UNIT- I

LESSON 1 MANAGERIAL ECONOMICS STRUCTURE

1.1 INTRODUCTION
1.2 OBJECTIVES
1.3 NATURE OF MANAGERIAL ECONOMICS

1.3.1 Managerial Economics is a Science

1.3.2 Managerial Economics requires Art

1.3.3 Managerial Economics for administration of organisation

1.3.4 Managerial economics is helpful in optimum resource

allocation 1.3.5 Managerial Economics has components of

micro economics 1.3.6 Economics has components of

macro economics

1.3.7 Managerial Economics is dynamic in nature

1.4 IMPORTANCE
1.5 SCOPE OF MANAGERIAL ECONOMICS
1.6 ROLE OF MANAGERIAL ECONOMICS
1.7 SUMMARY
1.8 SELF ASSESSMENT QUESTIONS
1.9 SUGGESTED READINGS
1.1 INTRODUCTION
The science of Managerial Economics has emerged only recently. With

the growing1

variability and unpredictability of the business environment, business

managers have become increasingly concerned with finding rational and
ways of adjusting to an exploiting environmental change. The problems of
the business world attracted the attentions of the academicians from 1950
onwards. Mana­gerial economics as a subject gained popularity in the USA
after the publication of the book “Managerial Economics” by Joel Dean in
1951.

Managerial Economics can be defined as amalgamation of economic

theory with business practices so as to ease decision­making and future
planning by management. Managerial Economics assists the managers of
a firm in a rational solution of obstacles faced in the firm’s activities. It
makes use of economic theory and concepts. It helps in formulating logical
managerial decisions. The key of Managerial Economics is the
micro­economic theory of the firm. It lessens the gap between economics in
theory and economics in practice. Managerial Economics is a science
dealing with effective use of scarce resources. It guides the managers in
taking decisions relating to the firm’s customers, competitors, suppliers as
well as relating to the internal functioning of a firm. It makes use of
statistical and analytical tools to assess economic theories in solving
practical business problems. Study of Managerial Economics helps in
enhancement of analytical skills, assists in rational configuration as well as
solution of problems. While microeconomics is the study of decisions made
regarding the allocation of resources and prices of goods and services,
macroeconomics is the field of economics that studies the behaviour of the
economy as a whole (i.e. entire industries and economies).

The following figure tells the primary ways in which Managerial Economics
correlates to managerial decision­making.
1.1.2 DEFINITION:
Managerial economists have defined managerial economics in a variety of
ways:

According to E.F. Brigham and J. L. Pappar, Managerial Economics is “The

application of economic theory and methodology to business
administration practice.”

Christopher Savage and John R. Small: “Managerial Economics is

concerned with business efficiency”.
Milton H. Spencer and Lonis Siegelman define Managerial Economics as
“The integration2
of eco­nomic theory with business practice for the purpose of facilitating
decision making and forward plan­ning by management.”

In the words of Me Nair and Meriam, “Managerial Economics consists of

the use of economic modes of thought to analyse business situations.”

D.C. Hague describes Managerial Economics as “A fundamental academic

subject which seeks to understand and analyse the problems of business
decision making.”

In the opinion of W.W. Haynes “Managerial Economics is the study of the

allocation of resources available to a firm of other unit of management
among the activities of that unit.”

According to Floyd E. Gillis, “Managerial Economics deals almost

exclusively with those busi­ness situations that can be quantified and dealt
with in a model or at least approximated quantitatively.”
1.2 OBJECTIVES
The objectives of this lesson is:

 To understand the concept of managerial economics.

 To know the scope and importance of managerial

economics. 1.3 NATURE OF MANAGERIAL ECONOMICS

Managers study managerial economics because it gives them insight to

reign the functioning of the organisation. If manager uses the principles
applicable to economic behaviour reasonably, then it will result in smooth
functioning of the organisation. 1.3.1 Managerial Economics is a Science

Managerial Economics is an essential scholastic field. It can be compared

to science in a sense that it fulfills the criteria of being a science in
following sense:
  Science is a Systematic body of Knowledge. It is based on the
methodical observation. Managerial economics is also a science of making
decisions with regard to scarce resources with alternative applications. It is
a body of knowledge that determines or observes the internal and external
environment for decision making.

 In science any conclusion is arrived at after continuous

experimentation. In3
Managerial economics also policies are made after persistent testing and
trailing. Though economic environment consists of human variable, which
is unpredictable, thus the policies made are not rigid. Managerial
economist takes decisions by utilising his valuable past experience and
observations.

 Science principles are universally applicable. Similarly policies of

Managerial economics are also universally applicable partially if not fully.
The policies need to be changed from time to time depending on the
situation and attitude of individuals to those particular situations. Policies
are applicable universally but modifications are required periodically.
1.3.2 Managerial Economics requires Art

Managerial economist is required to have an art of utilising his

capability, knowledge and understanding to achieve the organizational
objective. Managerial economist should have an art to put in practice his
theoretical knowledge regarding elements of economic environment.
1.3.3 Managerial Economics for administration of organisation
Managerial economics helps the management in decision making.
These decisions are based on the economic rationale and are valid in the
existing economic environment. 1.3.4 Managerial economics is helpful in
optimum resource allocation

The resources are scarce with alternative uses. Managers need to

use these limited resources optimally. Each resource has several uses. It
is manager who decides with his knowledge of economics that which one
is the preeminent use of the resource. 1.3.5 Managerial Economics has
components of micro economics

Managers study and manage the internal environment of the

organization and work for the profitable and long­term functioning of the
organisation. This aspect refers to the micro economics study. The
managerial economics deals with the problems faced by the individual
organization such as main objective of the organisation, demand for its
product, price and output determination of the organisation, available
substitute and complimentary goods, supply of inputs and raw material,
target or prospective consumers of its products etc.
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1.3.6 Economics has components of macro economics
None of the organisation works in isolation. They are affected by the
external environment of the economy in which it operates such as
government policies, general price level, income and employment levels in
the economy, stage of business cycle in which economy is operating,
exchange rate, balance of payment, general expenditure, saving and
investment patterns of the consumers, market conditions etc. These
aspects are related to macro economics.
1.3.7 Managerial Economics is dynamic in nature

Managerial Economics deals with human­beings (i.e. human

resource, consumers, producers etc.). The nature and attitude differs from
person to person. Thus to cope up with dynamism and vitality managerial
economics also changes itself over a period of time.
1.4 IMPORTANCE OF MANAGERIAL ECONOMICS

The significance or importance of business/managerial economics

can be discussed as:

1. Business economics is concerned with those aspects of traditional

economics which are relevant for business decision making in real life.
 These are adapted or modified with a view to enable the manager take
better decisions. Thus, business economic accomplishes the objective
of building a suitable tool kit from traditional economics.

2. It also incorporates useful ideas from other disciplines such as

psychology, sociology, etc. If they are found relevant to decision
making. In fact, business economics takes the help of other disciplines
having a bearing on the business decisions in relation various explicit
and implicit constraints subject to which resource allocation is to be
optimised.

3. Business economics helps in reaching a variety of business decisions in

a complicated environment. Certain examples are:
(i) What products and services should be produced?
(ii) What input and production technique should be used?
(iii) How much output should be produced and at what prices it
should be sold?5
(iv) What are the best sizes and locations of new plants?
(v) When should equipment be replaced?
(vi) How should the available capital be allocated?
4. Business economics makes a manager a more competent model
builder. It helps him appreciate the essential relationship Characterising
a given situation.

5. At the level of the firm. Where its operations are conducted though
known focus functional areas, such as finance, marketing, personnel
and production, business economics serves as an integrating agent by
coordinating the activities in these different areas.

6. Business economics takes cognizance of the interaction between the

firm and society, and accomplishes the key role of an agent in
achieving the its social and economic welfare goals. It has come to be
realised that a business, apart from its obligations to shareholders, has
certain social obligations. Business economics focuses attention on
 these social obligations as constraints subject to which business
decisions are taken. It serves as an instrument in furthering the
economic welfare of the society through socially oriented business
decisions.
1.5 SCOPE OF MANAGERIAL ECONOMICS

Managerial Economics is a developing subject. The scope of

managerial economics refers to its area of study. Managerial economics
has its roots in economic theory. The empirical nature of managerial
economics makes its scope wider. Managerial economics provides
management with strategic planning tools that can be used to get a clear
perspective of the way the business world works and what can be done to
maintain profitability in an ever changing environment. Managerial
economics refers to those aspects of economic theory and application
which are directly relevant to the practice of manage­ment and the decision
making process within the enterprise. Its scope does not extend to macro
eco­nomic theory and the economics of public policy which will also be of
interest to the manager.

While considering the scope of managerial economics we have to

understand whether it is positive economics or normative economics.

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1.5.1 Positive versus Normative Economics:
Most of the managerial economists are of the opinion that
managerial economics is fundamentally normative and prescriptive in
nature. It is concerned with what decisions ought to be made. The
applica­tion of managerial economics is inseparable from consideration of
values or norms, for it is always concerned with the achievement of
objectives or the optimisation of goals. In managerial economics, we are
interested in what should happen rather than what does happen. Instead of
explaining what a firm is doing, we explain what it should do to make its
decision effective.
I. Positive Economics:
 A positive science is concerned with ‘what is’. Robbins regards
economics as a pure science of what is, which is not concerned with moral
or ethical questions. Economics is neutral between ends. The economist
has no right to pass judgment on the wisdom or folly of the ends itself. He
is simply concerned with the problem of resources in relation to the ends
desired. The manufacture and sale of cigarettes and wine may be injurious
to health and therefore morally unjustifiable, but the economist has no right
to pass judgment on these since both satisfy human wants and involve
economic activity.
II. Normative Economics:

Normative economics is concerned with describing what should be

the things. It is, therefore, also called prescriptive economics. What price
for a product should be fixed, what wage should be paid, how income
should be distributed and so on, fall within the purview of normative
economics?

It should be noted that normative economics involves value

judgments. Almost all the leading managerial econo­mists are of the
opinion that managerial economics is fundamentally normative and
prescriptive in nature. It refers mostly to what ought to be and cannot be
neutral about the ends. The application of managerial economics is
inseparable from consideration of values, or norms for it is always
concerned with the achievement of objectives or the optimisation of goals.

Further, in managerial economics, we are interested in what should

happen rather than what does happen. Instead of explaining what a firm is
doing, we explain what it should do to make its decision effective.
Managerial economists are generally preoccupied7
with the optimum allocation of scarce resources among competing ends
with a view to obtaining the maximum benefit according to predetermined
criteria.

To achieve these objectives they do not assume ceteris paribus, but

try to introduce policies. The very important aspect of managerial
economics is that it tries to find out the cause and effect relationship by
factual study and logical reasoning. The scope of managerial economics is
so wide that it embraces almost all the problems and areas of the manager
and the firm.
1.5.2 Subject Matter of Marginal Economics
1. Demand Analysis and Forecasting
A firm is an economic organisation which transforms inputs into
output that is to be sold in a market. Accurate estimation of demand, by
analysing the forces acting on demand of the product produced by the firm,
forms the vital issue in taking effective decision at the firm level. A major
part of managerial decision making depends on accurate estimates of
demand. When demand is estimated, the manager does not stop at the
stage of assessing the current demand but estimates future demand as
well. This is what is meant by demand forecasting. This forecast can also
serve as a guide to management for maintaining or strengthening market
position and enlarging profit. Demand analysis helps in identifying the
various factors influencing the demand for a firm’s product and thus
provides guidelines to manipu­late demand. The main topics covered are:
Demand Determinants, Demand Distinctions and Demand Forecasting.
2. Cost and Production Analysis
Cost analysis is yet another function of managerial economics. In
decision making, cost estimates are very essential. The factors causing
variation in costs must be recognised and allowed for if management is to
arrive at cost estimates which are significant for planning purposes.

The determinants of estimating costs, the relationship between cost

and output, the forecast of cost and profit are very vital to a firm. An
element of cost uncertainty exists because all the factors determining
costs are not always known or controllable. Managerial economics touches
these aspects of cost analysis as an effective knowledge and the
application of which is corner stone for the success of a firm.
 8
Production analysis frequently proceeds in physical terms. Inputs
play a vital role in the economics of production. The factors of production
otherwise called inputs, may be combined in a particular way to yield the
maximum output.

Alternatively, when the price of inputs shoots up, a firm is forced to

work out a combination of inputs so as to ensure that this combination
becomes the least cost combination. The main topics covered under cost
and production analysis are production function, least cost combination of
factor inputs, factor productiveness, returns to scale, cost concepts and
classification, cost­output relationship and linear programming.
3. Inventory Management
An inventory refers to a stock of raw materials which a firm keeps.
Now the problem is how much of the inventory is the ideal stock. If it is
high, capital is unproductively tied up. If the level of inventory is low,
production will be affected.

Therefore, managerial economics will use such methods as

Economic Order Quantity (EOQ) approach, ABC analysis with a view to
minimising the inventory cost. It also goes deeper into such aspects as
motives of holding inventory, cost of holding inventory, inventory control,
and main methods of inventory control and management.
4. Advertising

To produce a commodity is one thing and to market it is another. Yet

the message about the product should reach the consumer before he
thinks of buying it. Therefore, advertising forms an integral part of decision
making and forward planning. Expenditure on advertising and related
types of promotional activities is called selling costs by economists.

There are different methods for setting advertising budget: Percentage of

Sales Approach, All You can Afford Approach, Competitive Parity
Approach, Objective and Task Approach and Return on Investment
Approach.
 5. Pricing Decision, Policies and Practices

Pricing is very important area of managerial economics. The control

functions of an enterprise are not only productions but pricing as well.
When pricing a commodity, the cost of production has to be taken into
account. Business decisions are greatly influenced by pervading market
structure and the structure of markets that has been evolved by the
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nature of competition existing in the market.

Pricing is actually guided by consideration of cost plan pricing and

the policies of public enterprises. The knowledge of the pricing of a product
under conditions of oligopoly is also essential. The price system guides the
manager to take valid and profitable decision. 6. Profit Management

A business firm is an organisation designed to make profits. Profits

are acid test of the individual firm’s performance. In appraising a company,
we must first understand how profit arises. The concept of profit
maximisation is very useful in selecting the alternatives in making a
decision at the firm level.

Profit forecasting is an essential function of any management. It

relates to projection of future earnings and involves the analysis of actual
and expected behaviour of firms, the sales volume, prices and competitor’s
strategies, etc. The main aspects covered under this area are the nature
and measurement of profit, and profit policies of special significance to
managerial decision making.

