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MBA

PAPER 1.3

MANAGERIAL ECONOMICS

SYLLABUSUnit 1 Managerial economics: Meaning, nature and scope;

Economic theory and managerial economic;

Managerial economics and business decision making;

Role of managerial economics.Unit 2 Demand Analysis: Meaning, types and determinants of

demand.Unit 3 Cost Concepts: Cost function and cost output

relationship; Economics and diseconomies of scale;

Cost control and cost reduction.Unit 4 Production Functions: Pricing and output decisions

under competitive conditions; Government control

over pricing; Price discrimination; Price discount and

differentials.Unit 5 Profit: Measurement of profit; Profit planning and

forecasting; Profit maximization; Cost volume profitanalysis; Investment analysis.

Unit 6 National Income: Business cycle; Inflation and

deflation; Balance of payment; Their implications in

managerial decision.

REFERENCE BOOKS:

1. Gupta G S, Managrial Economics, Tata McGraw-Hill

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2. Varshney and Maheswari, Managerial Economics, Sultan Chand

and Sons.

3. Mehta P L, Managerial Economics, Sultan Chand and Sons.

4. Joel Dean, Managerial Economics, Prentice-Hall.5. Rangarajan, Principles of Macro Economics, Tata McGraw-Hill.

CONTENTS0. SYLLABUS MgrEco-1300.doc

1. NATURE & SCOPE OF MANAGERIAL

ECONOMICS

MgrEco-1301.doc

2. DEMAND ANALYSIS MgrEco-1302.doc

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3. COST CONCEPTS MgrEco-1303.doc

4. PRODUCTION FUNCTION MgrEco-1304.doc

5. PROFIT MgrEco-1305.doc

6. NATIONAL INCOME MgrEco-1306.doc

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LESSON 1

NATURE & SCOPE OF MANAGERIAL ECONOMICS

The terms Managerial Economics and Business Economics are often

used interchangeably. However, the terms Managerial Economics

has become more popular and seems to displace Business

Economics.

DECISION-MAKING AND FORWARD PLANNING

The chief function of a management executive in a business firm is

decision-making and forward planning. Decision-making refers to

the process of selecting one action from two or more alternative

courses of action. Forward planning on the other hand is arranging

plans for the future. In the functioning of a firm the question of

choice arises because the available resources such as capital, land,

labour and management, are limited and can be employed in

alternative uses. The decision-making function thus involves making

choices or decisions that will provide the most efficient means of

attaining an organisational objectives, for example profit

maximization. Once a decision is made about the particular goal to

be achieved, plans for the future regarding production, pricing,

capital, raw materials and labour are prepared. Forward planning

thus goes hand in hand with decision-making. The conditions in

which firms work and take decisions, is characterised with

uncertainty. And this uncertainty not only makes the function of

decision-making and forward planning complicated but also adds a

different dimension to it. If the knowledge of the future were

perfect, plans could be formulated without error and hence without

any need for subsequent revision. In the real world, however, the

business manager rarely has complete information about the future

sales, costs, profits, capital conditions. etc. Hence, decisions are

made and plans are formulated on the basis of past data, current

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shows the relationship between economics, business management

and managerial economics.

APPLICATION OF ECONOMICS TO BUSINESS MANAGEMENT

The application of economics to business management or the

integration of economic theory with business practice, as Spencer

and Siegelman have put it, has the following aspects :

Reconciling traditional theoretical concepts ofeconomics in relation to the actual business behavior

and conditions: In economic theory, the technique of

analysis is that of model building. This involves making some

assumptions and, drawing conclusions on the basis of the

assumptions about the behavior of the firms. The

assumptions, however, make the theory of the firm unrealistic

since it fails to provide a satisfactory explanation of what thefirms actually do. Hence, there is need to reconcile the

theoretical principles based on simplified assumptions with

actual business practice and develop appropriate extensions

and reformulation of economic theory. For example, it is

usually assumed that firms aim at maximising profits. Based

on this, the theory of the firm suggests how much the firm

will produce and at what price it would sell. In practice,however, firms do not always aim at maximum profits (as they

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may think of diversifying or introducing new product etc.) To

that extent, the theory of the firm fails to provide a

satisfactory explanation of the firms actual behavior.

Moreover, in actual business language, certain terms likeprofits and costs have accounting concepts as distinguished

from economic concepts. In managerial economics, an

attempt is made to merge the accounting concepts with the

economics, an attempt is made to merge the accounting

concepts with the economic concepts. This helps in a more

effective use of financial data related to profits and costs to

suit the needs of decision-making and forward planning.

Estimating economic relationships: This involves the

measurement of various types of elasticities of demand such

as price elasticity, income elasticity, cross-elasticity,

promotional elasticity and cost-output relationships. The

estimates of these economic relationships are to be used for

the purpose of forecasting.

Predicting relevant economic quantities: Economic

quantities such as profit, demand, production, costs, pricing

and capital are predicated in numerical terms together with

their probabilities. As the business manager has to work in an

environment of uncertainty, the future needs to be foreseen

so that in the light of the predicted estimates, decision-making

and forward planning may be possible.

Using economic quantities in decision-making and

forward planning: This involves formulating business

policies for establishing future business plans. This nature of

economic forecasting indicates the degree of probability of

various possible outcomes, i.e., losses or gains that will occur

as a result of following each one of the available strategies.

Thus, a quantified picture gets set up, that indicates the

number of courses open, their possible outcomes and the

quantified probability of each outcome. Keeping this picture in

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view, the business manager is able to decide about which

strategy should be chosen.

Understanding significant external forces: Applying

economic theory to business management also involvesunderstanding the important external forces that constitute

the business environment and with which a business must

adjust. Business cycles, fluctuations in national income and

government policies pertaining to taxation, foreign trade,

labour relations, antimonopoly measures, industrial licensing

and price controls are typical examples. The business

manager has to appraise the relevance and impact of theseexternal forces in relation to the particular business unit and

its business policies.

CHARACTERISTICS OF MANAGERIAL ECONOMICS

There are certain chief characteristics of managerial economics,

which can help to understand the nature of the subject matter and

help in a clear understanding of the following terms:

Managerial economics is micro-economic in character. This is

because the unit of study is a firm and its problems.

Managerial economics does not deal with the entire economy

as a unit of study.

Managerial economics largely uses that body of economic

concepts and principles, which is known as Theory of the Firm

or Economics of the Firm. In addition, it also seeks to apply

profit theory, which forms part of distribution theories in

economics.

Managerial economics is concrete and realistic. I avoids

difficult abstract issues of economic theory. But it also

involves complications ignored in economic theory in order to

face the overall situation in which decisions are made.

Economic theory ignores the variety of backgrounds and

training found in individual firms. Conversely, managerial

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economics is concerned more with the particular environment

that influences decision-making.

Managerial economics belongs to normative economics rather

than positive economics. Normative economy is the branch ofeconomics in which judgments about the desirability of

various policies are made. Positive economics describes how

the economy behaves and predicts how it might change. In

other words, managerial economics is prescriptive rather than

descriptive. It remains confined to descriptive hypothesis.

Managerial economics also simplifies the relations among

different variables without judging what is desirable orundesirable. For instance, the law of demand states that as

price increases, demand goes down or vice-versa but this

statement does not imply if the result is desirable or not.

Managerial economics, however, is concerned with what

decisions ought to be made and hence involves value

judgments. This further has two aspects: first, it tells what

aims and objectives a firm should pursue; and secondly, how

best to achieve these aims in particular situations. Managerial

economics, therefore, has been described as normative

microeconomics of the firm.

