economic analysis for business management-lesson - 1
TRANSCRIPT
SRM INSTITUTE OF SCIENCE & TECHNOLOGY(SRM UNIVERSITY)
DEPARTMENT OF MANAGEMENTMBA (MASTER OF BUSINESS ADMINISTRATION)
MB: ECONOMIC ANALYSIS FOR BUSINESS MANAGEMENT
LESSON NO. 1 : Economic Analysis for Business Management
TOPICS COVERED: Introduction, Demand-Theory, Law and Elasticity Demand -Forecasting -Supply-Theory and Elasticity Market – Price
Determination
PRE-REQUISITIES:
To understand this lesson, the basic knowledge of “Quantitative Techniques for Management” (Mathematical calculus and Statistics) is required. These concepts and methods have already been covered in the course of Quantitative Techniques for Management (MB505). If you have not completed that course, please, register for the course first, study understand and then continue this course.
LEARNING OBJECTIVES:
Economic Analysis is a core subject to MBA Degree so that to acquire basic knowledge of economic analysis is the key to understand the other subjects. A few examples can be given to you to understand the importance of the subject of economic analysis.
Marketing management needs to determinate price of goods or service. Financial management needs to decide suitable capital budget for business ventures. Operations and Production management want to determinate minimum cost of
production. Human Resource Management needs to determinate wage rate to the labours and so
on.
These are a few of them answered with the economic analysis.
Since the all business decision-making are taken under the light of economic analysis, you have to study detail this subject for effective decision making. Further, to forward planning the subject, economic analysis helps your business –introduction, expansion and renovation. And to research point of view, the economic analysis covers more than 65 per cent in business environment and so it provides more data and information to business research – These are enlightened in economic analysis and so you should study the subject to acquire analytical skill to managerial business decision making.
EXPECTED OUTCOMES:
After studying and completing the lesson, you
will have a clear concept of economic analysis.
will be able to identify the differences between micro economics and macro economics approaches for various decisions making.
will be in a prior to understand about how vary the quantity demand and supply of product by change of price, price of related product, income, etc.
and also will be able to measure the change of demand and supply of product for business decision making.
can construct suitable demand forecast model for your product sales and also able to understand the factors are governing the product demand in future.
Thus, various skills of economic analyses that will all add one more feather to your cap of manager skill i.e. analytical skill.
1.0 INTRODUCTION:
What is the important place of economic analysis in business management?
The direct answer is forward business planning and decision making to the business management. Decision-making refers to the process of selecting one action from two or more alternatives courses of action. Forward planning means establishing plans for future. The economic analysis helps to clarify the two core areas of business management with the analytical frame works. That is, in many situations, there may be more than one alternative courses of action available to the business decision maker like you. He will have to select the best out of many alternative opportunities open to him. In short, there are four main steps in the process of decision making namely,
Step: One Identification of objectivesStep: Two Statement of problemStep: Three Listing and evaluation of alternativesStep: Four Implementation, and monitoring of the decision.
CHART: 1-1 PRESENTS ON OVERVIEW OF FRAMEWORK FOR DECISION MAKING
Political, Social problems
Step 1 Identification of objectives
Ethical and moral responsibilities
Uncertainty Step 2 Statement of problems
Limited information
External constraints
Step 3 Listing and evaluation of alternatives
Internal constraints
Step 4 Implementation monitoring of the
decision
Sometimes, you may think of the economic analysis is only for the political or the Government functions but it is not so. That is, economic analysis now days is the most important to business world too. The economic analysis governs the entire areas of business under the light of forward planning and decision-making.
What are salient features of the study?
Answer: Economic analysis finds the relationship between cause and effect of every business change. For examples,
1. Why the consumer “A” prefers more goods of “X” in a given price, ruppees.xxx compare to the consumer “B” does?
2. Why the producer “A” selects the labor- intensive technology, compare to the producer “B” selects capital-intensive technology to produce the same product.
There are economic benefits by acting upon rational behavior rather than blindly select or prefer the situation to handle.
There are a number of governing factors in every business change-success or failure. Economic analysis searches for finding the problems / solutions from the factors relationship analysis. There is systematic analysis in terms of scientific method.
SCIENTIFIC METHOD : Prof. CASSA, “Science is a systematic body of knowledge that traces to find out the relationship between “cause and effect” – basis on this, the economic analysis approaches the business decision making. Let us see the various definitions for the subject economic analysis.
LIONEL ROBBINES“Scarcity and Choice”
“Economic analysis is the science which studies human behavior as a relationship between ends and scarce means which have alternative uses”
Mr. NAIR : “The integration of economic theory with the theory of business practice for the purpose of facilitating decision making and forward planning by management”.
Prof. HAGUE : “Economic analysis is a fundamental subject that seeks to understand and to analyse the problem of business decision making” –
E.F.BRIGHAM : “Economic analysis is the application of economic theory and methodology to business administration practice”.
Economic analysis for business management is thus to solve the problems faced by the manager with the decision-making. But all the same one should remember that even though economic analysis for business management helps a great deal in solving the problems of the managers by influencing decision making process, yet there are general
factors which also significantly influence the decision making process of the managers. They are human and behavioral consideration, technological forces, and environmental factors.
1.1. APPROACHES TO ECONOMICS ANALSIS :
We already mentioned that economics is a science and so there is a proper approach to the subject, economic analysis. It needs to deal each business functions systematically i.e. there is easy way to understand the subject issues. Under the light of it;
Economic analysis is divided into two,
1. Micro economic analysis and2. Macro economic analysis
Now, let us see what is micro economic analysis?
MICRO ECONOMIC ANALYSIS:“Micro” means a millionth part-micro economic analysis thus, deals with a small part
of the national economy. That is, it analysis the behavior of the individual unit or a particular firm.
An enquiry as to how a particular person maximizes satisfaction or how a particular firm maximises profit or a particular family adjust its expenditure to income is an enquiry in the domain of micro economic analysis.
However, there are some limitations in the micro economic analysis.
1. Firstly, what is true in the case of individual units may not be true the case of aggregated.Example: Individual thrift may be good but social thrift is definitely harmful for the community.2. Secondly, it assumes other things being equal (ceteries paripassu), and full-employment of the social. It is unrealistic.This, however, does not imply that micro economic analysis is not useful for macro economic studies; several micro economic studies throw light on macro economic problems.
MACRO ECONOMIC ANALYSIS:Macro economic analysis may be defined as that branch of economic analysis that studies the behavior of not one particular unit but of all the units. Macroeconomics is an aggregate economics. The field covered by macroeconomics may be forth below; Theory of income output, employment with its two constitutes namely, the theory of
consumption and theory of investment function and theory of business cycle. Theory of prices of microeconomics interrelated with the theories of inflation,
deflation, and recession of macroeconomics. Theory of economic growth constituents with developed and under developed
countries. Theory of distribution of macroeconomics deals with relative share of wages and
profits in the total national income. However, some limitations are there.
1. Firstly, the dangerous of excessive generalization is from individual experience to the system as a whole.
2. Secondly, aggregate in which things are by not means homogenous.3. Thirdly, all the economic sectors are the same tendering but it is not so.4. Fourthly, a study of aggregates may lead us to believe that not change has taken place
and as such as new policy is called for.
Example: If agricultural price fall by 50 percent while industrial price rise by 50 percent, the general price-level will remain unchanged because the type of price changes neutralizes each other. We have out lined above the two seemingly alternative approaches to economic analysis. Viz., the micro and macro approaches. They may even to be competitive approaches but of bottom, they are complementary to each other. In fact, they are so independent that neither approach is complete without the other.
IMPORTANT NOTE : Since these two approaches take place in the total lesson plan, you have to study the two approaches differently. That is, in first two units, the micro economic analysis covers whereas, the rest, three units cover macro economic analysis.
Therefore, the forth-coming lessons are in the first unit of micro economic analysis.
1.1.1 ECONOMIC ANALYSIS AND ITS APPLICATIONS [OPERATIONS OF THE FIRM] FOR BUSINESS MANAGEMENT :
Let us see how the economic analysis is limited to the operations of every segment of a business – “Economic Analysis” is a method of thinking about business that is rooted in basic theoretical models of economic behavior.
This part provides a general overview of the various business operational issues that relate to economic analysis. After studying it, you can feel the scope of the subject that is immense importance of every businessperson like you.
