BUSINESS (MANAGERIAL) ECONOMICS

Module:1.1: Nature and Scope of Managerial Economics.

1. Business Issues and Economic Theory

Operational or Internal Issues:o Choice of business (What to produce?)o Choice of size of the firm (How much to produce)o Choice of technology (How to produce ie choice of factor/input

combinations)o How to price the commodity, how to promote sales, how to face

price competitions, how to decide on new investments, how to manage profits, how to manage inventory etc.

Microeconomic Theory: Deals with some of these operational issues theory of demand, theory of production and cost, market structure and product/factor pricing, profit management etc.

Environmental or External Issues:o Economic system of the country.o General trends in production, employment, income, price level,

saving and investment.o Structure of financial institutions.o Nature and magnitude of foreign trade.o Monetary and fiscal policies, and industrial and labour policies.o Social factors like the value system of the society, property rights,

and political environment.o Degree of openness of the economy and the influence of MNCs on

the domestic market.

These are all the macroeconomic issues relevant to business decision – making: Trends in GDP, price trends, saving, investment, consumption, foreign trade, other economic policies.

Hence: Prominent role of micro and macro economics in the process of business decision – making.

• B/M Economics: Subject Matter.

o B/M Economics: Economics applied to decision making.

Use tools of economics to identify the problems, to organize and evaluate information, to compare alternative courses of action, to choose the best course of action, and to implement it.

Provides the link between traditional economics and the decision sciences (Mathematics and Statistics) in management decision making.

Also relevant to the management of non-profit organisations: Hospitals etc.

Microeconomics in character, but macroeconomics, equally important for decision making by the business firm.

More normative than positive: More prescriptive than descriptive.

• Association of B/M Economics with other Sciences:

Mathematical Tools: Cost minimization, sales maximization and profit maximization etc.

Statistical Tools: Most of business decisions based on probable economic events. Use theory of probability and forecasting techniques.

Operational Research Theory: An interdisciplinary solution – finding techniques. Combines economics, mathematics and statistics to build models for solving specific business problems. Ex: L.P – widely used in business decision – making.

Management Theory: Behaviour of the firm to achieve certain predetermined objectives.

Accountancy: Data on functioning and performance of the firm.

4. Functions of a Managerial / Business Economist:

● Demand forecasting by formulating econometric models.

● Cost analysis and supply forecasting – focusing on input prices, product prices, technology flow etc.

● Product pricing and competitive strategies.

● Study and anticipation of government policies and planning business strategies accordingly.

● Risk analysis to suggest alternative courses of action to cope with.

● Capital Budgeting: Investment criteria and decisions, and profitability analysis.

Module: 1.2: Basic Concepts, Principles, Decision Rules and Tools of Analysis in B/M Economics.

1. Time Perspective in B-Decision-Making.

• Decision Making: A task of coordination along the time scale, past, present and future.

• Maintain the right balance between the long-run, short-run and intermediate-run perspective.

• Building inventories of finished products: Need short-run time perspective.

• Investment in plant, building, land and introduction of a new product: Need long-run time perspective.

• Opportunity Cost Principle:

• Most economic resources have more than one use Have opportunity costs scarcity and alternative use of the resources opportunity costs.

• Opportunity cost of a decision:Sacrifice of the alternatives.

O. C of availing an opportunity is the expected income foregone from the second best opportunity of using the resources.

• O. C Concept: Can be applied to all kinds of business decisions where there are at past two alternative options involving costs and benefits.

• Examples: Invest ones own capital in once own business O. C: Interest that

could have been earned through investment in other ventures. The O. C of managing once own business: Salary that be could

have earned in other occupations. The O. C of watching cricket match by a student?

• Discounting and compounding principle:

• Time Value of money and decision analysis

Future value of the present sum: Compounding

o Let PV = Rs.95.24 γ = 0.05 FV1 = 95.24 + (95.24 X 0.05)

= 100 at the end of first year.

o To generalize: PV = present value γ = rate of interest FV1 = amount received at the end of first year FV1 = PV + PV(γ) = PV (1+γ) FV2 = PV (1+γ) (1+γ) = PV (1+γ)2

FVn = PV (1+γ)n

If γ = 0 FVn = PV.

