Managerial Economics Fs

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Managerial Economics


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Wh at is Economics ?


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Economics is t h e science of c h oice in t h e face of unlimited ends and scarce resources t h at h ave

alternative uses.

Since resources are scarce and t h e uses to w h ich

th

ey can be put to are unlimited, one is requiredto c h oose t h e best amongst t h e availablealternatives.


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Several t h inkers h ave given differentdefinitions of economics.

According to Alfred Mars h all, economics isth e study of mans actions in t h e ordinarybusiness of life, it enquires as to h ow h egets h is income and h ow h e utilises it.

Th us on t h e one h and it is t h e study of wealt h , on t h e ot h er it is t h e study of man.


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According to Lionel Robbins, economicsstudies h uman be h aviour as a relations h ip

between unlimited ends and scarcemeans, w h ich h ave alternative uses.

Th us, Robbins says t h at, economics canh elp a man to c h oose h ow to make use of h is scarce means for t h e maximumsatisfaction of h is unlimited ends.


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It was J.M.Keynes w h o pointed out t h ateconomics also dealt wit h issuesconcerning t h e nation as a w h ole.

Keynes defined economics as t h e studyof administration of scarce resourcesand of t h e determinants of employment, income and growt h .


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Wh at is managerial economics?


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Managerial Economics is concerned wit h th e application of economic principles

and met h odologies to business decisionproblems.


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F oundation of ManagerialEconomics

Economics can be broadly divided into twocategories:

microeconomicsand macroeconomics.

Macroeconomics studies t h e economic systemin aggregate and relates to issues suc h asdetermination of national income, savings,investment, employment at aggregate levels, taxcollection, government expenditure, foreigntrade, money supply, price level, etc.


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micro-economics studies t h e be h avior of anindividual decision-making economic unit like a

firm, a consumer, or an individual supplier of some factor of production

In simple terms, managerial economics isapplied micro-economics. It is an application of

th at part of micro-economics, w h ich is directlyrelated to decision making by a manager.


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Th us, managerial economics analysesth e process t h roug h wh ich a manager uses economic t h eories to address t h ecomplex problems of business world, andth en take rational decisions in suc h away t h at t h e preconceived objectives of th e concerned firm may be attained

(Barla, 2000).


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Like an economy, t h e manager of a firm alsofaces five basic issues:-

1 ) Ch oice of product, i.e., t h e products a firmh as to produce - A manager h as to allocate t h e

available resources, so as to maximize th

eprofit of th e firm.

(2) Ch

oice of inputs After determining th

eprofit maximising level of output, t h e manager h as to identify t h e input-mix w h ich wouldproduce t h e profit maximizing level of output atminimum cost.


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(3) Distribution of t h e firms revenue Th e revenue received by t h e firm t h roug h salesh

as to be distributed in a just and fair manner by th e manager.

W orkers, owner of factory building, bankers,and all t h ose w h o h ave contributed t h eir materials and services in t h e process of production, storage and

transportation,h

ave to be paid remunerations,according to t h e terms and conditions alreadyagreed upon.Th e residual after suc h payments constitutesth e firms profit wh ich h as to be distributed


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(4) Rationing - T h is constitutes an importantfunction of a manager.

H e/s h e s h ould utilize t h e scarce resourcesoptimally, w h ich involves expenditure.

As th e manager h as to often look after severalplants simultaneously, h e/s h e must prioritize

not only th

e allocation of resources but also th

etime.


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(5) Maintenance and expansion In addition,th e manager h as to plan strategies to ensureth at t h e level of output is maintained, t h eefficiency of t h e firm is retained over time, andalso to plan t h e future expansion of t h e firm.

Expansion of t h e firm imvolves makingadequate provisions for mobilizing additionalcapital from t h e market and/or borrowing moneyfrom banks.

A dynamic manager always aspires to expand t h efirms scale of operation, so as to increase t h e

profits.


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Economic analysis attempts to explain t h e working of

economic systems.Assume a simple economic system consisting of twosectors, w h ose activities are systematically connectedwith one anot h er. T h e economic activities performed

by economic agents are generally classified into t h reeinter-related activities:

a) Supplying factor inputs, like land, labour, capital,organisation and enterprise, w h ich enable t h e agentsto earn incomes w h ich in turn could be used for purc h asing consumable goods;

Circular F low of Economic Activities


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(b) Using t h e factor inputs (raw materials,mac h ines, labour, land, etc.) for producing

goods to be supplied to th

e consumers; and

(c) Providing intangible and specialized

services directly to th

e people (example,lawyers, teac h ers, doctors, and porters) or working for t h e government (example, soldiers,judges, policemen, etc.).


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Th e nature and dimensions of economicactivities are generally determined by t h e extent

of overall economic development.F

or instance,a developed economic system like t h at of t h eUnited States or Japan, h as more specializedactivities and division of labour, as compared toa traditional economic system


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Forms of Organisation I n modern times, organisation of business assume

several forms, viz., sole proprietors h ip, individual

entrepreneur or one-man business, partnersh

ip, jointstock companies, industrial combination, co-operativeenterprises and State enterprises.

a) Individual Entrepreneur: Under t h e one-manconcern, organiser invests h is/h er own capital andmay also borrow some.

H e/s h e rents a s h op and employs a worker, if necessary. H e/s h e personally make purc h ases and

attends to th

e sales, and is also th

e owner manager,wh o also takes t h e entire risks.Th us, an entrepreneur organizes, directs all economicactivity and takes t h e full risks, and is t h e soleproprietor.


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b)Partners h ip: In partners h ip firm, two,th ree or more people join toget h er,

contribute capital, and s h are t h e profitsand risks of losses in agreed proportions.

c) Joint-stock company: It is t h e mostimportant type of business organisationtoday. It overcomes t h e disadvantages of th e artners h ip arising out of smallfinancial resources and limited businesstalent.


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Co-operative enterprise:Th ey are of two types

1) producers cooperation, and2) consumers cooperation .

i) Producers cooperation: Under it, t h e workers takeup t h e entrepreneurial work, T h ey contribute somecapital and borrow t h e rest; elect t h eir own foremanand managers and employ ot h er staff. After allexpenses on rent, capital, salaries and wages, t h eprofits are divided by t h e workers.Th is type of co-operation is called t h e productive co-operation or producers co-operation.


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ii) Consumers cooperation: Under it, t h econsumers of a region contribute small

sh

ares of capital and start a store. Th

eseco-operative stores buy goods fromwh olesalers or, and sells t h em to t h emembers at t h e market price.

Th e profits are s h ared by t h e members inproportion to t h eir purc h ases or,commonly, in proportion to t h eir capitals h are. Usually, t h e capital s h are iscontributed equally and t h erefore profits

are, also equally s h ared by t h e members.


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S tate enterprise: Th e organisation of stateenterprise is similar to t h at of t h e private

enterprises with

consisting of general manager,foremen, works manager, accountants,treasurer, departmental h eads, etc.

I ts working is generally similar to t h at of a joint-stock company. But, t h e fundamental differenceis th at all its employees are governmentservants wit h fixed tenure and pension benefitson retirement. T h e capital comes from t h e staterevenue, w h ich are attributed by t h e tax-payers.

Th

erefore, th

e profits, if any, go to th

e state.


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Publ ic enterprises: Public enterprises may bein th e form of

i) Departments, i.e., run by a governmentdepartment, e.g., railways and posts andtelegrap h in India,

ii) Corporation, e.g., Life Insurance Corporationof India establis h ed by a special Act of Parliament, and

iii) Limited Liability Company registered under th e Companies Act.


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Definition of Managerial Economics

Managerial Economics is t h e discipline

th

at deals with

th

e application of economic concepts, t h eories andmet h odologies to t h e practicalproblems of businesses /firms inorder to formulate rational managerialdecisions for solving t h ose problems


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Basic economic problem :-

-Resources are scarce-Uses to resources are unlimited-H ence, decisions are required at every

stage of production

Be it,

Sourcing of inputs, conversion of inputs intooutputs or distribution of output.


