managerial economics (2)

MANAGERIAL ECONOMICS

“TEXT FOR THE SUBJECT”

“Managerial Economics – Analysis, Problems and Cases”

By

P. L. Mehta

Sultan Chand & Sons

Prepared by Mr. R. Sriram, Lecturer - MBA, STC - Pollacih.

MANAGERIAL ECONOMICS

Evaluation Methodology:

1.1 Cycle Test. 2.Assignments (Questions) at the completion of each unit.3.1 Model Examination.


WHAT IS MANAGERIAL ECONOMICS?

• Managerial Economics is Economics applied in Business Decision Making.• Serves as a link between Abstract Theory and Managerial Practice.• Economic Analysis for:

• Identifying Problems• Organizing Information• Evaluating Alternatives

• Managerial Economics involves analysis of allocation of the resources available to a firm or a unit of Management within that unit.• Managerial Economics is:

• Goal Oriented• Prescriptive• Maximizing achievement of objectives


MANAGERIAL ECONOMICS – DEFINITIONS

Mc Nair and Meriam defines:“Managerial Economics is the use of Economic modes of thought to analyse

business situations”Spencer and Siegelman:

“Managerial Economics is the integration of economic theory with business practice for the purpose of facilitating decision making and forward planning by management”Watson defines Managerial Economics as:

“Price theory in the service of business executives”Brigham and Pappas defines:

“Managerial Economics is the application of economic theory and methodology to business administration practice”. Hague defines:

“Managerial Economics is the fundamental academic subject which seeks to understand and to analyze the problems of business decision making”.


MANAGERIAL ECONOMICS – NATURE

1. Macro-economic Conditions: Decisions of firms are made within their economic environment in which they operate. This environment is called Macro-economic conditions. The Macro Economic conditions include:

1. A free enterprise economy using prices and market.2. One undergoing rapid technological and economic change.3. Increased intervention of government presently and in future.

2. Micro-economic Analysis: A study on Micro-economics help in understanding 1. What is going on within the firm.2. How best to use the available scarce resources between various activities of the firm.3. How to be technically as well as economically efficient.

1. Positive Vs Normative Approach: Positive Approach concerns with what is, was or will be while Normative Approach concerns with what ought to be.

2. Integration of Economic Theory & Business Practice: Managerial Economist’s role is to modify or extend the theoretical construct of economics to conform to actual business behavior.


MANAGERIAL ECONOMICS - CHARACTERISTICS

• Microeconomic in character: Study restricted only to a firm and not on the working of the economy.

• Takes the help of macroeconomics to understand and adjust to the environment in which the firm operates.

• Normative than Positive in character (Prescriptive rather than Descriptive). It deals with the type of decisions that the firm should take in order to prosper which involves value judgments and not a mere description of behavior of the firm.

• Conceptual (to understand and analyze the decision problems) and Metrical (takes the help of quantitative techniques to measure the impact of different factors and policies).

• Based mainly on “Theory of firm” and “Theory of distribution” (Analysis of Profits).• Making wise choices (To face the problems of scarcities)• The study of the allocation of resources available to a firm along the activities of that unit.• It is goal oriented and maximize the objectives.


MANAGERIAL ECONOMICS - SIGNIFICANCE

• Provides a number of Tools and Techniques to enable a manager to capture the essential relationships that represent the real situation eliminating relatively less important details.

• Provides most of the concepts such as:• Elasticity of Demand• Fixed and Variable Costs• Short and Long Run Costs• Opportunity Costs• Net Present Value.

• Provides help in making decisions such as:• What should be the product-mix• Which is the production technique and the input-mix that is least costly.• What should be the level of output and price of the product• How to take investment decisions• How much should the firm advertise• How to allocate an advertisement fund between different media.

Prepared by Mr. R. Sriram, Lecturer - MBA, STC - Pollachi.

MANAGERIAL ECONOMICS – SUBJECT MATTER

• The Subject matter of Managerial Economics consists• Objectives of the Business Firm• Demand Analysis and Demand Forecasting• Production and Cost• Competition• Pricing and Output• Profit• Investment and Capital Budgeting• Product Policy, Sales Promotion and Marketing Strategy


MANAGERIAL ECONOMICS WITH VARIOUS DISCIPLINES

Managerial Economics and Economics:• Both the subjects have common ideals with identical problems.

