Assignment on

Managerial economics mid term and

assignment
Submitted by
Kanwal shaikh
2K18/BBAe/79
Submitted to
Sir nazeer
SUBJECT: managerial economics

Q1
What is Cost?
To an economist, the cost of producing any good or service is its opportunity cost. In everyday
living, all man-made choices have alternatives. Therefore the opportunity cost of obtaining a
commodity is the foregone utility which could have been derived from the forgone alternatives.
Cost is best described as a sacrifice made in order to get something. In business, cost is usually a
monetary valuation of all efforts, materials, resources, time and utilities consumed, risk incurred
and opportunities forgone in production and delivery of goods and services. More explicitly, the
costs attached to resources that a firm uses to produce its product are divided into explicit costs
and implicit costs. All expenses are costs but not all costs are expenses. Those costs incurred in
the acquisition of income generating assets are not considered as expenses. The theory of costs is
better categorized under the traditional and modern theory of cost.
In the Cost Theory, there are two types of costs associated with production – Fixed Costs and
Variable Costs.
In the short-run, at least one factor of production is fixed, so firms face both fixed and variable
costs. The shape of the cost curves in the short run reflect the law of diminishing returns.

Cost Theory – Types of Costs

Direct costs are costs which are directly accountable to a cost object. Some overhead costs which
can be directly attributed to a project may also be classified as a direct cost. Direct costs are
directly attributable to the object

Indirect costs are costs that are not directly accountable to a cost object. Indirect costs may be
either fixed or variable. Indirect costs include administration, personnel and security costs. These
are those costs which are not directly related to production. Some indirect costs may be overhead.
An explicit cost is a direct payment made to others in the course of running a business, such as
wage, rent and materials, as opposed to implicit costs, where no actual payment is made.
An implicit cost is any cost that has already occurred but not necessarily shown or reported as a
separate expense. It represents an opportunity cost that arises when a company uses internal
resources toward a project without any explicit compensation for the utilization of resource.
Opportunity cost
When an option is chosen from alternatives, the opportunity cost is the "cost" incurred by not
enjoying the benefit associated with the best alternative choice. The New Oxford American
Dictionary defines it as "the loss of potential gain from other alternatives when one alternative is
chosen.
In economics and business decision-making, a sunk cost is a cost that has already been incurred
and cannot be recovered. Sunk costs are contrasted with prospective costs, which are future costs
that may be avoided if action is taken.
Fixed Cost

Fixed costs are costs that do not vary with different levels of production and fixed costs exists
even if output is zero. Example: rent or salaries.

In the above diagram, the fixed cost remains constant regardless of the quantity produced.

B. Average Fixed Cost

Average Fixed Cost = Fixed Costs/Quantity.

In the above diagram, we see that when the quantity produced is low, the average fixed cost is
very high and this cost lowers as the quantity produced increases.
For example, if the Fixed Cost is $100 and initially you produce two units, then the average fixed
cost is $50. If you start creating 20 units, then the average fixed cost falls to $5.

C. Variable Costs

Variable Costs are costs that vary with the level of output. Ex: electricity

In the above diagram, the variable cost curve starts from zero. It means when output is zero, the
variable cost is zero, but as production increases the variable cost increases. It keeps rising to the
point that economies of scale cannot lower the per unit cost anymore hence the steep incline
Marginal Cost
Marginal Cost is the increase in cost caused by producing one more unit of the good.

marginal cost graph

The Marginal Cost curve is U shaped because initially when a firm increases its output, total
costs, as well as variable costs, start to increase at a diminishing rate. At this stage, due to
economies of scale and the Law of Diminishing Returns, Marginal Cost falls till it becomes
minimum. Then as output rises, the marginal cost increases.

Total Cost
Total Cost = Fixed Cost + Variable Cost

Total Cost = Fixed Cost + Variable Cost

When the output is zero, variable costs are also zero. But we have fixed costs which is where the
Total Costs start. The Total Cost remains parallel to the Variable Cost, and the distance between
the two curves is the Fixed Cost.
Average Total Cost
Average Total Cost = Total Cost/Quantity. (Total Cost = Fixed Cost + Variable Cost)

