the cost of driving and thusreduced the total number of miles individuals tended to drive. Second, smaller, more fuel-efficient cars became more attractive relative to big cars.

Similarly, tennis racket and tennis balls are complementary goods. As price of tennis racket rises, the demand curve of ball shifted leftward. Which means demand of balls decreases,which is illustrated in demand curve below



To illustrate the relationship, let us consider that, we observe two goods, c and d, and d issubstitute to c. Rise of price of c (or d) will cause the increase in demand of d (or c). As eachproduct is substitute of each other; rise in one product makes people to move towardanother substitute product, which automatically increases the demand of substituteproduct.

Example

7 up and sprites are two well-known soft drinks in market. They are substitute product. Asshown in graph, when the price of sprite increases, the demand curve of 7 up shifted right ward. This means demand of 7 up increases.



Q3) Compare and contrast Economies of Scale and Economies of Scope. Explain whyit is important for managers to understand Economies of Scale.

Answer

Economies of scale is a term that refers to the reduction of per-unit costs through an

increase in production volume. This idea is also referred to as diminishing marginal cost.

Example

Let's assume that it costs Company XYZ $1,000,000 to produce 1 million widgets per year(or $1.00 per widget). This $1,000,000 cost includes $500,000 ($0.50 per widget) of administrative, insurance, and marketing expenses, which are generally fixed, as well as$500,000 ($0.50 per widget) of variable costs.

Now, let's suppose that XYZ decides to produce 2,000,000 widgets next year. In this case,the variable costs will double, because the number of items produced has doubled. Thus,variable costs will rise from $500,000 to $1,000,000 (2 million x $0.50 each = $1,000,000).

However, the firm's fixed costs will not change regardless of the number of widgetsmanufactured. As such, fixed costs will remain at $500,000.

In this example, the total cost to produce 2 million widgets will rise to $1,500,000, andtherefore the cost per widget will fall to $0.75 ($1.5 million/2 million widgets). Because thefixed costs have been spread over a larger number of units, the net cost per unit willdecline from $1.00 to $0.75.

Obviously, if XYZ decided to increase its production capacity to 3 million widgets, then itsper-unit costs would fall even further. Variable costs would increase to $1,500,000 (3million widgets x $0.50 each = $1,500,000). But again, fixed costs would be unchanged at $500,000. Therefore, the total cost to make 3 million widgets would rise to $2,000,000, but the per-unit cost would drop to just $0.66.

As production ramps up, total costs will also rise. However, because XYZ can spread itsfixed costs over more units -- or scale its business model -- it is able to reduce the costsincurred to produce each widget. However, note that the first 1 million increase droppedthe price by $0.25 each (from $1.00 to $0.75), but the next increase only resulted in a $0.09decline (from $0.75 to $0.66). Thus, costs are said to be decreasing at a decreasing rate. Assuch, as volume levels rise, the cost savings impact on each new unit is slightly smaller thanthe one before. This concept is closely related to the law of diminishing marginal returns. Inany case, the firm's costs can never fall below $0.50 per unit, unless the company can alsofind a way to decrease its variable production costs. When a company can effectively scaleits business and cut costs on a per-unit basis, this often gives it the flexibility to:

Drop its prices (thereby attracting more customers)

Charge the same amount and pocket a higher profit or

Combination of the two.



Spreading fixed costs over a larger production base is one way to generate operationalefficiencies. Other ways include specialization of labor, reorganization of key processes,implementation of new technology, or the purchase of materials at bulk prices.

Managers often calculate projected economies of scale in order to determine appropriate

production levels. Although economies of scale are often an incentive to expandproduction, the creation and manufacture of new products often turns out to be lessefficient than expected. The need for additional managerial expertise or personnel, higherraw materials costs, a reduction in competitive focus, and the need for additional facilitiescan actually increase a company's per-unit cost. When this happens, it is commonlyreferred to as diseconomies of scale. Furthermore, there is no guarantee that the extraunits will ever be sold, and the capital used to produce them might be tied up in slow-moving inventory.