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F inding optimal solutions to all suc h managerialproblems is rendered easy by t h e concepts

and th

eories of economics and th

emet h odologies of t h e decision sciences.

Th

e basic concepts of demand, cost, productionand price, along wit h th e t h eories of consumer be h avior, profit maximisation and marketstructures h elp in finding out optimalsolutions.


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Th e subject t h at uses t h e t h eories of economics and t h e met h odologies of th e decision sciences for managerialdecision-making is known asmanagerial economics


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is conceptual in natureUtilises some t h eories of macroeconomics

I s problem solving in nature.


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Microeconomics is t h e branc h of economics t h at deals wit h th e individualunits of an economy.

Since managerial economics is concernedwith th e analysis of and finding optimalsolutions to decision-making problems of businesses/firms, it is essentially

microeconomic in nature.


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Managerial economics is a practical subject.

It goes beyond providing rigid and abstractth eoretical framework for managers.

Economics can also be classified as positiveand normative. Positive economics describeswh at is, i.e observed economic p h enomenon.

N ormative economics on t h e ot h er h andprescribes w h at oug h t to be i.e it distinguis h esth e ideal from t h e actual. Managerial economicsis prescriptive, not merely descriptive


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Managerial economics is based on a soundframework of economic concepts.

I ts subject matter is not an arbitrary collection of prescriptions. It aims to analyse business

problems on th

e basis of establish

ed concepts.Th us it is also conceptual in nature.


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Besides analysing t h e managerial problemsof business units, managerial economics

aims at finding out t h e optimal solutions toth e business problems of firms.

In ot h er words, it is problem solving innature.


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S copeManagerial economics h elps in t h e following

Estimation of product demandAnalysis of product demandPlanning of production sc h eduleDeciding t h e input combinationEstimation of cost of t h e productAch ieving economies of scaleDetermination of price of product

Analysis of market structures


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Profit estimation and planningPlanning and control of capital expenditure


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1 . D efinition .

Managerial economics is t h e science of directingscarce resources to manage cost effectively.


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2. A pp licatio n. Managerial economics appliesto:

(a) Businesses (suc h as decisions in relation tocustomers including pricing and advertising;suppliers; competitors or t h e internal workings

of th

e organization), nonprofit organizations,and h ouse h olds.

(b) Th

e old economy and new economy inessentially t h e same way except for twodistinctive aspects of t h e new economy: t h eimportance of network effects and scale andscope economies.


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i. network effects in demand th e benefitprovided by a service depends on t h e totalnumber of ot h er users, e.g., w h en only one

person h ad email, s h e h ad no one tocommunicate wit h , but wit h 1 00 mm users online, t h e demand for Internet servicesmus h roomed.

ii. scale and scope economies scaleability isth e degree to w h ich scale and scope of abusiness can be increased wit h out a

corresponding increase in costs, e.g., th

einformation in Ya h oo is eminently scaleable (t h esame information can serve 1 00 as well as 1 00mm users) and to serve a larger number of users, Ya h oo needs only increase t h e capacityof its computers and links.


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Iii N ote: t h e term open tec h nology (of t h eInternet) refers to t h e relatively freeadmission of developers of content andapplications.(c) Bot h global and local markets.


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Profit MaximisationA majority of t h e organisations regard profit

maximisation as t h e sole criteria for t h eir existence.

Th e primary motivation of suc h organisation is toincrease profitsex (colgate, Britannia) (Titan)

Maximising profits involves maximising revenueswh ile simultaneously minimising costs.


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Th us, any managerial decision w h ich is able toincrease revenue wit h out a proportionate rise

in costs or can reduce costs with

out a fall inrevenue, will increase profits.

Profit maximisation in its most lucid connotationmeans t h e generation of t h e largest absoluteamount of profits over t h e time period beinganalysed s h ort or long-run Wh ile s h ort runis th e period w h ere at least one factor of production is constant, in t h e long-run all t h e

factors are variable.


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A company ability to control its costs variesdepending on t h e time it h as to react. As t h etime increases, t h e proportion of variable costsalso increases.

In th e s h ort-run some costs are fixed but in t h e

long run , all costs are variable. T h e companymust recover all its fixed costs w h et h er or not itproduces any output.

It s h ould continue producing t h e output , if it cansell it at a price t h at covers t h e additionalvariable cost t h at it will h ave to incur for

production.


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A printing operator operating one printing presson a one year lease. H e employs t h ree workers

on a one-day contract.

Wh ile th e one year lease rental for th e press isRs.50,000 . Eac h worker must be paid Rs.80per day . Th e cost of paper, ink, electricity andoth er miscellaneous expenses for printing onebook is Rs. 1 00 . On any given day, besides t h ecost of t h e press, t h e cost of t h e workers is alsofixed since t h ey h ave already been employed.


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F or th e following day, t h e cost of t h e press remains fixedbut t h e wage cost of t h e workers is variable, as t h eone-day contract can be allowed to lapse.

Similarly for t h e following year, all t h e costs of t h e printer become variable since t h en t h e printer h as t h e optionof not renewing t h e lease on t h e press and notemploying any worker eit h er.

N ow, suppose t h e printer receives an order in t h e s h ortrun , for printing books wort h Rs.400. T h is will besufficient to cover costs of t h e worker t h e raw materialand miscellaneous expenses and also contributeRs.60 to t h e fixed over h eads, w h ich h ave to be paidregardless of t h e order.


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In th is case, t h e printer s h ould accept t h e order.

If h owever, t h e wort h of a days job is less t h an t h at of Rs.340, t h en t h e printer s h ould not take up t h e order,since h e will be better off not h iring any worker or spending on raw material and ot h er expenses andletting h is press remain idle.

In th e long-run , in t h is case in a year, all t h e printerscosts are variable.

Th erefore, h e s h ould get out of t h e business unless h eexpects to generate enoug h revenue to cover t h ecosts of t h e printing press, workers, raw material,oth er expenses and t h e capital involved in t h ebusiness

h h fi l d


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In th e s h ort-run , a firm can only producemore output by working on its fixed factor h arder.

In our example, if t h e printer were to receivea h uge order to be completed t h e next

day, t h ere would not be enoug h time toincrease t h e number of presses.

Th e only way to meet t h e new demandwould be by increasing t h e number of workers.

In th e long-run, h owever, t h e firm can alter

bot h - th e fixed factor and tec h nology.


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A firms c h oice of tec h nology will determine t h ecost of production for different levels of output.

Besides, ac h ieving t h e lowest unit cost for anygiven level of production, t h e ot h er aim of profitmaximization is to earn t h e h igh est possible

revenues.

Th e extent of profits for a given level of costsdepend upon t h e revenues t h at a firm can

ac h ieve, w h ich in turn is a function of t h econsumers willingness to pay for a particular product.


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H ow muc h a consumer is willing to pay willdepend on h is income, tastes and also on t h eprice of related goods.

Th e maximum price t h at a consumer is willing topay for one more unit of a particular good isknown as t h e reservation price.

A firm must price its product in suc h a way t h atth e n th ranked consumer pays just t h isreservation price for t h e n th unit of t h e output.

G i h i fi ld t t h t h


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G iven a c h oice, any firm would want to c h arge t h ereservation price from every consumer. But t h isseems unlikely because it can usually c h arge

only a single price for all th

e output it sells.

Th us in order to sell to t h e n th consumer , it mustsell to t h e n- 1 consumers at a price below w h at

th ey will actually be willing to pay.

In ot h er words, if a firm lowers its price to expandits market by one additional consumer, it loses

th e value of price reduction to t h e last customer.

Th e net of t h ese two values is known as t h emarginal revenue.


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It represents t h e c h ange in total revenuedue to t h e sale of one additional unit.

