UNIT-I

Introduction To Managerial Economics:

Imagine for a while that you have finished your studies and have joined as an engineer in a
manufacturing organization. What do you do there? You plan to produce maximum quantity of goods
of a given quality at a reasonable cost. On the other hand, if you are a sale manager, you have to sell a
maximum amount of goods with minimum advertisement costs. In other words, you want to minimize
your costs and maximize your returns and by doing so, you are practicing the principles of managerial
economics.

Managers, in their day-to-day activities, are always confronted with several issues such as how much
quantity is to be supplied; at what price; should the product be made internally; or whether it should be
bought from outside; how much quantity is to be produced to make a given amount of profit and so on.
Managerial economics provides us a basic insight into seeking solutions for managerial problems.

Managerial economics, as the name itself implies, is an offshoot of two distinct disciplines: Economics
and Management. In other words, it is necessary to understand what these disciplines are, at least in
brief, to understand the nature and scope of managerial economics.

Introduction to Economics:

Economics is a study of human activity both at individual and national level. The economists of early
age treated economics merely as the science of wealth. The reason for this is clear. Every one of us in
involved in efforts aimed at earning money and spending this money to satisfy our wants such as food,
Clothing, shelter, and others. Such activities of earning and spending money are called “Economic
activities”. It was only during the eighteenth century that Adam Smith, the Father of Economics,
defined economics as the study of nature and uses of national wealth’.

Dr. Alfred Marshall, one of the greatest economists of the nineteenth century, writes “Economics is a
study of man’s actions in the ordinary business of life: it enquires how he gets his income and how he
uses it”. Thus, it is one side, a study of wealth; and on the other, and more important side; it is the study
of man. As Marshall observed, the chief aim of economics is to promote ‘human welfare’, but not
wealth. Prof. Lionel Robbins defined Economics as “the science, which studies human behaviour as a
relationship between ends and scarce means which have alternative uses”. With this, the focus of
economics shifted from ‘wealth’ to human behaviour’.

Microeconomics:

The study of an individual consumer or a firm is called microeconomics (also called the Theory of
Firm). Micro means ‘one millionth’. Microeconomics deals with behavior and problems of single
individual and of micro organization.

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Macroeconomics:

The study of ‘aggregate’ or total level of economics activity in a country is called macroeconomics. It
studies the flow of economics resources or factors of production (such as land, labour, capital,
organisation and technology) from the resource owner to the business firms and then from the business
firms to the households. It deals with total aggregates, for instance, total national income total
employment, output and total investment. It studies the interrelations among various aggregates and
examines their nature and behaviour, their determination and causes of fluctuations in the. It deals with
the price level in general, instead of studying the prices of individual commodities. It is concerned with
the level of employment in the economy. It discusses aggregate consumption, aggregate investment,
price level, and payment, theories of employment, and so on.

Management:

Management is the science and art of getting things done through people in formally organized groups.
It is necessary that every organisation be well managed to enable it to achieve its desired goals.
Management includes a number of functions: Planning, organizing, staffing, directing, and controlling.
The manager while directing the efforts of his staff communicates to them the goals, objectives,
policies, and procedures; coordinates their efforts; motivates them to sustain their enthusiasm; and
leads them to achieve the corporate goals.

Managerial Economics:

Introduction: Managerial Economics as a subject gained popularity in USA after the publication of the
book “Managerial Economics” by Joel Dean in 1951. Managerial Economics refers to the firm’s
decision making process. Managerial Economics is also called as “Industrial Economics” or “Business
Economics”. As Joel Dean observes managerial economics shows how economic analysis can be used
in formulating polices.

Meaning & Definition:

In the words of E. F. Brigham and J. L. Pappas Managerial Economics is “the applications of

economics theory and methodology to business administration practice”.

Managerial Economics bridges the gap between traditional economics theory and real business
practices in two ways. First it provides a number of tools and techniques to enable the manager to
become more competent to take decisions in real and practical situations. Secondly it serves as an
integrating course to show the interaction between various areas in which the firm operates.

C. I. Savage & T. R. Small therefore believes that managerial economics “is concerned with
business efficiency”.
M. H. Spencer and Louis Siegelman explain the “Managerial Economics is the integration of
economic theory with business practice for the purpose of facilitating decision making and forward
planning by management”.
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It is clear, therefore, that managerial economics deals with economic aspects of managerial decisions of
with those managerial decisions, which have an economics contest. Managerial economics may
therefore, be defined as a body of knowledge, techniques and practices which give substance to those
economic concepts which are useful in deciding the business strategy of a unit of management.

Managerial Economics, therefore, focuses on those tools and techniques, which are useful in decision-
making.

