Managerial Economics:

Unit 1: introduction and concept of Demand and supply.

Define:

Different authors have defined the term Managerial economics in different ways but
definition of Spencer and siegelman is self explanatory.

According to them “ Managerial economics is the integration of economic theories

with the business practices for the purpose of facilitating decision making and
forward plan by management”.

Collectively “Managerial economics analyses the process through which the

manager uses economic theories to address the complex problems of the business
world, and then take rational decisions in such a way that the pre conceived
objectives of the concerned firm may be attained”

Scope of Managerial economics:

Managerial economics gains its scope when economic concepts are applied to
business management for effective decision making. Managerial economics proves
in scope in five categories effectively.

1. The Demand analysis.

2. Cost analysis

3. Production Analysis

4. Market structure.

5. Pricing methods.

Apart from these there are few other fields where managerial economics gains
importance such as Capital Budgeting, Performance appraisal and other
Management concepts.

Whenever someone wants to start a business or launch a product, he/she should

definitely find out whether the product is demanded or not. The next step is to
analyze if cost of production is feasible or not. Once we are satisfied with the cost
and budgeting, we have to frame the production schedule based on the model, style
and requirement by the customer. After producing the product, it is the duty of the
firm to fix the price of the product, not only considering the cost of production but
also the market condition. Once the price is fixed, incurring the cost factor and
required profit margin, effective marketing is required. Thus there are five stages in
business that require managerial economics as indigenous factor.
1. The Demand Analysis: The demand factor is inevitable for any business for
which managerial economics has included number of concepts such as law of
demand, elasticity of demand, demand determinacy and how to forecast the
demand for the existing product but also for the new product.

2. The Cost Analysis: Cost analysis includes all types of cost concepts along with
the cost of capital, constructing the cost function( cost-output relationship)
for short term as well as long term is needed to construct the cost budget. A
cost function expresses the relationship between the cost of production and
the level of output.

3. The Production Analysis: The production function expresses the technological

or engineering relationship between the output of commodity and its factor
input namely land, labor, capital and organization. It also includes production
theories such as laws of variable proportions and law of return to scale.

4. Pricing Methods: there are different methods of pricing based on the business
situation. The type of pricing will differ. Some of the pricing methods are
skimmed pricing, penetrating pricing, differential pricing, shadow pricing,
targeted pricing etc. Once the prices are framed for the product, it should be
marketed effectively to get back the invested capital through sales revenue.

5. Market structure: Analysis of market structure and competition is very

important for marketing a product. The type of competition varies with time
and market such as

a. Perfect competition

b. Monopoly Competition

c. Monopolistic Competition

d. Oligopoly Competition.
Fundamentals of Managerial economics:

The managerial economics consists of 5 fundamental concepts namely

1. Incremental principle

2. Principles of time perspective

3. The opportunity cost principle

4. Discounting principle

5. Equi-marginal principle.
The basic concepts of M.E are otherwise called the fundamentals of business
economics. There are 5 fundamental principles to analyze and understand the
business values.

Opportunity cost principle: The opportunity cost principle refers to the cost or
the revenue incurred or enjoyed from the alternative. In simple words, the
opportunity cost is the cost of the alternative solution which was not implemented
on resolving an issue. For example, there are 2 options A and B for business
decision. Opportunity cost is the cost of A when B is chosen as the right solution. In
simple words it is the costs of displaced alternatives.

Incremental principle: The incremental concept involves estimation of impact of

the decision alternatives on costs and revenues that results from changes in various
factors on business environment such as price, products, procedures and
investment. The 2 fundamental concepts in this principle is incremental cost and
incremental revenue. It is the cost or revenue change resulting from a business
decision. A decision is profitable only when increases revenue more than the cost or
decreases the cost more than the revenue.
Marginal cost and marginal revenue also has an impact on the incremental concept
but MC and MR are always in terms of unit changes in output but incremental cost
and revenue are not necessarily restricted to unit changes. The marginalism is
generally limited to effects of change in output but in decision making there are
much more complexities than change in output. Therefore Marginalism does not
suited to all kinds of incremental principles.

Principle of Time perspective: Time plays a decisive role in economic theory,

particularly pricing. Alfred Marshall introduced the time concept in value theory; he
conceived 4 market forms based on time; very short period, short period, long
period and very long period or secular period.

Managerial economists are generally concerned with the short term and long term
effects of decision on costs and revenues. A decision made on the basis of short run
considerations may, in long run, prove less profitable than it first seemed. A
decision should be made considering short run and long run effects on costs, giving
appropriate weight to most relevant time periods.

Discounting Principle: This principle has its genesis in valuing the money
received at different points of time. Whenever we make comparisons between
present and future values of money, we always discount future value to make it
comparable with the present value. The choice of getting Rs1000 today and next
year always end up the same way, 1000rs now would be preferred as it can be
invested and multiplied, say by Rs100. The value next year would be Rs1100,
therefore Rs1000 at a future date is to be discounted at the rate of 10%.

Present Value = 100/1+Interest rate.