• The problems of scarcity and resource allocation.• The best ways of utilizing the labour and capital resources for achieving the set goals.• The use of opportunity cost principle depicted in business is prevalent in general

economic theory.• The study of types of markets (impact of markets or technological changes on

competitive position of the firm and their likely reactions). Managerial Economics and Operations Research:• Operations Research models are being used in Economics like Queuing, Linear

Programming, etc.• Provides the manager with the tools he needs to carry out instant operations research.Managerial Economics and Mathematics:• It uses the metrical concepts available in mathematics to find estimate and predict the

relevant economic factors for decision making and forward planning.• The descriptive research from mathematics is also used in managerial economics.


MANAGERIAL ECONOMICS WITH VARIOUS DISCIPLINES (Contd…)

Managerial Economics and Statistics:• Quantifying the past economic activity to predict its future (for correct judgment)• Predict uncertainties raising in the firms • Usage of Theory of probabilities in decision making Managerial Economics and Theory of Decision Making:• Single Objective – “Profit Maximization”.• Theory of uncertainty creates new choices.• It helps the executives to understand how managerial process combines and synthesizes

with various functional fields like:• Sales Management• Production Management

• It has close connections with various disciplines of knowledge like• Traditional Economic Theory• Statistics• Operations Research


ROLE OF MANAGERIAL ECONOMIST

• He has TWO primary tasks namely• Specific Decisions• General Tasks

• Specific Decisions:Specific Decisions are undertaken by the Managerial Economist in terms of business

operations which include shut down of operations of a plant, stay in business and produce goods at optimum cost, making or buying decisions in business investments as well as processing of goods. In performing these decisions, an economist undertakes the following functions:• Production Scheduling• Demand Forecasting• Market Research• Economic Analysis of the Industry• Investment Appraisal• Security Management Analysis• Advice on Foreign Exchange Management• Advice on Trade


ROLE OF MANAGERIAL ECONOMIST (Contd…)

• Specific Decisions:• Pricing and the related decisions• Analyzing and Forecasting environmental factors

• General Tasks:• To know information which is necessary to make intelligent decisions• To find the correct solution to a problem• To learn how to process and use that information• To check for economical feasibility of information obtained with theoretical and

statistical tools for decision making.• Divided into two set of factors such as:

• External Factors – General Economic condition of the economy. (Demand, Cost, Market Conditions, Market Share, Economic Policies)

• Internal Factors – Pricing and Profit Policies, Investment Decisions, ROI and Cost of Investment.


FUNDAMENTAL CONCEPTS• Managerial Economics covers several major concepts which includes:

• Incremental Reasoning – Covers the concepts of Incremental Costs and Incremental Revenue. Incremental Costs is defined as the change in total cost as a result of change in level of output, investment. Incremental Revenue is a change in total revenue resulting from a change in the level of output, price etc.

• If the revenue generated from the original costs is Rs. 2000, then the company would earn a loss of Rs. 400 while employing with original costs but when the company plans to change its costs for earning additional revenue it earns a profit of Rs.600.


FUNDAMENTAL CONCEPTS (Contd…)• Incremental Reasoning is guided by the following two theorems:

• Theorem 1: A course of action should be pursued up to the point where its incremental benefits equal its incremental costs.

• Theorem 2: Different courses of action should be pursued up to the point where all the courses provide equal marginal benefit per unit of cost.

(It follows the Equi-Marginal Principle where the Marginal Utility of product x should be equal to the Marginal Utility of product y).

• The concept of Opportunity Cost:• It represents the benefits or revenue forgone by pursuing one course of action rather

than another.“When a choice is made in favour of a particular alternative that appears to be most desirable of all the given alternatives, it obviously implies that the next best alternative has not been chosen”

Some illustrations:a. The Opportunity cost of the funds employed in one’s own business is the amount of interest which could have been earned had these funds been invested in the next best channel of investment.


FUNDAMENTAL CONCEPTS (Contd…)• Opportunity Cost Illustrations (Contd…):

b. When a product X rather than a product Y is produced by using a machine which can produce both, the opportunity cost of producing X is the amount of Y sacrificed as a result.c. The opportunity cost of using an idle machine is zero, as its use needs no sacrifice of opportunities.d. The opportunity cost of one’s own business is the income one could have earned accepting a job outside.

The sacrifices made on the opportunity cost principle can either be Monetary Costs which are called as Explicit costs and the costs which are Social Costs are called Implicit Costs.

Explicit Costs: The Costs which are recognized in the accounts. It includes the Payments for Labour, Raw Materials.

Implicit Costs: The Costs are sacrifices that are not recorded in accounts. It includes the Cost of Capital supplied by owners of business.


FUNDAMENTAL CONCEPTS (Contd…)


Incremental Cost Opportunity Cost

1. Difference in Costs due to a Decision 1. Includes all the Economic Costs (rather than Difference in Costs) of a scarce input.