Present value of future sum: Discounting PV = Present Value FV1 = Amount receivable at the end of one year from now (Rs.100) γ = 0.05 = Rate of discount PV = FV1 = 100 = 95.24

(1+γ) 1+0.05 FV2 = Amount receivable two years from now (Rs.100) PV = FV2 = 100 = 90.70 (1+γ)2 (1+0.05)2

For N Years: PV = FV1 + FV2 + … + FVN

(1+γ) (1+γ)2 (1+γ)N

Relationship between PV and γ

PV

Higher γ, Lower PV Lower γ, higher PV γ

If γ = O, PV of Rs.100 receivable one year from now: Rs.100 NO time value for money.

If γ → ∞, PV → O.

Suppose a company is considering buying a new machine. It should estimate the discounted value of net added earnings from that machine before venturing to buy it.

4. Marginal Principle and Decision Rule:

• Concept of M.P widely used in business decision making: M U, M C, M R, M P and M П.

• M C = TCn – TCn – 1TCn = total cost of producing n unitsTCn-1 = total cost of production of n-1 unitsM C = TCn – TCn – 1

= 2550 – 2500 = 50

Similarly: MR = TRn – TRn -1

• The decision rule:MR > MC: Carry on business activityMR < MC: ?MR = MC Necessary Condition for П – maximization.

• To apply Marginal Principle: Need TC and TR data for each and every unit of output.

• Equi – Marginal Principle:

A rational decision – maker: Decision Rule The ratio of marginal returns and marginal costs of various uses of a given resource

orVarious resources in a given use is the same.

Ex1: Consumption basketMU1 = MU2 = … = MUn Equi – marginalMC1 MC2 MCnMU1 > MU2 → Decision Rule?MC1 < MC2

Ex2: Input useMRP1 = MRP2 = … = MRPnMC1 MC2 MCnMRP1, MRP2: MRP1 from input 1 (say labour)

MRP2 from input 2 (say capital)MC1, MC2: Marginal cost of Labour and CapitalMRP1 > MRP2 → Decision Rule? MC1 < MC2

• Contribution Analysis and Incremental Concept:

IC = Change in total cost due to a specific decision

IR = Change in total revenue caused by a decision

IR > IC → Decision, profitable

The contribution of a business decision: Difference between IR and IC.

• Difference between marginal and incremental concepts:

M – Principle: Change in revenue, cost or profit with respect to change in output only. Change in output is infinitesimally small.

IC: Applicable with respect to any variable and for any extent of change.

5. Profits:• Accounting Profit and Economic (pure) Profit: AP = TR – Explicit Costs. EP = TR – (Explicit Costs + Implicit Costs). EP: Makes provision for insurable risks, depreciation, and necessary minimum payment to shareholders to prevent them from withdrawing their capital.

• Theories of Profit: Sources of Profit. Innovation Theory:o Innovation in new products, new production techniques, new marketing strategieso Cost of innovationso Profits: Reward for innovation.

Risk – Bearing Theory: Companies bear risks – Non-availability of inputs and adequate market for products. Profit: Reward for risk-bearing

Monopoly Theory of Profit:

Powers to control supply & price Powers to prevent the entry of competitors Sole ownership of certain crucial raw materials Legal sanction and protection. Monopoly is the source of pure profit.

Friction Theory of Profit:

Ex: Severe and prolonged winter companies producing woolen garments, and those producing items like ice cream and fans.

Managerial Efficiency Theory:

Profits – Reward for exceptional managerial skills Hence profit for good performance.

Same element of truth in all these theories. Profit is a reward for innovation, risk – bearing, monopoly power and managerial efficiency.

6. Plant, Firm and Industry:

• Plant:

A technical unit of production Technical similarity in the production processes of goods production within a plant A body of persons working at a given place.

