Managerial Economics

Meaning
Managerial economics is defined as the study of economic theories, logic and tools of economic analysis that are used in process of business decision-making. In other words economic theories and techniques of economic analysis are applied to analyze business problems, evaluate business opportunities with a view to arrive at appropriate business decision. .

Managerial Decision Areas Assessment of Investible funds Selecting Business areas Choice of Product Determining optimum Output Determining input-Combination of the product Sales promotion

Application of Economic Concepts and Theories in Decision Making

Use of Quantitative Methods Mathematical tools Statistical Tools Econometrics

Application of Economic Concepts, Theories and analytical Tools to find Optimum Solution to Business Problems

Why Economics?
Biology contributes to medical profession. Physics to Engineering. Economics to Managerial profession. Achieve objective of the firm Constraints is limited resources

Application of Economics to Decision Making

I. Determining and defining the objective to be achieved. II. Collection and analysis of business related data and other information(Economic, social, Political and technological environment.). III. Inventing the possible courses of action IV. Select the possible action from the given alternatives. II and III are crucial in decision making

Example Launching a product

Production Related issues and Sales related issues.

Production Related issues

Available techniques of Production. Cost of Production Supply position of inputs Price structure of inputs Cost structure of competitive products Availability of foreign exchange if inputs are available.

Sales related issues

Market size, general market trends and demand prospectus for the product Trends in Industry Competitors Pricing of product Pricing strategy of competitors Degree of competition Supply position of complementary goods

Scope of Managerial Economics

Economics applied to the analysis of business problems and decision making. Area of business issues to which economic theories can be directly applied are broadly divided into 1. Micro Economics (Operational and internal issues) 2. Macro Economics (Environmental and external issues)

Operational or Internal issues

What to produce Nature of product or Business How much to produce Size of firm How to produce Choice of technology How to price the commodity How to promote sales How to face price competition How to manage profit and capital How to manage an inventory

Environmental or External issues

The type of economic system in the country Trends in GDP, Prices, Saving and Investment Employment, etc. Trends in Financial System Banks, Financial and Insurance companies Trends in Foreign Trade Government Economic policies Social Factors like value system, property rights, customs and habits. Socio-economic organization like trade unions, consumers associations, Consumer co-operatives and producers unions. Political environment Degree of Globalization and Influence of MNCs

Micro Economic Issues

What to produce How much to produce How to produce How to price the commodity How to promote sales How to face competition How to decide on new investment How to manage profit and capital How to manage an inventory

Examples of Economic Theories

Theory of Demand It deals with the consumer behaviour How do the consumer decides to buy the commodity How do they decide on Quantity When do they stop consuming How consumer behave on Price It helps in making choice in commodity, optimum level of production and price

Theory of Production and Decision Making

It explains the relationship between inputs and output. Under what conditions the cost increases or decreases Helps to decide the optimum size of the firm Size of total output and amt of capital and labour to be employed given the objective

Market structure and Pricing theory

How price is determined. When price discrimination is desirable, feasible and profitable. How advertising will be helpful to increase sales. Thus pricing and production decision will help to determine the optimum size of the firm.

Profit analysis and Management

Elements of risk is always there even if most efficient techniques are used. It guide the firm to measure and manage profit, to make the allowance of risk premium, to calculate the pure return on capital and also future profit.

Theory of Capital and investment decision

It contribute to deciding choice of project, maintaining capital, capital budgeting, etc

Macro economic Issues

Trends in Economics: Level of GDP Investment climate Trends in National Output and employment Price trends

 Issues related to Foreign Trade Trends in International Trade Trends in International Prices Exchange rates Prospectus in International Market

 Issues related to Government Policies: Monetary Policy Fiscal Policy Foreign Trade Policy Environmental Policy etc

Other Topics related to Managerial Economics

Mathematical Tools

Economic theories for Decision Making

Economic concepts (Cost, Price, Demand etc.) Ascertaining the variables which is relevant. Relationship between the two or more variables.