Macroeconomics is also useful to managerial economics since

it provides an intelligent understanding of the business

environment. This understanding enables a business

executive to adjust with the external forces that are beyond

the managements control but which play a crucial role in the

well being of the firm. The important forces are: business

cycles, national income accounting, and economic policies of

the government like those relating to taxation foreign trade,

anti-monopoly measures and labour relations.

DIFFFFERENCE BETWEEN MANAGERIAL ECONOMICS AND

ECONOMICS

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The difference between managerial economics and economics can

be understood with the help of the following points:

Managerial economics involves application of economic

principles to the problems of a business firm whereas;economics deals with the study of these principles only.

Economics ignores the application of economic principles to

the problems of a business firm.

Managerial economics is micro-economic in character,

however, Economics is both macro-economic and micro-

economic.

Managerial economics, though micro in character, deals onlywith a firm and has nothing to do with an individuals

economic problems. But microeconomics as a branch of

economics deals with both economics of the individual as well

as economics of a firm.

Under microeconomics, the distribution theories, viz., wages,

interest and profit, are also dealt with. Managerial economics

on the contrary is mainly concerned with profit theory anddoes not consider other distribution theories. Thus, the scope

of economics is wider than that of managerial economics.

Economic theory assumes economic relationships and builds

economic models. Managerial economics adopts, modifies and

reformulates the economic models to suit the specific

conditions and serves the specific problem solving process.

Thus, economics gives the simplified model, whereasmanagerial economics modifies and enlarges it.

Economics involves the study of certain assumptions like in

the law of proportion where it is assumed that The variable

input as applied, unit by unit is homogeneous or identical in

amount and quality. Managerial economics on the other

hand, introduces certain feedbacks. These feedbacks are in

the form of objectives of the firm, multi-product nature ofmanufacture, behavioral constraints, environmental aspects,

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legal constraints, constraints on resource availability, etc.

Thus managerial economics, attempts to solve the

complexities in real life, which are assumed in economics. this

is done with the help of mathematics, statistics, econometrics,accounting, operations research, etc.

OTHER TERMS FOR MANAGERIAL ECONOMICS

Certain other expressions like economic analysis for business

decisions and economics of business management have also been

used instead of managerial economics but they are not so popular.

Sometimes expressions like Economics of the Enterprise, Theory

of the Firm or Economics of the Firm have also been used for

managerial economics. It is, however, not appropriate t use theses

terms because managerial economics, though primarily related to

the economics of the firm, differs from it in the following respects:

First, Economics of the Firm deals with the theory of the firm,

which is a body of economic principles relating to the firm

alone. Managerial economics on the other hand deals with

the, application of the same principles to business.

Secondly, the term Economics of the firm is too simple in its

assumptions whereas managerial economics has to reckon

with actual business behaviour, which is much more complex.

SCOPE OF MANAGERIAL ECONOMICS

As regards the scope of managerial economics, there is no general

uniform pattern. However, the following aspects may be said to be

inclusive under managerial economics:

Demand analysis and forecasting.

Cost and production analysis.

Pricing decisions, policies and practices.

Profit management.

Capital management.

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These aspects may also be defined as the Subject-Matter of

Managerial Economics. In recent years, there is a trend towards

integrations of managerial economics and operations research.

Hence, techniques such as linear programming, inventory modelsand theory of games have also been regarded as a part of

managerial economics.

Demand Analysis and Forecasting

A business firm is an economic Organisation, which transforms

productive resources into goods that are to be sold in a market. A

major part of managerial decision-making depends on accurate

estimates of demand. This is because before production schedules

can be prepared and resources are employed, a forecast of future

sales is essential. This forecast can also guide the management in

maintaining or strengthening the market position and enlarging

profits. The demand analysis helps to identify the various factors

influencing demand for a firms product and thus provides

guidelines to manipulate demand. Demand analysis and forecasting,

thus, is essential for business planning and occupies a strategic

place in managerial economics. It comprises of discovering the

forces determining sales and their measurement. The chief topics

covered in this are:

Demand determinants

Demand distinctions

Demand forecasting.

Cost and Production Analysis

A study of economic costs, combined with the data drawn from the

firms accounting records, can yield significant cost estimates.

These estimates are useful for management decisions. The factors

causing variations in costs must be recognised and thereby should

be used for taking management decisions. This facilitates the

management to arrive at cost estimates, which are significant for

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planning purposes. An element of cost uncertainty exists in this

because all the factors determining costs are not always known or

controllable. Therefore, it is essential to discover economic costs

and measure them for effective profit planning, cost control andsound pricing practices. Production analysis is narrower in scope

than cost analysis. The chief topics covered under cost and

production analysis are:

Cost concepts and classifications

Cost-output relationships

Economics of scale

Production functions

Cost control.

Pricing Decisions, Policies and Practices

Pricing is a very important area of managerial economics. In fact

price is the origin of the revenue of a firm. As such the success of a

usiness firm largely depends on the accuracy of price decisions of

that firm. The important aspects dealt under area, are as follows:

Price determination in various market forms

Pricing methods

Differential pricing product-line pricing and price forecasting.

Profit Management

Business firms are generally organised with the purpose of making

profits. In the long run, profits provide the chief measure of success.

In this connection, an important point worth considering is the

element of uncertainty existing about profits. This uncertainty

occurs because of variations in costs and revenues. These are

caused by factors such as internal and external. If knowledge about

the future were perfect, profit analysis would have been a very easy

task. However, in a world of uncertainty, expectations are not

always realised. Thus profit planning and measurement make up the

difficult area of managerial economics. The important aspects

covered under this area are:

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Nature and measurement of profit.

Profit policies and techniques of profit planning.

Capital Management

Among the various types and classes of business problems, themost complex and troublesome for the business manager are those

relating to the firms capital investments. Capital management

implies planning and control and capital expenditure. In this

procedure, relatively large sums are involved and the problems are

so complex that their disposal not only requires considerable time

and labour but also top-level decisions. The main elements dealt

with cost management are: Cost of capital

Rate of return and selection of projects.

The various aspects outlined above represent the major

uncertainties, which a business firm has to consider viz., demand

uncertainty, cost uncertainty, price uncertainty, profit uncertainty

and capital uncertainty. We can, therefore, conclude that

managerial economics is mainly concerned with applying economicprinciples and concepts to adjust with the various uncertainties

faced by a business firm.

MANAGERIAL ECONOMICS AND OTHER SUBJECTS

Yet another useful method of explaining the nature and scope of

managerial economics is to examine its relationship with other

subjects. The following discussion helps to understand relationship

between managerial economics and economics, statistics,mathematics, accounting and operations research.

Managerial Economics and Economics

Managerial economics is defined as a subdivision of economics that

deals with decision-making. It may be viewed as a special branch of

economics bridging the gulf between pure economic theory and

managerial practice. Economics has two main divisions-microeconomics and Macroeconomics. Microeconomics has been

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defined as that branch where the unit of study is an individual or a

firm. It is also called price theory (or Marshallian economics) and

is the main source of concepts and analytical tools for managerial

economics. To illustrate, various micro-economic concepts such aselasticity of demand, marginal cost, the short and the long runs,

various market forms, etc., are all of great significance to

managerial economics.

Macroeconomics, on the other hand, is aggregative in

character and has the entire economy as a unit of study. The chief

contribution of macroeconomics to managerial economics is in the

area of forecasting. The modern theory of income and employment

has direct implications for forecasting general business conditions.

As the prospects of an individual firm often depend greatly on

general business conditions, individual firm forecasts rely on general

business forecasts.

A survey in the U.K. has shown that business economists have

found the following economic concepts quite useful and of frequent

application:

Price elasticity of demand

Income elasticity of demand

Opportunity cost

Multiplier

Propensity to consume

Marginal revenue product

Speculative motive

Production function

Liquidity preference

Business economists have also found the following main areas

of economics as useful in their work. Demand theory

Theory of firms price, output and investment decisions

Business financing

Public finance and fiscal policy

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Money and banking

National income and social accounting

Theory of international trade

Economies of developing countries.