2. By Subtracting incremental cost from incremental revenue, one can find the gain from a proposed change in the activity.

2. Opportunity Cost is subtracted from Total Revenue of the Chosen alternative to find the gain from the proposed use of the input.

3. The Incremental Cost concept is used to show the contrast between the Sunk Costs (the costs that do not change with the change in activity) and the costs that change with a change in the level of business activity.

3. Opportunity Costs focuses on the Net Revenue that could be generated in the next best alternative use of a scarce resource.

FUNDAMENTAL CONCEPTS (Contd…)• Contribution:

• It tells us about the contribution of a unit of output to overheads and profit.• It helps in determining the best product mix when allocation of scarce resources are

involved.• It indicates whether or not it is advantageous to

• To accept fresh orders• To introduce a new product• To shut down• To continue with the existing plant

• Unit contribution is the per unit difference of incremental revenue from incremental cost.

• Introducing a new product at the time when the plant is run with backlog of orders will require the company to compete with backlog and new product’s being introduced. Here the contributions of the new product will be compared with existing product

• In short, the contribution that each product makes in terms of the cost saving and production is taken for calculation in deciding the best methods of production and gaining better revenues.


FUNDAMENTAL CONCEPTS (Contd…)• Time Perspective:

• The concept of Short Run and Long Run are introduced.• The Short Run is approximately for a period of 3-5 years• The Long Run is for a period of 15-20 years.• Short Run is one where the concept of Fixed Input and Variable Inputs are being

used for producing goods. In the short run, the change in the output can be achieved by changing the intensity of use of fixed inputs.

• Long Run is one where there are not fixed and variable inputs and all the inputs(resources) are continuously changed to achieve the desired production levels. In the long run, the change in the output can be achieved by a massive change in the scale of resources mainly labour and capital.


FUNDAMENTAL CONCEPTS (Contd…)• Discounting Principle (Time Value of Money (TVOM))

• The Concept of Discounting Principle is based on the fundamental fact that a rupee now is worth than a rupee earned a year after. The discounting happens due to the fact that the waiting period of our investments volunteers a sacrifice for the present. In other words, the discounting involves the transaction costs for a particular investment / Financial Transaction.

• For example, if a person A is given a choice of accepting Rs. 1000 today or next year, he would rather accept it today since Rs.1000 invested today with an interest of 10% would earn him Rs. 1,100.

• Formulae:Discounted Value (v) =

Rk

-----------

(1+i)k


FUNDAMENTAL CONCEPTS (Contd…)• Risk and Uncertainty:

• Economic Theory assumes that the firm has perfect knowledge of its cost and demand relationships and of its environment. Uncertainty is not allowed to influence the decisions of the firm. The firm proceeds to maximize the profits after it has acquired the relevant information on costs and revenue.

• Uncertainty influences the estimation of costs and revenues. Management deals with decisions which have long term bearing, and since future conditions are not perfectly predictable. There is always a sense of risk and uncertainty about the outcome of the decisions.

• When a firm operates with other firms in the market, there is generally an element of uncertainty regarding the actions and reactions of competitors. The Consumers shift choices based on their level of satisfaction.

• Uncertainty can arise due to unexpected environmental changes such as,(i) Changes in Governmental policies

(i) Changes in National and International Political Scenario• Probability is widely used in assessing the uncertainty. The profit of a firm is

expected from the adoption of any action that may assume any value within a certain range of values, each value having an associated probability of being realized.


FUNDAMENTAL CONCEPTS (Contd…)• Risk and Uncertainty (Contd…):

• The decision maker assigns these subjective probabilities to the possible profits of each strategy and estimates its mathematical expectations.

• After having done such computations for all alternatives, the entrepreneur chooses that action which gives the highest expected value.

• Computing the above is difficult since:• Lot of information, knowledge, computational ability and time on the part of

managers which the firms lack• The criterion of choosing an action with highest expected value is not adequate.

• A risk averter will choose a project which has low risk and low bankruptcy.

• A risk lover will choose a project that has higher risk and higher bankruptcy.


OBJECTIVES OF THE FIRM• The Objectives of the Firms can be categorised into two groups. They are

• The Optimising Models• The Non-Optimising Models

• The Optimising Models can be further classified into the following:• Profit Maximising Theories popularly known as the Theory of Firm• Managerial Theories of the firm like

• Sales Revenue Maximisation Model• Utility Models• Growth Maximisation Models• Behavioural Models – Satisficing Behaviour and Behavioural Theory of the

Firm.