What is Demand ?
When the desire for a commodity is backed by the willingness and the ability to spent adequate sums of money, it becomes demand or effective demand in the economic sense of the curve. Only desire for commodity or having money for the same cannot give rise to its demand Marshall Demand for a product refers the amount of it which will be bought per unit of time at a particular price.

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RELATIVE CONCEPT
Demand is the relative concept i.e. it is related to price and time: 1. The demand for rice is 100Kg 2. The demand for rice at Rs 5/- per Kg is 100Kg per day. Second statement is complete because it mentions the price and time period, becoz demand varies from time and price. The demand refers to the quantity of it purchased at a given price, during a specific time period.

Determinants of Demand
1. 2. 3. 4. Price of the product. Income and wealth distribution. Tastes, habits and preferences. Relative prices of other goods Substitute products. Complementary products. 5. Consumers satisfaction. 6. Quantity of money in circulation. 7. Utility of the commodity. 8. Quality. 9. Expectation regarding future price. 10. Number consumers, time and place: Transport, communication and market facilities will increase the consumers

11. Advertisements effects. 12. Growth of population. 13. Level of taxation. 14. Climatic or weather conditions. 15. Special occasions. 16. Technology. 17. Psychology of the consumers: Bandwagon effect: Demand arises becoz others have it others, Snob effect: Demand arises becoz when it is not commonly demanded, Demonstration effect: Copying the others.

INDIVIDUAL DEMAND
It is the tabular representation of the various quantities of a commodity demanded by an Individual at a different prices during a given period of time
Price per unit 50 40 30 20 10 05 Demand for commodity X 10 20 30 40 50 60

Individual Demand

MARKET DEMAND
Price per Unit Qty Demanded

A 50 40 30 20 10 10 20 30 40 50

B 12 22 32 42 52

C 15 25 35 45 55

Total market Demand(A + B + C) 37 67 97 127 157

Demand and Demand Curves (d)

The market demand curve is the horizontal sum of the demand curves of all individuals. Market dd curve is also negatively sloped because 1. Individual dd curves are downward sloping 2. At high prices some buyers will exit the market

MARKET DEMAND

Generalized demand function

The generalized demand function just set forth is expressed in the most mathematical form. Economist and market researchers often expressed generalized demand function in a linear functional form. The following equation is an example of a linear form of the generalized demand function: Qd = a + bP + cM + dPR + eT + fPe + gN Where the Variables are (P,M,PR,T,Pe,N). And a,b,c,d,e,f and g are parameters.

Generalized demand function

The intercept a shows the value of Qd when the variables P,M,PR,T,Pe,N are all simultaneously equal to zero. The other parameter a,b,c,d,e,f and g are called slope parameters. They measure the effect on quantity demanded of changing one of the variables while holding rest of it as constant. E.g. b measures the change in Qty dd per unit change in price i.e b = Qd/ P.

Summary of Generalized demand function

Variable P M PR Relation to quantity demanded INVERSE Direct for normal goods Inverse for inferior goods Direct for substitute goods Inverse for the complementary goods Direct Direct Direct Sign of Slope parameter Negative Positive Negative Positive Negative Positive Positive Positive

T Pe N

Demand functions
The relation between price and quantity demanded per period of time, when all other factors that affect demand held constant is called as demand function or simply demand. It can be expressed as Qd = f (P)

illustration
Generalized demand function is Qd = 1800 20P + 0.6M 50PR To derive a demand functions Qd = (P) The variables M and PR must be assigned fixed value. Suppose M = 20000, PR = 250 Substitute the value in generalized demand function.

 Qd = 1800 20P- 0.6(20000) 50(250) = 1800 20P + 12000 12500 = 1300 20P The intercept parameter 1300 is the amount of the good consumers would demand if price is zero. The slope of the demand function is -20 and indicates that a Rs 1 increase in price causes qty dd to decrease by 20 units. Qd = 1300 20 (1) = 1300 -20 = 1280

Demand Schedule
70 60 50 Price 40 30 20 10 0 0 200 400 600 Demand 800 1000 1200

Demand function Qd = 1300 20P

The Law of Demand

Other factors remaining same (habits, tastes etc.) as price decreases demand increases and vice versa Marshall Ceteris paribus, higher the price of a commodity, smaller is the quantity demanded and lower the price, larger the quantity demanded.

