UNIT

1
Managerial economics is a stream of management studies that
emphasizes primarily on solving business problems and decision-
making by applying the theories and principles of microeconomics and
macroeconomics. It is a specialized stream dealing with an
organization’s internal issues using various economic tools.
Economics is an indispensable part of any business. This single
concept derives all the business assumptions, forecasting, and
investments.

Nature of Managerial Economics

1. Art and Science

Management theory requires a lot of critical and logical thinking and
analytical skills to make decisions or solve problems. Many
economists also find it a source of research, saying it includes
applying different economic concepts, techniques, and methods to
solve business problems.

2. Microeconomics
Managers typically deal with the problems relevant to a single entity
rather than the economy as a whole. It is, therefore, considered an
integral part of microeconomics.

3. Uses of Macro Economics

A corporation works in an external world, i.e., serving the consumer,
an important part of the economy. For this purpose, managers must
evaluate the various macroeconomic factors, such as market
dynamics, economic changes, government policies, etc., and their
effect on the company.

4. Multidisciplinary
Managerial economics uses many tools and principles that belong to
different disciplines, such as accounting, finance, statistics,
mathematics, production, operational research, human resources,
marketing, etc.

5. Prescriptive or Normative Discipline

By introducing corrective steps managerial economics aims at
achieving the objective and solves specific issues or problems.

6. Management Oriented
This serves as an instrument in managers’ hands to deal effectively
with business-related problems and uncertainties. This also allows for
setting priorities, formulating policies, and making successful
decisions.

7. Pragmatic
The solution to day-to-day business challenges is realistic and
rational.
Different individuals take different views of the principles of managerial
economics. Others may concentrate more on customer service and
prioritize efficient production.

Scope of Managerial Economics

The definition of managerial economics is commonly used to deal with
various business problems within organizations. Both microeconomics
and macroeconomics have an equal effect on the organization and its
work. The following points illustrate its significance:

Micro-economics Applied to Operational Matters

The various theories or principles of microeconomics used to solve the
internal problems of the organization arising in the course of business
operations are as follows:
1. Demand Theory: Demand Theory emphasizes the consumer’s
behavior toward a product or service. This considers the
customers’ desires, expectations, preferences, and conditions to
enhance the manufacturing process.
 2. Decisions on Production and Production Theory: This theory
is primarily concerned with the volume of production, process,
capital and labour, costs involved, etc. It aims to optimize the
production analysis to meet customer demand.
3. Market Structure Pricing Theory and Analysis: It focuses on
assessing a product’s price considering the competition, market
dynamics, production costs, optimizing sales volume, etc.
4. Exam and management of profit: the companies are operating
for assets; hence, they aim to maximize profit. It also depends on
demand from the market, input costs, level of competition, etc.
5. Decisions on capital and investment theory: Capital is the
most important business element. This philosophy takes priority
over the proper distribution of the resources of the company and
investments in productive programs or initiatives to boost
operational performance.

The Concepts of Managerial Economics

1. Liberal Managerialism
A market is a democratic space where people make their choices and
decisions. The organization and its managers must function according
to the customers’ demand and market trends otherwise; this can lead
to business failures.

2. Normative Managerialism
Managerial economics’ normative view states that administrative
decisions are based on experiences and practices of real life. They
systematically study demand, forecasting, cost control, product design
and promotion, recruitment, etc.

3. Radical Managership
Managers have to have a creative approach to business concerns,
i.e., make decisions to improve the current situation or circumstance.
We concentrate more on the need and satisfaction of the consumer
rather than just the maximization of income.
4. Managerial Economic Values
The excellent macroeconomist N. Gregory Mankiw has given ten
principles to explain the significance of managerial economics in
business operations.

Role and Responsibilities of Managerial Economist

Studies Business Environment
The managerial economist is responsible for analyzing the
environment in which business operates. Proper study of all external
factors that affect the functioning of organization is must for proper
functioning. He studies various factors like growth of national income,
competition level, price trends, phase of the business cycle and
economy and updates the management regarding it from time to time.

Analyses Operations Of Business

He analyses the internal operation of business and helps
management in making better decisions in regard to internal workings.
Managerial economist through his analytical and forecasting skills
provides advice to managers for formulating policies regarding internal
operations of the business.
Demand Forecasting And Estimation
Proper estimation and forecasting of future trends helps the business
in achieving desired profitability and growth. Managerial economist
through proper study of all internal and external forces makes
successful forecasting of future uncertainties or trends.
Production Planning
Managerial economist is responsible for scheduling all production
activities of business. He evaluates the capital budgets of
organizations and accordingly helps in deciding timing and locating of
various actions.

