Managerial Ecconomics - Lecture Notes

7/31/2019 Managerial Ecconomics - Lecture Notes

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NATIONAL UNIVERSITY OF SCIENCE

AND TECHNOLOGY

MANAGERIAL ECONOMICS

Peter NkalaPhD Candidate

University of Natural Resources and Applied Life Sciences (BOKU), GregorMendel Strasse 33, A-1180 Vienna, Austria, Europe, Phone: ++43(1) 47 654-

3785, Fax: ++43(1) 47 654-3792,E-mail: [email protected]

E-mail: [email protected]

Master of Business administration (MBA)


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BACKGROUND TO MANAGERIAL ECONOMICSDavies H, - Chapter 1

Managerial economics is generally concerned withresource allocation decisions that are made bymanagers in both the private and public sectors of theeconomy using applications of economic theory

principles and methodologies to decision makingunder conditions of risk and uncertainty.

Economic concepts, models and analytical techniquesof economics are used to study and analyze businessdecisions or operations and types of decisions

managers face, thereby getting a better understandingof the business environment and the making of qualitydecisions.


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Managerial economics applies economic toolsand techniques to business and administrativedecision-making.

Managerial economics uses tools and techniquesof economic analysis to solve managerialproblems.

Managerial economics links traditional economicswith decision sciences to develop vital tools formanagerial decision making.


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Managerial economics is the application of economicanalysis to business problems and this definition iswide ranging covering a number of very differenta ppr oa c he s to the s ub j e c t (D a v i e s , 1 9 9 1 )

Managerial economics has its origins in theoreticalmicroeconomics particularly theory of demand,theory of the firm, optimizing and advertisingexpenditures and the impact of market structure on

the firms behaviour are all studied using theeconomist tool kit of model building and testing


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Economic Concept frameworkfor decision, theory of consumerbehavior, theory of markets andpricing

Management decision problem product, price and output, make or buy,production technique, inventory level, advertising intensity and media, laborhiring and training, investment and financing

Decision Tools tools and technicalanalysis, numerical analysis,statistical estimation, forecasting,game theory, optimization

Managerial economics the use of economic concepts and decisionscience methodology to solve managerial decision problems

Optimal solutions to managerial decision problems

Source: Hirschey M. and Pappas J. L. (1996): Managerial Economics, 8th edition, the Dryden press, Illinois, USA


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Managerial economics is important in making strategicmanagerial decisions of high quality because the worldhas not been endowed with ubiquitous resources; aneed arises to make the best use of such resources inwhich firms are faced and guided by the profit motiverather than sustainability in the exploitation of theseresources

Resources are limited or insufficient hence the need touse them efficiently.

Managerial economics therefore emphasizes on thepractical applications rather than theoreticalunderpinnings of economics, on making quality

economic decisions drawing heavily onmicroeconomics analysis. There is need to follow this up with examples where

practical managerial economics decisions were takenand organizations turned around.


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METHODOLOGY OF MANAGERIAL ECONOMICS

Definitions and assumptions about phenomenon to be modeled

Theoretical analysis

Predictions

Predictions tested against data

If predictions are tested and

not supported by data, modelis amended or discarded

If predictions are

supported by the data, themodel is valid for themoment until provenotherwise


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BUILDING AND TESTING ECONOMIC MODELS The issue of building and testing models cuts across all disciplines as

approaches to different types of investigations.

For example engineers will build prototypes or computerized simulations inorder to examine their behaviour, meteorologists will use computer modelsof weather patterns in order to make weather forecasts.

The first step involves establishing a set of definitions and a set ofassumptions about the entity to be modelled which could be an individualhousehold, market for an individual product, national economy as a wholeor individual firm.

Theoretical analysis or logical deduction or the process of followingthrough the and identifying implications of the function follows the first stepand it is the most challenging aspect of the process of model building andare very sensitive to the changes in the model assumptions.

The model has very little value unless it has been tested against data. If the model is able to explain the phenomenon being modelled better than

the alternatives it then becomes a useful means of predicting behaviourwhich has been modelled.


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MANAGERIAL ECONOMICS AND RELATED DISCIPLINES

MANAGERIAL ECONOMICS - emphasizes on the firm, the

general business or economic environment and businessdecisions

INDUSTRIAL ECONOMICS - focuses on the whole industryviews the firm as a component

MANAGEMENT SCIENCE - concerned with techniques thatcan be applied to improve decision making and is entirelynormative, using operational research, linearprogramming, goal programming, queuing theory and

forecasting all inform the subject matter of managementscience

The study of industrial economics follows the famous structure-

conduct-performance approach which is driven largely by the

structure of the industry, which is considered as an exogenous

variable.


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STRUCTURE-CONDUCT-PERFORMANCE APPROACH

STRUCTURE - generally has a number of dimensions

including the level of concentration, the height ofbarriers to entry, degree of product differentiation, theextent of vertical product differentiation and the extent ofdiversification.

CONDUCT - of an industry refers to the type of behaviour

engaged in by its component firms which includecompany objectives, collusive versus competitivebehaviour, pricing policies, advertising policies andcompetitive strategies.

PERFORMANCE - of an industry refers to its resultsfocusing on profitability, growth, productivity increases,and export performance and internationalcompetitiveness.


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Managerial economics analyses the activity of the

firm without any explicit reference to the legal andorganizational forms which the firm may take. Textbooks on company or commercial law and we

should bear in mind that the legal framework thatgoverns various companies varies from country

to country. In this study of managerial economics will

however deal with the general issues that arecommon in most economies based on free private

enterprise. This includes sole proprietorship, partnership,

Joint Stock Company, cooperatives, publiccorporations, and private corporations.


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BUSINESS OBJECTIVES AND MODELS

OF THE FIRM

Different models of the firm based ondifferent assumptions on the firms basicsobjective.

The theory of the firm is the centrepiece ofmanagerial economics

The basic model is the neoclassical model

while others are just reactions to this modeland suggestions on how it can beimproved.


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A firm is any organization that combines andorganizes resources to produce goods andservices.

Firms are autonomous and different from thepeople who own it.

Theory of the firm is that firms exist in order tomake profits but sometimes firms sacrifice

short-term profits for long terms gains orincreases in long term profits.

It should also be noted that both the short andlong term profits are important and as a result

the firm would want to maximize the wealth orvalue of the firm.


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WEALTH OF THE FIRM

)1()1()1(............

22

11

rrrn

nPV

PV is the present value of expected future profits of the firm, 1,2, ------, n, represent the profits in any of the n yearsconsidered and r, is the appropriate discount rate that could beused to find the expected present value of future profits.

n

tt

t

rPV

1 )1(


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WEALTH OF THE FIRM

n

tt

t

rTCTRf irmValueofthe

1 )1()(

This means that the value of the firms isdetermined by profits generated whichare the difference between revenue andcosts.

This equation unifies theme for analysisof managerial decision making andindeed the whole subject matter of

managerial economics


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THE NEOCLASSICAL MODEL OF THE FIRM The neoclassical model is the anvil of the theory of the firm found in

elementary textbooks.