Thus, it is obvious that Managerial Economics is very closely

related to Economics.

Managerial Economics and Statistics

Statistics is important to managerial economics in several ways.

Managerial economics calls for the organising quantitative data and

deriving a useful measure of appropriate functional relationshipsinvolved in decision-making. For instance, in order to base its pricing

decisions on demand and cost considerations, a firm should have

statistically derived or calculated demand and cost functions.

Managerial economics also employs statistical methods for

experimental testing of economic generalisations. The

generalisations can be accepted in practice only when they are

checked against the data from the world of reality and are foundvalid. Managers do not have exact information about the variables

affecting decisions and have to deal with the uncertainty of future

events. The theory of probability, upon which statistics is based,

provides logic for dealing with such uncertainties.

Managerial Economics and Mathematics

Mathematics is yet another important subject closely related tomanagerial economics. This is because managerial economics is

mathematical in character, as it involves estimating various

economic relationships, predicting relevant economic quantities and

using them in decision-making and forward planning. Knowledge of

geometry, trigonometry ad algebra is not only essential but also

certain mathematical tools and concepts such as logarithms and

exponential, vectors, determinants, matrix, algebra, calculus,differential as well as integral, are the most commonly used devices.

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Further, operations research, which is closely related to managerial

economics, is mathematical in character. It provides and analyses

data ad develops models, benefiting from the experiences of

experts drawn from different disciplines, viz., psychology, sociology,statistics and engineering.

MANAGERIAL ECONOMICS AND ACCOUNTING

Managerial economics is also closely related to accounting, which is

concerned with recording the financial operations of a business firm.

In fact, a managerial economist depends chiefly on the accounting

information as an important source of data required for his decision-

making purpose. for instance, the profit and loss statement of a firm

shows how well the firm has done and whether the information it

contains can be used by managerial economist to throw significant

light on the future course of action that is whether the firm should

improve its productivity or close down. Therefore, accounting data

require careful interpretation, reconstruction and adjustments

before they can be used safely and effectively. It is in this context

that the link between management accounting and managerial

economics deserves special mention. The main task of management

accounting is to provide the sort of data, which managers need if

they are to apply the ideas of managerial economics to solve

business problems correctly. The accounting data should be

provided in such a form that they fit easily into the concepts and

analysis of managerial economics.

Managerial Economics and Operations Research

Operations research is a subject field that emerged during the

Second World War and the years thereafter. A good deal of

interdisciplinary research was done in the USA. as well as other

western countries to solve the complex operational problems of

planning and resource allocation in defence and basic industries.

Several experts like mathematicians, statisticians, engineers and

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others teamed up together and developed models and analytical

tools leading to the emergence of this specialised subject. Much of

the development of techniques and concepts, such as linear

programming, inventory models, game theory, etc., emerged fromthe working of the operation researchers. Several problems of

managerial economics are solved by the operation research

techniques. These highlight the significant relationship between

managerial economics and operations research. The problems

solved by operation research are as follows:

Allocation problems: An allocation problem confronts with

the issue that men, machines and other resources are scarce,related to the number sand size of the jobs that need to be

completed. The examples are production programming and

transportation problems.

Competitive problems: competitive problems deal with

situations where managerial decision-making is to be made in

the face of competitive action. That is, one of the factors to be

considered is: What will competitors do if certain steps are

taken? Price reduction, for example, will not lead to increased

market share if rivals follow suit.

Waiting line problems : Waiting line problems arise when a

firm wants to know how many machines it should install in

order to ensure that the amount of work-in-progress waiting

to be machined is neither too small nor too large. Such

situations arise when for example, a post office, or a bank

wants to know how many cash desks or counter clerks it

should employ in order to balance the business lost through

long guesses against the cost of installing more equipment or

hiring more labour.

Inventory problems: Inventory problems deal with the

principal question: What is the optimum level of stocks of

raw-materials, components or finished goods for the firm to

hold?

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The above discussion explains that the managerial economics is

closely related to certain subjects such as economics, statistics,

mathematics and accounting. A trained managerial economist

combines concepts and methods from all these subjects by bringingthem together to solve business problems. In particular, operations

research and management accounting are getting very close to

managerial economics.

USES OF MANAGERIAL ECONOMICS

Managerial economics achieves several objectives. The principal

objectives are as follows:

It presents those aspects of traditional economics, which are

relevant for business decision-making in real life. For this

purpose, it picks from economic theory those concepts,

principles and techniques of analysis, which are concerned

with the decision-making process. These are adapted or

modified in such a way that it enables the manager to take

better decisions. Thus, managerial economics attains the

objective of building a suitable tool kit from traditional

economics.

Managerial economics also incorporates useful ideas from

other disciplines such as psychology, sociology, etc. If they are

found relevant for decision-making. In fact, managerial

economics takes the aid of other academic disciplines that are

concerned with the business decisions of a manager in view of

the various explicit and implicit constraints subject to which

resource allocation is to be optimised.

It helps in reaching a variety of business decisions even in a

complicated environment. Certain examples of such decisions

are those decisions concerned with:

o The products and services to be produced

o The inputs and production techniques to be used

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Borrowing and adopting the tool-kit from economic theory.

Incorporating relevant ideas from other disciplines to achieve

better business decisions.

Serving as a catalytic agent in the course of decision-makingby different functional departments/specialists at the firms

level.

Accomplishing a social purpose by adjusting business

decisions to social obligations.

ECONOMIC THEORY AND MANAGERIAL ECONOMICS

Economic theory offers a variety of concepts and analytical toolsthat can assist the manager in the decision-making practices.

Problem solving in business has, however, found that there exists a

wide disparity between the economic theory of a firm and actual

observed practice, thus necessitating the use of many skills and be

quite useful to examine two aspects in this regard:

The basic tools of managerial economics which it has

borrowed from economics, and The nature and extent of gap between the economic theory of

the firm and the managerial theory of the firm.

Basic Economic Tools in Managerial Economics

The most significant contribution of economics to managerial

economics lies in certain principles, which are basic to the entire

range of managerial economics. The basic principles may be

identified as follows:1. Opportunity Cost Principle

The opportunity cost of a decision means the sacrifice of

alternatives required by that decision. This can be best understood

with the help of a few illustrations, which are as follows:

The opportunity cost of the funds employed in ones own

business is equal to the interest that could be earned on those

funds if they were employed in other ventures.

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The opportunity cost of the time as an entrepreneur

devotes to his own business is equal to the salary he could

earn by seeking employment.

The opportunity cost of using a machine to produce oneproduct is equal to the earnings forgone which would have

been possible from other products.

The opportunity cost of using a machine that is useless for

any other purpose is zero since its use requires no sacrifice of

other opportunities.

If a machine can produce either X or Y, the opportunity cost

of producing a given quantity of X is equal to the quantity of Y,which it would have produced. If that machine can produce 10

units of X or 20 units of Y, the opportunity cost of 1 X is equal

to 2 Y.

If no information is provided about quantities produced,

except about their prices then the opportunity cost can be

computed in terms of the ratio of their respective prices, say

Px/Py.The opportunity cost of holding Rs. 500 as cash in hand for

one year is equal to the 10% rate of interest, which would

have been earned had the money been kept as fixed deposit

in a bank. Thus, it is clear that opportunity costs require the

ascertaining of sacrifices. If a decision involves no sacrifice, its

opportunity cost is nil.

