MB0026 – Managerial Economics – Set I

Define Managerial Economics and discuss its importance.1

.and functions
:Definition of Managerial Economics•
Managerial Economics is a science that deals with the application of
various economic theories, principles, concepts and techniques to
business management in order to solve business management problems.
It deals with the practical application of economic theory and
methodology to decision-making problems faced by private and non-
.profit making organizations
Spencer and Seigelman defines managerial economics as the integration
of economic theory with business practice for the purpose of facilitating
.decision making and forward planning by the management
According to Mc Nair and Meriam "Managerial Economics is the use of
."economic modes of thought to analyze business situation
Brighman and Pappas define Managerial Economics as "the application of
.economic theory and methodology to business administration practice
Joel Dean is of the opinion that use of economic analysis in formulating
.business and management policies is known as managerial economics

:Importance of Managerial Economics•

Managerial economics does not give importance to the study of
theoretical economic concepts. Its main concern is to apply theories to
find solutions to day-to-day practical problems faced by a firm. The
following points indicate the significance of the study of this subject in its
:right perspective
It gives guidance for identification of key variables in decision-making (1
.process
It helps business executives to understand the various intricacies of(2
business and managerial problems and to take right decision at the
.right time
It provides the necessary conceptual, technical skills, toolbox of(3
analysis and techniques of thinking and other such most modern tools,
and instruments like elasticity of demand and supply, cost and
revenue, income and expenditure, profit and volume of production to
.solve various business problems
It is both a science and an art. In the context of globalization, (4
privatization, liberalization and marketization and a highly competitive
dynamic economy, it helps in identifying various business and
managerial problems, their causes and consequence, and suggests
.various policies and programs to overcome them
It helps in the business executives to become much more responsive,(5
realistic and competent to face the ever changing challenges in the
.modern business world
It helps in the optimum use of scarce resources of a firm to maximize(6
.its profits
It also helps in achieving other objectives a firm like attaining industry(7
.leadership, market share expansion and social responsibilities etc
It helps a firm in forecasting the most important economic variables(8
like demand, supply, cost, revenue, price, sales and profit and
.formulate sound business polices
It also helps in understanding the various external factors and forces (9
.which affect the decision making of a firm

:Two major Functions of Managerial Economics•

A Managerial Economist is specialist and an expert in analyzing and
finding answers to business and managerial problems. He has in-depth
knowledge of the subject .He is an authority and has total command over
.his subject
A Managerial Economist has to perform several functions in an
.organization
Among them decision-making and forward planning are described as the
tow major functions and all other functions are derived from these two
basic function .A detailed two functions is given below for a
understanding
Decision-making(1
The word decision suggests a deliberate choice made out of several
possible alternative courses of action after carefully considering them.
The act of choice signifying solution to an economic problem is
economic decision making. It involves choices among a set alternative
.course of action
Decision-making is essentially a process of selection the best out of
many alternative opportunities or courses of action that are open to a
.management
Decision-making is management function. Decision-making is a
routine affaire in any business unit .hence, it is a part of business
activity .it is a basic function of managerial economist. In the day to
day-to-day business, he has to take innumerable decisions.
Sometimes the manager takes the decision himself, sometimes in
.collaboration and consultation with others
Some decisions are taken on the spot and some others are taken after
careful thinking. Some decision is major and complex while others are
minor and simple. Some decisions are taken in the absence of any
information .some decision are taken in the background of certainty,
Known factors and information. Some others decision are taken in the
.in the midst of uncertainties
The choice made by the business executives are difficult and have far-
reaching consequences. The basic aim of taking a decision is to select
the best course of action which maximizes the economic benefits and
minimize the use of scarce resources of a firm .Hence; each decision
involves cost-benefit analysis. Any slight error or delay in decision
making may cause considerable economic and financial damage to
firm .it is for this reason, management exports are of the opinion that
right decision –making at right time is the secret of a successful
.manager
Forward planning(2
The term 'planning 'implies a consciously directed activity with certain
predetermined goals and means to carry them out. It is a deliberate
activity. It is a programmed action .Basically planning is concerned
.with tackling future situations in systematic manner
Forward planning implies planning in advance for the future. It is
associated with deciding the future course of action of a firm. It is
prepared on the basis of past and current experience of a firm. It is
prepared in the background of uncertain and unpredictable
environment and guess work .future events and happening cannot be
.predicted accurately
The success or failure of the future plan depends on number of factors
and forces which are unknown in nature .much of economic activity is
forward looking .every time we build a new factory ,add to the stocks
of inputs ,trucks, computers or improvements in R&D, our intension is
to enhance the future productivity of the firm .growing firms devote a
significant share of their current output to net capital formation to
bolster future economic output .A business executive must be
sufficiently intelligent enough to think in advance . Prepare a sound
plan and take all possible precautionary measure to meet all types of
challenges of the future business .hence, forward planning has
.acquired greater significance in business circles