There are three basic assumptions about model of the firm

- are centred on profit maximization- costs and output- demand conditions in the market

The objective of the firm is to maximize profits which are essentially thedifference between revenue and costs without reference to the period or timeover which profits are to be maximized.

(TR TC = )

This assumption is bridged by dividing the periods into the short run and thelong run. Another complex version which established a multi-period setting for the

model is to assume that the objective of the firm is to maximize the wealth ofthe shareholders, measured by the discounted value of expected future netcash flows of the firm.


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THE NEOCLASSICAL MODEL OF THE FIRM

This requires that the firm makes a decision on its investment criteria aboutthe size and type of plant to operate and the most profitable use of that set ofplant equipment

When profits in the short-term and long term are not related then consistencyin the two periods is possible but if these profits are interrelated in the twoperiods then, the situation becomes more complicated

The simple neoclassical model does not consider complications of this natureabout the maximization of short and long run profits

The firm is seen as a single entity which can be said to have its ownobjectives and can make own decisions, in this case it is seen as beingholistic

Remember that the behavioural model argues that only human beings canmake decisions and not firms

The firm seeks to optimize, that is seen to want to achieve the best possibleperformance rather than just simple performance meeting certain minimumcriteria.


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THE NEOCLASSICAL MODEL OF THE FIRM

The firm produces a single, perfectly divisible and standardized productfor which production costs are known with certainty and the short runaverage costs curve is U-shaped as shown in the figure below

The costs per level of output will decrease as they are spread over largenumber of units during the period the firm will be experiencing increasingreturns to scale but these will increase beyond a certain level when thefirm starts experiencing diminishing returns to scale

The model generally focuses on the short run or the period during whichthe firm is constrained by a plant of a particular size facing a particularshort run cost curve

The model is also based on the assumption that the firm has fullknowledge about the demand and output conditions in the market and thevolume that can be sold at each given price

Demand essentially depends on the behaviour of consumers andstructure of the industry in which the firm is operating and the behaviourof rival firms.


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EQUILIBRIUM CONDITIONS

Maximize $(q), Where $(q) = R (q) C (q) where

- $(q) = profit,

- R (q) = revenue,

- C (q) = costs,

- q = units sold orproduced.

This means maximize profits defined as thedifference between revenue and costs andwhere revenue and costs depend on the level ofoutput produced


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ELEMENTARY CALCULUS

0

$

q

C

q

R

q

q

C

q

R

qq

CR

2

2

2

2

CONDITION 1

CONDITION 2

CONDITION 1

This means that profit will be maximized if the firm produces alevel of output such that the marginal revenue ( )

q

R

equals marginal cost when the slope of the marginal cost curveexceeds the slope of the marginal revenue curve.


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EQUILIBRIUM CONDITIONS(diagrammatically)

$

Output

Marginal cost

curve

P

X

Demand / average

revenue curveMarginalrevenue curve

Profit maximizing equilibrium Davies Howard (1990): Managerial Economics, for Business,

Management and accounting, 2nd edition, Pitman publishing, England.

T h e m a r g i n a l

R e v e n u e a n d

m a r g i n a l

C o s t c u r v e s

should intersectand at the point of

equilibrium the

marginal revenue

c u r v e s h o u l d

a p p r o a c h t h e

m a r g i n a l c o s t

curve from above

Both the diagram

and the equations

s h o w n a b o v e

identify the profit

m a x i m i z i n g

equilibrium for the

firm. The firm will

p r o d u c e t h e

indicated and the

firm is said to be in

equilibriumlevel of

output and sell it at

the indicated price.

If cost conditions

do not change thef i r m h a s n o

incentive to change

its price or output


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Applications of the simple model

Change in parameter Impact on

Price Output

Demand increase + +

Demand falls - -

Increase in variable cost + -

Lump sum tax or cost increase 0 0

The purpose of the mainstream economic theory is to

predict the firms responses to business environmentalchanges particularly demand, cost and tax structures and howt h e n e w e q u i l i b r i u m w i l l b e e s t a b l i s h e d

PROFITS IN THE LONG RUN THE MAXIMIZATION OF


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PROFITS IN THE LONG RUN: THE MAXIMIZATION OFSHAREHOLDERS WEALTH

The firm has to make some investmentdecisions which are essentially concernedwith the long run in which there are no fixed

costs. It is therefore not sufficient tocharacterize the firms objective as profitmaximization which is defined by thed i f f e r e n c e b e t w e e n r e v e n u e a n d

opportunity costs in a single period withoutreference to a pattern of returns over time

ompara ve a c proper es


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ompara ve a c proper esof the profit maximizingmodel

The model can also be used for normativepurposes in assisting managers on what they

o u g h t t o d o o r n o t t o d o . For instance in supporting the traditional

management accounting thinking that firmsshould always agree to accept businessdecisions which bring in greater incrementalr e v e n u e t h a n i n c r e m e n t a l c o s t


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Managerial discretion modelsof the firm

The neoclassical model of the firms has received alot of opposition from various authors in the latefifties and sixties because in the modern dayeconomies ownership and control of firms lay with

different groups of individuals other than the realowners.

The classical assumption that ownership andcontrol were unified in one person does not holdanymore and this therefore implies two groups of

persons Owners (shareholders)

Controllers (managers)


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These two do not or may not necessarily share thesame interests.

Managers salaries for example may not entirelydepend on the firms profitability but may be tied to

organizational performance- remember the bonus orprofit-sharing schemes.

For this reason managers may therefore not pursueprofit maximization but follow other objectives but ingenerally, the manager of a large normally

profitable company will earn a higher salary thanthat of a small but highly profitable company.


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Berle and Means (1932) demonstrated that modernenterprise had not only evolved in size but theownership and control of firms had changedsubstantially.

Control lay in the hands of professional managers whileownership rested with share holders and in the casewhere the interests of managers and shareholdersdiffer, shareholders may not know the goings own infirms that they own.

As long as shareholders have limited interest in what isgoing on in the operations of the firms provided theyreceive a good dividend, a lot of discretion is given tomanagers who can exercise it to pursue personalinterests.


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Some firms may aim at achieving a minimumlevel of profits and once these are realized

- there is no incentive to increase profits,

- that is pressure for profits may be relaxedalthough it may be possible to still earnhigher profits,

- this behaviour is known as satisficing as

according to Simon and others whoproposed an alternative to the profitmaximization behaviour.


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It has been suggested therefore that firms inoligopolistic markets do not necessarily pursuethe profit motive and this facilitated thegeneration or search for newer models whichare based on different assumptions from thoseespoused by the neoclassical model.

These models include the sales-revenue-maximizing model by Baumol (1958), themanagerial utility maximizing model by

Williamson (1963), the multi-period profit-maximizing rate of growth model by Baumol(1967), the Marris model by Marris (1964) andthe integrative model by Williamson (1966).


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The sales maximization model

$Total cost

Total Revenue

Profit

Output

AD

B

E

C


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Managers salaries, their status and

other perks are related to size of the

companies in which they work,measured by sales rather thanprofitability. Managers will therefore be

keen to increase size and other factorsto which their remuneration is tiedother than profits.


