Unit – I

1
 Definition
Managerial Economics can be broadly
defined as the study of economic theories,
logic and tools of economic analysis that
are used in the process of business
decision making

2
 Introduction
Emergence of Managerial Economics
contributed by –
• Growing complexity of business decision
making process due to change in market
conditions and business environment
• Increasing use of economic logic, concepts,
theories, and tools of economic analysis in the
process of business decision making
• Rapid increase in demand for professionally
trained managerial man power
3
 Scope of Managerial Economics
Comprises economic concepts, theories and tools
of analysis which can be used to analyze issues
related to demand prospects, production cost,
market structure, level of competition and
general business environment and to find
solutions to practical business problems

4
 Meaning of Managerial Economics
Managerial economics is a discipline that combines
economic theory with managerial Practices
• The subject offers powerful tools and techniques
for managerial policy making. An integration of
economic theory and tools of decision sciences works
successfully in optimal decision making
• Study of managerial economics enriches the
analytical skills, helps in the logical structuring of
problems, and provides adequate solution to the
economic problems,

5
 Nature of Managerial Economics
Ragnar Frisch divided economics in two broad
categories – macro and micro. Macroeconomics is
the study of economy as a whole. It deals with
national income, unemployment, inflation, fiscal
policies and monetary policies.
Microeconomics is concerned with the study of
individuals like a consumer, a commodity, a market
and a producer. Managerial Economics is micro-
economics in nature because it deals with the study
of a firm, which is an individual entity. It analyses
the supply and demand in a market, the pricing of
specific input, the cost structure of individual goods
and services and the like.
 Managerial Economics and other
disciplines
Mathematical Tools – Linear Programming,
Inventory models and Game theory – helps in
decision making
Statistics – Theory of probability, forecasting
techniques, regression analysis
Operation Research - It is an inter – disciplinary
technique of finding the solutions to managerial
problems. It is combination of economics,
mathematics and statistics

7
Management theory and Accountancy:
Management theory brings out the behavior of
the organization.
Accounting reflects the functioning and
performance of the organization.

8
CIRCULAR FLOW OF INCOME
 Introduction
• The term circular flow of income or circular flow
of economic activity refers to a simple
economic model which describes the
circulation/flow of income between producers
and consumers.
• In the circular flow model, producer is referred to
as firms and consumer are referred to as
households.
• The major exchanges are represented as
flows of money, goods and services, etc.
 Determinants

Household Firm

Financial Foreign sector

Government
institutions
 Household
• It is a person or group of people that share their
income.
• Require goods and services to satisfy their
personal wants.
• Owns all resources ( i.e. labor, capital, land
enterprise)
• The members of households have two
functions.
1. They supply different factors of production.
2. Members of household also work as
consumers.
 Firms
• An organization that produces goods and services for
sale.
• Main objective is to maximize profit in the production
process
• Uses resources provided by households to products
goods and services
• Sells those good and services for income
• The two main functions are as follows:
1. Produce goods and series and supply them in the
market
2. Firms purchase inputs or raw materials from households
to use them in the production process.
 Government
• Just like households and firms the government
also earns incomes and makes expenses.
• Two major functions are:
1. Government earns revenue from either tax or
non tax sources both from households and
firms.
2. Government provides essential public services
such as maintenance of law and order, defense
services, judiciary etc.
 Financial institutions
• Consists of banks and non-bank
intermediaries who engage in the borrowing
(savings from households) and lending of
money
• The leakage that financial institutions provide
in the economy is the option for households
to save their money.
 Foreign sector
• It consists of two kinds of international
economic transactions i.e.
1. Export and import of goods and services
2. Inflow and outflow of capital.
 Two Three
sector
Four sector
Five
sector sector
 Two sector model
• In the basic circular flow of income, or two sector circular
flow of income model, the state of equilibrium is defined as
a situation in which there is no tendency for the levels of
income (Y), expenditure (E) and output (O) to change, that
is:
• Y=E=O
• This means that the expenditure of buyers (households)
becomes income for sellers (firms). The firms then spend
this income on factors of production such as labour, capital
and raw materials, "transferring" their income to the factor
owners. The factor owners spend this income on goods
which leads to a circular flow of income.
 Three sector model
• It includes household sector, producing sector
and government sector.
• Here flows from household sector and producing
sector to government sector are in the form of
taxes.
• The income received from the government
sector flows to producing and household sector
in the form of payments for government
purchases of goods and services as well as
payment of subsidies and transfer payments.
 Four sector model
• A modern monetary economy comprises a network of four
sector economy these are:
1. Household sector
2. Firms or Producing sector
3. Government sector
4. Financial sector.
• Each of the above sectors receives some payments from
the other in lieu of goods and services which makes a
regular flow of goods and physical services. Money
facilitates such an exchange smoothly.
• Financial institutions role it is to accept and protect the
savings of consumers and to make investment funds
available to producers.
 Five sector model
• In the five sector model the economy is
divided into five sectors:
1. Household sector
2. Firms or Producing sector
3. Financial sector :
4. Government sector
5. Rest of the world sector: transforms the model
from a closed economy to an open economy.
• Leakage means withdrawal from the flow. When
households and firms save part of their incomes
it constitutes leakage. They may be in form of
savings, tax payments, and imports. Leakages
reduce the flow of income.
• Injection means introduction of income into the
flow. When households and firms borrow the
savings, they constitute injections. Injections
increase the flow of income. Injections can take
the forms of investment, government spending
and exports.
 The state of equilibrium
• In terms of the five sector circular flow of
income model the state of equilibrium occurs
when the total leakages are equal to the total
injections that occur in the economy. This
can be shown as:
• Savings + Taxes + Imports = Investment +
Government Spending + Exports
• S+T+M≠I+G+X
• If the state of the sum of total leakages does
not equal the sum of total injections it will
result in disequilibrium. Disequilibrium can be
shown as:
• Savings + Taxes + Imports ≠ Investment +
Government Spending + Exports
• S+T+M≠I+G+X
 Significance
• Measurement of national income - National income is an
estimation of aggregation of any of economic activity of the circular
flow. It is either the income of all the factors of production or the
expenditure of various sectors of economy.
• Knowledge of interdependence - Circular flow of income signifies
the interdependence of each of activity upon one another. If there
is no consumption, there will be no demand and expenditure which
in fact restricts the amount of production and income.
• Unending nature of economic activities - It signifies that production,
income and expenditure are of unending nature, therefore,
economic activities in an economy can never come to a halt.
National income is also bound to rise in future.
• Injections and Leakages
 FUNDAMENTAL CONCEPTS OF
MANAGERIAL ECONOMICS
These concepts and tools help in reasoning and
precise thinking and useful in managerial
decision-making.
Opportunity cost:
It is the amount of subjective value foregone in
choosing one alternative over the next best
alternative.
Marginal principle
Marginal analysis helps to assess the impact of
a unit change in one variable on the other.
For example: A firms’ decision to change prices
would depend on the resulting change in
marginal revenue and marginal cost. Changes in
these variables would, in turn, depend on the
units sold as a result of a change in price.
Change in the price is desirable if the additional
revenue earned is more than the additional cost.
Similarly, decision on additional investment is
taken on the basis of the additional return from
that investment, that is, the marginal changes.
Incremental principle: This concept applies to
changes in revenue and cost due to a policy
change.

