INTRODUCTION TO MANAGERIAL ECONOMICS Managerial economics is a discipline which deals with the application of economic theory to business management.

It deals with the use of economic concepts and principles of business decision making. Formerly it was known as Business Economics but the term has now been discarded in favour of Managerial Economics. Managerial Economics may be defined as the study of economic theories, logic and methodology which are generally applied to seek solution to the practical problems of business. Managerial Economics is thus constituted of that part of economic knowledge or economic theories which is used as a tool of analysing business problems for rational business decisions. Managerial Economics is often called as Business Economics or Economic for Firms. Definition of Managerial Economics: Managerial Economics is economics applied in decision making. It is a special branch of economics bridging the gap between abstract theory and managerial practice. Haynes, Mote and Paul. Business Economics consists of the use of economic modes of thought to analyse business situations. McNair and Meriam Business Economics (Managerial Economics) is the integration of economic theory with business practice for the purpose of facilitating decision making and forward planning by management. Spencer and Seegelman. Managerial economics is concerned with application of economic concepts and economic analysis to the problems of formulating rational managerial decision. Mansfield Nature of Managerial Economics:

The primary function of management executive in a business organisation is decision making and forward planning. Decision making and forward planning go hand in hand with each other. Decision making means the process of selecting one action from two or more alternative courses of action. Forward planning means establishing plans for the future to carry out the decision so taken. The problem of choice arises because resources at the disposal of a business unit (land, labour, capital, and managerial capacity) are limited and the firm has to make the most profitable use of these resources. The decision making function is that of the business executive, he takes the decision which will ensure the most efficient means of attaining a desired objective, say profit maximisation. After taking the decision about the particular output, pricing, capital, rawmaterials and power etc., are prepared. Forward planning and decision-making thus go on at the same time.

A business managers task is made difficult by the uncertainty which surrounds business decision-making. Nobody can predict the future course of business conditions. He prepares the best possible plans for the future depending on past experience and future outlook and yet he has to go on revising his plans in the light of new experience to minimise the failure. Managers are thus engaged in a continuous process of decisionmaking through an uncertain future and the overall problem confronting them is one of adjusting to uncertainty. In fulfilling the function of decision-making in an uncertainty framework, economic theory can be, pressed into service with considerable advantage as it deals with a number of concepts and principles which can be used to solve or at least throw some light upon the problems of business management. E.g are profit, demand, cost, pricing, production, competition, business cycles, national income etc. The way economic analysis can be used towards solving business problems, constitutes the subject-matter of Managerial Economics. Thus in brief we can say that Managerial Economics is both a science and an art.

Scope of Managerial Economics: The scope of managerial economics is not yet clearly laid out because it is a developing science. Even then the following fields may be said to generally fall under Managerial Economics: 1. 2. 3. 4. 5. Demand Analysis and Forecasting Cost and Production Analysis Pricing Decisions, Policies and Practices Profit Management Capital Management

These divisions of business economics constitute its subject matter. Recently, managerial economists have started making increased use of Operation Research methods like Linear programming, inventory models, Games theory, queuing up theory etc., have also come to be regarded as part of Managerial Economics.
1. Demand Analysis and Forecasting: A business firm is an economic organisation which

is engaged in transforming productive resources into goods that are to be sold in the market. A major part of managerial decision making depends on accurate estimates of demand. A forecast of future sales serves as a guide to management for preparing production schedules and employing resources. It will help management to maintain or strengthen its market position and profit base. Demand analysis also identifies a number of other factors influencing the demand for a product. Demand analysis and forecasting occupies a strategic place in Managerial Economics. 2. Cost and production analysis: A firms profitability depends much on its cost of production. A wise manager would prepare cost estimates of a range of output, identify the factors causing are cause variations in cost estimates and choose the cost-minimising output level, taking also into consideration the degree of uncertainty in production and cost calculations. Production processes are under the charge of engineers but the business

manager is supposed to carry out the production function analysis in order to avoid wastages of materials and time. Sound pricing practices depend much on cost control. The main topics discussed under cost and production analysis are: Cost concepts, costoutput relationships, Economics and Diseconomies of scale and cost control. 3. Pricing decisions, policies and practices: Pricing is a very important area of Managerial Economics. In fact, price is the genesis of the revenue of a firm ad as such the success of a business firm largely depends on the correctness of the price decisions taken by it. The important aspects dealt with this area are: Price determination in various market forms, pricing methods, differential pricing, product-line pricing and price forecasting. 4. Profit management: Business firms are generally organized for earning profit and in the long period, it is profit which provides the chief measure of success of a firm. Economics tells us that profits are the reward for uncertainty bearing and risk taking. A successful business manager is one who can form more or less correct estimates of costs and revenues likely to accrue to the firm at different levels of output. The more successful a manager is in reducing uncertainty, the higher are the profits earned by him. In fact, profit-planning and profit measurement constitute the most challenging area of Managerial Economics. 5. Capital management: The problems relating to firms capital investments are perhaps the most complex and troublesome. Capital management implies planning and control of capital expenditure because it involves a large sum and moreover the problems in disposing the capital assets off are so complex that they require considerable time and labour. The main topics dealt with under capital management are cost of capital, rate of return and selection of projects. Basic economic tools in managerial economics for decision making: Economic theory offers a variety of concepts and analytical tools which can be of considerable assistance to the managers in his decision making practice. These tools are helpful for managers in solving their business related problems. These tools are taken as guide in making decision. Following are the basic economic tools for decision making: 1. 2. 3. 4. 5. Opportunity cost Incremental principle Principle of the time perspective Discounting principle Equi-marginal principle

