EC ONO MI CS : Economics is one of the most widely studied and used social sciences.

The origin of the term “Economics” lies in the Greek works ‘Oikons’ and ‘Nomos,’ which
means ‘Laws of Households. Thus, the significance of economics to households.

The Importance of Economics in the words of Lord Keynes , “The ideas of economists and
political philosophers, both when they are right and when they are wrong, are more powerful
than is commonly understood.”

EC ONO MI CS : WH ET HE R N ATU RA L OR SO CI AL S CIE NC E.

CU RI OS ITY : Man’s efforts to know what he saw around him, when resulted in success,
knowledge came into existence. The horizons of such knowledge went on widening. The
expanse of knowledge needed specialization. This resulted in a branching of knowledge into
what we call SCIENCES.

SC IEN CE is usually defined as a systematized body of knowledge. A science is

characterized by an explanation in terms of cause and effect relationship. Science tries to
answer the question ‘Why’ e.g. The law of demand in economics seeks to find out why
demand expands when price falls. Every science is expected to be capable of prediction.
Just as a lunar eclipse can be predicted, the effects of particular tax can also be predicted.
This makes a science practically important.

DI ST IN CT ION B ETW EE N NATUR AL AND SO CI AL S CI ENC ES:

NATU RA L SCI EN CE SOCIAL SCIENCES:

i) Study physical environment of man. =S tu dy hu man be hav io ur ,

Study celestial bodies, the climatic inst it ut io ns , rel at io ns hi ps and
conditions, vegetation, animal world ac tiv it ie s.
etc.
ii) Ar e co ncer ne d wit h=Because man is the subject matter of
ina ni mat e mate ri al obj ec ts, social sciences and because he has a mind
th ei r ge ne ra liz at io ns ar eand brain, his responses to the same
un iv ersa l. situations can be different from person to
person, from time to time and from place to
place.
iii) Physical scientist can test their =S oc ia l Sci en ti sts hav e to rel y on
laws in laboratories. ex per ie nce or on o bs erva ti ons .

iv ) Pre dict io ns ar e ex act an d =The laws of social sciences indicate

acc ura te. tendencies.
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 v) Because of the exactness, the laws =L aws of Soc ia l Sc ie nc es cont ai n
are applicable without exceptions. exc ept io ns , i.e . wi th qua lif ica ti ons ,
ot he r t hi ng s r em ai nin g th e s am e.

EC ONO MI CS : A SOC IA L SCI ENC E : A social science, as we saw, concerns the

people living in a society. Social sciences study the social system in all aspects. Out of all the
aspects of the system, each social science selects one for its study.
The problem arising out of unlimited wants and limited means to satisfy them and man’s
efforts of solving this problem along with all the institutions and activities, resulting out of
these efforts is subject matter of economics.

DE FI NI TIO NS : Dr . Alf re d M ars ha ll : W ea lt h a nd W el far e a pp ro ach-- --

“Economics is a study of mankind in the ordinary business of life; it examines
that part of individual and social action which is most closely connected with the attainment
and with the use of material requisites of well-being.”

Pr of . L ion el R ob bin s: Sc arc ity an d Gro wt h App ro ach es --- --

“Economics is the science which studies human behaviour as a
relationship between ends and scarce means which have alternative uses.”

Although the above definition of Prof. Robbins’ is widely accepted and serves the purpose of
outlining the scope of modern economics, there remains one serious shortcoming:
Robbinsian definition ignores the possibility of growth of resources over time. As such, the
definition becomes static while we need a dynamic approach.

Pr of . Pau l Samu elso n modifies Robbinsian definition when he gives a growth-oriented

dynamic definition which is generally accepted by economists today:
“Ec on om ics is th e stu dy of how pe op le an d soci ety cho ose to em plo y
res ourc es th at cou ld hav e alt er na tiv e us es in or der to pro duc e var io us
co mm od it ies an d to dis tri bu te th em fo r cons um pt io n, no w or in fu tu re ,
am on g var io us p ers ons an d gr ou ps i n soc ie ty .”

The basic frame is Robbinsian. However, (i) by saying ‘how people and society’ Samuelson
implies micro and macro approaches; (ii) by using the words ’now or in future’ he suggests a
dynamic approach; and (iii) by taking a dynamic view, he makes room for ‘economics of
development’ in the widened scope of the present science of Economics.