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The assumption of maximization of sales rather thanprofits therefore results in a different model from theneoclassical model. Other assumptions of this model are:

Single product firm aims at a single objective There is perfect information about cost and demand

conditions

The revenue maximizer will produce more and charge lessfor the following reasons: Marginal revenue = 0 for the revenue maximizer Marginal revenue = marginal cost for the profit maximizer Marginal cost must be positive and as such marginal

revenue must be greater than zero for the profitmaximizer.


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The marginal revenue for a profit maximizer must be

greater than the marginal revenue for a revenuemaximizer. As marginal revenue slopes downwards to the right

equilibrium output must be higher for a revenue maximizerthan for a profit maximizer.

Under this model the firm does make some profit likeespoused in the neoclassical model although this may notsatisfy the shareholders and in many cases revenuemaximization may imply incurring losses.

It is therefore necessary to introduce constraints into themodel to make it more realistic, so the model is alsoknown as the sales revenue maximization model subjectto meeting a minimum profit constraint and this model isdemonstrated in the figure below.


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The sales maximization model$

Total cost

Total Revenue

Profit

Output

AC

B

E

PC3

PC1

PC2

B


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The sales maximization model There are three possible scenarios demonstrated in this

model. In the first case represented by PC1PC3. For PC1 the constraint does not bite or seriously affect the

level of profits expected by the shareholders. PC2 is another possible scenario where the at the revenue

maximizing level insufficient profit is being made and this

does not satisfy the shareholders and output is reduceduntil that constraint is met at output level B. For PC3 maximum profit required to satisfy the

shareholders is the same as that for the profit maximizingfirm and in this case output has to be reduced to level C.

This is despite the fact that the firm has set itself adifferent objective.

The managerial utility maximization model


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The relative efficiency of the firm comparedwith the market depends on the extent to whichthe interests of different parties within itcoincide,

That is the extent to which the principal-agent

problem exists and this is a generalphenomenon. This occurs when the principal hires an agent

to act on his behalf but the agent may have

objectives totally different from those of theprincipal, Who may be unable to monitor whether his

instructions are being rigorously implemented.

Th i l ili i i i d l


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Williamsons managerial-utility-maximizing model takes

account of wider range of variables by introducing theconcept of expense preferences and beginning with theassumption that managers want to maximize their ownutility.

Expense preferences simply mean that managers getsatisfaction from using some of the firms potential profitsfor unnecessary spending on items from which theypersonally benefit and three major types of theseexpenses are:

Amount managers spend on staff over and above thoseneeded to run the firms operations (S), including power,prestige, status and satisfaction among other variables

e manager a ut ty max m zat on mo e


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e manager a ut ty max m zat on mo e

Additions to managers salaries and benefits in the

form of perks (M) including unnecessary luxurycompany cars, extravagant entertainment andclothing allowances, club subscriptions, palatialoffices, which may also be thought of as managerialslack leading to X-inefficiency.

Discretionary profits (D), which are after tax profitsover and above the minimum required to satisfy theshareholders which managers spend on pet projectsto further propagate their power, status, andsatisfaction. If the minimum profit required byshareholders is equal to the maximum possible then

D will be zero, and managers may not have the libertyto indulge their taste for perks and unnecessarypayments to staff.

The managerial utility maximization


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The managerial utility maximizationmodel

The basic form of the model is summarized as: U = f(S,M,D) which can be interpreted as managerial utility

is a function of S, M, and D available to the individualmanager subject to the usual economic laws regardingdiminishing marginal utility. That is each additional unitsof S, M and D yield less utility to the manager.

If R= Revenue, C= Costs and T=Taxes the actual profitswhich are a difference between revenues and costs wouldbe given by:

Actual Profit = R-C-S The manager will however report the following profits to

the shareholders: Reported profits = R-C-S-M


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If shareholders require minimumprofits Z, after tax deductions, then

the Discretionary profits (D) will begiven by:

D= R-C-S-M-T-Z


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MUMUMU tDMS )1(

According to the equimarginalprinciple managerial utility will be

maximized when the last poundspent on S, M, and D yield the samemarginal utility such that:


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If the demand declines then at every level of outputthe discretionary profits (D) become less and less andon the other hand the utility derived from D at themargin increases that are MUD increases resulting ina continuous disequilibrium.

The manager will then engage in a redistribution ofprofits from S and M towards D resulting in seriousimplications on costs.

On the other hand if tax on profits increases there willbe a redistribution towards S and M, given that taxes

do not yield utility to management resulting in anincrease in output as workers get more motivated toperform and add more to output.


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While this model may be easy to understand it has somecomplexities which make it difficult to grasp every detailof it but it practical application comes in the explaininghigh profits usually reported by take-overs or mergers.

New managers may have totally different ideas regarding

S and M they will seek to prune these in line with whatthey believe is good for the organization.

This will result in high profits being reported than was thecase before.

This however depends on managements decision and

preparedness to earn less than maximum profits.


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The Marris model

This is a dynamic model concerning itselfwith growth rates but shares the same basicassumptions as the managerial utilitymaximizing model. However in this case theutility derives from:

managers seeing reasonable growth of thefirm

job security which depends on satisfactionof the shareholders interests

growth and profitability of the firm aretherefore key in this model

Th M i d l


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The Marris model Growth in this model is characterized by

diversification into new products, rather than increase

in output per se. There are two dimensions to in therelationship between profits and growth in this model,

first, supply growth which results from the profitsgenerated that are ploughed back as additionalinvestment into the firm or obtaining funds from the

capital market Secondly, demand growth, which starts of as positive

at low levels and declines with time until it becomesnegative.


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The Marris model

The rationale is that at low levels high profitsmotivate management to work even harderand are excited about growth being realized atthis level,

however as the organization experiencesmore growth , managers are burdened with a larger team to

work with,

a feat that may be demotivating to managers. This can also be explained in terms of the

diseconomies of scale setting in and retardinggrowth.


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The Marris model The optimal combinations of supply and demand

growth would be where the two curves depicting thetwo combinations of growth intersect.

The Marris model is shown in the diagram below. As can be seen the combination of profits and growth

chosen is not where the profits are necessarilymaximized.

The desire by managers to seek more growth resultsin them being more incensed with growth than profitsbut the extent to which they do this is governed by

their concern for job security subject to constraintsplaced on them by shareholders who want to see theirwealth being maximized.


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The Marris model

Demand

Growth

SupplyGrowth

AB

X

ProfitRate

Growth rate

SG1


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The Marris model A high retention ratio, that is percentage of profits

paid out in dividends is too high, will realize lowerlevels of growth as there will be limited finance forfurther expansion.

In this case the supply growth curve will be very

steep as shown by SG1 and equilibrium at A depictsa situation where growth is low and less thanmaximum profits are being realized.

If the retention ration rises then the equilibriumcombination of growth and profitability also rises

until it reaches point like B where profits earned aremaximum.


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The Marris model

Up to point B managers have no fears for theirjob security as the combination of growth andprofits must meet with approval of theshareholders.