1) Opportunity cost principle: By the opportunity cost of a decision is meant the sacrifice of alternatives required by that decision. For e.g.

a) The opportunity cost of the funds employed in ones own business is the interest that could be earned on those funds if they have been employed in other ventures. b) The opportunity cost of using a machine to produce one product is the earnings forgone which would have been possible from other products. c) The opportunity cost of holding Rs. 1000as cash in hand for one year is the 10% rate of interest, which would have been earned had the money been kept as fixed deposit in bank. Its clear now that opportunity cost requires ascertainment of sacrifices. If a decision involves no sacrifices, its opportunity cost is nil. For decision making opportunity costs are the only relevant costs. 2) Incremental principle: It is related to the marginal cost and marginal revenues, for economic theory. Incremental concept involves estimating the impact of decision alternatives on costs and revenue, emphasizing the changes in total cost and total revenue resulting from changes in prices, products, procedures, investments or whatever may be at stake in the decisions. The two basic components of incremental reasoning are 1. Incremental cost 2. Incremental Revenue The incremental principle may be stated as under: A decision is obviously a profitable one if

it increases revenue more than costs it decreases some costs to a greater extent than it increases others it increases some revenues more than it decreases others and it reduces cost more than revenues

3) Principle of Time Perspective Managerial economists are also concerned with the short run and the long run effects of decisions on revenues as well as costs. The very important problem in decision making is to maintain the right balance between the long run and short run considerations. For example; Suppose there is a firm with a temporary idle capacity. An order for 5000 units comes to managements attention. The customer is willing to pay Rs 4/- unit or Rs.20000/- for the whole lot but not more. The short run incremental cost(ignoring the fixed cost) is only Rs.3/-. There fore the contribution to overhead and profit is Rs.1/- per unit (Rs.5000/- for the lot)

Analysis: From the above example the following long run repercussion of the order is to be taken into account: 1) If the management commits itself with too much of business at lower price or with a small contribution it will not have sufficient capacity to take up business with higher contribution. 2) If the other customers come to know about this low price, they may demand a similar low price. Such customers may complain of being treated unfairly and feel discriminated against. In the above example it is therefore important to give due consideration to the time perspectives. a decision should take into account both the short run and long run effects on revenues and costs and maintain the right balance between long run and short run perspective. 4) Discounting Principle: One of the fundamental ideas in Economics is that a rupee tomorrow is worth less than a rupee today. Suppose a person is offered a choice to make between a gift of Rs.100/- today or Rs.100/next year. Naturally he will chose Rs.100/- today. This is true for two reasonsi) The future is uncertain and there may be uncertainty in getting Rs. 100/- if the present opportunity is not availed of ii) Even if he is sure to receive the gift in future, todays Rs.100/- can be invested so as to earn interest say as 8% so that one year after Rs.100/- will become 108 5) Equi marginal Principle: This principle deals with the allocation of an available resource among the alternative activities. According to this principle, an input should be so allocated that the value added by the last unit is the same in all cases. This generalization is called the equi-marginal principle. Suppose, a firm has 100 units of labor at its disposal. The firm is engaged in four activities which need labors services, viz, A,B,C and D. it can enhance any one of these activities by adding more labor but only at the cost of other activities. The Micro Economics and Macro Economics: Economic analysis is of two types (a) Micro economic analysis and (b) Macro economic analysis a) Definition of Micro economics: According to E. Boulding, Micro economics is the study of particular firm, particular household, individual price, wage, income, industry, and particular commodity.

In the words of Leftwitch, Micro economics is concerned with the economic activities of such economic units as consumers, resource owners and business firms.

Micro is a Greek word means small. Micro economic theory studies the behaviour of individual decision-making units such as consumers resource owners, business firms, individual households, wages of workers, etc. It studies the flow of economic resources or factors of production from the resource owners to business firms and the flow of goods and services from the business firms to households. It studies the composition of such flows and how the prices of goods and services in the flow are determined. In this analysis economists pick up a small unit and observe the details of its operation. It provides analytical tools for the study of the behaviour of market mechanism. It is also called as Price theory and It is also called as Partial Equilibrium analysis.

Conclusion: Micro economics has been defined as that branch where the unit of study is an individual, firm or household. It studies how individual make their choices about what to produce, how to produce, and for whom to produce, and what price to charge. It is also known as the price theory is the main source of concepts and analytical tools for managerial decision making. Various micro economic concepts such as demand, supply, elasticity of demand and supply, marginal cost, various market forms, etc. are of great significance to managerial economics. Importance of Micro economics:

Micro economics occupies a very important place in the study of economic theory. It has both theoretical and practical importance. It explains the functioning of a free enterprise economy. It tells how millions of consumers and producers in an economy take decisions about the allocation of productive resources among millions of goods and services. It explains how through market mechanism goods and services produced in the community are distributed. It explains the determination of the relative prices of the various products and productive services. It helps in the formulation of economic policies calculated to promote efficiency in production and the welfare of the masses.

Limitations of Micro economics:

It cannot give an idea of the functioning of the economy as a whole. An individual industry may be flourishing, where as the economy as a whole may be languishing. It assumes full employment which is a rare phenomenon, at any rate in the capitalist world. Therefore it is an unrealistic assumption.

b) Definition of Macro economics:

According to E. Boulding Macro economics deals not with individual quantities as such but with aggregates of these quantities, not with individual income but with national income not with individual prices but with price levels, not with individual outputs but with national output. According to Gardner Ackely, Macro economics concerns with such variables as the aggregate volume of the output of an economy, with the extent to which its resources are employed, with the size of national income and with the general price level.

