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UUEC5100 - Economics for Decision Makers Assignment - UUNZ Institute of Business, New Zealand
Learning Outcomes -
- Demonstrate how as a problem solving approach the rational economic approach can be used to assist in firm decision-making
- Demonstrate an understanding of pricing decision making in the conventional economics model of choice, and apply the model in a real world business context
- Demonstrate the influence of strategic decision making and uncertainty on the pricing and investment behaviour of firms.
Economics for Decision Makers - Case Study Report
Overview - This assignment gives you background information on Fonterra (case study) and asks you to demonstrate the knowledge acquired from the paper.
Answer - Economics for Business Decision Making
Abstract
The business managers have lots of tools at their disposal for decision making but they have to decide which one to use. The objective of the managers is to maximize profits, but they don't consider the owner objective of revenue profit maximization or the consumer preferences of utility maximization. The total profit is maximized where the marginal cost is equal to the marginal revenue and hence, the corresponding output is produced. Thus, a manager makes production decisions on the basis of some objective. The demand plays a crucial role and the elasticity of demand helps the manager to see the impact of changes on either prices or income on the demand of the product.
Introduction
The assignment is about the case study of the company named Fonterra based in New Zealand. The company deals with the production of milk and related products. The company has experienced losses in the year 2018 and now forecasting its production for 2019. The company foresees a decrease in the price of milk in the coming years and hence, tries to evaluate the impact on the demand and hence, the output of milk to be produced to meet the demand. The assignment uses various economics based concepts to analyze the case.
The case sturdy report contains the answers to the questions that the managers of the company are trying to understand. The first is related to the theories of the firm and what is the objective of the firm vis-à-vis the owners of the company. The second question deals with the consumer behavior and the utility maximization theory of indifference curves and budget lines. The third deals with the production possibilities and the decisions under scarcity. The other questions deal with the income elasticity of demand, the costs, the decisions to be made under scarcity, and the mathematical problem for calculating the equilibrium price and quantity.
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Question 1 - Theories of the firm
a. Explain the profit maximization assumption found in the conventional economics model and how using this assumption has allowed economists to develop a set of rules to be used as a problem solving approach to guide decision making at the firm.
Profit maximization is the objective where the managers decide upon the production and price of the product where the profit is at its maximum. The condition for profit maximized is where the marginal cost of the firm is equal to the marginal revenue of the firm. The output is produced where marginal revenue and marginal cost are equal and the demand curve gives the corresponding price for the output (Mankiw 2014).
b. Discuss conditions under which the model may not hold from both theoretical and empirical perspectives.
The empirical criticism of the profit maximization is that it is a poor description of what the firms actually try to achieve. However, besides profit maximization, there other objectives such as sales maximization can be important for the managers. There is never a possibility of maximizing a single objective. Marginalization is a very poor description of the processes used by businesses to decide output and price. Profit is a residual element and its outcome is uncertain. As far as empirical criticisms are involved, in reality perfect competition is not there. Managers are faced from stiff competition and uncertain information. During a trade, a firm may lower short run profit in order to achieve huge profits in the long run. The objective of profit maximisation doesn't take into consideration the complexities of the modern organisation.
Question 2 - Consumer behaviour
a. Explain the concept of indifference curves and how they represent consumer preferences. Then explain how indifference curve analysis can be used by decision makers at Fonterra to anticipate the effects of a fall in the price of milk, from a consumer's perspective.
Every consumer is faced by a budget constraint and utility constraint. Indifference curves measures the utility achieved by a consumer and the budget line measures the available budget for the consumers (Foxall 2017). From the consumer point of view, the consumers will consume where the utility is maximized with the given budget constraint. The decision makers at Fonterra can use the indifference curve analysis to determine the effect of fall in price of milk on the consumer preferences. A fall in the price of the milk causes the budget line to rotate and more milk can be produced within the given budget.
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b. Behaviour economics theory provides an alternative approach to understanding consumer behaviour. Discuss how this theory differs from the mainstream approach in question 2.a and give one example where behaviour economics can be used to explain the consumer behaviour for Fonterra's products.
There is an alternative to understanding the consumer behavior. One of the methods is Maslow's hierarchy of needs. As per Maslow's hierarchy of needs, psychological needs are the first, then safety and security needs followed by social needs. The next need is the ego needs and finally the self-actualization need. Fonterra should use the consumer behavior that the products such as milk are psychological needs and the basic needs. This can be used by Fonterra for understanding the consumer preferences.
Question 3 - Production and scarcity: What is the likely effect on competition and prices for Fonterra's products.
With the migration taking place, there will be greater impact on the human capital. Because of this, there will be less production of some products as human power will reduce. Other examples include land and capital mind become scarcity because of migration. Fonterra will receive stiff competition from migration. This will cause the prices of the products to increase as the supply will reduce due to migration. New Zealand specializes in production of milk. This milk production will reduce because of migration. People may move to other countries in search of better provisions and salary causing scarcity in New Zealand. There will be a shift in the production possibility curve because of the migration, which will reduce the production and hence increasing the prices of the products in the country (Norgaard 1990).
Question 4 - Income elasticity of demand: Suppose the income elasticity of demand for smartphones in New Zealand is 2 and the income elasticity of demand for milk in the country is 0.8. Compare the impact on the demand for smartphones and milk of a recession that reduces consumer income by 5%.