For decision-making, opportunity costs are the only relevantcosts. The opportunity cost principle may be stated as under:

The cost involved in any decision consists of the sacrifices of

alternatives required by that decision. If there are no sacrifices,

there is no cost.

Thus in macro sense, the opportunity cost of more guns in an

economy is less butter. That is the expenditure to national fund for

buying armour has cost the nation of losing an opportunity of buyingmore butter. Similarly, a continued diversion of funds towards

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defence spending, amounts to a heavy tax on alternative spending

required for growth and development.

2. Incremental Principle

The incremental concept is closely related to the marginal costs andmarginal revenues of economic theory. Incremental concept

involves two important activities which are as follows:

Estimating the impact of decision alternatives on costs and

revenues.

Emphasising the changes in total cost and total cost and total

revenue resulting from changes in prices, products,

procedures, investments or whatever may be at stake in thedecision.

The two basic components of incremental reasoning are as

follows:

Incremental cost: Incremental cost may be defined as the

change in total cost resulting from a particular decision.

Incremental revenue: Incremental revenue means the change

in total revenue resulting from a particular decision.The incremental principle may be stated as under:

A decision is obviously a profitable one if:

o It increases revenue more than costs

o It decreases some costs to a greater extent than it

increases other costs

o It increases some revenues more than it decreases

other revenueso It reduces costs more that revenues.

Some businessmen hold the view that to make an overall

profit, they must make a profit on every job. Consequently, they

refuse orders that do not cover full cost (labour, materials and

overhead) plus a provision for profit. Incremental reasoning

indicates that this rule may be inconsistent with profit maximisation

in the short run. A refusal to accept business below full cost maymean rejection of a possibility of adding more to revenue than cost.

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The relevant cost is not the full cost but rather the incremental cost.

A simple problem will illustrate this point.

IIIustration

Suppose a new order is estimated to bring in additional revenue ofRs. 5,000. The costs are estimated as under:

Labour Rs. 1,500Material Rs. 2,000Overhead (Allocated at 120% of labour cost) Rs. 1,800Selling administrative expenses(Allocated at 20% of labour and material

cost)

Rs. 700

Total Cost Rs. 6,000

The order at first appears to be unprofitable. However,

suppose, if there is idle capacity, which can be, utilised to execute

this order then the order can be accepted. If the order adds only Rs.

500 of overhead (that is, the added use of heat, power and light, the

added wear and tear on machinery, the added costs of supervision,

and so on), Rs. 1,000 by way of labour cost because some of the idle

workers already on the payroll will be deployed without added pay

and no extra selling and administrative cost then the incremental

cost of accepting the order will be as follows.

Labour Rs. 1,500Material Rs. 2,000Overhead Rs. 500Total Incremental Cost Rs. 3,500

While it appeared in the first instance that the order will result

in a loss of Rs. 1,000, it now appears that it will lead to an addition

of Rs. 1,500 (Rs. 5,000- Rs. 3,500) to profit. Incremental reasoning

does not mean that the firm should accept all orders at prices,

which cover merely their incremental costs. The acceptance of the

Rs. 5,000 order depends upon the existence of idle capacity and

labour that would go unutilised in the absence of more profitable

opportunities. Earleys study of excellently managed large firms

suggests that progressive corporations do make formal use of

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incremental analysis. It is, however, impossible to generalise on the

use of incremental principle, since the observed behaviour is

variable.

3. Principle of Time Perspective

The economic concepts of the long run and the short run have

become part of everyday language. Managerial economists are also

concerned with the short-run and long-run effects of decisions on

revenues as well as on costs. The actual problem in decision-making

is to maintain the right balance between the long-run and short-run

considerations. A decision may be made on the basis of short-run

considerations, but may in the course of time offer long-run

repercussions, which make it more or less profitable than it

appeared at first. An illustration will make this point clear.

IIIustration

Suppose there is a firm with temporary idle capacity. An order for

5,000 units comes to managements attention. The customer is

willing to pay Rs. 4.00 per unit or Rs. 20,000 for the whole lot but

not more. The short-run incremental cost (ignoring the fixed cost) is

only Rs. 3.00. Therefore, the contribution to overhead and profit is

Re. 1.00 per unit (Rs. 5,000 for the lot. However, the long-run

repercussions of the order ought to be taken into account are as

follows:

If the management commits itself with too much of business

at lower prices or with a small contribution, it may not have

sufficient capacity to take up business with higher

contributions when the opportunity arises. The management

may be compelled to consider the question of expansion of

capacity and in such cases; even the so-called fixed costs

may become variable.

If any particular set of customers come to know about this

low price, they may demand a similar low price. Such

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customers may complain of being treated unfairly and feel

discriminated. In response, they may opt to patronise

manufacturers with more decent views on pricing. The

reduction or prices under conditions of excess capacity mayadversely affect the image of the company in the minds of its

clientele, which will in turn affect its sales.

It is, therefore, important to give due consideration to the time

perspective. The principle of time perspective may be stated as

under: A decision should take into account both the short-run and

long-run effects on revenues and costs and maintain the right

balance between the long-run and short-run perspectives.

Haynes, Mote and Paul have cited the case of a printing

company. This company pursued the policy of never quoting prices

below full cost though it often experienced idle capacity and the

management was fully aware that the incremental cost was far

below full cost. This was because the management realised that the

long-run repercussions of pricing below full cost would make up for

any short-run gain. The management felt that the reduction in rates

for some customers might have an undesirable effect on customer

goodwill particularly among regular customers not benefiting from

price reductions. It wanted to avoid crating such an image of the

firm that it exploited the market when demand was favorable but

which was willing to negotiate prices downward when demand was

unfavorable.

4. Discounting Principle

One of the fundamental ideas in economics is that a rupee

tomorrow is worth less than a rupee today. This seems similar to the

saying that a bird in hand is worth two in the bush. A simple

example would make this point clear. Suppose a person is offered a

choice to make between a gift of Rs. 100 today or Rs. 100 next year.

Naturally he will choose the Rs. 100 today.

This is true for two reasons. First, the future is uncertain and

there may be uncertainty in getting Rs. 100 if the present

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opportunity is not availed of. Secondly, even if he is sure to receive

the gift in future, todays Rs. 100 can be invested so as to earn

interest, say, at 8 percent so that. one year after the Rs. 100 of

today will become Rs. 108 whereas if he does not accept Rs. 100today, he will get Rs. 100 only in the next year. Naturally, he would

prefer the first alternative because he is likely to gain by Rs. 8 in

future. Another way of saying the same thing is that the value of Rs.

100 after one year is not equal to the value of Rs. 100 of today but

less than that. To find out how much money today is equal to Rs.

100 would earn if one decides to invest the money. Suppose the

rate of interest is 8 percent. Then we shall have to discount Rs. 100

at 8 per cent in order to ascertain how much money today will

become Rs. 100 one year after. The formula is:

V =

Rs. 1001 + i

where,

V = present value

i = rate of interest.

Now, applying the formula, we get

V =

Rs. 1001 + i

=

1001.08

If we multiply Rs. 92.59 by 1.08, we shall get the amount of

money, which will accumulate at 8 per cent after one year.

92.59 x 1.08 = 99.0072

= 1.00

The same reasoning applies to longer periods. A sum of Rs.

100 two years from now is worth:

V =

Rs. 100

=

Rs. 100

=

Rs. 100(1+i)2 (1.08)2 1.1664

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Similarly, we can also check by computing how much the

cumulative interest will be after two years. The principle involved in

the above discussion is called the discounting principle and is stated

as follows: If a decision affects costs and revenues at future dates,it is necessary to discount those costs and revenues to present

values before a valid comparison of alternatives is possible.

5. Equi-marginal Principle

This principle deals with the allocation of the available resource

among the alternative activities. According to this principle, an input

should be allocated in such a way that the value added by the last

unit is the same in all cases. This generalisation is called the equi-

marginal principle.