Macro economics is the obverse of microeconomics. It is the study of economic system as a whole. It studies not one economic unit like a firm or an industry but the whole economic system. Therefore it deals with totals or aggregates national income output and employment, total consumption, saving and investment and the genera level of prices. It is also called as Income theory and It is also called as aggregative economics.

Conclusion: Macro economics studies the economics as a whole. It is aggregative in character and takes the entire economic as a unit of study. Macro economics helps in the area of forecasting. It includes National Income, aggregate consumption, investments, employment etc. Importance of Macro economics:

It helps in understanding the functioning of a complicated economic system It gives a birds eye view of the economic world For the formulation of useful economic policies for the nation macro economics is of the utmost significance. It is far more fruitful to regulate aggregate employment and national income and to work out a national wage policy It occupies most important place in economic theory in its pursuit of the solution of urgent economic problems.

Limitations of Macro economics:

Individual is ignored altogether. It is individual welfare which is the main aim of economics. It overlooks individual differences. Say the general price level may be stable, but the price of food grains may have gone spelling ruin to the poor.

Difference between Micro economics and Macro economics: The main differences between micro economics and macro economics are the following: S.no Micro economics Macro economics

1.

2.

3.

4.

5.

6.

Difference in the degreeIt studies the individual unitsIt deals with aggregates like of aggregation: of the economy like a firm, anational income and particular commodity. aggregate savings. It studies the problem of the economy as a whole Difference in objectives It is to study of principles,It studies the problems, problems and policiespolicies and principles concerning the optimumrelating full employment of allocation of resources resources and growth of resources. Difference of subjectIt deals with the determinationIt is full employment, matter of price, consumersnational income, general equilibrium, distribution andprice-level, trade cycles, welfare, etc. economic growth, etc. Method of study Micro economics lawsMacro economics elements establish relationship betweenare categorized into the causes and effects ofaggregate units like economics phenomena and itaggregate demand, is formulated by taking someaggregate supply, total assumptions. consumption, total investment, etc. Different assumptions It analysis how productionIt analysis how full and factors of production areemployment can be allocated among differentachieved. uses. Difference of the forcesIt studies the equilibriumIt deals with equilibrium of equilibrium between the forces ofbetween the forces demand individual demand and supplyand supply of whole or market demand and supply. economy.

Concept of Demand in Managerial Economics: In Economics, use of the word demand is made to show the relationship between the prices of a commodity and the amounts of the commodity which consumers want to purchase at those price. Definition of Demand: Hibdon defines, Demand means the various quantities of goods that would be purchased per time period at different prices in a given market. Bober defines, By demand we mean the various quantities of given commodity or service which consumers would buy in one market in a given period of time at various prices, or at various incomes, or at various prices of related goods.

Demand for product implies: a) desires to acquire it, b) willingness to pay for it, and c) Ability to pay for it. All three must be checked to identify and establish demand. For example : A poor mans desires to stay in a five-star hotel room and his willingness to pay rent for that room is not demand, because he lacks the necessary purchasing power; so it is merely his wishful thinking. Similarly, a misers desire for and his ability to pay for a car is not demand, because he does not have the necessary willingness to pay for a car. One may also come across a well-established person who processes both the willingness and the ability to pay for higher education. But he has really no desire to have it, he pays the fees for a regular cause, and eventually does not attend his classes. Thus, in an economics sense, he does not have a demand for higher education degree/diploma. It should also be noted that the demand for a product-a commodity or a servicehas no meaning unless it is stated with specific reference to the time, its price, price of is related goods, consumers income and tastes etc. This is because demand, as is used in Economics, varies with fluctuations in these factors. To say that demand for an Atlas cycle in India is 60,000 is not meaningful unless it is stated in terms of the year, say 1983 when an Atlas cycles price was around Rs. 800, competing cycles prices were around the same, a scooters prices was around Rs. 5,000. In 1984, the demand for an Atlas cycle could be different if any of the above factors happened to be different. For example, instead of domestic (Indian), market, one may be interested in foreign (abroad) market as well. Naturally the demand estimate will be different. Furthermore, it should be noted that a commodity is defined with reference to its particular quality/brand; if its quality/brand changes, it can be deemed as another commodity. To sum up, we can say that the demand for a product is the desire for that product backed by willingness as well as ability to pay for it. It is always defined with reference to a particular time, place, price and given values of other variables on which it depends. Demand Function and Demand Curve Demand function is a comprehensive formulation which specifies the factors that influence the demand for the product. What can be those factors which affect the demand? For example, Dx = D (Px, Py, Pz, B, W, A, E, T, U) Here Dx, stands for demand for item x (say, a car)