Marketing Management function relates to the economic factors ofo Priceo Product Design and Qualityo Competitiono Promotion and Differentiationo Distributions channels ando Credit practices
Production function relates with the factors of economic analysis namely,o Technologyo Resources prices & Substitutabilityo Production techniques and Cost efficiency and Flexibilityo Inventory controlo Internal and External Economies ando Alternative transportation
Finance function implies the economic factors namely,o Investors performanceo Cost of capital
o Financial Structureo Sources of fundo Financial Regulationso Dividend policyo Tax laws ando Cash flow for business expansion.
o Legal function needs economic regulations namely,o Anti Trust Regulationso Tax Lawso Regulatory commissionso Barriers to Entryo Credit practices ando Hiring policies –
o Human resource function is strong on the economic factors namely,o Wage determinationo Incentive wage systemo Equal employment opportunityo Hiring policies ando Management education
Now you can understand that the economic analysis is a queen of all management functions – In other words, without concern of economic analysis, the subject management science does not grow.
1.1.2 MICRO ECONOMIC ANALYSIS :The micro economic analysis is to the following propositions
1. Positive versus normative economics2. Province of study3. Profit planning4. Optimization5. Micro economic analysis and other branches of subjects.
1. Positive versus Normative Economic Analysis: Positive economics studies the things “as they are”. Normative economics deals with things, as they “ought to be.” Positive economics is descriptive and explanative of economic behavior. The normative economics is prescriptive and value judgment in nature.
EXAMPLE:a. India exported 500 tonnes of coal to United States in 2003-04 periods – a positive
statement under the light of `as it is’ principle.b. “International Environmental Protection Agency (EPA) requested that Indian ought
not burn coal more than global standard level for her industrialization in 2003-04 period – a normative statement under the light of `ought to do’ principle.
Thus, the both principles should follow equally in all business decisions.
2. Province of Study: Broadly specking that micro economic analysis covers the following areas.
a. Demand analysisb. Cost-Output relationship
c. Decisions, policies and practices of pricingd. Profit planninge. Capital budgeting and investment appraisal
3. Profit Planning : Profit planning is the central concept in macroeconomic analysis. Maximisation of profits is the main objective of any firm / business unit. Profit is the main indicator of a firm’s success. Business efficiency is the core of economic analysis.
4. Optimization: Optimization refers to maximizing satisfaction through profit maximization. In recent years, operation researchers have discovered to term” such optimization” – This concept is useful in bringing a compromises between theory and reality.
5. Micro Economic Analysis and its Relation to other Branches of Learning : Economic Analysis and Operations Research: Operations research has been
broadly defined as the application of mathematical techniques in solving the business problems. It deals with model building, the construction of theoretical model that helps the decision-making process.The popular techniques –
a. Linear programmingb. Input-output analysisc. Inventory theoryd. Game theory ande. Queuing theory are few of them.
Economic Analysis and Mathematics: Economic analysis should be both concept ional and material for while measurement without theory can only lead to false precision, theory without measurement can rarely be operationally useful. Modern business executive should have knowledge of geometry, trigonometry, and algebra and of integral and differential calculus; tools are useful in estimating the various economic relationship so that these help in decision-making and forward planning.
Economic Analysis and Statistics: Statistical techniques are useful in collecting, marshalling, and analyzing data. It provides the basis for the empirical testing of a theory.
Economic Analysis and Accounting: Accounting is concerned with recording the financial operations of a business firm. The profit and loss statement of the firm helps the manager to identify the specific areas of loss and to arrive at suitable decision.
Thus, these subjects are inter-related each other with the economic analysis. You are learning these subjects in the present degree course and so they will help you to understand more.
1.1.3 OBJECTIVES OF THE FIRM:Now you have to understand the basic objective of a business firm first.
a. Wealth maximization objective deals with how the firm maximizes the present value of its future profit.
b. Sales maximization objective explains with how the firm maximizes sales subject to minimum profit constraint.
c. “Satisfying” objective roots how the firm tries to achieve satisfactory performance for multiple targets such as market share, profit and customer service.
d. Growth maximization objective needs how the firm tries to maximize the growth rate of a market share and likes.
e. Prestige and service maximization objectives for non-profit or regulated business in which the firm tries to maximize the service provided and prestige earned given its budget constraint.
The selection of the best objective depends on given type of situation to the manager like you for taking effective decision-makings.
EXAMPLE: If there is more competition to your business, then, the objective of sales maximization set and so it is better than wealth/profit maximisation, likewise,The growth maximization objective is better than satisfying objective for long-run life on stabilization to the firm.
1.1.4 BASIC CONCEPTS IN MICRO ECONOMIC ANALYSIS :
You have to understand firstly the basic concepts of micro economic analysis before to study the various analyses in the entire lessons because the concepts frequently appear in the entire subject.
There are five basic concepts in the study of economic analysis. They are,
A. The Incremental Concept:
Two important incremental concepts are common in the study.
a. Incremental Revenue: In incremental revenue is the change in the total revenue by selling additional units of a commodity.
Formula is, IR=R2 – R1 = R ----------------------------------equation (eqn.) 1.1 where,
IR = Incremental revenueR2 = New total revenueR1 = Old total revenue = (delta) change in
b. Incremental Cost: Incremental cost is an additional cost increased due to change in the nature of activity.
EXAMPLE: 1. Adding a new product2. Changing distribution channel3. Install a new machine.
There is difference between incremental reasoning and marginal cost concept.
(i) Marginal costs and revenues always defined in terms of unit changes in output. However, incremental cost and revenues are not necessarily restricted to unit changes.
(ii) Generally, marginal costs and marginal revenues are restricted to the effects of changes in output. Nevertheless, in managerial economics decision-making may not confine to change output at all.
B. The Concept of Time Perspective:
Time element has a place to a decisive role in economic analysis. There are four concepts in time elements, viz.,
(i) Short period(ii) Medium period(iii) Long period(iv) Secular period
The distinction not based on time but on the ability of business firms to change the use of different inputs such as raw materials, management, plant, equipment, etc.
If the firm can alter all these inputs, the period is long run.
On the other hand, if the firms can change only a few inputs but not all, the period is short run. Short term refers to a period during which supply of certain inputs is inelastic, and long term is a period during which supply of all inputs is elastic – short-term price determined by demand and long-term price by supply.
C. The Discounting Concept:
The discounting (concept) principle based on the principle that a rupee tomorrow is worth less than a rupee today. For instance, a firm makes an investment, which expects to yield returns over a period. It is necessary to find out its net present worth. The rate of returns will be the different for various investment proposals. Even the same amount may yield different returns for different users.
EXAMPLE: If we have a choice of accepting Rs.100/- today, or Rs.100/- next year, we naturally prefer the former. This is because Rs.100/- today after a year would fetch an interest of say Rs.10 making the total Rs.110/-. This means Rs.100 at a future date discounted at the rate of 10 percent. According to the discounting principle, it is necessary to discount costs and revenues to present values when an alternative decision affects costs and revenues at future dates.
D. Opportunity Cost:
Opportunity costs are the costs of displaced alternatives. They represent only sacrificed alternatives. Since the factors of production are scare in relation to demand, they employ for many alternative uses. When one factor employs for one use, the next best use for which it will put in sacrificed. The opportunity cost of funds employed in house construction is the amount of interest, which could have been invested in the next best alternative investment.
The sacrificed alternative means opportunity cost. If a factor has no alternative source of employment, its opportunity cost is zero.
E. Equi -Marginal Principle:
The equi-marginal principle states that the inputs available to a firm should be allocated in such a manner the value added by each unit in all uses. This considered as a condition of optimal allocation.
Let us consider a case in which a firm has five activities, K, L, M, N and O.and all these activities can be done by adding more labour. However, more labour can be added only at the sacrifice of other activities, in this case, the firm allocates labour for each of the activities in such a manner that the value of the marginal product (VMP) is equal in all activities.
VMP LK = VMP LL = VMPLM = VMPLN = VMP=O. where, “L” indicates labour and K, L, M, N, and O represent the activities. The value of the marginal product of the labour employed in activities “L” which is equal to the value of the product of the labour employed in activitivity `M’ and soon.
1.1.5 TEST YOUR KNOWLEDGE:
Match the Following:
a. Scarcity and choice 1. Legalb. Product ,Pricing, , Position and Promotion 2. Production managementc. Economic analysis – of individual behavour
3. Financial operation
d.Economic analysis of the whole community 4. Lionel Robbinse. Anti trust law 5. Marketing operationf. Discounting factor 6. Microeconomicsg. Inventory 7. Macroeconomics.