Wh ile eac h additional unit brings inadditional revenue, it also increases t h efirms cost. T h is increase in t h e total costdue to t h e sale of one additional unit isknown as marginal cost.

i l i h i i


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Marginal revenue is t h e increase inrevenue from selling one more unit of aproduct. It differs from t h e price of t h eproduct because it takes into account t h eeffect of c h anges in price.

F or example if you can sell 1 0 units atRs.20 eac h or 11 units at Rs. 19 eac h , th enyour marginal revenue from t h e elevent h unit is ( 1 0 20) - ( 11 19 ) = Rs. 9 .


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Th e concept is important in microeconomicsbecause a firm's optimal output (mostprofitable) is w h ere its marginal revenueequals its marginal cost : i.e. as long as t h eextra revenue from selling one more unit is

greater t h an t h e extra cost of making it, itis profitable to do so.

Id ll h fi h i


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Ideally, t h e firm must c h oose a price-outputcombination t h at yields t h e h igh est revenue atlowest cost, for maximising profits.

As long as t h e marginal revenue exceeds t h emarginal cost, it will be wort h wh ile to add t h atextra customer as t h en t h e overall profit willincrease.

Once t h e marginal cost equals t h e marginalrevenue, t h e last consumer makes no additionalcontribution to t h e profits of t h e firm.

Th l i b h d


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Th e same conclusion can be reac h edmat h ematically by constructing a model.Th e model of profit maximisation is basedon t h e following assumptions.

Th e firm is owned by a single personTh e objective of t h e firm is profitmaximisationTh e operating market conditions are givento th e firmTh e firm acts rationally to ac h ieve itsobjectives.

Since profit is t h e excess of total revenue


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Since, profit is t h e excess of total revenueover total cost

= TR - TCWh ere is t h e profit of t h e firm. TR is t h e

total revenue and TC is t h e total cost.

Since bot h TR & TC are functions of output,th at is

TR = f 1 (Q) and TC = f 2(Q) = f 1 (Q) - f 2(Q) = f 3(Q)


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Th us, profit is also a function of output


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Profit Maximizing Casetwo break even points - only normal profit

is earned at t h ese pointstotal revenue is a straig h t linetotal cost c h anges according to law of diminis h ing returnseveryt h ing inside two break even points isprofitableth e most profitable output is at t h e pointwh ere t h e difference between totalrevenue and total cost is greatest


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OPP ORTUNITY CO S T


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OPP ORTUNITY CO S TOpportunity cost of a decision is t h e cost of

sacrificing t h e alternatives to t h at decision.

Th e question of sacrificing arises because of t h e

fundamental economic problem of scarceresources w h ich forces t h e manager to c h ooseth e best out of t h e available alternatives.

Ch oosing t h e best automatically means leavingbe h ind all t h e remaining alternatives.

Opportunity cost confronts us at every point in


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Opportunity cost confronts us at every point inlife. But, most of t h e times, we dont take t h iscost into account w h en making decisions.

F or example, a s h oemaker making c h appalsinstead of s h oes and sandals.

Even w h en a person decides to invest h is moneyin th e debenture of a company, h e comparesth e returns on h is investment wit h wh at h ecould h ave earned if t h is money was kept in abank as fixed deposit.


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Th e benefits from t h e last action (suc h as unit


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T e benefits from t e last action (suc as unitof production or consumption) are termedmarginal revenue , and t h e costs from t h at

action are termed marginal costs

In 1990, the National Aeronautics and SpaceAdministration (NASA) launched into orbit the

Hubble Space Telescope, a new orbiting telescope that by being in space avoided atmospheric distortions from astronomical observations. Astronomers expected vast new

gains and insights in their scientific explorations.

Unfortunately someone goofed Wh ile being


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Unfortunately, someone goofed. ile beingtested after being in orbit, scientists andengineers at N ASA discovered some flaws in

th

e mirrors used in th

e telescope th

atsignificantly diminis h ed t h e ability of t h etelescope to gat h er signals from deep space.Th e scientists were devastated, butimmediately set upon ways to rectify t h eproblem. Of course t h e solution was costly.

Politicians were outraged, some calling t h eH

ubble Space Telescope a $2 billion debacle.Th ere was a strong movement to deny anymore funds to t h e project, since N ASA h ad notgotten it rig h t initially. B u t margina l ana lysisrevea ls a m u ch different perspective.

Th e $2 billion or so dollars already spent on t h e H ubble


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Th e $2 billion or so dollars already spent on t h e H ubbleTelescope did not matter. Wh at was relevant at t h atpoint was w h at were t h e gains and losses from fixing

th e problem or leaving t h e telescope as it was.

In its flawed state, t h e H ubble Telescope could stillperform many useful and interesting scientificfunctions. Corrected, it could perform more.

Th e only relevant question at t h at point was w h et h er or

not t h e additional scientific discoveries t h at wouldcome from fixing t h e problems would be wort h th e costof th e repairs. T h e initial expenditure to build andlaunc h th e H ubble Space Telescope did not matter

anymore.

Th M th ti f M i l A l i


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The M athematics of M argina l A na lysisWh en we do marginal analysis we are seeing h ow one t h ingch anges w h en t h ere is a small c h ange in somet h ing

else. Relationsh

ips between different variables are expressedas functions. W e write y=f(x) to mean t h at t h e variable ydepends in some clear way -- t h e function -- on t h e value of variable x. Examples of functions we mig h t see are:

y=3x

y=4x2

y=log(x)

y=ax 2+bx+c w h ere a, b and c are parameters

y=1 /x


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M argina l A na lysis (contnd)

PriceQuantity Total

Revenue10 14 140

12 13 156

Tota l reven u e is th e total money received fromth e sale of any given quantity of output.Th e total revenue is calculated by taking t h e

price of th

e sale times th

e quantity sold, i.e.tota l reven u e = price X q u antit y.


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Average Revenue


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Average Revenue

Average Revenue is obtained by dividing t h etotal revenue by t h e number of units of quantity sold.

Reven u e is th e income generated from t h e


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Reven u e is th e income generated from t h eoutput produced by firms and t h en sold ingoods markets. It is also known as sa lestu rnover.

Th e revenue t h e firm can create depends onth e strength of demand for th e products t h eyare supplying - in ot h er words h ow muc h outputcan be sold at a given price.

TOT AL REVENUE = Price per unit x Quantitysold ( TR = p x q)

A VER AG E REVENUE = Total revenue


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VER E REVENUE Total revenuedivided by output

MA RG INAL REVENUE = th e c h ange intotal revenue as a result of selling oneextra unit of output.

If th e average revenue curve is downwardsloping t h en marginal revenue will liebelow AR. In fact MR cuts t h e x-axis ath alf th e distance from t h e origin fromwh ere AR cuts t h e origin.

d l


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TOT AL REVENUE is maximised w h en marginalrevenue = zero

Wh en t h e demand c u rve (AR) is perfectly


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en t e demand c u rve (AR) is perfectlyelastic, AR = MR and total revenue will rise at aconstant rate as price per unit increases.

Most firms face a downward s loping demandc u rve for th eir products. As AR falls, MR willfall as well (price h as to be lowered to selladditional units). Total revenue will rise at adecreasing rate (see bottom rig h t diagram) until

marginal revenue is zero. At t h is point (MR=0),total revenue is maximised.Th e area s h aded in yellow s h ows t h e maximum

total area underneath

th

e demand curve AR.


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l


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Discounting Principle

Almost all managerial decisions relate to t h efuture. T h e value of money today is not t h esame as it will be at a later point of time.

Anyth ing th at is received later alwaysinvolves an element of risk.

A rupee received today is more valuableth an a rupee t h at will be received later.Th is is known as t h e time value of money.