BAS IC E CONO MI C P RO BL EM S:

The world is at work because of the existence of wants. Wants are the beginning of
economics. These wants are unlimited. Had they been limited, the economic problem would
not have arisen at all. On one hand, wants are unlimited and on the other, the means
(resources) available to satisfy them are always limited.

Normally, any society or economy has three types of RE SOU RC ES :

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 (1) LA ND : Land, forests, minerals, etc. which are supplied by nature or are known as, the
free gifts of nature are referred to in economics by the term ‘Land’.
(2) LA BOU R : Human Resources which includes the physical and mental energies and
also the inherited and acquired qualities of human beings.
(3) CA PIT AL : Various tools and implements produced by human beings for the
production of consumer’s goods are called as ‘Capital’.

These three are generally referred to as “fa ct ors of pro duc ti on ”, in economics. The
person who brings all these three factors of production, together and actually starts
production is called the ‘en tr epr en eur ’ and is referred to as the fou rt h fact or of
pr od uct io n.

These means which can be used for satisfying human wants are always limited. Because of
the limited nature of means and unlimited nature of wants, economic problems are created. It
is said that, this is the basic reason for the creation of economic problems. But as a matter of
fact this is not the reason for the creation of economic problems. I n fa ct “ sc arc ity ” is th e
fu nd am en ta l th eme of e co no mi cs.

But scarcity and limitedness are two different things. Scarcity is the result of circumstances.
When a person is made to forgo something in order to obtain something else we say that
there is scarcity. This is the real characteristic of scarcity. Scarce resources have alternative
uses. When we decide to use these resources for a particular purpose, we have to forgo the
rest of the purposes. This is called OP PO RTU NIT Y CO ST. Thus the basic problems in
economics spring up from these two sets of things: one is the scarcity of resources to satisfy
human wants and the other is the possibility of using these resources alternatively.

In this attempt to satisfy unlimited wants with scarce resources with alternative uses the
following six fu nd am en ta l pr ob le ms arise. Every economy has to face and solve these
problems.

i) Are the available resources in any country fully and optimally utilized ? As
resources are scarce, they need to be utilized fully. This problem is discussed in
the an alysi s of bus in ess cycl es an d in the Keyn esi an Ana lys is of
Emp lo ym en t.

ii) Which commodities are produced and in what quantities? Under the condition of
full employment, you cannot increase the output of any one commodity without
reducing the output of another commodity. That is why, it is essential to ensure
proper allocation of available resources. Under conditions of perfect competition,
the proper allocation of resources is done by the price mechanism. This aspect is
studied in the Th eory of V alue .

iii) The methods and techniques used to get the required production. When these
methods and techniques change, there is also a corresponding change in the
proportion of factors of production. This forms the subject matter of the The ory
of P ro duc ti on .
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 iv) How the produced goods and services are shared by the population of a country
or how they are distributed? This is studied in the Th eory of D is tri bu ti on .

v) How are the available resources utilized? By applying the test of maximum
efficiency to the problems studied under (ii),(iii) & (iv) above, the optimum pattern of
production and distribution is determined. This is studied by the ‘Ec on om ics of
Welf ar e’ .

vi) Whether the capacity of the economy to produce goods and services is growing or
static? This capacity is called the productivity of the economy. In order to satisfy
more and more wants of the people and improve the standard of living, it is
necessary that the productivity of the economy grows. All this is studied in the
‘T he or ie s of E co no mi c Gr ow th .’
The efforts to solve these basic problems show the sc op e of e co no mi cs.
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MIC RO EC ONO MI CS & M ACR O E CO NOM IC S

MI CR O-E CO NOM IC S : NATUR E & SCO PE :

Micro-economics studies the behaviour of small individual factors or participants in an

economy or or a small group. As Prof. Lerner puts it, micro-economics looks at the economy
through a microscope. The entire economy is just like a living organism. Hundreds and
thousands of individuals behaving as consumers, and similarly, a large number of persons
participating in production are like the blood cells in our body. These cells can be studied
through a microscope only. Similarly, the study of economic behaviour of these individuals or
groups is done through micro-economics.