However, when executed correctly, economies of scale can help companies gain significant competitive advantages. Not only do they often lead to greater profitability, but they can

also eliminate less-efficient competitors or discourage potential rivals from entering themarket. Occasionally, economies of scale can even lead to an oligopoly, where only ahandful of companies produce the majority of an industry's output. In rare cases, they caneven lead to a monopoly-like environment.

'Economies of Scope'

According to the concept of economies of scale, cost advantages follow the increase involume of production or what is called the scale of output. On the other hand, according tothe concept of economies of scope, such cost advantages may follow from a variety of output.An economic theory stating that the average total cost of production decreases as a result

of increasing the number of different goods produced.For example, McDonalds can produce both hamburgers and French fries at a lower averagecost than what it would cost two separate firms to produce the same goods. This is becauseMcDonald’s hamburgers and French fries share the use of food storage, preparationfacilities, and so forth during production.

Another example is a company such as Proctor & Gamble, which produces hundreds of products from razors to toothpaste. They can afford to hire expensive graphic designersand marketing experts who will use their skills across the product lines. Because the costsare spread out, this lowers the average total cost of production for each product.

For example, a firm produces 10000 TV sets and 5000 Radio sets per year at a cost of Rs.8.40 crores, and another firm produces 10000 TV sets only, then the cost would beRs.10.00 crores, and if it produced 5000 Radio sets only, then the cost would be Rs. 0.50crores. In this case, the cost of producing both the TV and Radio sets is less than the totalcost of producing each separately. Thus, there are economies of scope. Thus,



This means that there is a 25% saving of cost by going for joint production. With economiesof scope, the joint cost is less than the sum of the individual costs, so that SC is greater than0. With diseconomies of scope, SC is negative. In general, the larger the value of SC, thegreater is the economies of scope.

Economies of scale were the main drivers of corporate gigantism in the 20th century. Theywere fundamental to Henry Ford's revolutionary assembly line, and they continue to be thespur to many mergers and acquisitions today.

There are two types of economies of scale:

• Internal . These are cost savings that accrue to a firm regardless of the industry, market orenvironment in which it operates.• External . These are economies that benefit a firm because of the way in which its industryis organized.

Internal economies of scale arise in a number of areas. For example, it is easier for largefirms to carry the overheads of sophisticated research and development (R&D). In thepharmaceuticals industry R&D is crucial. Yet the cost of discovering the next blockbusterdrug is enormous and increasing. Several of the mergers between pharmaceuticalscompanies in recent years have been driven by the companies' desire to spread their R&Dexpenditure across a greater volume of sales.Economies of scale, however, have a dark side, called diseconomies of scale. The larger anorganization becomes in order to reap economies of scale, the more complex it has to be tomanage and run such scale. This complexity incurs a cost, and eventually this cost maycome to outweigh the savings gained from greater scale. In other words, economies of scalecannot be gleaned forever.

Frederick Herzberg, a distinguished professor of management, suggested a reason whycompanies should not aim blindly for economies of scale:Numbers numb our feelings for what is being counted and lead to adoration of theeconomies of scale. Passion is in feeling the quality of experience, not in trying to measureit.

T. Boone Pickens, a geologist turned oil magnate turned corporate raider, wrote about diseconomies of scale in his 1987 autobiography:It's unusual to find a large corporation that's efficient. I know about economies of scale andall the other advantages that are supposed to come with size. But when you get an insidelook, it's easy to see how inefficient big business really is. Most corporate bureaucracieshave more people than they have work.



The desire to garner economies of scope was the driving force behind the vast internationalconglomerates built up in the 1970s and 1980s, including BTR and Hanson in the UK andITT in the United States. The logic behind these amalgamations lay mostly in the scope forthe companies to leverage their financial skills across a diversified range of industries.

A number of conglomerates put together in the 1990s relied on cross-selling, thus reapingeconomies of scope by using the same people and systems to market many different products. The combination of Travelers Group and Citicorp in 1998, for instance, was basedon the logic of selling the financial products of the one by using the sales teams of the other.



5. Do you think Monopoly is undesirable? Take any real life example of monopoly in Indiaand state its advantages and disadvantages.