[Ans : a-4, b-5, c-6, d-7, e-1, f-3, g-2]
Select True / False:
1. Macroeconomics studies how an organization earns profit – T/F2. Microeconomics studies the aggregate employment problem – T/F3. Economic analysis is more practical rather than more theoretical – T/F4. Economic analysis is a science which deals with cause – effect – T/F5. Micro economics models are static and macro economics models are dynamic – T/F
[Ans : 1-F, 2-F, 3-T, 4-T, 5-T]
Fill in the Blanks:
1. Economic analysis for business management is ______________ science.2. Economic value is expressed into ____________ .
3. Opportunity cost is the cost of _________ value of the next alternative4. Consumer behaviour in the market system is ___________ behaviour.5. Consumer protection deals with ___________ economics.
[Ans : 1. applied, 2. price, 3. forgone, 4. rational, 5. welfare]
1.2 DETERMINANTS OF DEMANDAs said earlier that the value of product / service is expressed with price. To
determinate value / price of a product is a central problem of economic analysis of business management. That is, the equilibrium point of the forces of demand for the product and supply of the product the price is determined.
In this lesson, we can study meaning, measurement and forecasting of demand first.
I.MEANING OF DEMANDIn ordinary sense the demand is used to express the desire for a commodity. But in
economics mere desire alone is not called demand. A beggar may desire a suit. This will not affect the seller of suit. The desire for a commodity should be backed by money. Moreover, the person should have the willingness to purchase the product
Thus,i. desire for the commodityii. ability to pay the priceiii. willingness to pay the price
Therefore, demand is defined as “a desire for a commodity lacked by willingness and ability to pay a price”.
The term “demand” for a commodity has always a reference to ‘a price’, ‘a period of time’ and ‘a place’. A meaningful statement regarding the demand for a commodity should, therefore, contain the information regarding.
i. quantities demandedii. price of the demandiii. period of demand andiv. place of demand
Example: To say the demand for computers of Chennai city is said to be 50,000 per / year at a price of Rs.30, 000 is a complete statement.
II.THEORY OF DEMAND In economics, to define the theories, through a mathematical (function and relationship) forms, graphical forms and verbal forms, can be utilized so that to analyze them easy. In this manner the theory of demand for a SONY colour television (g) is expressed as,
------------ (eqn.) 1.2
Where,Quantity demanded = for the SDNY television is a function of – i.e. depends on
i. The price of T.V. itself (Pg)ii. Taste (T)
iii. The price of substitute good (Ps1, Ps2, … Psm)iv. The price of complementary goods (Pc1, Pc2, … Pcm)v. Total consumer income (Y)vi. The distribution of income (B) andvii. The expected price of the good (Pg) at some future time (t+1)
These are the inependent variables to affect the quantity demand for the SONY T.V.
III. LAW OF DEMAND There is a difference between theory and law. That is, theory is an explanation and its prediction is a tentative suggestion whereas, law is proved theories and its prediction is more reliable. In economics you can see more laws that enable to rise degree of reliable decision making.
The law of demand shows us the relation between price and quantity demanded.
“Quantity demanded of a product per unit of time increases when its price fall and decreases when its price increases, “Other (things) factors remaining the same”.
The assumption “other things remain the same” – implies that price of substitution, complements (Ps and Pc), income of the consumer (Y), taste of the consumer (T), distribution of income (B) and expected future price of the commodity , remain unchanged.
IV. DEMAND SCHEDULE A demand schedule contains details of price and qualities and it states that the relation between the price and quantity.
There are two types of demand schedules.(i) Individual demand schedule and(ii) Market demand schedule
1. The individual demand schedule takes into account the demand of an individual for a commodity at various prices.
Table 1.1 Individual Demand Schedule for Apples.
Price Per Unit (Rs.) Quantity Demanded
1 602 503 404 305 206 107 Zero
Based on this data, we can draw a demand curve, the mathematical expression isP = f (Q) -------------------------------------------------------- (eqn.)- 1.2
Fig.1.1 QUANTITY DEMANDED FOR ORANGES
Series1, 0, 7Series1, 10, 6
Series1, 20, 5Series1, 30, 4
Series1, 40, 3Series1, 50, 2
Series1, 60, 1Series1, 70, 00
2
4
6
8
0 20 40 60 80
QUANTITY OF ORANGES
PR
ICE
S (
Rs.
)Series1
Fig: 1.1 shows that fewer amounts are demanded at a higher price and more amounts are demanded at a lower price. That is,
----------------------------------------------------- (eqn.) 1.3
V. REASONS TO OPERATE LAW OF DEMANDWhy people demand more if price came down that can explain by the following reasons-
(i) Operations of the Law of Diminishing Marginal Utility:This law operates when a consumer purchases more and more quantities of a commodity. The marginal utility of additional units gives him lesser and lesser satisfaction.
Example: Suppose a man derives utility worth Rs.1.00 from the first orange and Rs.0.70 from the second. If the price of the orange is Rs.1.00 each, he will buy just only one because the marginal utility derived from that is equal to the price period viz., Rs.1.00. He will never go in for the second one orange as the utility contained in the second orange is only Rs.0.70, he has to pay Rs.1.00. A rational consumer will never pay more for getting lesser satisfaction. The marginal utility is defined as demand curve. The law of demand is simply a corollary of the law of diminishing utility.
Box : 1-1Law of Diminishing Marginal Utility and Rational Behavior of Consumer.
Mr. S. Ramsay reveals his different levels of satisfaction through different quantities of organs by different utilities. (Utility = Power of satisfaction) in the following schedules.
TABLE 1.2 TOTAL AND MARGINAL UTILITY OF CONSUMPTION OF ORANGES BY MR.S.RAMSAY.
Qty of Orange Total Utility Marginal Utility1 45 -2 50 53 52 24 52 05 50 -26 45 -5
FIG.1.2 TOTAL AND MARGINAL UTILITY OF CONSUMPTION OF ORANGES
12 3 4 5
6
23 4 5
6-10
0
10
20
30
40
50
60
0 1 2 3 4 5 6 7
QUANTITY OF ORANGES
TO
TA
L A
ND
MA
RG
INA
L
UT
ILIT
Y
Series1
Series2
I – Phase:Indicates the change in increase in TU is greater than the change in quantity of commodity i.e
---------------------------------------------------------- (eqn.)1.4
It is known as increasing marginal utility.
II – Phase : Indicates the change in TU is equal to the change in quantity of commodity, i.e.
--------------------------------------------------------- (eqn.) 1.5
It is known as constant marginal utility.
III – Phase : Indicates the change in TU is smaller than the change in quantity of commodity. i.e,
-------------------------------------------------------- (eqn.) 1.6
The MU curve shows us as increase the consumption of commodity by the consumer, the MU continuously diminishing.
------------------------------------------ (eqn.) 1.7
MU is expressed as a change in TU by a commodity increases or decreases.
Rational Behaviour of Consumer: From this analysis, we can find out the sufficient condition to maximize the consumer’s satisfaction and the optimum commodities are determined.
Sufficient condition is, -------------------------------------------------------- (eqn.) 1.8
--------------------------------------------------------- (eqn.) 1.9
VI. Usefulness of the Analysis(i) To price payment that will maintain economic efficiency.
For instance,
(1) MU = P ------------------------------------------------------- (eqn.)1.10reveals maximize the satisfaction.
(2) MU<P -------------------------------------------------------- (eqn.)1.11reveals the low satisfaction
(3) MU>P ------------------------------------------------------- (eqn.)1.12reveals the consumers surplus.
For your understanding, the MU curve is the demand curve. Then, Is demand curve is the average revenue (AR) curve to the firm?Yes, the demand curve is the average revenue curve.
How is it true?Ans : Every payment of price for the quantity demanded goes to the firm as revenue. So, price is average revenue to the unit of commodity.
Derivatives of Total Revenue.
AR = P ----------------------------------------------------- (eqn.) 1.13TR = PQ ---------------------------------------------------- (eqn.) 1.14 AR = TR/Q --------------------------------------------------- (eqn.) 1.15
This can help you how a firm can maintain its position in maximum total revenue available to the firm through the best pricing policies.
(ii) Income Effect The fall in the price of commodity is equivalent to an increase in the income of the consumer. It is known as “positive income effect”.