Managerial economics tries to find out the cause and effect

relationship by factual study and logical reasoning. For example, the
statement that profits are at a maximum when marginal revenue is equal to
marginal cost, a substantial part of economic analysis of this deductive
proposition attempts to reach specific conclusions about what should be
done.

The logic of linear programming is deduction of mathematical form.

In fine, managerial economics is a branch of normative economics that
draws from descriptive economics and from well established deductive
patterns of logic.
7. Capital Management

Planning and control of capital expenditures is the basic executive

function. The managerial problem of planning and control of capital is
examined from an economic stand point. The capital budgeting process
takes different forms in different industries.

It involves the equi­marginal principle. The objective is to assure the

most profitable use of funds, which means that funds must not be applied
when the managerial returns are less than in other uses. The main topics
dealt with are: Cost of Capital, Rate of Return and
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Selection of Projects.

Thus we see that a firm has uncertainties to rock on with.

Therefore, we can conclude that the subject matter of managerial
economics consists of applying economic principles and concepts towards
adjusting with these uncertainties of the firm.

In recent years, there is a trend towards integration of managerial

economics and Operation Research. Hence, techniques such as linear
Programming, Inventory Models, Waiting Line Models, Bidding Models,
Theory of Games, etc. have also come to be regarded as part of
managerial economics.
1.5.3 Relation to Other Branches of Knowledge
A useful method of throwing light on the nature and scope of
managerial economics is to examine its relationship with other disciplines.
To classify the scope of a field of study is to discuss its relation to other
subjects. If we take the subject in isolation, our study would not be useful.
Managerial economics has a close linkage with other disciplines and fields
of study.
 The subject has gained by the interaction with economics,
mathematics and statistics and has drawn upon management theory and
accounting concepts. The managerial eco­nomics integrates concepts and
methods from these disciplines and bringing them to bear on managerial
problems.
(i) Managerial Economics and Economics:

Managerial Economics has been described as economics applied to

decision making. It may be studied as a special branch of economics,
bridging the gap between pure economic theory and managerial practice.
Economics has two main branches micro economics and
macroeconomics.

Micro-economics:

‘Micro’ means small. It studies the behaviour of the individual units

and small groups of such units. It is a study of particular firms, particular
households, individual prices, wages, incomes, individual industries and
particular commodities. Thus micro economics gives a microscopic view of
the economy.

11
The micro-economic analysis may be undertaken at three

levels: (i) The equalisation of individual consumers and

produces;

(ii) The equalisation of the single market;

(iii) The simultaneous equilibrium of all markets. The problems of

scarcity and optimal or ideal allocation of resources are the central
problem in micro­economics.

The roots of managerial economics spring from micro­economic

theory. In price theory, demand concepts, elasticity of demand, marginal
cost marginal revenue, the short and long runs and theories of market
structure are sources of the elements of micro economics which
managerial economics draws upon. It also makes use of well known
models in price theory such as the model for monopoly price, the kinked
demand theory
and the model of price discrimination.

Macro-economics:

‘Macro’ means large. It deals with the behaviour of the large

aggregates in the economy. The large aggregates are total saving, total
consumption, total income, total employment, general price level, wage
level, cost structure, etc. Thus macro­economics is aggregative economics.

It examines the interrelations among the various aggregates, and

causes of fluctuations in them. Problems of determination of total income,
total employment and general price level are the central problems in
macro­economics.

Macro­economies is also related to managerial economics. The

environment, in which a business operates, fluctuations in national income,
changes in fiscal and monetary measures and variations in the level of
business activity have relevance to business decisions. The understanding
of the overall opera­tion of the economic system is very useful to the
managerial economist in the formulation of his policies.

The chief contribution of macro­economics is in the area of

forecasting. The post Keynesian aggregative theory has direct implications
for forecasting general business conditions. Since the prospects of an
individual firm often depend greatly on business in general, forcasts of an
individual firm depend on general business forecasts, which make use of
models derived from theory. The most widely used model in modern
forecasting is
12
the gross national product model.
(ii) Managerial Economics and Theory of Decision Making:
 The theory of decision making is a relatively new subject that has a
significance for managerial economics. In the entire process of
management and in each of the management activities such as planning,
organising, leading and controlling, decision making is always essential. In
fact, decision making is an integral part of today’s business management.
A manager faces a number of problems connected with his/her business
such as production, inventory, cost, marketing, pricing, investment and
personnel.

Economist are interested in the efficient use of scarce resources

hence they are naturally interested in business decision problems and they
apply economics in management of business problems. Hence managerial
economics is economics applied in decision making. According to M.H.
Spencer and L. Siegelman, “Managerial economics is the integration of
economic theory with business practice for the purpose of facilitating
decision making up and forward planning by management”. Managerial
economics is a fundamental academic subject which seeks to understand
and to analyse the problems of busi­ness decision making.

The theory of decision making recognises the multiplicity of goals

and the pervasiveness of uncertainty in the real world of management. The
theory of decision making replaces the notion of a single optimum solution
with the view that the objective is to find solution that ‘satisfies’ rather than
maximise. It probes into an analysis of motivation of the relation of rewards
and aspiration levels, and of pattern of influence and authority.

Economic theory and theory of decision making appear to be in

conflict, each based on different set of assumptions. Much of the economic
theory is based on the assumption of single goal­maximisation of utility for
the individual or maximisation of profit for the firm.
(iii) Managerial Economics and Operations Research:

Mathematicians, statisticians, engineers and others teamed up

together and developed models and analytical tools which have since
grown into a specialised subject, known as operation research. The basic
 purpose of the approach is to develop a scientific model of the system
which may be utilised for policy making.
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Much of the development of techniques and concepts such as
Linear Programming, Dynamic Programming, Input­output Analysis,
Inventory Theory, Information Theory, Probability Theory, Queueing
Theory, Game Theory, Decision Theory and Symbolic Logic.

Linear programming deals with those programming problems where

the relationship among the variables is linear. It is a useful tool for the
managerial economist for reducing transportation costs and allocating
purchase amongst different supplies and site depots. It is employed when
the objective func­tion is to maximise profit, output or efficiency.

Dynamic programming helps in solving certain types of sequential

decision problems. A sequen­tial decision problem is one in which a
sequence of decision must be made with each decision affecting future
decision. It has been applied in cases of maintenance and repair, financial
portfolio balancing, inventory and production control, equipment
replacement and directed marketing.

Input­output analysis is a technique for analysing inter­industry

relation. Prof. W.W. Leontief tries to establish inter industry relationships by
dividing the economy into different sectors. In this model, the final demand
is treated as exogenously determined and the input­output technique is
used to find out the levels of activity in the various sectors of the economic
system. It can be used by firms for planning, co­ordination and mobilisation
of resources.

Queueing is a particular application of the statistical decision theory.

It is employed to get the optimum solution. The theory may be applied to
such problems as how to meet a given demand most economically or how
to minimise the waiting period or idle time. The theory of games holds out
the hope of solving certain problems concerning oligopolistic interminacy.

When we apply the game theory, we have to consider the

following: (i) The players are the two firms;
(ii) They play the game in the market place;
(iii) Their strategies are their price or output decision; and
(iv) The pay­offs or rewards are their profits. The numerical figures are what
is called pay­off matrix. This matrix is the most important tool of game
theory.
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(iv) Managerial Economics and Statistics:
Statistics is important to managerial economics. It provides the
basis for the empirical testing of theory. Statistics is important in providing
the individual firm with measures of the appropriate func­tional relationship
involved in decision making. Statistics is a very useful science for business
executives because a business runs on estimates and probabilities.
Statistics supplies many tools to managerial economics. Suppose
forecasting has to be done. For this purpose, trend projections are used.
Similarly, multiple regression technique is used. In managerial economics,
measures of central tendency like the mean, median, mode, and measures
of dispersion, correlation, regression, least square, estimators are widely
used. The managerial economics is con­stantly faced with the choice
between models ignoring uncertainty and those that explicitly incorporate
probability theory.
Statistical tools are widely used in the solution of managerial
problems. For example, sampling is very useful in data collection.
Managerial economics makes use of correlation and multiple regression in
business problems involving some kind of cause and effect relationship.
(v) Managerial Economics and Accounting:
Managerial economics is closely related to accounting. It is
concerned with recording the financial operation of a business firm. A
business is started with the main aim of earning profit. Capital is invested it
is employed for purchasing properties such as building, furniture, etc and
for meeting the current expenses of the business.
 Goods are bought and sold for cash as well as credit. Cash is paid
to credit sellers. It is received from credit buyers. Expenses are met and
incomes derived. This goes on the daily routine work of the business. The
buying of goods, sale of goods, payment of cash, receipt of cash and
similar dealings are called business transactions.
The business transactions are varied and multifarious. They are too
numerous to be kept in one’s memory. This has given rise to the necessity
of recording business transaction in books. They are written in a set of
books in a systematic manner so as to facilitate proper study of their
results.
There are three classes of accounts:
(i) Personal account,
15
(ii) Property accounts, and
(iii) Nominal accounts.

Management accounting provides the accounting data for taking

business decisions. The accounting techniques are very essential for the
success of the firm because profit maximisation is the major objective of
the firm.
(vi) Managerial Economics and Mathematics:
Mathematics is yet another important subject closely related to
managerial economics. For the derivation and exposition of economic
analysis, we require a set of mathematical tools. Mathematics has helped
in the development of economic theories and now mathematical
economics has become a very important branch of the science of
economics.

Mathematical approach to economic theories makes them more

precise and logical. For the estimation and prediction of economic factors
for decision making and forward planning, the mathematical method is very
helpful. The important branches of mathematics generally used by a
managerial economist are geometry, algebra and calculus.

The mathemati­cal concepts used by the managerial economists are

the logarithms and exponential, vectors and determinants, input­output
tables. Operations research which is closely related to managerial
economics is mathematical in character. 1.6 ROLE OF MANAGERIAL
ECONOMICS IN BUSINESS DECISION

Decision making is an integral part of today’s business

management. Making a decision is one of the most difficult tasks faced by
a professional manager. A manager has to take several decisions in the
management of business. The life of a manager is filled with making
decisions alter decisions.

Decision making is a process and a decision is the product of such

a process. Managerial decisions are based on the flow of information.
Decision making is both a managerial function and an organisational
process. Managerial function is exercised through decision making.

The purpose of decision making as well as planning is to direct

human behaviour16

and effort towards a future goal or objective. It is organisational in that

many decisions transcend the individual manager and become the product
of groups, teams, committees, etc.

Once the decision is taken it is implemented within the minimum

time and cost. A study of the principles of business decisions will enable
managers to understand business problems in a better perspective and
increase their ability to solve business problems facing them in the
management of business.

Executives make many types of decisions connected with the

business such as production, inventory, cost, marketing, pricing,
investment and personnel. In the long­run, application of principles of
business decisions will result in successful outcomes. A good decision is
 one that is based on logic, considers all available data and possible
alternatives and applies the quantitative approach.

Organisa­tional decisions are those which the executive makes in

his personal capacity as a manager. They include the adoption of the
strategies, the framing of objectives and the approval of plans. These
decisions can be delegated to the organisational members so that
decisions could be implemented with their support. These decisions aim at
achieving the best interests of the organisation. The basic decisions are
those which are more important, they involve long­range commitment and
heavy expenditure of funds.

A high degree of importance is attached to them. A serious mistake

will endanger the company s existence. The selection of a location,
selection of a product line, and decision relating to manage the business
are all basic decisions. They are considered basic because they affect the
whole organisation.

1.6.1 IMPORTANT TYPES OF BUSINESS DECISIONS

(i) Production Decisions:
Production is an economic activity which supplies goods and
services for sale in a market to satisfy consumer wants thereby profit
maximisation is made possible. The business executive has to make the
rational allocation of available resources at his disposal. He may face
problems relating to best combination of the factors to gain maximum profit
or how to use different machine hours for maximum production advantage,
etc.

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(ii) Inventory Decision:
Inventory refers to the quantity of goods, raw material or other
resources that are idle at any given point of time held by the firm. The
decision to hold inventories to meet demand is quite important for a firm
and in certain situation the level of inventories serves as a guide to plan
production and is therefore, a strategic management variable. Large
inventory of raw materials, intermediate goods and finished goods means
blocking of capital.
(iii) Cost Decisions:

The competitive ability of the firm depends upon the ability to

produce the commodity at the minimum cost. Hence, cost structure,
reduction of cost and cost control has come to occupy important places in
business decisions. In the absence of cost control, profits would come
down due to increasing cost.

Business decisions about the future require the businessmen to

choose among alternatives, and to do this, it is necessary to know the
costs involved. Cost information about the resources is very essential for
business decision making.
(iv) Marketing Decisions:

Within market planning, the marketing executive must make

decisions on target market, market positioning, product development,
pricing channels of distribution, physical distribution, communica­tion and
promotion. A businessman has to take mainly two different but interrelated
decisions in marketing.

They are the sales decision and purchase decision. Sales decision
is concerned with how much to produce and sell for maximising profit. The
purchase decision is concerned with the objective of acquiring these
resources at the lowest possible prices so as to maximise profit. Here the
executive’s basic skill lies in influencing the level, timing, and composition
of demand for a product, service, organisation, place, person or idea.
(v) Investment Decision:

The problems of risks and imperfect foresight are very crucial for
the investment decision. In real business situation, there is seldom an
investment which does not involve uncertainties. Investment decision
covers issues like the decisions regarding the amount of
 18
money for capital investment, the source of financing this investment,
allocation of this investment among different projects over time. These
decisions are of immense significance for ensuring the growth of an
enterprise on sound lines. Hence, decisions on investment are to be taken
with utmost caution and care by the executive.
(vi) Personnel Decision:

An organisation requires the services of a large number of

personnel. These personnel occupy various positions. Each position of the
organisation has certain specific contributions to achieve organi­sational
objectives. Personnel decisions cover the areas of manpower planning,
recruitment, selection, training and development, performance appraisal,
promotion, transfer, etc. Business executives should take personnel
decisions as an essential element.
1.7 SUMMARY
Managerial economics generally refers to the integration of
economic theory with business practice. Economics provides tools and
managerial economics applies these tools to the management of business.
In simple terms, managerial economics means the application of economic
theory to the problem of management. Managerial economics may be
viewed as economics applied to problem solving at the level of the firm.

It enables the business executive to assume and analyse things.

Every firm tries to get satisfactory profit even though economics
emphasises maximising of profit. Hence, it becomes neces­sary to redesign
economic ideas to the practical world. This function is being done by
managerial economics.