Going beyond B without the firms share pricefalling is also possible but when the threat oftakeover becomes great the managers wouldthen be more concerned with job security thanother issues.

If the threat of takeover is weak, manager willnot be concerned and will be more concernedwith growth of the firm rather than job securityand will therefore adopt retentions policiesensuring more growth but reduced profits.

e n egra ve mo e


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e n egra ve mo e

This model combines single period profit and

sales maximization with growth maximizationand the maximization of present value offuture sales.

In the upper quandrant the relationship

between the rate of growth and current salesrevenue is shown.

The lower quandrant shows the total cost,total revenue and profit in a single period with

a constraint as depicted in Baumols model.


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The integrative model Growth of sales is directly related to profits so that

growth is maximized when profits are maximum andgrowth is zero when profits are zero.

A single period growth maximizer and profitmaximizer will both produce output level Q1

A single period revenue maximizer subject an

externally imposed constraint will produce outputlevel Q2

However a firm which aims to maximize the presentvalue of future sales will seek the combination ofcurrent revenue and growth rate which gives thatmaximum and this is obtained by constructing iso-present-value curves joining all points which havethe same present value.


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The integrative model

The iso-present-value lines musttherefore be negatively sloped as

shown by the lines PV1 PV3. The properties of indifference

curves still apply in this case, thatis the further away from the origin is

the iso-present-value line, thehigher the present value at thatlevel.

B h i l d l f h fi


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Behavioral model of the firm Managerial discretion models came about as a result of

the criticism of the neoclassical or traditional model of thefirm driven by the understanding that where ownershipand control are not in the hands on one person,

Many firms compete in relatively comfortable oligopolisticconditions, managers are able to pursue own objectivesand direct resources to their own ends.

Cyert R. M. and March J. G. in their book A BehavioralTheory of the Firm argue that the modern firm is acoalition of individual interests, whereby the interests ofmanagers and shareholders may diverge with the thirdgroup in the organization,

The labour force may pursue interests different from thoseof the other two, and the 4th group or suppliers andcustomers interests may also influence the firmsoperations.

Behavioural model of the firm


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Behavioural model of the firm However most of the assumptions of the orthodox model

still hold and the only underlying principle in this model is

that firms cannot be regarded as single entities becausethey are a conglomeration of many people coming fromvarious backgrounds and with own set of objectives.

In essence the behavioral model is different from the

neoclassical and discretion models because of therejection of the concept of the holistic firm.

The model does not emphasize so much on optimizationand does not assume certainty as information is seen as a

scarce commodity.

Behavioural model of the


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Behavioural model of thefirm

The key elements of this model are that the firmhardly exists as a single entity but consists of agroup of people who form coalitions andalliances amongst themselves based on

common group and individual interests. Eachindividual will have own objectives based ontheir historical background, preferences, andposition within the firm.

This therefore implies that the firm will have

multiple objectives which are in conflict witheach other which cannot be reconciled in asingle utility function.

Behavioral model of the firm


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Behavioral model of the firm Decision-making therefore acknowledges a score or

average that allows group and individual interests to be

considered and taken care of. Decision makers exhibit satisficing behaviour rather than

an optimizing one. There is no minimization ormaximization of anything in this firm, the incentive is justnot there to do so.

Organizational costs will therefore not be kept to aminimum but instead there is organizational slackassociated with higher than normal costs in all aspects ofoperational activities.

Departments in an organization may have own set ofagendas which may not necessarily be in tandem,accounts, human resources, marketing, etc may all behaving objectives which are in conflict with each other.


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Behavioural model of the firm If one of the multiple organizational objectives is not

met there will be problem oriented search using rule of

thumb to ensure that this is met. The problem is that this search will be fairly narrow

probably concentrating on this one objective not metand ignoring other issues which may be equallyimportant. Past experience and individuals concerned

assist in this rule of thumb problem oriented search. Organizational learning helps change the individual and

group aspirations and if aspirations are met during thefirst level of problem search these increase and moreaspirations come about which will need another round

of search but eventually a point will be reached wheneveryone achieves a satisficing level in respect ofindividual objectives.


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Behavioral model of the firm

However where a solution does not seemanyway in sight the level of aspirations isreduced.

Overall, there is the process known asquasi-resolution of conflict which isthe process whereby organizational

objectives are met by negotiation andbargaining between differing sectionalinterests.



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Behavioural model of the firm Critique of the model

It is a very realistic model which depictsa lot of commonalities in terms of howorganizations are run, so it isdescriptively more realistic

Model does not offer insights into howorganizations responds to changes in theenvironment because it is too inwardlooking

Model does not fully address thequestion on what firms should do to meettheir objectives



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Behavioural model of the firm If all the stakeholders share a common

objective which is very unlikely, the process of

organizational learning may lead the firmtowards profit maximization. Decision making takes time if all suggestions of

this model are followed and for this reason it isof limited use in managerial economics.

However the model still offers an alternativeway that fosters democratization inorganization that allows participation by all andif properly applied this may yield positive

benefits to the firm.


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THEORY OF CONSUMER BEHAVIOUR AND DEMAND

The individual is important in economics as

a consumer, supplier of productive servicesand as an active participant in the politicalprocess.

The study of consumer behaviour proceedsby looking at consumer preferencerelations which essentially analyze howconsumers make choices under the

assumption that consumers are rationaland would want to maximize utility subjectto the budget constraint.


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THEORY OF CONSUMER BEHAVIOUR ANDDEMAND

Preference relations are formal descriptionsof the consumers capabilities andinclinations when faced with choice

making. There are basically three categories of

preference relations namely the strict

preference relation, weak preferencerelation and indifference preference relation(~)


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THEORY OF CONSUMER BEHAVIOUR AND DEMAND-Consumer preferences and Choice

The consumer makes choices in the consumption spacewhich is defined as the non-negative Euclidian n-orthant(where n is a finite integer, R+).

The properties of the consumption space are as follows: Set X is not a null set Set X is a closed set Set X is bound from below Zero is an element of set X X is a convex set(based on the assumption that goods are

divisible) B is a subset of X or B is an alternative choice

consumption plans both conceivable and realisticallyobtainable.

THEORY OF CONSUMER BEHAVIOUR AND DEMAND- Utilityanalysis


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analysis

The utility function is a formal way of

consolidating preference relations and can bedefined as a real valued function and there arethree approaches to the utility function namely,cardinal measurement, ordinal measurement andrevealed preference.

The utility function is drawn under the followinggeneral assumptions; preference relations hold,utility is continuous, utility is differentiable, utilityis a regular and strictly quasi-concave function,

and utility is invariant to positive monotonictransformation of the function.