What is elasticity of demand? Explain the different degree.1

?of price elasticity with suitable example
Meaning and definition
The term elasticity is borrowed from physics. It shows the reaction of one
variable with respect to a change in other variables on which it is
.dependent. Elasticity is an index of reaction
In economics the term elasticity refers to ratio of relative changes in two
quantities. It measures the responsiveness of one variable to the changes in
.another variable
Elasticity of demand is generally defined as the responsiveness or
sensitiveness of demand to a given change in the price of a commodity .it
refers to the capacity of demand either to stretch or shrink to a given
change in price. Elasticity of demand indicates a ratio of relative changes in
. two quantities .i.e., price and demand .according to Prof .boulding
Elasticity of demand measures the responsiveness of demand to changes"
in price "1 In the words of Marshall ,the elasticity (or responsiveness) of
demand in a market is great or small according to the amount demanded
much or little for given fall in price , and diminishes much or given rise in
price"2

Kinds of elasticity of demand

Broadly speaking there are five kinds of elasticity of demand. We shall
.discuss each one of them in some detail
Price Elasticity of demand
Price elasticity of demand is one of the important concepts of elasticity
which is used to describe the effect of change in price on quantity
demanded .In the words of prof . stonier and hague , price elasticity of
demand is technical term used by economists to explain
EP=Percentage change the degree of
in quantity
responsiveness of demand is a ratio ofdemandedpercentage
two pure numbers, change
the numerator
in price is
the percentage change in quantity demanded and the denominator is the
percentage change in price of the commodity . It is measure by using the
.following formula
Demand rises by 80% i.e.+80i.e.+80-20=-4 demand falls by 80%,i.e.-
80+20=-4
Price falls by 20% i.e price rises by 20%
i.e
It implies that at the present level with every change in price, there will be a
change in demand four times inversely. Generally the co-efficient of price
elasticity of demand always holds a negative sign because there is an
.inverse relation between the price and quantity demanded

Symbolically EP= ∆D∆P ×PD 40-2× 620=6

Original demand=20 units original price = 6 – 00

New demand =60 units new price = 4 –00
.In the above example price elasticity is – 6

The rate of change in demand may not always be proportionate to the

.change in price
A small change in price may lead to very great change in demand or big
.change in price may not lead to great change in demand
Based on numerical values of the co-efficient of elasticity, we can have the
.following five degrees of price elasticity of demand

Different degree of price elasticity of demand

Perfectly elastic demand: In this case, a very small change in price .1
leads to an infinite change in demand .the demand curve is a horizontal
.line and parallel to OX axis
(∞=The numerical co-efficient of perfectly elastic demand is infinity (ED
Y
P
r =ED
i D ∞ D
c
e