OPTIMISING MODEL – PROFIT MAXIMISATION MODEL

• The Economists have been using this model for a long period of time.• It has been developed on the basis of the assumption that rational firms pursue the objective

of profit maximisation, subject to the technical and market constraints.• The Basic propositions are:

• The firm is a unit which transforms valued inputs into outputs of a higher value, given the state of technology.

• The firm strives towards the achievement of goal – usually profit maximisation.• The Market conditions (like competition, monopoly etc) for a firm to operate are

given.• While choosing between alternatives, the firm prefers the alternative which helps it to

consistently achieve profit maximisation.• The primary concern of the theory of firm is to analyse changes in the prices and

quantities of inputs and outputs. • Assumptions:

• The firm has a single goal – to maximise profit (Motivational Assumption)• The firm acts rationally to pursue its goal. Rationally implies perfect knowledge of all

relevant variables at the time of decision making (Cognitive Assumption)• The firm is a single-ownership one i.e. run by its owner, called the entrepreneur.


OPTIMISING MODEL – PROFIT MAXIMISATION MODEL (Contd…)

• The term “Profit Maximisation” is usually the generation of largest absolute amount of profits over the time period being analysed.

• The Time periods defined has been categorised into two broad periods: Short Run and Long Run.

• Short Run is defined as period where adjustments to the changed conditions are only partial. For Ex. If demand for the product of a firm increases, in the short run it can meet the increased demand through changes in manhours and intensive use of existing machinery but it cannot increase its production capacity.

• Long Run is a period where adjustment to changed circumstances is complete. Here a firm can meet the increased demand in the long run by making changes in its production capacity or by setting up an additional plant, besides changes in man-hours and intensive use of its existing machinery.

• The relationship between short and long run profit maximisation is based on two assumptions. (a) assumption of independence of periods (b) assumption of period linkages. In the first assumption (a) both short and long run profit max. are consistent and identical. But in the second assumption (b) the profit max. in the two periods may conflict. Few examples could be (1) higher profits in the short run may in the long run induce workers to demand higher wages. (2) max of profits in short run give an impression of being exploitative inviting legal and govt. intervention which would affect long run profits.



• The Traditional Economic theory of Firm compares Costs and Revenue implications for different output levels. It picks up the output level that maximises the absolute difference between the two.TR is taken as Total Revenue. TC is taken as Total Cost. Thus the Profit in economic terms is the difference between Total Revenue and Total Cost.Profit (∏ ) = Total Revenue (TR) – Total Cost (TC)There are two conditions for attaining maximum value for ∏ . They areFirst Condition:• ∏ = Change in TR – Change in TC equals “ZERO”.• Ə (∏ ) / Ə X = Ə (TR) / Ə X – Ə (TC) / Ə X equals “ZERO”.

Or• Marginal Revenue (MR) = Marginal Cost (MC)

Second Condition:• Ə2 ∏ / Ə X2 = Ə2 (TR) / Ə X2 – Ə2 (TC) / Ə X2 less than “ZERO”. • Ə2 (TR) / Ə X2 < Ə2 (TC) / Ə X2

The above means the slope of MR curve is less than MC Curve.



• There are several critiques of profit maximising theories. They are provided below• Traditional economic theory assumes that the firm is owner-managed. Hence profit

maximisation implies the maximisation of income of owner. It would be the rational behaviour of every owner managed enterprise since it counts his amount of effort (reward for risk that the owner takes in his business).

• The Survival of the firm depends upon the owner’s (entrepreneur) ability to maximise profits in long run. The competition between firms is forcing the owner to look for the goals of profit maximisation. The objective here is to accumulate financial assets for the company which allows it to grow faster than those firms which pursue other goals. The situation is different in the case of Monopoly.

• Firms by working towards the goal of profit maximisation achieve other goals including product quality, competitive edge and delivery.



• The theory has been subjected to severe criticism. They are listed below:• In the real business scenario the assumption of profit maximisation is a doubtful

validity. Every businessmen aim at sales maximisation, expansion of market share.• A Firm is a complex organisation run by salaried manager whose interests may and

often differ from those of the shareholders who want maximum profits.• The absence of incomplete information may be optimal. There are two types of lack

of information. They are• Business directly or indirectly relate to the future. Since future is uncertain, the

decisions made by a person (businessman) may not be what he wants them to be.

• The lack of information is due to the failure or inability of the firm to collect the adequate information and to use the information it has.

• A Firm is split into may departments each of them carrying its operations. It is certainly not possible for the firm to ensure that the decisions made fit well within the overall policy framed for the organisation and whether it will be optimal or not. It becomes complex for the firms to look upon them in a holistic view.

