UNIT - IUNIT - I

MANAGERIAL ECONOMICSMANAGERIAL ECONOMICS

It’s a group of people It’s a Profession It’s a Discipline It’s a Process

Introduction to Management

Management is concerned with Ideas, Things, People of an organization

Management has deals with human behavior under dynamic conditions

Introduction to Management

“Management is science and art of getting things done through people formally organized groups.”

According to lousis allen Management is “what managers do” is called management.

Definition

It’s a study of human activity both at Individual & National level It’s also called as “Science of wealth” Its satisfying human needs such as food, clothing and shelter

Introduction to Economics

According to Adam smith- Economics as the “study of nature and uses of national wealth”

According to A. Marshal- Economics is a “study of man’s actions in the ordinary business life, its enquires how he gets his income and how he uses it”.

According to Robbins- “Economics as the science which studies human behavior as a relationship b/w ends and scarce means which have alternative uses”.

Meaning & Definition

Micro Economics

The study of individual consumer or a firm is called micro economics It is also called as “Theory of firm”. It deals with behavior & Problems of individual persons & small organizations Its includes price theory, law of demand and theory of market

Types of Economics

Macro Economics

Its means the study of aggregate or total level of economic activities in a country

It studies flow of economic resource or factors of production Factors of production includes L,L,C,O,T Its capital structure

Types of Economics (contd.)

welfare economics is that branch of economics which primary deals with talking of poverty, famine and distribution of wealth in an economy. This is also called as “developmental economics.”

Welfare economics

Spencer and Siegel man- “Managerial economics as the integration of economic theory and methodology to business administration practice.”

Brigham- “Managerial economics as the application of economic theory with business practice or business administrative practices.”

Huger- “Managerial economics is a fundamental academic subject which seeks to understand and to analyze the problems of business decision making.”

Managerial Economics

Scope of ME

Concepts & Techniques

of ME

Optimum solutions

o Productiono Reduction or control of costso Price of a producto Make or buy decisionso Inventory decisionso Capital managemento Profit planning Managemento Investment decisions

Managerial decisions areas

Demand decisions Input-Output decisions Price-Output decisions Profit related decisions Investment decisions Forecasting & Forward decisions

Main areas of ME

Economics Operation research Mathematics Statistics Accountancy Psychology HRM Organizational behavior

Linkages with other discipline of ME

Nature of MEEconomic

TheoryDecisionScience

ME

SolutionsTo Business

Problems

Objectives of the firm Allocation of resources Demand analysis and forecasting Competitive analysis Strategic planning Production planning Cost analysis Pricing strategies Market structure analysis Capital budgeting decisions Marketing strategies Achieving economic scale

Role of ME in decision making process

Asking with authority Popularity Good will of a product Claim Need Want Request Call for authority

Introduction to Demand

Basically 3 concepts included in Demand

Consumer’s desire to purchase the product Consumer’s willingness to purchase the product Sufficient purchasing power or ability to pay

Introduction to Demand

Individual Demand

when demand arises from an individual consumer, it is called as individual demand. Individual consumers usually demand for product like clothes, foot wares

House hold Demand

when demand arises from a house hold, it is called house hold demand, house hold demand generally demand for refrigerator, TV, washing machine

Market Demand

when demand arises of all individual and house hold for a product in given a market is considered, it is called market demand.

Types Demand

Demand analysis

D

D

Y

OX

P2

P1

Q1 Q2

In above diagrams Q1,Q2 are quantities of the commodities at the prices of P1,P2 respectively., i.e Price is P1 (Low) the quantity demanded is Q2 (High) and it the price is P2 (High) the quantity demanded is Q2 (Low)

Price Demand

Increase DecreaseDecrease Increase

Basically 2 types of functions

1.Individual function

Qx = f {Px, I, P1…Pn, T, A, Ep, Ei, U}

Qx = Quantity demanded of the commodity ‘X’

Px = Price of the commodity

I = Consumer’s income

P1..Pn = Prices of the other related goods

T = Consumer’s tastes and preferences

A = Advertisement

Ep = Consumer’s expectations about future prices

Ei = Consumer’s expectations about future income

U = Other determinants

F = Function

Demand function

2. Market Demand Function

Qx = f {Px, I, P1…Pn, T, A, Ep, Ei, U}

Qx = Quantity demanded of the commodity ‘X’

Px = Price of the commodity

I = Consumer’s income

P1..Pn = Prices of the other related goods

T = Consumer’s tastes and preferences

A = Advertisement

Ep = Consumer’s expectations about future prices

Ei = Consumer’s expectations about future income

P = Population or market size

D = Distribution or the consumers in the market according to income,

age, demand etc

U = Other determinants

F = Function

Demand function

“The law of demand states that a consumer’s behavior, in demanding a commodity in relation to the variations in its prices”.