The discount concept is very useful in making investment decisions. It has profound
relevance in capital budgeting.

Equi-Marginal principle: According to this concept, an input should be allocated

in such a way that the value added by the last unit is same in all the cases. Suppose
there are three activities A, B and C and the firm have 100 units of labor. If the firm
adds one unit of labor to activity B from A or C then the increase in output of B is
the marginal product of labor in B. The optimum is achieved only when the marginal
product of labor in A, B and C is equal.

VMPa = VMPb = VMPc

The Equi-marginal principle holds good only in cases where the law of diminishing
returns operate.
DEMAND:-
Law of Demand:

The law of demand indicates the relationship between the price of a commodity and
the quantity demanded in the market. It may be stated as “other things being
constant, the quantity demanded extends with a fall in price and contracts with a
rise in price” The quantity demanded varies inversely with price.

Marshall defined law of demand as “The greater the amount to be sold, smaller
must be the price at which it is offered in order that it finds more purchasers, in
other words the amount demanded increases with a fall in price and diminishes with
a rise in price”

The other factors influencing the demand are as stated already, the income of
consumers, tastes and preferences, existence of substitute commodities, changes
in weather and expectation of future trends.

Features of Law of Demand:

1. There is an inverse relationship between demand and price of the product.

2. Price is independent variable whereas demand is a dependant variable.

3. Other things remain constant.

Exception to Law of Demand: The law of demand is only a general statement

telling that the prices and quantities of a product are inversely related. There are
peculiar cases in which the law of demand will not hold well. A few cases are as
following:

1. Inferior Goods ( Giffen effect or Giffen paradox)

2. Necessary Products

3. Prestige goods

4. Emergency goods

5. Consumer ignorance

6. Taste and preference

7. Fashion and style

8. Advancement in technology.
Inferior Goods: Sir Robert Giffen has explained the law of demand does not hold for
inferior products because the consumption of inferior goods is not decided by the
price of the goods. Example: Common salt.

Necessary Products: The law of demand is not applicable for necessary products as
irrespective of the price change people have to consume the minimum amount of
necessary commodities such as food, shelter and clothing.

Prestige Goods: Prestige goods are afforded only by rich people and as the prices
rise for these goods, so does their attraction from people. Found by Veblen it is
called as the Veblen effect. As the products price goes up, the demand rises as well
thus proving as an exception for the law of demand.

Emergency Goods: The law of demand cannot be applied in cases of emergencies.

Suppose a person met with an accident and needs intensive medication he cannot
afford to change the demand as the prices are high for certain medications. He has
to opt irrespective of price rise.

Consumer Ignorance: If the consumer is not aware of the product or its impact, he
does not apply the law of demand; he buys the product whenever he needs it.

Fashion and style: With change in fashion and trends, people will never opt for
outdated fashion or old styled goods irrespective of the change in price. Thus it
proves as an exception of law of demand.
With all features and exceptions, it is a fact that the demand curve slopes
downwards from left to right. The reasons are

1. Income effect

2. Law of diminishing marginal utility

3. Substitution effect.

Income effect: The fall in the price is equivalent to an increase in the income of the
consumer and this gives the effect of increase in real income for him to purchase
more.

Law of Diminishing Marginal utility: The additional units consumed or purchased

give lesser and lesser utility. The consumer will never pay a price or money value
more than the marginal utility of the commodity. Therefore the consumer will not
buy a large quantity unless the price is low. The law of demand is nearly a corollary
from the law of diminishing marginal utility.

Substitution effect: If the price of the commodity falls, it will be substituted for
costlier things and so the quantity demanded will go up.

Elasticity of demand:

The Law of demand tells us about the direction of change of price through quantity
demanded or vice versa, it does not tell about the quantum of change. This is
explained by elasticity of demand.

Alfred Marshall explained it as “The elasticity (or responsiveness) of demand in a

market is great or small according to amount demanded increases much or small
for a given fall in price and diminishes much or little for a given rise in price.”

A different definition says “elasticity is the technical term used to describe the
degree of responsiveness of demand for a commodity to fall in its price.” Since it
deals with the change in price it is referred as price elasticity of demand.

Determinants of Price elasticity:

1. Availability of substitutes

2. Proportion of income spent

3. Time period

Thus price elasticity can be formulated as

Ep= % change in demand/ % change in price.

The price elasticity can be classified into 5 categories on the basis of values.

1. Perfectly Elastic

2. Perfectly inelastic

3. Unitary elasticity

4. Relatively elastic and

5. Relatively Inelastic.

Unitary Elasticity:

When the percentage change in demand is equal to the percentage change in price,
the value of Price elasticity according to the above mentioned formula is 1. This is
called unitary elasticity. Graphically it may be represented as

Perfectly Elastic:

If the percentage change of demand is 5% without any change in the price then
elasticity of demand is considered to be perfectly elastic. If there is 5% change in
demand without any change in price, we cannot calculate the elasticity. The
elasticity is infinity or indeterminate.