Micro-economics studies the equilibrium of an individual consumer from the point of view of
maximizing his satisfaction. It also takes in to account or studies the market demand for the
product of an individual product. Similarly from production side, it studies the equilibrium of a
firm and of an industry.

Micro-economic analysis also explains the allocation of resources, assuming that the total
resources are given. This includes the explanation of the proportion in which various goods
and services will be produced. Under the conditions of perfect competition, the price
mechanism performs the function of allocating resources. So, in micro-economics analysis
studies the process of determination of prices of different goods and services and also the
payment of the different factors of production i.e. it studies the ways in which rent, wages,
interest and profits etc. are determined.

Further micro-economics aims at studying the way in which the best use of the available
factors of production is made and how the goods and services that are produced are utilized
by consumers in the best possible manner. In other words it studies the structure of
production and distribution in the economy.
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The study of the efficiency of production and consumption is connected with welfare
economics. Prof. A.P. Lerner aptly put it “in micro-economics we are more concerned with the
avoidance or elimination of waste.”

Of the six basic problems, the first four come within the scope of micro-economics

(1) Th eo ry of v al ue ,
(2) La ws of Pr od uc ti on ,
(3) Th eo ry of D is tri bu tio n o r t he p ri ci ng of t he f act ors o f pr od ucti on ,
(4) Ec on om ics of W el far e.

This does not mean that micro-economics is in no way connected with the economy as a
whole. On the contrary, when the equilibrium of an individual firm or industry or of a
household is disturbed, it does have repercussions on the entire economy, and in the process
of re-establishing equilibrium the entire economy is affected. Actually, micro-economics
studies all the interrelations of the various sectors of the economy, and their actions and
reactions on each other in a very minute manner. That is why; it is called the micro-economic
view of the economy.

However, there are limitations to micro-economics. Some of the problems faced by an

economy are just beyond the scope of micro-economics. For example, public finance or the
monetary policy, etc. cannot be studied with the help of micro-economics. But at the same
time, it is true that, some macro-economic problems become more intelligible because of
micro-economic analysis. For example, the behaviour of an individual consumer is studied in
micro-economics, but, it becomes useful in determining the propensity to consume which is a
macro variable.

MAC RO-E CO NOM IC S : NATU RE & S COP E:

The equilibrium of demand and supply is also studied in macro-economics. But here, the
demand means the demand of the entire economy as whole. Similarly, the supply means the
aggregate supply of all commodities. It is the sum total of individual demand and supply. The
individual supply and demand quantities cannot be aggregated in actual units. How can you
add the demand of an individual for eggs, milk, vegetables, and medical help and so on? So,
all these are expressed in terms of money and then aggregated. If you find that demand
expressed in terms of money is more or less than the supply expressed in terms of money,
then, you can conclude that the economy is not in equilibrium. If the demand is less, prices
will fall, and this will affect employment and so on, as the entire economy is inter-related.
That is, if production is to be reduced, you have to reduce employment and it is not yet clear
whether this will bring about equilibrium. It is here that the similarity between the demand or
supply of a single commodity and the aggregate demand and supply, ends.

Macro-economics takes into account the changes in the demand and supply of all the goods
and services simultaneously; it has to take into account all these effects. This is because
most of those who participate in production, also participate in consumption. So, if there is a
5
general increase in wages, the purchasing power at the disposal of every worker will increase
and this will bring about a general increase in demand. This effect is very important for
macro-economic analysis.

In micro-economic analysis, the demand schedule is prepared by taking into account the
alternative levels of prices. In macro-economic analysis, the demand schedule is prepared by
taking into account the alternative levels of income.
After evaluating the responses of various classes to a change in income, one has to find out
its effect on the demand. The macro-economics tries to explain the process of the equilibrium
of the entire economy as a whole. The sum total of the expenditure of the consumers,
different firms, the government and the foreigners in the country must be equal to the money
value of the total supply of various commodities in the country plus the value of imports into
the country. As all this expenditure is to be incurred from the income, income and expenditure
must be equal to each other.
Thus, the determination of the level of economic activity and the equilibrium of aggregate
demand and supply is the subject matter of macro-economics. The issues which crop up in
the above discussion of equilibrium are as follows:

i) What will be the level of total national income and wages? Th eory of Inco me
an d Emp lo ym en t.
ii) Will the demand for and supply of money be equal? Th eory of Gen era l Pr ic e
Le ve l a nd I nf la tio n.
iii) And if they are not equal what will be the effect of it on the level of prices? The ory
of E co no mi c Gr ow th.
iv) Will the distribution of income be equitable? Ma cro-e co no mi c Th eory of
Distr ib ut ion .
v) In addition to this, macro-economics studies the The ory of Co ns um pt io n,
Th eory of I nves tm en t and Th eory of B us in ess C ycl es.
DI ST IN CT ION B ETW EE N MI CR O & M ACR O E CO NOM IC S