The rise in the price of commodity leads to “negative income effect” i.e. he borrows money to compensate to rise the price of the commodity. For the result of it, the demand curve can be slopping downward.
(iii) Substitution Effect When the price of commodity falls, it will be substituted for costlier things. By so doing the consumer will gain.
Example: if the price of rice falls, same people in the place of other cereals to same extent will use it. It is known as “Positive substitution effect”.
Likewise, if the price of rice (increases) rises, other commodities like wheat will be used. It is known as “negative substitution effect”.
The income effect and substitution effect is functioning in same situation of price of commodity increases or falls.
Box : 1-2Explains the two effects with an indifference curve analysis.
INDIFFERENCE CURVE ANALYSIS
The aim of indifference curve analysis is to analyse how a rational consumer chooses between two goods. In other words, how the change in the wage rate will affect the choice between leisure time and work time.
Indifference analysis combines two concepts; indifference curves and budget lines (constraints)
The indifference curve
An indifference curve is a line that shows all the possible combinations of two goods between which a person is indifferent. In other words, it is a line that shows the consumption of different combinations of two goods that will give the same utility (satisfaction) to the person.
For instance, in Figure 1 the indifference curve is I1. A person would receive the same utility (satisfaction) from consuming 4 hours of work and 6 hours of leisure, as they would if they consumed 7 hours of work and 3 hours of leisure.
FIGURE :1.3 AN INDIFFERENCE CURVE FOR WORK AND LEISURE
An important point is to remember that the use of an indifference curve does not try to put a physical measure onto how much utility a person receives.
The shape of the indifference curve
Figure 1 highlights that the shape of the indifference curve is not a straight line. It is conventional to draw the curve as bowed. This is due to the concept of the diminishing marginal rate of substitution between the two goods.
The marginal rate of substitution is the amount of one good (i.e. work) that has to be given up if the consumer is to obtain one extra unit of the other good (leisure).
The equation is below
The marginal rate of substitution (MRS) = change in good X / change in good Y
Using Figure 1, the marginal rate of substitution between point A and Point B is;
MRS = -3 / 3 = -1 = 1 ---------------------------------------------------- (eqn.) 1.16
Note, the convention is to ignore the sign.
The reason why the marginal rate of substitution diminishes is due to the principle of diminishing marginal utility. Where this principle states that the more units of a good are consumed, then additional units will provide less additional satisfaction than the previous units. Therefore, as a person consumes more of one good (i.e. work) then they will receive diminishing utility for that extra unit (satisfaction), hence, they will be willing to give up less of their leisure to obtain one more unit of work.
The relationship between marginal utility and the marginal rate of substitution is often summarised with the following equation;
MRS = Mux / Muy ---------------------------------------------------------------- (eqn.)1.17
It is possible to draw more than one indifference curve on the same diagram. If this occurs then it is termed an indifference curve map (Figure 2).
FIGURE: 1.4 AN INDIFFERENCE MAP
The general rule is that indifference curves further too the right (I4 and I5) show combinations of the two goods that yield a higher utility, while curves to the left (I2 and I1) show combinations that yield lower levels of utility.
A Budget Line (budget constraints)
The budget line is an important component when analysing consumer behaviour. The budget line illustrates all the possible combinations of two goods that can be purchased at given prices and for a given consumer budget. Remember, that the amount of a good that a person can buy will depend upon their income and the price of the good.
This discussion outlines the construction of a budget line and explains the two effects with an indifference curve analysis and how the change in the determinants will affect the budget line.
FIGURE: 1.5 CONSTRUCTS A BUDGET LINE FOR A GIVEN BUDGET OF RS.60,RS.2 PER UNIT OF X AND RS.1 PER UNIT OF Y.
With a limited budget the consumer can only consume a limited combination of x and y (the maximum combinations are on the actual budget line).
A change in consumer income and the budget line
If consumer income increases then the consumer will be able to purchase higher combinations of goods. Hence an increase in consumer income will result in a shift in the budget line. This is illustrated in Figure 4. Note that the prices of the two goods have remained the same; therefore, the increase in income will result in a parallel shift in the budget line.
Assume consumer income increased to Rs.90.
FIGURE: 1.6 AN INCREASE IN CONSUMER INCOME
If consumer income fell then there would be a corresponding parallel shift to the left to represent a fall in the potential combinations of the two goods that can be purchased.
A change in the price of a good and the budget line
If income is held constant, and the price of one of the goods changes then the slope of the curve will change. In other words, the curve will pivot. This is illustrated in Figure 5.
FIGURE: 1.7 A CHANGE IN PRICE
The reduction of the price of good x from Rs.2 to £Rs.1 means that on a fixed budget of Rs.60, the consumer could purchase a maximum of 60 units, as opposed to 30. Note that the price of good y has remained fixed; hence the maximum point for good y will remain fixed.
Indifference analysis combines two concepts; indifference curves and budget lines (constraints)
The first stage is to impose the indifference curve and the budget line to identify the consumption point between two goods that a rational consumer with a given budget would purchase.
The optimum consumption point is illustrated on Figure 6.
FIGURE: 1.8 THE OPTIMUM CONSUMPTION POINT
A rational, maximising consumer would prefer to be on the highest possible indifference curve given their budget constraint. This point occurs where the indifference curve touches (is tangential to) the budget line. In the case of Figure 6, the optimum consumption point occurs at point A on indifference curve I3.
Indifference analysis can be used to analyse how a consumer would change the combination of two goods for a given change in their income or the price of the good.
The next section looks at the income and substitution effects of a change in price.
If we assume that the good is normal, then the increase in price will result in a fall in the quantity demanded. This is for two reasons; the income effect (have a limited budget, therefore can purchase lower quantities of the good) and the substitution effect (swap with alternative goods that are cheaper).
These two processes can be visualised using indifference analysis (see Figure 7).
FIGURE: 1.9 AN INCREASE IN THE PRICE OF GOOD X (A NORMAL GOOD)
Due to the price of good x increasing, the budget line has pivoted from B1 to B2 and the consumption point has moved.
The decrease in the quantity demanded can be divided into two effects;
The substitution effect
The substitution effect is when the consumer switches consumption patterns due to the price change alone but remains on the same indifference curve. To identify the substitution effect a new budget line needs to be constructed. The budget line B1* is added, this budget line needs to be parallel with the budget line B2 and tangential to I1.
Therefore, the movement from Q1 to Q2 is purely due to the substitution effect.
The income effect
The income effect highlights how consumption will change due to the consumer having a change in purchasing power as a result of the price change. The higher price means the budget line is B2; hence, the optimum consumption point is Q2. This point is on a lower indifference curve (I2).
Therefore, in the case of a normal good, the income and substitution effects work to reinforce each other.
iv Principle of Difference Uses:
There are certain commodities that can be put to various uses. If the price of such commodity is very high, it will be used only for important purposes. If the price falls, the commodity will be utilized in less important uses and consequently the demand will go up.
Example: If the price of copper is too high, it will be used only for electricity wiring purpose. If it becomes cheaper, it will be used for household utensils, coins, ornaments etc. It is reflecting into the demand curve for copper is slopping downward.
H. Exceptions to the Law of Demand There are certain peculiar cases where the law of demand will not hold good. In such cases more will be demanded at a higher price and less will be demanded at a lower price. The exceptions to the law of demand can be had in the following.
H.1 Veblen Effect Prof. Thorstein Veblen, in his principle of “conspicuous consumption” has pointed out that there are certain commodities, which are purchased not for their real value, but for their “Snob-Value” – very rich people for their social prestige normally demand such articles. e.g. Historical paintings, Royal cars, Modern ornaments etc.
H.2 Fear of Shortage When people expect a shortage of a particular commodity in the near future they would like to buy the commodity at any price.
Example: During times of war and emergency, people will purchase the commodities despite rise in price.
H.3 Speculative Effect In the speculative market when people deal in shares, buy more as increased price or shares to make profit more, here, the law of demand is not applied.
H.4 Giffen Paradox Sir Robert Giffen discovered that the poor people will demand more of inferior goods if their prices rise and demand less if their price fall. eg. Rice, Maize etc. They are called some times as Giffen Goods or inferior goods.
H.5 Ignorance Sometimes a consumer may not be aware of the prices prevailing in the market due to his ignorance, he may not be able to buy more units at a lower price. eg. New models of T.V. univels with a few number to the market at that time the law or demand is not worked.