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Rational consumer

Cardinal utility or the fact that utilitycan be measured in cardinal units

The measurement assumes constant

utility of money Diminishing marginal utility

Total utility depends on the number of

commodities in the consumptionbasket

C iti f th di li t


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Critique of the cardinalistapproach

The assumption of cardinal utility isextremely doubtful

Satisfaction derived from various

commodities cannot be measuredobjectively

Constant utility of money is extremelydoubtful and unrealistic

Axiom of diminishing marginal utility hasbeen established from introspection, is onlya psychological law which must be taken

for granted

Ordinal Utility


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Ordinal UtilityAssumptions of ordinal utility

Rationality

Utility is ordinal

Diminishing marginal rate of substitution

Total utility depends on the quantities ofcommodities consumed

Consistency and transitivity of choice

Critique of the ordinalist


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qapproach

Assumptions less stringent than those of the cardinalist Made it possible for framework of consumer surplus

which is important in welfare economics and governmentpolicy to be measured

Makes possible the classification of goods intosubstitutes, complements, neutrals and bads, etc

Axiomatic assumptions of existence and convexity of theindifference curves does not either establish existence orshape of the indifference curves

It is doubtful whether consumers can really order theirpreferences, precisely and rationally as assumed

Critique of the ordinalist


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Critique of the ordinalistapproach

Consumer ordering works through a lot of influences,like advertising, availability of commodities, etc

Theory inherits weaknesses of the cardinalist approachwith strong assumption of rationality and the concept of

marginal utility in the definition of marginal rate ofsubstitution.

Does not analyze effects of advertising, habitpersistence, etc

Rules out the speculative demand and random

behaviour and these are important in pricing decisionsof the firm

Revealed preference


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Revealed preferencehypothesis Paul Samuelson

This dismisses outright the existence and need ofindifference curves in the study of consumer behaviourand derivation of demand curves.

Assumptions of the revealed preference hypothesis Rational consumer Consistency in consumer decision making Transitivity of choice Revealed preference axiom - When the consumer chooses

a particular bundle of commodities they are revealing theirpreference for that and other bundles and the chosenbundle being the one that maximizes utility

Revealed preference


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Revealed preferencehypothesis Paul Samuelson

Critique of the Revealed Preference Hypothesis A major contribution by Paul Samuelson to the theory of

consumer behaviour

Provides a direct way of deriving the demand curve not

requiring the concept of utility Can prove existence and convexity of indifference curves

under the weaker assumptions than the earlier theories

Has made possible construction of index numbers of thecost of living and their use for judging consumer welfarein situations where prices remain constant


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The indirect utility function

A utility function that expresses the utility obtained from aset of goods as being determined by the prices of goodsand level of income, that is

The properties of such a function are: is a homogeneous function of degree zero in prices and

income It is a non increasing function in prices, consumer

reduces consumption and this leads to a reduction inutility.

is an increasing function in income

is continuous in both income and prices is demand generating where the first part shows the

Marshallian demand function and the whole equation iscalled Roys identity

analysis


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Consumer preferences are explained by the three

approaches to consumer choice described below of whichthe most common is the indifference curve approach. The indifference curve is defined as the locus of

combinations of amounts of two goods, say X and Y suchthat the consumer is indifferent between consuming any

one combination or basket of commodities. Properties of indifference curves are as follows: They are negatively sloped showing the inverse

relationship between increase or decrease in quantityconsumed of each of X and Y.

higher indifference curves yield more utility and hence arepreferred indifference curves will not intersect indifference curves are convex to the origin


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Consumer income and price constraints The budget constraint also called the consumer

possibility line, income line, wealth constraint or theprice line is given by the following equation: where =price; = quantity and = income.

The budget constraint is based on the followingassumptions:

Consumers have a given budget

Consumers operate in a market where prices are given

Prices of all commodities are strictly positive

Consumer purchases non-negative amounts of n-commodities

Expenditure on the ith commodity is a product ofquantity and price


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Properties of the budget set The budget line is a set of bundles that cost

exactly It is a subset of the consumption space Is a closed, convex, compact set The set is bound from below Properties of the expenditure function This is a minimum value function stated as min

subject to to attain level of utility U. . The specific properties of the utility function

include: It is an increasing function in U, meaning that

higher levels of expenditure are required for

greater utility to be realized.


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Properties of the budget set

is non-decreasing in prices and the resultingHessian demand function is demandgenerating.

where is known as the Hessian matrix.

is homogeneous of degree 1 in prices

is concave in prices such that where HD is the

Hessian matrix

Consumer choice


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Consumer choice

Good Y

Good X

IC1

IC2

IC3


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Consumer choice Other effects that managers need to understand

about consumer choice include the Bandwagon,Snob and Veblen effects because they have adifferent impact on demand for the commodity.

A bandwagon effects exists in the market whenconsumers for one reason or another would wantto identify with the crowd and suddenly exhibit anincreased demand for the commodity, much more

than was originally anticipated. This is very common with fad items.

Changes in income


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Changes in income Consumers incomes do not remain constant but change

over time resulting in an outward shift of the budget line.

This essentially means that the consumer is now able topurchase more of one or both commodities given theirnew increase in income.

On each new income constraint line there will be a new

equilibrium established and if these points are joined theyresult in a curve known as the income expansion path.

The shape or direction of the income expansion pathhelps explain the consumers perception about thecommodity.

That is, for normal goods the income expansion pathtends to be a straight line from the origin out into theconsumption space.

Changes in income


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Changes in income

Good Y

Good X

Income consumption curveGood Y inferior to X

Income consumption curveNormal goods

IC3

IC2

IC1


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Changes in income

Understanding of this concept helps managersdefine their products and price themappropriately knowing fully well how consumerswill react to changes in incomes.

Each individual manager need to determinethrough some market analysis whether theirproduct is perceived to be a normal good orotherwise with reference to changes in

consumers incomes. However most of the time managers assume a

positive relationship between income and thedemand for their product although thisassumption may not necessarily be true.

Substitution and income effects


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For normal goods the substitution and income

effects of a price change are both positive andreinforce each other in leading to greaterquantities of the product being purchased. Forinferior goods the income effect moves in theopposite direction from the substitution effect.

That is when the price of an inferior good falls,the substitution effect continues to operate asbefore to increase the quantity purchased of thegoods.

Increase in purchasing power or real incomeresulting from the price decline leads consumersto purchase less of the inferior good.



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Substitution and income effects However since the substitution effect is

usually larger than the income effect, thequantity demanded of the inferior goodincreases when its price falls and the demandcurve is still negatively sloped.

The diagram below shows the relationshipbetween the income and substitution effectsof a price curve and the correspondingdemand curves in the case of normal, inferiorand giffen goods.

The net effect of the income and substitutioneffect is called the price effect.


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Substitutioneffect

Income effect

GoodX

GoodY

Q2 Q3Q1

1 Q2 Q3

Giffen

good

Normal andother inferiorgoods

Quantity

Price

Q


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Note the upward sloping nature of the demandcurve in the case of the giffen good implying thatthe income effect more than offsets thesubstitution effect to the extent that quantitydemanded of the commodity is far less than wasthe case before the price change.

This analysis is very useful in explaining whether

consumers will and always respect the law ofdemand or there are situations during which thisis violated?

Substitution between domestic andforeign goods


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foreign goods

The substitution between domestic and foreign goods

has risen sharply in recent years due to more liberalapproaches to international trade. Other reasons for this increase are a decrease in

transportation costs for most products, increasedknowledge of foreign products due to the internationalinformation revolution, global operations ofmultinational corporations, explosion of internationaltravel and rapid convergence of tastes globally.