The scope of managerial economics is not yet clearly laid out

because it is a developing science. Even then the following fields may be
said to generally fall under Managerial Economics:

1. Demand Analysis and Forecasting

 2. Cost and Production Analysis

3. Pricing Decisions, Policies and Practices

4. Profit Management

19
5. Capital Management

The usefulness of business economics lies in borrowing and

adopting the toolkit from economic theory, incorporating relevant ideas
from other disciplines to take better business decisions, serving as a
catalytic agent in the process of decision making by different functional
departments at the firm’s level, and finally accomplishing a social purpose
by orienting business decisions towards social obligations.

1.8 SELF ASSESSMENT QUESTIONS

1. Discuss the principles of managerial decision analysis?

___________________________________________________________
_
___________________________________________________________
_
___________________________________________________________
_ 2. State the relationship between micro economics, macro economics
and managerial
economics.

__________________________________________________________
__
 __________________________________________________________
__
__________________________________________________________
__ 3. Throw light on goals and scope of economics.

__________________________________________________________
__
__________________________________________________________
__
__________________________________________________________
__ 1.9 SUGGESTED READINGS
• Managerial economics, Dwivedi D.N., Vikas publishing house, New
Delhi. • Managerial Economics, Mehta, P.L., S. Chand, Delhi.
• Mithani, D.M., Managerial Economics­Theory & application, Himalaya
Publishing House Pvt. Ltd., New Delhi.

20
• Gupta, G.S., Macro Economic­Theory & Application, Tata Mcgraw Hill Publishing
House, New Delhi.
• Vaish, M.C., Macro Economic Theory, Vikas Publishing House Pvt. Ltd., New Delhi.
• Mishra, S.k., and Puri, V.K., Modern Macro Economic Theory, Himalayan Publishing
House.
• Edward Shapiro, Macro Economic Analysis, Tata McGraw Hill, New Delhi. • Jhingam,
M.L. & Stephen, J.K, Managerial Econbomics, Vrinda Publications Pvt. Ltd. Delhi.
• Dingra, I.C Managerial Economics, Sultan Chand, New Delhi.21

UNIT-I

LESSON 2 MANAGERIAL DECISION ANALYSIS STRUCTURE

2.1 INTRODUCTION
2.2 OBJECTIVE
2.3 ECONOMIC THEORY AND MANAGERIAL THEORY 2.4
WHY DO MANAGERS NEED TO KNOW ECONOMICS? 2.5
DECISION MAKING
2.5.1 Contribution of Managerial Economics in Business
Decision Making 2.6 MANAGERIAL DECISION ANALYSIS

2.6.1 Principles in Managerial Economics

2.6.2 Application of Economics to Business decisions­Example

2.6.3 Other Economic Principles Relevant to Managerial

Decisions 2.7 SUMMARY
2.8 SELF ASSESSMENT QUESTIONS
2.9 SUGGESTED READING
2.1 INTRODUCTION

Business Economics, also called Managerial Economics, is the

application of economic theory and methodology to business. Business
involves decision­making. Decision making means the process of selecting
one out of two or more alternative courses of action. The question of
choice arises because the basic resources such as capital, land, labour
and management are limited and can be employed in alternative uses. The
decision­

22
making function thus becomes one of making choice and taking decisions
that will provide the most efficient means of attaining a desired end, say,
profit maximisation. Managerial Economics applies micro­economic tools to
make business decisions. It deals with a firm. The use of Managerial
Economics is not limited to profit­making firms and organisations. But it can
also be used to help in decision­making process of non­profit organisations
(hospitals, educational institutions, etc). It enables optimum utilisation of
scarce resources in such organizations as well as helps in achieving the
goals in most efficient manner. Managerial Economics is of great help in
price analysis, production analysis, capital budgeting, risk analysis and
determination of demand. Managerial economics uses both Economic
theory as well as Econometrics for rational managerial decision making.
Econometrics is defined as use of statistical tools for assessing economic
theories by empirically measuring relationship between economic
variables. It uses factual data for solution of economic problems.
Managerial Economics is associated with the economic theory which
constitutes “Theory of Firm”. Theory of firm states that the primary aim of
the firm is to maximise wealth. Decision making in managerial economics
generally involves establishment of firm’s objectives, identification of
problems involved in achievement of those objectives, development of
various alternative solutions, selection of best alternative and finally
 implementation of the decision.
2.2 OBJECTIVES

The objectives of this lesson are:

 To provide knowledge of economic and managerial theory.

 To explain the concept of managerial decision making.

 To explain principles of managerial decision.

2.3 ECONOMIC THEORY AND MANAGERIAL THEORY
Economic Theory is a system of inter­relationships. Among the social
sciences, economics is the most advanced in terms of theoretical
orientations. There are well defined theoretical structures in economics.
One of the most widely discussed structures is the postulational or
axiomatic method of theory formulation. It insists that there is a logical core
of theory consisting of postulates and their predictions which forms the
basis of economic reasoning and analysis. This logical core of theory
cannot easily be detached23
from the empirical part of the theory. Economics has a logically consistent
system of reasoning. The theory of competitive equilibrium is entirely
based on axiomatic method. Both in deductive inferences and inductive
generalisations, the underlying principle is the interrelationships.

Managerial theory refers to those aspects of economic theory and

application which are directly relevant to the practice of management and
the decision making process. Managerial theory is pragmatic. It is
concerned with those analytical tools which are useful in improving
decision making. Managerial theory provides necessary conceptional tools
which can be of considerable help to the manager in taking scientific
decisions. The managerial theory provides the maximum help to a
business manager in his decision making and business planning. The
managerial theoretical concepts and techniques are basic to the entire
gamut of managerial theory.

Economic theory deals with the body of principles. But managerial

theory deals with the application of certain principles to solve the problem
of a firm. Economic theory has the characteristics of both micro and macro
economics. But managerial theory has only micro characteristics.
Economic theory deals with a study of individual firm as well as individual
consumer. But managerial theory studies only about individual firm.
Economic theory deals with a study of distribution theories of rent, wages,
interest and profits. But managerial theory deals with a study of only profit
theories. Economic theory is based on certain assumptions. But in
managerial theory these assumptions disappear due to practical situations.
Economic theory is both positive and normative in character but
managerial theory is essentially normative in nature. Economic theory
studies only economic aspect of the problem whereas managerial theory
studies both economic and non­economic aspects.

2.4 WHY DO MANAGERS NEED TO KNOW ECONOMICS?

Economics contributes a great deal towards the performance of

managerial duties and responsibilities. Just as biology contributes to the
medical profession and physics to engineering, economics contributes to
the managerial profession. All other professional qualifications being the
same, managers with a working knowledge of economics can perform their
functions more efficiently than those without it. The basic function of the
managers of a business firm is to achieve the objective of the firm to the
maximum possible extent with the limited resources placed at their
disposal. The emphasis here is on the

24
maximisation of the objective and limitedness of resources. Had the
resources been unlimited, the problem of recognising on the resources or
resource management would have never arisen. But resources at the
disposal of a firm, be it finance, men, or material, are by all means limited.
Therefore, the basic task of the management is to optimise their use.

As mentioned, economics, though variously defined, is essentially

the study of logic, tools and techniques of making optimum use of the
 available resources to achieve the given ends. Economics thus provide
analytical tools and techniques that managers need to achieve the goals of
the organisation they manage. Therefore, a working knowledge of
economics, not necessarily a formal degree, is essential for managers. In
other words, managers are essentially practicing economists.

In performing their functions, managers have to take a number of

decisions in conformity with the goals of the firm. Many business decisions
are taken under the conditions of uncertainty and risk. These arise mainly
due to uncertain behaviour of the market forces, changing business
environment, emergence of competitors with highly competitive products,
government policy, international factors impacting the domestic market due
to increasing globalisation as well as social and political changes in the
country. The complexity of the modern business world adds complexity to
business decision making. However, the degree of uncertainity and risk
can be greatly reduced if market conditions are predicted with a high
degree of reliability. Economics offers models, tolls and techniques to
predict the future course of market conditions and business prospects.

The prediction of the future course of business environment alone

is not sufficient. What is equally important is to take appropriate business
decisions and to formulate a business strategy in conformity with the goals
of the firm. Taking a rational business requires a clear understanding of the
technical and environmental conditions related to the business issues for
which decisions are taken. Application of economic theories to explain and
analyse the technical conditions and the business environment contributes
a good deal to rational decision­making. Economic theories have, therefore,
gained a wide range of application in the analysis of practical problems of
the business. With the growing complexity of business environment, the
usefulness of economic theory as a tool of analysis and its contribution to
the process of decision making has been widely recognised.

25
2.5 DECISION MAKING
 Managerial economics is supposed to enrich the conceptual and
technical skill of a manager. It is concerned with economic behaviour of the
firm. It concentrates on the decision process, decision model and decision
variables at the firm level. It is the application of economic analysis to
evaluate business decisions. The primary function of a manager in
business organisation is decision making and forward planning under
uncertain business conditions. Some of the important management
decisions are production decision, inventory decision, cost decision,
marketing decision, financial decision, personnel decision and
miscellaneous decisions. One of the hallmarks of a good executive is the
ability to take quick decision. He must have the clarity of goals, use all the
information he can get, weigh pros and cons and make fast decisions.

The decisions are taken to achieve certain objectives. Objectives

are the motivating factors in taking decision. Several acts are performed to
attain the objectives quantitative techniques are also used in decision
making. But it may be noted that acts and quantitative techniques alone
will not produce desirable results. It is important to remember that other
variables such as human and behavioural con­siderations, technological
forces and environmental factors influence the choices and decisions
made by managers.

2.5.1 Contribution of Managerial Economics in Business Decision Making

Mathematical Economics and Econometrics are utilized to construct

and estimate decision models useful in determining the optimal behaviour
of a firm. The former helps to express economic theory in the form of
equations while the latter applies statistical techniques and real world data
to economic problems. Like, regression is applied for forecasting and
probability theory is used in risk analysis. In addition to this, economists
use various optimization techniques, such as linear programming, in the
study of behavior of a firm. They have also found it most efficient to
express their models of behavior of firms and consumers in terms of the
symbols and logic of calculus. Thus, Managerial Economics deals with the
economic principles and concepts, which constitute “Theory of the Firm”.
The subject is a synthesis of economic theory and quantitative techniques
to solve managerial decision problems. It is micro­economic in character.
Further, it is normative since it makes value judgments, that is, it states
what goals a firm should pursue. Fig. below summarises our discussion of
the principal ways in which Economics relates to managerial decision­

26
making. Managerial Economics plays an equally important role in the
management of non business organizations such as government
agencies, hospitals and educational institutions. Regardless of whether
one manages the ABC hospital, Eastman Kodak or College of Fine Arts,
logical managerial decisions can be taken by a mind trained in economic
logic. 2.6 MANAGERIAL DECISION ANALYSIS

Managerial Economics deals with allocating the scarce resources in

a manner that minimizes the cost. As we have already discussed,
Managerial Economics is different from microeconomics and
macro­economics. Managerial Economics has a more narrow scope ­ it is
actually solving managerial issues using micro­economics. Wherever there
are scarce resources, managerial economics ensures that managers make
effective and efficient decisions concerning customers, suppliers,
competitors as well as within an organization. The fact of scarcity of
resources gives rise to three fundamental questions
a. What to produce?
b. How to produce?
c. For whom to produce?
To answer these questions, a firm makes use of managerial economics
principles.

The first question relates to what goods and services should be

produced and in what amount/quantities. The managers use demand
theory for deciding this. The demand theory examines consumer behaviour
with respect to the kind of purchases they would like to make currently and
 in future; the factors influencing purchase and consumption of a specific
good or service; the impact of change in these factors on the demand of
that specific good or service; and the goods or services which consumers
might not purchase and consume in future. In order to decide the amount
of goods and services to be produced, the managers use methods of
demand forecasting.

The second question relates to how to produce goods and services.

The firm has now to choose among different alternative techniques of
production. It has to make decision regarding purchase of raw materials,
capital equipments, manpower, etc. The managers can use various
managerial economics tools such as production and cost analysis (for
hiring and acquiring of inputs), project appraisal methods (for long term
investment decisions),

27
etc for making these crucial decisions.

The third question is regarding who should consume and claim the
goods and services produced by the firm. The firm, for instance, must
decide which is it’s niche market domestic or foreign? It must segment the
market. It must conduct a thorough analysis of market structure and thus
take price and output decisions depending upon the type of market.

Managerial economics helps in decision­making as it involves logical

thinking. Moreover, by studying simple models, managers can deal with
more complex and practical situations. Also, a general approach is
implemented. Managerial Economics take a wider picture of firm, i.e., it
deals with questions such as what is a firm, what are the firm’s objectives,
and what forces push the firm towards profit and away from profit. In short,
managerial economics emphasises upon the firm, the decisions relating to
individual firms and the environment in which the firm operates. It deals
with key issues such as what conditions favour entry and exit of firms in
market, why are people paid well in some jobs and not so well in other
jobs, etc. Managerial Economics is a great rational and analytical tool.
 Managerial Economics is not only applicable to profit­making
business organizations, but also to non­ profit organisations such as
hospitals, schools, government agencies, etc.
2.6.1 Principles in Managerial Economics

Economic principles assist in rational reasoning and defined

thinking. They develop logical ability and strength of a manager. Some
important principles of managerial economics are:
1. Marginal and Incremental Principle: This principle states that a decision
is said to be rational and sound if given the firm’s objective of profit
maximisation, it leads to increase in profit, which is in either of two
scenarios­

 If total revenue increases more than total cost.

 If total revenue declines less than total cost.

Marginal analysis implies judging the impact of a unit change in one

variable on the28
other. Marginal generally refers to small changes. Marginal revenue is
change in total revenue per unit change in output sold. Marginal cost refers
to change in total costs per unit change in output produced (While
incremental cost refers to change in total costs due to change in total
output). The decision of a firm to change the price would depend upon the
resulting impact/change in marginal revenue and marginal cost. If the
marginal revenue is greater than the marginal cost, then the firm should
bring about the change in price.