Average Total Cost

Average Variable Cost = Variable Costs/Quantity.
Marginal Cost, Average Cost, Average Variable Cost
Marginal Cost, Average Cost, Average Variable Cost
Note: If average costs are falling then marginal costs must be less than average while if average
costs are rising then marginal must be more than average. Marginal cost on its way up must cut
the cost curve at its minimum point.
If Marginal Cost is less than Average Variable Cost, then the Average Cost goes down.
If Marginal Cost is higher than Average Variable Cost, then the Average Cost goes up.
If Marginal Cost is equal to Average Variable Cost, then the Average Cost will be at a minimum.
Solve Problem: Based on consulting economist’s report, th total and marginal cost functions for
Advanced Electronics, Inc. are
TC = 200 + 5Q – 0.04Q2 + 0.001Q3
MC = 5 – 0.08Q + 0.003Q2
The president of the company determines that knowing only these equations is inadequate for
decision making. You have been directed to do the following:
a. Determine the level of fixed cost (if any) and equations for average total cost.
b. Determine the rate of output that results in minimum average variable cost
If fixed costs increase to $500, what output rate will result in minimum average variable cost
Solution: -
a) Determine the level of fixed cost (if any) and equations for average total cost.
Answer: -
ATC , AVC , AFC , FC
FC=200

AVERAGE TOTAL COST=TC/Q

(200+5Q-0.04Q^2+0.001Q^3)/Q
ATC=200Q^-1+5-0.04+0.001Q^2
AFC=200Q^-1
AVERAGE VARIABLE COST=TVC/Q
(5Q-0.04Q^2+0.001Q^3)/Q
AVC=5-0.04Q+0.001Q^2
b) Determine the rate of output that results in minimum average variable cost

Answer:-
AVC=MC
5-0.04Q+0.001Q^2=5-0.08Q+0.003Q^2
0.04Q-0.002Q^2=0
Q(0.04-0.002Q)=0
0.04=0.002Q
Q=20
c) If fixed costs increase to $500, what output rate will result in minimum average variable cost

IF FC=500 THE RESULT WOULD BE SAME

Q2

Pricing of multiple products

As the name suggests, multiple pricing refers to the practice of offering more than one price for
the same product. The supplier charges different prices based on:

 Ordered Quantity
 Type of customer
 Delivery time
 Payment terms etc.

Although this is sometimes not ethical, many suppliers do follow this approach to improve profits.
The basic idea is to make the best offer that the consumer doesn’t refuse. By offering a spectrum
of prices, companies can serve a more diverse customer segment and maximize their profits.
For example, small-time fruit and vegetable vendors often offer different prices for different
quantities bought- e.g. 2 guavas for Rs. 10, 5 guavas for Rs. 20. This is done to incentivize
consumers to buy more of the product. Similarly, in flea markets, the vendors don’t have display
prices for most products and charge customers based on their perception of their willingness to
buy or propensity to spend. Tourists are often charged more because they are not aware of the
actual value or price.
Also consider the example of Amazon that offers different shipping costs based on delivery time.
It offers same day delivery at a higher price than standard delivery.
Multiple pricing can also refer to use of several display prices for the same good. According to
laws and regulations, if a business has more than one price on display for the same item, it must
sell the products at the lower price or withdraw those products from sale.

Price discrimination
Price discrimination is a selling strategy that charges customers different prices for the same
product or service based on what the seller thinks they can get the customer to agree to. In pure
price discrimination, the seller charges each customer the maximum price he or she will pay. In
more common forms of price discrimination, the seller places customers in groups based on
certain attributes and charges each group a different price.
Types of Price Discrimination
There are three types of price discrimination: first-degree or perfect price discrimination, second-
degree, and third-degree. These degrees of price discrimination are also known as personalized
pricing (1st-degree pricing), product versioning or menu pricing (2nd-degree pricing), and group
pricing (3rd-degree pricing).

First-degree Price Discrimination

First-degree discrimination, or perfect price discrimination, occurs when a business charges the
maximum possible price for each unit consumed. Because prices vary among units, the firm
captures all available consumer surplus for itself, or the economic surplus. Many industries
involving client services practice first-degree price discrimination, where a company charges a
different price for every good or service sold.
Second-degree Price Discrimination
Second-degree price discrimination occurs when a company charges a different price for different
quantities consumed, such as quantity discounts on bulk purchases.
Third-degree Price Discrimination
Third-degree price discrimination occurs when a company charges a different price to different
consumer groups. For example, a theater may divide moviegoers into seniors, adults, and children,
each paying a different price when seeing the same movie. This discrimination is the most
common.