For example, additional cost of installing

computer facilities will be incremental cost and
the additional revenue earned due to access to
Internet will be incremental revenue.

Thus, a change in output because of a change in

process, product or investment is regarded as an
incremental change
 Time perspective principle
Manager should consider both short run and
long run while taking decisions. Economists
regard short run as the current period whereas
long run as a future period. Some inputs of
production are regarded as fixed in the short run.
It is a time period in which the existing producers
respond to price changes by using more or less of
their variable inputs. From the standpoint of
consumers, the short run is a period in which
they respond to price changes with the prevalent
tastes and preferences.
Long run is a time period in which new sellers
may enter a market or a seller already existing
may leave. This time period is sufficient for both
old and new sellers to vary all their factors of
production. From the standpoint of consumers,
long run provides enough time to respond to
price changes by actually changing their tastes
and preferences or their alternative goods and
services.
 Discounting principle
Discounting principle states that when 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. This is because money
has time value, that is, a rupee to be received in
the future is not worth a rupee today.
Therefore, it is necessary to have techniques for
measuring the value today (i.e.,the present value)
of rupee to be received or paid at different points
in future.
 Business Decision Making

Economic Theory Quantitative Techniques

Supply, Demand, Cost, Mathematical Economics,
Competition, Econometrics

Managerial economics
Application of Economic theory and Quantitative
techniques to solve Managerial Decision Problems

Optimal Decision Making

 Decision making process involves the
following steps
Step 1: Establish the objectives - Identification
of objective of the organisation is necessary to
make a decision. Unless one knows what is to be
achieved, there is no sensible way to make a
decision.
Step 2: Define the problem – Specification of the
problem is a crucial part of decision making.
The problem may arise due to firm’s planning
process or may be prompted by new
opportunities.
37
Step 3: Identification of alternatives – Once the
problem is defined, possible courses of action
should be identified. After addressing the
question, “What do we want?”, it is natural to
ask, “What are our options?” The decision-
maker should identify the variables under his
control and the constraints that limit his choice.
Step 4: Selection of best alternative – Having
identified the set of alternative possible solutions,
revenues and costs associated with each course of
action should be stated. Then the best possible
alternative should be selected, given the goals of
the firm. 38
Step 5: Implement the decision – Once an
alternative is chosen, it must be implemented in
order to be effective. Even organisations as
disciplined as armies, find it difficult to carry out
orders effectively.

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Theory of the Firm
 What is a Firm?
• Firm is a unit of organization that
transforms inputs into outputs.
*Produces homogeneous commodity
*Technology is represented by a production
function.

• Neoclassical Theory: Firm as a collection of Resources that

is transformed into products demanded by the consumers.

• Cost of Production: Governed by available Technology

• Output Produced and Selling Price are determined by Market

Structure

• Aim of firm: Maximize Profit

4/18/2016 41
 Large Firm vis-à-vis Small Firm
IF COST OF PRODUCTION DECLINES in a FIRM then Why can’t there be a Large
ONE Firm like Hindustan Lever, Proctor & Gamble so on (which produce
variety of goods and Services)?

Cost of Organizing Transactions increases with increase in Size of Firm

Sometimes Internal Transaction Cost is equal to Transacting in the Market

Ex: SHOULD AUTOMOBILE PRODUCERS (General Motors) BUY TYRE from

MRF,
GOODYEAR or Build Plant to Produce Own Tyre .

Cost of Developing New Management Skill for a Different Type of Production

(TYRE) can be Higher.