Suppose a person is offered a c h oice to make


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Suppose a person is offered a c h oice to makebetween a gift of Rs. 1 00/- today or a Rs. 1 00next year. N aturally, h e will ch oose Rs. 1 00today. T h is is true for two reasons :-

- Th e future is uncertain and t h ere may beuncertainty in getting Rs. 1 00/- if th e opportunityis not availed of

- Even if h

e is sure to receive th

e gift in future,todays Rs. 1 00 can be invested, so as to earninterest say as 8%, so one year after it willbecome RS. 1 08

E i M i l P i i l


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Equi-Marginal Principle

Th is principle deals wit h th e allocation of an available resource among t h ealternative activities. According to t h is

principle, an input s h ould be so allocatedth at t h e value added by t h e last unit issame in all cases.

Th is generalisation is called t h e equi-marginal principle.


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Suppose a firm h as 1 00 units of labor at itsdisposal. T h e firm is engaged in four activities w h ich need labor services A, B ,C and D. It can en h ance any one of t h eseactivities by adding more labor but only atth e cost of ot h er activities

D emand and Su pp ly


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pp y

Economics studies h ow society allocates t h elimited resources of t h e eart h to th einsatiable appetites of h umans.

Supply and demand are t h e forces at work.At wh at is referred to as t h e equilibrium(E), t h e market price allows t h e quantitysupplied to equal t h e quantity demanded.

Suppliers are willing to sell, and consumersare willing to buy. Supply equals demandfor a price.

Th at in a nuts h ell, is t h e basis of all economic


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,th eory.

F or example, lets take a look at t h e local pub,Port h Tavern w h ich brews its own beer, spudbeer. Imagine you are a fosters drinker and t h ebar is running a 25 cents special discount onmugs of Spud beer.

Th e owner h as ten kegs on h and, but feels if h ewere to c h arge t h e usual dollor per mug, h emigh t be able to sell one or two kegs.

You like F osters, but at 25 cents you decide to try


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, y yth e c h eaper brew. H ere, in t h is bar, t h einvisible h and of economics is at work. At t h erigh t price, t h ere is a demand for t h e ten kegs.

s u pp ly

demand

M u g price

.25cents

0 2 4 6 8 10 14 16 18 20


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A S

AD

P rice L eve l (P )

P

0 2 4 6 8 10 14 16 18 20Economic O u tp u t (Y)

Level of Economics : M ICRO OR MACRO


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Micro economics deals wit h th e supply and

demand equation of individuals, families,companies, or industries. T h e F osters versusSpud beer competition was an example of Micro-economic battle.

Macro-economics , on t h e ot h er h and, concernsitself with th e economies of cities, countries or th e world as s h own in t h e second grap h . Simply

put, micro economics deals with

small,specific situations; macro economics loos atth e big picture of entire economies.

Micro Economics


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Micro-economics is less glamorous t h anmacro-economics, but it is a little morepractical.

Since most of us are not likely to h ave a

macro-effect on a w h ole economy , we willconcentrate on a few basic concepts t h atmake-up micro-economic knowledge.

Opportunity Costs Revision


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Opportunity Costs - RevisionBecause our appetite for goods and services

are insatiable, decisions h ave to be madeto determine h ow to allocate limitedresources.

Most often, t h e increase in production of agood or service requires t h at a cost or

sacrifice be incurred. Economists callth ese costs opportunity costs.

F or example, in 199 2 th e demand for H arley-


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Davidson motorcycles h ad t h e companysfactories operating at 1 00 % of capacity.

H arley controlled 60% of t h e big-ticket, big-bikemarket, and management was forces to decideh ow best to allocate limited production capacityto satisfy demand.

Th ey c h ose to produce several models for sale inth e United States and abroad.

As a result, H arley Davidson, incurred asignificant opportunity costs because t h ecompany decided not to devote its entirecapacity to its most expensive and profitablemodels for export to Japan.

H ad H arley tried to maximise s h ort term profits


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H ad H arley tried to maximise s h ort term profits,it would h ave risked alienating t h e domestic

market of devoted bikers t h e very groupth at h elped create t h e H arley mystique t h atth e Japanese are buying.

Opportunity cost, t h erefore, is t h e cost of ch oice, w h en output, time and money arelimited.

Marginal Revenue and Cost - revision


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Marginal Revenue and Cost revision

A concept closely associated wit h opportunitycost is marginal revenue and marginal cost.

Companies are motivated to maximise totalprofits by maximising revenues and minimisingcosts. If a business h as t h e opportunity to selleven a single additional unit at a profit, it s h ould

produce it. Th

e Marginal Revenue (MR) fromsale s h ould exceed t h e marginal cost (MC) toproduce.

Enterprises s h ould continue to produce until t h eir


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MR=MC. At th at point of equilibrium t h emarginal profit on t h e next unit sold will equalzero.

N o profits are left on t h e table. Past t h at level, t h emarginal revenue of eac h additional unit solddecreases and t h e marginal cost increases.

Experience tells us t h at more units businesses tryto pus h on t h e market, t h e less t h e market iswilling to pay for t h ese goods.

Th e cost of producing one additional unit isl f d


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minimal. But if t h ere is no excess capacity anda company wants to produce more units, new

workers will need to be h ired, new equipmentpurc h ased and a larger factory leased or built.

Th

erefore, once a factory reach

es capacity , th

emarginal cost of producing one additional unitincreases beyond t h e cost of last unit produced.

In th e case of a cattle ranc h er, ram sing h , th emarginal cost of adding a s h eep to t h e h erd isminimal. F ences still h ave to be mended andth e pasture maintained.

Since h e is a rational decision market, Ram Sing h


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will add cattle to t h e point t h at t h e marginalrevenue from t h e same of an additional s h eepwill cover t h ese marginal costs of raising t h iss h eep. (MR=MC).

If th e cost of raising one additional unit becomesh igh er t h an t h e current market price, t h en RamSing h will stop adding s h eep to h is h erd.

M argina l Re en e and Cost Eq ilib ri m


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P rice ( P )P

E

M C

M R= P

QQu antit y P rod u ced ( Q)

M argina l Reven u e and Cost Eq u ilib riu m

Wh y th e demand curve is flat rat h er t h and d l i i h f h


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downward sloping, as in t h e case of ot h er demand curves. It is because t h e price of meat

is determined in a competitive auction.

Th e few additional h ead of cattle t h at Ram Sing h

migh

t bring to th

e market will not affect th

e priceth at is determined by t h e output of t h ousands of ranc h ers and meat processors.

But if Ram Sing h h ad a corner on t h e meatmarket , or a monopoly t h en presumably h ewould always produce and sell at t h e pointwh ere MR=MC.

In th at case h is marginal revenue curve would


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slope downward to t h e rig h t as in t h e instanceof th e standard demand curve s h own in t h ebeer illustration.

Th e marginal cost and revenue concepts wouldalso h old true for a cookie factory manager faced wit h a large special order.

Imagine yourself in h is apron. T h e customer wants to pay 1 .00 Rs. Per dozen for 1 00dozens to be sold at t h e local mela. You h ave

some excess capacity and so you go to your

Accountant and ask w h at your cost is to


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ysatisfy t h is order. S h e asserts t h at it wouldcost Rs. 1 .45 per dozen. S h e gives you t h isbreakdown as proof.

Cookie Batter Rs.0.80

Labor Rs.0.25F actory utilities Rs.0.20F actory upkeep Rs. 0.20

----------Total cost Rs. 1 .45


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As s h own in t h e s h eep and cookies examples,


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marginal costs and revenues are critical inmaking marginal pricing and productiondecisions.

H owever, to evaluate profitability of an entirebusiness , rat h er t h an one transaction , totalrevenue must exceed total costs to make abottom line company profit.

Before, we analyse demand in order to forecast


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it, it is very important to understand t h e basis of consumer demand i.e w h y , wh en and h owmuc h does t h e consumer purc h ase.

Utility i.e t h e want satisfying quality of a good or service, is t h e prime factor t h at generatesdemand.Utility is th e terms used to describe t h e value of

a product to a consumer.

