#3 GM 04 Explain the following concepts with suitable example. a. Opportunity Cost b. Discounting Principle MANAGERIAL ECONOMICS AIMA PGDM assignment solution

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 3. Explain the following concepts with suitable example.

a. Opportunity Cost

b. Discounting Principle

A.Opportunity Cost

Opportunity cost refers to highest valued alternative forgone whenever a choice is made. It is the loss of potential gain from other alternatives when one particular alternative is chosen over the others.

As a representation of the relationship between scarcity and choice, the objective of opportunity cost is to ensure efficient use of scarce resources. It incorporates all associated costs of a decision, both explicit and implicit. Opportunity cost also includes the utility or economic benefit an individual lost; it is indeed more than the monetary payment or actions taken. As an example, to go for a walk may not have any financial costs imbedded to it. Yet, the opportunity forgone is the time spent walking which could have been used instead for other purposes such as earning an income. Concept of opportunity cost can be well understood with the help of following example-

Mr. X is the owner of a small grocery store in a busy section of Mumbai. Adam’s annual revenue is Rs. 20, 00,000 and his total explicit cost (Adam pays himself an annual salary of $3, 00,000) is Rs.15,00,000 per year. A supermarket chain wants to hire Adam as its general manager for Rs. 6, 00,000 per year. In this case, the opportunity cost to Mr. X of owning and managing the grocery store is the Rs.6,00,000 in forgone salary that he might have earned had he decided to work as general manager for the supermarket chain.

Types of opportunity cost

Opportunity cost can be of two types-

1. Explicit costs

Sometimes referred to as out-of-pocket expenses, explicit costs are “visible” in the sense that they are direct payments for factors of production. Explicit costs are visible expenditures associated with the procurement of the services of a factor of production Operation and maintenance costs  such as Wages paid to workers, overhead, materials and rental payments, Land and infrastructure costs are examples of explicit costs.

For instance, if a person leaves work for an hour and spends Rs. 200 on office supplies, then the explicit costs for the individual equates to the total expenses for the office supplies of Rs. 200. If a printer of a company malfunctions, then the explicit costs for the company equates to the total amount to be paid to the repair technician.

2. Implicit costs

Implicit costs are “invisible” in the sense that no direct monetary payments are involved. They are the value of any forgone opportunities. Implicit costs, however, may be made explicit. Implicit costs represent the value of resources used in the production process for which no direct payment is made. This value is generally taken to be the money earnings of resources in their next best alternative employment. When a computer software programmer quits his or her job to open a consulting firm, the forgone salary is an example of an implicit cost. When the owner of an office building decides to open a hobby shop, the forgone rental income from that store is an example of an implicit cost. When a housewife decides to redeem a certificate of deposit to establish a day-care center for children, the forgone interest earnings represent an implicit cost. Examples of implicit costs regarding production are mainly resources contributed by a business owner which includes human labour, Infrastructure and time

Significance of Opportunity Cost

Opportunity cost is an inevitable part of any business activity since it triggers the process of decision making. Major reasons for which any business needs to determine the opportunity cost are as follows:

·         Base forDecision Making

Opportunity cost provides support for making an appropriate choice while selecting one out of many available alternatives.

·         PriceDetermination

Based on the expenses incurred in the procurement of any goods or services along with the cost which may have been committed to acquiring alternative options, the price of the products or services is determined.

·         Efficient Resource Allocation

It helps in investing the resources in the right opportunity by analysing the opportunity cost of all the alternatives.

·         Remuneration Decisions

In organisations, it played a crucial role in determining the expected value an employee would create for the organisation. It is acquired after his/her comparison to the other alternatives available, and thus, personnel remuneration is considered accordingly.

 

B. Discounting principle

According to this principle, if a decision affects costs and revenues in long-run, all those costs and revenues must be discounted to present values before valid comparison of alternatives is possible. This is essential because a rupee worth of money at a future date is not worth a rupee today. Money actually has time value. Discounting can be defined as a process used to transform future dollars into an equivalent number of present dollars.

Since future is unknown and incalculable, there is lot of risk and uncertainty in future. Everyone knows that a rupee today is worth more than a rupee will be two years from now. This appears similar to the saying that “a bird in hand is more worth than two in the bush.” This judgment is made not on account of the uncertainty surround­ing the future or the risk of inflation.