0 Quantit X
y

Perfectly inelastic demand: In this case, whatever may be the change .2

in price, quantity demand will remain perfectly constant .the demand
curve is a vertical straight line and parallel to OY axis. Quantity demand
would be 10 units, irrespective of price changes from RS. 10.00 to
Rs.2.00 Hence, the numerical co-efficient of perfectly inelastic demand is
zero. ED=0
Y
D
10.
0
 Pr
ic
e
2.0
0
0 D X
10
Quantity

Relative elastic demand: in this case a slight change in price leads to .3

more than proportionate change in demand .one can notice here that a
change in demand is more than that of change in the price. hence, the
elasticity is greater than one .for e.g. price falls by 3% and demand rises
by 9% hence the numerical co. Efficient of demand is greater than one

Y
D ED>1

3- = 3% / 9% 3%
PRICE 9% D
X 0
DEMAND

Relative inelastic demand: in this case a large change in price ,say 8%.4
fall price leads to less than proportionate change in demand ,say 4% rise
in demand .one can notice here that change in demand is less than that
of change in price .this can be represented by a steeper demand curve
hence elasticity is less than one

Y
D ED<1

0.5 = 8% / 4% 8%
D PRICE
4%
X 0
DEMAND

In all economic discussion, relatively elastic demand is generally called

as 'elastic demand' or 'more elastic demand' while relatively inelastic
'demand is popularly known as 'inelastic demand' or 'less elastic demand

Unitary elastic demand: in this case, proportionate change in price .5

leads to equal proportionate change in demand. for e.g. 5%fall in price
leads to exactly 5% increase in demand .hence elasticity is equal to unity
.it is possible to come across unitary elastic demand but it is a rare
phenomenon
 Y

ED=1
5% / 5%=1 5% PRICE

D
5% 0
X
DEMAND

Suppose your manufacturing company planning to release.1

a new product a new product into market explain the
various methods forecasting for a new product
Demand forecasting for a new product
Demand for casting for new products is quite different from that for
established products. Here the firms will not have any past experience or
past data for this purpose .An intensive study of the economic and
competitive characteristics of the product should be to make to make
.efficient forecasts
Professor Joel Dean, however, has suggested a few guidelines to make
.forecasting of demand for new products
Evolutionary approach.a
The demand for new product may be considered as an outgrowth of an
existing product. For e.g. Demand for new Tata indica which is modified
version of old indica can most effectively be projected based on sales of
the old indica, the demand for new pulsar can be forecasted based on the
a sales of the pulsor. thus when a new product is evolved from the old
product, the demand conditions of the old product can be taken as a basis
. for forecasting the demand for the new products
substitute approach.b
If the new products developed serves as substitute for the existing
product, the demand for new product may be worked out on the basis of a
market share the growths of demand for all the products have to be
worked out on the basis of intelligent forecasts for independent variables
that influence the demand for the substitutes. After that, a portion of the
market can be sliced out for the new product. For e.g, Amped as a
substituted for scooter , a cell phone as a substitute for land line .in some
cases price plays an important role in shaping future demand for the
.product
Opinion poll approach.c
Under this approach the potential buyers are directly contacted, or
through the use of samples of new product and their responses are found
out. These are finally blown up to forecast the demand for the new
.products
Sales experience approach.d
Offer the new product for sale in a sample market ;say supermarkets or
big bazaars in big cities, which are also big marketing centers .the
product may be offered for sale through one super market and the
estimate of sales obtained may be blown up to arrive at estimated
. demand for the product
Growth Curve approach.e
According to this the rate of growth and the ultimate level of demand for
the new product are estimated on basis of pattern of growth of
established products. For e.g., An Automobile Co., while introducing a
.new version of a car will study the level of demand for the existing car
Vicarious approach.f
A firm will survey consumers' reactions to new product indirectly through
getting in touch with some specialized and informed dealers who have
good knowledge about the market , about the different varieties of the
product already available in the market ,the consumers preferences etc.
.this helps in making a more efficient estimation of future demand
These methods are not mutually exclusive the management can use a
.combination of several of them supplement and cross check each other