Answer

Monopoly is a situation in which a single company owns all or nearly all of the market for agiven type of product or service.

1. Monopoly is desirable in cases like- Nuclear energy production.- Railways transport system.

2. Monopoly is undesirable in cases like- Consumer products- Educational services.

Monopoly would happen in the case that there is a barrier to entry into the industry that allows the single company to operate without competition (for example, vast economies of scale, barriers to entry, or governmental regulation). In such an industry structure, theproducer will often produce a volume that is less than the amount which would maximize

Characteristics

Only one single seller in the market. There is no competition. There are many buyers in the market.

The firm enjoys abnormal profits.

The seller controls the prices in that particular product or service and is the pricemaker.

Consumers don’t have perfect information.

There are barriers to entry. These barriers many be natural or artificial.

The product does not have close substitutes.

Advantages of Monopoly

Monopoly avoids duplication and hence wastage of resources. A monopoly enjoys economics of scale as it is the only supplier of product or service in

the market. The benefits can be passed on to the consumers. Due to the fact that monopolies make lot of profits, it can be used for research and

development and to maintain their status as a monopoly. Monopolies may use price discrimination which benefits the economically weaker

sections of the society. For example, Indian railways provide discounts to studentstravelling through its network.



Monopolies can afford to invest in latest technology and machinery in order to beefficient and to avoid competition.

Disadvantages of monopoly

Poor level of service. No consumer sovereignty. Consumers may be charged high prices for low quality of goods and services. Lack of competition may lead to low quality and out dated goods and services. Price discrimination

Monopoly IN INDIA

Indian Railways has monopoly in Railroad transportation

State Electricity board has monopoly over generation and distribution of electricityin many of the states.

Hindustan Aeronautics Limited has monopoly over production of aircraft.

There is Government monopoly over production of nuclear power. Operation of bus transportation within many cities.

Land line telephone service in most of the country is provided only by thegovernment run BSNL.

Example of monopoly in India

Introduction to Indian Railways

Indian Railways (IR) is the state-owned railway company of India. Indian Railways had,until very recently, a monopoly on the country’s rail transport. It is one of the largest andbusiest rail networks in the world, transporting just over six billion passengers and almost

750 million tons of freight annually. IR is the world’s largest commercial or utilityemployer, with more than 1.6 million employees.

The railways traverse through the length and width of the country; the routes cover a totallength of 63,940 km (39,230 miles). As of 2005 IR owns a total of 216,717 wagons, 39,936coaches and 7,339 locomotives and runs a total of 14,244 trains daily, including about 8,002 passenger trains.

Railways were first introduced to India in 1853. By 1947, the year of India’s independence,there were forty-two rail systems. In 1951 the systems were nationalized as one unit,becoming one of the largest networks in the world. Indian Railways operates both longdistance and suburban rail systems.

Advantages of Indian Railways

1. Stability of prices- the prices are most of the times stable. This happens becausethere is only one railway transportation service in the market that sets the price.

2. Source of revenue for the government- since the Indian railway is owned bygovernment, every profit is revenue.



3. Massive profits- due to the absence of competitors and control over, the organizationhas massive profit. The massive profits have used in expansion of railway tracks andservices.

Disadvantages of monopoly

1. Exploitation of consumers- there is always consumer exploitation in monopolymarket, and Indian railway is also influenced by it.

2. Dissatisfied consumers- people need transportation service hence they will use it compromising quality and condition of railway. Hence, there is no wonder to findenormous number of dis satisfied travellers.

3. Higher prices- since there is no competing in market, there is no reference to tallythe price of service taking account of quality. Economic factor like price war which canbe beneficial for consumer has no effect in monopoly firm like Indian railwaytransportation

4. Inferior goods and services- lack of competition made firm to produce low quality of service because after all they know the people will use it, because they doesn’t haveany other alternative.



Q) 6. Suppose you are working as a marketing head for an organization producing soft drinks. The company is planning to float a new juice which is blue in color. What lessonsfrom the concept of price elasticity can you draw while fixing the price for this newproduct?