Px, its own price (of the car) Py, the price of its substitutes (other brands/models) Pz, the price of its complements (like petrol) B, the income (budget) of the purchaser (user/consumer) W, the wealth of the purchaser A, the advertisement for the product (car) E, the price expectation of the user T, taste or preferences of user U, all other factors. Briefly we can state the impact of these determinants, as we observe in normal circumstances: i) Demand for X is inversely related to its own price. As price rises, the demand tends to fall and vice versa. ii) The demand for X is also influenced by its related priceof goods related to X. For example, if Y is a substitute of X, then as the price of Y goes up, the demand for X also tends to increase, and vice versa. In the same way, if Z goes up and, therefore, the demand for X tends to go up. iii) The demand for X is also sensitive to price expectation of the consumer; but here, much would depend on the psychology of the consumer; there may not be any definite relation. This is speculative demand. When the price of a share is expected to go up, some people may buy more of it in their attempt to make future gains; others may buy less of it, rather may dispose it off, to make some immediate gain. Thus the price expectation effect on demand is not certain. iv) The income (budget position) of the consumer is another important influence on demand. As income (real purchasing capacity) goes up, people buy more of normal goods and less of inferior goods. Thus income effect on demand may be positive as well as negative. The demand of a person (or a household) may be influenced not only by the level of his own absolute income, but also by relative incomehis income relative to his neighbours income and his purchase pattern. Thus a household may demand a new set of furniture, because his neighbour has recently renovated his old set of furniture. This is called demonstration effect. v) Past income or accumulated savings out of that income and expected future income, its discounted value along with the present incomepermanent and transitoryall together determine the nominal stock of wealth of a person. To this, you may also add his current stock of assets and other forms of physical capital; finally adjust this to price level. The real wealth of the

consumer, thus computed, will have an influence on his demand. A person may pool all his resources to construct the ground floor of his house. If he has access to some additional resources, he may then construct the first floor rather than buying a flat. Similarly one who has a color TV (rather than a black-and-white one) may demand a V.C.R./V.C.P. This is regarded as the real wealth effect on demand. vi) Advertisement also affects demand. It is observed that the sales revenue of a firm increases in response to advertisement up to a point. This is promotional effect on demand (sales). Thus vii) Tastes, preferences, and habits of individuals have a decisive influence on their pattern of demand. Sometimes, even social pressurecustoms, traditions and conventions exercise a strong influence on demand. These socio-psychological determinants of demand often defy any theoretical construction; these are non-economic and non-market factorshighly indeterminate. In some cases, the individual reveal his choice (demand) preferences; in some cases, his choice may be strongly ordered. We will revisit these concepts in the next unit. You may now note that there are various determinants of demand, which may be explicitly taken care of in the form of a demand function. By contrast, a demand curve only considers the pricedemand relation, other things (factors) remaining the same. This relationship can be illustrated in the form of a table called demand schedule and the data from the table may be given a diagrammatic representation in the form of a curve. In other words, a generalized demand function is a multivariate function whereas the demand curve is a single variable demand function. Dx = D(Px)

In the slopeintercept from, the demand curve which may be stated as

Dx = + Px, where is the intercept term and the slope which is negative because of inverse relationship between Dx and Px. Suppose, = (-) 0.5, and = 10 Then the demand function is : D=10-0.5P TYPES OF DEMAND: The different types of demand are: i) Direct and Derived Demands Direct demand refers to demand for goods meant for final consumption; it is the demand for consumers goods like food items, readymade garments and houses. By contrast, derived demand refers to demand for goods which are needed for further production; it is the demand for producers goods like industrial raw materials, machine tools and equipments. Thus the demand for an input or what is called a factor of production is a derived demand; its demand depends on the demand for output where the input enters. In fact, the quantity of demand for the final output as well as the degree of substituability/complementarty between inputs would determine the derived demand for a given input. For example, the demand for gas in a fertilizer plant depends on the amount of fertilizer to be produced and substitutability between gas and coal as the basis for fertilizer production. However, the direct demand for a product is not contingent upon the demand for other products. ii) Domestic and Industrial Demands The example of the refrigerator can be restated to distinguish between the demand for domestic consumption and the demand for industrial use. In case of certain industrial raw materials which are also used for domestic purpose, this distinction is very meaningful. For example, coal has both domestic and industrial demand, and the distinction is important from the standpoint of pricing and distribution of coal. iii) Autonomous and Induced Demand When the demand for a product is tied to the purchase of some parent product, its demand is called induced or derived. For example, the demand for cement is induced by (derived from) the demand for housing. As stated above, the demand for all producers goods is derived or induced. In addition, even in the realm of consumers goods, we may think of induced demand. Consider the complementary items like tea and sugar, bread and butter etc. The demand for butter (sugar) may be induced by

the purchase of bread (tea). Autonomous demand, on the other hand, is not derived or induced. Unless a product is totally independent of the use of other products, it is difficult to talk about autonomous demand. In the present world of dependence, there is hardly any autonomous demand. Nobody today consumers just a single commodity; everybody consumes a bundle of commodities. Even then, all direct demand may be loosely called autonomous. iv) Perishable and Durable Goods Demands Both consumers goods and producers goods are further classified into perishable/nondurable/single-use goods and durable/non-perishable/repeated-use goods. The former refers to final output like bread or raw material like cement which can be used only once. The latter refers to items like shirt, car or a machine which can be used repeatedly. In other words, we can classify goods into several categories: single-use consumer goods, single-use producer goods, durable-use consumer goods and durable-use producers goods. This distinction is useful because durable products present more complicated problems of demand analysis than perishable products. Non-durable items are meant for meeting immediate (current) demand, but durable items are designed to meet current as well as future demand as they are used over a period of time. So, when durable items are purchased, they are considered to be an addition to stock of assets or wealth. Because of continuous use, such assets like furniture or washing machine, suffer depreciation and thus call for replacement. Thus durable goods demand has two varieties replacement of old products and expansion of total stock. Such demands fluctuate with business conditions, speculation and price expectations. Real wealth effect influences demand for consumer durables. v) New and Replacement Demands This distinction follows readily from the previous one. If the purchase or acquisition of an item is meant as an addition to stock, it is a new demand. If the purchase of an item is meant for maintaining the old stock of capital/asset, it is replacement demand. Such replacement expenditure is to overcome depreciation in the existing stock. Producers goods like machines. The demand for spare parts of a machine is replacement demand, but the demand for the latest model of a particular machine (say, the latest generation computer) is anew demand. In course of preventive maintenance and breakdown maintenance, the engineer and his crew often express their replacement demand, but when a new process or a new technique or anew product is to be introduced, there is always a new demand. You may now argue that replacement demand is induced by the quantity and quality of the existing stock, whereas the new demand is of an autonomous type. However, such a distinction is more of degree than of kind. For example, when demonstration effect operates, a new demand may also be an induced demand. You may buy a new VCR, because your neighbor has recently bought one. Yours is a new purchase, yet it is induced by your neighbors demonstration. vi) Final and Intermediate Demands