I. CHANGES IN DEMAND AND AMOUNT DEMANDED
Change in demand implies two types of meaning asi. increase / decrease in demandii. expansion contraction of demand
To understand these concepts it gives clear idea of consumer behaviour to predict by changes of variables of demand for the commodity in the future.
1. Increase / Decrease in Demand: Increase in demand can be expressed as in a given price for a commodity, suppose the other variables is increased, the demand curve will shift right side. It shows increase in demand.
Example :
---------------------------------------------------- (eqn.)
1.18Where,
= Price is not changed
= Income of consumer is changed (increased)
FIG: 1.10 RIGHTWARD SHIFTING OF DEMAND CURVE – INCREASE AND DECREASE IN DEMAND
As income increases, the demand curve shifts to right side and increase the quantity demanded from Q1 level to Q2 level. Similarly, if the income decreases from Rs.2 Lac to Rs. 1 Lac, the demand curve shifts to leftward and decreases the quantity demanded from the level of Q2 to Q1 level. Likewise, we can see how other variables change and they response to change demand increase or decrease.
CHART : 1.2 Changes of Variables and Changes of DemandS.
No.Changes of Variables Demand Curve
ShiftsDemand Changes
1. Price of substitution increased ↑ Shifts to rightward Demand Increases ↑2. Price of substitution decrease ↓ Shift to leftward Demand Decreases ↓3. Tax increases (negative income effect) ↑ Shift to leftward Demand Decreases ↓4. Tax decreases (Positive Income Effect) ↓ Shift to rightward Demand Increases ↑5. Price of complement by good increases ↑ Shift to leftward Demand Decreases ↓
Price
P1
Q1 Q2
D1
D2
Quantity0
6. Price of complementary good decreases Shifts to rightward Demand Increases ↑
B. Extension / Contraction in Demand As price increase or decrease is a response to change in demand under the condition of other things being constant. That is,
---------------------------- (eqn)
1.19
Where,
= Change in price of ‘n’ good and other variables are not changed.
Fig: 1.11 Demand Curve Expansion by Change of Price of a Commodity.
As price of apple decreases from Price P1 to P2 level, the quantity of demand for apple increases from Q1 level to Q2 level and it is known as demand expansion.
Likewise, price increases from P1 to P2, the quantity demand for apple decreases from Q2
to Q1 level. It is demand contraction.
I. TYPES OF DEMAND There are various types of demand and you have to understand them.
A. Demand for Durable Good: Durable goods are those which can be used more than once – the services are consumed. It is storable for long-time and volatile demand – price movement.
B. Demand for Perishable Good: Perishable Goods are only one-time consumption. The demand for those good is more dependent on the current conditions.
Price
0Q1 Q2
Quantity
D1
P1
P2
C. Autonomous Demand When the demand for a commodity is completely independent of the demand for any other commodity, is autonomous demand.
Example: Demand for automobile.
D. Derived Demand When the commodity is demanded because of the demand for another commodity, it is known as derived demand.
Example: Capital goods like machine for the Bread making.
E. Short – run Demand The short – run demand is the existing demands with its immediate reaction to price-changes, income variations etc.
F. Long-run Demand The long-run demand indicates the demand that ultimately exists because of changes in pricing promotion or product development.
G. Industry Demand Industry demand represents the total demand for the product of a particular industry. It represents the quantity of a particular product demanded by all the firms in the industry.
H. Company Demand The demand for automobile produced by Maruthi Udhyog is a company demand. The projection to industry demand is useful in forecasting company demand.
1.2.3. ELASTICITY OF DEMAND AND BUSINESS DECISION Elasticity of demand is as “the degree of responsiveness of quantity demanded to change in price.
------ (eqn.)
1.20Where the parameter “A” may be any of the following.
1. Current price of the commodity (Px)2. Current price of the related good (Ps)3. Current income of the consumer(y)4. The expected price of the commodity
There is a different between the law of demand and elasticity of demand. The law of demand shows only the direction of change and not the rate at which the change takes place. To know about it, one should know about the elasticity of demand.
Important elasticities of demand in business decision are;i. Price elasticity of demandii. Income elasticity of demand
iii. Cross elasticity of demand andiv. Promotional or advertisement elasticity of demand
You can ascertain the salient information of business for your decision making after studying the elasticity of demand, namely
i. Seller has the price maker / takerii. Buyer has the price maker /takeriii. The firm is in higher profit / normal profit earneriv. The firm has higher – level technology or low – level technologyv. The product quality is homogeneity or heterogeneityvi. To exit / entry into market is easy or difficult.vii. To say a firm is monopoly / non monopoly.
A.PRICE ELASTICITY OF DEMANDPrice elasticity of demand refers to the rate of responsiveness of demand to change in
the price level. Formula to measure it,
---------------------------------------------
(eqn) 1.21
Example: Calculation of elasticity of demand for Radios in Chennai City, April 2006.
Table: 1.3 Price Elasticity of Radio
Product Old Amount
New Amount
Change in Amount
Average Amount
Percentage Change Elasticity
Radio Price(Rs.)
3000 2800 -200 2980
Quantity(in 1000)
5 5.5 +0.5 5.25 = +1.418
Column 7 shows us eta, = is degree of elasticity of radio’s demand in Chennai city market. That is = + 1.418, is positive elasticity of demand for radio.
FIG: 1.12 PRICE MOVEMENTS AND QUANTITY CHANGES IN DEMAND FOR RADIOS.
Fig1. Shows us how the price of Radio Rs.3000/per unit decreases to Rs.2800/per unit by the result of it, the quantity shows in increases to from 5000 units to 5500 units.
It mathematically represented as,
------------------------------------ (eqn.)
1.22It is based on numerical values of the co-efficient () of elasticity. We have five types
of price elasticities.
1. Perfectly inelastic demand2. Inelastic demand3. Unitary elasticity of demand4. Elasticity of demand and5. Perfecting elasticity of demand
a. Perfectly Inelastic DemandThe co-efficient of elasticity of demand is zero.i.e.
Ep = 0 ---------------------------------------------- (eqn.) 1.23
0
Price
Old price 3000
New price 2000
Quantity
D1
Old qty 5
New qty 5.5
FIG: 1.13 PERFECTLY INELASTIC DEMAND
As the price rise or fall, the quantity demand has no change.
Salient Features Seller is the price maker Buyer is the price taker The firm earns higher profit The product quality is homogeneity Exit / Entry into the market is difficult The firm has high-level technology It has higher degree of monopoly power
b. Inelastic DemandThe coefficient of elasticity of demand is less than one ie:
Ep>1>0 --------------------------------------------------------- (eqn.) 1.24
0
D1
Qty
Price
P2
P1
Quantity
FIG: 1.14 INELASTIC DEMAND
As the price rise or fall, the quantity change is low
Salient Features Seller is the price maker Buyer is the price taker The firm earns higher profit The firm has high-level technology The product quality is homogeneity Entry/Exit into the market is difficult The firm enjoys monopoly power.
c. Unitary Elasticity of DemandThe coefficient of elasticity of demand is equal to one i.e.
Ep=1 ------------------------------------------------------------ (eqn.) 1.25
Quantity0
P2
P1
Price
Q2 Q1
D
FIG: 1.15 UNITARY ELASTICITY OF DEMAND
As the price rise or fall., the quantity change is equally increase / decrease.
Salient Features Price making /taking power is balance between seller and buyer. The firm earning normal profit The firm has medium –level technology The product has close substitutes Entry/exit into the market is normal The firm enjoys minimum level of monopoly power.
d. Elastic DemandThe coefficient of elasticity of is greater than zero, i.e.,
Ep >1 ------------------------------------------- (eqn.) 1.26
FIG: 1.16 ELASTIC DEMAND
0
P1
P2
Price
D
QuantityQ2 Q1
As the price rise or fall, the quantity changes larger one.
Salient Features Seller is almost price taken Buyer is price match The firm earns normal profit The product is heterogeneity and so it has close substitutes It has low- level technology It enjoys low-level monopoly power Entry/exist into the market is easy.
e. Perfectly Elastic Demand The co-efficient of elasticity of demand is infinite,ie. Ep=∞ --------------------------------------- (eqn.) 1.27
FIG: 1.17 PERFECTLY ELASTIC DEMAND
0Q2 Q1
Quantity
D
P2
P1
Price
As the price rise or fall, the quantity change is infinite.