4/18/2016 42
 Rationale of having Small Firm
• Limitations of Entrepreneur’s Organizational Skill:
If firm size exceeds the manager’s ability to control the
operation then resources may not be efficiently allocated in
the firm.

Production cost Per unit of Output tends to rise as firms grow

larger because of limited managerial ability-Known as
DIMINSHING RETURNS TO MANAGEMENT

The Way out: Decentralize by Establishing number of

separate divisions or profit centre

4/18/2016 43
 Why do firms Exist…….?
• Ronald Coase (1937): Production is organised in firm rather
than through series of Individual contracts. Why?

– To reduce Transaction Cost

– Higher Productivity under Team Work

(Group production can offer Benefit of Specialization)

Drawbacks: ‘Shirking’ and ‘Free-riding’ in Group Production

Difficult to Assess Contribution of Each Employee

The Way Out: Hire Monitor to Discipline the Team.

Solution: Compare Benefit of Greater Productivity under group

Production with Cost of Monitoring
Offer Incentives (BONUS, PERKS) etc to IMPROVE PRODUCTIVITY
4/18/2016 44
 Firm and Industry: A
Comparison
Industry: A group of firms producing the SAME
product or SIMILAR product.

Exp: Sugar & Automobile Industry

Number of firms selling cheese, butter, milk are

part of Dairy Industry
(Nandini, Amul, Indore Dairy….)

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 Objectives of Firm
• Profit Maximization (Max. Market Share)-
Major Goal

• Subsidiary Goals: Large volumes of sales/

Company Image

• But can a firm afford to Maximize profit

always by compromising on Ethical Issues?

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Unit : 2
Demand
ANALYSIS
 DEMAND
• Quantity Demanded refers to
the amount (quantity) of a
good that buyers are willing
to purchase at alternative
prices for a given period.
 Determinants of Market Demand
•Price of the product
•Price of the related products – Substitutes,
compliments and supplements
•Consumers Income
•Consumers taste and preference
•Advertisement of the product
•Consumers’ expectations about future price
and supply position
•Consumer credit facility
•Population of the country
•Distribution pattern of National Income
50
Types of Demand

51
 Types of Demand
Individual demand: It is the quantity of a commodity
demanded by an individual consumer at a particular
price during a given period of time.
Market demand: It is the total quantity of a
commodity demanded by all the consumers in the
market during a given period of time.
Complimentary Demand:
When two or more commodities are jointly needed to
satisfy a single want, then the demand for such
goods are said to be joint demand.
Ex: pen &ink, car &petrol
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Autonomous or Direct demand: Spontaneous
demand for goods, based on an urge to satisfy some
wants directly is called autonomous demand. Ex:
Consumer goods
Indirect demand : Goods that are not used directly by
consumers, but used by producers Ex: Yarn to
produce cloth
Derived demand:
When demand for a commodity gives rise to demand
for another commodity, then it is said to be as a
derived demand Ex: Demand for doors and windows
derived from demand from houses, demand for
antennas derived from demand for TV sets
53
Industry demand: Total demand for the commodity
produced by a particular industry Ex: Total demand
for cars in India.
Firm or company demand: Market demand for the
commodity produced by one company
Ex: Maruthi – Alto
Composite demand: When a commodity is demanded
for a number of uses, then the demand for that
commodity is said to composite in nature. Ex: Steel,
electricity

54
Composite demand:
When a commodity is demanded for a number of
uses, then the demand for that commodity is said to
composite in nature. Ex: Steel, electricity

Price Demand: Various quantities of a product

purchased by the consumer at alternative prices.
The demand function is based on the single price.
Thus: D = f (p), f = functional relationship, D =
demand, p = price

55
Income demand: Various quantities of a
commodity demanded by the consumer at
alternative levels of his changing income.
Demand function is based on the income variable
(M) Thus: D = f(M)
Cross Demand: Various quantities of commodity
( say- X) purchased by the consumer in relation
to changes in the price of a related commodity
(say- Y, which may be either a substitute or a
complimentary product)
Cross demand function = Dx = f (Py)
Dx = demand for the commodity X, Py = price of
the commodity Y , f = functional relationship.
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• Long-term demand: Demand exists for long
period Ex: Consumer and producer goods
• Short-term: Demand exists for short period Ex:
seasonal products
• Demand for durables: Goods with long shelf
life Ex: Furniture, clothes
• Demand for non-durables: Goods with short
shelf life Ex: : Milk. Egg, fish
Demand for Substitute goods : Two commodities
are considered to be substitutes for one another,
If they satisfy the same want and change in price
of the one affects the demand for the other in
same direction Ex: Tea and coffee 57
Demand Function

58
 Demand Function
Demand function is a mathematical technique of stating the
relationship between any two or more variables having cause
effect relationship.
Ex: Relationship between the demand for a product
(dependent variable) and its determinants (Independent
variables) – bi-variable function, one dependent variable and
more than two independent variables – multi-variable
function.
- X is the commodity and its all determinants remain constant
-Price is not constant
-Quantity demanded of X (Dx) depends on its price (Px)
-Market demand function can be symbolically written as Dx =
f(Px)
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• Dx is the dependent variable
• Px is the independent variable
• Change in Px causes change in Dx
• The form of a demand function depends on the
nature of demand – price relationship.
• Bi-variable function - Two independent
variable.
• Multi-variable function more than two
independent variables.
The most common forms of demand functions
are linear and non – linear demand function
60
 Demand Curve
&
Demand schedule
61
 Demand Curve
Law of Demand : All other things remaining
constant, the quantity demanded of a commodity
increases when its price decreases and decreases
when its price increases.
Demand schedule: is a tabular presentation of
different prices of a commodity and its
corresponding quantity demanded per unit of
time*
Demand Curve: is a graphical presentation of the
demand schedule. A demand curve obtaining by
plotting a demand schedule*
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 Demand Schedule
Price of Ice-cream Quantity of cones
Cone Demanded
0.00 12