For most products like computers, fibre optics,television sets, automobiles, soft drinks and otherspecialized machinery substitutability between domestic

and foreign products is apparent and has notencountered any major problems.

Managers should note that a small shift in prices of thedomestic product may lead to customers shifting totallyfrom the consumption of local brands to international

brands.

foreign goods


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Managers should note that a small shift in prices of thedomestic product may lead to customers shifting totally

from the consumption of local brands to internationalbrands.

Consumers will spend their incomes on foreign anddomestic goods until the marginal utility per dollar derivedfrom each is equalized.

For this reason again the multinational companies areforced more and more by international competition toequalize costs in production and components as well assales revenues between domestic and foreign markets.

The modern manager must therefore have a good

understanding of this substitutability between foreign anddomestic goods for them to be current and relevant andthe study of managerial economics needs to acknowledgethis phenomenon.

curve analysis


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Governments in developing countries have amajor role to play in ensuring that the vulnerableare protected through sustainable social safetynets and the options open to government or other

institution involved with the same are eitherproviding cash or providing food stamps.

Each of the approaches has its own merits anddemerits which every manager of such a

programme needs to think seriously about.

Further application of indifference


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Further application of indifferencecurve analysis

Food

Money for nonfood items (Mt)

Food

F1

BII

F

B

BI



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The fundamental question is whether it is better to give anequal amount of subsidy in cash to poor families. In thediagram above we assume that each family has anaverage income which it spends entirely on food and non-food items as shown by the lower budget line.

This budget line changes with free food stamps thatrequire the family to purchase food and becomes the solidinverted L-shaped curve above the original budget lineintersecting with it on the vertical axis.

Where government gives cash instead of food stamps thebudget line become the straight line above the originalbudget line and touches both axes.



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Indifference curves shown represent the familysutility maximization points for example point B isone such point before family receives assistanceand this is a family that has strong preference fornon-food items. Another family with strongpreference for food will maximize utility at a pointlike F but on the same budget line. These familieswill move upwards and enjoy utility at BI or FI witheither cash or food stamps. A family with morepreference for non-food items will however move toa higher indifference curve from the food axis topurchase more of non-food items if given cashinstead of cash.



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We note that in both cases individualhouseholds are better off but cash allowshouseholds to have more liberty to purchaseother items other than food.

The reasons why governments however maycontinue to give this assistance in terms orfood-stamps or food per se is because there is

a deliberate need to improve nutrition statuswhich objective may not be achieved if cashinstead was given.

ar e eman or a commo y


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The market demand curve for a commodity is thehorizontal summation of demand curves for all individuals

in the market. Thus the market demanded quantity at each price is the

sum of the individual demand quantities at that price.

Assume two individuals in the market and assume thateach individual is demanding a certain amount of thecommodity at that price.

The market demanded quantity will therefore be the sumtotal of the quantities demanded by these individuals andnothing more.

However we need to note that the market demand curvegenerally is flatter than the individual demand curve, butstill maintains the downward sloping nature of the demandcurve, ceteris paribus.


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When drawing the market demand curve for acommodity we hold the income, prices of substitutes

and complements and the number of consumers inthe market constant.

A change in any one of these will lead to a shift in thein the market demand curve for the commodity.

It is also important to note that the market demandcurve will be a horizontal summation of individualdemand curves if consumption decisions are

independent but we know that this is not always thecase.

ar e eman or acommodity


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commodity There are effects like the band wagon effect, that is keep

up with the Joneses such that the greater the number of

people purchasing the commodity in the event of a pricechange others follow suit so that they do not get left out. This results in much flatter market demand curve than

would be the case. On the other hand the Snob effect will result in some

consumers disassociating themselves from the productresulting in a much steeper market demand curve. Veblens will demand more of the commodity the more

expensive it is in order to impress other people. This postulation was developed by Thorstein Veblen who

observed that the slope of the market demand curve is notalways what we expect it to be.

Price elasticity of market demand


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ce e ast c ty o a et de a d Decisions taken have to be sensitive to the elasticity of

demand, whether quantity or price.

Elasticity is nothing but the responsiveness of quantitydemanded to a change in any of the variables that affectdemand.

Demand for a commodity can exhibit either elastic or

inelastic demand and managers have to understand thenature of commodities that they are dealing with in termsof the elasticity concept so that they can price themappropriately.

Further governments also need to understand elasticity

and use that understanding in determining what wouldbe appropriate taxes to charge on certain commodities toeither encourage or discourage their consumption.

r ce e as c y o mar edemand


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demand

Price

Quantity

Unitary elasticity

Elastic region

Inelastic region



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y A normal price and quantity diagram would

exhibit three elasticity regions that is unitary

elasticity, elastic and inelastic regions. These are defined in terms of how consumers

behave in each region is there is a change in theprice of the commodity.

For example the region below unitary elasticity issaid to be inelastic because changes in priceresult in less than proportionate changes inquantity demanded.

One major reason for this is that prices are stillfairly low in this region and any marginalincreases will not result in an outcry fromconsumers.



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For example take a commodity like salt which are

lowly priced in most economies, a change in theprice of salt will not be quickly reacted to by theconsumers because the commodity cost verylittle anyway compared to the other commodities

in the consumption basket. However in the region above the quantity tends to

be highly price elastic because any small changesin price tend to be noticed and reacted to byconsumers.

r ce e as c y o mar edemand


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demand Unitary elasticity results when percentage changes in

price result in an equal percentage change in quantitydemanded.

That is, when the price of the commodity changes, thatdoes not change overall consumer expenditure and thequantity purchased of the commodity does not change as

well. As a policy principle it is not advisable to reduce the price

when the commodity is of unitary elasticity. For luxuries itis advisable to reduce the price in order to boost demand.

However the concept of unitary elasticity, although veryreasonable, does not exist in practice because thecommodities will either exhibit elastic or inelastic demand.

Factors that affect elasticity of


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ydemand

Factors that drive the elasticity of demand of commodities include (1)how the commodity is defined, (2) relative expenditure on the good,(3) availability of substitutes, (4) geographical location and (5) time.

Basic commodities tend to be very much price inelastic becauseconsumers are given no choice because they need the commoditiesanyway while on the other hand luxuries tend to on average exhibit

elastic demand because consumers can easily go without them. If a commodity takes a larger chunk of the household budget, it tends

to exhibit elastic demand because consumers are quick to notice anyprice changes of such commoditities.

Prices that are high tend to be more elastic than low ones. Furthercommoditities that have many close substitutes are more price elastic

than those that have not close substitutes. The question however is why is it that salt has no close substitutes

but is generally lowly priced?

Factors that affect elasticity of


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ydemand

Geographical location of the commodity also affects theelasticity of demand because the relative importance of acommodity varies as you move from one country to the next.

For example, blankets in Lesotho and Tanzania because ofthe differences in weather conditions will tend to exhibit

inelastic demand.

Sometimes consumer tastes and preferences change overtime. For example the way consumers perceived the firstHonda car was so negative that it did not sell.