Nature Of Managerial Economics:

Nature of managerial economics: Managerial economics is, perhaps, the youngest of all the social
sciences. Since it originates from economics, it has the basic features of Economics, such as assuming
that other things remaining the same (ceteris paribus- Latin phrase means "all other things being equal” ). This
assumption is made to simplify the complexity of the managerial phenomenon under study in a
dynamic business environment i.e. so many things are changing simultaneously.

The other features of managerial economics are explained as below:

(a) Close to microeconomics : Managerial economics is concerned with finding the solutions for
different managerial problems of a particular firm. Thus, it is more close to microeconomics.

(b) Operates against the backdrop of macroeconomics: The macroeconomic conditions of the
economy are also seen as limiting factors for the firm to operate. In other words, the managerial
economist has to be aware of the limits set by the macroeconomic conditions such as government
industrial polity, inflation, and so on.

(c) Normative statements: A normative statement usually includes or implies the words ‘ought’ or
‘should’. They reflect people’s moral attitudes and are expressions of what a term of people ought to
do.

(d) Prescriptive actions: Prescriptive action is goal oriented. It does not merely mention the concept, it
also explains whether the concept can be applied in a given context or not.

(e) Applied in nature: ‘Models’ are built to reflect the real life complex business situations and these
models are of immense help to managers for decision making. The different areas where models are
extensively used include inventory control, optimization, project management etc.

(f) Offers scope to evaluate each alternative: Managerial economics provides an opportunity to
evaluate each alternative in terms of its costs and revenues.

(g) Interdisciplinary: The contents, tools and techniques of managerial economics are drawn from
different subject such as economics, management, mathematics, statistics, accountancy, psychology,
organizational behaviour, sociology, etc.
(h) Assumptions and limitations: Every concept and theory of managerial economics is based on
certain assumptions and as such their validity is not universal. Where there is change in assumptions,
the theory may not hold good at all.
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Scope of Managerial Economics:

The main focus in managerial economics is to find an optimal solution to a given managerial problem.
The problem may relate to production, reduction or control of costs, determination of price of a given
product or service, make or buy decisions, inventory decisions, capital management or profit planning
and management, investment decisions or human resource management etc.

The concept can be explained in following diagram:

Managerial decision areas:

o Production
o Reduction or control of costs
o Determination of price of a given product
Concepts and
techniques Applied or service for Optimum
of managerial o Make or buy decisions Solutions
to
economics o Inventory decisions
o Capital management
o Profit planning and management
o Investment decisions

The Main Areas of Managerial Economics

The main areas of applications in managerial economics are discussed below:
1. Demand Decision: The analysis and forecasting of demand for a given product and service is
the first task of the managerial economist. The behavioural implications such as the needs of the
customers, responses to a given change in the price or supply are analysed in a scientific
manner. The impact of changes in prices, income levels and prices of alternative
products/services are assessed and accordingly the decisions are taken to maximize the profits.

2. Input-output Decision: It is necessary for the manager to know the relationship between the
cost and output both in the short-run and long-run to position his products in the competitive
environment.

3. Price-output Decision: The pricing policies, methods, strategies and practices constitute crucial
part of the study of managerial economics.

4. Profit-related Decisions: Cost reduction and cost control deal with the strategies to reduce the
wastage and thereby reduce the costs. These indirectly enhance the level of profits.

5. Investment Decisions: Investments decisions are also called capital budgeting decisions. These
involve commitment of large funds, which determine the fate of the firm. These decisions are
irreversible. Hence, the manager needs to be more attentive while committing his scare funds,
which have alternative uses.
6. Economic Forecasting and Forward Planning: Economic forecasting leads to for forward
planning.
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Managerial economics relationship with other Disciplines:

Managerial economics is closely linked with many other disciplines such as:

1. Economics
2. Accountancy
3. Mathematics
4. Statistics
5. Operations research
6. Psychology and
7. Organizational behaviour

1. Economics: Economics and managerial economics, both are concerned with the problems of
scarcity and resource allocation. If the economist is concerned with the study of ‘markets’, the
managerial economist is interested in studying the impact of such markets on the performance of a
given firm. Economics provides to the managerial economist.

2. Accountancy: The main objective of accounting function is to record, classify and interpret the
given accounting data. The managerial economist profusely depends upon accounting data for
decision making and forward planning.

3. Mathematics: Managerial economist is concerned with estimating and predicting the relevant
economic factors for decision making and forward planning. In this process, he extensively makes
use of the tools and techniques of mathematics such as algebra, calculus, exponentials, vectors,
input-out tables and such other.

4. Statistics: Statistics deals with different techniques useful to analyse the cause and effect
relationships in a given variable or phenomenon. It also empowers the manager to deal with the
situations of risk and uncertainty through its techniques such as probability etc.