Suppose a firm has 100 units of labour at its disposal. The firm

is engaged in four activities, which need labour services, viz., A, B, C

and D. It can enhance any one of these activities by adding more

labour but sacrificing in return the cost of other activities. If the

value of the marginal product is higher in one activity than another,

then it should be assumed that an optimum allocation has not been

attained. Hence it would, be profitable to shift labour from low

marginal value activity to high marginal value activity, thus

increasing the total value of all products taken together. For

example, if the values of certain two activities are as follows:

Value of Marginal Product of labour

Activity A = Rs. 20

Activity B = Rs. 30

In this case it will be profitable to shift labour from A to

activity B thereby expanding activity B and reducing activity A. The

optimum will be reach when the value of the marginal product is

equal in all the four activities or, when in symbolic terms:

VMPLA = VMPLB = VMPLC = VMPLD

Where the subscripts indicate labour in respective activities.

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Certain aspects of the equi-marginal principle need

clarifications, which are as follows:

First, the values of marginal products are net of incremental

costs. In activity B, we may add one unit of labour with anincrease in physical output of 100 units. Each unit is worth 50

paise so that the 100 units will sell for Rs. 50. But the

increased output consumes raw materials, fuel and other

inputs so that variable costs in activity B (not counting the

labour cost) are higher. Let us say that the incremental costs

are Rs. 30 leaving a net addition of Rs. 20. The value of the

marginal product relevant for our purpose is thus Rs. 20. Secondly, if the revenues resulting from the addition of labour

are to occur in future, these revenues should be discounted

before comparisons in the alternative activities are possible.

Activity A may produce revenue immediately but activities B,

C and D may take 2, 3 and 5 years respectively. Here the

discounting of these revenues will make them equivalent.

Thirdly, the measurement of value of the marginal productmay have to be corrected if the expansion of an activity

requires an alternative reduction in the prices of the output. If

activity B represents the production of radios and it is not

possible to sell more radios without a reduction in price, it is

necessary to make adjustment for the fall in price.

Fourthly, the equi-marginal principle may break under

sociological pressures. For instance, du to inertia, activitiesare continued simply because they exist. Similarly, due to

their empire building ambitions, managers may keep on

expanding activities to fulfil their desire for power.

Department, which are already over-budgeted often, use

some of their excess resources to build up propaganda

machines (public relations offices) to win additional support.

Governmental agencies are more prone to bureaucratic self-

perpetuation and inertia.

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Gaps between Theory of the Firm and managerial Economics

The theory of the firm is a body of theory, which contains certain

assumptions, theorems and conclusions. These theorems deal with

the way in which businessmen make decisions about pricing, and

production under prescribed market conditions. It is concerned with

the study of the optimisation process.

For optimality to exist profit must be maximised and this can

occur only when marginal cost equals marginal revenue. Thus, the

optimum position of the firm is that which maximises net revenue.

Managerial economics, on the other hand, aims at developing a

managerial theory of the firm and for the purpose it takes the help

of economic theory of the firm. However, there are certain

difficulties in using economic theory as an aid to the study of

decision-making at the level of the firm. This is because for the

purposes of business decision-making it fails to provide sufficient

analytical tools that are useful to managers. Some of the reasons

are as follows:

Underlying all economic theory is the assumption that the

decision-maker is omniscient and rational or simply that he is

an economic man. Thus being omniscient means that he

knows the alternatives that are available to him as well as the

outcome of any action he chooses. The model of economic

man however as an omniscient person who is confronted

with a compete set of known or probabilistic outcomes is a

distorted representation of reality. The typical business

decision-maker usually has limited information at his disposal,

limited computing ability and a limited number of feasible

alternatives involving varying degrees of risk. Further, the net

revenue function, which he is expected to maximise, and the

marginal cost and marginal revenue functions, which he is

expected to equate, require excessive knowledge of

information, which is not known and cannot be obtained even

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by the most careful analysis. Hence, it is absurd to expect a

manager to maximise and equalise certain critical functional

relationships, which he does not know and cannot find out.

In micro-economic theory, the most profitable output is wheremarginal cost (MC) and marginal revenue (MR) are equal. In

Figure 1.2, the most profitable output will be at ON where

MR=MC. This is the point at which the slope of the profit

function or marginal profit is zero. This is highlighted in Figure

1.3 where the most profitable output will be again at ON. In

economic theory, the decision-maker has to identify this

unique output level, which maximises profit.

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In real world, however, a complexity often arises, viz., certain

resource limitations exist. As a result, it is not possible to attain the

maximum output level (ON). In practical terms the maximum output

possible as a result of resource limitations is, say, OM. Now the

problem before the decision-maker is to find out whether the

output, which maximises profit, is OM or some other level of output

to the left of OM. It is obvious that economic theory is of no help for

ON level of output because it is not relevant in view of the resource

limitations. A managerial economist here has to take the aid of

linear programming, which enables the manager to optimise or

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search for the best values within the limits set by inequality

conditions.

Another central assumption in the economic theory of the

firm is that the entrepreneur strives to maximise hisresidual share, or profit. Several criticisms of this

assumption have been made:

o The theory is ambiguous, as it doesnt clarify.

Whether it is short or long run profit that is to be

maximised. For example, in the short run, profits

could be maximised by firing all research and

development personnel and thereby eliminatingconsiderable immediate expenses. This decision

would, however, have a substantial impact on long-

run profitability.

o Certain questions create some confusion around the

concept of profit maximisation. Should the firm seek

to maximise the amount of profit or the rate of profit?

What is the rate of profit? Is it profit in relation tototal capital or profit in relation to shareholders

equity?

o There is no allowance for the existence of psychic

income (Income other than monetary, power,

prestige, or fame), which the entrepreneur might

obtain from the firm, quite apart from his monetary

income.

o The theory does not recognise that under modern

conditions, owners and managers are separate and

distinct groups of people and the latter may not be

motivated to maximise profits.

o Under imperfect competition, maximisation is an

ambiguous goal, because actions that are optimal for

one will depend on the actions of the other firms.

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with the benefits, the greater the risk associated with the

project.

Baumol on the other hand is of the view that firms do not

devote all their energies to maximising profit. Rather acompany will seek to maximise its sales revenue as long as

a satisfactory level of profit is maintained. Thus Baumol has

substituted Total sales revenue for profits. Also, two

decision criteria or objectives have been advanced viz., a

satisfactory level of profit and the highest sales possible. In

other words, the firm is no longer viewed as working

towards one objective alone. Instead, it is portrayed asaiming at balancing two competing and non-consistent

goals. Baumols model is based on the view that managers

salaries, their status and other rewards often appear as

closely related to the companies size in which they work

and is measured by sales revenue rather than their

profitability. As such, managers may be more concerned to

increased size than profits. And the firms objective thus

becomes sales maximisation rather than profits

maximisation.

Empirical studies of pricing behaviour also give results that

differ from those of the economic theory of firm as can be

seen from the following examples:

o Several studies of the pricing practices of business

firms have indicated that managers tend to set

prices by applying some sort of a standard mark-up

on costs. They do not attempt to estimate marginal

costs, marginal revenues or demand elasticities,

even if these could be accurately measured.

o For many firms, prices are more often set to attain,

a particular target return on investment, say, 10 per

cent, than to maximise short or long-run profits.

o There is some evidence that firms experiencing

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declining market shares in their industry strive

more vigorously to increase their sales than do

competing firms, which are experiencing steady or

increasing market shares. An alternative model to profit maximisation is the concept of

wealth maximisation, which assumes that firms seek to

maximise the present value of expected net revenues over

all periods within the forecasted future.