Define the term equilibrium. explain the changes in.1

market equilibrium and effects to shifts in supply and
demand
Meaning of equilibrium
The word equilibrium is derived from the Latin word "aequilibrium" which
mean equal balance. It mean state of even balance in which opposing
forces or tendencies neutralize each other .it is position of rest
characterized by absence of change. It is a state where there is
complete agreement of the economic plans of various market
participants so that no one has tendency to revise or alter his
decision. In the words of professor Mehta: "Equilibrium denotes in
"economics absence of change in movement

Changes in Market Equilibrium

The changes in equilibrium price will occur when there will be shift
:either in demand curve or in supply curve or both
Effects of Shift in demand•
Demand changes when there is a change in the determinants of demand
like the income, tastes, prices of substitutes and complements, size of
the population etc. If demand raises due to a change in anyone of these
conditions the demand curve shifts upward to the right. If, on the other
hand, demand falls, the demand curve shifts downward to the left. Such
rise and fall in demand are referred to as increase and decrease in
.demand
A change in the market equilibrium caused by the shifts in demand can
.be explained with the help of a diagram
Y
S D1
D
D2

E1 P1
D1 E P

Price
E2 P2
D
S
D2 0
X Q2 Q Q1
DEMAND &SUPPLY
Effects of Shifts in Supply•
To study of the effects of changes in supply on market equilibrium we
assume the demand to remain constant. An increase in supply is
represented by a shift of the supply curve to the right and a decrease in
supply is represented by a shift to the left. The general rule is, if supply
.increases, price falls and if supply
S2 decreases price rises
D Y
S
S1
E2
P1
E
P
Price
E1 S2
P2
D S
S0
1
X
Q2 Q Q1
DEMAND &SUPPLY
In the diagram supply and demand curves intersect each other at point E, establishing
equilibrium price at OP and equilibrium quantity supplied and demanded at 00. Suppose
supply increases and the supply curve shifts from SS to S1S1. The new supply curve
intersects the demand curve at E1 reducing the equilibrium price to P1 and raising the
quantity demanded to OQ1. On the other hand if the supply decreases and the supply
curve shifts backward to S2S2, the equilibrium price is pushed upwards to OP2 and the
quantity demanded is reduced to OQ2. Thus changes in supply, demand remaining
.constant will cause changes in the market equilibrium

Effects of Changes in Both Demand and Supply•

Changes can occur in both demand and supply conditions. The effects of
such changes on the market equilibrium depend on the rate of change in
the two variables. If the rate of change in demand is matched with the
rate of change in supply there will be no change in the market
equilibrium, the new equilibrium shows expanded
S1 DS1market
D with
Y increased
.quantity of both supply and demand at thePsame price

0
 E1 E

Price
D1
D S1 S
X
Q Q1
DEMAND &SUPPLY
If the increase in demand is greater than the increase in supply, the new market
equilibrium is at a higher level showing a rise in both the equilibrium price and the
equilibrium quantity demanded and supplied. On the other hand if the increase in
supply is greater than the increase in demand, the new market equilibrium is at lower
level, showing a lower equilibrium price and a higher quantity of good supplied and
.demanded

S D1 Y
Y
S D1 D D
S1 S1

E1 E
P1P P
E E1
Price

Price
P1
D1 D1 S
S
D S1 0 D S1
X X 0
Q Q1 Q Q1
Quantity Quantity
Similar will be the effects when the decrease in demand is greater than
.the decrease in supply on the market equilibrium
D Y D1
S1
S

E1
P
E
Price

P1
S1
D D1 S
X 0
Q Q1
Quantity

Give a brief description of.1

Implicit and Explicit cost(a)
Actual and opportunity cost(b)