0.50 10

1.00 8

1.50 6

2.00 4

2.50 2

3.00 0
 Demand Curve
Price of
Ice-Cream
Cone
3.00

2.50

2.00

1.50

1.00

0.50

0 2 4 6 8 10 12 Quantity of Ice-
Cream Cones
 Linear & Non linear demand curve
When the demand curve turns out
to be a straight line , it is called a
D LINEAR DEMAND CURVE
Y At high price OP1, demand is OQ1,
P1
At low price – OP2 large quantity is
P
R
demanded OQ2
I P2 Its slope is negative but constant,
C means proportionate inverse
E D
relationship between Price and
O Q1 Q2 X quantity demanded at each stage and
Quantity Demanded point on the demand curve.
In case of NON LINEAR DEMAND CURVE the
relationship between quantity demanded and price is
disproportionate
65
 Change in Quantity demanded
( Movement along the demand curve)

A movement along the demand curve is caused by a change in the

price of the commodity and other things remaining constant.
Movement is always along the same demand curve.
Two types of Curves: Expansion and Contraction of demand
A – Original situation, B – Contraction- less quantity demanded at
higher price C – Expansion – more quantity demanded at lower
price 66
 Increase in Demand Decrease in Demand

Increase and decrease in demand: Change in demand is a result

of the change in the conditions or factors determining demand
other than the price. A change in the demand implies an increase
or decrease in demand. When more of a commodity is bought
than before at any given price, there is an increase in demand,
same way if the consumer bought less commodity at same price,
then the demand is decreasing. (Keeping the price same)
When increase in demand the demand curve shifts UPWARD or
to the right and decrease in demand curves shifts DOWNWORD
or the left. 67
 Marginal Utility Analysis

Utility
Product angle - Want satisfying property of a
commodity
Consumer’s angle – Utility is the psychological
feeling of satisfaction, pleasure, happiness or
well-being, which a consumer derives from the
consumption, possession or the use of a
commodity

68
Assumptions: The law of diminishing
marginal utility holds only under certain
conditions
• Consumer goods must be standard
• Consumer’s taste or preference must remain
the same during the period of consumption.
• There must be continuity in consumption, the
time interval between the consumption of two
units must be appropriately
• Mental condition of the consumer must remain
normal during the period of consumption.
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 Total Utility
The sum of the utility derived by a consumer
from the various units of a goods or service he
consumes at a point or over a period of time.

A Consumer consumes four units of commodity

–X at a time or over a period of time and derives
utility from the successive units of consumption
as u1,u2,u3,u4. His total utility Ux from the
commodity x measured as Ux = u1+u2+u3+u4

70
Elasticity
of
Demand

71
 Elasticity of Demand
Elasticity of demand (Ed) measures the degree of
responsiveness of quantity demanded of a
product to changes in its own price. In
mathematical form it is expressed as:
Percentage change in quantity demanded
Ed = Percentage change in price

OR Ed = ∆Q/Q D Q = change in quantity demanded

D P = change in price
∆P/P Q = Original quantity demanded
P = Original Price

72
 Categories
Depending on how the total revenue changes, when
price changes we can classify all demand curves in the
following five categories:
1. Perfectly elastic (Infinitely) demand curves.
2. Perfectly Inelastic (completely) demand curve.
2. Relatively elastic demand curves.
3. Relatively inelastic demand curves.
4. Unitary elastic demand curves.
73
Elasticity co Terminology Description
efficient
e=a Perfectly elastic OR Consumers have infinite demand
(Infinitely) at a particular price and none at all
at an even slightly higher than this
given price
e=0 Perfectly inelastic Demands remains unchanged what
(Completely) ever be the change in price

e >1 Relatively elastic Quantity demanded changes by a

larger percentage than does price

e <1 Relatively inelastic Quantity demanded changes by a

smaller percentage than does
price

E=1 Unitary elastic Quantity demanded changes by

exactly the same percentage than
does price

74
 NUMERICAL MEASUREMENT OF
ELASTICITY
What does it mean to say that the elasticity of
demand is 0.5? 0.4? 2.3?. To answer this question
we have to examine the following definition for
elasticity coefficient (Ed).

Elasticity Coefficient (Ed):

Ed = Percentage change in quantity demanded

Percentage change in Price

75
 Change in the quantity demanded
Original quantity demanded
Ed = Change in the price
Original price
Q1 – Qo
Qo
Formula = P1 – Po
Po

Po - Original price, P1 – New price,

Qo = Original quantity, Q1 = New quantity
∆Q
Ed = Q
∆P
P 76
Price Elasticity of Demand

77
 Price Elasticity of Demand
The responsiveness or sensitivity of
consumers to a price change is measured
by a product’s Price elasticity of demand.

Price elasticity of demand shows that how

much quantity demanded of a commodity
changes when its price changes.