MIC RO-E CONO MI CS MACRO-ECONOMICS

i) .. Stu die s th e ec on om ic beh av io ur
of an indiv id ua l, or a sin gle
ho us eh ol d, or of an in du str ia l un it
or fi rm e tc.
i) Studies the behaviour of an economy
from the point of view of the en ti re
ec on omy as a whole i.e. it studies the
total income, or employment, production or
such other things which are large or in big
quantities.

ii) Accor di ng to Pro f. Bou ldi ng
micr o eco no mics st ud ies th e
economics of a single firm or an
ind iv id ua l fa mily or a spec if ic
gr ou p of fa mi lies; or th e pr ic es of
si ng le c om mo di ties , e tc .
ii) According to Prof. Boulding macro
economics studies the to ta l e ffect o f a ll
th es e i.e. it studies the prices of all
commodities used by society, total
production and consumption of all
individuals, and so on.

iii) Production of a single firm is the iii) Pr od uct io n of th e en tir e n at io n is

6
su bj ect-m att er o f micr o-ec on om ics. the subject-matter of micro-economics.

iv ) Individual income, the price of a single iv) Na ti on al inco me , gen er al pri ce

commodity, the expenditure of an leve l or wa ge le ve l, in ves tm en t or
individual etc. com e wit hi n the sav in gs of th e cou ntry as a who le
pu rvi ew of m icro-e co no mi cs. etc. come under the jurisdiction of macro-
economics.
v) Th e PRICE of a co mm od it y is
ta ke n to be equ ilib ra ti ng forc e in v) The INC OM E of a nation is taken to be
th e stu dy of th e con di ti on s of equilibrating force in the study of the
eq uil ibr iu m of d em an d & su pp ly . conditions of equilibrium of demand &
supply.
vi ) One ca n thi nk in ter ms of
PHYSICAL UNITS of the com mo di ty , vi) One cannot think in terms of physical
as th e equ ilib ri um to be st ud ie d is units of the commodities as all the
in t er ms o f go od s a nd se rvic es. commodities are to be aggregated and
hence, one has to introduce MO NE Y in
the analysis. The changes in the demand
for and supply of money bring about
vi i) The co nsu mers an d pr od ucers changes in the demand for and supply of
ar e tr ea te d as tw o inde pe nd en t the commodities.
cl asses , an d th e rel at io ns hi p vii) But, this is no t so in Ma cro-
be tw ee n the sup pl y and de man d is ec on om ics . One cannot afford to
es ta bl is he d thr ou gh pri ces . One neglect the influence of the supply side on
can afford to neglect the influence of the demand in micro-economics.
supply side on demand in micro-
ec on om ics.
vi ii) It is suf fi ci en t to tak e int o viii) It is necessary to ana lys e the
acc ou nt only the market supply and so urce of su pp ly and dema nd , so as
market demand. to find out the probable changes in the
units of supply and demand.
ix ) A stu dy of eco no my is do ne in ix) So, it becomes necessary to have a
pa rts . But the conc lus io ns whi ch separate macro approach and this gives
ma y h old go od i n t he cas e o f pa rts, rise to some paradoxes. If viewed from
ma y not hol d go od in th e cas e of individual point, it is better to save as much
th e eco no my a s a w ho le. as possible, but if entire society tries to do
the same, then the income in the
subsequent period will be reduced and that
will reduce the savings also. This is called
the “Para dox of Sav in gs” .
x) Se ver al int er-r el at ion s ar e x) Macro-economic analysis cannot afford
ne glec te d in mic ro-e co no mic to neglect the inter-relations. The actual
an alysi s. Th er e ma y be differ enc e investment in any economy can neither be
be tw ee n the indivi du al sav in gs and more or less that the savings.
inves tm en t.