• It cannot be said that a firm in a non-competitive situation which does not maximise its profits will be out of business even with changes in its economic environment. A firm in the situation of the highest demand can still survive without changing its systems if it remains among the large group of firms operating in business.



• In the modern business world firms operate in dominant market structure such as Oligopoly where few large firms dominate the market. The small firms have to follow these large firms in pricing matters. Here how can these firms achieve the goal of PROFIT MAXIMISATION.

• Lack of predictive power managers, firms with risk averse managers result in less than maximum profit as their goal. This is mainly due to intra firm communication.


OPTIMISING MODEL – SALES REVENUE MAXIMISATION (BAUMOL’S)

• According to Baumol’s Model, the oligopolistic firms aim at maximising their sales revenue. The various reasons are:• Financial Institutions judge the health of a firm largely in terms of the rate of growth

of its sales revenue.• There is evidence that slack earnings and salaries of Top management are correlated

more closely with the firms sales than with its profits.• While increasing sales revenue over time provides prestige to the top management,

profits go to share holders.• Growing sales help in keeping a health personnel policy, thus keeping employees

happy by giving them higher salaries and better terms, vice-versa if sales drop.• Managers prefer “steady performance with satisfactory profits” than spectacular profit

maximisation projects. It is due to the reason that announcing spectacular profit as goal will tend to push firms into profit making rather than revenue generation. If any manager is unable to produce profits year-on-year then the firm shall penalise the manager for non-achievement of the goal.

• Large sales will increase market share of the firm and prove its competitiveness in the business.


OPTIMISING MODEL – SALES REVENUE MAXIMISATION (BAUMOL’S)

• Assumptions:• Goal of the firm is sales maximisation to minimum profit constraint• Advertisement is a major instrument of the firm as non-price competition is the

typical form of competition in oligopolistic markets• Production costs are independent of advertising• Advertisements create favorable conditions for the product. It will help sell larger

quantities of the product and earn larger revenue.• Price of the product is assumed as constant.

• It is only after the profit constraint has been satisfied that profits become subordinate to sales in the firm’s hierarchy of goals. (Only after setting the goals for minimum profits does organisations start looking for the goals of Sales Maximisation)

• Implications of the Model (Refer Fig. 3.2 – Pg. No: 40)• Both the profit maximiser and sales maximiser will face the same market condition,

sales maximiser will charge a lower price to sell extra output.• A sales maximiser will spend more on advertising than a profit maximiser. The

advertisements will not affect the price but the objective here is to target an increased sale of output to the consumer.

• Advertisements will increase the Total Cost of the firm but it will be until the profit constraint is not disturbed.


MANAGERIAL UTILITY MODELS – TRADITIONAL VIEW


Owners / Shareholders

Top-Level Management

(Board of Directors)

Middle-Level Management

(Line Managers, etc.)

Lower-Level Management

(Supervisory staff)

Workers

MANAGERIAL UTILITY MODELS – MODERN VIEW


Share Holder

Blue Collar

White Collar

Tech & Sci

Mgmt

BEHAVIOURAL THEORY OF FIRM - “SATISIFICING” MODEL – H. A. SIMONS

• H. A. Simons proposes an alternative model to the profit maximising one. • Believes that relevant information with the managers is far from complete.• Managers take decisions for future on the basis of incomplete information.• Management, realising the complexities of calculations, inevitable uncertainties of future,

and imperfections of the data that has to be employed for “Optimal decisions”, cannot help but be satisfied with something less, illustrating the model of “Satisficing”. Here the management aims at “satisfactory profits”. It is an aspiration for the Management based on the past experiences and judgment about future uncertainty.

• Useful brainstorming is done through “Search Behaviour” to find reasons for the deviations from “Aspiration level”.


DEMAND ANALYSIS

Joel Dean comments on DEMAND ANALYSIS:Demand Analysis seeks to search out and measure the forces that determine sales

Demand:• Demand for a commodity refers to the quantity of the commodity which an individual

consumer or a household is willing to purchase per unit of time at a particular price.• The definition for demand implies:

• Desire of the commodity to buy the product• His willingness to buy the product• Sufficient purchasing power in his possession to buy the product.

Individual and Household DemandDemand arises from an individual.• There are commodities which are generally demanded by individual consumers. E.g.

Cigarettes, footwear etc which are called as Individual Demand• There are commodities which are demanded by households. E.g. Refrigerator, house

etc which are called as Household Demand.


