UNIT -1 Introduction to Business Economics

• Meaning, Nature and Scope of Business Economics – Micro and Macro

• Basic Economic Problems• Market forces in solving economic problems.• Circular Flow of Income and Expenditure

Meaning , Nature & Scope of B.E

Business Economics, also called Managerial Economics, is the application of economic theory and methodology to business.

• Decision making means the process of selecting one out of two or more alternative courses of action. The question of choice arises because the basic resources such as capital, land, labour and management are limited and can be employed in alternative uses.

• Forward Planning means establishing plans for the future. Once the decision is made about the particular goal to be achieved , plans as to production, pricing, capital & labour etc. are prepared.

Business Economics

Decision Making

Forward Planning

Business Economics ( Application of Economic theory & Methodology to solving Business Problem)

Optimal Solutions to business problems

Business Problems Decision Making & Forward Planning

Economic Theory & Methodology

Nature of Business Economics Traditional economic theory has developed along two lines; viz.,

normative and positive.

Positive economics is objective and fact based, while normative economics is subjective and value based.

For Example : • The unemployment rate is currently at 9 percent. (Positive

Statement )• The unemployment rate is too high. ( Normative Statement)• The government must take action in order to reduce the

unemployment rate. (Normative statement)

Business economics combines the essentials of the normative and positive economic theory, but the emphasis being more on the former than the latter.

Scope of Business Economics

As regards the scope of business economics, the following aspects are said to generally fall under business economics.

1. Demand Analysis and Forecasting

2. Cost and production Analysis.

3. Pricing Decisions, policies and practices.

4. Profit Management.

5. Capital Management

ECONOMICS VS BUSINESS ECONOMICS:

1. Economics has both micro and macro aspects. But Business Economics is essentially micro in character.

2. Economics studies both firm and individual while Business Economics studies only the problems of a business firm.

3. In Economics we study the concepts and theoretical aspects of economic analysis. But Business Economics is an applied part of the study.

4. Economics is both positive and normative science. But Business Economics is essentially normative in nature.

5. Economics studies only economic aspects of the problem whereas Business Economics studies both Economic and non economic aspects.

6. Economics studies the principles underlying rent, wages, interest and profit. But Business Economics studies mainly the principles of profit only.

7. In Economics, before explaining a concept or theory certain assumptions are being made. But in Business Economics these assumptions disappear due to practical situations.

Basic Economic Problems

• Business economics helps in reaching a variety of business decisions in a complicated environment. Certain examples are :

(i) What products and services should be produced?

(ii) What input and production technique should be used?

(iii) How much output should be produced and at what prices it should be sold?

(iv)What are the best sizes and locations of new plants?

(v) When should equipment be replaced?

(vi) How should the available capital be allocated?

Branches of economics & nature of Business Economic

Micro Economics : (MIKROS)

Microeconomics is that branch of economics which is concerned with the decision-making of a single unit of an economic system. For e.g Individual Demand, Supply of a firm, Consumption of an Individual and Pricing etc.

Macroeconomics (MARKROS)

Is that branch of economics which is concerned with the economic magnitudes relating to the economic system as a whole, rather than to the microeconomic units like individuals or firms. It has, therefore, been called

‘aggregative economics’ According to Mc Nair and

Meriam, “Business economic consists of the use of economic modes of thought to analyze business situations.”

Siegel man has defined managerial economic (or business economic) as “the integration of economic theory with business practice for the purpose of facilitating decision-making and forward planning by management.” Economics

Macro

Micro/ Business

Economics/ Managerial Economics

Differences between Microeconomics and Macroeconomics

Micro Economics • It is that branch of economics which

deals with the economic decision-making of individual economic agents such as the producer, the consumer, etc.

• It takes into account small components of the whole economy.

• It deals with the process of price determination in case of individual products and factors of production.

• It is known as price theory

• It is concerned with the optimization goals of individual consumers and

producers

Macro Economics• It is that branch of economics which

deals with aggregates and averages of the entire economy, e.g., aggregate output, national income, aggregate savings and investment, etc.

• It takes into consideration the economy of any country as a whole.

• It deals with general price-level in any economy.

• It is also known as the income theory• It is concerned with the optimization

of the growth process of the entire economy.

Circular flow of Income

Meaning of Circular Flow:

• The terms circular flow refer to a simple economic model which describes the reciprocal circulation of income between producers and consumers.

• In the circular flow model, the inter-dependent entities of producer and consumer are referred to as "firms" and "households“ respectively and provide each other with factors in order to facilitate the flow of income.

• Firms provide consumers with goods and services in exchange for consumer expenditure and "factors of production" from households .

Assumptions

The basic circular flow of income model consists of seven assumptions:

1. The economy consists of two sectors: households and firms.

2. Households spend all of their income (Y) on goods and services or consumption (C). There is no saving (S).

3. All output (O) produced by firms is purchased by households through their expenditure (E).

4. There is no financial sector.

5. There is no government sector.

6. There is no overseas sector (no exports or imports)

7. It is a closed economy

Two sector model House & Firm

In the simple 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.

Circular Flow – 2 Sector model

House Hold(Consumers)

Firm(Producers)

Consumption spending (C)

Income (Y) – Wages, Salaries, Rent, Interest & Profit

Labour, Land, Capital and Enterprise

Goods and Services

Two Sector Model Financial Sector

• Financial Sector that consists of banks and non-bank intermediaries who engage in the borrowing (savings from households) and lending of money.

• In terms of the circular flow of income model the leakage that financial institutions provide in the economy is the option for households to save their money. This is a leakage because the saved money can not be spent in the economy and thus is an idle asset that means not all output will be purchased.

• The injection that the financial sector provides into the economy is investment (I) into the business/firms sector.

Circular Flow – 2 Sector modelFinancial sector

Consumers Producers

Consumption spending (C)

Income (Y) – Wages, Salaries, Rent, Interest & Profit

Savings (S) Investment (I)

Financial Sector

• As long as Savings equals Investment the economy will not expand or contract

• If Savings is larger than Investment the leakage will contract the economy• If Investment is larger than Savings then the economy will expand (There

is an injection of extra funds)

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 subsides and transfer payments. Every payment has a receipt in response of it by which aggregate expenditure of an economy becomes identical to aggregate income and makes this circular flow and unending.

• It will study a circular flow income in these sectors excluding rest of the world i.e. closed economy income.

Circular Flow of Income : Three Sector Model Consumers, Producers, Financial and Government Sectors

Consumers Producers

Savings (S)

Government Sector

Investment (I)

Consumption spending (C)

Income (Y)

Taxation (T)

GovernmentSpending (G)

• As long as Taxation equals Government Spending the economy will not expand or contract

• If Taxation is larger than Government Spending there is a leakage and the economy will contract

• If Taxation is less than Government Spending there is a injection into the economy and it will expand

Four Sector ModelExternal Sector

• 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.Rest of the world 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.

Circular Flow of IncomeFour Sector Model

Consumers, Producers, Financial, Government and Overseas

Consumers Producers

Savings (S)

Government Sector

Investment (I)

Taxation (T) Spending (G)

Overseas SectorImports (M) Exports (X)

Consumption spending (C)

Income (Y)

• Savings, Taxation and Imports are leakages• Investment, Govt. Spending and Exports are injections into the

economy• Savings and Investments can be altered by the Reserve Bank’s

control of interest rates• Taxation and Govt. Spending can be adjusted by the Govt.’s

Budget.• Imports and Exports is very difficult to make adjustments –

market forces prevail.