Implicit or Imputed Costs and Explicit Costs•

Explicit costs are those costs which are in the nature of contractual
payments and are paid by an entrepreneur to the factors of production
[excluding himself] in the form of rent, wages, interest 'and profits, utility
expenses, and payments for raw materials etc. They can be estimated
.and calculated exactly and recorded in the books of accounts
Implicit or imputed costs are implied costs. They do not take the form of
cash outlays and as such do not appear in the books of accounts. They
are the earnings of owner-employed resources. For example, the factor
inputs owned by the entrepreneur himself like capital that can be utilized
by himself or can be supplied to others for a contractual sum if he himself
does not utilize them in the business. It is to be remembered that the
.total cost is a sum of both implicit and explicit costs
Actual costs and Opportunity Costs•
Actual costs are also called as outlay costs, absolute costs and
acquisition costs. They are those costs that involve financial expenditures
at some time and hence are recorded in the books of accounts. They are
the actual expenses incurred for producing or acquiring a commodity or
service by a firm. For example, wages paid to workers, expenses on raw
materials, power, fuel and other types of inputs. They can be exactly
.calculated and accounted without any difficulty
Opportunity cost of a good or service is measured in terms of revenue
which could have been earned by employing that good or service in some
other alternative uses. In other words, opportunity cost of anything is the
cost of displaced alternatives or costs of sacrificed alternatives. It implies
that opportunity cost of anything is the alternative that has been
foregone. Hence, they are also called as alternative costs. Opportunity
cost represents only sacrificed alternatives. Hence, they can never be
.exactly measured and recorded in the books of accounts
The knowledge of opportunity cost is of great importance to
management decision. They help in taking decisions among alternatives.
While taking a decision among several alternatives, a manager selects
the best one which is more profitable or beneficial by sacrificing other
alternatives. For example, a firm may decide to buy a computer which
.can do the work of 10 laborers

.Critically examine Boumal's static and dynamic models.1

Prof. Boumal has developed two models. The first is static model
.and the second one is the dynamic model
The Static Model
This model is based on the following assumptions.
1. The model is applicable to a particular time period and the model does
not operate at different periods of time.
2. The firm aims at maximizing its sales revenue subject to a minimum
profit constraint.
3. The demand curve of the firm slope downwards from left to right.
4. The average cost curve of the firm is U-shaped one.
Sales maximization [dynamic model]
In the real world many changes takes place which affects business decisions
of a firm. In order to include such changes, Boumal has developed another
dynamic model. This model explains how changes in advertisement
expenditure, a major determinant of demand, would affect the sales
revenue of a firm under severe competitions. Assumptions:
1. Higher advertisement expenditure would certainly increase sales revenue
of a firm.
2. Market price remains constant.
3. Demand and cost curves of the firm are conventional in nature.

Generally under competitive conditions, a firm in order to increase its

volume of sales and sales revenue would go for aggressive advertisements.
This leads to a shift in the demand curve to the right. Forward shift in
demand curve implies increased advertisement expenditure resulting in
higher sales and sales revenue. A price cut may increase sales in general.
But increase in sales mainly depends on whether the demand for a product
is elastic or inelastic. A price reduction policy may increase its sales only
when the demand is elastic and if the demand is inelastic; such a policy
would have adverse effects on sales. Hence, to promote sales,
advertisements become an effective instrument today. It is the experience
of most of the firms that with an increase in advertisement expenditure,
sales of the company would also go up. A sales maximizer would generally
incur higher amounts of advertisement expenditure than a profit maximizer.
However, it is to be remembered that amount allotted for sales promotion
should bring more than proportionate increase in sales and total profits of a
firm. Otherwise, it will have a negative effect on business decisions
Thus, by introducing, a non-price variable in to his model, Boumal makes a
successful attempt to analyze the behavior of a competitive firm under
oligopoly market conditions. Under oligopoly conditions as there are only a
few big firms competing with each other either producing similar or
differentiated products, would resort to heavy advertisements as an
effective means to increase their sales and sales revenue. This appears to
be more practical in the present day situations.