DETERMINANTS OF DEMAND

Determinants of Demand:• An individuals demand for a commodity depends on the household’s Desire for the

commodity and to purchase it.• The desire to purchase is revealed by Tastes and preferences of the individual /

households.• The capability to purchase depends upon his Purchasing power (Income and Price

of the commodity).• Since households purchase a number of commodity, their quantity depends upon the

price of that particular commodity and prices of other commodities. All of the above are all called as explanatory variables and the quantity demanded of a product by a consumer is called the explained variables.The important determinants of demand are:

a. Price of the Commodityb. Income of the Consumerc. Price of Related goodsd. Tastes and Preferences.e. Advertisementf. Expectations


DETERMINANTS OF DEMANDPrice of the Commodity:• A Consumer buys more of a commodity when its price declines and vice-versa. • For any normal good the price of a commodity and its demand varies inversely other

factors remaining constant.• A fall in the price of a normal good leads to rise in consumers purchasing power. He can

buy more of the product. This is called as Substitution Effect.• An increase in price will reduce his purchasing power and thereby reducing demand for the

commodity. This is called as Income Effect.

Income of the Consumer (Refer Fig. 5.1 Pg No. 76):• An increase in the income of the consumer will lead to increase in purchasing power of

consumer. He would buy more of a product that he had bought earlier.• Here the extent of increase may differ between commodities.• The shifts in the quantity demanded and income move in the same direction.• Incase of commodities like foods, fruits and vegetables the quantity demanded increases

with an increase in income (beyond a period, the demand remains unchanged even with an increase in income).

• There are cases where the quantity demanded decreases even with an increase in income (Giffen Goods or Inferior Goods) – Negative or Exceptional Demand Curve.


DETERMINANTS OF DEMANDPrice of Related Goods:• A change in price of one commodity influences the demand of the other commodity, then,

the two commodities are related.• When price of one commodity and the quantity demanded of other commodity move in the

same direction the two are called as Substitutes (Goods that have essentially the same use).

• When price of one commodity and the quantity demanded of the other commodity move in opposite direction the two are called as Complements (Goods that are used together).

Tastes and Preferences:• The change in tastes and preferences of a consumer in favour of a commodity results in

greater demand for a commodity and vice versa.

Advertisement:• It is to influence the tastes and preference of consumers towards a product and increase

sales.


DETERMINANTS OF DEMANDExpectations:• Expectations of are two types:

• Related to their future income: If the consumer expects a higher income in future, he spends more at present and thereby the demand for goods increases and vice versa.

• Related to future price of the good and its related goods: If the consumer expects the future prices of the goods to increase then he would rather like to buy the commodity now than later. This would increase the demand for the commodity. The opposite holds good when it is expected that prices in future will come down.


DEMAND FUNCTIONDemand Function – Meaning:

A mathematical expression of the relationship between quantity demanded of the commodity and its determinants is known as the demand function.

• When this relationship relates to the demand by an individual consumer it is known a individual’s demand function.

• When it relates to the market it is called market demand function.

Mathematical Expression of Demand Function (Individual Demand):QdX = f(Px, Y, P1….Pn-1, T, A, Ey, Ep, u)

QdX refers to the quantity demanded of product X

Px, refers to the price of the product X

Y refers to the level of household incomeP1….Pn-1 refers to the prices of all the other related products in economy (related

products include substitutes and compliments)T refers to the tastes of the consumersA refers to the advertisingEy refers to the expected future income

Ep refers to the expected future prices

u refers to all those determinants which are not covered in the above.Prepared by Mr. R. Sriram, Lecturer - MBA, STC - Pollachi.

DEMAND FUNCTIONMathematical Expression of Demand Function (Market Demand):

QdX = f(Px, Y, P1….Pn-1, T, A, Ey, Ep, P, D, u)

QdX refers to the quantity demanded of product X

Px, refers to the price of the product X

Y refers to the level of household incomeP1….Pn-1 refers to the prices of all the other related products in economy (related products include substitutes and compliments)T refers to the tastes of the consumersA refers to the advertisingEy refers to the expected future income

Ep refers to the expected future prices

P refers to the population (size of the market)D refers to the distribution of consumers in various categories depending on income, age, sex etc.u refers to all those determinants which are not covered in the above.


LAW OF DEMAND

The Law of Demand:The Law of Demand states that higher the price lower the quantity demanded and vice

versa, other things remaining constant. i.e., Qd = f(P) other things remaining same.

The Operating Procedure of Law of Demand• Given the prices of the related goods, income and tastes and preferences of the consumer, if

prices of the good increases its quantity demanded decreases, while if price of the good decreases its quantity demanded increases.