5. Operations Research: Decision marking is the main focus in operations research and managerial
economics. The Operations Research Models such as linear programming, queuing, transportation,
optimization techniques and so on, are extensively used in solving the managerial problems.
Optimisation is an interesting word. It refers to both minimization of costs and maximization of
revenues

6. Psychology: Consumer psychology is the basis on which managerial economist acts upon.

7. Organisational Behaviour: Organisational Behaviour enables the managerial economist to study

and develop behavioural models of the firm integrating the manager’s behaviour with that of the
owner.

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Demand Analysis:

Introduction & Meaning: Demand in common parlance means the desire for an object. But in
economics demand is something more than this. According to Stonier and Hague, “Demand in
economics means demand backed up by enough money to pay for the goods demanded”. This means
that the demand becomes effective only it if is backed by the purchasing power in addition to this there
must be willingness to buy a commodity.

A product or service is said to have demand when three conditions are satisfied:
 Desire on the part of the buyer to buy
 Willingness to pay for it.
 Ability to pay the specified price for it.

Unless all these conditions are fulfilled, the product is not said to have any demand.

Nature and Types of Demand:

Demand always implies at a given price. How much is the quantity demanded at a given level of
price? This is the volume of demand. The nature of demand is better understood when we see these
variations given below:

1. Consumer Goods vs Producer Goods

2. Autonomous Demand vs derived Demand
3. Durable vs perishable Goods
4. Firm Demand vs Industry Demand
5. Short-run Demand vs Long-run Demand
6. New Demand vs Replacement Demand
7. Total Market and Segment Market Demand

1. Consumer Goods vs Producer Goods: Consumer Goods are those which are available for ultimate
consumption. These give direct and immediate satisfaction. Examples- Bread, apple, rice, and so on.

Producer goods are those which are used for further processing or production of goods/services
to earn income. These goods yield satisfaction indirectly. Examples Machinery, Tractor, etc.

2. Autonomous Demand vs Derived Demand: Autonomous demand refers to the demand for
products and services directly. If there is no demand for houses, there may not be demand for steel,
cement, bricks, and so on. Demand for houses is autonomous whereas demand for these inputs is
derived demand.

3. Durable vs Perishable Goods: Durable goods are those goods which give service relatively for a
long period. The life of perishable goods is very less, may be in hours or days.

Examples of perishable goods Examples of durable goods

Milk Rice
Vegetables Wheat
Fish etc. Sugar etc.
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4. Firm Demand vs Industry Demand: The firm is a single business unit whereas industry refers to
the group of firms carrying on similar activity. The quantity of goods demanded by a single firm is
called firm demand and the quantity demanded by the industry as a whole is called industry demand.

Example: The construction company may use 100 tonnes of cement during a given month. This is firm
demand. The construction industry in a particular state may have used ten million tones. This is
industry demand.

5. Short-run Demand vs Long-run Demand: Joel Dean defines short-run demand as ‘the demand
with its immediate reaction to price changes, income fluctuations and so on. Long-run demand is that
demand which will ultimately exist as a result of the changes in pricing, promotion or product
improvement, after enough time is allowed to let the market adjust itself to the given situation.’

6. New Demand vs Replacement Demand: New demand refers to the demand for the new products
and it is the addition to the existing stock. In replacement demand, the item is purchased to maintain the
asset in good condition. The demand for cars is new demand and the demand for spare parts is
replacement demand.

7. Total Market and Segment Market Demand: The total demand for sugar in the region is the total
market demand. The demand for sugar from the sweet-making industry from this region is the segment
market demand.

Factors Determining Demand:

There are factors on which the demand for a commodity depends. These factors are economic, social as
well as political factors. The effect of all the factors on the amount demanded for the commodity is
called Demand Function. These factors are as follows:
1. Price of the product (P)
2. Income level of the consumer (I)
3. Tastes and preferences of the consumer (T)
4. Prices of related goods which may be substitutes/complementary (PR)
5. Expectations about the prices in future (EP)
6. Expectations about the incomes in future (EI)
7. Size of population (SP)
8. Distribution of consumers over different regions (DC)
9. Advertising efforts (A)
10. Any other factor capable of affecting the demand (O)

1. Price of the Product: The most important factor-affecting amount demanded is the price of the
product. The amount of a product demanded at a particular price is more properly called price
demand. The relation between price and demand is called the Law of Demand. It is not only the
existing price but also the expected changes in price, which affect demand.

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2. Income Level of the Consumer: The second most important factor influencing demand is
consumer income. In fact, we can establish a relation between the consumer income and the demand at
different levels of income, price and other things remaining the same. The demand for a normal
commodity goes up when income rises and falls down when income falls. But in case of Giffen goods
the relationship is the opposite.