The most common elasticity measurement is

that of price elasticity of demand. It
measures how much consumers respond
in their buying decisions to a change in
price.
78
 There are five types of price elasticity
of demand:
• Unit elasticity

• Relatively elastic

• Relatively inelastic

• Perfectly inelastic

• Perfectly elastic
79
Price elasticity can be measured with the
following equation-

Price elasticity of demand =

% change in quantity
% change in price

80
Perfectly
Perfectly elastic(Ed=
elastic(Ed= ∞)
∞)

81
 Perfectly elastic(Ed= ∞)
The prices of a commodity is totally unresponsive
to changes in quantity demanded that means there
is no change in price when quantity demand
changes.
Price = 4, 4 & Quantity Demanded = 120, 150
When price is 4, quantity demanded is 120. When
no change in price brings a change in quantity
demanded from 120 to 150. There is no change in
price of a commodity… 82
 Perfectly Elastic Demand Curve

ED =
4 D
Price

0 150 Quantity
120
Perfectly Elastic
83
Here, Price=4, QD=120

Price=4, QD=150
QD=150-120=30
P = 4-4= 0
By using equation we can say,
Ed= (QD/P) × (P/QD)
= (30/0 × 4/120) = ∞
84
 Perfectly
Perfectly
Inelastic(Ed=0)
Inelastic(Ed=0)

85
 Perfectly Inelastic(Ed=0)
The quantity demanded is totally unresponsive to
changes in price that means there is no change in
quantity demanded when its price changes.

Price = 4, 3 & Quantity Demanded =120, 120

When price is 4, quantity demanded is 120. When

price decreases from 4 to 3 then quantity
demanded are still 120. There is no change in
quantity demanded...

86
 A Perfectly Inelastic Demand Curve

D'
Price

ED = 0
3

0 120 Quantity

Perfectly Inelastic 87
Here, Price=4, QD=120
Price=3, QD=120
QD=120-120=0
P = 4-3= 1
By using equation we can say,
Ed= (QD/P) × (P/QD)
= (0/1 × 4/120) = 0
88
Relatively
Relatively Elastic(Ed
Elastic(Ed >1)
>1)

89
 Relatively Elasticity(Ed>1)
A small change in the price of the
commodity leads to a more than
proportionate change in the
quantity demanded. That means
change in the quantity demanded is
greater than change in price.

Ex: Luxurious goods like video

cassette and television and
substitutes goods are included in
more elastic demand.
90
 A More Elastic Demand Curve
Price

ED > 1
3

D
0 120 160 Quantity demand

Relatively Elastic 91
 Price = 4,3 Quantity Demanded=120,160

When price is 4, quantity demanded is 120. When

price decreases from 4 to 3 then quantity
demanded is increased at a greater rate from
proportionate change that is 120 to 160.The
change is more than proportionate change.

92
Here, Price=4, QD=120
Price=3, QD=160
QD=160-120=40
P = 4-3= 1
By using equation we can say,
Ed= (QD/P) × (P/QD)
= (40/1 × 4/120) =1.33
93
 Relatively
Relatively
Inelastic(Ed<1)
Inelastic(Ed<1)

94
 A More Inelastic Demand Curve
Price

4
ED < 1
3

D
0 120 140 Quantity demand
Relatively Inelastic
95
 Relatively Inelastic(Ed<1)
A change in price will bring about a less than
proportionate change in the quantity demanded.
That means the change in the quantity demanded is
lower than change in price.

Ex: Basic necessities goods (rice, salt) are included

in this case.

Price = 4, 3 Quantity Demanded = 120, 140

96
 When price is 4, quantity demanded is 120.
When price decreases from 4 to 3 then
quantity demanded is increased at a lower rate
from proportionate change that is 120 to 160.
Here, Price=4, QD=120
Price=3, QD=140
QD=140-120=20
P = 4-3= 1
By using equation we can say,
Ed= (QD/P) × (P/QD)
= (20/1 × 4/120) =0.66
97
Unit
Unit elasticity(Ed=1)
elasticity(Ed=1)

98
 Unitary elasticity(Ed=1)

A change in the price of a good will bring

about a proportionate change in the
quantity demanded.
That means the rate of change between
price and quantity demanded is same.
If price decrease 50 percent then
quantity demanded will be increased
50 percent.
99
 Unit Elasticity

A Unit Elastic Demand Curve

Price

ED = –1
4

3
D''

0 120 150 Quantity demand

100
Price = 4, 3 & Quantity Demanded= 120, 150
When price is 4, quantity demanded is 120.
When price decreases from 4 to 3 then
quantity demanded is also changed but
proportionately. Then the quantity
demanded is 150.

101
Here, Price=4, QD=120
Price=3, QD=150
QD=150-120=30
P = 4-3= 1
By using equation we can say,
Ed= (QD/P) × (P/QD)
= (30/1 × 4/120) = 1

102
 Factors that determine the price
Elasticity of demand

1. Availability of close substitutes – price elasticity

of demand will tend to be:
- High if there are close substitutes.
- Low if there are no close substitutes.

2. Necessities vs. luxury goods - price elasticity of

demand tend to be:
- Low if the good is a necessity
- High if the good is a luxury 103
3. Time - long-run p rice elasticity of demand is
often higher than the short-run elasticity

4. Price relative to income - price elasticity of

demand will tend to be:
- High if the price of the good is high relative to
income
- Low if the price of the good is low relative to
income.