Incremental analysis differs from marginal analysis only in that it

analysis the change in the firm’s performance for a given managerial
decision, whereas marginal analysis often is generated by a change in
outputs or inputs. Incremental analysis is generalisation of marginal
concept. It refers to changes in cost and revenue due to a policy change.
For example ­ adding a new business, buying new inputs, processing
products, etc. Change in output due to change in process, product or
 investment is considered as incremental change. Incremental principle
states that a decision is profitable if revenue increases more than costs; if
costs reduce more than revenues; if increase in some revenues is more
than decrease in others; and if decrease in some costs is greater than
increase in others.
2. Equi-marginal Principle: Marginal Utility is the utility derived from the
additional unit of a commodity consumed. The laws of equi­marginal utility
states that a consumer will reach the stage of equilibrium when the
marginal utilities of various commodities he consumes are equal.
According to the modern economists, this law has been formulated in form
of law of proportional marginal utility. It states that the consumer will spend
his money­income on different goods in such a way that the marginal utility
of each good is proportional to its price, i.e.,
MUx / Px = MUy / Py = MUz / Pz
Where, MU represents marginal utility and P is the price of good.

Similarly, a producer who wants to maximize profit (or reach

equilibrium) will use the technique of production which satisfies the
following condition:

MRP1 / MC1 = MRP2 / MC2 = MRP3 / MC3

Where, MRP is marginal revenue product of inputs and MC

represents marginal cost.

Thus, a manger can make rational decision by allocating/hiring

resources in a29
manner which equalizes the ratio of marginal returns and marginal costs of
various use of resources in a specific use.
3. Opportunity Cost Principle: By opportunity cost of a decision is meant
the sacrifice of alternatives required by that decision. If there are no
sacrifices, there is no cost. According to Opportunity cost principle, a firm
can hire a factor of production if and only if that factor earns a reward in
that occupation/job equal or greater than it’s opportunity cost. Opportunity
cost is the minimum price that would be necessary to retain a factor
service in it’s given use. It is also defined as the cost of sacrificed
alternatives. For instance, a person chooses to forgo his present lucrative
job which offers him Rs.50000 per month, and organizes his own business.
The opportunity lost (earning Rs. 50,000) will be the opportunity cost of
running his own business.
4. Time Perspective Principle: According to this principle, a
manger/decision maker should give due emphasis, both to short­term and
long­term impact of his decisions, giving apt significance to the different
time periods before reaching any decision. Short­run refers to a time period
in which some factors are fixed while others are variable. The production
can be increased by increasing the quantity of variable factors. While
long­run is a time period in which all factors of production can become
variable. Entry and exit of seller firms can take place easily. From
consumers point of view, short­run refers to a period in which they respond
to the changes in price, given the taste and preferences of the consumers,
while long­run is a time period in which the consumers have enough time to
respond to price changes by varying their tastes and preferences.
5. Discounting Principle: According to this principle, if a decision affects
costs and revenues in long­run, all those costs and revenues must be
discounted to present values before valid comparison of alternatives is
possible. This is essential because a rupee worth of money at a future date
is not worth a rupee today. Money actually has time value. Discounting can
be defined as a process used to transform future dollars into an equivalent
number of present dollars. For instance, $1 invested today at 10% interest
is equivalent to $1.10 next year.

FV = PV*(1+r)t
Where, FV is the future value (time at some future time), PV is the present
value (value at t0, r is the discount (interest) rate, and t is the time between
the future value and30
present value.
2.6.2 Application of Economics to Business decisions- Example

We have discussed above how economics can contribute to

 business decision making. Business decision making is essentially a
process of selecting the best out of alternative opportunities open to the
firm. The process of decision making comprises four main phases:
a) Determining and defining the objective to be achieves;
b) Collections and analysis of business related data and other information
regarding economic, social, political and technological environment
and foreseeing the necessity and occasion for decision making;
c) Inventing, developing and analysing possible courses of
action; and d) Selecting a particular course of action, from the
available alternatives.
This process of decision making is, however, not as simple as it
appears to be. Step (ii) and (iii) are crucial in business decision making.
These steps put managers’ analytical ability to test and determine the
appropriateness and validity of decisions in the modern business world.
Modern business conditions are changing so fast and becoming so
competitive and complex that personal sense, intuition and experience
alone may not prove sufficient to make appropriate business decisions.
2.6.3 Other Economic Principles Relevant to Managerial Decisions Some
other key economic principles that are relevant to managerial decisions
are: 1) Division of Labour

I put the division of labour first mainly because Adam Smith did argue that
division of labour is the key cause of improving standards of living. Modern
economics doesn’t do much with the concept of division of labour, but two
closely related concepts are important:

Returns to Scale: Returns to scale may be increasing, constant or

decreasing. Increasing returns to scale is the case that leads to special
results, and division of labor is one cause (arguably the main cause) of
increasing returns to scale.

31
Virtuous Circles in Economic Growth: For Smith, a major consequence of
division of labour and resulting increasing productivity was a “virtuous
circle” of continuing growth. Modern “virtuous circle” theories have more
dimensions, but division of labour and increasing returns to scale are
among them.
2) Market Equilibrium
The market equilibrium model could be broken down into several
principles­the definitions of supply, demand, quantity supplied and
demanded and equilibrium, at least but these all complement one another
so strongly that there is not much profit in taking them separately.
However, there are many applications and at least four important
subsidiary principles:

Elasticity and Revenue: These ideas are a key to understanding how

market changes transform society.
The Entry Principle: This tells us that, when entry into a field of activity is
free, profits (beyond opportunity costs) will be eliminated by increasing
competition. This has a somewhat different significance depending on
whether competition is “perfect” or monopolistic.
Cobweb Adjustment: This might give the explanations when the
market does not move smoothly to equilibrium, but overshoots.
Competition vs. Monopoly:Why economists tend to think highly of
competition, and lowly of monopoly.
3) Diminishing Returns
Perhaps the best­known of major economic principles, the Principle
of Diminishing Returns is much more reliable in short­run than in long­run
applications, so the Long Run/ Short Run dichotomy is an important
subsidiary principle. Modern economists think of diminishing returns mainly
in marginal terms, so marginal analysis and the equi­marginal principle are
closely associated.
4) Game Equilibrium
Game theory allows strategy to be part of the story. One result is that we
 have to allow for32
several kinds of equilibriums.

Non-cooperative equilibrium
(a) Prisoners’ Dilemma (dominant strategy) equilibrium
(b) Nash (best response) equilibrium, (but not all Nash equilibrium are
dominant strategy equilibrium),
Cooperative equilibrium

Oligopoly
5) Measurement Principles

Economics is multidimensional, and that creates some difficulties in

measuring things like production, incomes, and price levels. Some of the
problems can be solved more or less fully.

Value Added and Double Counting: One for which we have a pretty
complete solution is the problem of double counting: the solution is, use
value added.

“Real” Values and Index Numbers: Since we measure production and

related quantities in dollar terms, we have to correct for inflation. Index
numbers are a pretty good workable solution, but there are some problems
and criticisms.

Measurement of Inequality: Another issue is that the “average income”

may not mean very much, because nobody is average and income is
unequally distributed. Even if we cannot correct for that we can get a rough
measure of the relative inequality and see where it is going.
6) Medium of Exchange
Money is whatever is generally acceptable as a medium of
exchange. That means a bank, or similar institution, can literally create
money, so long as people trust the bank enough to accept its paper as a
medium of exchange. We might call this magical fact the Fiduciary
Principle.
 7) Income-Expenditure Equilibrium

Like the market equilibrium principle, but even more so, this model
pulls together33
a number of subsidiary principles that complement one another and
together constitute the “Keynesian” theory of aggregate demand. The
implications of this theory are less controversial than the word “Keynesian”
is ­controversy has to do more with the details than the applications.

Among the subsidiary principles are

1. Coordination Failure
2. The income­consumption relationship
3. The Multiplier
4. Unplanned inventory investment
5. Fiscal Policy
6. The Marginal Efficiency of Investment
7. The influence of money on interest
8. Real Money Balances
9. Monetary Policy
8) Surprise Principle
People respond differently to the same stimuli if the stimuli come as
a surprise than they would if the stimuli do not come as a surprise. This
new economic principle plays the key role with respect to aggregate supply
that “Income­Expenditure Equilibrium” plays with respect to aggregate
demand.

Rational Expectations: People don’t want too many unpleasant

surprises. If they use the information available to them efficiently, then they
won’t be surprised in the same way very often. This can lead to:
(a) Policy ineffectiveness
(b) Permanence
(c) Path Dependence.
 34
2.7 SUMMARY
Managerial economics is a science applied to decision making. It
bridges the gap between abstract theory and managerial practice. It
concentrates more on the method of reasoning. In short, managerial
economics is “Economics applied in decision making”. The primary
function of management executive in a business organisation is decision
making and forward planning. Decision making and forward planning go
hand in hand with each other. Decision making means the process of
selecting one action from two or more alternative courses of action.
Forward planning means establishing plans for the future to carry out the
decision so taken. The problem of choice arises because resources at the
disposal of a business unit (Land, Labour, capital, and managerial
capacity) are limited and the firm has to make the most profitable use of
these resources. The decision making function is that of the business
executive, he takes the decision which will ensure the most efficient means
of attaining a desired objective, say profit maximisation. After taking the
decision about the particular output, pricing, capital, raw­materials and
power etc., are prepared. Forward planning and decision­making thus go on
at the same time. A business manager’s task is made difficult by the
uncertainty which surrounds business decision­making. Nobody can predict
the future course of business conditions. He prepares the best possible
plans for the future depending on past experience and future outlook and
yet he has to go on revising his plans in the light of new experience to
minimise the failure. Managers are thus engaged in a continuous process
of decision­making through an uncertain future and the overall problem
confronting them is one of adjusting to uncertainty.
2.8 SELF ASSESSMENT QUESTIONS
1. What is economic theory? How it is different from managerial theory?
__________________________________________________________
 _
__________________________________________________________
_
__________________________________________________________
_ 2. Explain the concept of managerial decision analysis?

_____________________________________________________
______
_____________________________________________________
______35
_____________________________________________________
______ 3. Discuss the principles followed in decision making.

_____________________________________________________

______

_____________________________________________________

______

_____________________________________________________

______

4. Give the importance of managerial economics in business decision

making.
___________________________________________________________
_
___________________________________________________________
_
___________________________________________________________
_ 2.8 SUGGESTED READINGS
 Dwivedi D.N., Managerial Economics, Vikas Publishing House, New Delhi.

 Mithani, D.M., Managerial Economics­Theory & Application, Himalaya

Publishing House Pvt. Ltd., New Delhi.

 Shapiro Edward, Macro Economic Analysis, Tata McGraw Hill, New

Delhi.  Dingra, I.C., Managerial Economics, Sultan Chand, New

Delhi.

36
UNIT I

LESSON 3 MANAGERIAL ECONOMICS-A POSITIVE OR NORMATIVE

SCIENCE

STRUCTURE
3.1 INTRODUCTION
3.2 OBJECTIVE
3.3 METHODOLOGY OF ECONOMICS
3.4 GOALS OF ECONOMICS
3.5 MANAGERIAL ECONOMICS­POSITIVE OR NORMATIVE SCIENCE
3.6 IMPORTANCE OF ECONOMICS IN OUR LIFE
 3.7 CENTRAL PROBLEMS OF AN ECONOMY
3.8 SUMMARY
3.9 SELF ASSESSMENT QUESTIONS
3.10 SUGGESTED READINGS
3.1 INTRODUCTION

We observe that there are different types of people or stakeholders who

use economics in different ways. For example, a practising economist or a
policy practitioner uses economic tools and information to make any
suggestion or critical analysis. Generally, such people use economic
theories and tools for proper understanding and specific forecasting of
economic variables. It is because use of economic sciences is generally
for proper decision making and accuracy in economic forecasting. Thus,
positive statements are about facts. They state what the reality is. To be
specific, economics is strictly positive in character and is concerned with
merely positive statements. Since positive statements are about facts, any
disagreement over such statement or analysis can be handled properly
only by use of facts and their analysis. Thus, positive economics is one
that deals with the37
real life situations or the facts or evidences. Any inferences are derived
and disputed based upon such facts and analysis only. Normative
economics is based on the normative statements. Normative statements
are concerned with what are to be? In this case, economics is not
concerned with real life experiences rather, it is concerned with, how things
should operate. As against the positive economics, the normative
economics cannot be challenged based upon any fact. For example, if a
political leader projects his party’s vision in election that the unemployment
rate should be brought down to 2.0 per cent, this statement is not based
upon any analysis or fact, rather it is desire or the wish or the norm applied
by the particular political party. Now, if the political party comes to the
power the policy maker must tune the system to realise this target. Despite
there being differences between positive economics and normative
economics, economics is a science having both positive and normative
aspects. It is more so because economics is a social science.
According to Ross D. Eckert and Richard H. Leftwich, (1988),
“Economic policy making­conscious intervention in economic activity with
the intent of altering the course that it will take­is essentially normative in
character. But if economic policy­making is to be effective in improving
economic well­being, it must obviously be rooted in sound positive
economic analysis. Policy­makers should be cognised of the full range of
consequences of the policies they recommend.” (“The Price System and
Resource Allocation”, New York, 10th edition, p. 10) According to
Samuelson and Nordhaus, (2000), positive and normative economics may
be interpreted as under. “Positive economics deals with questions such as:
why do doctors earn more than janitors? Does free trade raise or lower
wages for most Americans? …Although these are difficult questions to
answer, they can all be resolved by reference to analysis and empirical
evidence. That puts them in the realm of positive economics.” “Normative
economics involves ethical precepts and norms of fairness. Should poor
people be required to work if they are to get government assistance?
Should unemployment be raised to ensure that price inflation does not
become too rapid? … There are no right or wrong answers to these
questions because they involve ethics and values rather than facts. They
can be resolved only by political debate and decisions, not by economic
analysis alone.”
3.2 OBJECTIVES
The objectives of this lesson are to explain the:
 Positive and Normative science of economics.
38
 Inductive and deductive methods of economics.
3.3 METHODOLOGY OF ECONOMICS

Economics is also like a science but it is a social science. It deals

mainly with the human behaviour. Therefore, many economists argue that
economics can not be as precise a science as the natural sciences like
physics, chemistry etc. The latter can be studied in the laboratory
conditions where variables can be easily controlled during experiments.
However, social sciences like economics cannot be easily controlled. Still
over a period of time economic sciences have gained maturity to develop
its methodology which is proving now to be quite efficient and such
methodologies can be used for efficient analysis of the economic
relationships and predictions can be made with sufficient accuracy that
generate a sense of confidence and faith. There are two broad methods
used in the economic sciences.

1. The deductive method

2. The inductive method

1. The deductive method: This method involves going from general to

particular. Certain hypotheses or postulates regarding human behaviour
are taken to be true and then with the help of logical reasoning and
examination, Nature and Scope of Economics.