3. Tastes of the Consumers: The amount demanded also depends on consumer’s taste. Tastes
include fashion, habit, customs, etc. A consumer’s taste is also affected by advertisement. If the
taste for a commodity goes up, its amount demanded is more even at the same price. This is called
increase in demand. The opposite is called decrease in demand.

4. Prices of related goods: The demand for a commodity is also affected by the changes in prices of
the related goods also. Related goods can be of two types:

(i). Substitutes which can replace each other in use; for example, tea and coffee are
substitutes. The change in price of a substitute has effect on a commodity’s demand
in the same direction in which price changes. The rise in price of coffee shall raise
the demand for tea;

(ii). Complementary foods are those which are jointly demanded, such as pen and ink. In
such cases complementary goods have opposite relationship between price of one
commodity and the amount demanded for the other. If the price of pens goes up,
their demand is less as a result of which the demand for ink is also less. The price
and demand go in opposite direction. The effect of changes in price of a commodity on
amounts demanded of related commodities is called Cross Demand.

5. Expectations about the prices in future: If consumers expect changes in price of commodity in
future, they will change the demand at present even when the present price remains the same.

6. Expectations about income in future: If consumers expect their incomes to rise in the near future
they may increase the demand for a commodity just now.

7. Size of Population: Increase in population increases demand for necessaries of life. The
composition of population also affects demand. Composition of population means the proportion of
young and old and children as well as the ratio of men to women. A change in composition of
population has an effect on the nature of demand for different commodities.
8. Distribution of consumers over different regions: Distribution of consumer will also affects
demand

9. Advertising efforts: With an increase in advertising efforts there will be increase in demand.

10. Any other factor capable of affecting the demand: Others factors such as wealth, government
policy, climate and weather, state of business etc also affects demand

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Demand Function:

The demand function shows the functional relationship between the quantity demanded and the
various factors that determine demand for a commodity. It can be expressed mathematically

D = f (P, I, T, PR, EP, EI, SP, DC, A, O)

Demand Schedule:

The demand schedule shows the functional relationship between the quantity of a commodity
demanded and its price i.e. it shows the different quantities of a commodity demanded at various prices
in a given time. The demand schedule are of two types

a) Individual demand schedule: Individual demand schedule shows the various quantities of a
commodity demanded by a consumer at different prices in a given period of time. The following
imaginary table shows the consumer’s demand for apples.

Price (Rs). Quantity demanded

7 1
6 2
5 3
4 4
3 5
2 6
1 7

a) Market Demand Schedule: The market demand schedule shows the quantity demanded of a
commodity by all consumers in the market at various prices in particular period of time. The
composite demand schedule thus compiled shows the market demand for the commodity.

Quantity demanded by Consumers Market

Price of apple
A B C demand
6 5 5 40 50
5 10 15 45 70
4 15 25 50 90
3 20 35 55 110
2 25 45 60 130
1 30 55 65 150

Demand Curve:
Demand curve is a graphic representation of the relationship between product price
and the quantity of the product demanded. It is drawn with price on the vertical axis of the graph and
quantity demanded on the horizontal axis.

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The demand curve DD shows the inverse relation between price and quantity demand. It is downward sloping.

Law of Demand:

The Law of Demand states: Other things remaining the same, the amount of quantity demanded
rises with every fall in the price and vice versa.

Assumptions of the Law of Demand:

The phrase ‘other things remaining the same’ is the assumption under the law of demand. Here,
other things include

 Income level of the consumer,

 Tastes and preferences of the consumer
 Prices of related goods,
 Expectations about the prices or incomes in the future,
 Size of population,
 Advertising efforts, and
 Any other factor capable of affecting the demand.

The law does not hold good if any one of these factors tend to change.

Operation of the Law of Demand:

Price of product

The law of demand explains that with every fall in the price of a particular product, its demand
goes on increasing and vice versa. This holds good as long as other determinants of demand do not
change. Once there is change in the other demand determinants, the Law does not hold good.

Quantity demanded

Exceptions to the Law of Demand:

The law of demand is generally acceptable in all situations with the following exceptions.

1) Prestige goods: Commodities like gold, diamonds etc. are the prestige goods. If the prices of these
goods decrease consumers reduce their purchase.

2) Giffen’s Paradox : Sir Robert Giffen in mid 19 th century observed that the low paid workers in
Britain purchased more bread when its price increased by decreasing the purchases of meat, cake etc.

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 The Giffen good or inferior good is an exception to the law of demand. When the price of an inferior
good falls, the poor will buy less and vice versa.

3) Speculation: When the prices are expected to rise in the future, people buy more. E.g., a rise in the
price of shares may induce speculators to buy in the hope of a further rise in price.
In case of these exceptions, the demand curve slopes upwards.