Salient Features: The quantity of buyers and sellers are more Buyer is price maker Sellers are price taker The firm earns normal profit The product quality is homogeneity The firm has low-level technology There is no monopoly power There is close substitute to the existing product Exit/entry into the market is easy.
K. METHODS OF MEASUREMENT OF PRICE ELASTICITY There are four methods of measurement of price elasticity of demand
1. Percentage method2. Slope method3. Mathematical method4. Total outlay method
1. Percentage MethodIn this case, the elasticity of demand is as the percentage change in quantity
demanded divided by percentage change in price of the commodity.
-------------------------------------------------- (eqn) 1.28
[See: Detail Analysis (Page Number.xx)]
2. Slope Method In this method, elasticity of demand is measured with the help of a tangent. A tangent is a drawn on the demand curve at the point where elasticity is to be found.
--------------------- (eqn.) 1.29
Fig: 1.11 Slope Method
Fig: 1.11 indicates that if them and curve is a straight line then point elasticity is simplythe ratio between this
2. Mathematical MethodWith the help of differential calculus, the point elasticity can be calculated
mathematically. Expressed by the differential the slope of the curve at the any point is expressed by the differential.
of the demand function ------------------------------(eqn.) 1.30
But at differentiation is an absolute measure it has to be multiplied by the ratio P/Q to arrive at the elasticity of demand at the given point which gives the elasticity of demand
----------------------------------------------------- (eqn.) 1.31
4. Total Outlay MethodIn this method the total revenue does not change when the elasticity of demand is
unity. The total revenue shows a following tendency. The elasticity of demand is less than unity and a rising tendency when elasticity is greater than unity.
L. Determinants of Price Elasticity
a. Nature of commodity-Comforts or luxuries goods differentially affect the demand. The demand for
necessities is generally inelastic.
b. Extent of useWhen a commodity has general uses, its demand will be elastic.
A
B
O
P
Q1
Quantity
D
X
Price
c. Range of substituteWhen a commodity has a large number of substitutes, its demand will be elastic.
d. Income LevelPeople with high income are less affected by price changes than people with low
income. A rich man will not reduce his consumption of fruits and milk even if their price has gone up. Hence, demand for fruit and milk is inelastic for the rich and elastic for the poor.
e. Consumer’s Income spending activityWhen the money spent on a community is just a small amount of consumer’s budget,
he does not care for small price changes.
Example: Salt, newspaper, mach box etc. The demand for such commodities is inelastic on the other hand, if the proportion of income spent is very large, he has to think very much about price changes. In the case demand will be more elastic.
f. Urgency of demand For the consumption of postponable goods, there is more elastic.
For non postponable i.e., urgent consumption, there is inelastic.
g. Durability of a commodityIn the case of the commodity is durable or repairable, if price rises one may use the
commodity for a long time. Thus the more durable commodity is the height is the elastic of demand directly to be.
h. Habit When once people form a habit of consuming a particular type of commodity they
never care for price changes over a period of time. Demand for such commodities is inelastic.
Example: Demand for alcohol and tobacco.
i. Time: The price elasticity at demand varies with the long of time period. The longer the
period, the more elastic is the demand for a particular commodity and vice versa.
Price Elasticity of Demand and Business Decision-makingThe producers will be able to fix a higher price when the demand is inelastic and
lower price when the demand is elastic. It helps for price discriminations too and this would enable the firm to anticipate the likely demand for the product at different prices.
M. INCOME ELASTICITYYou could understand how the price elasticity of demand varies in different situation
that effect revenue stream to the firm in different way. On the other hand, the income elasticity reveals the nature of quality of commodity to prefer by the consumers in different situation. It helps how a commodity is defined as inferior, normal and luxurious items.
Income elasticity of demand refers to the rate of responses of quantity demanded to a given change in income.
------------------------------ (eqn.)
1.32
That is
------------------------------------ (eqn.)
1.33
----------------------------------------- (eqn.) 1.34
--------------------------------------------- (eqn.)
1.35
Where,Q1 = Original quantityQ2 = New quantity demandedY1 = Original incomeY2 = New income“” = Change inQ = Quantity demandedY = Income of the consumer
Based on this, five types of income elasticities can be drawn.
1. Zero income elasticity of demand2. Negative income elasticity of demand3. Unitary income elasticity4. Income elasticity of demand is greater than one5. Income elasticity of demand is less than one.
a. Zero Income Elasticity of DemandThe coefficient of income elasticity is zero, i.e.
Ey = 0 -------------------------------------------------------------- (eqn.).1.36
FIG: 1.18 ZERO INCOME ELASTICITY
As the income of the consumer increases on decreases, the quantity of demand has no changes.
Salient Features
1. Commodities in the list of elasticity are essential commodities.
Example: Salt, Firebox, etc.
b. Negative Income Elasticity of DemandThe coefficient of income elasticity of demand is negative. i.e.
Ey < 0 ------------------------------------------------- (eqn) 1.37
FIG 1.19 NEGATIVE INCOME ELASTICITY
Price
Y2
Y1
O
Q1
D
Quantity
As the income of the consumer rises, the quantity demands for goods falls and viscera.
Salient Features1. Commodities falls in the list of the elasticity of demand are inferior
commodities.
Example: Food items like Ragi etc.
c. Unitary Income Elasticity of DemandThe coefficient of income elasticity of demand is one i.e.
Ey = 1 --------------------------------------- (eqn) 1.38
FIG 1.20 UNITARY INCOME ELASTICITY
O
Y2
Y1
Q1Q2
D
Price
Quantity
As the income of the consumer increases, the quantity demand for commodities increases and vise versa.
Salient Features1. Commodities in the list of elasticity are normal commodities.
Example: House, Cloth etc.
d. Income Elasticity of Demand Greater than one:
The coefficient of income elasticity of demand is greater than one i.e. Ey > 1 ------------------------------------------------------ (eqn) 1.39
FIG: 1.20 INCOME ELASTICITY OF DEMAND GREATER THAN ONE
OQ1 Q2
Y2
Y1
Price
Quantity
As the income of the consumer increases, the quantity demand for commodities increases greater than that of income.
Salient Features1. Commodities fall in this list of elasticity are superior commodities.
Example: Home theatre, Air Condition etc.
e. Income Elasticity of Demand Less Than OneThe coefficient of elasticity of demand for the commodities is less than one i.e.
Ey<1 ----------------------------------------------------- (eqn) 1.40
FIG 1.21 INCOME ELASTICITY OF DEMAND LESS THAN ONE
O
Y2
Y1
Price
Q1 Q2
Quantity
As the income of consumer increases, the quantity demand for the commodities increases but less than that of income increases.
Salient Features:1. Commodities fall in the list of elasticity are luxuries commodities
Example: luxuries car, computer, Bungalow etc.
In competitive business, the production of superior and inferior goods yield alternative revenue compare to essential and normal goods.
N. CROSS ELASTICITY OF DEMANDThe demand for certain commodities may also be influenced by changes in the price
of related goods. There are two kinds of goods.
1. Substitute goods and 2. Complement goods
Commodities are substituted when one commodity is replaced by another. Here, a change in the price of one commodity, would lead to a change in demand for that commodity at the expense or some other commodity.
Example:An increase in the demand for SONY television may be at the cost of PHILIPS Television.
Commodities are complements. That is, a change in the demand for one commodity leads to a change in the demand for other commodity in the same direction.
Example: An increase demand for a car will lead to an increase in demand for petrol.
OQ1 Q2
Y2
Y1
Price
Quantity
The responsiveness of demand for commodity (say coffee) to change in the price of another commodity (say tea) is called “CROSS ELASTICITY” OF DEMAND”.
----------------- (eqn.) 1.41
“Cross Elasticity can vary from minus infinity to plus infinity.
Complementary goods have negative cross elasticity and substitute goods have positive cross elasticity.
Income effect and substitution effect with in difference curve approach.See Indifferent Curve Analysis.
2.2.3. ADVERTISING OR PROMOTIONAL ELASTICITY OF DEMAND
Advertising is non-pricing business strategy to the competitive firm, it is an important device in promoting the sales of a product. The features of advertising for sales relationship:
Other things remaining the same, an increase in expenditure on advertisement is likely to lead to an increase in sales.
A certain amount of sales is possible even without advertisement.
Up to a certain an increases in advertisement will load to more than proportionate increase in sales. But beyond this point, any increase in advertisement will lead to less than proportionate increase in sales till the saturation point is reached after which there will be no increase in sales.