Answer

Pricing is one of the most important elements of the marketing mix, as it is the only mix,which generates a turnover for the organization. The remaining 3p’s are the variable cost for the organization. It costs to produce and design a product; it costs to distribute aproduct and costs to promote it. Price must support these elements of the mix. Pricing isdifficult and must reflect supply and demand relationship. Pricing a product too high or toolow could mean a loss of sales for the organization. Pricing should take into account thefollowing factors:

• Fixed and variable costs.• Competition• Company objectives• Proposed positioning strategies.• Target group and willingness to pay.

Pricing Strategies

An organization can adopt a number of pricing strategies. The pricing strategies are basedmuch on what objectives the company has set itself to achieve.

Penetration pricing: Where the organization sets a low price to increase sales and market share.

Skimming pricing: The organization sets an initial high price and then slowly lowers theprice to make the product available to a wider market. The objective is to skim profits of the market layer by layer.

Competition pricing: Setting a price in comparison with competitors.

Product Line Pricing: Pricing different products within the same product range at different price points. An example would be a video manufacturer offering different video recorderswith different features at different prices. The greater the features and the benefit obtainedthe greater the consumer will pay. This form of price discrimination assists the company inmaximizing turnover and profits.

Bundle Pricing: The organization bundles a group of products at a reduced price.

Psychological pricing: The seller here will consider the psychology of price and thepositioning of price within the market place. The seller will therefore charge 99p instead £1or $199 instead of $200



Premium pricing: The price set is high to reflect the exclusiveness of the product. Anexample of products using this strategy would be Harrods, first class airline services,porsche etc.

Optional pricing: The organization sells optional extras along with the product to maximizeits turnover. This strategy is used commonly within the car industry.

Thoroughly analyses your product, your buyers, your competitors (and their possibleactions and reactions), and your market before you decide which pricing strategy wouldbest-fit your business. Then review pricing strategy by product, and by product line, on aregular basis to make sure that the fit remains the best.

Costs

For many for-profit companies, the starting point for setting a product’s price is to first determine how much it will cost to get the product to customers. Obviously, whatever pricecustomer’s pay must exceed the cost of producing a good or delivering a service otherwisethe company will lose money. When analyzing cost, the marketer will consider all costs

needed to get the product to market including those associated with production, marketing,distribution and company administration (e.g., office expense). These costs can be dividedinto two main categories:• Fixed Costs - Also referred to as overhead costs, these represent costs the marketingorganization incurs that are not affected by level of production or sales. For example, for amanufacturer of writing instruments that has just built a new production facility, whetherthey produce one pen or one million they will still need to pay the monthly mortgage forthe building. From the marketing side, fixed costs may also exist in the form of expenditurefor fielding a sales force, carrying out an advertising campaign and paying a service to host the company’s website. These costs are fixed because there is a level of commitment tospending that is largely not affected by production or sales levels.

• Variable Costs – These costs are directly associated with the production and sales of products and, consequently, may change as the level of production or sales changes.Typically variable costs are evaluated on a per-unit basis since the cost is directlyassociated with individual items. Most variable costs involve costs of items that are eithercomponents of the product (e.g., parts, packaging) or are directly associated with creatingthe product (e.g., electricity to run an assembly line). However, there are also marketingvariable costs such as coupons, which are likely to cost the company more as sales increase(i.e., customers using the coupon). Variable costs, especially for tangible products, tend todecline as more units are produced. This is due to the producing company’s ability topurchase product components for lower prices since component suppliers often provide

discounted pricing for large quantity purchases.

Lesson from price elasticity

Determining individual unit cost can be a complicated process. While variable costs areoften determined on a per-unit basis, applying fixed costs to individual products is lessstraightforward. For example, if a company manufactures five different products in onemanufacturing plant how would it distribute the plant’s fixed costs (e.g., mortgage,production workers’ cost) over the five products? In general, a company will assign fixed



cost to individual products if the company can clearly associate the cost with the product,such as assigning the cost of operating production machines based on how much time it takes to produce each item. Alternatively, if it is too difficult to associate to specificproducts the company may simply divide the total fixed cost by production of each itemand assign it on percentage basis.