Economic Intelligence
He provides economic intelligence services by communicating all
economic information to management. Managerial economist keeps
management always updated of all prevailing economic trends so that
they can confidently talk in seminars and conferences.
Performing Investment Analysis
A managerial economist analyzes various investment avenues and
chooses the most appropriate one. He studies and discovers new
possible fields of business for earning better returns.
Focuses On Earning Reasonable Profit
He assists management in earning a reasonable rate of profit on
capital employed in the business. Managerial economist monitors
activities of organizations to check whether all operations are running
efficiently as per the plans and policies.
Maintaining Better Relations
A managerial economist maintains better relations with all internal and
external individuals connected with the business. It is his duty to
develop a peaceful and cooperative environment within the
organization and aims to reduce any opposition taking place.
UNIT
2
The law of demand states that other factors being constant
(cetris peribus), price and quantity demand of any good and
service are inversely related to each other. When the price of
a product increases, the demand for the same product will
fall. Description: Law of demand explains consumer choice
behavior when the price changes. In the market, assuming
other factors affecting demand being constant, when the
price of a good rises, it leads to a fall in the demand of that
good. This is the natural consumer choice behavior. This
happens because a consumer hesitates to spend more for the
good with the fear of going out of cash.

The above diagram shows the demand curve which is

downward sloping. Clearly when the price of the commodity
increases from price p3 to p2, then its quantity demand
comes down from Q3 to Q2 and then to Q3 and vice versa.

We define demand as the quantity of a good or service that

consumers choose to buy at any possible price in a given
period.

When we refer to demand we are typically referring

to effective demand, which combines the will to buy
something with the purchasing power to buy it. If a
consumer doesn’t have the purchasing power, then they
have only a notional demand.

The factors that affect demand can be loosely grouped into

the following four categories:

 the price;
 your income;
 the price of other goods; and
 your preferences.

Market demand is the aggregate of all individuals demand,

that is the total quantity of a good or service that all
potential buyers would choose to buy at a given price.

In our following reasoning, we will make use of the

term ceteris paribus, which means that we will often
assume that all factors not under consideration remain
unchanged (literally: “all things being equal”). This has its
limitations, but it allows us to analyse individual
determinants.

A typical demand curve decreases from left to right,

reflecting the fact that the quantity of a product demanded
increases as the price decreases (this is known as the law of
demand, and holds true ceteris paribus).

Demand Forecasting
It is a technique for estimation of probable demand for a
product or services in the future. It is based on the analysis of
past demand for that product or service in the present market
condition. Demand forecasting should be done on a scientific
basis and facts and events related to forecasting should be
considered.
Therefore, in simple words, we can say that after gathering
information about various aspect of the market and demand
based on the past, an attempt may be made to estimate future
demand. This concept is called forecasting of demand.
For example, suppose we sold 200, 250, 300 units of product X
in the month of January, February, and March respectively.
Now we can say that there will be a demand for 250 units
approx. of product X in the month of April, if the market
condition remains the same.
Usefulness of Demand Forecasting
Demand plays a vital role in the decision making of a business.
In competitive market conditions, there is a need to take correct
decision and make planning for future events related to business
like a sale, production, etc. The effectiveness of a decision taken
by business managers depends upon the accuracy of the
decision taken by them.
Demand is the most important aspect for business for achieving
its objectives. Many decisions of business depend on demand
like production, sales, staff requirement, etc. Forecasting is the
necessity of business at an international level as well as
domestic level.

Demand forecasting reduces risk related to business activities and helps it to

take efficient decisions. For firms having production at the mass level, the
importance of forecasting had increased more. A good forecasting helps a firm
in better planning related to business goals.
There is a huge role of forecasting in functional areas of accounting. Good
forecast helps in appropriate production planning, process selection, capacity
planning, facility layout planning, and inventory management, etc.

Demand forecasting provides reasonable data for the

organization’s capital investment and expansion decision. It also provides a
way for the formulation of suitable pricing and advertisement strategies.
Following is the significance of Demand Forecasting:

 Fulfilling objectives of the business

 Preparing the budget
 Taking management decision
 Evaluating performance etc.