4) Ignorance: Sometimes, the quality of the commodity is Judge by its price. Consumers think that the
product is superior if the price is high. As such they buy more at a higher price.

5) Fear of shortage: During the times of emergency of war People may expect shortage of a
commodity. At that time, they may buy more at a higher price to keep stocks for the future.

6) Necessaries: In the case of necessaries like rice, vegetables etc. people buy more even at a higher
Price of product X

price.

D
D

Quantity Demanded
An Exceptional Demand Curve

ELASTICITY OF DEMAND

The term ‘elasticity’ is defined as the rate of responsiveness in the demand of a commodity for a given
change in price or any other determinants of demand.

Elasticity of demand explains the relationship between a change in price and consequent change in
amount demanded. “Marshall” introduced the concept of elasticity of demand. Elasticity of demand
shows the extent of change in quantity demanded to a change in price.

In the words of “Marshall”, “The elasticity of demand in a market is great or small according as the
amount demanded increases much or little for a given fall in the price and diminishes much or little for
a given rise in Price”
Elastic demand: A small change in price may lead to a great change in quantity demanded. In this
case, demand is elastic.
In-elastic demand: If a big change in price is followed by a small change in demanded then the
demand in “inelastic”.
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 Mathematically it can be expressed as

Proportionate change in quantity demanded

Elasticity of demand (E) = -----------------------------------------------------------------
Proportionate change in determinants of demand

It can also be written as

Percentage change in demand
Price Elasticity of demand(Ep) = ---------------------------------------
Percentage change in price

Measurement of Elasticity:
The elasticity is measured in the following ways:

1. Perfectly elastic demand

2. Perfectly inelastic demand
3. Relatively elastic demand
4. Relatively inelastic demand
5. Unity elasticity

These are explained below.

1. Perfectly Elastic Demand : In negligible change in price leads to an infinite expansion in

demand. Even when the price remains constant the quantity demanded increases. It is a
horizontal straight line to X axis.

Price P

O Q Q1 Q2
Quantity demanded

2. Perfectly inelastic demand: The demand is said to be relatively elastic when there is no
change in the quantity demanded even though there is a big change (increase or decrease) in
price.

P2

Price P1

O Q
Quantity demanded
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3. Relatively Elastic demand: The demand is said to be relatively elastic when the change in
demand is more than the change in the price.

Price P1
P2
D

O Q1 Q2
Quantity demanded

4. Relatively Inelastic Demand: The demand is said to be relatively inelastic when the
change in demand is less than the change in the price.

Price P1

P2
D

O Q1 Q2
Quantity demanded

5. Unity Elasticity : The elasticity in demand is said to be unity when the change in demand is
equality to the change in price. This is illustrated in below diagram.

Price P1

P2`
D

O Q1 Q2
Quantity demanded

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Types of Elasticity:

The following are the four types of elasticity of demand:

(a) Price elasticity of demand
(b) Income elasticity of demand
(c) Cross elasticity of demand
(d) Advertising elasticity of demand

These are explained below:

(a) Price Elasticity of Demand : Elasticity of demand in general refers to price elasticity of
demand. In other words, it refers to the quantity demanded of a commodity in response to a given
change in price. Price elasticity is always negative which indicates that the customer tends to buy
more with every fall in the price. The relationship between the price and the demand is inverse.

It is measured as follows:
Proportionate change in the quantity demanded for product X
Price elasticity of demand =------------------------------------------------------------------------------
Proportionate change in the price of X

The same is expressed as (Q2-Q1)/Q1

Edp = ------------------
(P2-P1)/P1

Where Q1 is the quantity demanded before price change,

Q2 is quantity demanded after price change,
P1 is the price before change and
P2 is the price after change.

(b) Income Elasticity of Demand : Income elasticity of demand refers to the quantity demanded of
a commodity in response to a given change in income of the consumer. Income elasticity is
normally positive.
Proportionate change in quantity demanded for product X
Income elasticity of demand = -----------------------------------------------------------------------------
Proportionate change in income

The same is expressed

(Q2-Q1)/Q1
Edi =-------------------
(I2-I1)/I1
Where Q1 is the quantity demanded before change,
Q2 is quantity demanded after change I1 is income before change and I2 is the income after change.

(c) Cross Elasticity of Demand : Cross elasticity of demand refers to the quantity demanded of a
commodity in response to a change in the price of a related good, which may be substitute or
complement.
It is measured as follows:

Proportionate change in quantity demanded for product X

Cross elasticity of demand =----------------------------------------------------------------------------
Proportionate change in price of product Y

The same is expressed as

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 (Q2 – Q1)/Q1
Edc = -------------------
(P2y-P1y)/P1y

Where Q1 is the quantity demanded before change, Q 2 is quantity demanded after change, P 1y is the
price before change and P2y is the price after change in the case of product Y.