“Other things remaining the same, the amount of the quantity demanded arises with every fall in the prices and vice versa.”

The law of demand states that other things remaining constant, the higher the price of the commodity, the lower is the demand and low the price, higher is the quantity demanded.

Law of Demand

Consumer income throughout the operation of law of demand remain unchanged

Consumer tastes & preferences remain unchanged No change in fads, fashions & latest trends Prices of the related goods un changed or are equal

Assumptions of Law of Demand

Giffen goods or Giffen paradox Goods of status Future prices of goods Ignorance effect War or emergency

Exceptions of Law of Demand

Consumption Production Exchange Distribution

Basic Law of Demand

A demand schedule is a tabular presentation of the relationship between the amount demanded of a commodities and different price levels of that commodity.

In other words demand schedule is a tabular statement of price and quantity relationship.

Demand schedule

Price of the Commodity (Y)

Demand of a Commodity (X)

5 15

8 14

10 12

12 10

15 8

20 5

A demand schedule shows variations in demand of a commodity at its varying prices

It indicated behavior of an individual consumer in purchasing the commodity at alternative prices

It shows the inverse relationship b/w demand and price of a commodity

Characteristics of Demand schedule

Types of Demand schedule

Price of orangesPer dozen (Rs)

Demand of Oranges (Nos)

45 2

38 3

30 4

25 6

20 10

Individual Demand Schedule

Types of Demand schedule

Market Demand Schedule

Price of the Commodity

Demand by Individuals

Total Market demand

A B C

6 1 1 2 4

5 2 3 4 9

4 3 5 5 13

3 4 6 7 17

2 5 7 10 22

1 6 8 12 26

Price Demand

Income Demand

Cross Demand

Various types of Demand

It shows the inverse relationship b/w the prices of a commodity and its demand of a commodity. That means other things being constant if price fall demand extends, and if price rises demand contracts.

Price Demand

It shows the functional relationship b/w income of a consumer and quantity demand when other factors are constant. That means when other things constant if the income of consumer increases the quantity demand also increase and if income decreases the quantity demand falls.

Income Demand

Basically 2 types

1. Substitute goods : the goods satisfy the same want are called substitute goods. Eg. Coffee and Tea

1. Complementary Goods : The goods required at the same time to satisfy a want are called complementary goods. Eg.

Car and petrol

Cross Demand

Elasticity Demand

It means expanding Its process It’s a product capacity

Meaning & Definition

According to Dr. Marchall – Elasticity demand means the degree of responsiveness of demand or the sensitiveness of demand to change in price.

“The concept of Elasticity of demand explain How much demand increases due to a certain fall in price and How much demand decreases due to a certain rise in the price”.

“The term Elasticity is defined as the rate of responsiveness in the demand of a commodity for a given change in price or any other determinants of demand”.

Formulae

Proportionate change in quantity demand of X

Ep = --------------------------------------------------------

proportionate change in its determinate of Y

Types

Price Elasticity Demand

Income Elasticity Demand

Cross Elasticity Demand

Importance of price elastic demand

Importance to Monopolistic

Importance to finance manager/minister

Importance to international trade

Help full to decision making process

Price Elasticity Demand

It means the degree of responsiveness or sensitiveness of a demand for a commodity to changes in its price (Ep)

Proportionate change in quantity demand of X

Ep = --------------------------------------------------------

proportionate change in its determinate of Y

Q P

Ep = ------ * -----

Q P

Income Elasticity Demand

It means the ratio of proportionate change in the quantity of demand for a commodity to given proportionate change in income of a product.

Proportionate change in quantity demand of a product

Ey = --------------------------------------------------------------------

proportionate change in its determinate of a consumer

Q Y

Ey = ------ / -----

Q Y

Cross Elasticity Demand

Proportionate change in quantity demand of X

Exy = ---------------------------------------------------------

proportionate change in price of Y

Q X P Y

Exy = ------ /-------

QX P Y

Measurement of Elasticity

Perfect elastic demand Perfect in elastic demand Relatively elastic demand Relatively in elastic demand Unitary elastic demand

Numerical Measures

Types of elasticity Relationship of demand with the price

1. Ed = Perfectly elastic demand

Increase or decrease in demand to any extent irrespective of change in price.Eg. Imaginary

2.Ed=0 Perfectly inelastic demand

Demand does not change with the change in price.Eg. Salt

3.Ed>1 Relative elastic demand

Percentage change in demand more then percentage change in price.Eg. Petrol

4.Ed<1 Relative inelastic demand

Percentage change in demand is lesser than the percentage change in price.Eg. Sugar