• Firm:

May own one or more than one plant Exercises a unified control over its plants Separate legal entity

Undertakes production to maximize profits.

• Industry:

A group of firms Some common factor among all the firms: The raw material used and production technique employed – supply

side. Products produced – Demand side. Firms compete more for same raw material raw material use criterion

to classify industries. Firms compete more for capturing the market for their goods

substitutability of goods. Standard industrial classifications (SICs): Raw material used and similar

production processes rather than the substitutability among products.

Ex: Plastic buckets in the plastic industry, and metal bucket in metal working industry.

But: On the demand side, these two are substitutes.

To identify degree of competition among the firms in the market, define industry as a group of firms producing closely substitutable products.

Concept of cross elasticity of demand EXY = % change in quantity of X demanded % change in price of Y How do you decide degree of substitutability?

Can we use cross elasticity of supply also to classify industries?

Module 1.3: Demand Analysis:

• Read Section 2 of Module 2 in the hand out on “Orientation In Economics”.

• Importance of demand analysis to a decision – maker: Existing potential demand for the product of the company Business strategies to augment the demand for the company’s product.

• Demand Effective demand.

• Three characteristics of effective demand: Desire for the product Ability to pay for the product Willingness to pay for the product.

• See Module 2 in the handout on “Orientation In Economics” for definition of demand, demand schedule, demand curve and law of Demand.

• Types of Demand:

Demand for consumer’s goods and producer’s goods

Goods/services used for final consumption → Consumer’s goods Producer’s goods: Machines, buildings, raw materials etc. Study consumer’s goods under demand and producer’s goods

under supply.

Perishable and durable goods

Perishable goods: Can be consumed only once. Ex:? Durable goods: Only services are consumed. Ex:? Implications to business decision-analysis.

Autonomous (Direct) and Derived (Indirect) Demand:

A (D) Demand: Demand not tied down with demand for some other goods.

D (I) Demand: All produced goods.

Individual and Market Demand

Assignment: Draw individual and market demand curves.

Demand by Market Segments and Total Market: Domestic and Foreign Markets Rural and Urban Markets.

Firm and Industry Demand: Demand facing an industry (Say car industry) Demand facing a firm (Demand for Maruti Car) Refrigerators Industry and Godrej Refrigerator firm.

Price, Income and Cross Demand: Refer to Section 2 of Module 2 in the hand out on “Orientation In Economics”.

Milk Price Rs/Lit

Milk Demand (Litr.)Market DemandB – 1 B – 2 B – 3

8 5 10 0 15

7 8 12 4 24

6 12 15 7 34

5 20 19 12 51

4 30 25 20 75

3 45 30 30 105

• Determinants of Demand and Demand Function:

Determinants of Market Demand:

DX = fCPX, PS, PC, M, T, E, A.E, C.F, NB, POP. ID PX, PS, PC, M, T, E: As in orientation handout A.E = Adv. expenditure C.F = Credit facility N.B = Member of buyers POP. = Population of the country I.D. = Income distribution pattern in the country.

Postulate demand for X and determinants i.e Explanatory Variables.

For Ex: ∂DX < O ∂PX

: ∂DX < ? ∂PS <

: ∂DX > ? ∂PC <

: - - - - - - - - - - : - - - - - - - - - -

Individual Consumer Demand Function:DX = fCPX, PS, PC, M, T, E, A.E ……)

Three Kinds of Demand: Recall: PD, CD & ID

P. D: DX = f(PX), OR C

C. D: DX = f(PS), OR C

DX = f(PC), OR C → Substitutes, Complements and independent goods → Draw diagrams.

I. D: DX = f(M), OR C → Normal, inferior and neutral goods.

Why the inverse relationship between price and quantity demanded?

Substitution effect: PX↓, prices of its substitutes remaining constant

Hence more of X is demanded with a fall in its price PX↑, PS

Hence less of X is demanded with a rise in price of X, because the substitutes are cheaper.