Here in this lesson we try to figure out the cause and effect relationship
between the factors under consideration. The following steps are involved
in the deductive method.

I. Firstly, a problem needs to be identified and then it should be

properly specified for the study.

II. The assumptions required in the study should be clear.

Appropriate assumptions are crucial in economic analysis.

III. After specifying the assumptions, hypotheses should be clearly

framed. The hypothesis formulation requires likely relationship among the
different economic variables.

IV. In the last phase, hypotheses should be tested through different

tools like mathematical economics and econometrics.

V. Based on the above analysis proper inference needs to be

derived for specific39

economic decision making.

2. The inductive method: Although deductive method has strong points of

merit to depend upon, this methodology seems to suffer from certain
weaknesses. Therefore, economists belonging to the historical school and
many other economists have favoured the inductive or empirical method.

The method of induction involves going from particular to general. Here the
appeal is to facts, rather than reasoning and an attempt is made to arrive
at conclusions from the known facts of actual life. The inductive method
required the following steps:

I. The first step, as under the deductive method, is selecting and

specifying the problem that is to be studied.

II. The second step involves collection of data pertaining to the

problem selected for study.

III. The stage of collection is followed by classification and then

analysis of the data by appropriate statistical techniques.

IV. The fourth stage is that of ‘inference’, i.e. drawing conclusions

from the statistical analysis conducted. The conclusions are presented in
the form of economic generalisation. 3.4 ECONOMIC GOALS

Any science moves with certain goals to be achieved. Economics

has become now a crucial branch of knowledge. Being a social science it
keeps on revising its goals from time to time. The list might be quite large,
but we would like to focus only on certain major goals of economics as
given under:

1. A low rate of unemployment: People willing to work should be able to

find jobs reasonably quickly. Widespread unemployment is
demoralising and it represents an economic waste. Society forgoes the
goods and services that the unemployed could have produced.

2. Price stability: It is desirable to avoid rapid increases­or decreases­in the

average level of price.
3. Efficiency: When we work, we want to get as much as we reasonably

can take out of40

our productive efforts. For this, efficient technology becomes quite

useful.

4. An equitable distribution of income: When many live in affluence, no

group of citizens should suffer stark poverty. Given this, developing
countries are strategising goals like participatory growth and inclusive
growth.

5. Growth: Continuing growth, which would make possible an even higher

standard of living in the future, is generally considered an important
objective.

6. Economic freedom and choice: Any economy should grow and develop
in such a manner that people should get more choices and there
should not be any outside pressure on their choices.

7. Economic welfare: Economic policies should be pursued in such a

manner that welfare of the people or the social benefits get maximised.

8. Sustainable development: It has become a major challenge for

economists to carry on the process of economic growth in such a
manner that the resources are optimally utilized not only for
intergenerational equity but also for sustainable development in quite
long run.
3.5 MANAGERIAL ECONOMICS- A POSITIVE OR NORMATIVE
SCIENCE
Most of the managerial economists are of the opinion that
managerial economics is fundamentally normative and prescriptive in
nature. It is concerned with what decisions ought to be made. The
application of managerial economics is inseparable from consideration of
values or norms, for it is always concerned with the achievement of
objectives or the optimisation of goals. In managerial economics, we are
 interested in what should happen rather than what does happen. Instead of
explaining what a firm is doing, we explain what it should do to make its
decision effective.

Positive Economics:

A positive science is concerned with ‘what is’. Robbins regards

economics as a pure science of what is, which is not concerned with moral
or ethical questions. Economics is neutral between ends. The economist
has no right to pass judgment on the wisdom or folly of the ends itself.

41
He is simply concerned with the problem of resources in relation to
the ends desired. The manufacture and sale of cigarettes and wine may be
injurious to health and therefore morally unjustifiable, but the economist
has no right to pass judgment on these since both satisfy human wants
and involve economic activity.

Normative Economics:

Normative economics is concerned with describing what should be

the things. It is, therefore, also called prescriptive economics. What price
for a product should be fixed, what wage should be paid, how income
should be distributed and so on, fall within the purview of normative
economics?

It should be noted that normative economics involves value

judgments. Almost all the leading managerial economists are of the
opinion that managerial economics is fundamentally normative and
prescriptive in nature.

It refers mostly to what ought to be and cannot be neutral about the

ends. The application of managerial economics is inseparable from
consideration of values, or norms for it is always concerned with the
achievement of objectives or the optimisation of goals.

Managerial economists are generally preoccupied with the optimum

allocation of scarce resources among competing ends with a view to
obtaining the maximum benefit according to predetermined criteria.

To achieve these objectives they do not assume ceteris paribus, but

try to introduce policies. The very important aspect of managerial
economics is that it tries to find out the cause and effect relationship by
factual study and logical reasoning. The scope of managerial economics is
so wide that it embraces almost all the problems and areas of the manager
and the firm.
3.6 IMPORTANCE OF ECONOMICS IN OUR LIFE
Economics is the study of how finite resources are consumed by
demand, according to the costs imposed by their supply in relation to that
demand. In other words, economics tells us that a freeze in Florida that
damages the orange crop will cause the price of orange juice to change
and how the price will modify demand over time.

Modern economic theory is said to have originated in “The Wealth

of Nations,” a42
book written by Scottish scholar Adam Smith in 1776. The theory holds
that rational self interest pursued by individuals and businesses in a free
market society leads to optimal economic conditions.

The study of economics helps formulate an understanding of the

effects of financial actions and reactions by individuals and institutions.
This understanding allows the projection of future economic conditions
based on current indications.

An understanding of economics assists governments in managing

macroeconomic conditions such as limiting a recession by inducing
recovery. However, economic theory is not foolproof because it is a social
science based on the interplay between culture and money. Economic
effects change as cultural customs change.
3.7 CENTRAL PROBLEMS OF AN ECONOMY

Every economy faces some problems. These problems are

associated with growth, business cycles, unemployment and inflation. The
 macroeconomic theory is designed to explain how supply and demand in
the aggregate interact to concern with these four problems. Economists
these very important national problems as macroeconomic problems ­that
is, as problems that could not be understood or solved without an
understanding of the workings of the economic system as a whole. The
four distinctively macroeconomic problems are:
1. Recession
2. Unemployment
3. Inflation
4. Economic Growth or Stagnation
A. Recessions, Depressions and Economic Fluctuations

The event that created modern macroeconomics was called “the

Great Depression,” but the general term for decreasing national
production, in modern economics, is a recession.

But why do economists regard a recession as a problem?

It is not self­evident that a drop in production is a bad thing. For example, it
might be that people want to enjoy more leisure, and spend less time
producing goods and43
services. If production dropped for that reason, we would have no reason
to think of it as an economic problem. But, in some periods of recession,
we have evidence that this was not what happened. In many recession
periods, businesses that announced they were hiring had long lines of
people who wanted to apply, with many more people than they could hire.
This suggests that the people standing in line for a job had more leisure
than they wanted, and would have preferred jobs and income to buy more
goods and services. In the 1930’s, some people sold apples or pencils in
the street to get a little income, typically much less than they would have
had in their old jobs. Again, this suggests that people had too much leisure
and would have preferred more work and income. If this is so, then it
seems that something was going wrong. In different terms, it seemed that
the recession had caused unemployment. Another possibility is that
production might drop because a war or disaster had destroyed factories
and other capital goods. But, in 1933, it seems very unlikely that the
productive capacity of the economy could have dropped by 30%. There
had been no war. And in fact, factories had been closed that could have
been reopened and put to work, at the same time as many people were
looking for work. Perhaps these circumstances show why the recession is
regarded as a major economic problem.
B. Unemployment
Our second macroeconomic problem is unemployment. This
problem is highly correlated with recession, but is distinct, and we need to
look at it in its own terms. Unemployment occurs when a person is
available to work and currently seeking work, but the person is without
work. The prevalence of unemployment is usually measured using the
unemployment rate, which is defined as the percentage of those in the
labour force who are unemployed.
Economists distinguish between various types of unemployment.
For example, cyclical, frictional, structural and classical, seasonal,
hardcore and hidden. Real­world unemployment may combine different
types. The magnitude of each of these is difficult to measure, partly
because they overlap.
Unemployment is a status in which individuals are without job and
are seeking a job. It is one of the most pressing problems of any economy
especially the underdeveloped ones. This has macroeconomic implications
too some of which are discussed below:

44
Reduction in the Output: The unemployed workforce could be
utilised for the production of goods and services. Since they are not doing
so, the economy is losing out on its output.

Reduction in Tax Revenue: Since income tax is an important part of

the revenue for the government. The unemployed are unable to earn, the
government loses out on the income tax revenue.
 Rise in the Government Expenditure: The government has to give
unemployment insurance benefits to the claimants. Hence the government
will lose from both sides in terms of unemployment benefits and loss of tax
revenue. C. Inflation

In economics, inflation is a rise in the general level of prices of

goods and services in an economy over a period of time. A rising price
level – inflation­has the following disadvantages:
1. It creates uncertainty, in that people do not know what the money they
earn today will buy tomorrow.
2. Uncertainty, in turn, discourages productive activity, saving and
investing. 3. Inflation reduces the competitiveness of the country in
international trade. If this is not offset by a devaluation of the national
currency against other currencies, it makes the country’s exports less
attractive, and makes imports into the country more attractive, which in
turn tends to create unbalance in trade.
4. Inflation is a hidden tax on “nominal balances.” That is, people who hold
bonds and bank accounts in dollars lose the value of those accounts
when the price level rises, just as if their money had been taxed away.
5. The inflation tax is capricious­some lose by it and some do not without
any good economic reason.
6. As the purchasing power of the monetary unit becomes less predictable,
people resort to other means to carry out their business, means which
use up resources and are inefficient.

45
D. Economic Growth or Stagnation
Stagnation is a period of many years of slow growth of gross
domestic product, in which the growth is, on the average, slower than the
potential growth in the economy.

Causes of Stagnation
1. Population growth might high.
 2. Fewer people might choose to work.
3. The growth of labour productivity might slow.

Stagnation is economic growth that, while positive, is less than the

potential growth of the economy. Some economists believe that stagnation
is a serious problem and a cause of other problems, but since identification
of stagnation depends on one’s idea of the potential, it remains
controversial whether the slowing we see is stagnation or a reduction of
the potential.
3.8 SUMMARY

Traditional economic theory has developed along two lines; viz.,

normative and positive. Normative focuses on prescriptive statements, and
help establish rules aimed at attaining the specified goals of business.
Positive, on the other hand, focuses on description it aims at describing the
manner in which the economic system operates without staffing how they
should operate. The emphasis in business economics also known as
managerial economics is on normative theory. Business economics seeks
to establish rules which help business firms attain their goals, which indeed
is also the essence of the word normative. However, if the firms are to
establish valid decision rules, they must thoroughly understand their
environment. This requires the study of positive or descriptive theory.
Thus, managerial economics combines the essentials of the normative and
positive economic theory, the emphasis being more on the former than the
latter.
3.9 SELF ASSESSMENT QUESTIONS

1. What is meant by business environment? What branch of economics is

related to the environment issues of private business?

___________________________________________________________

_46
____________________________________________________________

____________________________________________________________

2. What are basic functions of business managers? How does economics help business
managers in performing their functions?

____________________________________________________________

____________________________________________________________

____________________________________________________________ 3.

Differentiate between positive economics and normative economics.

____________________________________________________________
____________________________________________________________
____________________________________________________________ 3.10
SUGGESTED READINGS

 Managerial economics, Dwivedi D.N., Vikas Publishing house, New Delhi.

 Mishra, S.K., and Puri, V.K., Modern Macro Economic Theory, Himalayan Publishing
house.

 Edward Shapiro, Macro Economic Analysis, Tata McGraw Hill, New Delhi.

 Jhingam, M.L. & Stephen, J.K, Managerial Economics, Vrinda Publications Pvt. Ltd.
Delhi.

 Dingra, I.C., Managerial economics, Sultan Chand, New Delhi.47

Unit-I

LESSON 4 APPROACHES TO MANAGERIAL DECISIONS STRUCTURE

4.1 INTRODUCTION
4.2 OBJECTIVES
4.3 ROLE OF A MANAGERIAL ECONOMIST
4.4 RESPONSIBILITIES OF A MANAGERIAL ECONOMIST 4.5
TECHNIQUES OR APPROACHES TO MANAGERIAL DECISION
MAKING

4.5.1 Scientific Method

4.5.2 The Statistical Method

4.5.3 Method of Intellectual Experiment

4.5.4 Method of Simulation

4.5.5 Historical Method

4.5.6 DESCRIPTIVE METHOD

4.6 SUMMARY
4.7 SELF ASSESSMENT QUESTIONS
4.8 SUGGESTED READINGS
4.1 INTRODUCTION

Decision making is an essential part of planning. Decision making

and problem solving are used in all management functions, although
usually they are considered a part of the planning phase. A discussion of
the origins of management science leads into one on modeling, the
five­step process of management science, and the process of engineering
48
problem solving. Managerial decision making is the process of making a
conscious choice between two or more rational alternatives in order to
select the one that will produce the most desirable consequences
(benefits) relative to unwanted consequences (costs). If there is only one
alternative, there is nothing to decide. In this lesson, we consider the
process of developing and evaluating alternatives and selecting from
among them the best alternative, and we review briefly some of the tools of
management science available to help us in this evaluation and selection.
If planning is truly “deciding in advance what to do, how to do it, when to
do it, and who is to do it” (as proposed by Amos and Sarchet1), then
decision making is an essential part of planning. Decision making is also
required in designing and staffing an organisation, developing methods of
motivating subordinates, and identifying corrective actions in the control
process. However, it is conventionally studied as part of the planning
function, and it is discussed here.
4.2 OBJECTIVES

After reading this Lesson, you will be able:

• To discuss how decision making relates to planning.
• To explain the process of problem solving.
• To discuss the differences between decision making under
certainty, risk, and uncertainty.
• To describe decision­making techniques.
4.3 ROLE OF A MANAGERIAL ECONOMIST
With the advent of managerial revolution and transition from the
owner­ manager to the professional executive, the managerial economists
have occupied an important place in modern business. In real practice,
firms do not behave in a deterministic world.

They strive to attain a multiplicity of objectives. Economic theory

makes a fundamental assumption of maximising profits as the basic
objective of every firm. The application of pure economic theory seldom
leads us to direct executive decisions.

Present business problems are either too obvious in their solution or purely
speculative and they need a special form of insight. A managerial
economist with his sound knowledge of theory and analytical tools can find
out solution to the business problems. In49
advanced countries, big firms employ managerial economists to assist the
management.