As pointed out by Haynes and Henry, a study of the

behaviour of actual firms shows that their decisions are not

completely determined by the market. These firms havesome freedom to develop decisions, strategies or rules,

which become part of the decision-making system within

the firm. This gap in economic theory has led to what has

come to be known as Behavioural Theory of the Firm. This

theory, however, does not replace the former but rather

powerfully supplements it. The behavioural theory

represents the firm as an adoptive institution. It learnsfrom experience and has a memory. Organisational

behaviour, is embodies into decision rules and standard

operating procedures. These may be altered over long run

as the firm reacts to feedback from experience. However,

in the short run, decisions of the organisation are

dominated by its rules of thumb and standard methods.

CONCLUSION

The various gaps between the economic theory of the firm and the

actual decision-making process at the firm level are many in

number. They do, however, stress that economic theory seriously

needs major fixing up and substantial changes are in progress for

creating better and different models. Thus the classical economic

concepts like those of rational man is undergoing important

changes; the notion of satisfying is pushing aside the aim of

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maximisation and newer lines and patterns of thoughts are being

developed for finding improved applications to managerial decision-

making. A strong emphasis is laid on quantitative model building,

experimentation and empirical investigation and newer techniquesand concepts, such as linear programming, game theory, statistical

decision-making, etc., are being applied to revolutionise the

approaches to problem solving in business and economics.

MANAGERIAL ECONOMIST: ROLE AND RESPONSIBILITIES

A managerial economist can play a very important role by assisting

the management in using the increasingly specialised skills and

sophisticated techniques, required to solve the difficult problems of

successful decision-making and forward planning. In business

concerns, the importance of the managerial economist is therefore

recognised a lot today. In advanced countries like the USA, large

companies employ one or more economists. In our country too, big

industrial houses have understood the need for managerial

economists. Such business firms like the Tatas, DCM and Hindustan

Lever employ economists. A managerial economist can contribute to

decision-making in business in specific terms. In this connection,

two important questions need be considered:

1. What role does he play in business, that is, what particular

management problems lend themselves to solution through

economic analysis?

2. How can the managerial economist best serve management,

that is, what are the responsibilities of a successful

managerial economist?

Role of a Managerial Economist

One of the principal objectives of any management in its decision-

making process is to determine the key factors, which will influence

the business over the period ahead. In general, these factors can be

divided into two categories:

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External

Internal

The external factors lie outside the control of management

because they are external to the firm and are said to constitutebusiness environment. The internal factors lie within the scope and

operations of a firm and hence within the control of management,

and they are known as business operations. To illustrate, a business

firm is free to take decisions about what to invest, where to invest,

how much labour to employ and what to pay for it, how to price its

products, and so on. But all these decisions are taken within the

framework of a particular business environment, and the firmsdegree of freedom depends on such factors as the governments

economic policy, the actions of its competitors and the like.

Environmental Studies of a Business Firm

An analysis and forecast of external factors constituting general

business conditions, for example, prices, national income and

output, volume of trade, etc., are of great significance since theyaffect every business firm. Certain important relevant factors to be

considered in this connection are as follows:

The outlook for the national economy, the most important

local, regional or worldwide economic trends, the nature of

phase of the business cycle that lies immediately ahead.

Population shifts and the resultant ups and downs in regional

purchasing power. The demand prospects in new as well as established markets.

Impact of changes in social behaviour and fashions, i.e.,

whether they will tend to expand or limit the sales of a

companys products, or possibly make the products obsolete?

The areas in which the market and customer opportunities are

likely to expand or contract most rapidly.

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Whether overseas markets expand or contract and the affect

of new foreign government legislations on the operation of the

overseas plants?

Whether the availability and cost of credit tend to increase ordecrease buying, and whether money or credit conditions

ahead are likely to easy or tight?

The prices of raw materials and finished products.

Whether the competition will increase or decrease.

The main components of the five-year plan, the areas where

outlays have been increased and the segments, which have

suffered a cut in their outlays.

The outlook to governments economic policies and

regulations and changes in defence expenditure, tax rates

tariffs and import restrictions.

Whether the Reserve Banks decisions will stimulate or

depress industrial production and consumer spending and

how will these decisions affect the companys cost, credit,

sales and profits.Reasonably accurate data regarding these factors can enable the

management to chalk out the scope and direction of their own

business plans effectively. It will also help them to determine the

timing of their specific actions. And it is these factors, which present

some of the areas where a managerial economist can make

effective contribution. The managerial economist has not only to

study the economic trends at the micro-level but also must interprettheir relevance to the particular industry or firm where he works. He

has to digest the ever-growing economic literature and advise top

management by means of short, business-like practical notes. In

mixed economy like that of India, the managerial economist

pragmatically interprets the intentions of controls and evaluates

their impact. He acts as a bridge between the government and the

industry, translating the governments intentions and transmittingthe reactions of the industry. In fact, the government policies

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emerge out of the performance of industry, the expectations of the

people and political expediency.

Business OperationsA managerial economist can also be helpful to the management in

making decisions relating to the internal operations of a firm in

respect of such problems as price, rate of operations, investment,

expansion or contraction. Certain relevant questions in this

context would be as follows:

What will be a reasonable sales and profit budget for the

next year? What will be the most appropriate production schedules

and inventory policies for the next six months?

What changes in wage and price policies should be made

now?

How much cash will be available next month and how

should it be invested?

Specific Functions

The managerial economists can play a further role, which can cover

the following specific functions as revealed by a survey pertaining to

Brittain conducted by K.J.W. Alexander and Alexander G. Kemp:

Sales forecasting.

Industrial market research.

Economic analysis of competing companies.

Pricing problems of industry.

Capital projects.

Production programmes.

Security / Investment analysis and forecasts.

Advice on trade and public relations.

Advice on primary commodities.

Advice on foreign exchange.

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Economic analysis of agriculture.

Analysis of underdeveloped economics.

Environmental forecasting.

The managerial economist has to gather economic data, analyse

all relevant information about the business environment and

prepare position papers on issues facing the firm and the industry.

In the case of industries prone to rapid theological advances, the

manager may have to make continuous assessment of tl1e impact

of changing technology. The manager' may need to evaluate the

capital budget in the light of short and long-range financial, profit

and market potentialities. Very often, he also needs to prepare

speeches for the corporate executives. It is thus clear that in

practice, managerial economists perform many and various

functions. However, of all these, the marketing functions, i.e., sales

force listing an industrial market research, are the most important.

For this purpose, the managers may collect statistical records of

the sales performance of their own business and those rehiring to

their rivals, carry out analysis of these records and report on trends

in demand, their market shares, and the relative efficiency of their

retail outlets. Thus, while carrying out heir functions, the managers

may have to undertake detailed statistical analysis. There are, of

course, differences in the relative importance of the various

functions performed from firm to firm and in the degree of

sophistication of the methods used in performing these functions.But there is no doubt that the job of a managerial economist

requires alertness and the ability to work uriderpressure.

Economic Intelligence

Besides these functions involving sophisticated analysis, managerial

economist may also provide general intelligence service. Thus the

economist may supply the management with economic information

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of general interest such as competitors

prices and products, tax rates, tariff rates, etc.

Participating in Public Debates

Many well-known business economists participate in public debates.

The government and society alike are seeking their advice and

views. Their practical experience in business and industry adds

prestige to their views. Their public recognition enhances their

protg in the .firm itself.

Indian Context

In the Indian context, a managerial economist is expected to

perform the following functions:

Macro-forecasting for

demand and supply.

Production planning at macro and micro levels.

Capacity planning and product-mix determination.

Economics of various production lines.

Economic feasibility of new production lines / processes and

projects.

Assistance in preparation of overall development plans.