It is simply that in the intervening period a sum of money can earn a return which is ruled out if the same sum is available only at the end of the period. In technical parlance, it is said that the present value of one rupee available at the end of two years is the present value of one rupee available today. The mathematical technique for adjusting for the time value of money and computing present value is called ‘discounting’.

The following example would make this point clear. Suppose, we are offered a choice of Rs. 1,000 today or Rs. 1,000 next year. Naturally, we will select Rs. 1,000 today. That is true because future is uncertain. Let us assume we can earn 10 per cent interest during a year. We would be indifferent between Rs. 1,000 today and Rs. 1,100 next year i.e., Rs. 1,100 has the present worth of Rs. 1,000. Therefore, for making a decision in regard to any investment which will yield a return over a period of time, it is advisable to find out its ‘net present worth’. Unless these returns are discounted and the present value of returns calculated, it is not possible to judge whether or not the cost of undertaking the investment today is worth.

The concept of discounting is found most useful in managerial economics in decision problems pertaining to investment planning or capital budgeting. Discount rates are used to compress a stream of future benefits and costs into a single present value amount. Thus, present value is the value today of a stream of payments, receipts, or costs occurring over time, as discounted through the use of an interest rate. Present value calculations of benefits and costs are then compared to determine benefit-cost ratios. For example, if the present value of all discounted future benefits of a restoration project is equal to $30 million and the discounted present value of project costs totals $20 million, the benefit-cost ratio would be 1.5 ($30 million / $20 million), and the net benefit would be $10 million ($30 million — $20million). Any benefit-cost ratio in excess of 1.0 or net benefit above 0.0 demonstrates positive economic returns to society. Note that values used for benefit-cost analysis are often amortized over the project time horizon, yielding annualized benefits and costs. This practice allows for comparison of projects with different timeframes. The formula of computing the present value is given below:

V = A/1+i

where:

V = Present value

A = Amount invested suppose Rs. 100

i = Rate of interest supposed to be 5 per cent

V = 100/1+.05 = 100/1.05 =Rs. 95.24

Similarly, the present value of Rs. 100 which will be discounted at the end of 2 years:

A 2 years V = A/ (1+i) ²

= 100/ 1.05² = Rs. 90.70

For n years V = A/ (1+i) ⁿ

Rationale for Discounting

Discounting reflects how individuals value economic resources. Empirical evidence suggests that humans’ value immediate or near-term resources at higher levels than those acquired in the distant future.  Thus, discounting has been introduced to address the issues raised by the existence of this phenomenon, which is known as time preference. Time preference is of significant interest to economists but the weight it is given depends on the discount rates used to perform present-value calculations.

 

Inflation is a primary reason for discounting; however, independent of inflation, discounting is an important tool for assessing environmental benefit streams. Discount rates also reflect the opportunity cost of capital. The opportunity cost of capital is the expected financial return forgone by investing in a project rather than in comparable financial securities. For example, if Rs.10 is invested today in the private capital markets and earns an annual real rate of return of 10 percent, the initial Rs.10 investment would be valued at Rs. 25.94 at the end of 10 years. Therefore, discount rates reflect the forgone interest earning potential of the capital invested in the public project.

Humans prefer near-term to future benefits. The inability to defer gratification results in decisions that are slanted toward obtaining near-term benefits, often at the cost of those available in the long-term. Regardless of whether this represents a sound policy, economic value is established based on human preferences, and humans prefer near-term benefits to those that accrue in the distant future

#1 GM 04 What are the key points in short run production functions that delineate the three stages of production? Explain the relationship between the law of diminishing return and three stages of production.GM 04 MANAGERIAL ECONOMICS assignment AIMA PGDM

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1. What are the key points in short run production functions that delineate the three stages of production?  Explain the relationship between the law of diminishing return and three stages of production.

Short run production function studies the effect on output due to change in variable input, assuming no change in other factors. As there is change in variable input only, the ratio between different inputs tends to change at different levels of output. This relationship is explained by the slopes, shapes, and interrelationships of the total, marginal, and average product curves. It shows the nature of rate of change in output due to a change in only one variable factor of production

 

Key points in short run production functions that delineate the three stages of production

 

The key points in short run production functions that delineate the three stages of production are slopes, shapes, and interrelationships of the total, marginal, and average product curves.