Perfectly inelastic:

Suppose there is no change in the demand even though there is a change in the
price, the elasticity of demand is said to be perfectly inelastic. For example, there is
no change in demand for a 5% decrease in price; the value of elasticity is zero. This
condition is called perfectly inelastic.

Relatively Elasticity:

The proportional change in demand is greater than the proportional change in price.
We get a value that is greater than unitary. This condition is said to be relatively
elastic.

Relatively Inelastic:

The proportional change in demand is lesser than the proportional change in price,
we get a value that is lesser than 1. This condition is referred to as relatively
inelastic.

These are the 5 types of price elasticity of demand.

Cross elasticity of demand:

Cross elasticity of demand tells us the extent of change in the quantity demanded
of a particular commodity A, due to the change in price of a commodity B which
may be either substitute for A or a complementary commodity for A.

It can be formulated as

Ec = % change in demand of A/% change in price of B

Where B is a complementary or substitution commodity.

In case of substitute commodities the cross elasticity is either positive or infinity

since they are directly proportional. When the price of B increases, the demand for
A also increases; when the price of B reduces, the demand for A decreases and vice
versa.

In case of complementary, the rise in price of one will lead to the fall in the quantity
demanded of that commodity, but also of the complementary commodity. In such
cases the cross elasticity of demand will be negative.

Demand Forecasting:
The production of any product is meaningful only when it has consumers. Thus the
level of demand decides the success of a company. A forecast is an estimation of a
future situation. Forecasting demand denotes an estimation of the level of demand
of the product at a future period under given circumstances. To put it simply
“Objective assessment of future course of demand”

Demand Forecasting is classified based on 2 approaches

1. Time Perspective

2. Level of forecasting.

Considering time as the major factor, it is classified as

a. Short term forecasting: This is limited to short period not exceeding one year.
This is useful in taking adhoc decisions concerning the day to day working of
the concern. Many companies use it for setting targets and establishing
controls and incentives.

b. Long term forecasting: It involves assessment of long term demand for the
product and involves expansion of production units. This is used for taking
strategic decisions at the top level of management.

Considering the level of forecasting as the major factor, it is classified into

 a. Macroeconomic forecasting is concerned with business conditions over the
whole economy, usually measured by appropriate index. Ex: National income
or expenditure.

b. Industrial level forecasting is made available by chamber of commerce or

trade associations to its members based on consumer intentions and
statistical trends.

c. Firm level forecasting is related to individual firm and what they are
concerned about.

Forecasting Methods:

There are several methods employed for forecasting demand. All of them can be
classified under 2 categories, namely, statistical methods and survey methods. By
survey method, we try to elicit information about the desires of the consumers and
the opinions of experts by interviewing them. Statistical methods, on the other
hand, use the past data as a guide for knowing the level of future demand.

Under survey method there are 2 types,

a. Expert’s opinion survey method

b. Consumer survey method.

Opinion survey method: It refers to collecting opinion from experts or people so

close to the business and predicting the level of demand in the future based on
their prediction. This is too easy method but is not accurate since it depends on
personal opinions.

Consumer survey method: In this method, forecasting is done by directly

interviewing the customers and asking them about their plans and preferences
regarding the consumption of the product. This approach is passive; it does not
expose and measure the variables under management’s control.

Consumer’s survey method may be of three types;

1. Complete enumeration method

2. Sample survey method

3. Consumer end-use method.

Complete enumeration method involves aggregation of individual expected

demands, sample survey method is used by selecting a sample of consumers for
interview and manipulate the total demand while consumer end-use method
depends upon end use of the product for different sectors and segment the sectors
and predict the demand for specific sectors.

There are various approaches under the statistical methods:

TREND PROJECTION METHOD:

A firm in existence for a long time will have its own accumulated data relating to
sales during past years. The trend in these data will be used to project the future
trends in demand and sales. This requires an ordered sequence of events over a
period of time pertaining to certain variable. Thus it is also called time series
method.

The time series has got four types of components:

a. Secular trends

b. Seasonal variations

c. Cyclical variations

d. Random variations

REGRESSION AND CORRELATION METHOD:

Another method of forecasting demand is the regression and correlation analysis.

According to this method, one has to ascertain the variables which determine the
variable under forecast i.e. the relationship between sales and other variables. An
attempt is made to relate sales to socio-economic variables so as to ascertain future
probable sales. Such relationship established on the basis of past data is used to
analyze the future trend.

BAROMETRIC METHOD:

Events of the present are used to predict the directions of change in the future. This
is done by the use of certain economic and statistical indicators from the selected
time series to predict variables. These variables are put into any of the economic
indicators and the future demand is predicted accordingly.

Law of supply:
The law of supply also expresses the relationship between the price and the supply
of the product. According to Alfred Marshall other things remain constant; the price
of the commodity has a direct influence to the quantity supplied. As the price of the
commodity increases, its supply is extended; as the price falls, the supply is
contracted. The following table shows an imaginary supply schedule for product x.

Price of X Quantity Supplied

3 40
4 50
5 60
6 75
7 90

When represented graphically, the supply curve slopes upwards from left to right.