Marginal Utility (MU) means t h e usefulness or


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utility of h aving an additional unit of a product.At some point a buyer is fully satisfied, and anadditional unit is of no value.

G oing back to t h e beer example, suppose youare looking to forget w h atever troubles youh ave and you order one more beer at PortTavern. A second beer would be welcome and

infact would be of great Marginal utility. F iveh ours later you h ave h ad twelve beers, playedbowling, danced and in t h e process forgottenyour troubles.


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At h is point, an extra beer would be of littlevalue.

TH E MARG IN AL UTILITY OF TH ETHI RTEE N TH BEER IS N EG LIG IBLE.

Concept of demand (revision)


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p ( )Demand for a commodity implies

Desire to acquire itW illingness to pay for itAbility to pay for it

Mere desire to buy a product is notdemand. A misers desire for t h is ability to

pay for a car is not demand because h edoes not h ave t h e willingness to pay for it.

Similarly a poor mans desire for and h isilli f i d d


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willingness to pay for a car is not demandbecause h e lacks t h e necessary purc h asingpower.

One can also conceive of a person w h opossesses bot h th e will and purc h asing power

to pay for a commodity, yet t h is is not demandfor th at commodity if h e does not h ave desire toh ave t h at commodity.

Demand for a commodity refers to t h e quantity of th e commodity w h ich an individual h ouse h old iswilling to purc h ase per unit of time at aparticular price/

Types of demand


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Direct and indirect demand

Demand for goods t h at are directly used for consumption by t h e ultimate consumer isknown as direct demand. Demand for allconsumers goods suc h as bread, tea,readymade s h irts, scooters, h ouses is directdemand.

Indirect demand is t h e demand for goods t h at arenot used by consumers directly. T h ey are usedby producers for producing ot h er goods.

Examples of indirect demand are demands for h i l l d i l


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mac h ines, tools, coal and any raw material.

Wh ile direct demand depends primarily upon t h econsumers income, indirect demand dependsupon t h e concerned producers output.

In th e above example, if clot h is a consumer good, t h en its demand will depend on t h econsumers income, w h ile if it is used by agarment manufacturer, t h en its demand woulddepend for readymade s h irts and trousers.


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Durable and N on-durable goods demand


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Durable goods are t h ose t h at can be used moreth an once, over a period of time, as againstnon-durable goods t h at can be used only once.Both producer and consumer goods can bedurable and non-durable.

Durable goods are used wh ile non-durable goodsare consumed . Amoung producers goods w h ilemac h ines, tools, etc are non-durable.Consumers goods suc h as bread, jam etc arenon-durable w h ile car, readymade garmentsare durable.


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Total Market and Market Segment Demand.


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Demand analysis requires not only th

e totaldemand for a product but also a break-up of t h edemand for t h e product in different parts of t h emarket.

Th e market may be segmented on t h e basis of age, geograp h ical region etc. T h us w h ile th edemand for kwality ice cream in India is TotalMarket Demand , demand for Kwality ice creamin Rajast h an or demand for Kwality ice cream

by women is a market segment demand

REVIS ION


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Variables

Variables are th

ings wh

ich

ch

ange and can take aset of possible values wit h in a given problem.

A constant or parameter is a quantity wh

ich

doesnot c h ange in a given problem.

For example Y = a +bx

H ere a and b are constants and X and Y arevariables.


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Q = Q (P)


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Q Q ( )It s h ows t h e relations h ip between two variables Q

& P, suc h th at for every value of P t h ere is onlyone value of Q.

Th ese are t h e basic building blocks of economicmodels.

Th e function D = D (P ) is a demand function andits grap h with price on one axis and quantity onth e ot h er will give a demand curve.

D D(P)


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D = D(P)

P is t h e independent variable and D is t h edependent variable.

It indicates t h e cause-effect relations h ip betweenvariables ( P is t h e cause variable, w h ile D isth e effect variable)

A function can be represented by means of atable or grap h .

G rap h s of functions can take different forms,depending on t h e form of t h e function


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depending on t h e form of t h e function.

Th ree functions frequently used in managerialeconomics involving a single dependentvariable are given below :

Q

A

o BP

L inear

Q = a- bP

A = O A

B = O A/ OB


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QQu adratic


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A

o P

Q = a + B p C P 2

a = O A

Cub ic

Q = a + bP + c P 2 + d P 3

a = O A

Utility Analysis


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Th

e Utility analysis was developed by AlfredMars h all to explain consumer demand. T h isapproac h was based on t h e fact t h at utility isquantifiable i.e it can be measured in someunits. T h e unit for measurement of utility isknown as util.

Th us for example, it can be said t h at ice creamh as 1 0 utils w h ile Rasgulla h as 6 utils. T h ish olds true for a person w h o likes ice cream

more th

an rasgulla.

Since utility can be measured in specific units ,so it can also be added W e t h us h ave total


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so it can also be added. W e t h us h ave totalutility and marginal utility.

Total utility , wh ich is a measure of t h e overallsatisfaction, is defined as t h e total satisfactionderived from t h e consumption of all t h e units of a good or service .

Marginal utility, on t h e ot h er h and is t h e c h angein total utility w h en one additional unit of a goodor service is consumed. T h us, if t h e utility

derived from th

e consumption of 1

,2,3.n..

Units of goods or services are U 1 , U2, U3.U nth en


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th en

Total Utility for 1 unit TU 1 = U1for 2 units TU 2 = U1 + U2

for 3 units TU 3 = U1 + U2 +U3for n units TUn = U1 +U2 +U3 +..Un

Marginal utility for t h e 2 nd unit MU2 = TU2 TU1for th e 3 rd unit MU3 = TU3-TU2

Assumptions of Utility Analysis1 Utilit i di l


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1 . Utility is cardinal

2. Utility being quantifiable is additive3. Various units of a commodity consumed areh omogenous. F or example, if t h e case relatesto th e consumption of 200ml bottles of softdrink , t h en all t h e units consumed must be200ml bottles of t h e same soft drink

4. T h ere is no time gap between t h econsumption of successive units. T h econsumer goes on consuming t h e units oneby one, wit h out any break

5. Th e consumer is rational, i.e h e h as perfectknowledge and maximises utility


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knowledge and maximises utility.6. Th e consumers income is limited and

constant7. Th e tastes and preferences of t h e consumer

remain unc h anged8. Th e marginal utility of money is constant.

H ere t h e marginal utility of money is t h ech ange in total utility t h at results from

spending one additional unit of money.

RevisionI i i d i h h d f


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In most economies, prices determine w h at, h ow, and for wh om goods are produced.

F irms will produce w h atever goods can be sold at aprofitable price and will c h oose resources on t h e basis

of wh at prices must be paid to employ t h em.

Th e consumers willing to pay t h e price will be t h e onesfor wh om goods are produced. G iven t h e importanceof prices, we need to know h ow th ey aredetermined. Wh y are some h igh and ot h erslow? Wh y do some rise w h ile oth ers fall? Its alldemand and supply.

D emand


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Economists use t h e term demand to indicatewillingness to buy . Wh ile th e demand for a productdepends upon many different factors, one obviousdeterminant is price. Price h as a negative effect onwillingness to buy. All else equal, as t h e price of aproduct falls, t h e quantity demanded will rise.

I t is often useful to illustrate t h ese relations h ips

graph

ically.W

e draw a demand curve to sh

ow th

erelations h ip between t h e price of t h e good and t h equantity t h at consumers are willing to buy.

F or example, suppose people are willing to buy 20 numbers of strawberries at a price of Rs.20, but are willing to buy 30 if t h e price falls


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strawberries at a price of Rs.20, but are willing to buy 30 if t e price fallsto Re 1 0.

Because a c h ange in price will always pus h th e quantity demanded inth e opposite direction, all demand curves will h ave a negative slope.

10

20

20 30Qu antit y of S traw b erries

P rice


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Using t h e above numbers, suppose t h is newresearc h triples t h e quantities people are willing


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researc triples t e quantities people are willingto buy at eac h price.