This distinction is again based on the type of goods- final or intermediate. The demand for semifinished products, industrial raw materials and similar intermediate goods are all derived demands, i.e., induced by the demand for final goods. In the context of input-output models, such distinction is often employed. vii) Individual and Market Demands This distinction is often employed by the economist to study the size of the buyers demand, individual as well as collective. A market is visited by different consumers, consumer differences depending on factors like income, age, sex etc. They all react differently to the prevailing market price of a commodity. For example, when the price is very high, a low-income buyer may not buy anything, though a high income buyer may buy something. In such a case, we may distinguish between the demand of an individual buyer and that of the market which is the market which is the aggregate of individuals. You may note that both individual and market demand schedules (and hence curves, when plotted) obey the law of demand. But the purchasing capacity varies between individuals. For example, A is a high income consumer, B is a middleincome consumer and C is in the low-income group. This information is useful for personalized service or target-group-planning as a part of sales strategy formulation. viii) Total Market and Segmented Market Demands This distinction is made mostly on the same lines as above. Different individual buyers together may represent a given market segment; and several market segments together may represent the total market. For example, the Hindustan Machine Tools may compute the demand for its watches in the home and foreign markets separately; and then aggregate them together to estimate the total market demand for its HMT watches. This distinction takes care of different patterns of buying behavior and consumers preferences in different segments of the market. Such market segments may be defined in terms of criteria like location, age, sex, income, nationality, and so on x) Company and Industry Demands An industry is the aggregate of firms (companies). Thus the Companys demand is similar to an individual demand, whereas the industrys demand is similar to aggregated total demand. You may examine this distinction from the standpoint of both output and input. For example, you may think of the demand for cement produced by the Cement Corporation of India (i.e., a companys demand), or the demand for cement produced by all cement manufacturing units including the CCI (i.e., an industrys demand). Similarly, there may be demand for engineers by a single firm or demand for engineers by the industry as a whole, which is an example of demand for an input. You can appreciate that the determinants of a companys demand may not always be the same as those of an industrys. The inter-firm differences with regard to technology, product quality, financial position, market (demand) share, market leadership and competitiveness- all these are possible explanatory factors. In fact, a clear understanding of the relation between company and industry demands necessitates an understanding of different market structures.

Law of demand: Suppose you want to buy mangoes at Rs.100 per dozen you buy 6 dozens. If the price of mangoes increase to 200/- then how much will you buy? Definitely less quantity of goods. What kind of relationship is there between the price and quantity demanded? There is inverse relation. The law of demand states that Ceteris paribus (other things remaining the same), higher the price, lower the demand and vice versa. The law is stated primarily in terms of the price and quantity relationship. The quantity demanded is inversely related to its price. Here we consider only two factors i.e. price and quantity demanded. All the other factors which determine are assumed to be constant. Which are those factors? Assumptions:

Income of the consumer is constant. There is no change in the availability and the price of the related commodities (i.e. complimentary and substitutes) There are no expectations of the consumers about changes in the future price and income. Consumers taste and preferences remain the same. There is no change in the population and its structure.

Illustration: Price (in $) Quantity demanded (in units) 4 40 3 70 2 90 1 100 Take quantity on X axis and price on Y axis. Draw the demand curve and describe it.

Chief characteristics: So by observing a demand curve the chief characteristics are;

Inverse relationship between the price and the quantity demanded. This is shown by the downward sloping demand curve. Price is an independent variable and the demand is dependent. It is the effect of price on demand and not vice versa.

Reasons underling the law of demand- this inverse relationship can be explained in terms of two reasons, viz,
1. Income effect: The decline in the price of a commodity leads to an equivalent increase in

the income of a consumer because he has to spend less to buy the same quantity of goods. The part of the money left can be used for buying some more units of commodity. For e.g. Suppose the price of mangoes falls from Rs.100/- per dozen to 50/- per dozen. Then with the same amount of 100/- you can buy one more dozen, i.e.,2 dozens at Rs. 50/2. Substitution effect: When the price of a commodity falls, the consumer tends to substitute that commodity for other commodity which is relatively dearer. For e.g. Suppose the price of the Urad falls, it will be used by some people in place of other pulses. Thus the demand will increase.