5.Ed=1 Unitary elastic demand

Percentage change in demand is equal to percentage change in price.Eg. Cloth

Types of price elasticity demand

Perfect elastic demand ( Ep=Infinity)

If a negligible change in price leads to an infinitive change in demand is said to be perfectly elastic demand. The infinity elastic demand curve is a horizontal straight line to X axis

Y

OX

M M1

Pprice

Quantity demand

Perfect in elastic demand (Ep=0)

Even a great rise or fall in price does not lead and change in quantity demand is known as perfectly in elastic demand

Y

OX

M

P

P1

price

Quantity demand

Relatively elastic demand (Ep greater than 1)

When a proportionate change in price leads to a more then proportionate change in quantity demand is called relatively elastic demand

Y

OX

M1

P

P1

price

Demand

M

A

B

D

D

Relatively in elastic demand (Ep less than 1)

When a proportionate change in price leads to a less then proportionate change in quantity demand is called relatively elastic demand.

Y

OX

M1

P

P1

price

Demand

M

A

B

D

D

Y

OX

M1

P1

Demand

Price

M

PA

B

D

D

Unitary elastic demand (Ep=1)

If the proportionate change in price leads to the same proportionate change in quantity demand is called unitary elastic demand

Significance of Elastic demand

Prices of factors of production Price fixation Govt. policies Forecasting demand Planning the level of output and price

Importance of Elasticity of Demand

Finance minister Monopolist Terms of Trade Determination of wages Price under discriminating monopoly

Demand forecasting

“Demand forecasting is the key driver for success or failure. Future demand of the product acts as a game changing factor in today’s competitive business environment”.

Demand forecasting

The importance of demand forecasting is paramount when either production or demand is uncertain.

When the supply is not in accordance with the demand, it results in the development of black market or excessive prices.

The results of demand forecasting guide the entrepreneur to set up their business or industrial activities accordingly

Importance of Demand forecasting

Price control

Business planning

Competitive strategy

Types of Demand forecasting (based on time)

Short-term demand forecasting

Long-term demand forecasting

Types of Demand forecasting (based on level)

Firm level

Industry level

National level

Global level

Factors affecting demand forecasting

Nature of demand Types of forecasting Forecasting level Degree of orientation Introduce new products Nature of goods Degree of competition Market demand

Methods of demand forecasting

Quantitative Methods Qualitative Methods

Time seriesanalysis

Smoothing Technique

BarometricTechnique

Econometric method

SurveyMethod

Economic polls

1.Moving average method2.Exponential smoothing

1.Trend line method2.Time series analysis3.Least square method

Equation Method

Correlation analysis

Regressionanalysis

Censusmethod

Samplemethod

Introduction to Introduction to

MANAGERIAL ECONOMICS

Managers in their day to day activities, are

always confronted with the several issues

such as :

How much quantity is to be produced

At what price

Make or buy decision

What will be the likely demand…etc

Managerial Economics provides basic insight

into seeking solutions for managerial

problems

As the name itself implies Managerial Economics is an offshoot of two distinct disciplines:

Economics & Management

Economics is the social science

 that analyzes the production,

distribution, and consumption of 

goods and services.

Economics is study of human

activity both at individual and

national level

Economics is derived from two

Greek words which means house

hold management

The term economics comes from

the Ancient Greek οἰκονομία 

(oikonomia,"management of a

household, administration")

from οἶκος  (oikos,"house") + 

νόμος (nomos, "custom" or "law)

Adam Smith the father of Economics

defined Economics as

“The study of the nature & uses of national

wealth”.

There are two branches in Economics

Micro Economics & Macro Economics.

The study of individual firm is Micro

Economics also called theory of firm

The study of total level of economic activity

in a country is called Macro Economics.

Management is the science & art of

getting things done through others.

Management includes several functions

such as:

Planning

Organizing

Staffing

Directing

Coordinating

Regulating

Budgeting & Motivating ….etc

Definition of Managerial Definition of Managerial EconomicsEconomics

“The integration of economic theory with

the business practice for the purpose of

facilitating decision making & foreword

planning by management”. Spencer &

Siegel man

Supplement notes

Managerial economics refers to application

of principles of Economics to solve the

managerial problems such as Minimizing

the cost or Maximizing profit.

Managerial economics directs the utilization

of scarce resources in a goal oriented

manner.

Seeks to understand & analyze the

problems of business decision making.

Facilitates foreword planning.

Examines how an organization can achieve

its objectives in most effectively.