Understanding how price changes impact the market requires the marketer have a firmunderstanding of the concept economists call elasticity of demand, which relates to howpurchase quantity changes as prices change. Elasticity is evaluated under the assumptionthat no other changes are being made (i.e., “all things being equal”) and only price isadjusted. The logic is to see how price by itself will affect overall demand. Obviously, thechance of nothing else changing in the market but the price of one product is oftenunrealistic. For example, competitors may react to the marketer’s price change by changingthe price on their product. Despite this, elasticity analysis does serve as a useful tool forestimating market reaction.

Elasticity deals with three types of demand scenarios:

Elastic Demand – Products are considered to exist in a market that exhibits elasticdemand when a certain percentage change in price results in a larger and oppositepercentage change in demand. For example, if the price of a product increases(decreases) by 10%, the demand for the product is likely to decline (rise) by greaterthan 10%.

Inelastic Demand – Products are considered to exist in an inelastic market when acertain percentage change in price results in a smaller and opposite percentagechange in demand. For example, if the price of a product increases (decreases) by10%, the demand for the product is likely to decline (rise) by less than 10%.

Unitary Demand – This demand occurs when a percentage change in price results in

an equal and opposite percentage change in demand. For example, if the price of aproduct increases (decreases) by 10%, the demand for the product is likely todecline (rise) by 10%.

For marketers the important issue with elasticity of demand is to understand how it impacts company revenue. In general the following scenarios apply to making pricechanges for a given type of market demand:

For elastic markets – increasing price lowers total revenue while decreasing priceincreases total revenue.

For inelastic markets – increasing price raises total revenue while decreasing pricelowers total revenue.

For unitary markets – there is no change in revenue when price is changed.

Concept of price elasticity

-price elasticity of demand = 2 per bottle-P1 original price of the bottle [say =100]-Q1 the original volume sold, when the price was P1 PRICE INCREASE, say, and 10%



-P2 the new price of the bottle .[ 110 , an increase of 10% ]-Q2 the new volume sold, when the price is P2 [110]

Using following formula, we get

2 = [Q1-Q2] / [P2-P1] X [ P1+P2 ] / [Q1+Q2 ]

2= [Q1 - Q2] / [110 - 100] X [100+110 ] X [Q1+Q2 ]

2= [Q1 - Q2 ] / 10 X 210 / [ Q1 +Q2 ]

2 =21 [ Q1 - Q2 ] / [Q1+Q2 ]

Q2 =19/23 OF Q1

Which means the new volume of sales of the bottles will fall by [17-18] %, if the price is

raised by 10%.

The graph given below shows the relationships between total revenue and demandcurve. Over the range between 0 and 200 units, the demand function is elastic; over thissame range, total revenue increases as price is reduced and quantity demandedincreases beyond 200 units, demand is inelastic and total revenue decreases as price isreduced and quantity demand increases.



These results can be summarized as follows:Elastic Demand1. Decrease price..... Increase total revenue

2. Increase price......Decrease total revenuePrice and total revenue move in opposite directions.

Inelastic Demand1. Decrease price..... Decrease total revenue2. Increase price......Increase total revenuePrice and total revenue move in the same direction.

Conclusion

If a company has elastic demand function then it will be feasible if new launch product hasreduced price. On another hand a company should take decision to launch new product considering marginal cost and marginal revenue. In long run organization, fixed cost spreadover all quantity produced, so no matter how much it produces under its capacity, the fixed

cost is same. Cost that varies is variable cost.

If a demand function has a unitary elasticity, then the same level of revenue will be generated,regardless of price. You see that for a linear demand function, as price falls, demand becomesless elastic or more inelastic. You have also seen that when demand is elastic, price cuts areassociated with increases in total revenue. But if a price continues to be lowered in therange in which demand is inelastic, total revenue will fall. Thus, total revenue will bemaximized at the price (and related quantity) at which demand is unitarily elastic.

Date post:	14-Apr-2018
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