Income Effect: PX↓ RI↑ → An increase in his purchasing power. Buy more of X, if

it is a normal good. PX↑ RI↓ → A decrease in his purchasing power. Buy less of X, if it

is a normal good. Note: In case of inferior goods: PX↓ → RI↑ - Buy less of X.

PX↑ → RI↓ - Buy more of X. Because still cheaper compared to other goods.

Exceptions to Law of (Price) Demand:

Giffen Goods Articles of snob appeal Speculation.

Movement (Change in equality demand or extension and contraction of demand) and shift in demand (change in demand or increase and decrease in demand).

Why movement and why shift?

Module 1.4: Price Elasticity of Demand:

• Recall from the handout on “Orientation in Economics”.

EP = Price Elasticity of D = % change in quantity of X demanded % change in price of X

Point EP = ∆Q . PO ∆P QO

Arc EP = ∆Q . P1 + P2 Average price elasticity between ∆P Q1 + Q2 two points

Also called Mid – Point Formula

Sign of price elasticity coefficient: Negative, but consider the size and ignore the sign, i.e│EP│.

o Five Kinds of Price Elasticity of Demand:

Elastic D: │EP│> 1 % ∆Q >% ∆P QO PO

Inelastic D: │EP│< 1 % ∆Q <% ∆P QO PO

Unitary el. D: │EP│= 1 % ∆Q =% ∆P ∆O PO

Perfectly ine. D: │EP│= 0 % ∆Q = 0 for a QO

given % ∆P PO

Perfectly /infinitely el. D: EP = ∞ All output is sold at the same price % ∆P = 0

PO

Draw diagrams for all five kinds of PED.

o Total Revenue (Total Expenditure) Test and Price el. of D:

Recall:

│EP│> 1 A Price change leads to more than proportionate change in Q – demanded.

│EP│= 1 Price and quantity change in the same proportion.

│EP│< 1 A price change leads to a less than proportionate change in Q – demanded.

Price Elasticity and Revenue Relations

Observe:Q: 1 to 5: │EP│>1 → P↓TR ↑ MR > 0Q: 5 to 6: │EP│=1 → P↓TR MR = 0Q: Greater than 6: │EP│< 1 → P↓TR↓MR < 0

Price (P)

Quantity (Q)

TR = P.Q

MR MR= ∆TR ∆Q

Arc. E │EP│

100 1 100 - -

90 2 180 80 6.33

80 3 240 60 3.40

70 4 280 40 2.14

60 5 300 20 1.44

50 6 300 0 1.00

40 7 280 -20 0.69

30 8 240 -40 0.47

20 9 180 -60 0.29

10 10 100 -80 0.16

Do you agree with this analysis?

│EP│

Effect of P ↓on

Effects of P ↑on

TR MR TR MR

>1 ↑ > 0 ↓ < 0

=1 Constant = 0 Constant = 0

<1 ↓ < 0 ↑ > 0

Module 1.5: Determinants of Price Elasticity:

• Nature of the commodity: Luxury/Comforts: Price Elastic Necessary Goods: Price Inelastic.

• Availability of substitutes: More number of substitutes: More Elastic Ex: Beverages Less/no substitutions: Less elastic/inelastic Ex: Salt, Onion.

• Number of uses: Single – use commodities: Less elastic Ex: ? Multi – use commodities: More elastic Ex: Aluminum used in Construction of airplanes automobiles, boats and buildings.

• Consumer’s income:Poor Consumers: More elasticRich Consumers: Less/inelastic.

• The products position in buyersBudget: The proportion of income spent on the commodity.

Module 1.6: Practical Significance of the Concept of P. E. D:

• Questions facing a business firm:

5% P ↑ → Expected impact on sales?

Sales to increase by 10% → How much of reduction in price?

Whether reduced prices attract sufficient additional customers to offset lower revenue per unit.

Discounts to different customer groups like in airlines, restaurants etc to students, senior citizens, vacation travelers.