The total product curve is a reflection of the firm’s overall production and is the basis of the two other curves. The average product curve is the quantity of the total output produced per unit of a "variable input," such as hours of labor. The marginal product curve is slightly different: It measures the change in product output per unit of variable input. For example, if the average curve depicts the number of units produced based on an overall number of employees, the marginal curve would show the number of additional units produced if one more employee is added.

Since both average and marginal products are derived from total product, the average and marginal product curves are closely related to the total product curve. The input-output relationship showing total, average and marginal productivity can be divided into three stages of production and a set of product curves is presented in the diagram. The variable input in this example is labor and the fixed factor is capital.

Stage I

• The total product curve has a positive slope.
• TP increases at increasing rate increasing and MP also increases.
• Marginal product is greater than average product. Marginal product initially increases then decreases until it is equal to average product at the end of Stage I.
• Average product is positive and the average product curve has a positive slope.

Stage II

The three product curves reveal the following patterns in Stage II.

• The total product curve has a decreasing positive slope. In other words, the slope becomes flatter with each additional unit of variable input.
• Marginal product is positive and the marginal product curve has a negative slope. The marginal product curve intersects the horizontal quantity axis at the end of Stage II.
• Average product is positive and the average product curve has a negative slope. The average product curve is at its a peak at the onset of Stage II. At this peak, average product is equal to marginal product.
• TP increases at decreasing rate and MP falls. This phase ends when MP becomes zero and TP reaches its maximum point:

Stage III

• The total product curve has a negative slope. It has passed its peak and is heading down.
• Marginal product is negative and the marginal product curve has a negative slope. The marginal product curve has intersected the horizontal axis and is moving down.
• Average product remains positive but the average product curve has a negative slope.
• TP starts decreasing and MP not only falls, but also becomes negative.

Relationship between the law of diminishing return and three stages of production.

 

Law of diminishing returns states that as more and more of the factor input is employed, all other input quantities remaining constant, a point will finally be reached where additional quantities of varying input will produce diminishing marginal contributions to total product. It states that marginal product diminishes when proportion between variable and fixed factors increase beyond a point.

Three stages of production in short run is an extension to Law of Diminishing Returns as it also considers the phase of rising MP in addition to falling MP. The common element between both is that MP is bound to decrease sooner or later with increase in units of variable factor.

 

Short-run production Stage I arise due to increasing average product. As more of the variable input is added to the fixed input, the marginal product of the variable input increases. Most importantly, marginal product is greater than average product, which causes average product to increase. This is directly illustrated by the slope of the average product curve.

 

In Stage II, short-run production is characterized by decreasing, but positive marginal returns. As more of the variable input is added to the fixed input, the marginal product of the variable input decreases. Stage two is the period where marginal returns start to decrease. Each additional variable input will still produce additional units but at a decreasing rate. This is because of the law of diminishing returns: Output steadily decreases on each additional unit of variable input, holding all other inputs fixed.

 

Stage III of production function results due to negative marginal returns. In this stage of short-run production, the law of diminishing marginal returns causes marginal product to decrease so much that it becomes negative. Stage III production is most obvious for the marginal product curve, but is also indicated by the total product curve. Adding more variable inputs becomes counterproductive; an additional source of labor will lessen overall production.

 

Diminishing returns to a factor can be understood with the help of total and marginal product curves. Total Product rises first to an increasing rate in stage I and later at a diminishing rate in stage II. At stage II, Total Product remains constant. Correspondingly when TP is rising at an increasing rate, MP and AP curves are rising; and when total product is rising at a diminishing rate, the MP and AP curves are declining. When TP becomes constant, the MP becomes zero, and additional labour beyond this level makes MP negative.

No firm will choose to operate either in Stage I or Stage III. In Stage I the marginal physical product is rising, i.e., each additional unit of the variable factor is contributing to output more than the earlier units of the factor; it is therefore profitable for the firm to keep on increasing the use of labour. In Stage III, marginal contribution to output of each additional unit of labour is negative; it is therefore, not advisable to use any additional labour. Even if cost of labour used is zero, it is still unprofitable to move into Stage III. Thus, Stage II i.e. law of diminishing return is the only important range for a rational firm in a competitive situation to operate in.