(d) Advertising Elasticity : It refers to increase in the sales revenue because of change in the
advertising expenditure. In other words, there is a direct relationship between the amount of money
spent on advertising and its impact on sales. Advertising elasticity is always positive.

Proportionate change in quantity demanded for product X

Advertising elasticity = -------------------------------------------------------------------------
Proportionate change in advertisement costs

The same is expressed as

(Q2-Q1)/Q1
Eda = ------------------
(A2-A1)/A1

Where Q1 is the quantity demanded before change, Q2 is quantity demanded after change A1 is the
amount spent on advertisement before and A2 is the amount spent on advertisement after change.

Factors Governing Elasticity Of Demand:

Elasticity is governed by a number of factors.

(a) Nature of product
(b) Time frame
(c) Degree of postponement
(d) Number of alternative uses
(e) Tastes and preferences of the consumer
(f) Availability of close substitutes
(g) In case of complementaries or joint goods
(h) Level of prices
(i) Availability of subsidies
(j) Expectation of prices
(k) Durability of the product
(l) Government policy

(a) Nature of product : Based on their nature, the products and services are classified into necessities.
Necessaries imply the absolute or basic necessities such as food, clothing, housing.
Comforts refer to TV, Refrigerator and so on. Luxuries refers to Sofa sets, Marble flooring in house and
such others.
If there is an increase in price, we tend to buy the necessaries such as petrol, diesel and so on. In
other words, the demand does not fall because of increase n price. From this, we can say that the
necessaries have inelastic demand. For comforts and luxuries, the demand is relatively elastic. It means
that any increase in the price of comforts or luxuries will lead to moderate to significant fall in their
demand.

(b) Time frame : The more the time available for the customer, the demand for a particular product
may be elastic and vice versa.

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(c) Degree of postponement: The consumption of necessaries cannot be postponed and hence they
have inelastic demand.

(d) Number of alternative uses : If the number of alternative uses are more, the demand is said to be
highly inelastic and vice versa.

(e) Tastes and preferences of the consumer : Where the customer is particular about his taste and
preferences, the product is said to be inelastic.

(f) Availability of close substitutes: Where there are a good number of close substitutes, the demand is
said to be elastic and vice versa.

(g) In case of complementaries or joint goods : In case of complementaries or goods having joint
demand, the elasticity is comparatively low.

(h) Level of prices : If the price is very expensive (such as diamonds) or very cheap (such as salt), then
the product is likely to have an inelastic demand.

(i) Availability of subsidies : There is need for subsidies in case of goods with inelastic demand such
as LPG, sugar, wheat and so on.

(j) Expectation of prices : Where people expect a fall in the price, the demand for the product is likely
to be inelastic.

(k) Durability of the product : Where the product is durable in case of consumer durables such as TV,
the demand is elastic. In the case of perishable goods such as milk, the demand is inelastic.

(l) Government policy : Where the government policy is liberal, the product is likely to have elastic
demand and vice versa. Government, in the interest of the lower income group consumers, closely
monitors the prices of certain products (such as, ration goods as sold in fair price shops are likely to
have inelastic demand).

Significance of Elasticity of Demand:

The concept of elasticity is very useful to the producers and policy-makers alike. It is a very valuable
tool to decide the extent of increase or decrease in price for a desired change in the quantity demanded
for the products and services in the firm or the economy. The following are its applications:

(a) to fix the prices of factors of production

(b) to fix the prices of goods and services provided rendered
(c) to formulate or revise government policies
(d) to forecast demand
(e) to plan the level of output and price

(a) Prices of factors of production : The factors of production are land, labour, capital
organization and technology. These have a cost. We have to pay rent, wages, interest, profits
and price for these factors of production.
(b) Price fixation : The manufacturer can decide the amount of price that can be fixed for his
product based on the concept of elasticity.
(c) Government policies: Government uses the concept of elasticity for formulating policies such
as

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 (i) Tax policies
(ii) Raising bank deposits
(iii) Public utilities
(iv) Revaluation or devaluation of currencies
(v) Formulate government policy
(d) Forecasting demand: Income elasticity is used to forecast demand for a particular product or
service.
(e) Planning the levels of output and price : The knowledge of price elasticity is very useful to
producers. The producer can evaluate whether a change in price will bring in adequate revue or
not.

Measurement of Elasticity of Demand:

Generally price elasticity of demand is estimated by the following methods.
1. Point method and
2. Arc Elasticity

1. Point method: This method is introduced by Marshall. In this method, elasticity of demand is
measured at point on the demand curve.