In ot h er words, consumers are now willing to buy60 nos (rat h er t h an 20) at t h e Rs.20 price and9 0 nos (rat h er t h an 30) at t h e Re. 1 0 price.

Th e demand curve will s h ift to th e rig h t

P rice


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Qu antit y of S traw b erries

10

20

20 30 60 90

D 1 D 2

th e original demand curve (D 1 ) h as s h ifted tobecome a new demand curve (D2).


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Supply Supply indicates willingness to sell . Like demand,

th e supply of a product depends upon many differentfactors and, like demand, one obvious factor is price.

H owever, w h ile h igh prices discourage buyers, t h eyare likely to encourage sellers.

Price h as a positive effect on willingness to sell. Allelse equal, as t h e price of a product rises, t h e quantityfirms are willing to sell will rise as well.

A supply curve illustrates t h e relations h ipbetween t h e price of t h e good and t h e quantity


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between t e price of t e good and t e quantityth at firms are willing to sell.

F or example, firms mig h t be willing to sell 600Sacks of w h eat at a price of Rs.300, but bewilling to sell 9 00 Sacks at a price of Rs.400.Because a c h ange in price will pus h th equantity supplied in t h e same direction, supply

curves will h ave a positive slope.


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P rice

Qu antit y

300

400

600 900

Su pp ly Cu rve


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F or example, suppose new tec h nology lowers t h ecost of growing w h eat.


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g gH ow will farmers react?

Th e new tec h nology increases t h e profitability,and t h erefore t h e willingness to sell at every price. Suppose t h e new tec h nology doublesth e quantities people are willing to sell at eac h price. In ot h er words, firms are now willing to

sell 1 200 sacks (rat h er t h an 600) at t h e Rs.300price and 1 800 Sacks (rat h er t h an 9 00) at t h eRs400 price. T h e supply curve will s h ift to th erigh t.


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th e original supply curve (S 1 ) h as s h ifted tobecome a new supply curve (S2).


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Ch ange t h e example. T h is time, suppose consumersare clamoring to buy 1 00 nos of strawberries, but you


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h ave only 70 to sell.

Migh t you raise t h e price? In fact, consumers probablywill offer a h igh er price.

If you were one of t h e 1 00 potential customers, h owcould you make sure t h at t h e firm sold t h e scarcestrawberries to you rat h er t h an someone else? Offer

to pay ah

igh

er price!In ot

her words, w

hen t

hequantity demanded exceeds t h e quantity supplied (a

s h ortage), prices will rise. Prices will be stable or inequilibrium only if t h e quantities supplied and

demanded are equal.


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In the examp le b e low, P 1 is the eq u ilib riu m priceand Q1 is the eq u ilib riu m q u antit y. A n y pricea b ove P 1 (s u ch as P 2) wi ll create an excess


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a b ove P 1 (s u ch as P 2) wi ll create an excesss u pp ly or s u rp lu s. The q u antit y s u pp lied (asshown by the s u pp ly c u rve) wi ll exceed theq u antit y demanded (shown by the demandc u rve). In light of the s u rp lu s, firms wi ll lower price to P 1 to se ll their extra goods.

A n y price b e low P 1 (s u ch as P3 ) wi ll createan excess demand or shortage. The q u antit y demanded wi ll exceed the q u antit y

s u pp lied. B eca u se of the shortage, firms wi ll soondiscover that the y can se ll a ll the y have even at ahigher price. A s a res ul t, the price wi ll rise toP 1. In the long r u n, the price a lwa ys moves to theeq u ilib riu m.


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H owever, some families mig h t perceive of burgers as an inferior good.


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Th ey mig h t look at t h e increase in income as anopportunity to eat fewer burgers and s h ift tomore expensive foods instead.

If so, t h e demand for t h e burgers will s h ift to th eleft and bot h th e equilibrium price and quantity

will fall.


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Micro Economics T h e study of individual,family, company and industry economic


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be h avior

Macro Economics T h e study of t h e be h avior of entire economies

Equilibrium T h e point at w h ich th e quantitysupplied equals t h e quantity demanded and a

mutually agreeable price is determined


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Marginal Revenue and Cost T h e addedrevenue and cost of producing and sellingone additional unit.

P rice E lasticit y of D emand


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Buyers responsiveness or sensitivity toch anges in price is called elasticity.

F or Example, Brand managers at Proctor &G amble, for example, want to know h ow a pricech ange will affect demand for t h eir brand of soap. Production foremen at F ord Motor

Company want to know h ow price c h anges willaffect t h eir production requirements

If consumers are very sensitive to price c h anges,th eir demand is termed elastic.


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Consider t h e example of McDonalds w h ile itintroduced burger for Rs.20 and softy ice creamcone for RS.7. Consumers responded stronglypurc h asing more of t h ese items.

Wh en consumers are not sensitive to prices,

economists call t h eir demand inelastic . Th eir purc h asing be h avior does not c h ange wit h pricech anges. N ecessities suc h as medical services

or cigarettes fall into th

e inelastic category.

H ard-core nicotine addicts accept cigarette priceincreases.


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Th e price elasticity of consumer demand for aproduct is very important to consider w h enpricing a product.


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Price, Income

and Cross Elasticity


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Elasticity t h e concept


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y p

I f price rises by 1 0% - w h at h appens todemand?W e know demand will fallBy more t h an 1 0%?By less t h an 1 0%?Elasticit y meas u res the extent to whichdemand wi ll change

Elasticity


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y

4 basic types used:P rice e lasticit y of demandP rice e lasticit y of s u pp lyIncome e lasticit y of demandCross e lasticit y

Elasticity


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y

Price Elasticity of Demand Th e responsiveness of demand

to c h anges in price

Wh ere % c h ange in demandis greater t h an % c h ange in price e lastic

Wh ere % c h ange in demand is less t h an %ch ange in price - ine lastic


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Elasticity


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yPrice

Quantity Demanded (000s)

D

The importance of elasticityis the information itprovides on the effect ontotal revenue of changes inprice.

5

100

Total revenue is price xquantity sold. In thisexample, TR = 5 x 100,000= 500,000.

This value is represented bythe grey shaded rectangle.

Total Revenue

El i i


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ElasticityPrice

Quantity Demanded (000s)

D

If the firm decides todecrease price to (say) 3,the degree of priceelasticity of the demandcurve would determine theextent of the increase indemand and the changetherefore in total revenue.5

100

3

140

Total Revenue


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And % c h ange in price= N ew Price Old Price


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------------------------------- x 1 00Old Price

Let P = Old priceQ = Old quantityQ = N ew Quantity - Old Quantity

P = N ew Price Old Price

QX 1 00


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----- X 1 00

Qe P=(-)--------------- Q P

P = ------ . ---

----- X 1 00 P QP


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W hat D oes L aw Of Demand M ean?A microeconomic law t h at states t h at, alloth er factors being equal, as t h e price of a

good or service increases, consumer demand for t h e good or service willdecrease and vice versa.

Exceptions?Th e law of demand says t h at as price goes up, demand falls.Can you t h ink of exceptions, in w h ich raising price couldactually increase demand for a good? Economists h ave


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actually increase demand for a good? Economists h ave

th

ough

t of th

ree possibilities.Inferior goods . Th e classic story is t h at 200 years ago, if your income went up, you would consume more meat andless potatoes. Wh en you consume less of a good as incomegoes up, we call it an inferior good. Two h undred years ago,

potatoes were an inferior good. I f you eat mostly potatoes to begin wit h , and t h e price of potatoes goes up, t h e reduction in purc h asing power effectively lowers your income--so t h at you cannot afford asmuc h meat, and you mig h t even consume more potatoes!

Usually, even wit h an inferior good, as t h e price goes up youconsume less of it. T h e inferior good h as to be a major part of your consumption basket in order for t h e possibility to ariseth at an increase in price could increase demand.