Preparation of periodical economic reports bearing on various

matters such as the company's product-lines, future growth

opportunities, market pricing situation, general business,. and

various national/international factors affecting industry and

business.

Preparing briefs; speeches, articles and papers for top

management for various chambers, Committees, Seminars,

Conferences, etc

Keeping management informed of various national and

International Developments on economic/industrial matters.

With the adoption of the new economic policy, the macro-

economic environment is changing fast and these changes have

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tremendous implications for business. The managerial economists

have to playa much more significant role. They ha'1e to constantly

measure the possibilities of translating the rapidly changing

economic scenario into workable business opportunities. As Indiamarches towards globalisation, the managerial economists will have

to interpret the global economic events and find out how the firm

can avail itself of the various export opportunities or of establishing

plants abroad either wholly owned or in association with local

partners.

Responsibilities of a Managerial Economist

Besides considering the opportunities that lie before a managerialeconomist it is necessary to take into account the services that are

expected by the management. For this, it is necessary for a

managerial economist to thoroughly recognise the responsibilities

and obligations. A managerial economist can serve the mana-

gement best by recognising that the main objective of the

business, is to make a profit on its invested capital. Academic

training and the critical comments from people outside thebusiness may lead a managerial economist to adopt an apologetic

or defensive attitude towards profits. There should be a strong

personal conviction on part of the managerial economist that

profits are essential and it is necessary to help enhance the ability

of the firm to make profits. Otherwise it is difficult to succeed in

serving management.

Most management decisions necessarily concern the future,which is rather uncertain. It is, therefore, absolutely essential that a

managerial economist recognises his responsibility to make

successful forecast. By making the best possible forecasts and

through constant efforts to improve, a managerial' ng, the risks

involved in uncertainties. This enables the management to follow a

more orderly course of business planning. At times, it is required

for the managerial economist to reassure the management that animportant trend will continue. In other cases, it is necessary to

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point out the probabilities of a turning point in some activity of

importance to management. In any case, managerial economist

must be willing to make fairly positive statements about impending

economic developments. These can be based upon the bestpossible information and analysis. The management's confidence in

a managerial economist increases more quickly and thoroughly

with

a record of successful forecasts, well documented in advance

and modestly evaluated when the actual results become

available.

A few consequences to the above proposition need also be

emphasised here.

First, a managerial economist has a major responsibility to alert

managelI1ent at the earliest possible moment in' case there is

an err6r' in his forecast. This will assist the mallagement in

making appropriate adjustment in policies and programmes

and strengthen his oWn position as a member of the

management team by keeplrighis fingers on the economicpulse of the

business.

Secondly, a managerial economist must establish and maintain

many contacts with individuals and data sources: which would

not be immediately available to the other members of the

management. Extensive familiarity with reference sources and

material is essential. It is still more important that the knownindividuals who are specialists in particular fields have a

bearing on tpe managerial economist's work. For this purpose,

it is required that managerial economist joins professional

associations and tak~ active part in them. In fact, one of the

best means of determining the quality of a managerial

economist is to evaluate his ability to obtain information

quickly by personal contacts rather than by lengthy researchfrom either readily available or obscure reference sources.

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Within any business, there' may be a wealth of knowledge and

experience but the managerial economist would be really

useful ifit is possible pn his part to supplement the existing

know-how with additional information and in the quickestpossible manner.

Again, if a managerial economist is to be really helpful to the

management in successful decision-making and forward planning, it

is necessary'" to able to earn full status on the business team.

Readiness to take up special assignments, be that in study teams,

committees or special projects is another important requirement.

This is because it is necessary for the managerial economist to wincontinuing support for himself and his professional ideas. Clarity of

expression and attempting to minimise the use of technical

terminology while communJcating his ideas to management

executives is also an essential role so as to win approval.

To conclude, a managerial economist has a very important role

to play by helping management in successful decision-making and

forward planning. But to discharge his role successfully, it isnecessary to recognise the 'relevant responsibilities and obligations.

To some business executives, however, a managerial economist is

still a luxury or perhaps even a necessary evil. It is not surprising,

therefore, to find that while tneir status is improving and their

impor;ance is gradually rising, managerial economists in certain

firms still 'feel quite insecure. Nevertheless, there is a definite and

growing realisation that they can contribute significantly to theprofitable growth of firms and effective solution oftMir problems,

and this' promises them a positive future.

REVIEW QUESTIONS

1. What is managerial economics? How does it differ from

traditional economics?

2. Discuss the nature and scopeofmanagerial economics.

3. Show the significance of economic analysis in business

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decisions.

4. Managerial Economics is perspective rather than descriptive in

character? Examine this statement.

5. Assess the contribution and limitations of economic analysis tobusiness decision-making.

6. Briefly explain the five principles, which are basic to the entire

gamut of managerial economics.

7. Explain the role of marginal analysis in determining optimal

solution if managerial economics. How does it compare with

break-even analysis?

8.Discuss some of the important economic concepts andtechniques that help busirless management.

9. Explain the various functions of a managerial economist. How

can he best serve the management?

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LESSON 2

DEMAND ANALYSIS

Demand is one of the crucial requirements for the existence of

any business firm. Firms are interested in their profit and sales,

both of which depend partially upon the demand for the product.

The decisions, which management makes with respect to

production, advertising, cost allocation, pricing, inventory

holdings, etc. call for an analysis of demand. While how much a

firm can produce depends upon its capacity and demand for its

products. If there is no demand for a product, its production is

unworthy. If demand falls short of production, one way to

balance the two is to create new demand through more and

better advertisements. The more the future demand for a

product, the more inventories the firm would hold. The larger

the demand for a firm's product, the higher is the price it can

charge.

Demand analysis seeks to identify and measure the forces

that determine sales. Once this is done the alternative ways of

manipulating or managing demand can easily be inferred.

Although, demand for a finri's product reflects what the

consumers buy, this can be influenced through manipulating the

factors on which consumers base their demands. Demand

analysis attempts to estiinate the demand for a product in

future, which further helps to plan production based on the

estimated demand.

MEANING OF DEMAND

Demand for a good implies the desire of an individual to acquire

the product. It also includes willingness and ability of ail individual

to pay for the product. For example, a miser's desire for and his

ability to pay for a car is not demand, for he does not have the

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necessary will to pay for the car. Similarly, a poor person's desire

for and his willingness to pay for a car is not demand because he

lacks the necessary purchasing power. One can also imagine an

individual, who possesses both the will and the purchasing powerto pay for a good. But this purchasing power is not the demand for

that good, this is because he does not have the desire to buy that

product. Therefore, demand is successful when there are all the

three factors: desire, willingness and ability. It should also be

noted that demand for any goods or services has no meaning

unless it is stated with reference to time, price, competing

product, consumer's incomes, tastes and preferences. This is

because demand varies with fluctuations in these factors. For

example, the demand for an Ambassador car in India is 40,000 is

meaningless unless it is stated that this was the demand in 1976

when an Ambassador car's price was around thirty thousand

rupees. The price of the competing cars prices were around the

same, a Bajaj scooter's price was around five thousand rupees and

petrol price was around three and a half rupees per litre. In 1977,

the demand for Ambassador cars could be different if any of the

above factors happened to be different. Furthermore, it should be

noted that a product is defined with reference to its particular

quality. If its quality changes it can be deemed as another

product. Thus, the demand for any product is the desire,

wi1lihigness and ability to buy the product with reference to a

partkular time and given values of variables on which it depends.