104
• Arc elasticity: The measure of elasticity of
demand between any two finite points on a
demand curve is known as Arc elasticity
•Point elasticity: Measure of elasticity of demand
at a point on a demand curve is known as Point
elasticity.
105
 Arc elasticity
Movement from J to K on the curve
Fall in price = 20 – 10 = 10
Increase in demand = 75 – 43 = 32

ep = ∆ Q P 32 20 = 1.49
∆P Q 10 43

106
 Point Elasticity(Geometric Method)
Point elasticity = Lower segment of the curve
Upper segment of the curve

e=L PB
U PA
AB is the straight line demand curve
P is the given point
PB = 3 cm
PA = 2 cm

107
 Types of elasticities of demand
Demand depends not only on own price but also
on other factors.
•Cross (Price) Elasticity of Demand
•Income Elasticity of Demand
•Elasticity of Demand with Respect to
Advertisement

108
 Cross (Price) elasticity of demand
In cross elasticity of demand we take into account
the change in the price of the commodity Y and
its effect on the demand for commodity X. The
concept of cross elasticity is important in the case
of commodities which are substitutes - tea &
coffee and complimentary: Car and petrol, pen &
ink.
109
Definition: Degree of responsiveness of demand
for a commodity to a given change in the price of
some related commodity.
The cross elasticity of demand between any two
commodities X and Y is measured by dividing the
proportionate change in the quantity demanded
of X by the proportionate change in the price of Y

Cross elasticity of demand :

Proportionate or % change in demand for X
Proportionate or % change in price for Y

110
exy = ∆Qx ÷ ∆Py OR ∆Qx X Py
Qx Py ∆Py Qx
exy = cross elasticity of demand (demand for X
in relation to the price of Y)
• ∆Qx = change in the quantity demanded for
commodity X
• Qx = Initial demand for X
• Py = Initial price of commodity Y
• ∆Py = Change in price of commodity Y
(Preferably d instead of ∆ is used to represent a
point change)
111
 Income Elasticity of Demand
The income elasticity is defined as a ratio
percentage OR proportional change in the
quantity demanded to the percentage OR
proportional change in income.
Income elasticity co-efficient is measured by the
following formula:
= Percentage change in quantity demanded
Percentage change in income
em = % ∆ Q
%∆ M
112
 ∆Q X M OR ∆Q . M
Q ∆M ∆M Q

•∆Q is change in demand

•Q is Initial demand
•M is initial income
•∆M is change in income

113
Advertising or Promotional Elasticity of demand
The market demand is influenced through
advertisement or promotional efforts
Demand function is = Q = f (A)
Qx = demand for the product X measured through the
quantity sold in the market
A = is advertisement expenditure of the firm
The degree of responsiveness of demand to changes in
advertising or promotional elasticity of demand
(ea)measured 114
ea = % or proportionate change in the sales
% or proportionate change in advertisement expenditure

ea = %∆Q, Q is quantity of sales

%∆A, A is Advt. expenditure

115
DEMAND FORECASTING
 DEMAND FORECASTING
• DEMAND FORECASTING MEANS PREDICTING
OR ESTIMATING THE FUTURE DEMAND FOR A
PRODUCT .

• IT IS UNDERTAKEN FOR THE PURPOSE OF

PLANNING AND MAKING LONGTERM DECISIONS
 Business Decision Making –Use of
Demand Forecasting
• Forward Planning and Scheduling
• Acquiring Inputs
• Making provision for finance
• Formulating pricing strategy
• Planning advertisement
 Forecasting Horizons.
• Short Term (0 to 3 months): for inventory
management and scheduling.
• Medium Term (3 months to 2 years): for
production planning, purchasing, and
distribution.
• Long Term (2 years and more): for capacity
planning, facility location, and strategic
planning.
 Steps in Demand Forecasting

• Specifying the Objective

• Determining the time Perspective and type of
good
• Selecting a proper method of forecasting
• Collection of data
• Interpretation of results
Factors involved in Demand Forecasting
Demand forecasting is undertaken at three levels:
a. Macro-level
b. Industry level eg., trade associations
c. Firm level
- Should the forecast be general or specific (product-
wise)?
- Problems or methods of forecasting for “new” vis-à-vis
“well established” products.
- Classification of products – producer goods, consumer
durables, consumer goods, services.
- Special factors peculiar to the product and the market –
risk and uncertainty. (eg., ladies’ dresses)
 Criteria of a good forecasting method

1 . Simplicity and ease of comprehension.

2. Accuracy – measured by (a) degree of deviations

between forecasts and actual, and (b) the extent of success
in forecasting directional changes.
3. Economy.
4. Availability.
5. Maintenance of timeliness.
 Demand Forecasting
General considerations:
1. Purposes of forecasting
2. Determinants of demand
3. Length of forecasts
4. Forecasting demand for new products
5. Criteria of a good forecasting method
6. Presentation of a forecast to the management
7. Methods of demand forecasting
8. Approach to forecasting
 Production Function
A production function defines the relationship
between inputs and the maximum amount that
can be produced within a given period of time
with a given level of technology.
Decisions on input and output are taken after
considering various technological specifications.
The technological information is summarized in
the equation Q = Q (L, N, K.................)
Mathematically, the production function can also
be shown as: Q = f (X1, X2 ...............Xk)

124
SURVEY METHODS
 Techniques of Demand Forecasting-
Survey Methods

Though statistical techniques are essential in

clarifying relationships and providing
techniques of analysis, they are not
substitutes for judgement. What is needed is
some common sense mean between pure
guessing and too much mathematics.
 Delphi Method
• Delphi method: it consists of an effort to arrive at a
consensus in an uncertain area by questioning a
group of experts repeatedly until the results appear
to converge along a single line of the issues causing
disagreement are clearly defined.
• Developed by Rand Corporation of the U.S.A in
1940s by Olaf Helmer, Dalkey and Gordon. Useful
in technological forecasting (non-economic
variables).
 STATISTICAL METHODS

• Statistical methods are considered to be

superior due to the following reasons :
• The element of subjectivity is minimum

• Method of estimation is Scientific.