Organisationally, a managerial economist is placed nearer to the

policy maker simple because his main role is to improve the quality of
policy making as it affects short term operation and long range planning.
He has a significant role to play in assisting the management of a firm in
decision making and forward planning by using specialised skills and
techniques.

The factors which influence the business over a period are:

(i) External and (ii) Internal.

The external factors lie outside the control of the firm and these
factors constitute ‘Business Environment’. The internal factors lie within the
scope and operation of a firm and they are known as ‘Business
Operations’.
1. External Factors
The prime duty of a managerial economist is to make extensive
study of the business environment and external factors affecting the firm’s
interest, viz., the level and growth of national income, influence of global
economy on domestic economy, trade cycle, volume of trade and nature of
financial markets, etc. They are of great significance since every business
firm is affected by them.

These factors have to be thoroughly analysed by the managerial

economist and answers to the following questions have also to be found
out:
(i) What are the current trends in the local, regional, national and
international economies? What phase of trade cycle is going to occur in
the near future? (ii) What about the change in the size of population and
the resultant change in regional purchasing power?
(iii) Is competition likely to increase or decrease with reference to the
products produced by the firm?
(iv) Are fashions, tastes and preferences undergoing any change and have
they affected the demand for the product?
(v) What about the availability of credit in the money and capital
markets?50
(vi) Is there any change in the credit policy of the government?
(vii) What are the strategies of five year plan? Is there any special
emphasis for industrial promotion?
(viii) What will be the outlook of the government regarding its commercial
and economic policies?
(ix) Will the international market expand or contract and what are the
provisions given by the trade organisations?
(x) What are the regulatory and promotional policies of the central bank of a
country?

Answer to these and similar questions will throw more light on the
perspective business and these questions present some of the areas
where a managerial economist can make effective contributions through
scientific decision making. He infuses objectivity, broad perspective and
concept of alternatives into decision making process.

His focus on long term trends helps maximise profits and ensures
the ultimate success of the firm. The role of the managerial economist is
not to take decisions but to analyse, conclude and recommend. His basic
role is to provide quantitative base for decision making. He should
concentrate on the economic aspects of problems. He should have a rare
intuitive ability of perception.
2. Internal Factors
The managerial economist can help the management in making
decision regarding the internal operations of a firm in respect of such
problems as cost structure, forecasting of demand, price, investment, etc.

Some of the important relevant questions in this connection

are as follows: (i) What should be the production schedule for
 the coming year? (ii) What should be the profit budget for the
coming year?
(iii) What type of technology should be adopted in the specific process and
specify it? (iv) What strategies have to be adopted for sales promotion,
inventory control and utilisation of manpower?

51
(v) What are the factors influencing the input cost?
(vi) How different input components can be combined to minimise the cost of
production?
Apart from the above studies, the managerial economist has to
perform certain specific functions. He helps to co­ordinate practices relating
to production, investment, price, sales and inventory schedules of the firm.
Forecasting is the fundamental activity which consumes most of the time of
the managerial economist.

The sales forecast acts as a link between the external

uncontrollable factors and the internal controllable factors and are
intimately related to general economic activity. The managerial economist
is usually assigned the task of preparing short term general economic and
specific market forecasts to provide a framework for the development of
sales and profit. He has to help the firm to plan product improvement, new
product policy, and pricing and sales promotion strategy.

The managerial economist often needs focused studies of specific

problems and opportunities. He should indulge in market survey, a product
preference test, an advertising effectiveness study and marketing
research. Marketing research is undertaken to understand a marketing
problem better.

The managerial economist has to undertake an economic analysis

of competing firms. He should also under­take investment appraisal, project
evaluation and feasibility study. It is the duty of the managerial economist
to provide necessary intelligence.
 To conclude, a managerial economist has a very important role to
play. He should be held in the confidence of the management. A
managerial economist can serve the management best only if he always
keeps in mind the main objective of his firm, which is to make a profit.
4.4 RESPONSIBILITIES OF A MANAGERIAL ECONOMIST
The managerial economist can play a very important role by
assisting management in using the increasingly specialised skills and
sophisticated techniques which are required to solve the different problems
of successful decision making and forward planning.

The functions of a managerial economist can be broadly defined as

the study and interpretation of economic data in the light of the problems of
the management. The
52
managerial economist should be in a position to spare more time and
thought on problems of an economic nature than the firm’s administration.
His job may involve a number of routine duties closely tied in with the
firm’s day to day activities.

The managerial economist is employed primarily as a general

adviser. The advisory service refers to the opportunities open to the
managerial economist because of the growing role of government in
business life. He is responsible for the working of the whole business
concern. The most important obligations of a managerial economist is that
his objective must coincide with that of the business. Traditionally, the
basic objective of business has been defined in terms of profit
maximisation.

As a managerial economist, he must do something more than

routine management to earn profit. He cannot expect to succeed in serving
management unless he has a strong conviction which helps him in
enhancing the ability of the firm. The other most important responsibility of
a managerial economist is to try to make as accurate forecast as possible.
The managerial economist has to forecast not only the various
 components of the external business picture, but he has also to forecast
the various phases of company’s activity, that is the internal picture of the
company.

The managerial economist should recognise his responsibilities to

make successful forecast. By making the best possible forecasts, the
management can follow a more closely course of business planning. Yet
another responsibility of the managerial economist is to bring about a
synthesis of policies pertaining to production, investment, inventories, price
and cost. Production is an organised activity of transforming inputs into
output. The process of production adds to the values or creation of utilities.
The money expenses incurred in the process of production constitute the
cost of production. Cost of production provides the floor, to pricing. It
provides a basis for managerial decision.

There are several areas which have attracted the attention of the
managerial economist, such as maximising profit, reducing stocks,
forecasting sales, etc. If the inventory level is very low, it hampers
production. A managerial economist’s first responsibility, therefore, is to
reduce his stocks, for a great deal of capital is unprofitably tied up in the
inventory. The managerial economist’s contribution will be adequate only
when he is a member of full status in the business team. The managerial
economist should make use of his experience and facts in deciding the
nature of action.

53
He should be ready to undertake special assignments with full
seriousness. The managerial economist can put even the most
sophisticated ideas in simple language and avoid hard technical terms. It is
also the managerial economist’s responsibility to alert the management at
the earliest possible moment in case he discovers an error in his forecast.
By this way, he can assist the management in adopting appropriate
adjustment in policies and programmes. He must be alert to new
developments both economic and political in order to appraise their
possible effects on business. The managerial economist should establish
and maintain many contacts and data sources which would not be
immedi­ately available to the other members of management. For this
purpose, he should join professional and trade associations and take an
active part in them.

To conclude, a managerial economist should enlarge the area of

certainty. To discharge his role successfully, he must recognise his
responsibilities and obligations. No one can deny that the managerial
economist contributes significantly to the profitable growth of the firm
through his realistic attitude.
4.5 TECHNIQUES OR APPROACHES TO MANAGERIAL DECISION
MAKING
Six most important methods used by managerial economics to
explain and solve business problems of a firm are:
4.5.1 SCIENTIFIC METHOD

Scientific method is a branch of study which is concerned with

observed facts systematically classified and which includes trustworthy
method for the discovery of truths. It refers to a procedure or mode of
investigation by which scientific and systematic knowledge is acquired.

The method of enquiry is a very important aspect of science,

perhaps this is the most significant feature. Scientific method alone can
bring about confidence in the validity of conclusions. It concentrates on
controlled experiments and investigates the behaviour of preconceived
elements in a highly simplified environment.

The experimental method may be usefully applied to those aspects of

managerial behaviour which call for accurate and logical thinking. The
experimental methods are of limited use to managerial economics. A
managerial economist cannot apply experimental54
methods to the same extent and in the same way as a physicist can in
physical sciences.

We usually adopt an inductive as well as deductive approach in any

analysis of managerial behaviour. The deductive method begins with
postulates and hypotheses which are arbitrary. For the rationalists, there
stands at the head of the system, a set of self evident propositions and it is
from these that other propositions (theorems) are derived by the process of
reasoning.

At the other end are inductionist (empiricists) who believe that

science must construct its axioms from the same data and particularly by
ascending continually and gradually till it finally arrives at the most general
axioms.

It is often asked what the method of science is, whether induction or

deduction? The proper answer to this is, both. Both the methods are
interdependent and hold an equally important place in any scientific
analysis.
4.5.2 THE STATISTICAL METHOD

Statistical methods are a mechanical process especially designed

to facilitate the condensation and analysis of the large body of quantitative
data. The aim of statistical method is to facilitate comparison, study
relationships between the two phenomena and to interpret the complicated
data for the purpose of analysis.

Many a time comparison has to be made between the changes and

results which are due to changes in time, frequency of occurrence, and
many other factors. Statistical methods are used for such comparison
among past, present and future estimates.

For example, such methods as extrapolation can be applied for the

purpose of making future forecast about the trends of say, demand and
supply of a particular commodity. The statistical method of drawing
inference is mathematical in nature. It not only establishes causal
connection between two variables but also tries to establish a
mathematical relation­ship between them.

Statistical approach is a quantitative micro­approach. Certain

 important correlation and association of attributes can be found with the
help of statistics. It is useful for the study of manage­ment, economics, etc.
and it is very helpful to bankers, state, planners, speculators, researchers,
etc.

55
Though statistical methods are the handmaid of managerial
economics, they should be used with care. The most significant peculiarity
of the statistical method is that it helps us to seek regularities or patterns in
economic data and permits us to arrive at generalisations that cannot be
reached by any other method.
4.5.3 METHOD OF INTELLECTUAL EXPERIMENT
The fundamental problem in managerial economics is to find out the
nature of any relationship between different variables such as cost, price
and output. The real world is also invariably complex. It is influenced by
many factors such as physical, social, temperamental and psychological. It
is difficult to locate any order, sequence or law in such a confused and
complex structure. In this context, it is essential for the managerial
economist to engage in model building.

At times, to analyse behaviour we use models. A model is an

abstraction from reality. A model may be in the form of diagram, a verbal
description or a mathematical description. It can be classified into three
categories such as iconic, analogue and symbolic.

Managerial economics may be viewed as economics applied to

problem solving at the level of the firm. The problems relate to choices and
allocation of resources is faced by managers all the time. Managerial
economics is more concrete and situational and mainly concerned with
purposefully managed process of allocation. For this purpose the
managerial economist can and does use an abstract model of the
enterprise.

Models are approximate representations of reality. They help us in

understanding the underlying forces of the complex world of reality through
approximation. Model building is more useful in mana­gerial economics, as
it helps us to know the actual socio­economic relationship prevailing in a
firm.

Firms have only limited resources at their disposal which they must
utilise to make profit. The managers of these firms must make judgements
about the disposition of their resources and decide which priorities among
the various competing claims they have upon them. Models can guide
business executives to predict the future consequences.
4.5.4 METHOD OF SIMULATION
It is an extension of the intellectual experiment. This method has gained
popularity with the development of electronic computers, calculators and
other similar equipment56
and internet services. We can programme a complex system of
relationship with the help of this method. Computer is not only used for
scientific or mathematical applications, it may also be used for some
business applications, document generations and graphical solutions.
Computer is a fast electronic calculating machine capable of absorbing,
processing, integrating, relating and producing the resultant output
information within a short span of time.

A manager has to take numerous decisions in the management of

business which may be minor or major, simple or complex. They have to
ensure that once the decision is taken, it is to be implemented within the
minimum time and cost. The electronic gadgets will enable the manager to
understand business problems in a better perspective and increase his
ability to solve the business problems facing him in the management of
business.
4.5.5 HISTORICAL METHOD
Past knowledge is considered to be a pre­requisite for present
knowledge. This is the main argument for the adoption of historical method
in the present day managerial economics. In order to discover some basis
for business activity, the method becomes generic in character.
 The main objective of this method is to apply mind in the matter of
various business problems by discovering the past trend regarding facts,
events and attitudes and by demarcating the lines of development of
thought and action. If we have an idea of the past events, we can
understand the current economic problems much better. The wisdom of a
particular economic policy is an inevitable product of its past.

The historical method requires experience not only in collecting data

but also in finding out their relations and significance in the particular
context. The managerial economist must take up the analytical view in
order to get perfect control over facts and the synthetic view of facts.

He should be able to find out the relations between events and

events and between events and environment. It is necessary to make an
objective approach both in discovering facts and interpreting them. But in
order to be objective, the approach must be based on relevant, adequate
and reliable data.

For applying historical method, the managerial economist should be

familiar with57
the general field of his topic and be clear with regard to his own objective.
A good deal of imagination is required to apply the historical method.
4.5.6 DESCRIPTIVE METHOD
The descriptive method is simple and easily applicable to various
business problems, particularly in developing countries. It is a fact finding
approach related mainly to the present and abstract generalisations
through the cross sectional study of the present situation.

This method is mainly concerned with the collection of data. To

some extent, the descriptive method is also concerned with the
interpretation of data. In order to apply the descriptive method, the data
should be accurate and objective and if possible quantifiable.

Since the descriptive method wants to relate causality of the

collected facts, it is necessary for it to make comparisons between one
situation with the other and among different aspects of the same situation.
Thus, situational comparability is an essential element of this method.

This method is used to describe the organisation and functioning of

institutions and the policies which have economic significance. To analyse
the impact of the organisational structure in the working of business
enterprises, it is widely used by the managerial economist.

The best descriptive studies are observational in nature. This

method provides the empirical and logical basis for drawing conclusions
and gaining knowledge. Thus it enables the managerial economists to
describe or present the picture of a phenomenon or phenomena under
investigation.
4.6 SUMMARY
Managerial Economics is a discipline that combines economic
theory with managerial practice. Managerial Economics bridge the gap
between the problems of logic that intrigue economic theorist and
problems of policy that plague practical managers. Managerial economics
enriches the analytical skill, helps in logical structuring of problems and
provides adequate solutions to the economic problems. The study of it
helps in all direction of managerial decision making process to execute
business efficiently and effectively.

58
Managerial economics leverages economic concepts and decision
science techniques to solve managerial problems. It provides optimal
solutions to managerial decision making issues. Business firms are a
combination of manpower, financial, and physical resources which help in
making managerial decisions. Societies can be classified into two main
categories ­ production and consumption. Firms are the economic entities
and are on the production side, whereas consumers are on the
consumption side.