TYPES OF DEMAND

The demand for various kinds of goods is generally classified on

the basis of kinds of consumers, suppliers of goods, nature of

goods, duration of consumption goods, interdependence of

demand, period of demand and nature of use of goods

(intermediate or final), The major classifications of demand are asfollows:

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Individual and market demand

Demand for firm's prodtictand industry's products

Autonomous and derived demand

Demand for durable and non-durable goods

Short-term and long-term demand

Individual and Market Demand

The quantity of a product, which an individual is willing to buy at

a particular price during a specific time period, given his money

income, his taste, and prices of other commodities (particularly

substitutes and complements), is called 'individual's demand for a

product'. The total quantity, which all comsumers are willing to

buy at a given price per time unit, given their money income,

taste, and prices of other commodities is known as 'market

demand for the good'. In other words, the market demand for a

good is the sum of the individual demands of all the c6-nsumers

of a product, over a time period at given prices.

Demand for Firm's Product and Industry's Products

The quantity of a firm's yield, that can be disposed of at a given

price over a period refers to the demand for firm's product. The

aggregate demand for the product of all firms of an industry is

known as the market-demand or demand for industry's product.

This distinction between the two kinds of demand is not of much

use in a highly competitive market since it merely signifies thedistinction between a sum and its parts. However, where market

structure is oligopolistic, a distinction between the demand for

firm's product and industry's product is useful from managerial

point of view. The product of each firm is so differentiated from the

products of the rival firms that consumers treat each product

different from the other. This gives firms an opportunity to plan the

price of a product, advertise it in order to capture a larger marketshare thereby to enhance profits. For instance, market of cars,

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radios, TV sets, refrigerators, scooters, toilet soaps and toothpaste,

all belong to this category of markets.

In case of monopoly and perfect competition, the distinction

between demand for a firm's product and industry's product is notof much use from managerial point of view. In case of monopoly,

industry is one-firmindustiy andthe demand for firm's product is

the same as that of the industry. In case of perfect competition,

products of all firms .of the industry are homogeneous and price

for each firm is determined by industry. Firms have little

opportunity to plan the prices permissible under local conditions

and advertisement by a firm becomes effective for the wholeindustry. Therefore, conceptual distinction between demand for

film's product and industry's product is not much use in business

decisions making.

Autonomous and Derived Demand

An Autonomous demand for a product is one that arises

independently of the demand for any other good whereas a derived

demand is one, which is derived from demand of some other good.

To look more closely at the distinction between the two kinds of

demand, consider the demand for commodities, which arise directly

from the biological or physical needs of the human beings, such as

demand for food, clothes and shelter. The demand for these goods

is autonomous demand. Autotnomous demand also arises as a'

result of demonstration effect, rise in income, and increase in

population and advertisement of new produCts. On the other hand,

the demand for a good that arises because of the demand for some

other good is called derived demand. For instance, demand for

land, fertiliser and agricultural tools and implements are derived

demand, since the demand of goods, depends on the demand of

food. Similarly, demand for steel, bricks, cement etc., is a derived

demand because it is derived from the demand for houses and

other kind of buildings. [n general, the demand for, producer goods

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or industrial inputs is a derived one. Besides, demand for

complementary goods (which complement the use of other goods)

or for supplementary goods (which supplement or provide

additional utility from the use of other goods) is a derived demand.For instance petrol is a complementary goods for automobiles and

a chair is a complement to a table. Consider some examples of

supplement goods. Butter is supplement to bread, mattress is

supplement to cot and sugar is supplement to tea. Therefore,

demand for petrol, chair, and sugar would be considered as derived

demand. The conceptual distinction between autonomous demand

and derived demand would be useful according to the point of view

of a bllsinessman to the extent the former can serve as an indicator

of the latter.

Demand for Durable and Non-durable Goods

Demand is often classified under demand for durable and non-

durable goods. Durable goods are those goods whose total utility is

not exhausted in single or short-run use. Such goods can be used

continuously over a period of time. Durable goods may be consumer

goods as well as producer goods. Durable consumer goods include

clothes, shoes, house furniture, refrigerators, scooters, and cars.

The durable producer goods include mainly the items under fixed

assets, such as building, plant and machinery, office furniture and

fixture. The durable goods, both consumer and producer goods, may

be further classified as semi-durable goods such as, clothes and

furniture and durable goods such as residential and factory

buildings and cars. On the other harid, non-durable goods are those

goods, which can be used only once such as food items and their

total utility is exhausted in a single use. This category of goods can

also be grouped under non-durable consumer and producer goods.

All food items such as drinks, soap, cooking fuel, gas, kerosene, coal

and cosmetics fall in the former category whereas, goods such as

raw materials', fuel and power, finishing materials and packing

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items come in the latter category.

The demand for non-durable goods depends largely on their

current prices, consumers' income and fashion whereas the

expected price, income and change in technology influence thedemand for the durable good. The demand for durable goods

changes over a relatively longer period. There is another point of

distinction between demands for durable and non-durable goods.

Durable goods create demand for replacement or substitution of the

goods whereas non-durable goods do not. Also the demand for non-

durable goods increases or decreases with a fixed or constant rate

whereas the demand for durable goods increases or decreasesexponentially, i.e., it may depend upon some factors such as

obsolescence of machinery, etg. For example, let us suppose that

the annual demand for cigarettes in a city is 10 million packets and

it increases at the rate of half-a-million packets per annum on

account of increase in population when other factors remain

constant. Thus, the total demand for cigarettes in the next year will

be 10.5 million packets and 11 million packets in the next to next

year and so on. This is a linear increase in the demand for a non-

durable good like cigarette. Now consider the demand for a durable

good, e.g., automobiles. Let us suppose: (i1 the existing number of

automobiles in a city, in a year is 10,000, (ii) the annual

replacement demand equals 10 per cent of the total demand, and

(iii) the annual autonomous increase in demand is 1000

automobiles. As such, the total annual clemand for automobiles in

four subsequent years is calculated and presented in Table 2.1.

Table 2.1: Annual Demand for Automobiles

Beginning Total no. of ReplacementAnnual Total Annualof the ear automobilesdemand autonomous demand increas

(Stock) demand in, demand

1st year 10,000 - - 10,000 -

2nd year 10,000 1000 1000 12,000 2000

-3id year 12,000 1200 1000 14,200 2200

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4th year 14,200 1420 1000 16,620 2420

Stock + Replacement + Autonomous demand = TotalDemand

It may be seen from the Table 2.1 that the total demand for

automobiles is increasing at an increasing rate due to

acceleration in the replacement demand. Another factor, which

might accelerate the demand for automobiles and such durable

goods, is the rate of obsolescence of this category of goods.

Short-term and Long-term Demand

Short-term demand refers to the demand for goods that are

demanoed over a short period. In this category fall mostly the

fashion consumer goods, goods of seasonal use and inferior

substitutes during the scarcity period of superior goods. For

instance, the demand for fashion wears is short-term demand

though the demand for the generic goods such as trousers, shoes

and ties continues to remain a longterm demand. Similarly, demand

for umbrella, raincoats, gumboots, cold drinks and ice creams is of

seasonal nature; 'The demand for such goods lasts till the season

lasts. Some goods of this category are demanded for a very short

period, i.e., 1-2 week, for example, new greeting cards, candles and

crackers on occasion of diwali.

Although some goods are used only seasonally but are durable in

pature, e.g., electric fans, woollen garments, etc. The demand for

such goods is of also durable in nature but it is subject to seasonal

fluctuations. Sometimes, demand for certain gools suddenly

increases because of scarcity of their superior substitutes. For

examp1e, when supply of cooking gas suddenly decreases, demand

for kerosene, cooking coal and charcoal increases. In such cases,

additional demand is of shGrtterm nature. The long-term demand,

on the hand, refers to the demand, which exists over a long-period.

The change in long-term demand is visible only after a long period.

Most generic goods have long-term demand. For example, demand

fo