Focuses on Minimizing the cost &

Maximizing the profit.

Nature of Managerial Nature of Managerial economics economics

Close to Micro economics: Managerial

economics is concerned with the finding

solutions for different managerial problems

of a particular firm, thus it is more close to

Micro economics.

Operates against the backdrop of

Macro economics: Manager of a firm has

to be aware of the limits set by the

economic conditions such as government

industrial policies, monetary policy, fiscal

policy, foreign trade policy inflation and so

on.

Interdisciplinary in nature:

The tools, techniques & contents of

Managerial economics are drawn from

different disciplines such as Economics,

Management, Statistics, Psychology,

Accounting, Organizational behavior,

Sociology Etc….

Offers scope to evaluate each

alternative: Managerial economics provide

an opportunity to evaluate each alternative

in terms of cost & revenues, the manager of

a firm can decide which is the best

alternative to maximize the profit for the

firm.

Scope of Managerial Scope of Managerial Economics:Economics:

Or subject matter of Managerial Economics.

Subject matter of Managerial Economics consists of applying economic principles & concepts towards adjusting various uncertainties faced by the business firms, such as

Demand uncertainty Cost uncertainty Price uncertainty profit uncertainty Production uncertainty

The scope of managerial economics refers to its area of study.

The scope of managerial economics covers two areas of decision making.

a)Operational or Internal issuesb)Environmental or External issues

Operational issues refer to those, which wise within the business organization and they are under the control of the management. Those are:

1.Theory of demand and Demand Forecasting2.Pricing and Competitive strategy3.Production cost analysis4.Resource allocation5.Profit analysis6.Capital or Investment analysis7.Strategic planning

Operational or Internal issuesOperational or Internal issues

A firm can survive only if it is able to forecast demand for its product at the right time, within the right quantity. Understanding the basic concepts of demand is essential for demand forecasting.

Demand analysis also highlights for factors, which influence the demand for a product. This helps to manipulate demand.

1. Demand Analysis and Forecasting:1. Demand Analysis and Forecasting:

Pricing decisions have been always within the preview of managerial economics. Pricing policies are merely a subset of broader class of managerial economic problems. Price theory helps to explain how prices are determined under different types of market conditions. Competitions analysis includes the anticipation of the response of competitions the firm’s pricing, advertising and marketing strategies. Product line pricing and price forecasting occupy an important place here.

2. Pricing and competitive strategy:2. Pricing and competitive strategy:

Production analysis is in physical terms. While the cost analysis is in monetary terms cost concepts and classifications, cost-out-put relationships, economies and diseconomies of scale and production functions are some of the points constituting cost and production analysis.

 

3. Production and cost 3. Production and cost analysis:analysis:

  Managerial Economics is the traditional

economic theory that is concerned with the problem of optimum allocation of scarce resources. Marginal analysis is applied to the problem of determining the level of output, which maximizes profit. In this respect linear programming techniques has been used to solve optimization problems. In fact lines programming is one of the most practical and powerful managerial decision making tools currently available.

 

4. Resource Allocation:4. Resource Allocation:

Profit making is the major goal of firms. There are several constraints here an account of competition from other products, changing input prices and changing business environment hence in spite of careful planning, there is always certain risk involved. Managerial economics deals with techniques of averting of minimizing risks. Profit theory guides in the measurement and management of profit, in calculating the pure return on capital, besides future profit planning.

5. Profit analysis:5. Profit analysis:

  Capital is the foundation of business. Lack

of capital may result in small size of operations. Availability of capital from various sources like equity capital, institutional finance etc. may help to undertake large-scale operations. Hence efficient allocation and management of capital is one of the most important tasks of the managers. The major issues related to capital analysis are:

  The choice of investment project Evaluation of the efficiency of capital Most efficient allocation of capital  Knowledge of capital theory can help very

much in taking investment decisions. This involves, capital budgeting, feasibility studies, analysis of cost of capital etc.

. Capital or investment . Capital or investment analyses:analyses:

  Strategic planning provides management

with a framework on which long-term decisions can be made which has an impact on the behavior of the firm. The firm sets certain long-term goals and objectives and selects the strategies to achieve the same. Strategic planning is now a new addition to the scope of managerial economics with the emergence of multinational corporations. The perspective of strategic planning is global.

  It is in contrast to project planning which

focuses on a specific project or activity. In fact the integration of managerial economics and strategic planning has given rise to be new area of study called corporate economics.

7. Strategic planning:7. Strategic planning:  

  An environmental issue in managerial

economics refers to the general business environment in which the firm operates

A study of economic environment should include:

  The type of economic system in the

country. The general trends in production,

employment, income, prices, saving and investment.