Moreover, forecasting is not completely full of proof and correct. It thus helps
in evaluating various factors which affect demand and enables management
staff to know about various forces relevant to the study of demand behavior.
The Scope of Demand Forecasting

The scope of demand forecasting depends upon the operated area of the firm,
present as well as what is proposed in the future. Forecasting can be at an
international level if the area of operation is international. If the firm supplies
its products and services in the local market then forecasting will be at local
level.

The scope should be decided considering the time and cost involved in relation
to the benefit of the information acquired through the study of demand. Cost of
forecasting and benefit flows from such forecasting should be in a balanced
manner.
Types of Forecasting

There are two types of forecasting:

 Based on Economy
 Based on the time period
1. Based on Economy

There are three types of forecasting based on the economy:

i. Macro-level forecasting: It deals with the general

economic environment relating to the economy as
measured by the Index of Industrial Production(IIP),
national income and general level of employment, etc.
ii. Industry level forecasting: Industry level forecasting deals
with the demand for the industry’s products as a whole.
For example demand for cement in India, demand for
clothes in India, etc.
iii. Firm-level forecasting: It means forecasting the demand
for a particular firm’s product. For example, demand for
Birla cement, demand for Raymond clothes, etc.
2. Based on the Time Period

Forecasting based on time may be short-term forecasting and long-term

forecasting

Short-term forecasting: It covers a short period of time, depending upon the

nature of the industry. It is done generally for six months or less than one
year. Short-term forecasting is generally useful in tactical decisions.
 i. Long-term forecasting casting: Long-term forecasts are
for a longer period of time say, two to five years or more.
It gives information for major strategic decisions of the
firm. For example, expansion of plant capacity, opening a
new unit of business, etc.

Demand Function
A demand function is a mathematical function describing the
relationship between a variable, like the demand of quantity,
and various factors determining the demand. The purpose of
this function is to analyze the behavior of consumers in a
market and to help firms make pricing decisions.
The demand function, or the demand curve, describes the
relationship between the quantity demanded by customers
and the product price. Thus, the price of goods becomes vital
in determining the number of goods consumers buy in a
market. The most common form of this function is the linear
demand function. However, economists often use different
functional forms apart from the linear process, such as
logarithmic and polynomial functions, to capture different
consumer behavior patterns.

Moreover, the process of demand describes the relationship

between the need for a product with that of other factors:
 Commodity demand: the demand for a commodity affects
the item’s price either positively or negatively.
 Commodity function: the quality of a commodity affects
demand.
 Goods or service prices: if the costs increase, demand
decreases.
 The expected price of the commodity in the future: if the
customers expect any change in their income or price change
of a product, the demand changes.
 Related products and services price: if the substitute
product’s price changes, then if the demand for the original
product changes, one can say the product is related to each
other as complement and substitute.
 Consumer’s pattern of taste: The company makes significant
investments in advertising to change the taste and preference
of consumers to like the advertised product.

We can refer to the above as the factors that affect demand. It

occurs because various factors influence the market for any
commodity. Furthermore, income is not a determinant in the
Marshallian demand function. Economist Alfred Marshall gave
his name to the Marshallian process of purchasing power.
Therefore, the market researcher can calculate the slope and
intercept of the economic demand function by forecasting
how price or other economic factors affect the requirement
for a specific product.

Price Elasticity of Demand

Price elasticity of demand is a measurement of the change in the
consumption of a product in relation to a change in its price.
Expressed mathematically, it is:

Price Elasticity of Demand = Percentage Change in Quantity

Demanded ÷ Percentage Change in Price
Economists use price elasticity to understand how supply and
demand for a product change when its price changes.
Harvard Business Review. “A Refresher on Price Elasticity.”
Like demand, supply also has an elasticity, known as price elasticity of supply. Price elasticity
of supply refers to the relationship between change in supply and change in price. It’s calculated
by dividing the percentage change in quantity supplied by the percentage change in price.
Together, the two elasticities combine to determine what goods are produced at what prices.

Understanding Price Elasticity of Demand

Economists have found that the prices of some goods are
very inelastic.2 That is, a reduction in price does not increase
demand much, and an increase in price does not hurt demand, either.
For example, gasoline has little price elasticity of demand. Drivers will
continue to buy as much as they have to, as will airlines, the trucking
industry, and nearly every other buyer.