The performances of firms get analysed in the framework of an

economic model. The economic model of a firm is called the theory of the
firm. Business decisions include many vital decisions like whether a firm
should undertake research and development program, should a company
launch a new product, etc. Business decisions made by the managers are
very important for the success and failure of a firm. Complexity in the
business world continuously grows making the role of a manager or a
decision maker of an organisation more challenging. The impact of goods
production, marketing, and technological changes highly contribute to the
complexity of the business environment.
4.7 SELF ASSESSMENT QUESTIONS
1. Critically evaluate micro economics. How micro economics is helpful in
taking business decisions?
______________________________________________________
_____
___________________________________________________________
___________________________________________________________
2. Determine strategies a manager can use to create a more effective
decision making
environment ?

_____________________________________________________
______
__________________________________________________________
_
__________________________________________________________
_ 3. Identify the factors that influence decision­making?

_____________________________________________________
 ______59

__________________________________________________________
_
__________________________________________________________
_ 4.8 SUGGESTED READINGS

 Managerial economics, Dwivedi D.N., Vikas Publishing House, New

Delhi.  Managerial Economics, Mehta, P.L., S. Chand, Delhi.

 Mithani, D.M., Managerial Economics­Theory & Application, Himalaya

Publishing House Pvt. Ltd., New Delhi.
 60
UNIT- II

LESSON 5 DEMAND ANALYSIS STRUCTURE

5.1 INTRODUCTION
5.2 OBJECTIVES
5.3 MEANING OF DEMAND
5.3.1 Types of Demand
5.4 FEATURES OF A DEMAND
 5.5 DETERMINANTS OF DEMAND
5.6 EXCEPTIONS TO THE LAW OF DEMAND
5.7 ELASTICITY OF DEMAND
5.8 SUMMARY
5.9 SELF ASSESSMENT QUESTIONS
5.10 SUGGESTED READINGS

5.1 INTRODUCTION

The concepts of demand and supply are useful for explaining what
is happening in the market place. Every market transaction involves an
exchange and many exchanges are undertaken in a single day. A market
is a place where we buy and sell goods and services. A buyer demands
goods and services from the market and the sellers supply the goods in
the market. This chapter describes demand which is the driving force
behind a market economy. In Economics, use of the word ‘demand’ is
made to show the relationship between the prices of a commodity and the
amounts of the commodity which consumers want to purchase at those
prices. Demand is one of the forces determining price. The theory of
demand is related to the economic activities of a consumer, called
consumption.
61
The process through which a consumer obtains the goods and services he
wants to consume is known as demand. Demand is one of the most
important managerial factors because it assists the managers in predicting
changes in production and input prices. The manager can take better
decisions regarding the kind of product to be produced, the quantity, the
cost of the product and its selling price. Let us understand the concept of
demand and its importance in decision making.

5.2 OBJECTIVES

The objectives of this chapter is:

 To understand the general theory of demand.

  To know about the various types of demand.

 To know about the factors affecting demand of a product.

5.3 DEFINITION OF DEMAND
An economic principle that describes a consumer’s desire and
willingness to pay a price for a specific good or service. Holding all other
factors constant, the price of a good or service increases as its demand
increases and vice versa. Demand means the ability and willingness to buy
a specific quantity of a commodity at the prevailing price in a given period
of time. Therefore, demand for a commodity implies the desire to acquire
it, willingness and the ability to pay for it.

According to Prof. Hibdon, “Demand means the various quantities

of goods that would be purchased per time period at different prices in a
given market.” Thus, three things are necessary for demand to exist; (1)
the price of a commodity (2) the amount of the commodity the consumer or
consumers are prepared to buy per unit of time; (3) a given time. Similarly,
Benham wrote down, “The demand for anything at a given price is the
amount of it which will be bought per unit of time at that price.”
5.3.1 Types of Demand

There are eight demand states and their details given below:

1. Negative Demand: Product is disliked in general. The product might

be beneficial but the customer does not want it.

62
For example: for dental care, and others have a negative demand
for air travel. 2. No demand: Target consumers may be unaware and
uninterested about the product. For examples: Farmers may be not
interested in new farming method. College students may not be
interested in foreign language course.
3. Latent demand: Consumers may share a strong need that cannot be
satisfied by any existing product. For examples: Harmless cigarette,
safer neighborhood, more fuel efficient car.
 4. Declining demand: When the demand of the product or service
becomes lower. For examples private colleges have seen
application falls.
5. Irregular demand: Demand varies on a seasonal, daily and hourly
basis. For examples: Museums are under visited in week days and
overcrowded on week days.
6. Full demand: When the organisation is pleased with their volume of
business. For example, Ideal Situation where supply is equal to
demand.
7. Overfull demand: Demand level is higher that the organisation can
and want to handle. For example, national park is terribly overcrowded
in the summer. 8. Unwholesome demand: Those kinds of demands, not
acceptable by the society. For example Cigarettes, hard drinks, alcohol.
5.4 FEATURES OF DEMAND
a) Difference between desire and demand. Demand is the amount of a
commodity for which a consumer has the willingness and the ability
to buy. There is difference between need and demand. Demand is
not only the need, it also implies that the consumer has the money
to purchase it.
b) Relationship between demand and price. Demand is always at a
price. Unless price is stated, the amount demanded has no
meaning. The consumer must know both the price and the
commodity and he will tell his amount demanded.
c) Demand at a point of time. The amount demanded must refer to
some period of time such as 10 quintals of wheat per year or six
shirts per year or five kilos of
63
sugar per month. Not only this, the amount demanded and the price
must refer to a particular date.
5.5 DETERMINANTS OF DEMAND
The demand for a product is determined by a large number of
factors. It would be impossible to include all possible determinants of
demand in any study. Therefore, a few factors which underlie the demand
for most of the products can be easily spotted. These factors are price of
the commodity, incomes of the buyers’ of the commodity, prices of related
goods, advertising and sales promotion. These factors are found to have a
substantial influence on the sales of a commodity. These are expressed
and measured in various ways. In demand studies, these constitute the
controlling variables. The importance of each determinant varies from
product to product. As such the demand for a particular product has to be
analysed only after the importance of each determinant is specified. Some
of these factors are within a firm’s control, others may not be so. For
example, a firm can change the price of the commodity, its promotional
expenditure, quality of the product and sales conditions. Let us discuss all
these determinants in brief:
i. Price of the Commodity-The most important factor affecting amount
demanded is the price of the commodity. The amount of a
commodity demanded at a particular price is more properly called
price demand. The relation between price and demand is called the
Law of Demand. It is not only the existing price but also the
expected changes in price which affect demand.
ii. Income of the Consumer-The second most important factor
influencing demand is consumer income. In fact, we can establish a
relation between the consumer income and the demand at different
levels of income, price and other things remaining the same. The
demand for a normal commodity goes up when income rises and
falls down when income falls. But in case of Giffen goods the
relationship is the opposite.
iii. Prices of related goods. The demand for a commodity is also
affected by the changes in prices of the related goods also. Related
goods can be of two types: (1) Substitutes which can replace each
other in use; for example, tea and coffee are substitutes. The change in
price of a substitute has effect on a commodity’s demand in the same
direction in which price changes. The rise in price of coffee64
shall raise the demand for tea; (2) Complementary goods are those
 which are jointly demanded, such as pen and ink. In such cases
complementary goods have opposite relationship between price of
one commodity and the amount demanded for the other. If the price
of pens goes up, their demand is less as a result of which the
demand for ink is also less. The price and the demand go in
opposite direction. The effect of changes in price of a commodity on
amounts demanded of related commodities is called Cross
Demand.
iv. Tastes of the Consumers- The amount demanded also depends on
consumer’s taste. Tastes include fashion, habit, customs, etc. A
consumer’” taste is also affected by advertisement. If the taste for a
commodity goes up” its amount demanded is more even at the
same price. This is called increase in demand. The opposite is
called decrease in demand.
v. Wealth-The amount demanded of a commodity is also affected by
the amount of wealth as well as its distribution. The wealthier are
the people higher is the demand for normal commodities. If wealth
is more equally distributed, the demand for necessaries and
comforts is more. On the other hand, if some people are rich, while
the majorities are poor, the demand for luxuries is generally higher.
vi. Population-Increase in population increases demand for
necessaries of life. The composition of population also affects
demand. Composition of population means the proportion of young
and old and children as well as the ratio of men to women. A
change in composition of population has an effect on the nature of
demand for different commodities.
vii. Government Policy- Government policy affects the demands for
commodities through taxation. Taxing a commodity increases its
price and the demand goes down. Similarly, financial help from the
government increases the demand for a commodity while lowering
its price.

5.6 EXCEPTIONAL DEMAND CURVE

 The demand curve slopes from left to right upward if despite the
increase in price of the commodity, people tend to buy more due to
reasons like fear of shortages or it may be an absolutely essential good.
The law of demand does not apply in every case and

65
situation. The circumstances when the law of demand becomes ineffective
are known as exceptions of the law. Some of these important exceptions
are as under. 1. Giffen Goods:

Some special varieties of inferior goods are termed as Giffen

goods. Cheaper varieties millets like bajra, cheaper vegetables like potato
etc come under this category. Sir Robert Giffen of Ireland first observed
that people used to spend more of their income on inferior goods like
potato and less of their income on meat. After purchasing potato the staple
food, they did not have staple food potato surplus to buy meat. So the rise
in price of potato compelled people to buy more potato and thus raised the
demand for potato. This is against the law of demand. This is also known
as Giffen paradox.
2. Conspicuous Consumption / Veblen Effect:
This exception to the law of demand is associated with the doctrine
propounded by Thorsten Veblen. A few goods like diamonds etc are
purchased by the rich and wealthy sections of society. The prices of these
goods are so high that they are beyond the reach of the common man. The
higher the price of the diamond, the higher its prestige value. So when
price of these goods falls, the consumers think that the prestige value of
these goods comes down. So quantity demanded of these goods falls with
fall in their price. So the law of demand does not hold good here.
3. Conspicuous Necessities:
Certain things become the necessities of modern life. So we have
to purchase them despite their high price. The demand for T.V. sets,
automobiles and refrigerators etc. has not gone down in spite of the
increase in their price. These things have become the symbol of status. So
they are purchased despite their rising price.
4. Ignorance:
A consumer’s ignorance is another factor that at times induces him
to purchase more of the commodity at a higher price. This is especially
true, when the consumer believes that a high­priced and branded
commodity is better in quality than a low­priced one. 5. Emergencies:

During emergencies like war, famine etc, households behave in an

abnormal way.66
Households accentuate scarcities and induce further price rise by making
increased purchases even at higher prices because of the apprehension
that they may not be available. . On the other hand during depression, , fall
in prices is not a sufficient condition for consumers to demand more if they
are needed.
6. Future Changes in Prices:

Households also act as speculators. When the prices are rising

households tend to purchase large quantities of the commodity out of the
apprehension that prices may still go up. When prices are expected to fall
further, they wait to buy goods in future at still lower prices. So quantity
demanded falls when prices are falling.
7. Change In Fashion:

A change in fashion and tastes affects the market for a commodity.

When a digital camera replaces a normal manual camera, no amount of
reduction in the price of the latter is sufficient to clear the stocks. Digital
cameras on the other hand, will have more customers even though its
price may be going up. The law of demand becomes ineffective.
8. Demonstration Effect:
It refers to a tendency of low income groups to imitate the
consumption pattern of high income groups. They will buy a commodity to
imitate the consumption of their neighbours even if they do not have the
purchasing power.
 9. Snob Effect:

Some buyers have a desire to own unusual or unique products to

show that they are different from others. In this situation even when the
price rises the demand for the commodity will be more.
10. Speculative Goods/ Outdated Goods/ Seasonal Goods:

Speculative goods such as shares do not follow the law of demand.

Whenever the prices rise, the traders expect the prices to rise further so
they buy more. Goods that go out of use due to advancement in the
underlying technology are called outdated goods. The demand for such
goods does not rise even with fall in prices

67
11. Seasonal Goods:
Goods which are not used during the off­season (seasonal goods)
will also be subject to similar demand behaviour.
12. Goods in Short Supply:

Goods that are available in limited quantity or whose future

availability is uncertain also violate the law of demand.
5.7 ELASTICITY OF DEMAND

In economics, the term elasticity means a proportionate

(percentage) change in one variable relative to a proportionate
(percentage) change in another variable. The quantity demanded of a
good is affected by changes in the price of the good, changes in price of
other goods, changes in income and changes in other factors. Elasticity is
a measure of just how much of the quantity demanded will be affected due
to a change in price or income. Elasticity of Demand is a technical term
used by economists to describe the degree of responsiveness of the
demand for a commodity due to a fall in its price. A fall in price leads to an
increase in quantity demanded and vice versa.
5.7 SUMMARY

Demand is one of the forces determining price. The theory of

demand is related to the economic activities of a consumer, called
consumption. The process through which a consumer obtains the goods
and services he wants to consume is known as demand. In Economics,
use of the word ‘demand’ is made to show the relationship between the
prices of a commodity and the amounts of the commodity which
consumers want to purchase at those prices.

The demand for a product is determined by a large number of

factors, viz., price, income, prices of related goods, tastes, preferences,
population etc. There is an inverse relationship between the price of a
commodity and the amount demanded.

In Economics, this relationship is known as the Law of Demand.

The demand curve is negatively sloped just because of law of diminishing
marginal utility, substitution effect, different uses of the commodity, and
because of income effect.

As we know that the demand curve is negatively sloped form left to

right, but in68
some cases it is positively sloped like in case of inferior or giffen goods,
expecting rise or fall in the prices of goods in future, due to ignorance of
consumers etc.

Law of demand is important to determine price of a product, budget

fixing by finance minister, How far a good shall or bad crop affect the
economic condition of the farmer can be known from the Law of Demand
and also in planning for individual commodities and industries.
5.8 SELF ASSESSMENT QUESTIONS
1. Explain the general theory of Demand?

______________________________________________________
_____
 ___________________________________________________________
___________________________________________________________
2. What are various factors an individual should consider while making a
demand of
a product?

_____________________________________________________
______
__________________________________________________________
_
__________________________________________________________
_ 3. Explain features/characteristics of demand?

_____________________________________________________
______
__________________________________________________________
_
__________________________________________________________
_ 5.9 SUGGESTED READINGS

 Business Economics, Chopra P.N., Kalyani Publishers, New

Delhi.  Managerial Economics, Mehta, P.L., S. Chand, Delhi.