Trends in the working of financial institutions like banks, financial corporations, insurance companies

Magnitude and trends in foreign trade; Trends in labour and capital markets; Government’s economic policies viz.

industrial policy monetary policy, fiscal policy, price policy etc.

 

B. Environmental or External B. Environmental or External Issues:Issues:

The environmental or external issues relate managerial economics to macro economic theory while operational issues relate the scope to micro economic theory. The scope of managerial economics is ever widening with the dynamic role of big firms in a society.

summarysummary

Managerial economics Managerial economics relationship with other relationship with other

disciplines:disciplines:

Managerial economics is closely linked with many other disciplines such as

1.Economics2.Mathematics3.Statistics4.Operations Research5.Accountancy6.Psychology7.Organizational behavior

Relationship with economics:Relationship with economics:

Managerial economics is the off shoot of ECONOMICS & hence concepts of Managerial economics are basically economic concepts.

Economics deals with theoretical concepts where as Managerial economics is concerned with application of these in real life.

Both Managerial economics & economics are concerned with problem of scarcity & resource allocation.

Managerial Economics and Managerial Economics and mathematics:mathematics:

Managerial economist is concerned with estimating and predicting various economic factors for purpose of decision making & planning.

In this process Managerial economist extensively makes use of tools & techniques of Mathematics such as

Algebra Calculus Exponentials Vectors etc..

Managerial Economics and Statistics:Managerial Economics and Statistics:

Statistics deals with various techniques which are useful to analyse CAUSE & EFFECT relationship.

Tools & techniques such asAverages Time seriesProbability CorrelationInterpolation RegressionAbove mentioned techniques are used by the

managerial economist to deal with situations of risk & uncertanity.

M.E and Operations ResearchM.E and Operations Research

Operation research discipline has many tools which helps the managerial economist to find solutions for many managerial problems.

The O.R Models such as Linear programming Queuing theory Transportation problem Project management techniqus PERT, CPM

& so on extensively used in solving managerial problems.

Relationship with AccountancyRelationship with Accountancy

Accountancy provides information relating to COST’S, REVENUES, RECEIVABLES, PAYABLES, PROFIT&LOSSES and etc, this forms the basis for the managerial economist to act upon.

Managerial economist depends upon the accounting data for decision making & planning.

Relationship with PsychologyRelationship with Psychology

Consumer Psychology is the basis on which managerial economist acts upon.

Example: how customer reacts to given change in the price.

Psychology contribute towards understanding the ATTITUDES & MOTIVATIONS of each micro economic variable such as consumer, seller/supplies etc.

Relationship with Organizational behaviorRelationship with Organizational behavior

Organisational behaviour enables the managerial economist to study & develop behavioural models of the firm, integrating the managers behaviour with that of the owners.

summarysummary To conclude, managerial economics, which is an

offshoot traditional economics, has gained strength to be a separate branch of knowledge. It strength lies in its ability to integrate ideas from various specialized subjects to gain a proper perspective for decision-making.

A successful managerial economist must be a mathematician, a statistician and an economist. He must be also able to combine philosophic methods with historical methods to get the right perspective only then; he will be good at predictions. In short managerial practices with the help of other allied sciences.

DEMAND ANALYSISDEMAND ANALYSIS

What is Demand ?What is Demand ? Demand: desire for a commodity or service

backed by purchasing power (ability to pay) & willingness to pay for it is called Demand.

A product or service is said to have demand when the following three conditions are satisfied.

1. Desire on the part of buyer to buy.2. Ability to pay the specified price for it

(purchasing power) 3. Willingness to pay for it Unless all these conditions are satisfied the

product/service is not said to have demand

FACTORS DETERMINING FACTORS DETERMINING DEMANDDEMAND

1. PRICE OF THE PRODUCT2. INCOME LEVEL OF THE CONSUMER3. TASTE & PREFERENCES OF THE

CONSUMERS4. PRICE OF RELATED GOODS

(SUBSTITUTES)5. EXPECTATIONS ABOUT THE PRICES IN

THE FUTURE6. EXPECTATIONS ABOUT THE INCOMES IN

THE FUTURE7. SIZE OF POPULATION8. ADVERTISING EFFORTS9. DISTRIBUTION OF CONSUMERS OVER

DIFFERENT REGIONS.

DEMAND FUNCTIONDEMAND FUNCTION Demand function explains the functional

relationship between quantity demanded and the various factors that determine demand.