• Estimates are more reliable.

• It is very economical method.

 CONSUMER SURPLUS

 Consumers buy goods because it makes

them better off (or provide utility).
Consumer Surplus measures how much
better off they are.
 Consumer Surplus

 from each unit: The amount a buyer

is willing to pay for a good minus the
amount the buyer actually pays for it.
 CONSUMER SURPLUS
P

Price

D
Qx
0
 CONSUMER SURPLUS AND DEMAND

 Consumer surplus for a given quantity is

therefore the difference between your
maximum willingness to pay (reservation
price) and what you actually paid
(actual price).
 CS = the sum of the difference between
reservation price and actual price for all
units consumed
CONSUMER
SURPLUS
EXAMPLE
 What happens when you purchase
something for a price that is less than your
maximum willingness to pay?
 E.g. you are willing to pay Rs. 20,0000 for a
new car and you buy it for 18,0000
 You receive a “surplus” of benefit over cost =
Rs.2,0000
Unit No. 3

134
Economies Of Scale
 When a firm expands its size & goes for large
scale production, it stands to enjoy certain
benefits. Such advantages which arise due to
large scale production are known as economies
of scale.

 According to Marshal, there are 2 types of

economies of scale. They are

 Internal Economies of Scale

 External Economies Of Scale
 Internal economies Of scale:
 IE are those advantages of large-scale production
which accrue to a firm on account of its superior
techniques & management. Following are some
of the IE of scale.
 Technical Economies
 Managerial Economies
 Marketing Economies
 Financial Economies
 Risk bearing Economies of scale
 External economies Of scale:
 when a particular industry grows in size &
strength, it brings many advantages to all the
firms within that industry. Those advantages
which are available to all the firms are called the
EE of scale. Following are some of the EE of scale.

 Economies of Localisation
 Economies of Information
 Economies of Specialisation
Diseconomies Of Scale
 Diseconomies refer to the disadvantages
suffered by a firm when it expands its
production beyond the stage of optimum
combination of factors or beyond the level of
optimum output. Following are such
diseconomies of scale:
 When the firm expands production beyond
certain level. It develops many complexities.
Effective management & smooth co-ordination
at different levels become difficult.
 Beyond the stage of optimum production, the
efficiency of machinery & equipment declines.
This is called the technical diseconomy

 Beyond certain point, the firm is compelled to

pay higher wages to recruit labour.
Consumption of raw material becomes costlier. It
faces the problem of shortage of fuel, power,
finance etc.
Return to factors and scale
 Production Function
Production is a process in which economic
resources or inputs are combined by
entrepreneurs to create economic goods and
services (outputs).
Fixed Inputs are those that cannot be readily
changed during the time period under
consideration except, perhaps at a very great
expenses. (e.g., a firm’s plant).
Variable Inputs are those that can be varied
easily and on very short notice (e.g., most raw
materials and unskilled labour).
144
where Q = Output, X1..............Xk = Inputs used.
For purposes of analysis, the equation can be
reduced to two inputs X and Y.
Restating, Q = f(X,Y), where Q = Output, X =
Labour, Y = Capital
Two special features of a production function
are given below:
(a)Labour and capital are both inevitable inputs
to produce any quantity of goods, and

(b) Labour and capital are substitutes to each

other in production.
145
Find the different combinations of labour and
capital used to produce 798 units and 997
units a commodity
C 4 798 997 1020 1152
A 3 756 920 997 1001
P
I 2 725 856 940 997
T 1 708 820 901 798
A
L 0 1 2 3 4

LABOUR
Some quantity of both the inputs are required to
produce a given quantity of output.
146
 Capital
0 1 2 3 4 5 6 7 8 9 10

L 0
1
0
0
0
5
0
15
0
35
0
47
0
55
0
62
0
61
0
59
0
56
0
52
a 2 0 12 31 49 58 66 72 77 72 74 71
3 0 35 48 59 68 75 82 87 91 89 87
b 4 0 48 59 68 72 84 91 96 99 102 101
5 0 56 68 76 85 92 99 104 108 111 113
o 6 0 55 72 83 91 99 107 112 117 120 122
7 0 53 73 89 97 104 111 117 122 125 127
u 8 0 50 72 91 100 107 114 120 124 127 129
60 0 46 70 90 102 109 116 121 125 128 130
r 10 0 40 67 89 103 110 117 122 126 129 131

147
 PRODUCTION FUNCTION
ONE VARIABLE INPUT : SHORT-RUN ANALYSIS
Law of Variable Proportion or
Diminishing Marginal Returns
If all inputs of a firm are fixed and only the amount of labour
services vary, then any decrease or increase in output is achieved
with the help of changes in the amount of labour services used.
When the firm changes the amount of labour services only, it
alters the proportion between the fixed input and the variable
input. As the firm keeps on altering this proportion by changing
the amount of labour, it experiences the law of variable proportion

or diminishing marginal returns. 148

This law states: As more and more of the factor input is
employed, all other input quantities constant, a point
will eventually be reached where additional quantities
of varying input will yield diminishing marginal
contributions to total product.