However, manufacturers were able to transform this carmodel to one that could compete very well with other cars inthe market. However this took a long time to accomplish anda lot of resource ploughed into research and development.

Income and cross elasticity of demand


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Own elasticity of demand if the ratio of

percentage change in quantity demanded topercentage change in the price of thecommodity or the product of the ratio ofchange in quantity to change in price andratio of price and quantity.

That is,

odiceofthegochangeinprpercentage

ndedantitydemachangeinqupercentage

quantity

price

icechangeinpr

antitychangeinqu*



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Q

P

P

Q *

For the downward sloping demand curve own price elasticity willalways take negative values because price and quantities change inopposite directions.We also talk about arc and point elasticity of demand where arcelasticity refers to elasticity over an interval along the demand

curve and this takes different values depending on the direction ofchange in values that would be considered at any point in time. Wetherefore define arc elasticity as the average of the two differentvalues although this raises a lot of ambiguity, so we should besatisfied that arc elasticity will take on different values depending

on the direction of change being considered.



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As the distance between the two pointsunder consideration is reduced thedifference between the two values for the

arc elasticity becomes smaller and at thispoint we discuss point elasticity which inelementary calculus it is defined as:

QP

P

Q*

demand


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This makes the whole ambiguity about arc elasticitydisappear. Curves depicting different elasticities ofdemand will always take on different shapes, that iswhere the demand curve is a vertical line elasticitywill be equal to zero, where it is a horizontal line

elasticity will be negative infinity and for the normalconvex demand curve the elasticity will be negativeunity at all points.

This is where the demand curve is a rectangularhyperbola and the product of price and quantity atany one point would be negative one.

Price elasticities of demand


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Examples given here are unlikely to be met in practice butare important to understand the elasticity concept for

purely academic purposes. At the point where the curve meets the price axis elasticity

is negative infinity and at the point where it meets thequantity axis it is zero.

Elastic and inelastic demand is also terms generally used

to describe the type of responsiveness that is beingconsidered.

When elasticity is less than 1 demand is generally said tobe inelastic and if the absolute value of elasticity isgreater than 1 then that is considered as being elastic.

In situations where elasticity is either infinity or zero, thenit is described as infinitely or perfectly elastic and where itis equal to one it is said to be unitary.

Marginal revenue and elasticity


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As elasticity measures the responsiveness ofdemand to changes in price, it is also properto think about a link as existing betweenelasticity and revenue.

This link is as follows, in the elastic region afall in the price leads to a more than

proportionate increase in quantity demandedthereby leading to an increase in revenuegenerated.

If demand is inelastic a fall in the price willlead to a less than proportionate increase inthe volume of demand and revenue will fall.

Marginal revenue and elasticity


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In short in the elastic region revenues and elasticity move in differentdirections but in the inelastic region revenues and elasticity move inthe same direction.

This is shown in the figure below:

X

Y

Z

Marginal revenue

Pricerice

Between X and Y wheredemand is elastic themarginal revenue is

positive and between Yand Z where demand isinelastic the marginalrevenue in negative. Wecan explain the latercase as meaning that inorder to sell one

additional unit of outputthe proportionatechange in price is solarge that revenue falls.


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Income elasticity of demand

While in economic theory we often talkabout price elasticity of demand incomeelasticity of demand is another veryimportant concept because demand isalso sensitive to changes in incomewhich can be expressed as:

comensumerchangeincopercentage

ndedantitydemachangeinqupercentage

sin'



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y

This can be expressed as both arcincome elasticity and point incomeelasticity and each on of them will be

expressed as follows:

mandedquantityde

incomeconsumers

comensumerchangeinco

ndedantitydemachangeinqu '*

sin'

Q

Y

Y

Q*

(point income elasticity)

arc income elasticity


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The size and sign of the income elasticity ofdemand depends to a great extent upon thenature of the product in question and thelevel of income which the consumers willhave reached.

At any level of income consumers willpurchase commodities in certain quantitiesand these quantities are likely to increase asthe level of income increases.

Remember that total utility depends on thetotal amount of commodities in theconsumption basket


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Income elasticity of demand The Engel curve which shows the relationship between

income and demand for the product will be relativelyflat in the case of necessities.

For luxuries the Engel curve will be upward slopingindicating that at higher levels of income theconsumers want to purchase more of the luxury goodthan they would at low levels of income.

For inferior goods consumers will purchase less astheir income increases and the opposite is true for

normal goods. These scenarios can be explained in the figures below:


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Quantity demanded Quantity demanded Quantity demanded

Income Income

(a) Necessities (b) Luxuries (c)Inferior for income

levels above X0

Income

The Engel curve has also been used to explain welfare. The greater the proportion of income spent on foodthe lesser will be the standard of living in any particular country. This means that consumers in that countryare more preoccupied with working just to buy food and cannot afford other non-food items. Managers needtherefore to understand the proportion of money that consumers spend on food in their respective targetmarkets and business environments. Where the Engel curve shows that a greater proportion of income isspent on food, those businesses selling non-food items should therefore be cautious about how they goabout their day to day business as demand is depressed for them.

Cross price elasticities of


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demand

This is the third most discussed elasticityconcept which indicates the responsiveness ofquantity demanded to changes in prices ofother goods which may either be substitutes or

compliments. We summarize the point crosselasticity of demand as:

P

P

P

Q

A

B

B

A *

where QA and QB are quantities and PA and PB are prices. In looking at this elasticity conceptit is important to pay particular attention to the sign of that type of elasticity. A positive signmeans that the two commodities in question are substitutes and a negative sign means theyare compliments. For commodities that are not related the cross elasticity of demand will bezero.

Cross price elasticities of


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demand

The magnitude of the cross elasticity figure obtained ifvery important in decision making as it indicates thedegree of industrial competition that exists.

A low magnitude indicates low levels of competition orthe degree of industrialization and high magnitudes

indicates still competition and more industrialization. The question now is how big is big, we are talking about

magnitudes of 6 and above. Practical application of the cross elasticity of demand is

in finding the appropriate definition of a market or

industry, that is an industry is a group of firms producinggoods which are close substitutes or have high positivecross elasticities of demand.

Constant Elasticity ofd d


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demand

Demand functions take various forms rangingfrom multiplicative to additive demandfunctions.

Given that quantity demanded is a function ofmany independent variables and assuming anaddictive demand function of the form:

...........255,1100 APcPsPQd



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demand

Where Qd = quantity demanded P = own price of the product

Ps = price of substitute good

Pc = price of complementary good

A = Advertising expenditure = error term

For a multiplicative demand function we shallassume a Cobb Douglas type of demand function

which is expressed as:

AYaPQbbb

d

321



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demand

Where Qd = quantity demanded P = own price of the product Y = Incomes of consumers A = Advertising expenditure a = coefficient The powers in such a demand function

represent the elasticities of demand withrespect to each of the variables to which they

are attached. Note that the elasticity ofdemand in the case of price is negative andthat with respect to income and Advertisingare positive.