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The D eterminants of D emand(1) IncomeC id t h d d f h Y


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Consider t h e demand for new h omes. Youwant a new h ome and c h oose one you like. T h eprice is Rs. 1 ,000,000. You don't buy. Onereason is t h at your income is not large enoug h to be able to afford t h is amount. T h erefore,income must be one of t h e factors t h at affectth e demand for a given product. N ormally, weexpect t h at as one's income rises (falls), thedemand for a product will rise (fall) .Because we normally expect t h is to be true, agood for w h ich th is statement is true is called anormal good . occasionally, we s h all encounter

a good for wh

ich

th

e statement is not true


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Knowing t h at as income rises, t h e demand will rise isuseful information. But, as wit h th e price of t h eproduct, it is not enoug h information. A company or a

k h


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government agency wants to know how m u ch th edemand will rise if income rises by a certain percent.In particular, t h ey want to know t h e income elasticity of demand , given by t h e formula:percentage change in demand for a prod u ct

----------------------------------------------------------------percentage change in income

I n th is case, we are measuring h ow greatly buyersrespond to a c h ange in t h eir income. I f the number ispositive, we know that this is a normal good (income and demand both rose). I f the number isnegative, we know that this is an inferior good (income rose and demand fell).

Again, we commonly divide at one. I f thenumber is less than or equal to +1, theproduct is called a necessity Th is means


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product is called a necessity . Th is means

th at if income falls, t h e demand falls very little --- because t h e product is needed. I f thenumber is greater than 1, the product is

called a luxury . T

h

is means th

at if incomefalls, t h e demand falls greatly --- because t h eproduct is not needed


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Determinants of demand

(contd)


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3) The P rice of a Sub stit u te G oodComplements are different goods t h at are related to t h e one we areconsidering. T h ere is anot h er kind of relations h ip: th e products may besubstitutes . Substitutes are different goods that compete with the oneunder consideration .


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Coca-Cola and Pepsi Cola are substitutes, as are butter and margarine,American cars and Japanese cars, Barista and Costa Coffee, (in t h e fall)and many ot h er examples.

I n our example, t h e main substitute for h omes is apartments. W hathappens to the demand for homes if the price of apartments fa lls? If

apartments rented for $ 1 00 per mont h , more people would want to live inapartments and fewer in h omes. It is also likely t h at t h e demand for CocaCola would rise (fall) if t h e price of Pepsi Cola rises (falls), t h e demand for American cars would rise (fall) if t h e price of Japanese cars rises (falls), andso on.

Th erefore, our relationship is: as the price of the substitute(apartments) rises (falls), the demand for the product (homes) rises(falls) .

Again, knowing t h ese relations h ips is important information. Butagain, it is not enoug h . W e want to know how m u ch th edemand for a product will c h ange if t h ere is a given percentagech ange in t h e price of anot h er product.


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Th is is called t h e cross elasticity of demand and is givenby th e formula:

P ercentage Change in the D emand for a P rod u ct /P ercentage Change in the P rice of a D ifferent P rod u ct

N otice t h at t h is number measures h ow muc h th e demand for one product responds to a c h ange in t h e price of a differentproduct. I f the number is positive, the products aresubstitutes (if th e price of t h e ot h er product rises, t h e demandfor th is product also rises). T h e larger t h e number, t h e closer th e products are as substitutes. I f the number is negative, theproducts are complements (if th e price of t h e ot h er productrises, t h e demand for th is product falls). I f the number iszero, the products are totally unrelated

One use for t h e cross elasticity of demand will be importantlater. An industry is a group of companies that sell asimilar product.


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We speak of t

he automobile industry or t

he computer industry. N otice t h at t h e products are similar but not exactly t h e

same. A H onda Civic is very different from a Lexus and a PC isdifferent from a Macintos h computer.

So h ow do we know w h ich companies are in t h e sameindustry? Are Coca-Cola and Pepsi Cola in t h e same industry?Most would say so. Are Coca-Cola and Orange Juice in t h esame industry? Bot h are drinks and neit h er h as alco h ol. AreCoca-Cola and beer in t h e same industry? Bot h are drinks areboth are carbonated. Are Coca-Cola and coffee in t h e sameindustry? Bot h are drinks and bot h h ave caffeine. T h e definitionof an industry would seem quite arbitrary. To get moreprecision, we will use t h e cross elasticity of demand .


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4) Tastes or P referencesW e h ave t h us far discussed t h ree factors affectingyour decision to buy a h ome ot h er t h an t h e price of t h e

f


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h ome: your income, t h e price of complements suc h asborrowing money and buying furniture, and t h e priceof substitutes suc h as apartments.One obvious ot h er factor involves t h e fact t h at you likeh omes. T h is we call tastes or preferences . It involvesth e fact t h at t h ere are certain psyc h ological reasonsfor liking or disliking a particular good. Our principle is:th e more (less) we like a good or service, thegreater (less) is our demand for it . So w h at do you

th

inkh

appened to th

e demand for red wine wh

en th

etelevision s h ow 60 Minutes reported t h at drinking redwine moderately every day lowered c h olesterol andth erefore lowered t h e risk of h aving a h eart attack?

(5) Expectations I n th e case of h omes, we h ave often observed people buying

not just one h ome but five or six.Th is does not mean buying one in S h imla, anot h er in J & K for


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y gskiing, and anot h er in G oa for surfing.

I t means several h omes in t h e same area. Wh y would one doth is? One answer is that the buy er expects the price to risein the near f u tu re. Of course, t h e buyer does not know t h at t h eprice will rise. So, t h ere is a gamble h ere; t h e buyer expects t h e

price to rise. T h ese expectations affect our demand for manyproducts.

F or example, people commonly buy stock or foreign moniesbecause t h ey expect t h e prices of t h e stock or of t h e foreign

money to rise soon. (Do not confuse th

is with

th

e last sectionwh ere we considered h ow buyers respond w h en t h e priceactually does c h ange. H ere, t h e price h as not c h anged; buyerssimply expect t h at it will ch ange soon.) Our principle h ere is: if buyers expect the price to rise (fall), the demand rises(falls) today

Th ere are ot h er kinds of expectations one mig h t h aveth at will affect t h e demand for products.I f one expects that the product will soon be


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p p

unavailable, the demand will rise today .If t

here is astrike in any oil and natural gas industry t h en expecting

th at gas stations would soon be out of gasoline, buyersrus h ed to stock-up. Also, if one expects that one's

income will fall, the demand for most products will fall.During recessions, ot h er people are losing t h eir jobs or oth erwise h aving t h eir incomes reduced. Even t h oug h

th is h as not yet h appened to you, you may be worriedth at it will. As a result, you may reduce your buying of many products. As we s h all see later, expectationsoften become self-fulfilling prophecie

6) P op ul ationTh e last of t h e factors affecting demand is th epop ul ation (n u m b er of buy ers) Th e market


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pop ul ation (n u m b er of buy ers) . Th e marketdemand is simply t h e sum of t h e individualdemands. If, at t h e price of Rs.200, Bill wants tobuy 2, one crate of Coca Cola, Jose wants to

buy 3, one crate of Coca Cola, and Mary wantsto buy 1 , one crate of Coca Cola, t h en, of course, t h e market demand is 6, one crates. If Jordan becomes a buyer and wis h es to buy 4one crate, t h e market demand rises to 1 0, onecrate packs. T herefore, if there are morebuyers, there must be more market demand.

A s ub stit u te is a product t h at is similar toanot h er product and can be used instead. F or example, butter and margarine, a bus or a taxi,


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example, butter and margarine, a bus or a taxi,

coffee and tea, gas and electricity and so on.