• The Law of Demand operates due to the underlying effects of substitution and real income changes. (Substitution effect on price change & Income effect on Price change)

• Indifference Curve Analysis: In case of those goods where positive income effect is of a lower magnitude than the negative substitution effect, the law of demand still holds good even while those goods are “inferior”. It is only in the case of those inferior goods where positive income is far from stronger than negative substitution effect that their combined effect become positive. These are known as “Giffen Goods”.


DEMAND SCHEDULE

The Demand Schedule:A Demand schedule at any particular time refers to the series of quantities the

consumer is prepared to buy at its different prices.

Illustration:

The Demand schedule when represented diagrammatically is known as Demand Curve


Quantities demanded by Consumers (In Units) (Individual Demands)

Market Demand

Price A B C

10 1 0 3 4

9 3 1 6 10

8 7 2 9 18

7 11 4 12 27

6 13 6 14 33

10

1

PRICE

QTY DEMANDED

Individual Dmd

10

4

PRICE

QTY DEMANDED

Market Demand

LAW OF DEMANDThe Demand Curve:

The Demand Curve shows the maximum amount of goods which the consumer would be willing to buy at each possible price of the goods, under given conditions of demand.The individual demand curve shows the maximum price which an individual consumer or a household would be prepared to pay for different amount of goods.

Why is the Demand Curve Sloping Downwards?• When other things remaining constant, an individual will buy more of a commodity at a

lower price and less of that commodity at higher price.• The reasons for a downward sloping demand curve are:

• The operation of the law of diminishing marginal utility. It states that as one goes on consuming more and more units of a commodity, its utility to him goes on diminishing. To get maximum satisfaction, a consumer buys a commodity in such ta way that marginal utility of the commodity is equal to its price.

• A commodity tends to be put to more use when it becomes cheaper. Thus the existing buyers purchase more and some new consumers enter the market. The cumulative effect is thus, an extension of demand when price falls.

• A fall in the price of a superior good will lead to a rise in the consumer’s real income. The consumer can therefore, buy more of it (Substitution Effect). When there is a rise in price of a superior good will result in decline in consumers real income (Income Effect), therefore, the consumer would buy less of the goods.


LAW OF DEMANDWhy is the Demand Curve Sloping Downwards? (Contd…)• The use of the concept of Income effect and Substitution effect is the main reason for a

downward sloping demand curve.

Exceptions to the Law of Demand:• Giffen Goods: If there is an inferior good in whose case the income effect is stronger than

the substitution effect, the law of demand would not hold. For Example, during Napoleon's period when gold was not even found, people used Aluminum. Once we discovered Gold, the use of aluminum became inferior. (The understanding here is when the price of Aluminum becomes cheaper, you buy less of it and shift or compensate the purchasing power to buy aluminum to other goods).

• Commodities which are used as status symbols: Some expensive commodities like diamonds, BMW cars are used as status symbols to display one’s wealth. The more expensive these commodities become, more will be their value as a status symbol and hence greater will be their demand. (The amount demanded increases with an increase in the price and decreases with a decrease in the price).

• Expectations of change in price of commodity: If a household expects the price of a commodity to increase, he may start purchasing greater amount of commodity even at the presently increased price (Substitution Effect). Similarly if a household expects the price of the commodity to decrease, he may postpone his purchase (Income Effect).


LAW OF DEMANDExpansion and Contraction of Demand:

Movement along a demand curve is caused by a change in the price of the commodity. This change is called Extension and Contraction of Demand.


Price

(Rs)

Change in Quantity (In Kgs)

Contraction Extension10

5

2

2 5 10

REVENUE CONCEPTSRevenue Concepts:

Revenue is closely related to demand. It is the sale proceeds of a firm (Price X Quantity) of a good during a particular period of time. • Total Revenue• Average Revenue• Marginal Revenue


TYPES OF DEMANDDemand can be categorised into different types based on its nature. They are provided below:Derived Demand and Autonomous Demand: Those inputs or commodities which are

demanded to help further production of commodities are said to have derived demand. For e.g.. Raw Materials, Labour Machines etc. The Derived Demand is strictly determined by the level of demand of the final goods in whose production these derived demand goods are used. Autonomous Demand is the one where a commodity is demanded because it is needed for direct consumption. For e.g.. Pieces of furniture, personal mode of transport.

• In specific cases of automobile commodities, both the derived and autonomous demand remains the same. For e.g., the demand generated for the private car is an autonomous demand that can also be a derived one if the same car is being used as a taxi.

• Autonomous demand is more price elastic than the derived demand.• Forecasting the derived demand is easy when the proportion between two products (raw

materials) is fixed and stable.