Demand Schedule (Hypothetical)

Price of commodity (in Rs) 5 4 3 2 1 Quantity demanded (unit per week) 100 200 300 400 500

Demand Curve
D P1 E1

P1 - old price P2 - new price

E2 D

Price(P)

P2

Q1 old quantity demanded Q2 new quantity demanded DD demand curve

Q1

Q2

Quantity demanded (Q)

A Linear Demand Curve

Characteristics of A Typical Demand Curve

Drawn by joining different loci. Downward sloping. Reciprocal relationship between price and quantity demanded ( P 1/Qd ) Linear Non - linear

Assumptions (Other things)

a) b) c) d) No change in consumers income. No change in consumers preferences. No change in the fashion. No change in the price of related goods : Substitute goods. Complementary goods. e) No expectation of future price changes or shortages. f) No change in size, age, composition and sex ratio of the population. g) No change in the range of goods available to the consumers.

Contd
h) No change in the distribution of income and wealth. i) No change in the government policy. j) No change in weather conditions.

EXCEPTION TO LAW OF DEMAND

Giffens Paradox: Giffen gods are inferior goods. When the price rises the real income of the consumer rises and he will move to a superior goods. This is also called as Giffens paradox. Qualitative changes: It may increase qty with the increase in the price. Price illusion: Higher the price better is the quality. Prestige goods: Purchased by the rich people.

 Demonstration effect: Imitating others or Snob appeal Fashion: Necessaries:

Movement along the curve OR Change in quantity demanded Extension of demand

With a decrease in price, there is increase in the quantity demand of the product.
D P1 E E` D Q1 Q2

Price
P2

Quantity demanded

Contraction of demand
With a increase in price, there is a decrease in quantity demanded.

E` P2

Price

P1

Q2

Q1

Quantity demanded

SOURCES OF SHIFTS IN THE DEMAND CURVES

Tastes Prices of related goods Income Demographics Information Availability of credit Changes in expectations

Movement of Demand Curve OR Change in demand

Increase in demand: a) More quantity demanded ------ at a given price. b) Same quantity demanded ------ at a higher price.
D` D P1 a b D` D Q1 Q2 Q1 P2 D D` b

Price
P1 a D D`

Pric e

Quantity demanded

Quantity demanded

Decrease in demand : a) Less quantity demanded ---- at same price. b) Same quantity demanded ---- lower price.
D D` P1 D` b D a D`
Q1

Price
P1

b D D`

Price
P2

Q2

Q1

Quantity demanded

Quantity demanded

Factors And Effects of Change (increase or decrease) in demand a) Change in income :

Increase
D` D` Price D Price D

Decrease

D D D` D` Quantity demanded

Quantity demanded

b) Change in taste, habit and preference :

D` D Price Price D` D D` D

Positive

D D`

Negative

Quantity demanded

Quantity demanded

c) Change in fashion and customs :

Favorable
D D` D` D

Unfavorable

Price

Price
D` D D` D

Quantity demanded

Quantity demanded

g) Change in population :
Increase
D D` D` D

Decrease

Price
D

Price
D` D` D

Quantity demanded

Quantity demanded

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h) Advertisement and publicity persuasion :

Aggressive
D` D D

Docile

Price

Price D`
D` D D` D

Quantity demanded

Quantity demanded

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i) Change in value of money :

Deflationary
D D`

Inflationary

Price

Price
D`

D`

D D D`

Quantity demanded ( Value of money)

Quantity demanded ( Value of money)

j) Change in level of taxation :

Low
D` D

High

Price D

Price
D` D

D` D D`

Quantity demanded

Quantity demanded

k) Expectation of future changes in prices :

D`

Rise

Fall

Price

Price

D` D

D` D

D`

Quantity demanded

Quantity demanded

Shift in Demand
Price Qd = 1300 20P (M = 20000) D0 0 100 300 500 700 900 1100 Qd = 1600 20P (M = 20500) D1 300 400 600 800 1000 1200 1400 Qd = 1000 20P (M = 19500) D2 0 0 0 200 400 600 800 65 60 50 40 30 20 10