A comp lement is a good t h at tends to be used

toget h er with anot h er related good. F or example, a DVD player and a DVD, toast andmarmalade, coffee and milk, pen and paper andso on

Factors Inf lu encing Su pp lyTh e major variables ot h er t h an price are:


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1. M one y Costs of P rod u ction :Th e cost of factor inputs like land, labour ,capital h as a major influence on supply. If atany given level of output, t h ere is an increasein costs of production, t h is will reduce t h eability of producers to purc h ase factors of

production at any given price for t h eir product. In consequence, t h e supply curve wills h ift to th e left t h ere will be reduction insupply.

I nter-related supply : Some goods are in jointsupply so t h at variations in t h e amount of onegood produced almost automatically affect t h e


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supply of by-products.

Oth er goods are in competitive supply,especially w h en t h ey use a common rawmaterial. T h us increase in supply of c h eese canreduce supply of butter as bot h are made frommilk.

Events beyond h uman control like good/badh arvest , weat h er conditions and naturaldisasters like floods.


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Wh at is demand forecasting?D emand Forecasting is th e activity of estimating


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th

e quantity of a product or service th

atconsumers will purc h ase.Demand forecasting involves tec h niques

including bot h informal met h ods, suc h aseducated guesses, and quantitative met h ods,suc h as t h e use of h istorical sales data or current data from test markets. Demandforecasting may be used in making pricingdecisions, in assessing future capacityrequirements, or in making decisions onwh et h er to enter a new market .

F orecasts can be classified into two categories :-

i) Passive forecasts


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i) Passive forecasts

ii) Active forecasts

Passive forecast is one w h ere prediction aboutth e future is based on t h e assumption t h at t h efirm does not c h ange t h e course of its action,and active forecast is w h ere forecasting isdone under t h e condition of likely futurech anges in t h e actions by t h e firm.

F orecasting Tec h niques


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A number of tec h niques are available for forecasting demand. F orecasting tec h niquescan be broadly classified into two categories

Qualitative and Quantitative tec h niques


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Qualitative tec h niques (contnd)Consumers Complete Enumeration Survey


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Th is met h od is based on a complete survey of allth e consumers for t h e commodity under

consideration.

Interviews or questionnaires are used to ask

consumers about th

e quantity of th

e commodityth ey would like to buy in t h e forecast period. Allth e data is added up to arrive at t h e totalexpected demand for t h at product.

Qualitative Tec h niques (contnd)S a les Force opinion s u rve y


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Th is met h od is similar to t h e expert opinion met h od. T h edifference h ere is t h at instead of external experts,employees of t h e company w h o are a part of t h e sales

and marketing teams are asked to predict future levelsof demand. T h e sales force, w h ich h as been sellingth e product to w h olesalers/retailers/consumers over aperiod of time, is considered to know t h e product and

th

e demand pattern very well. Moreover, th

ey beingcompany employees will be less likely to introduce t h eelement of bias in t h eir opinion.


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Wh ere

Dme = F inal consumption demand for milk


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me p

Dme = Export demand for milkIm = Import of milkXi = Per unit milk requirement of t h e ice cream

industryO i = Output of t h e ice cream industryXp and O p notations are similar to x i and O i for

paneer

Th e equation aforementioned can be generalisedto calculate t h e projected demand for comm.


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D = D c + De I +x1 . O 1 + x2. O 2 +..x n.On

Quantitative Tec h niquesTh ese are forecasting tec h niques t h at make use

of h istorical quantitative data


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of h istorical quantitative data.

A statistical concept is applied to t h is existingdata about t h e demand for a commodity over th e past years, in order to generate t h epredicted demand in t h e forecast period.

Due to t h is reason , t h ese quantitative tec h niquesare also known as statistical met h ods.


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F uture demand t h roug h th e trend met h od can befound by eit h er of t h e two met h ods


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G rap h ical met h odAlgebraic met h od

In th e grap h ical met h od, t h e past data will beplotted on a grap h and t h e identifiedtrend/be h avior will be extended furt h er in t h e

same pattern to ascertain t h e demand in t h eforecast period.


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In th is case, t h e construction of building is t h eleading indicator or t h e barometer.


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F orecasting tec h niques t h at use t h e lead and lagrelations h ip between economic variables for predicting t h e directional c h anges in t h e

concerned variables are known as BarometricTec h niques. T h ese tec h niques requireascertaining t h e lead-lag relations h ip betweentwo series and t h en keeping a track of t h emovement of t h e leading indicator,

Case : The price e lasticit y of demand for edi bl e refined oi ls


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Th e percentage c h ange in demand of Sundrop sunflower refined oil produced byITC Agrotec h Ltd and marketed by ITC ltd.W

ith

percentage ch

ange in price and th

ech ange in demand of substitutes wasstudied.

Th e effect of c h ange in Sundrop Suncflower andsubsequent c h ange in demand was studied inDelh i and t h ree satellite towns viz G h aziabad,G urgaon and F aridabad alt h oug h H aryana and


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G urgaon and F aridabad alt h oug h H aryana andUP h ave a different tax structure t h an Del h i.

Even as in t h e market structure Sundrop wasleader in sunflower species , t h e companydecided to reduce t h e price range from t h eexisting Rs.50-55 to Rs.40-45 per litre. T h eactual c h ange was broug h t about in August-one litre from Rs.5 1 .50 to Rs.44. 9 5

Earlier D h ara Tetra @ Rs.43.50 per litre was

Considered to be t h e most economical optionavailable in t h e market and was perceived aseconomy oil


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Species wise market structure in AugSegment Quantity Demanded (in metric tonnes)

Safflower 250

G roundnut 230Sunflower 350Soya 1 20

Mustard Refined 500Total 1 450

In Aug the market looked like (brandwise)Brand N ame Segment QuantitySaffola Safflower 250


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Dalda Refined Oil G roundnut 80Postman G roundnut 1 20Vital Soya 1 20Sweekar Sunflower 50Dh ara Mustard Refined 500Sundrop Sunflower 1 80Total 1 450

W ith th e price differential of only Rs. 1 .45/ ltr andbeing t h e market leader, and also becomingcompetitive among ot h er oil segment, t h e


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demand increased due to s h ift from oth er species to sunflower.

Since t h e brand is t h e leader and first to reduceth e price, it got major advantage over competition in terms of s h ift from oth er oils

By th e year end Marc h next year, t h e brandreduced its selling price to Rs.43 and even t h enth e retailer earned more market.

In additional to t h e companys, also h ad a priceoff offer for two mont h s. H ence reducing t h eeffective price in market.


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Brand N ame QuantitySaffola 220Dalda Refined 1 20

Post Man 60Vital 83Sweekar 87F lora 35Dh ara 350Sundrop 250Total 1 205

D eterminant of P rice E lasticit y

1 . Availability of Substitute : In th e above


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yexample, it is a clear case of substitution

2. Proportion of income spent : T h e disposableincome of a family is Rs.4000/- and it spends

Rs. 1 000/- on groceries of w h ich 20 to 25percent is spent on cooking medium, h enceprice plays a major factor in deciding aboutth e type of oil to be boug h t. In normalconsumption of four buys five litres of oil per mont h .

3. Time Period : Demand is usually more elasticin th e long run t h an in t h e s h ort run as we h aveseen in case of Sundrop sunflower as by year end t h e average t h at was 250 metric tonnes


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end t e average t at was 250 metric tonness h ot upto 375 metric tonnes by July next year.

Revenue increase in case of sundrop

Even t h oug h , th e company reduced its price,th ere is an increase in t h e total revenue earned

by th

e company.Before August , t h e contribution metric/tonneswas Rs. 1 0,000

Th erefore at 1 80 metric tonnes, t h e earningswere 1 80 x Rs. 1 0,000 = Rs. 1 8,00000.


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After reducing t h e price, t h e contributiondecreased to Rs.6000/- t h e earnings increaseddue to increase in quantity demanded from 1 80

to 375 metric tonnesRs.6000 x 375 = Rs.22,50,000

F rom t h e above case study we find t h at t h equantity demanded h as gone up due todecrease in price.


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Calculate t h e Price elasticity of demand

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