Product bundling is a technique in which several products are grouped together and sold as a
single unit for one price. This strategy is used to encourage customers to buy more products.
McDonald’s Happy Meals are an example of product bundles. Instead of selling a burger, soda,
and french fries separately, they are sold as a combination, which leads to more sales than offering
them separately.
Product bundling is a technique in which several products are grouped together and sold as a
single unit for one price. This strategy is used to encourage customers to buy more products.
McDonald’s Happy Meals are an example of product bundles. Instead of selling a burger, soda,
and french fries separately, they are sold as a combination, which leads to more sales than offering
them separately.

Importance of product bundling

Bundling helps you do much more with your existing stock. Let’s take a look at the advantages of
product bundling and how it can be beneficial for your business.
Increase your average order value
Product bundling can increase the profits and sales of individual items over time. By grouping
your items together you can make your customers buy more than one product during a single
purchase, which increases your average order value. For example: Instead of buying just one
pencil during a single purchase, your customer can be given an option to buy a pencil, eraser and
sharpener as a bundle, making them purchase more than one product thereby increasing your
average order value.
Decreases marketing and distribution costs
Bundling enables you to sell more and decrease marketing and distribution costs. Instead of
marketing every product you can group complementary products together and market them as a
single product. By packaging different items together you only need one warehouse bin to store
them instead of different bins. Also, bundling helps you ship fewer boxes of individual items and
saves you money on postage. Instead of making print and wed ads for every single item you can
show them as a bundle which helps you save more on your marketing costs and at the same time
markets all your products. For example: if you have 10 individual products you need to market
and sell 10 products, but if you bundle them you market and sell them as a single unit, helping you
increase efficiency by reducing marketing and distribution costs.
Reduce inventory waste
Merchandise that doesn’t get sold remains in your inventory as dead stock, adding to your holding
costs, and is eventually discarded as waste. You can use bundling to clear out this dead stock
before it becomes a problem. If you bundle a slow-moving or stagnant item with a faster-selling
product, customers will see the bundle as a bargain and be more inclined to buy it. This helps
reduce your inventory waste, free up warehouse space, and decrease your inventory holding costs.
Types of product bundles:
There are several different bundling techniques which are used to group products:
1. Pure bundles
2. New product bundles
3. Mix-and-match bundles
4. Cross-sell bundles
5. Gifting bundles
6. Inventory clearance bundles
7. Buy-one-get-one bundles

Peak Load Pricing

Definition: The Peak Load Pricing is the pricing strategy wherein the high price is charged for the
goods and services during times when their demand is at peak. In other words, the high price
charged during the high demand period is called as the peak load pricing.

Cost-plus pricing
Cost-plus pricing, also called markup pricing, is the practice by a company of determining the cost
of the product to the company and then adding a percentage on top of that price to determine the
selling price to the customer.
Cost-plus pricing is a very simple cost-based pricing strategy for setting the prices of goods and
services. With cost-plus pricing you first add the direct material cost, the direct labor cost, and
overhead to determine what it costs the company to offer the product or service. A markup
percentage is added to the total cost to determine the selling price. This markup percentage is
profit. Thus, you need to start out with a solid and accurate understanding of all the business' costs
and where those costs are coming from.
In certain cases, the markup percentage is agreed upon by both buyer and seller. This percentage
can also serve as a bargaining chip during the sale

Solve Problem: A small firm traps rabbits for their fur and feet. Each rabbit yields one
pelt and two feet (only the hind feet are used to make good-luck charms). The demand
for pelts is given by PP = 2.00 – 0.001QP and the demand for rabbit’s feet is
given by
PF = 1.60 – 0.001QF . The marginal cost of trapping and processing each rabbit is $0.60.
a. What are the profit-maximizing prices and quantities of pelts and rabbit’s feet?
b. If the demand of rabbit’s feet is PF = 1.00 – 0.001QF, what are the profit-
maximizing prices and rates of output?
Solution:-
a) What are the profit-maximizing prices and quantities of pelts and rabbit’s feet?
Answer:- PP + PF
= 2.00 – 0.001QP + ( 1.60 – 0.001QF ) = 2.16 – 0.002Q
= 2.16 = 0.002Q
Q = 2.16/0.002 = 1800 so Quantity is 1800 now put the value of Q in both equation to find the
value of rabbit’s pelt and feets.
For pelts:- PP = 2.00 – 0.001QP put 1800 In place of Q so
PP = 2.00 – 0.001(1800) = 0.2
For feet :- PF = 1.60 – 0.001(1800) = -0.2
b) If the demand of rabbit’s feet is PF = 1.00 – 0.001QF, what are the profit-maximizing prices
and rates of output?
So in this the Q will be 1500 and Prices will be put this in equation PF to answer will be -0.5
Q#3
What is Capital Budgeting?
Capital budgeting is a process of evaluating investments and huge expenses in order to obtain
the best returns on investment.
An organization is often faced with the challenges of selecting between two
projects/investments or the buy vs replace decision. Ideally, an organization would like to
invest in all profitable projects but due to the limitation on the availability of capital an
organization has to choose between different projects/investments.