Y
A Ep = ∞

C Ep >1

E Ep=1
Price
D Ep <1

Ep = 0
B
Quantity demanded

Then at point C elasticity of demand

Lower segment of demand curve CB

EP = ------------------------------------------------= ---------------
Upper segment of demand curve CA

At the point of D the elasticity of demand

DB
EP = ------- <1
DA

At the point of E the elasticity of demand

EB
EP = -------- =1
EA

At the point of C the elasticity of demand

CB

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 EP =--------- >1
CA
At the point of B the elasticity of demand
0
EP = ---------=0
AB

At the point of A the elasticity of demand

AB
EP = -------- = ∞
0

2. Arc Elasticity
Arc elasticity measures the average responsiveness to price change over a finite stretch on the demand
curve. Where MN refers to the stretch on the demand curve D1D2.

D1

P1 M

P2 N

D2

Q1 Q2

The arc elasticity is defined as below :

Q (P1+P2)/2 Q (P1+P2)
ArcEp = -------- ---------------- = -------- --------------
P (Q1+Q2)/2 P (Q1+Q2)

DEMAND FORECASTING

Demand forecasting is very popular in industrially advanced countries where demand conditions are
always more uncertain than the supply conditions.

Demand forecasting may be undertaken at three different levels:

(a) Macro-level concerned with business conditions over the whole economy measured by an
appropriate index of industrial production, national income or expenditure. Such external data
constitute the basic assumptions on which the business must base its forecasts.
(b) Industry-level prepared by different trade associations.
(c) Firm-level which is the most important from managerial viewpoint.

CRITERIA OF A GOOD FORECASTING METHOD

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The criteria for good forecasting method are as follows:
1. Accuracy
2. Simplicity and Ease of Comprehension
3. Economy
4. Availability
5. Maintenance of Timeliness

METHODS OF DEMAND FORECASTING:

1. Survey Methods:
(a) Survey of Buyers’ Intentions
 There are professional organizations specialized in marker research on behalf of the firms who
wish to forecast the demand for their products and/or services.
 Normally, a questionnaire is designed to know the information.
 The data thus collected forms the information base to design the consumer profiles. These
consumer profiles guide the firms to identify the factors that influence demand.
 The suvey of buyers can be conducted either by covering the whole population or by selecting a
sample group of buyers.
 Suppose there are 10,000 buyers for a particular product. If the company wishes to know the
opinion of all the buyers, this method is called census method or total enumeration method. On
the other hand, the firm can selected a group of buyers can represent the whole population. This
method is called the sample method.
Advantages
(i) where the product is new on the market for which no data previously exists
(ii) when the buyers are few and they are accessible
(iii) when the cost of reaching them is not significant
(iv) when the consumers sick to their intentions
(v) when they are willing to disclose what they intend to do.
Disadvantages
(i) Survey is expensive.
(ii) Survey is a time consuming procedure.
(iii) Inconsistent buying behaviour

(b) Sales Force Opinion

Sales force are those who are in constant touch with main and large buyers of a particular market.
Sales force is capable of assessing the relations of the consumer It is less costly as the survey can be
conducted instantaneously through telephone, fax or video conference and so on.

2. Statistical Methods:
For forecasting the demand for goods and services in the long-run, statistical and mathematical
methods are used considering the past data.
(a) Trend Projection Methods
 These are generally based on analysis of past sales patterns.
 There are five main techniques of mechanical extrapolation. In extrapolation, it is assumed that
existing trend will maintain all through.

(i) Trend line by observation : This method of forecasting trend is elementary, easy and quick
as it involves merely the plotting the actual sales data on a chart and then estimating just by
observation where the trend line lies. The line can be extended towards a future period and
corresponding sales forecast read from the graph.

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 (ii) Least Squares Method : Here it is assumed that there is a proportional (linear) change in
sales over a period of time. In such a case, the trend line equation is in linear form.

The estimating linear trend equation of sales is written as :

S = x + y(T)
Or
To find the values of x and y, the following normal equations have to be stated and solved:
∑S = Nx + y ∑T
∑ST = x∑T + y ∑T2

Where S is the sales ; T is the year number, n = number of years.

(iii) Time series analysis : Time series emerge from such a data when arranged chronologically.
Given significantly large data, the cause and effect relationships can be discovered through
quantitative analysis. The following are the four major components analysed from time
series while forecasting the demand:
Trend (T) : also called the long-term trend, is the result of basic developments in the population,
capital formation and technology.
Cyclic Trend (C) : is seen in the wave like movement of sales. For instance, during the period of
inflation, prices of the products go up and hence the demand slows down.
Seasonal Trend (S) : The seasonal component may be related to weather factors, holidays, and so
on.
Erratic Trend (E) : Results from the sporadic occurrence of strikes, riots, and so on.