Demand function can be expressed mathematically as follows

Dn = f (Pn,I,T)Here Dn = quantity demanded f = functional relationship Pn = price of the product I = income of the consumer T = taste & preference of the consumer

DEMAND SCHEDULEDEMAND SCHEDULE

Demand Schedule: it shows functional relationship between the quantity demanded of a product & its price.

i.e. demand schedule shows different quantities of a commodity demanded at various prices at a given time.

Price of Apple

(In. Rs.)

Quantity Demanded

10 1

8 2

6 3

4 4

1 5

LAW of DemandLAW of Demand

introductionintroduction Law of demand shows the relation between

price and quantity demanded of a commodity in the market.

In the words of Marshall, “the amount of demand increases with a fall in price and diminishes with a rise in price”.

The law of demand may be explained with the help of the following demand schedule.

Demand Schedule.

Price of Apple (In. Rs.) Quantity Demanded

10 1

8 2

6 3

4 4

2 5

When the price falls from Rs. 10 to 8 quantity demand increases from 1 to 2. In the same way as price falls, quantity demand increases on the basis of the demand schedule we can draw the demand curve.

 The demand curve DD shows the inverse relation between price and quantity demand of apple. It is downward sloping.

 

Assumptions of Assumptions of LAW of LAW of DemandDemand

  Law of demand is based on certain

assumptions: 1. This is no change in consumers taste and

preferences.2. Income should remain constant.3. Prices of other goods should not change.4. There should be no substitute for the

commodity 5. The commodity should not confer at any

distinction6. The demand for the commodity should be

continuous7. People should not expect any change in the

price of the commodity. 

EXCEPTIONS TO LAW OF EXCEPTIONS TO LAW OF DEMANDDEMAND

Veblen goods or luxury goodsVeblen goods or luxury goods

  ‘Veblan’ has explained the exceptional demand curve through his doctrine of conspicuous consumption. Rich people buy certain good because it gives social distinction or prestige for example diamonds are bought by the richer class for the prestige it possess. It the price of diamonds falls poor also will buy is hence they will not give prestige. Therefore, rich people may stop buying this commodity.

IgnoranceIgnorance

Sometimes, the quality of the commodity is Judge by its price. Consumers think that the product is superior if the price is high. As such they buy more at a higher price.

Speculative effectSpeculative effect

If the price of the commodity is increasing the consumers will buy more of it because of the fear that it increase still further, Thus, an increase in price may not be accomplished by a decrease in demand.

Fear of shortageFear of shortage

  During the times of emergency of war

People may expect shortage of a commodity. At that time, they may buy more at a higher price to keep stocks for the future.

Necessaries:Necessaries:

In the case of necessaries like rice, vegetables etc. people buy more even at a higher price.

 

Giffen paradox:Giffen paradox:

 The Giffen good or inferior good is an

exception to the law of demand. When the price of an inferior good falls, the poor will buy less and vice versa. For example, when the price of maize falls, the poor are willing to spend more on superior goods than on maize if the price of maize increases, he has to increase the quantity of money spent on it. Otherwise he will have to face starvation. Thus a fall in price is followed by reduction in quantity demanded and vice versa. “Giffen” first explained this and therefore it is called as Giffen’s paradox.

ELASTICITY OF DEMANDELASTICITY OF DEMAND

UNIT 2

IntroductionIntroduction The law of demand explains the direction

of change in the quantity demanded, due to the changes in the price in case of normal goods.

Law of demand explains only the direction but not magnitude of change i.e.,

Law of demand does not explain how much quantity demanded will change, in response to change in the price, the concept of ELASTICITY OF DEMAND explain this.

The concept of ELASTICITY OF DEMAND is very important to the Economic theory as it explains the extent to which the demand changes when the price changes.

ELASTICITY OF DEMAND in general it refers to PRICE ELASTICITY OF DEMAND.

ELASTICITY OF DEMAND is always negative (-) for NORMAL GOODS. This is due to inverse relationship between PRICE & DEMAND.

Definition of PRICE ELASTICITY OF DEMAND

Degree to which quantity demanded responds to a change in price is known as PRICE ELASTICITY OF DEMAND.

In other words, the PRICE ELASTICITY OF DEMAND is the ratio of percentage change in quantity demanded, to percentage change in price.

Mathematically it can be expressed as follows

PRICE ELASTICITY OF DEMAND (Ep) = Percentage change in quantity demanded

/Percentage change in price. OR (Ep) = Proportionate change in quantity

demanded / Proportionate change in price. Proportionate change in quantity demanded

=change in demand / initial demand Proportionate change in price = change in

price / initial price

TYPES OF ELASTICITY OF TYPES OF ELASTICITY OF DEAMANDDEAMAND

The following are various types of ELASTICITY OF DEAMAND

1. PRICE ELASTICITY OF DEMAND2. INCOME ELASTICITY OF DEMAND3. CROSS ELASTICITY OF DEMAND4. ADVERTISEMENT ELASTICITY OF DEMAND

PRICE ELASTICITY OF DEMAND: it refers to the responsiveness of quantity demanded to changes in prices.