What are the objectives of Capital budgeting?

Capital expenditures are huge and have a long-term effect. Therefore, while performing a
capital budgeting analysis an organization must keep the following objectives in mind:

1. Selecting  profitable projects

An organization comes across various profitable projects frequently. But due to capital
restrictions, an organization needs to select the right mix of profitable projects that will
increase its shareholders’ wealth.  

2. Capital expenditure control

Selecting the most profitable investment is the main objective of capital budgeting. However,
controlling capital costs is also an important objective. Forecasting capital expenditure
requirements and budgeting for it, and ensuring no investment opportunities are lost is the
crux of budgeting.  

3. Finding the right sources for  funds

Determining the quantum of funds and the sources for procuring them is another important
objective of capital budgeting. Finding the balance between the cost of borrowing and returns
on investment is an important goal of Capital Budgeting.  
Capital Budgeting Techniques
To assist the organization in selecting the best investment there are various techniques
available based on the comparison of cash inflows and outflows. 
These techniques are:

1. Payback period method

In this technique, the entity calculates the time period required to earn the initial investment
of the project or investment. The project or investment with the shortest duration is opted for.

2. Net Present value

The net present value is calculated by taking the difference between the present value of cash
inflows and the present value of cash outflows over a period of time. The investment with a
positive NPV will be considered. In case there are multiple projects, the project with a higher
NPV is more likely to be selected.

3. Accounting Rate of Return

In this technique, the total net income of the investment is divided by the initial or average
investment to derive at the most profitable investment.

4. Internal Rate of Return (IRR)

For NPV computation a discount rate is used. IRR is the rate at which the NPV becomes
zero.  The project with higher IRR is usually selected.

5. Profitability Index
Profitability Index is the ratio of the present value of future cash flows of the project to the
initial investment required for the project.  
Each technique comes with inherent advantages and disadvantages. An organization needs to
use the best-suited technique to assist it in budgeting.  It can also select different techniques
and compare the results to derive at the best profitable projects.

Conclusion
Capital budgeting is a predominant function of management. Right decisions taken can lead
the business to great heights.  However, a single wrong decision can inch the business closer
to shut down due to the number of funds involved and the tenure of these projects.
Staff members of financial analysis department of Global Electronics have determined
the required investment and rate of return on each of the following projects.
Capital Projects Required Investment (millions) Internal rate of return (%)
A 5.2 12.9
B 8.6 15.2
C 3.4 10.0
D 5.1 14.8
E 11.2 19.0
F 6.5 7.9
The firm’s marginal cost of capital is given by the function r = 8 + 0.10C where r is the
rate
of return (in percentage) and C is millions of dollars of capital raised for investment.
a. Graph the firm’s marginal cost of capital function and firm’s capital demand
function.
b. Which capital projects should be implemented? What should be the firm’s total
capital investment?
c. If a general tightening in the financial markets shifts the firm’s marginal cost of
capital function to r = 8 + 0.35C, determine which projects should be implemented
and the total amount spend on capital items.

Solution:-

a. Which capital projects should be implemented? What should be the firm’s total
capital investment?
Capital Projects Required Investment (millions) Internal rate of return (%)
b. A 5.2 12.9
c. B 8.6 15.2
d. C 3.4 10.0
e. D 5.1 14.8
f. E 11.2 19.0
g. F 6.5 7.9

The best project should have comparatively high IRR (internal rate of return) and low
required investment. According to these requirements, the best project is D, because it is
second according to the price and third according to IRR. So, we should choose project D.
So firm should invest required investment of 5.1 millions and firm’s marginal cost is given r
= 8 + 0.10C
We can replace C with required investment value so r = 8+0.10(5.1) =8.51 millions
B )If a general tightening in the financial markets shifts the firm’s marginal cost of
capital function to r = 8 + 0.35C, determine which projects should be implemented
and the total amount spend on capital items.

In this situation the firm will also implement project D because its internal rate of
return is high and has lowest required investment so its marginal cost of capital
function would be r = 8 + 0.35(5.1) = 9.785 millions