(iv) Moving Average Method: A moving average is a technique to get an overall idea of
the trends in a data set; it is an average of any subset of numbers. The moving average is extremely
useful for forecasting long-term trends. Moving average can be calculated for any period of time.
For example, if you have sales data for a twenty-year period, you can calculate a five-year moving
average, a four-year moving average, a three-year moving average and so on.

(v) A simple exponential smoothing is one of the simplest ways to forecast a time series. The basic
idea of this model is to assume that the future will be more or less the same as the (recent) past. The
exponential smoothing model had advantage compared to a moving average. The weight put on
each observation decreases exponentially over time (the most recent observation has the highest
weight). This is often better than moving average models that allocate the same weight to all the
relevant historical months.

(b) Barometric Technique: Simple trend projections are not capable of forecasting turning points.
Under Barometric method, present events are used to predict the directions of change in future. This is
done with the help of economics and statistical indicators. In this method one set of data is used to
predict another set of data
Example: demand for internet connection may be linked to the no of new houses occupied in a new
area

(c) Regression and correlation method: Regression and correlation are used for forecasting demand.
Based on past data the future data trend is forecasted. If the functional relationship is analyzed with the
independent variable it is simple correction. When there are several independent variables it is multiple
correlation. In correlation we analyze the nature of relation between the variables while in regression
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 the extent of relation between the variables is analyzed. The results are expressed in mathematical
form. Therefore, it is called as econometric model building. The main advantage of this method is that
it provides the values of the independent variables from within the model itself.

3. Others Methods:

(a) Controlled Experiments : Controlled experiments refer to such exercises where some of the
major determinants of demand are manipulated to suit to the customers with different tastes and
preferences, income groups, and such others. It is further assumed that all other factors remain
the same. In this method, the product is introduced with different packages, different prices in
different markets or same markets to assess which combination appeals to the customer most.
This method is still in the infancy stage and not much tried because of the following reasons:
 It is costly and time consuming
 It involves elaborate process of studying different markets and different permutations and
combinations that can push the product aggressively
 If it fails in one market, it may affect other markets also
(b) Judgemental Approach : When none of the above methods are directly related to the given
product or service, the management has no alternative other than using its own judgement. Even
when the above methods are used, the forecasting process is supplemented with the factor of
judgement for the following reasons:
 Historical data for significantly long period is not available
 Turning points in terms of policies or procedures or causal factors cannot be precisely
determined
 Sales fluctuations are wide and significant

(c) Collective Opinion : Under this method the opinions of those who have the feel of the market,
like salesmen, professional experts, market consultants etc. are collected. These salesmen can
have a feel of the reaction of consumers to the changing market situations and also towards a
new product and the demand for competing products. Their estimates are put together to find
out the total demand of the firm’s product.

Law of Supply:
The law of supply is a fundamental concept in microeconomics that governs supply
at a given price. The law of supply states that when the market price of a good increases, suppliers will
increase the supply of that good. And when the price decreases, the quantity they will supply decreases.
When employing the law of supply concept, economists assume that only the price changes and all
other variables that can affect supply (like consumer mindset or materials cost) remain constant.

On a graph with quantity (the dependent variable) on the horizontal axis and price (the
independent variable) on the vertical axis, the law of supply forms an upward slope, called a supply
curve, which shows the relationship between the cost of a product and the quantity that suppliers can
(or will) supply.

The chart below depicts the law of supply using a supply curve, which is upward sloping. A, B,
and C are points on the supply curve. Each point on the curve reflects a direct correlation between
quantity supplied (Q) and price (P). So, at point A, the quantity supplied will be Q1 and the price will
be P1, and so on.

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The law of supply is closely linked to the law of demand, which states that higher prices lead to lower
demand, and lower prices lead to higher demand. The consumer demand curve—a graph representing
the link between the cost of a good and customer demand—is a downward slope and intersects the
supply curve at the market equilibrium point, which is when the demand for a product and the supply
are equal.

The law of supply works in three major steps:

1. The price of a good increases. Suppliers may change the selling price of a product based on
any number of determinants, including quality, demand, cost of production, consumer income
and mindset, taxes, and even supply and demand.
2. Suppliers see more incentive to sell. When the price of the product rises, suppliers see more
incentive to sell higher quantities of the good. They may increase the gathering of materials,
divert resources from other markets, or make other changes in their business structure to
increase the production of a particular good or service.
3. The supply increases. After a certain period of time in the supply schedule, the fresh supply of
goods will hit the market, increasing the number of goods supplied to the market. Thus, when
the price increases, the supply increases.

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