Other goods are much more elastic, so price changes for these goods
cause substantial changes in their demand or their supply.2

Not surprisingly, this concept is of great interest to marketing

professionals.1 It could even be said that their purpose is to create
inelastic demand for the products that they market. They achieve that
by identifying a meaningful difference in their products from any
others that are available.

If the quantity demanded of a product changes greatly in response to

changes in its price, it is elastic. That is, the demand point for the
product is stretched far from its prior point. If the quantity purchased
shows a small change after a change in its price, it is inelastic. The
quantity didn’t stretch much from its prior point.

Factors That Affect Price Elasticity of Demand

Availability of Substitutes
The more easily a shopper can substitute one product for another, the
more the price will fall. For example, in a world in which people like
coffee and tea equally if the price of coffee goes up, people will have
no problem switching to tea, and the demand for coffee will fall. This
is because coffee and tea are considered good substitutes for each
other.
Urgency
The more discretionary a purchase is, the more its quantity of
demand will fall in response to price increases. That is, the product
demand has greater elasticity.3

Say you are considering buying a new washing machine, but the
current one still works; it’s just old and outdated. If the price of a new
washing machine goes up, you’re likely to forgo that immediate
purchase and wait until prices go down or the current machine breaks
down.

The less discretionary a product is, the less its quantity demanded will
fall. Inelastic examples include luxury items that people buy for their
brand names. Addictive products are quite inelastic, as are required
add-on products, such as inkjet printer cartridges.

One thing all these products have in common is that they lack good
substitutes. If you really want an Apple iPad, then a Kindle Fire won’t
do. Addicts are not dissuaded by higher prices, and only HP ink will
work in HP printers (unless you disable HP cartridge protection).
Duration of Price Change
The length of time that the price change lasts also matters.3 Demand
response to price fluctuations is different for a one-day sale than for a
price change that lasts for a season or a year.
Clarity of time sensitivity is vital to understanding the price elasticity of
demand and for comparing it with different products. Consumers may
accept a seasonal price fluctuation rather than change their habits.

Types of Price Elasticity of Demand

Price elasticity of demand can be categorized according to the
number calculated by dividing the percentage change in quantity
demanded by the percentage change in price. These categories
include the following:

Types of Price Elasticity of Demand

If the percentage change in quantity It is known Which means:
demanded divided by the percentage change as:
in price equals:

Infinity Perfectly Changes in price result in demand

elastic declining to zero

Greater than 1 Elastic Changes in price yield a

significant change in demand

1 Unitary Changes in price yield equivalent

(percentage) changes in demand

Less than 1 Inelastic Changes in price yield an

insignificant change in demand

0 Perfectly Changes in price yield no change

inelastic in demand

consumer surplus
consumer surplus, also
called social
surplus and consumer’s surplus,
in economics, the difference between
the price a consumer pays for an item
and the price he would be willing to
pay rather than do without it. As first
developed by Jules Dupuit, French
civil engineer and economist, in 1844
and popularized by British
economist Alfred Marshall, the
concept depended on the assumption
that degrees of consumer satisfaction
(utility) are measurable. Because the
utility yielded by each additional unit
of a commodity usually decreases as
the quantity purchased increases, and
because the commodity’s price
reflects only the utility of the last unit
purchased rather than the utility of
all units, the total utility will exceed
total market value. A telephone call
that costs only 20 cents, for example,
is often worth much more than that
to the caller. According to Marshall,
this excess utility, or consumer
surplus, is a measure of the surplus
benefits an individual derives from
his environment.
If the marginal utility of money is
assumed to be constant for
consumers of all income levels and
money is accepted as a measure of
utility, the consumer surplus can be
shown as the shaded area under the
consumer demand curve in the
figure. If the consumer purchases MO
of the commodity at a price of ON or
ME, the total market value, or
amount he pays, is MONE, but the
total utility is MONY. The differences
between them are the shaded area
NEY, the consumer surplus.
The concept fell into disrepute when
many 20th-century economists
realized that the utility derived from
one item is not independent of the
availability and price of other items;
in addition, there are difficulties in
the assumption that degrees of utility
are measurable.
The concept is still retained by
economists, in spite of the difficulties
of measurement, to describe the
benefits of purchasing mass-
produced goods at low prices. It is
used in the fields of welfare
economics and taxation. See utility
and value.