Taxation.

Demand for higher wages: can be met when EP for the product is inelastic.

International trade: Decision to devalue a country’s currency is based primarily on the price elasticities of imports and exports.

Product pricing strategy by business firm: Does it pay to reduce the price of a product the demand for which is inelastic or demand for which is elastic? Does a price rise yield a rise in TR when demand is elastic or

inelastic?

Module 1.7: Cross Elasticity of Demand:

• Recall:

DX = f (PR) Let related good by Y

DX = f (PY)

d DX = 0 X & Y are ……………….. ?d PY

d DX > 0 X & Y are …………………. ?d PY

d DX < 0 X & Y are …………………. ?d PY

• Draw diagrams for all the three situations:

• EXPY = ∆QX PYO

∆PY QXO

EXPY O when? <

• Consider the following examples: Monthly Demand of a Household

Question: Calculate cross elasticity efficients for Tea & Coffee and Bread and Butter and interpret results with respect to nature of relationships between commodities.

Commodity

Original New

P Q P Q

Tea 3 50 3 60

Coffee 4 30 5 20

Bread 2 80 2 90

Butter 75 30 6 40

Cross Elasticity of Demand in Transport System

Compute: ERFB = % change in Rail Service

% change in Fare of Bus Service

Fare (Rs)Daily No. of

Passengers

Rail Bus Rail Bus

1. Before fare change

45 40 500 200

2. After fare change

45 35 400 300

3. Percentage change

… … … …

• Significance of C E D in Business Management:

To define substitutes: C E Coefficient > 0 Goods are substitutes Greater the C E C → Closer the substitutes Smaller the C E C → - - - - - -

Similarly to define complements: C E C < 0 Goods are complements Higher the negative C E C → Higher the degree of

complementarily.

To define independent goods?

To measure the degree of threat due to competition in the market.

To define market structure: Lower the value of CEC, higher the monopoly power Higher the value of CEC?

To forecast demand for its products, consider price change by competing firms.

To define cluster of products: Substitutes, compliments and independ goods?

Module 1.8: Income Elasticity of Demand:

• Recall:DX = f (M), OR Cd DX O Normal Goodd M < Neutral Good

Interior Good.

• Draw diagrams to illustrate three kinds of goods.

• EM = ∆QX MO

∆M QO

• EM O N. G < Neu. G

I. G.

• EM = 1 → Unitary I. EEM = 0 → Zero I. EEM > 1 → I D curve flatterEM < 1 → Steeper I D CurveEM < 0 → Downward sloping I D curve.

M IDC (EM=1)

Draw other types of ID Curvein the same diagram.

450 Q

• Business Applications of IED: Long – term business planning for luxuries & comforts: High IED. High IED: A major determinant of construction industry and real estate business. Taxation policy:

High IEC Luxury goods Impose higher excise or sales tax.

Sectoral Production Plans: Usefulness of estimates of IED coefficients.

Module 1.9: Additional Demand Elasticity Concepts:

• Advertising elasticity.

• Interest rate elasticities to forecast demand for housing, automobiles etc.

• Weather elasticity of demand for public utilities like electricity.

Module 1.10: Demand Estimation and Forecasting:

• Methods of Estimating Demand Function:

Consumer interviews (Surveys) Interview consumers on their consumption habits Census and sample methods Information on quantities of the concerned good bought at

different periods at various prices of the product, prices of related goods, income of the consumer ……..

Market Experiments Method: Actual Experiment: Record consumer’s reactions in different shop locations with

respect to income, estimated religion, sex, age group etc.

Market simulation (Consumer clinic or laboratory experiment) method:

→ Provide token money to a set of consumers. → Vary prices of various goods, their quality, packaging etc and

record shopping behaviour of consumers. → Too costly and consumer’s may not take the experiment

seriously.