Exceptions of Law of demand: 1) Conspicuous consumption: The goods which are purchased for Snob appeal are called as the conspicuous consumption. They are also called as Veblen goods because Veblen coined this term. For e.g.- diamonds, curios. They are the prestige goods. The would like to hold it only when they are costly and rare. So, what can be the policy implication for the manager of a company who produces it? A producer can take advantage by charging high premium prices. 2) Speculative market: in this case the higher the price the higher will be the demand. It happens because of the expectation to increase the price in the future. For e.g. shares, lotteries, gamble and ply-win type of markets. 3) Giffens goods:

It is a special type of inferior goods where the increase in the price results into the increase In the quantity demanded. This happens because these goods are consumed by the poor people who would like to buy more if the price increases. For e.g. a poor person who buys inferior quality vegetables. If the price of such vegetable increase then they prefer to buy because they think that it would be of a better quality 4) Ignorance: Many a times consumer judges the quality of a good from its price. Such consumers may purchase high price goods because of the feeling of possessing a better quality. Demand Forecasting in Managerial Economics: One of the crucial aspects in which managerial economics differs from pure economic theory lies in the treatment of risk and uncertainty. Traditional economic theory assumes a risk-free world of certainty; but the real world business is full of all sorts of risk and uncertainty. A manager cannot, therefore, afford to ignore risk and uncertainty. The element of risk is associated with future which is indefinite and uncertain. To cope with future risk and uncertainty, the manager needs to predict the future event. The likely future event has to be given form and content in terms of projected course of variables, i.e. forecasting. Thus, business forecasting is an essential ingredient of corporate planning. Such forecasting enables the manager to minimize the element of risk and uncertainty. Demand forecasting is a specific type of business forecasting.

Concepts of Forecasting: The manager can conceptualize the future in definite terms. If he is concerned with future eventits order, intensity and duration, he can predict the future. If he is concerned with the course of future variables- like demand, price or profit, he can project the future. Thus prediction and projection-both have reference to future; in fact, one supplements the other. Suppose, it is predicted that there will be inflation (event). To establish the nature of this event, one needs to consider the projected course of general price index (variable). Exactly in the same way, the predicted event of business recession has to be established with reference to the projected course of variables like sales, inventory etc. Projection is of two types forward and backward. It is a forward projection of data variables, which is named forecasting. By contrast, the backward projection of data may be named back casting, a tool used by the new economic historians. For practical managers concerned with futurology, what is relevant is forecasting, the forward projection of data, which supports the production of an event. Thus, if a marketing manager fears demand recession, he must establish its basis in terms of trends in sales data; he can estimate such trends through extrapolation of his available sales data. This trend estimation is an exercise in forecasting.

Need for Demand Forecasting Business managers, depending upon their functional area, need various forecasts. They need to forecast demand, supply, price, profit, costs and returns from investments. The question may arise: Why have we chosen demand forecasting as a model? What is the use of demand forecasting? The significance of demand or sales forecasting in the context of business policy decisions can hardly be overemphasized. Sales constitute the primary source of revenue for the corporate unit and reduction for sales gives rise to most of the costs incurred by the firm. Demand forecasting is essential for a firm because it must plan its output to meet the forecasted demand according to the quantities demanded and the time at which these are demanded. The forecasting demand helps a firm to arrange for the supplies of the necessary inputs without any wastage of materials and time and also helps a firm to diversify its output to stabilize its income overtime. The purpose of demand forecasting differs according to the type of forecasting. (1) The purpose of the Short term forecasting: It is difficult to define short run for a firm because its duration may differ according to the nature of the commodity. For a highly sophisticated automatic plant 3 months time may be considered as short run, while for another plant duration may extend to 6 months or one year. Time duration may be set for demand forecasting depending upon how frequent the fluctuations in demand are, short- term forecasting can be undertaken by affirm for the following purpose;

Appropriate scheduling of production to avoid problems of over production and underproduction. Proper management of inventories Evolving suitable price strategy to maintain consistent sales Formulating a suitable sales strategy in accordance with the changing pattern of demand and extent of competition among the firms. Forecasting financial requirements for the short period.

(2) The purpose of long- term forecasting: The concept of demand forecasting is more relevant to the long-run that the short-run. It is comparatively easy to forecast the immediate future than to forecast the distant future. Fluctuations of a larger magnitude may take place in the distant future. In fast developing economy the duration may go up to 5 or 10 years, while in stagnant economy it may go up to 20 years. More over the time duration also depends upon the nature of the product for which demand forecasting is to be made. The purposes are;

Planning for a new project, expansion and modernization of an existing unit, diversification and technological up gradation. Assessing long term financial needs. It takes time to raise financial resources. Arranging suitable manpower. It can help a firm to arrange for specialized labour force and personnel. Evolving a suitable strategy for changing pattern of consumption.

Steps in Demand Forecasting: Demand or sales forecasting is a scientific exercise. It has to go through a number of steps. At each step, you have to make critical considerations. Such considerations are categorically listed below: 1) Nature of forecast: To begin with, you should be clear about the uses of forecast data- how it is related to forward planning and corporate planning by the firm. Depending upon its use, you have to choose the type of forecasts: short-run or long-run, active or passive, conditional or nonconditional etc. 2) Nature of product: The next important consideration is the nature of product for which you are attempting a demand forecast. You have to examine carefully whether the product is consumer goods or producer goods, perishable or durable, final or intermediate demand, new demand or replacement demand type etc. A couple of examples may illustrate the importance of this factor. The demand for intermediate goods like basic chemicals is derived from the final demand for finished goods like detergents. While forecasting the demand for basic chemicals, it becomes essential to analyze the nature of demand for detergents. Promoting sales through advertising or price competition is much less important in the case of intermediate goods compared to final goods. The elasticity of demand for intermediate goods depends on their relative importance in the price of the final product. Time factor is a crucial determinant in demand forecasting. Perishable commodities such as fresh vegetables and fruits can be sold over a limited period of time. Here skilful demand forecasting is needed to avoid waste. If there are storage facilities, then buyers can adjust their demand according to availability, price and income. The time taken for such adjustment varies from product to product. Goods of daily necessities that are bought more frequently will lead to quicker adjustments. Whereas in case of expensive equipment which is worn out and replaced after a long period of time, adaptation of demand will be spread over a longer duration of time. 3) Determinants of demand: Once you have identified the nature of product for which you are to build a forecast, your next task is to locate clearly the determinants of demand for the product. Depending on the nature of product and nature of forecasts, different determinants will assume different degree of importance in different demand functions. In the preceding unit, you have been exposed to a number of price-income factors or determinants-own price, related price, own income-disposable and discretionary, related income, advertisement, price expectation etc. In addition, it is important to consider socio-psychological