Shift in Demand

Determinants of Demand
Determinants of Demand Income (M) Normal Goods Inferior goods Price of related goods (PR) Substitute goods Complement good Consumer Tastes (T) Expected price (Pe) Number of consumers (N) PR rises PR falls T rises Pe rises N rises PR falls PR rises T falls Pe Falls N Falls d>0 d<0 e>0 f>0 g>0 Demand Demand decreases Increases M rises M Falls M Falls M rises Sign of Slope parameter C>0 C<0

Supply
The amount of a good or service offered for sale in a market during a given period of time (e.g a week, a month) is called quantity supplied.

Concept of Supply
Supply is defined as the various amounts of goods and services which the sellers are willing and able to sell at any given price during a specific period of time It is related to time, place and person The supply of sugar is 50 kg is not a complete sentence The supply of a sugar at price Rs 5/- is 50kg. Per day is the complete sentence

Factors affecting Supply

Price Price of other commodities Goals of the producer State of technology Cost of production Climate and forces of Nature Transport facilities Taxation: Heavy taxes supply will reduce Expectation regarding future prices

 Self-consumption Time element: Short period the supply is fixed and vice

Individual Supply Schedule

Individual supply schedule is a tabular representation of the various quantities of commodity offered for sale by an individual seller at different prices during given period of time

Price Per Unit of X U V W X Y Z 5 10 15 20 25 30

Qty. supplied of X 10 20 30 40 50 60

Individual Supply Curve

Market supply schedule

It is the tabular representation of the various qty. of a commodity offered for sale by all the sellers at different prices during a given period of time. It is the total supply of a commodity by all the sellers at different prices

Market supply schedule

Price( Rs ) Seller I U V W X Y Z 5 10 15 20 25 30 10 20 30 40 50 60

Qty. supplied of X Seller II 20 25 30 35 40 45 Seller III 30 40 50 60 70 80

Market supply (I + II+ III) 60 85 110 135 160 185

Market supply Curve

Price( Rs )
35 30 25 20 15 10 5 0 0 50 100 150 200 U V W X Price( Rs ) Y Z

Law of Supply
Others things remaining the same , qty. supplied of a commodity directly varies with its price. i.e. S= f (p)
SUPPLY SCHEDULE Price Per Unit of X U V W X Y Z 5 10 15 20 25 30 Qty. supplied of X 10 20 30 40 50 60

Supply Curve

Assumption
Price of other commodities remains the same The cost of production remains the same The method of production remains the same No change in the availability of goods No change in transport facilities No change in weather condition No change in tax structure and govt. policies Goals of producer remains the same No change in expectation about the price No natural calamities and no self consumption

Exceptions to the law of supply

Backward bending supply curve
Wage rate ( Rs.) 5 7 10 12 Hours of work 8 10 12 10 Daily Income (Rs.) 40 70 120 120

 Fixed income groups: If person expects the income of Rs.20 he will save 500 Rs at 4% rate of interest and at 5% rate he will save Rs. 400 Rs. Expectation regarding future prices Need for cash by the seller Rare collection the supply is permanently fixed whatever the price. Self consumption

Movements or variation in Supply

When there is change in supply exclusively due to change in Price

Shift in supply
When there is a change in supply due to change in factors other than the Price

Generalized supply function

It shows how the different variables jointly determine the quantity supplied. The generalized supply function is expressed mathematically as Qs = g(P, Pi, Pr, T, Pe, F) Qs = Qty of goods and service offered for sale P = Price of goods or service. PI = Price of inputs Pr = Price of goods that are related to production. T = Level of available technology. Pr = Expected price of the producer F = No. of firms in the industry

Generalized supply function

As in case of demand, economists often find itself to express the generalised supply function in linear functional form: Qs = h + kP + lPi+ mPr + nT + rPe + sF Where P, Pi, Pr, T, Pe, F is a variables affecting the supply, h is the intercept parameter, and k, l, m, n, r, and s are the slope parameters.