Regression Method:

→ Identify variables which influence demand for a particular commodity

→ Collect data

→ Select appropriate functional form

→ Estimate the functionEx: Demand Function for Groundnut OilDg = f (Y, Po, Pv, Pg, U)Where: Dg = demand for groundnut oil

Y = national income Po = price of groundnut oil Pv = price of vanaspathi Pg = price of pure ghee U = ‘other’ determinants of g.n.o

→ Time series or cross section data.

• Demand Forecasting

D. Forecasting: An estimate of the future demand, based on laws of probability. Levels of D. F:

Micro Level: Forecast by an individual business firm. Industry Level: Macro Level: Ex: Country consumption function.

Why D. F? Production planning Sales forecasting To control business and inventory To plan long term growth and investment programmes.

Demands Forecasting Methods: Consumers’ survey Experts’ opinion → Simple expert opinion poll → Delphi Method: An extension of the simple expert opinion poll → Use Delphi Method (DM) to consolidate the divergent expert

opinion and to arrive at a compromise estimate of future demand.

→ Under DM: Collect opinions from experts. Instead of taking averages, try to match the opinions by bringing experts to-gether and to arrive at a consensus.

• Statistical Methods: Trend method to extrapolate

Dg = f (T)Where: Dg = demand for groundnut oil

T = Time (Years)

Barometric Method of Forecasting Meteorologists use the barometer to forecast weather

conditions on the basis of movements of mercury in the barometer.

So use relevant economic indicators such as GDP, prices, lending rate for loans

Econometric Method: Regression Method Simple or Bivariate Regression Technique: Y = f (X) Y = Sugar consumed Y = Population Multivariate Regression Dx = f (Px, Ps, M, A) Where: Dx = Quantity of x demanded

Px = Price of X Ps = Price of substitutes M = Consumer’s income A = Advertisement expenditure

Module 1.11: Theoretical Foundation of Consumer Behaviour:

1. Cardinal and Ordinal numbers and C and O Utility Concepts

• Cardinal numbers:1, 2, 3, 4, - - - - - The number 2 is twice the site of number 1 Measure utility of commodities A & B by utilis: A: 20 utils B: 40 utils B Yields twice the utility of it.

• Ordinal numbers:I, II, III, . . . . . . . . II > I, but II less than III Don’t know, by how much size relation of number not known Rank utility, and explain consumer behaviour without the

assumption of measurable utility.

2. The Marshallian Cardinal Utility Theory:

• Assumptions: Maximization of satisfaction.

Rationality: Buys the commodity yielding highest amount of utility per rupee.

Utility is cardinally measurable. Measurable by the price that the consumer is prepared to pay.

Utility function exists:TU = (G, S) TU = M U of G, S G TU = M U of S, G S

Constant marginal, utility of money: Sine, money is used as a measure of utility.

Diminishing M U.

• Law of Diminishing M U:

No. of orangesconsumed

T U M U

0 0 -

1 20 20

2 35 15

3 45 10

4 50 5

5 53 3

6 55 2

7 56 1

8 56 0

9 55 -1

10 53 -2

Develop both TU and MU curves from this data.

Observe how behaviour of TU and MU related.

The LDMU: As an individual increases consumption of a given product (say

orange) holding consumption of other products constant, MU derived from consumption eventually diminishes.

What are the implications of this law to a business manager?

• Consumer Equilibrium and the Marshallian Proportionality Rule:MUA = MUB ……… = MUZ = K PA PB PZ

Can we say that K is the MU of money i.e MUM?

How does a consumer behaviour when: MUA MUB ?

PA < PB

• LDMU and Demand Curve: Co ↑ MU ↓ → P ↓ D ↑ Co ↓ MU ↑ → P ↑ D ↓

Hence inverse relationship between P and Quantity demanded.

Consumer Equilibrium: MUX = PX

If MU of X is measured in terms of money, then the MU curve becomes the demand curve of the good. P MU/Price

P1

P2 MU/Demand O Q

Q1 Q2

At P1 → Q1

At P2 → Q2

MU curve could enter IV Quadrant whether D. C could enter IV Quadrant?