determinants, specially demographic, sociological and psychological factors affecting demand. Without considering these factors, long-run demand forecasting is not possible. Such factors are particularly important for long-run active forecasts. The size of population, the age-composition, the location of household unit, the sex-composition-all these exercise influence on demand in. varying degrees. If more babies are born, more will be the demand for toys; if more youngsters marry, more will be the demand for furniture; if more old people survive, more will be the demand for sticks. In the same way buyers psychology-his need, social status, ego, demonstration effect etc. also effect demand. While forecasting you cannot neglect these factors. 4) Analysis of factors &determinants: Identifying the determinants alone would not do, their analysis is also important for demand forecasting. In an analysis of statistical demand function, it is customary to classify the explanatory factors into (a) trend factors, which affect demand over long-run, (b) cyclical factors whose effects on demand are periodic in nature, (c) seasonal factors, which are a little more certain compared to cyclical factors, because there is some regularly with regard to their occurrence, and (d) random factors which create disturbance because they are erratic in nature; their operation and effects are not very orderly. An analysis of factors is specially important depending upon whether it is the aggregate demand in the economy or the industrys demand or the companys demand or the consumers; demand which is being predicted. Also, for a long-run demand forecast, trend factors are important; but for a short-run demand forecast, cyclical and seasonal factors are important. 5) Choice of techniques: This is a very important step. You have to choose a particular technique from among various techniques of demand forecasting. Subsequently, you will be exposed to all such techniques, statistical or otherwise. You will find that different techniques may be appropriate for forecasting demand for different products depending upon their nature. In some cases, it may be possible to use more than one technique. However, the choice of technique has to be logical and appropriate; for it is a very critical choice. Much of the accuracy and relevance of the forecast data depends accuracy required, reference period of the forecast, complexity of the relationship postulated in the demand function, available time for forecasting exercise, size of cost budget for the forecast etc. 6) Testing accuracy: This is the final step in demand forecasting. There are various methods for testing statistical accuracy in a given forecast. Some of them are simple and inexpensive, others quite complex and difficult. This stating is needed to avoid/reduce the margin of error and thereby improve its validity for practical decision-making purpose. Subsequently you will be exposed briefly to some of these methods and their uses. TECHNIQUES OF DEMAND FORECASTING: Broadly speaking, there are two approaches to demand forecasting- one is to obtain information about the likely purchase behavior of the buyer through collecting experts opinion or by conducting interviews with consumers, the other is to use past experience as a guide through a set of statistical techniques. Both these methods rely on varying degrees of judgment. The first

method is usually found suitable for short-term forecasting, the latter for long-term forecasting. There are specific techniques which fall under each of these broad methods. Simple Survey Method: For forecasting the demand for existing product, such survey methods are often employed. In this set of methods, we may undertake the following exercise. 1) Experts Opinion Poll: In this method, the experts on the particular product whose demand is under study are requested to give their opinion or feel about the product. These experts, dealing in the same or similar product, are able to predict the likely sales of a given product in future periods under different conditions based on their experience. If the number of such experts is large and their experience-based reactions are different, then an average-simple or weighted is found to lead to unique forecasts. Sometimes this method is also called the hunch method but it replaces analysis by opinions and it can thus turn out to be highly subjective in nature. 2) Reasoned Opinion-Delphi Technique: This is a variant of the opinion poll method. Here is an attempt to arrive at a consensus in an uncertain area by questioning a group of experts repeatedly until the responses appear to converge along a single line. The participants are supplied with responses to previous questions (including seasonings from others in the group by a coordinator or a leader or operator of some sort). Such feedback may result in an expert revising his earlier opinion. This may lead to a narrowing down of the divergent views (of the experts) expressed earlier. The Delphi Techniques, followed by the Greeks earlier, thus generates reasoned opinion in place of unstructured opinion; but this is still a poor proxy for market behavior of economic variables. 3) Consumers Survey- Complete Enumeration Method: Under this, the forecaster undertakes a complete survey of all consumers whose demand he intends to forecast, Once this information is collected, the sales forecasts are obtained by simply adding the probable demands of all consumers. The principle merit of this method is that the forecaster does not introduce any bias or value judgment of his own. He simply records the data and aggregates. But it is a very tedious and cumbersome process; it is not feasible where a large number of consumers are involved. Moreover if the data are wrongly recorded, this method will be totally useless. 4) Consumer Survey-Sample Survey Method: Under this method, the forecaster selects a few consuming units out of the relevant population and then collects data on their probable demands for the product during the forecast period. The total demand of sample units is finally blown up to generate the total demand forecast. Compared to the former survey, this method is less tedious and less costly, and subject to less data error; but the choice of sample is very critical. If the sample is properly chosen, then it will yield dependable results; otherwise there may be sampling error. The sampling error can decrease with every increase in sample size 5) End-user Method of Consumers Survey: Under this method, the sales of a product are projected through a survey of its end-users. A product is used for final consumption or as an intermediate product in the production of other goods in the domestic market, or it may be exported as well as imported. The demands for final consumption and exports net of imports are