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demand

We can prove that the powers indeedrepresent the elasticities by solving

this function as follows: )1(21 YaPQ bbd

)2(*

QP

P

Q

This shows us that in such a multiplicative demand function of the Cobb Douglas form powerof the variables represent the elasticities of demand with respect to each of those variablesand there are two important issues to take note of in this case. You can also demonstrate thatb2 is the elasticity of demand with respect to income Y, by differentiating this function withrespect to the income variable.



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demand The marginal effect of each of the independent variables

depends on the value of all other independent variablesunlike is the case with the additive model where theimpact of each variable does not depend on othervariables.

This latter assertion does not make any realistic sensebecause in reality everything depends on everythingelse, there is no way we can think of variables as totallyunrelated.

For example it is erroneous to assume constant tastebecause these are likely to change with price.

Constant elasticity of demand is important because ittells us that there is uniform decision making within thefirm and that there are no variations among individualtastes within the group.



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demand

It is also possible to convert this CobbDouglas multiplicative model into a linear-log function as follows :

In this case the coefficients of the logs

give the elasticities of demand in thisfunction.

The other implication is to say we need notworry about these constants when makingdecisions because these values areconstants

YbPbaQ loglogloglog 21

How to estimate and forecastd d


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demand

The size of the market is very important to any businessand decision-making is better informed if the managerknows the size of their market share relative to that ofother competitors.

Market demand estimation can be done using consumer

surveys, market experimentation, regression analysis ormoving averages.

There are different types of markets that we need to thinkabout as we try to estimate demand for our product.

There is the potential market, which is composed of agroup of households and other consumers who indicatesome interest in the product on offer without necessarilyhaving the ability to purchase the commodity.



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demand

The available market is the group of consumers whohave the interest, the necessary income and accessto the product.

This is what is referred to in economics, asconsumers able to show effective demand and very

few companies are able to sell to every possibleconsumer.

The market that suppliers will decide to focus on isknown as the served market but these may not all be

reached and those consumers that the company willeventually settle for who will actually purchase theproduct are the penetrated market.



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demand

These markets can also be analyzed from theviewpoint of industry market, which is themarket for the whole industry and the marketfor the individual firm.

Markets also need categorization along theproduct line, product form and market for anindividual product item.

Further markets can also be classifiedaccording to geographical differences like the

local, regional, national , continental or globaland also in terms of the time factor such asshort-medium-long term.

Market surveys This is one way of estimating and forecasting demand for a


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This is one way of estimating and forecasting demand for aproduct which proceeds by way of a questionnaire to establishconsumers intentions about a product within a specified future

period. Market surveys may be used for a range of other purposes like

testing the consumers reactions to different productconfigurations and packaging, identifying the link betweenpurchasing behavior and other variables like consumer incomes,age, gender and social status.

A team of well-trained interviewers or scouts is sent out into themarket to ask consumers questions about how they feel aboutcertain products.

Some inherent problems of consumers surveys is that they maybe very expensive to carry out, some biased questions, samplemay be unrepresentative and answers may be associated withthese surveys and for these reasons some economists arguethat surveys may not necessarily be ideal for forecasting.

Market surveysTh f l d d


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The success of consumer surveys also depends verymuch on how clear consumers are about their attitudes

towards certain products because if buyers areambiguous or vague about their intentions they may notbe able to provide useful information to the researcher.

The cost-effectiveness of market surveys also dependson the cost of identifying and contacting buyers, buyerswillingness to disclose certain information and thebuyers propensity to carry out their actions.

Market surveys are therefore useful for those productswhere it is possible for consumers to plan ahead their

future demand and purchases of the product.

Market experiments or testing


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When a new product is introduced into the

market there may be no data available tocompare or use for the analysis and in thiscase direct questioning of potentialcustomers may be difficult as they have never

seen the product or its characteristics andneither the sales force nor expert opinion willbe useful in this regard.

Market testing therefore becomes the only

option available to estimate the demand forthe product and it takes the following differentforms and techniques.

Market experiments ortesting


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testing

Sales-wave research approach consist of selecting agroup of consumers and supplying the product forfree to them and reoffering the product at reducedcost to them and then determine the repeat purchasesof different brands.

Packaging can be varied to determine or monitor theeffect of variations on market demand for the product.

Market experiments generally proceed throughvarying only one variable and keeping the others

constant in order to see the effect of changes in thisone variable on market demand for the product.

Market experiments ortesting


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testing The other method of carrying out market experiments is known as

simulated store technique whereby a group of shoppers are shown anumber of advertising commercials including those on the product inquestion then giving them small amounts of money that they can spendon the product or other products or keep. Records are then taken on themoney spent on the product and that on other competing products andshoppers are then reassembled and asked on their immediate reactionsto the product and other competing products and their reasons for

purchasing the product. The problem with this approach is that it may be very expensive and

distorts consumer behavior since the consumers already know that theyare being watched and may not necessarily order their purchasing ideasindependently. For example some consumers will associate the moneygiven with the idea that they are suppose to buy products of that veryfirm and not that from other firms and this need to be honest in itself

may not really give a true picture about the consumers preferences forthe product.

Market experiments or testingT t k ti i th h t t bli hi


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Test marketing is another approach to establishingmarket demand which actually involves selling the

product in different markets, in varied packaging orpromotional concepts. This may be done on a very small scale or large scale

depending on the budget allocated to this exercise. Test marketing may be very expensive and may not

necessarily give accurate forecasting informationbecause of certain shortcomings in the exercise itself orthe methodology used, e.g. markets in which testing isdone may not be representative.

Market testing however gives companys intentions to

competitors who may as well take any counter-measures.

Sales force opinionThis approach does not focus on the consumers but on


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This approach does not focus on the consumers but onthe sales force who because of their closeness to the

consumers are asked to provide information onconsumers attitude and opinions on the product andasking them to make projections about the future volumesof sales quantities.

This relies very much on the knowledge of the sales forcesuch that if the sales force themselves are not wellinformed about changes in the economy may notnecessarily provide reliable information.

The sales force may also provide biased information

because they may be pursuing different interests, such asprotecting their jobs, giving low forecasts so that they willbe able to sell everything without much effort.

Sales force opinionThi h h f h ld fi d f b i h


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This approach therefore should find ways of bring theinterests of the sales force and that of the company

together and these may include bonuses for providingaccurate forecasts.

Despite these inherent problems the sale forceopinion has advantages because if properly done thesales force are closer to the customers and moreinformed about their attitudes towards certainproducts, may be able to spot the trends in demandfirst before anyone else does, and should they beinvolved in making these forecasts they may be more

committed and motivated to carry out the exercise.

Expert opinion Experts directly involved with selling like dealers, distributors and

li th l h i t t i i f ti h


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suppliers or other people whose interest is in forecasting such asstockbrokers industry analysts, marketing consultants, tradeassociation officers all have valuable information about thedemand for the product and may be approached for their opinionon how the future sales of the product will behave. Individuals givetheir own independent opinion and as a result are not affected bythe group-think influences.

The Delphi technique is one such approach where individuals areasked for their independent forecast and the forecasts then

discussed further with the participan

Documents

Managerial Ecconomics - Lecture Notes