Relation to Generalised demand function

Variable P Relation to Quantity supplied Direct Sign of slope parameter K= is Positive

Pi Pr

Inverse Inverse for substitute in production (Wheat and Corn) Direct for complement in production(Oil and Gas) Direct Inverse Direct

L= m=

is Negative is Negative

m=

is Positive

T Pe F

n= r= S=

is Positive is Negative is Positive

Supply function
Supply function is derived from generalised supply function. A supply function shows the relation between supply and price. Qs = g(P, Pi, Pr, T, Pe, F) = g (P) Illustration Qs = 50 + 10P 8pi + 5F Suppose the price of the input is Rs. 50 and there are 90 firms then the supply function will be Qs = 50 + 10P -8(50) + 5(90) = 100 + 10P The supply schedule with equation can be drawn and is given in next slide

Price 65 60 50 40 30 20 10 70 60 50 Price 40 30 20 10 0 0 200 400 Qty Supplied 200, 10 300, 20 400, 30

Quantity Supplied schedule 750 700 600 500 400 300 200 750, 65 700, 60 600, 50 500, 40 Price

Qs = 100 +10P

600

800

Shift in Supply
Price Qs = 100 + 10P Pi = 50, F = 90 750 700 600 500 400 300 200 Qs = 250 + 10P Pi = 31.25, F = 90 900 850 750 650 550 450 350 Qs = -200 + 10P Pi = 50, F = 30 450 400 300 200 100 0 0

65 60 50 40 30 20 10

Shift in Supply
Determinants of supply Price of inputs (Pi) Price of goods related in Production (Pr) Substitute good Complement good State of technology (T) Expected Price (Pe) Number of firms or productive capacity in Industry (F) Supply Increases Pi falls Supply Decreases Pi rises Sign of Slope parameter I<0

Pr falls Pr rises T rises Pe falls F rises

Pr rises Pr falls T falls Pe rises F falls

M<0 M>0 n>0 r<0 S>0

Market Equilibrium
Demand and supply provide an analytical framework for the analysis of the behaviour of buyers and sellers in markets. Demand shows how buyers respond to changes in price and other variables that determine quantities buyers are willing to purchase. Supply shows how sellers respond to changes in price and other variables that determine quantities offered for sale. The interaction of buyers and sellers in the market place leads to market equilibrium.

Market Equilibrium
Market equilibrium is a situation which at the prevailing price, consumers can buy all of a good they wish and producers can sell all of good they wish.

Market Equilibrium
Price Qs = 100 + 10P S0 Qd = 1300 20P D0 Excess supply ( +) Excess Demand ( -) +750 +600 +300 0 -300 -600 -900

65 60 50 40 30 20 10

750 700 600 500 400 300 200

0 100 300 500 700 900 1100

Qd = Qs 1300 20 P = 100 + 10P Solving this equation for the equilibrium price, 1200 = 30P P = 40

Market Equilibrium

Market Equilibrium
At Market clearing price of 40 Qd = 1300 (20 * 40) = 500 Qs = 100 + (10 * 40) = 500 If the price is Rs 50 there is a surplus of 300 units. Using the demand and supply. equations, when P = 50, Therefore, When price is Rs 50. Qd = 1300 (20 * 50) = 300 Qs = 100 + (10 * 50) = 600 There fore when the price is Rs 50 Qs Qd = 600 300 = 300

Changes in Market Equilibrium

Demand Shifts (Supply remains constant)

Supply Shifts (Demand Remains constant)

Simultaneous Shift in Demand and Supply

Simultaneous Shift in Demand and Supply

Predicting the Direction of change in Airfares

Suppose you manage a travel department for a U.S. corporation and your sales force makes heavy use of air travel to call on customers. The president of the corporation to reduce travel expenditures for 2004. You need to predict what will happen in future price of airfares in 2004. The wall street journal recently came with the news. A number of new, small airlines have recently entered the industry and others are expected to enter in 2004. Video-conferencing is becoming a popular, cost effective alternative to business travel for many U.S. corporation. The trend will cut the price on teleconferencing rates.

Direction of change in Airfares: Qualitative Analysis