The income elasticity of demand for Smartphone is 2. Income elasticity of demand is the percentage change in the demand due to the percentage change in the income. If the income reduces by 5% in New Zealand, the demand for the Smartphone decreases by 10%. Hence, there will be reduction in demand for Smartphone by 10%. Now, the income elasticity of milk is 0.8 and when the consumer income falls by 5%, the demand for milk will decrease by 4%. Since, income elasticity is greater for Smartphone than milk, thus, there is a greater reduction in demand for Smartphone than milk. Milk is a necessity and Smartphone is a luxury (Zuo, Wheeler, Adamowicz, Boxall & MacDonald 2016).
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Question 5 - Cost: Explain why the average total cost and the average variable cost move closer together as output expands.
Average total cost is per unit the total cost whereas average variable cost is per unit the variable cost (Mankiw 2014). The total cost is the sum of both fixed cost as well as the variable cost. The average fixed cost is the per unit cost of total fixed. Since, the average fixed cost is the fixed cost divided by the output and the numerator is a fixed value, so as the output is increases, the average fixed cost falls. So, the main reason for the closeness of the average total cost and average variable cost as the output expands is the falling value of average fixed cost. The gap between the average total cost and average variable cost is represented by the average fixed cost. As the average fixed cost is continuously falling with an increasing output, there is little increase in average total cost and hence, the gap between the average total cost and average variable cost narrows with increasing output.
Question 6 - Decision making under uncertainty
a. Discuss two sources of uncertainty that may influence business decision making.
Uncertainty affects the business decision making. There are various sources which can cause uncertainty and hence can influence decision making. The first source of uncertainty is the uncertainty in the pattern. The businesses can be certain and sure about the events that may occur in the future but they are uncertain and cannot accurately predict the pattern of that event. For example: One can predict the rain to occur but there is uncertainty about the pattern of distribution of the rainfall in the specific area. The second source of uncertainty is the bias of self-interest. The bias of self-interest means that the experience of all the past events is forecasted on the basis of personal judgment and feeling. Thus, personal judgment could cause uncertainty which could influence decision making in business. The personal feeling varies from individual to individual and this can lead to difference in opinions in the forecast. Hence, this is the cause of uncertainty in business.
b. Define the concept of expected value and explain how corporate planners and decision makers can use it at firms to make better price and investment decisions under conditions of risk and uncertainty.
Expected value is used by business by summing up the assigned probabilities of occurring an event to the value of the occurrence of the event. At the time of uncertainty and risk, the corporate planners can assign the probabilities as per the risk of occurrence of the event. Higher the risk of an occurrence of an event, higher will be the probability assigned to the particular event. In this way, the managers can get to know the expected value of a price or any other investment decision they are planning for the future. The expected value gives the manager the value of an event with all the risk and uncertainties associated with the event and hence, they can accordingly decide their future course of action.
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Question 7 - Pricing under perfect competition
a. What is the equilibrium quantity and price in this market given the above information?
The equilibrium is attained where market demand is equal to the market supply. (Robin, 1934) Hence, the following is the equilibrium quantity:
Market demand=Market supply
1000-2Q=100+Q
900=3Q
Q=900/3=300
The equilibrium quantity is actually 300 units of milk. The equilibrium price is follows:
P=100+300=$400
The equilibrium price is $400.
b. The firm's MC equation is based upon its TC equation and MC = 2q +1 Given this information and your answer in part (a), what is the firm's profit maximizing level of production, total revenue, total cost and profit at this market equilibrium? Is this a short-run or long-run equilibrium?
Profit maximizing condition is where the marginal revenue is equal to the marginal cost (Robinson 1934). In the perfectly competitive market structure, marginal revenue is equal to the price. Hence, the marginal revenue is $400.
MR=MC
400=2q+1
q=399/2=199.5 units
The profit maximizing level of output is 199.5 units.
The total revenue is the product of price and quantity:
TR=P*Q
TR=400*199.5=$79800
The total cost is as follows:
TC=100+q2+q
TC=100+199.52+199.5
TC=$40099.75
The total profit is total revenue minus total cost.
Profit=TR-TC
Profit=$79800-$40099.75
Profit=$39700.25
The total profit is greater than zero and not equal to zero. Hence, it is short run equilibrium because in perfectly competitive market in the long run, the profits are equal to zero.
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c. Given your answer in part (b), what do you anticipate will happen in this market in the long- run?
There are supernormal profits in the industry. Hence, this will attract new firms to enter the industry. As the number of firms increases and the price will decrease, there will be pressure on the profits. Hence, the profits will reduce to normal profits and all the firms will earn zero economic profits.
d. In this market, what is the Long run equilibrium price and what is the quantity for a representative firm long-run equilibrium to produce? Explain your answer.
For the equilibrium under long run, the marginal cost should be equal to the firm's total cost in average terms. Hence,
MC=ATC
2q+1=(100+q^2+q)/q
2q2+q=100+q^2+q
q2-100=0
q=10 units
Price will be where the marginal cost is:
2q+1=20+1=$21
Total revenue is as follows:
TR=21*10=$210
TC=100+100+10=$210
Hence, the profits under this market will be equal to 0 in the long run.
e. Given the long-run equilibrium price you calculated in part (d), how many units of this good are produced in this market?
The quantity to be produced in the long run is as follows:
P=1000-2Q
21=1000-2Q
Q=489.5 units
Thus, in the long run, the quantity to be produced is 489.5 units.
Conclusion
The assignment concludes that the pricing decisions are based on the profit maximization rule by the mangers. The equilibrium quantity as well as price under perfect competition is for the market whereas the individual firm's quantity is set where the marginal cost is equal to the marginal revenue. The firm has to make decisions under uncertainty and that is when the expected value plays an important role. The expected value is based on the probabilities assigned as per the risk. The theories of consumer behavior are based on indifference curves and the managers have to take care of the consumer preferences.
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