MEASUREMENT PRICE ELASTICITY OF DEMAND (Ep):

(Ep) = Proportionate change in quantity demanded / Proportionate change in price.

INCOME ELASTICITY OF DEMAND: it refers to the responsiveness of quantity demanded to changes in the incomes of the consumers.

MEASUREMENT INCOME ELASTICITY OF DEMAND

(Ei) = Proportionate change in quantity demanded / Proportionate change in income

CROSS ELASTICITY OF DEMAND: it refers to the responsiveness of quantity demanded to changes in the prices of the related goods, say which may be substitute goods.

MEASUREMENT CROSS ELASTICITY OF DEMAND (Ec):

(Ec) = Proportionate change in quantity demanded / Proportionate change in prices of related goods.

ADVERTISEMENT ELASTICITY OF DEMAND: it refers to the responsiveness of quantity demanded to changes in the advertisement efforts & expenditure.

MEASUREMENT ADVERTISEMENT ELASTICITY OF DEMAND

(Ea):

(Ea) = Proportionate change in quantity demanded / Proportionate change in advertisement efforts or cost.

TYPES OF PRICE ELASTICITY OF DEMAND

Based on numerical values price elasticity of demand can be of five (5) types.

1) Perfectly elastic demand (Ep = α)2)Perfectly inelastic demand (Ep = 0)3)Unit elastic demand (Ep = 1)4)Relatively elastic (Ep = > 1)5)Relatively inelastic (Ep = < 1)

Perfectly elastic demand Perfectly elastic demand is also called as

infinitely elastic demand. It means small change in price leads to an

infinite expansion in demand. Even if the price remain same the quantity

demanded increases. Perfectly elastic demand curve is horizontal

straight line to X axis

P

O Q1 Q2

Price

Demand

•Perfectly elastic demand curve is horizontal straight line to X axis•Even if the price remain same the quantity demanded increases.

Perfectly inelastic demand

In perfectly inelastic demand even with a great fall or rise in the price the quantity demanded of the product does not change.

perfectly inelastic demand curve is vertical straight line parallel to Y axis

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perfectly inelastic demand curve is vertical straight line parallel to Y axis

What ever may be the change in the price high or low the quantity demanded is the same.

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Unit elastic demand Proportionate change in price leads to a

proportionate change in quantity demand is called unit elastic demand.

If demand increases by 1% for a 1% fall in the price, the elasticity of demand is equal to 1.

When the change in demand is equal to change in price is called unit elasticity demand.

Relatively elastic It means Proportionate change in price

leads to more than proportionate change in quantity demanded is called Relative elastic demand.

If demand increases by more than 1% for a 1% fall in the price, the elasticity of demand is said to be Relative elastic demand.

Relatively inelastic It means Proportionate change in price

leads to less than proportionate change in quantity demanded is called Relative inelastic demand.

If demand increases by less than 1% for a 1% fall in the price, the elasticity of demand is said to be Relative inelastic demand.

Importance of Elasticity Importance of Elasticity of Demand:of Demand:

The concept of elasticity of demand is very useful to the Producers and the Policy makers.

It is used to fix prices of goods. To fix prices (rewards) of Factors of

production. To forecast demand. (income elasticity man

be used to forecast demand for the product) To plan the level of output & price.

1. Price fixation:1. Price fixation: Each seller has to take into account

elasticity of demand, while fixing the price for his product. If the demand for the product is inelastic, he can fix a higher price.

2.To fix prices of factors of 2.To fix prices of factors of productionproduction

Elasticity of demand also helps in the determination of rewards for factors of production. For example, if the demand for labour is inelastic, trade unions will be successful in raising wages. It is applicable to other factors of production.

3. Production:3. Production: Producers generally decide their production

level on the basis of demand for the product. Hence elasticity of demand helps the producers to take correct decision regarding the level of out put to be produced.

4. Public Finance:4. Public Finance: Elasticity of demand helps the government

in formulating tax policies. For example, for imposing tax on a

commodity, the Finance Minister has to take into account the elasticity of demand.

If a commodity has inelastic demand increase in the tax on such commodity will generate revenue for the government.

5. International Trade:5. International Trade: The concept of elasticity of demand plays

significant role in the international trade. Much foreign exchange can be earned by

exporting goods which has elastic demand. Small reduction in price of goods result in

good amount of foreign exchange.