estimated through some other forecasting method, and its demand for intermediate use is estimated through a survey of its user industries. Complex Statistical Methods: We shall now move from simple to complex set of methods of demand forecasting. Such methods are taken usually from statistics. As such, you may be quite familiar with some the statistical tools and techniques, as a part of quantitative methods for business decisions. (1) Time series analysis or trend method: Under this method, the time series data on the under forecast are used to fit a trend line or curve either graphically or through statistical method of Least Squares. The trend line is worked out by fitting a trend equation to time series data with the aid of an estimation method. The trend equation could take either a linear or any kind of nonlinear form. The trend method outlined above often yields a dependable forecast. The advantage in this method is that it does not require the formal knowledge of economic theory and the market, it only needs the time series data. The only limitation in this method is that it assumes that the past is repeated in future. Also, it is an appropriate method for long-run forecasts, but inappropriate for short-run forecasts. Sometimes the time series analysis may not reveal a significant trend of any kind. In that case, the moving average method or exponentially weighted moving average method is used to smoothen the series. (2) Barometric Techniques or Lead-Lag indicators method: This consists in discovering a set of series of some variables which exhibit a close association in their movement over a period or time. For example, it shows the movement of agricultural income (AY series) and the sale of tractors (ST series). The movement of AY is similar to that of ST, but the movement in ST takes place after a years time lag compared to the movement in AY. Thus if one knows the direction of the movement in agriculture income (AY), one can predict the direction of movement of tractors sale (ST) for the next year. Thus agricultural income (AY) may be used as a barometer (a leading indicator) to help the short-term forecast for the sale of tractors. Generally, this barometric method has been used in some of the developed countries for predicting business cycles situation. For this purpose, some countries construct what are known as diffusion indices by combining the movement of a number of leading series in the economy so that turning points in business activity could be discovered well in advance. Some of the limitations of this method may be noted however. The leading indicator method does not tell you anything about the magnitude of the change that can be expected in the lagging series, but only the direction of change. Also, the lead period itself may change overtime. Through our estimation we may find out the best-fitted lag period on the past data, but the same may not be true for the future. Finally, it may not be always possible to find out the leading, lagging or coincident indicators of the variable for which a demand forecast is being attempted. 3) Correlation and Regression: These involve the use of econometric methods to determine the nature and degree of association between/among a set of variables. Econometrics, you may recall, is the use of economic theory, statistical analysis and mathematical functions to determine

the relationship between a dependent variable (say, sales) and one or more independent variables (like price, income, advertisement etc.). The relationship may be expressed in the form of a demand function, as we have seen earlier. Such relationships, based on past data can be used for forecasting. The analysis can be carried with varying degrees of complexity. Here we shall not get into the methods of finding out correlation coefficient or regression equation; you must have covered those statistical techniques as a part of quantitative methods. Similarly, we shall not go into the question of economic theory. We shall concentrate simply on the use of these econometric techniques in forecasting. We are on the realm of multiple regression and multiple correlation. The form of the equation may be: DX = a + b1 A + b2PX + b3Py You know that the regression coefficients b1, b2, b3 and b4 are the components of relevant elasticity of demand. For example, b1 is a component of price elasticity of demand. The reflect the direction as well as proportion of change in demand for x as a result of a change in any of its explanatory variables. For example, b2< 0 suggest that DX and PX are inversely related; b4 > 0 suggest that x and y are substitutes; b3 > 0 suggest that x is a normal commodity with commodity with positive income-effect. Given the estimated value of and bi, you may forecast the expected sales (DX), if you know the future values of explanatory variables like own price (PX), related price (Py), income (B) and advertisement (A). Lastly, you may also recall that the statistics R2 (Co-efficient of determination) gives the measure of goodness of fit. The closer it is to unity, the better is the fit, and that way you get a more reliable forecast. The principle advantage of this method is that it is prescriptive as well descriptive. That is, besides generating demand forecast, it explains why the demand is what it is. In other words, this technique has got both explanatory and predictive value. The regression method is neither mechanistic like the trend method nor subjective like the opinion poll method. In this method of forecasting, you may use not only time-series data but also cross section data. The only precaution you need to take is that data analysis should be based on the logic of economic theory. (4) Simultaneous Equations Method: Here is a very sophisticated method of forecasting. It is also known as the complete system approach or econometric model building. In your earlier units, we have made reference to such econometric models. Presently we do not intend to get into the details of this method because it is a subject by itself. Moreover, this method is normally used in macro-level forecasting for the economy as a whole; in this course, our focus is limited to micro elements only. Of course, you, as corporate managers, should know the basic elements in such an approach. The method is indeed very complicated. However, in the days of computer, when package programmes are available, this method can be used easily to derive meaningful forecasts. The principle advantage in this method is that the forecaster needs to estimate the future values of only the exogenous variables unlike the regression method where he has to predict the future

values of all, endogenous and exogenous variables affecting the variable under forecast. The values of exogenous variables are easier to predict than those of the endogenous variables. However, such econometric models have limitations, similar to that of regression method.