A-AS Level (CIE) Business Studies Paper-3: Specimen Questions with Answers 16 - 18 of 20

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Case Study-2

Adam, the owner of Ever-Joy Ice-Cream Center, near University Campus, was also a part time student of management studies in a Commerce College. After having studied the theory of price elasticity of demand, he thought that the demand for ice-cream should be price elastic. For an experiment ho announced special-reduced price for the Ever Joy Ice-Cream cone in the second week of August 2001 under the 54th Independence Anniversary Week. He observed the following sales outcome.

He Observed the Following Sales Outcome
AugustPriceTotal Sales
Regular
I week$ 51000
Special
II Week$ 41500

Finding demand elasticity to be much above unity, he inferred that the price reduction led the total sales revenue to increase. This outcome encouraged him to reduce the price in October on permanent basis to ₹ 4.50. To his utter surprise he found that his average weekly sales revenue rather declined to ₹ 4,770.

What happened? Though the average weekly demand had risen to 1060 with the price reduction the sales revenue declined. Because, this time the degree of price elasticity is demand suddenly become price inelastic? Why? What went wrong?

Adam՚s approach to price policy was purely theoretical, assuming all other things being equal. He did not care to look at other factors influencing the demand for ice-cream, such as possibilities like winter, climate adverse effects, similar price-war by the rivals shops in the area. Besides, Adam offered a 20 % price reduction temporarily in August only for a week, so most buyers responded to take the advantage and probably the rival did not retaliate knowing it was a short-term phenomenon at that time. Furthermore, now when the buyers realized that price- reduction in October is permanent, they did not react much on the buying-spree. In the previous case of price reduction, the buyers expected that in future - after the celebration work is over- price will go back to the original level, therefore, they purchased more. This phenomenon of further expectations was also not taken into accounting determining the later price-reduction policy. In short, the business excision of Adam was misled by overestimation of price elasticity from the very short-term data in a special situation rather than resorting to demand estimation based on the long-term sales data under normal circumstances.

From Adam՚s experience, we should learn one important lesson that any judgement based on an aerial view may not always be good. Besides, reality widely differs from theory. Real life is never simple as depicted in theory. Managerial decision making in practice is, therefore, more of an art than science.

Question 16 (6 of 10 Based on Passage)

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Distinguish between Price Elasticity of demand and Income elasticity of demand.

Explanation

Distinguish between Price Elasticity of Demand and Income Elasticity of Demand
S. No.Price ElasticityIncome Elasticity
1.Price elasticity measures the change in quantity demanded against change in price of that product.Income elasticity of demand measures the change in quantity demanded against consumer՚s income.
2.General relationship between price and quantity demanded is adverse although there are some exceptionsGeneral relationship between price and quantity demanded is positive although there are some exceptions.
3.Products can be categorized as elastic, inelastic and unitary elasticProducts can be categorized as inferior, luxury, normal, necessities etc.

Question 17 (7 of 10 Based on Passage)

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Find out the Total sales Revenue for the first case.

Explanation

Find Out the Total Sales Revenue for the First Case
PriceTotal SalesTotal Sales Revenue
Regular
$ 510005000
Special
$ 415006000

Question 18 (8 of 10 Based on Passage)

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Explain the ceteris paribus assumption?

Explanation

In analyzing problems and business situation such as markets, demand, competition, price, and cost strategies and so on, managerial economics make use of economic and econometric models as an abstraction or realty. Eventually, this model tends to be less than perfectly realistic. This is simply because, the models are constructed with a focus on aspect or issue of the business or managerial economic problem assuming all other things being equal the typical ceteris paribus assumptions. Ceteris paribus is always taken for granted in constructing most of economic models. In fact, laws and hypothesis of economics are always stated with the qualifying phrase: “other things being equal” , i.e.. , ceteris paribus assumption. Ceteris paribus is a Latin phrase meaning “all other things remaining the same” or “all relevant factors being equal or unchanged.” The term is used frequently as an axiom in the analysis of a variety of economic phenomena. For example, in price theory the analysis of a price change is carried under ceteris assumption regarding the market behavior. It is assumed, for instance, that only demand changes, supply and determinants of supply remaining unchanged. Thus, it is inferred that when demand rises, supply being constant, price rises. Economic inferences based on ceteris paribus axiom models are logically sharp, but many times irrelevant for the practice. Ceteris paribus implies static model which is unsuitable for application to a dynamic situation. We usually find dynamism. Thus, static theoretical models have least practical relevance, they are good for theoretical understanding only.

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