DEMAND FORECASTING DEMAND FORECASTING METHODSMETHODS

WHY TO FORECAST WHY TO FORECAST DEMAND ?DEMAND ?

1. To assess the likely demand.2. To plan the production accordingly.3. To plan the INPUTS (factors of productions)

Manpower (labour), Raw material, and Capital.

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Demand Forecasting Methods

DEMAND FORECASTING DEMAND FORECASTING METHODSMETHODS

DEMAND FORECASTING METHODS are classified into

1. Survey methods2. Statistical methods3. Other methods

Survey methodsSurvey methodsSurvey of buyer intentions Census method Sample method

Sales force opinion method

Delphi Method

Statistical methodsStatistical methods

1. Trend projection methods2. Barometric techniques3. Simultaneous equation method4. Regression & correlation methods

Other methodsOther methods

1. Expert opinion method2. Test marketing3. Controlled experiments4. Judgmental approach

1. Survey of buyer intentions: in this method information is drawn from the buyer to estimate demand.

In this method each potential buyer is asked how much does he plan to buy, of the given product at a given point of time under particular condition.

This is the most effective method because the buyer is the ultimate decision maker, & we are collecting the information from the potential buyer.

Survey can be conducted by considering either whole population or by selecting a small group of potential buyers.

If survey is conducted by considering the whole population it is called CENSUS method. CENSUS method is also called as TOTAL ENUMERATION method.

If survey is conducted by considering the small group of potential buyers who can represent the whole population, it is called SAMPLE method.

2. Sales force opinion method: Sales people are in constant touch with the large number of buyers of a particular market.

Sales force constitute valid source of information about the likely sales of a product

Sales force is capable of assessing the likely reaction of the customers of their territories quickly, given the companies marketing strategy.

3.Delphi Method: A variant of the survey method is Delphi method. It is a sophisticated method to arrive at a consensus. Under this method, a panel is selected to give suggestions to solve the problems in hand. Both internal and external experts can be the members of the panel. Panel members one kept apart from each other and express their views in an anonymous manner. There is also a coordinator who acts as an intermediary among the panelists. He prepares the questionnaire and sends it to the panelist. At the end of each round, he prepares a summary report. On the basis of the summary report the panel members have to give suggestions.

1.Trend projection methods: 

A well-established firm will have accumulated data. These data is analyzed to determine the nature of existing trend. Then, this trend is projected in to the future and the results are used as the basis for forecast.

There are five main techniquesI. Trend line by observationII.Least square methodIII.Time series analysisIV.Moving averages methodV.Exponential smoothing

2.Barometric technique: under this technique one set of data is used to predict another set.

In other words to forecast demand for a product , some other relevant indicator, which is known as BAROMETER is used to forecast the future demand.

E.g.. To forecast demand for cement the relevant indicator number of new construction projects, are taken into consideration for forecasting demand.

3.Correlation describes the degree of association between two variables such as sales and advertisement expenditure.

When two variables tend to change together then they are said to be correlated.

The extent to which they are correlated is measured by correlation coefficient.

For example if sales have gone up as a result of increase in advertisement expenditure we can say that sales and advertisement are positively correlated.

4.Regression analysis: A statistical measure that attempts to determine the strength of the relationship between one dependent variable (usually denoted by Y) and a series of other changing variables (known as independent variables). 

The two basic types of regressions are linear regression and multiple regression. Linear regression uses one independent variable to explain and/or predict the outcome of Y, while multiple regression uses two or more independent variables to predict the outcome.

The general form of each type of regression is:

Linear Regression: Y = a + bX + u Multiple Regression: Y = a + b1X1 +  b2X2 + B3X3 + ... + BtXt + u

Where:Y= the variable that we are trying to predictX= the variable that we are using to predict Y a= the intercept b= the slope u= the regression residual.

1.Expert opinion method: an expert is good at forecasting and analyzing the future trends for a given product or service at a given level of technology.

Apart from salesmen, consumers & distributors, outside experts may also used for forecasting. In the United States of America, the automobile companies get sales estimates directly from their dealers. Firms in advanced countries make use of outside experts for estimating future demand.

2.Test marketing: in test marketing the entire product and marketing program is carried for the first time in a small number of well chosen and authentic sales environment.

The primary objective of test marketing is to know whether the customer will accept the product in the present form or not

3.Controlled experiments: major determinants of demand are manipulated to suit to the customers with different tastes and preferences

In this method the product is introduced with different packages, different prices, in different markets to assess which combination appeals to the customer most

4.Judgmental approach: when none of statistical and other methods are directly related to the given product/service the management has no alternative other than using its own judgment in forecasting the demand.

04/19/23