FIG: 1.22 SALES CURVE BEHAVIOUR OF ADVERTISING EXPENDITURE
I. Phase increasing sales -------------------------------------------- (eqn.) 1.42
II. Phase constant sales --------------------------------------------- (eqn.)1.43
III. Phase diminishing sales --------------------------------------- (eqn.) 1.44
(ds = change in sales, dAE = change in advertising outlay (Expenditure)]
To start with, sales are positive even when the expenditure on advertisement is zero indicating that at certain amount of sales is taking place even without advertisement. The advertisement – sales curve moves upwards after successive doses of expenditure on advertisement. After certain paint, the growth curve is at a decline rate indicating that an increase in advertisement gives a diminishing return. In the final analaysis the curve becomes the indicating saturation point.
Elasticity of advertisement on sales
-----------------------------------------
(eqn.) 1.45
So, idle expenditure on advertisement that will definitely bring more revenue by sales more of commodities.
Thus, the concepts of elasticities of demand have immense use in business decision making.
O
SALES Rs.
II
I
III
Advt. outlay (Rs,.)
O
SALES Rs.
1.2.4. DEMAND FORECASTINGDemand forecasting plays an important role in business planning. Forecasting means
an estimation of a future situation. It refers to an estimation of the level of demand that might be realized in future under given circumstances. That is by forecasting of demand we mean making an effective assessment of the future course of demand.
A. Period of forecast: A calendar time is selected according to the nature of business. A short term forecast
refers to period unto 3 months.
A medium term forecast refers to 3 months to 1 year.
The long term forecast refers to more than a year.
B. Levels of Forecast
There are five levels of forecasting methods.
(i) Macro Economic ForecastingMacro economic forecasting is concerned with business conditions over the whole
economy – wise National Income, Price Index etc.
(ii) Industry Demand ForecastingIt gives indications to the firm in which the whole industry is moving
Example: SONY will like to know the way T.V. industry behaves, before making future plan.
(iii) Firm Demand ForecastingA big firm or company will be willing to do its own forecasting independently.
(iv) Product-Line ForecastingIt helps the firm to decide the type of the product that is given priority in the
allocation of resources
Example: Hindustan Lever may like to know whether it should produce more Lux, Dalda, or Surf.
((v) General purpose or Specific purpose forecasting
(vi) Forecasts of Established products or New products.
STEPS INVOLVED IN FORECASTING
For an efficient forecasting the following steps are necessary.
Step – 1 Identification of objectivesStep – 2 Determining the nature or the good under considerationStep – 3 Selecting a proper modeStep – 4 Interpretation of results
Criteria for the choice of a good forecasting methodIn choosing of method of forecasting, the firm should take into account the following
criteria.
1. Accuracy: Forecasting should be accurate. Accuracy can ensure checking the present performance against past forecasting and present forecasting in relation to future performance. The prediction should be as far as possible realistic.
2. Plausibility: Demand forecasting must be done, in such a way that executives are able to understand it and are having the confident in the techniques adopted.
3. Durability: Simplicity and reasonableness ensure of forecasts. It refers to reasonable and continuous link between the fast and present and present to future.
4. Flexibility: Flexibility is necessary so that the influence of new elements are incorporated into the forecasts.
5. Economy: The demand forecasting is organized in such a way that the cost is cost at a minimum level.
6. Availability: Immediate availability of data is another important requirement of a good forecasting method. The method used for forecasting should give quick and meaningful results. Late availability of data and delay in results may adversely affect managerial decisions.
7. Consistency: Demand forecasting should be consistent. For this the firm should take into account the behaviour of various variables influencing the demand for product. When variables are homogeneous, forecasting should give considerable data and conclusion.
1.2.4. Demand Forecasting Method for Existing GoodsThere are several methods that are used for forecasting demand for existing goods.
They are divided into two categories.1. Survey method and 2. Statistical method
CHART: 1.3 DEMAND FORECASTING METHODS
a. Opinion Survey MethodIt is also called as “Sales-Force-Polling” or “Selective Opinion” method. In this
method, opinion is collected from expert sales representatives regarding the sales of the product in the future period. Sales representatives being very close to the consumers will be able to estimate the reaction of the consumers over the product.
b. Consumer’s Interview MethodIn this method, all the consumers (or) a selected group of them are interviewed
directly.
c. Sample Survey MethodInstead of interviewing all the units of population, a representation, the sample is to
interview. There are various sampling methods, random and non-random sampling methods to follow in this survey appropriately.
d. End- use method: It is used to bulk of the sales is of intermediate commodity used for industrial
purposes. This method is based on the rational expectations of the consumers.
e. Trend Projection Method:This method makes use of the statistical technique, “time series”.
Time series is an ordered sequence of events over a period of time pertaining to certain variable.
Survey Method Statistical Method
Opinion Survey
Consumers Interview
Trend Method
Regression Method
CorrelationMethod
Barometric
Method
CompleteEnumeration
Sample Survey Method
End-use Method
The variables are dependent say,1. sales of shirts monthly2. daily closing price of shares3. weekly demand for steel
When a data chronologically arranged, it becomes time series by using time series; it is possible to give projection regarding future trend values of sales. When presents in the form of a graph, we can get a curve called the sales curve. These curves fluctuate with turning points.
There are various components of time series.
1. Secular2. Cyclical3. Seasonal4. Random (irregular variation)
FIG 1.24 SECULAR TREND
FIG 1.25 CYCLICAL FLUCTUATION TREND
O
Times in years
Growth (%)
Secular trend
Actual time series
FIG 1.26 SEASONAL VARIATION TREND
O
Growth (%)
Times in years
Trend line
Cyclical fluctuation
O
Growth (%)
Times in years
Seasonal fluctuation trend
FIG 1.27 IRREGULAR VARIATION TREND
Various trends are in different business situation to forecast.
The trend in the time series is to estimate by using any one of the following methods.
1. The least square method2. The free hand method3. The moving average method4. The method of semi average
Note : These analysis are being studied in the subject code No. _______________ Quantitative Methods for Business Management detail.
In this method, post data serves as a better guide to predict the future sales etc.
Regression Analysis and Correlation Methods
The regression and correlation analyses help in relating demand with other variables such as price, rival’s price, advertisement etc.
The correlation analysis lies to find out the relationship between the movements of the variables. If the relationship between the movements of two variables seeks, it is simple correlation, if it is for more than two variables it is a multiple correlations.
On the other hand, regression analysis is to use to find out the extent of influence of related variables on sales. Among the several variables, independent variables, which have closeness of relationship with dependent variables selected.
O
Times in years
Irregular variation
Growth (%)
The date of the dependent variable and selected independent variable is then fed into the regression equation.
Sales = a (Price) + b (Price of Rivals) + C (Personal income) + …...+ u ------ (eqn.) 1.46
The coefficient point out the amount of change in sales as a result of 1 unit change in the respective demand that variable. The values of the coefficient in the function point out the elasticity of each independent variable.
It tells us how much change will occur in the dependent variable when the independent variable changes by 1 percent.
Regression Analysis
Equation for Straight Line
Y = a + b ------------------------------------------------------- (eqn.) 1.47
Y – Dependent Variable a – Y intercept b – Slope of the line – Independent Variable
a = the “a” is the Y intercept because value in the point at which the regression line crosses the Y-axis.
The Slope of ------------------------------------------------------------ (eqn.)
1.48FIG: 1.28 REGRESSION CURVE FITTING
a
yY= a + bx
(b) Slope
x0
Model 1. Given advertisement cost and profit values, find out regression values and project to sixth period profit if the advertisement cost wise Rs. 2000.
Table : 1.4 Advertisement .Cost Profit in (Lackhes)Annual advertisement cost ( Rs. 000’) 5 7
3 73 61 4
Table 1.5 Calculation of Inputs for Equations: _____________ and ______________
Advt – Cost (X) Profit (Y)
XY X2
5 7 35 253 7 21 93 6 18 91 4 4 1
X = 12 Y – 24 XY = 78 EX2 = 44
-------------------------------------------------------- (eqn.)
1.49= 12 /4
3 mean of the values of the independent variable
--------------------------------------------------------- (eqn.)
1.50= 24 / 4
6 mean of the value of the dependent variable
--------------------------------------------- (eqn.)