149
150
The TPP curve rises first to an increasing rate up to a point
1, and later at a diminishing rate up to point 2. At point 2,
the TPP remains constant. Thus, the total output increases
more than proportionately until X units of labour are
employed; between X units and Y units of labour use, the
total output rises with every additional unit of labour but this
increase is less than proportionate. If labour units increases
beyond level Y, the total output eventually starts declining.
Correspondingly when TPP is rising at an increasing rate,
MPP and APP curves rise; and when total product is rising
at a diminishing rate, this MPP and APP curves are
declining. At Y, where TPP becomes constant, the MPP
becomes zero, and additional labour beyond Y makes MPP
negative. These three phases of TPP curve are called the
three stages of production. 151
 Total Physical Marginal Physical Average Physical
Product Product Product
Stage -1 Increases and Increases (but
Increase at an reaches its slower than MPP)
increasing rate maximum

Stage – 2 Starts diminishing Starts diminishing

Increases at a and becomes equal
diminishing rate and to zero
becomes maximum

Stage – 3 Keeps on declining Continues, but

Reaches its maximum, And becomes always be greater
diminish becomes negative than zero
constant and then
starts declining

152
 Optimal Use of the Variable Input
The firm should employ an additional unit of labour as
long as the extra revenue generated from the sale of the
output produced exceeds the extra cost of hiring the unit
of labour, i.e., until the extra revenue equals the extra cost.
Thus, if an additional unit of labour generates Rs. 300 in
extra revenue and costs an extra Rs. 200 then it pays for
the firm to hire this unit of labour, as its total profit
increases. This is an example of application of the general
optimization principle.
153
The extra revenue generated by the use of an additional unit of
labour is called the MARGINAL REVENUE PRODUCT OF
LABOUR (MRPL). This equals the MARGINAL PRODUCT OF
LABOUR (MPL) times the MARGINAL REVENUE (MR) from the
sale of the extra output produced. Thus- MRP L. = (MPL) (MR)
The extra cost of hiring an additional unit of labour or MARGINAL
RESOURCE COST OF LABOUR (MRCL) is equal to the increase in
the total cost to the firm resulting from hiring the additional unit of
labour.
A firm should continue to hire labour as long as MRP L > MRCL and
until MRPL = MRCL This is applicable to any variable input and not
just labour
154
 THE PRODUCTION FUNCTION WITH TWO VARIABLE
INPUTS: LONG-RUN PRODUCTION FUNCTION

A firm may increase its output by using more of two

variable inputs that are substitutes for each other, e.g.
labour and capital. There may be various technical
possibilities of producing a given output by using
different factor combinations. Which particular factor
combination will be actually selected by the firm depends
both on the technical possibilities of factor substitution
as well as on the prices of the factors of production.
155
The technical possibilities of producing an output
level by various combinations of the two factors can
be graphically represented in terms of an isoquant
(also called iso-product curve, equal-product curve,
or production indifference curve).

156
 Types of Isoquants
The production isoquant may assume various shapes
depending on the degree of substitutability of factors.
A. Linear isoquant: This type assumes perfect
substitutability of factors of production. A given
commodity may be produced by using only capital, or
only labour, or by an infinite combination of K and L.

B. Input-output isoquant: This assumes strict

complementarity, that is, zero substitutability of the
factors of production. There is only one method of
production for any one commodity. The isoquant takes
the shape of a right angle. This type of isoquant is
called “Leontief Isoquant”.
157
Types of Isoquants
158
C. Kinked isoquant: This assumes limited substitutability
of K and L. There are only a few processes for producing
any one commodity. Substitutability of factors is possible
only at the kinks. It is also called “activity analysis-
isoquant” or “linear-programming isoquant”.

D. Smooth, convex isoquant: This form assumes

continuous substitutability of K and L only over a
certain range, beyond which factors cannot substitute
each other. This isoquant appears as a smooth curve
convex to the origin.

159
Kinked isoquants are more realistic. We may consider
the continuous isoquant as an approximation to the
more realistic form of a kinked isoquant: as we increase
the number of processes the kinks come closer and
closer, until at the limit the isoquant becomes a smooth
curve.
The production function describes not only a single
isoquant, but the whole array of isoquants, each of
which shows a different level of output. It shows how
output, X, varies as the factor inputs (L, K) change. It is
called an ISOQUANT MAP. A higher isoquant refers to
a larger output, while a lower isoquant refers to a
smaller output (X).
160
 Characteristics of Isoquant
The isoquants show the following properties:
(a) An isoquant slopes downward to the right.
(b) An isoquant is convex to origin.
(c) An isoquant is smooth and continuous.
(d) Two isoquants do not intersect.
Marginal Rate of Technical Substitution
The marginal rate of technical substitution (MRTS)
indicates the rate at which one input must be substituted
for another as one moves down towards right along an
isoquant. The MRTS of input X for input Y may be
defined as the amount of input Y which can be replaced
by one unit of input X so as to keep the level of output
same
161
Thank you

162