 Micro Economics, Mithani, D.M., Himalaya Publishing House, New

Delhi.69

UNIT-II

LESSON 6 MARKET DEMAND ANALYSIS STRUCTURE

6.1 INTRODUCTION
6.2 OBJECTIVE
6.3 MEANING OF MARKET DEMAND

6.3.1 Definition

6.3.2 Market demand Curve

6.3.3 Difference between Demand and Desire

6.4 DETERMINANTS OF MARKET DEMAND
6.5 FACTORS AFFECTING MARKET DEMAND
6.6 DIFFERENCE BETWEEN INDIVIDUAL DEMAND AND MARKET
DEMAND
6.7 SUMMARY
6.8 SELF ASSESSMENT QUESTIONS
6.9 SUGGESTED READING
6.1 INTRODUCTION
Demand for a good is defined as the quantity of the good
purchased at a given price at given time.

Thus the definition of demand includes three components

(a) Price of the commodity

(b) Quantity of the commodity bought

70
(c) Time period.

Note that time period may vary. This can be week, month,
year etc. 6.2 OBJECTIVES

The objectives of this lesson are:

 To explain the concept of market demand

 To explain the factors and determinants affecting

 market demand 6.3 MEANING OF MARKET DEMAND

The aggregate of the demands of all potential customers (market

participants) for a specific product over a specific period in a specific
market is called as market demand of a particular good.
6.3.1 Definition

The total demand for a product or service in the market as a whole.

Market demand is calculated to determine at what level to set production
output for a good or service, and to help to determine optimal pricing levels
to maximise sales revenues. 6.3.2 Market Demand Curve

A graph that shows the amount of a good or service that consumers

purchase on the X axis at a range of pricing levels that are plotted on the Y
axis. The market demand curve for a good or service provided by a
business can be combined with its market supply curve to determine the
product’s equilibrium price that is located where the two curves cross.
6.3.3 Difference between Demand and Desire
On many occasions people confuse between desire and demand
and use them interchangeably.In fact these are two different terms.
Demand is desire backed by ability to purchase. This means that if
somebody desires to have a good, he/she can demand it if he/she has the
money to purchase it by paying its price. Anyone can desire any good or
service. But just by desiring something, one cannot have it without paying
the price. Once the price is paid by the person who has desired it, only
then it becomes the demand for the

71
good by that person. Take the example given above once again­“Varsha
purchased 2 kg of mangoes at Rs. 50 per kg last week.” Thisis the demand
for mangoes by Varsha. Had Varsha desired to have mangoes but could
not pay the price to buy, then it would have been said as Varsha’s desire
but not demand for mangoes.
6.4 DETERMINANTS OF MARKET DEMAND
 Demand schedule and law of demand state the relationship
between price and quantity demanded by assuming “other things
remaining the same “. When there is a change in these other things, the
whole demand sched­ule or demand curve undergoes a change. In other
words, these other things determine the position and level of the demand
curve. If these other things or the determinants of demand change, the
whole demand schedule or the demand curve will change. As a result of
the changes in these determinants, a demand curve will shift above or
below as the case may be.

The following are the determinants of market demand for goods:

1. Tastes and Preferences of the Consumers:

An important factor which determines demand for a good is the

tastes and preferences of the consumers for it. A good for which
consumers’ tastes and preferences are greater, its demand would be large
and its demand curve will lie at a higher level.

People’s tastes and preferences for various goods often change

and as a result there is change in demand for them. The changes in
demand for various goods occur due to the changes in fashion and also
due to the pressure of advertisements by the manufacturers and sellers of
different prod­ucts.

For example, a few years back when Coca Cola plant was
established in New Delhi demand for it was very small. But now people’s
taste for Coca Cola has undergone a change and become favour­able to it
because of large advertisement and publicity done for it. The result of this
is that the demand for Coca­Cola has increased very much. In economics
we would say that the demand curve For Coca Cola has shifted upward.
On the contrary when any good goes out of fashion or people’s tastes and
preferences no longer remain favourable to it the demand for it decreases.
In economics we say that the demand curve for these goods will shift
downward.
 72
2. Changes in the Prices of the Related Goods:
The demand for a good is also affected by the prices of other
goods, especially those which are related to it as substitutes or
complements. When we draw a demand schedule or a demand curve for a
good we take the prices of the related goods as remaining constant.
Therefore, when the prices of the related goods, substitutes or
complements, change the whole demand curve would change its position;
it will shift upward or downward as the case may be. When price of a
substitute for a good falls, the demand for that good will decline and when
the price of the substitute rises, the demand for that good will increase.

For example, when price of the tea as well as the incomes of the
people remains the same but price of the coffee falls, the consumers would
demand less of tea than before. Tea and coffee are very close substitutes,
therefore when coffee becomes cheaper, the consumers substitute coffee
for tea and as a result the demand for tea declines. The goods which are
complementary with each other, the change in the price of any of them
would affect the demand of the other. For instance, if price of the milk falls,
the demand for sugar would also be affected. When people would take
more milk or would prepare more khoya, burfi, rasgullas with milk; the
demand for sugar will also increase. Likewise, when price of cars falls, the
demand for them will increase which in turn will increase the demand for
petrol Cars and petrol are complementary with each other.
3. The Number of Consumers in the Market:

We have already explained that the market demand for a good is

obtained by adding up the individual demands of the present as well as
pro­spective consumers or buyers of a good at various possible prices. The
greater the number of consumers of a good, the greater the market
demand for it. Now, the question arises on what factors the number of
consumers of a good depends. If the consumers substitute one good for
another, then the number of consumers of that good which has been
 substituted by the other will decline and for the good which has been used
in its place, the number of consumers will increase.

Besides, when the seller of a good succeeds in finding out new markets
for his good and as a result the market for his good expands the number of
consumers of that good will increase. Another Important cause for the
increase in the number of consumers is the growth in population. For
instance, in India the demand for many essential goods,73
especially food­grains, has increased because of the increase in the
popu­lation of the country and the resultant increase in the number of
consumers for them. 4. Changes in Propensity to Consume:

People’s propensity to consume also affects the de­mand for them.

The income of the people remaining constant, if their propensity to
consume rises, then out of the given income they would spend a greater
part of it with the result that the demand for goods will increase.

On the other hand, if propensity to save of the people increases,

that is, if propensity to consume declines, then the consumers would
spend a smaller part of their income on goods with the result that the
demand for goods will decrease. It is thus clear that with income remaining
constant, change in propensity to consume of the people will bring about a
change in the demand for goods. Similarly, when the consumers hope that
in the future they will have good income, then in the present they will
spend greater part of their incomes with the result that their present
demand for goods will increase.
5. Income Distribution:
Distribution of income in a society also affects the demand for
goods. If distribution of income is more equal, then the propensity to
consume of the society as a whole will be relatively high which means
greater demand for goods. On the other hand, if distribution of income is
more unequal, then propensity to consume of the society will be relatively
less, for the propensity to consume of the rich people is less than that of
the poor people.
 Consequently with more unequal distribution of income, the
demand for consumer goods will be comparatively less. This is the effect
of the income distribution on the propensity to consume and demand for
goods. But the change in the distribution of income in the society would
affect the demand for various goods differently. If progressive taxes are
levied on the rich people and the money so collected is spent on providing
employment to the poor people, the distribution of income would become
more equal and with this there would be a transfer of purchasing power
from the rich to the poor.

As a result of this, the demand for those goods will increase which are
generally purchased by the poor because the purchasing power of the
poor people has increased and, on the other hand, the demand for those
goods will decline which are usually consumed74
by the rich on whom progressive taxes have been levied.
6. Advertisement Expenditure:

Advertisement expenditure made by a firm to promote the sales of

its product is an important factor determining demand for a product,
especially of the product of the firm which gives advertisements. The
purpose of advertisement is to influence the consumers in favour of a
product. Advertisements are given in various media such as newspapers,
radio, and television. Advertisements for goods are repeated several times
so that consumers are convinced about their superior quality. When
advertisements prove successful they cause an increase in the demand for
the product.
6.5 FACTORS AFFECTING MARKET DEMAND

When examining demand factors, especially for businesses, it is

important to realize that there is a relationship between Individual and
Market Demand. These two, though slightly different, share the same
causes and are impacted by macro and micro economic variables in the
same way, but not the same magnitude.
 The demand changes as a result of changes in price, other factors
determining it being held constant. These other factors determine the
position or level of demand curve of a commodity. It may be noted that
when there is a change in these non­price factors, the whole curve shifts
rightward or leftward as the case may be. The following factors determine
market demand for a commodity.
6.5.1 PRICE OF GOOD

Individual and market demand are affected by the price of the good
or service being offered. The law of demand shows that there is an inverse
relationship between price and demand. An increase in one will cause a
decrease in the other. This holds true at both the individual and market
level.
6.5.2 PRICE OF COMPLIMENTARY GOODS

A complimentary good is one that is used with another good. For

example, when you buy a cooker, you have to buy cooking gas or
electricity. Another example would be a car and gas. By buying one good,
you have to buy the other in order to use it. When the price a
complimentary good increases all other factors remaining constant and the
demand
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for the others good decreases with it. With an increase in the price of cars,
less people will buy gas.
6.5.3 PRICE OF SUBSTITUTE GOODS
Substitute goods are goods that compete for consumption. When
you take one, you substitute it for the other. You consume either one or the
other. This is as long as the substitute is seen as matching or being better
in terms of quality. For both individual and market demand, when the price
of substitute goods change, there is an effect on the demand.
6.5.4 INCOME
Income is a major factor influencing individual and market demand.
When there is an increase in income, demand for goods increase. This is
because there is more money to be spent on the good. A good or service
that experiences this is called a “normal” good. However, some goods
experience a decrease in demand with an increase in income. These are
classified as “inferior goods”. People purchase these goods because they
are cheap and that is what they can afford. However, as their income
increase, they go for better quality goods and services. For example, some
people view public transport as an inferior good.
6.5.5 FUTURE EXPECTATIONS
People aim to place themselves at an advantage when they have
information about the future. If they expect, for example, to have a
shortage of a vital good, they will increase their demand drastically today
to beat the shortage. Every year you know winter is coming, so you buy
winter clothing before it happens.
6.5.6 TASTES AND PREFERENCE

Beyond the rational reasons, people purchase simply because they

like it. Sometimes they are influenced by fashion trends. Other times it is
because a celebrity endorsed a product, or they simply have a taste for it.
Out of all the factors influencing individual and market demand, this is
probably the hardest to predict. This is because it is influenced by
psychological factors, which are difficult to categorise and tabulate.

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6.6 DIFFERENCE BETWEEN INDIVIDUAL DEMAND AND MARKET
DEMAND
The quantity of a commodity an individual is willing and able to
purchase at a particular price, during a specific time period, given his/her
money income, his/her taste, and prices of other commodities, such as
substitutes and complements, is referred to as the individual demand for
the commodity whereas,

The total quantity which all the consumers of the commodity are
 willing and able to purchase at a given price per time unit, given their
money incomes, their tastes, and prices of other commodities, is referred
to as the market demand for the commodity. 6.7 SUMMARY

The analysis of total demand for a firm’s product plays a crucial role
in business decision making. The market demand or the size of the market
at a point in time at different prices gives the overall scope of business; it
gives prospects for expanding business; and it plays a crucial role in
planning for future production, inventories of raw materials,
advertisements, and setting up sales outlets. Therefore, the information
regarding the magnitude of the current and future demand for the product
is indispensable. Theory of demand provides an insight into these
problems. Form the analysis of market demand, business executives can
know:

 The factors that determine the size of the demand

 Elasticities of demand, i.e., how responsive or sensitive is the

demand to the changes in its determinants,

 Possibility of sales promotion through manipulation of prices,

 Responsiveness of demand to advertisement

expenditures, and  Optimum levels of sales, inventories

and advertisement cost, etc.

The law of demand plays a crucial role in decision­making and

forward planning of a business unit. The production planning in a firm
mainly rests on accurate demand analysis. The law of demand has
theoretical as well as practical advantages. These are as ; Price
determination: With the help of law of demand a monopolist fixes the price
of his

77
product. He is able to decide the most profitable quantity of output for him.
Useful to government: The finance minister takes the help of this law to
know the effects of his tax reforms and policies. Only those commodities
which have relatively inelastic demand should be taxed. Useful to farmers:
From the law of demand, the farmer knows how far a good or bad crop will
affect the economic condition of the fanner. If there is a good crop and
demand for it remains the same, price will definitely go down. The farmer
will not have much benefit from a good crop, but the rest of the society will
be benefited. In the field of planning: The demand schedule has great
importance in planning for individual commodities and industries. In such
cases it is necessary to know whether a given change in the price of the
commodity will have the desired effect on the demand for commodity
within the country or abroad. This is known from a study of the nature of
demand schedule for the commodity. 6.8 SELF ASSESSMENT
QUESTIONS
1. Explain the factors influencing market demand?
______________________________________________________
_____
___________________________________________________________
___________________________________________________________
2. How individual demand schedule and market demand schedule is
different form
market demand schedule?

_____________________________________________________
______
__________________________________________________________
_
__________________________________________________________
_ 3. Briefly illustrates the various types of market demand?

_____________________________________________________
 ______

__________________________________________________________

__________________________________________________________

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6.9 SUGGESTED READINGS

 Advanced Economic Theory. Micro Economic Analysis, Ahuja, H.L., 2012, S. Chand
and Company Ltd, New Delhi.

 Principles of Economics, Mishra and Puri, 2007, Himalaya Publishing House, New
Delhi.
 Economic Theory, Chopra, P.N., 2005, Kalyani Publishers New Delhi.79

UNIT II

LESSON 7 MARKET DEMAND SCHEDULE STRUCTURE

7.1 INTRODUCTION
7.2 OBJECTIVE
7.3 DEMAND SCHEDULE
 7.3.1 Types of Demand Schedule
7.4 TYPES OF MARKET DEMAND
7.5 MARKET DEMAND CURVE
7.6 SUMMARY
7.7 SELF ASSESSMENT QUESTIONS
7.8 SUGGESTED READINGS
7.1 INTRODUCTION

The individual demand curve­sometimes also called the household

demand curve that is based on an individual’s choice among different
goods. In this lesson we show how to build the market demand curve from
these individual demand curves. When demand changes due to the factors
other than price, there is a shift in the whole demand curve. Apart from
price, demand for a commodity is determined by incomes of the
consumers, his tastes and preferences, prices of related goods. Thus,
when there is any change in these factors, it will cause a shift in demand
curve.For example, if incomes of the consumers increase, say due to the
hike in their wages and salaries or due to the grant of dearness allowance,
they will demand more of a good, say cloth, at each price. This will cause a
shift in the demand curve to the right. Similarly, if preferences of the people
for a commodity, say colour TV, become greater, their demand for colour
TV will increase, that is, the

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