1.51
6 / 8
= 0.75 the slope of (b) line and y intercept is
a = Y – bx 1.52y = 0.75 + 3.75 (2)
= 0.75 + 7.50
= 8.25 (000) ie.
Y = 8250 i.e. Profit increases from Rs. 8000 to Rs. 8250
Likewise the demand forecast can be estimated with the regression analysis fro other goods / services.
Barometric Forecasting Method
Trend projection or time series data to predict the future based on past relationship. But if there is no clear pattern in time series, the data are of little value for forecasting. A alternative approach is to find a second series, it may be possible to predict change, in the first.
Example : A lumber company is sales exhibited large yearly fluctuations over the last decade so large that may forcast based on a trend projection of sales is useless. But over the same period, it is also determined that the firm’s sales where highly correlated with the number of housing starts. Thus, if housing starts can be predicted this information can be used to forecast lumber sales.
Two Types of Indicators
1. Coincident Indications
In two series data, the frequency increases or decreases at the same time, one series may be regarded as a coincident indicator of the ORG.
Example : # 1. Indicator (Civil services like drinking water supply, electricity and road provision.
# 2. Indication, housing growth in a location.
Fig. 1.23 Coincident Indicator
2. Leading Indicator
If changes in one series consistently occur prior to change in another series, a leading indicator
1. Series 1 can be considered a leading indicator of series 2 peaks and troughs of series 1 consistently occur before the corresponding peak and troughs of series 2.
# 1. Series 1 is rate of interest
# 2. Series 2 is demand for money (investment)
FIG. 1.29 LEADING INDICATOR
0
Growth of houses
Times in years
Likewise, the other sophisticated tools are utilized, they are,
1. Input – Output model2. The Box Jenkins method3. Chain Ratio Method4. Computer assisted forecasting
They are being studied detaily in your subject quantitative method or statistical methods for business management.
1.3 SUPPLY
You have so fat studied theory and application of demand from consumer behaviour point of view now, you can study what is supplier’s behaviour to supply of goods/services. Because, the demand and supply both are compulsory factors to determinate price of good / services.
What is meant by supply?Ans. Supply by an individual seller in the quantity of the commodity that he is willing to sell in the market in a given period of time at a given price.
1.3.1 Factored Determining supply of Goods
qgs = (pg, cg, a1, a2, ------------- an, j1, j2, ------ In, R A Pget +1)
qgs = quantity supply of “g” products.
pg = Price of good “g”a1, a2, ----- an = The profitability of alternative goodj1, j2 – jn = The profitability of good jointly supplied.R = nature and other random stockA = the aims of productionPg
e = the expected price of good’s.(t+1) = at some future time
1.3.2. Supply Schedule
Supply schedule shows a monthly supply schedule for potatoes books for an individual farmer (farmer X) and for all farmers together ((the whole market).
TABLE 1.6 THE SUPPLY OF POTATOES (MONTHLY)
Farmer Price of Potatoes Rs. (per Kg.)
Farmer X’s supply (tones)
Total market supply (tones 000’)
A 4 50 100B 8 70 200C 12 100 300D 16 120 530
E 20 130 700
FIG. 1.30 MARKET SUPPLY CURVE OF POTATOES (MONTHLY)
Fig. 1. depicts the supply curve of potatoes that shows the relationship between price potatoes and quantity supply is positive relationship under the condition of other things being constent.
1.3.3. Elasticity of Supply
1.52
There are five types of elasticity of supply
1. Perfectly inelastic supplyep
s = 0 1.532. Inelastic supply
eps <1> 0 1.54
3. Elastic supplyep
s > 1 1.55
4. Unitary elastic of supplyep
s = 0 1.56
5. Perfectly elasticity of supplyep
s = 1.57
These various types of elasticities of supply help to the supplier or manager of business to tape appropriate decisions to meet the demand for the goods in the market to accept / reject the price of goods.
1.4 EQUILIBURIUM OF DEMAND AND SUPPLY – MARKET PRICE DETERMINATION
We can now combine our analyses of demand and supply. This will show how the actual price of a product is determined and the actual quantity taught by the society in a free and competitive market.
Example : The market demand and market supply of potatoes and use the data from table 1 and these figures are given in table 1.
Table 1.7 The Market Demand and Supply of Potatoes [monthly]
Price of Potatoes, (Rs./per Kg.)
Total Market Demand [tones 000’]
Total Market Supply [tones 000’]
4 700 (A) 100 (a)8 500 (B) 200 (b)12 350 (C) 350 (c)16 200 (D) 530 (d)20 100 (E) 700 (e)
The sufficient condition to fix market price is, the market demand for potatoes equals the market supply of potatoes. The only point, say equilibrium between demand and supply that directs the resources/products efficiently and it is the most desire of the society.
FIG. 1.31 THE DETERMINATION OF MARKET EQUILIBRIUM (POTATOES MONTHLY)
Fig. 1.26 Shown the demand and supply curves of potatoes corresponding to the data in Table 1. Equilibrium price is Pe (Rs. 12) and equilibrium quantity is Qe (3,50,000 tonnes)
As any price above Rs. 12, there would be a surplus (goods stagnation waste). Thus at price there is surplus of 3,30,000 tonnes (d-D).
As any price below Rs. 12 the would be a shortage. Thus at price Rs. 8 there is a shortage of 3,00,000 tonnes (B-b) difficult to consume the product so inefficiency occur.
Therefore, the equilibrium point of price and quantity is the sufficient condition to value determination of goods and the market efficiecy determination.
Sometimes, the demand curve or supply curve or both can be moved (shift) by the changes of variables (factors) of consumer’s demand or producer’s supply. It would determine different positions of equilibrium and quantity.
FIG. 1.32 MARKET DEMAND CURVE SHIFTING AND PRICE DETERMINATION
(Note : It is reminded here that you know the dynamics of shifting and extension of demand and supply curves in previous lesions)
Fig. 1.27 shows as the demand and curve shifts from leftwared to rightward, on constant increasing supply of goods, the price and quantity increase from P1 to P2 and Q1 fo Q2 respectively and vice versa.
FIG. 1.33 MARKET SUPPLY CURVE SHIFTING AND PRICE DETERMINATION
Fig. 1.28 shows as the supply curve shifts from leftward to rightward on constand increases of demand for goods, the price falls from P1 to P2 and the quantity increases from Q1 to Q2 level and vice versa Fig.1.
FIG. 1.34 MARKET DEMAND CURVE AND SUPPLY CURVE (BOTH) SHIFTING AND PRICE DETERMINATION
Fig. 1.29 shows as the both curves are shifted towards some direction in a similar fasion, the price has no change but the quantity increases from Q1 to Q2 level.
It is a necessity condition but not a sufficient condition to predict such type of equilibrium always because, the elasticity of demand and supply in different degrees, the price and quantity places. So we need to identity the nature of the profit and shfting of both curves first and determine the price and quantity.
4.1 Government Intervention into market to fix ceiling and floor prices
Shortages and surpluses of the quantity of goods can occur after a shift in demand or supply. However, marks are assumed to adjust fairly. But some types of shortages and surpluses that market forces do not eliminate permenantly and it results from government interferences with the market mechanic which prevent price from freely moving up or down to clean the market.
There are two types of prices fixed by the government.
1. Ceiling price and2. Floor Price
FIG. 1.35 CEILING PRICE (MAXIMUM PRICE FIXATION BY THE GOVERNMENT)
Fig. 1.30, a ceiling price of Rs. 1 is on some good X no one legally sell X for more than Rs. 1 and Rs. Is less than the equilibrium price of Rs. 2. By a result, suppliers are willing to supply is 22 units, and the consumers will to purchase 62 units. A shortage of 40 units results from the position of the Rs. 1 price ceiling – But there will be illegal black market experiencing. It is predicts that future, the supply and demand will be select in the Rs. 1 equilibrium and the governments ceiling price can be removed.
FIG. 1.36 FLOOR PRICE FIXATION BY THE GOVERNMENT
Alternatively, the government may believe that the suppliers of the good are not earning as much income as they deserve and therefore, sets a (minimum price) or floor price.
Fig 1.31 dissatisfied with the equilibrium price of Rs. 2 and the quantity of 50, the government sets a minimum price of Rs. Since the government cannot reveal the law of demand, consumers reduce the amount they purchase to 5-2 units. Producers, of course are going to increase the production of X to 84 units in response to the Rs. 3 price. Now a surplus of 52 units exists. The surplus may be bought or destroy by the government.