Demand for Producers’ Goods and Consumers’ Goods: The difference in these two types of demand are that consumers’ goods are needed for direct consumption, while the producers’ goods are needed for producing other goods (consumers’ goods or further producers’ goods). Soft drinks, milk, bread etc., are the examples of consumers’ goods, while the various types of machines, steel, tools, etc., are some of the examples of producers’ goods.


TYPES OF DEMAND• Both Producers’ goods and Consumers’ goods can be categorised into two. They are (i)

durable and (ii) non-durable goods. The durable goods, are the ones which have repeated uses. Non-durable goods are the ones which cannot be used more than once. Shoes, Ready Made Garments, Residential House, Electrical and Electronic appliances etc., are examples of durable consumers’ goods while Machinery, Tools, Industrial Buildings, Transportation Equipments etc., are examples of durable producers’ goods.

• Distinctive Features of Durable Consumers’ Goods include:– The demand for consumers’ durable occur at irregular intervals of time as compared

to the regular demand for consumers’ non-durable goods.– Since the consumers’ durables are generally used several members of the family, the

demand for these products depends upon the needs and preferences of the family.– Some of the durable consumers’ goods can be used only after the co-operating services

are available.• Distinctive Features of Producers Goods include:

– Those who demand producers’ goods are professionals and they are conscious of the price and quality of the goods and are also its sensitive to the availability of substitutes.

– The buyers of the producers’ goods are not succumbed to pressure advertising but to go by prices since their motives to buy are purely for economic and profit prospects.

– Since producers’ goods are of a derived type of demand, price fluctuations and volatility is prevalent.


TYPES OF DEMANDDemand for Durable Goods and Non-Durable Goods: Durable goods are the ones which can

be stored and whose replacement can be postponed. On the other hand, the non durable goods are needed as a routine and their demand is therefore made largely to meet day to day needs. Durable goods meet both the current as well as future demand, whereas non durable goods meet only the current demand.

• In the case of non-durable goods, the demand ha simple relationship with price. Due to the reason being the demand is current, it has got a direct demand where the law of demand applies here. The goods of mass consumption falls into this category.

• Some of the non-durable goods include:– Perishable goods (Fruits, Vegetables)– Non-perishable goods (Pulses, Cereals, Sugar).

• Durable goods can be divided into two parts namely – demand for replacements and new demand.


TYPES OF DEMANDIndustry Demand and Firm Demand: The term Firm Demand denotes demand for a

particular product of a particular firm. When we add demand for a particular product faced by all the companies producing that product, we get what is called an Industry Demand. Industry Demand refers to the total demand for the product of a particular industry.

• For a firm, the company demand (firm demand) is very important than that of an Industry Demand. An entrepreneur should know how much does his company contribute towards the industry demand.

• Every company operates in the market with different operating structures called as Market Structure. The Market structure is generally classified based on two concepts.– The Number of Sellers– The Degree of Product Differentiation.


ELASTICITY OF DEMAND

Elasticity of Demand: The Elasticity of Demand (Ed) is defined as the percentage change in quantity demanded caused by one percent change in demand determinant under consideration while other determinants are held constant. It is represented by the following formulae:

Ed = Percentage Change in Quantity demanded of good X / Percentage change in Determinant Z.

The Determinants of Demand (earlier studied) can be categorised and their individual elasticity can be calculated by the following methods:

1. Price Elasticity of Demand2. Income Elasticity of Demand3. Cross Elasticity of Demand4. Promotional Elasticity of Demand5. Expectations Elasticity of Demand


ELASTICITY OF DEMAND - MEASUREMENTS

The Elasticity of demand can be measured in two methods:1. Arc Elasticity of Demand2. Point Elasticity of Demand

Point Elasticity of Demand: Point Elasticity of demand relates to the elasticity at a particular point on the demand curve. This approach can be used to evaluate the effect of very small price changes or to compute the price elasticity at a particular price.

Mathematically expressed:

Ep (Price Elasticity) = Change in Quantity demanded / Total Quantity Demanded Change in Price of the Product / Price of Product = Delta Qd / Qd Delta P / P = Delta Q * P / Delta P * Q


ELASTICITY OF DEMAND - MEASUREMENTS

Arc Elasticity: Arc Elasticity of demand is the average elasticity over a segment of the demand curve. It is appropriate for analyzing the effect of discrete changes in price.

Mathematically expressed:

Ep = Q2 – Q1 / ((Q2+Q1) /2) P2 – P1 / ((P2 + P1) / 2) = (Q2 - Q1) / (P2 – P1) * (P2 –P1) / (Q2+Q1)


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