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MANAGERIAL ECONOMICS

MAN AG ER IA L ECO NOM IC S

Managerial economics is considered to be applied micro-economics. That is, it is concerned

with the applications of micro-economic principles to decision making by firms. The ‘firm’ here
includes both business and non-business ones.
ME (Managerial Economics) in its simpler terms means the app lic at io n of ec on om ic
th eo ry t o t he p ro bl em s o f m ana ge me nt .

De fi nit ion of “Spen cer & Sie ge lma n”: “The Int eg ra ti on of Eco no mi c Th eory
wit h Busi ness Pr act ic e fo r the Pur pos e of Fac il ita ti ng Dec is io n-m ak in g and
fo rw ard Pla nn ing by Man ag em en t. ”

Pa rt I - In te gr at io n of Ec on om ic Th eory wit h Busi ness Pr act ic e: Economic

theory developed certain concepts/tools. For example, PRICE. Price is the interaction of
supply & demand. When supply is short of demand, the price goes up. Alternatively, if the
demand is less then he can cut down his production. When there is enough demand, the
manager can increase his production depending upon his capabilities. This is what is meant
by managerial economics.
Pa rt I I - It is obvious from the definition that the problems of management are of two kinds
i.e.
i) Problem of Decision-making, & ii) Problem of Forward planning.
Managerial economics, therefore, is a economic theory applied to the problems of
management to arrive at reasonably sound decisions on the strategies to be pursued in the
present and in the future.

The decision-making has two aspects i.e.

 Optimal allocation of the scarce resources, & Selection from amongst the alternate
uses of the scarce resources.
 Uncertainty. This generally arises when planning the future production. In this case,
he will have to consider the conditions that might prevail in the market the the future.
In other words, the problem now is the problem of a reasonably accurate forecast of
sales. As the course of events cannot be predicted, we say that the course of events
in the future is uncertain. It is this uncertainty which makes the decision-making
function very difficult.

But, why, one may ask, should a businessman plan for the future? This reminds one of a
Chinese proverb, which says that a person who cannot see beyond the day, will have good
wine to drink in the morning and green wine for hangover in the evening, and rainwater to
drink for the rest of his day. If a businessman does not think about the future, he will meet
with the same fate. That is the reason why the element of uncertainty has a vital role to play
in decision-making.

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For wa rd Plann in g: When a manager plans for the future, he has to make an accurate
forecast of the position of raw materials, the prices of the factors of production, the market
prices of his products, the demand for them etc.

In ve nto ry dec is io n: The manager has to take the decision regarding the quantity of raw
materials which should be kept in stock.
If the marginal cost of production is Rs. 8 and the market price is Rs. 9, it is profitable to go
ahead with the manufacture of the new product. It is here that economics becomes very
useful to the manager, in the sense that an understanding of what the marginal costs is helps
him to arrive at the right decision.
Therefore, we conclude that the concepts of economics are extensively used in managerial
economics; that is both micro-economics & macro-economics are pressed into service. Micro-
economics is useful because it deals with allocation of resources, etc. Macro-economics is
useful in the sense that the theories of income, employment, business cycles, etc are of
immense significance to the management. Bu t it is micr o-ec on om ics whic h is
pa rt icu la rl y us ef ul t o t he m an ag er .

RE LATIO N TO OTH ER D IS CI PL IN ES:

1) Appl ied Ec on om ics : Economics has developed several concepts. Managerial

economics makes use of some of them. For example, the production function, which has
been developed in economics, is usually put to managerial use in achieving the
maximum output with a particular combination of inputs. When the prices of inputs
increase, a least-cost combination can be worked out. The concept of opportunity cost, a
contribution of economics to managerial economics, can be put to managerial use. The
concept of prices, too, is similarly used. Economics tells us how prices are fixed. For this
purpose, the total cost of production is taken into account. Now managerial economics
makes use of it in the pricing of products. In this sense, managerial economics is called
applied economics.
2) Sta ti st ics : Statistics supplies several tools to managerial economics. Trend
projections are used for forecasting. Similarly, the multiple regression technique is used.
In managerial economics, measures of the central tendency like the mean, the median
and the mode, and measures of dispersion, correlation, regression, least-square
estimators, etc. are widely used.
3) Mat he ma tics: Mathematics plays a significant role, especially when several economic
relationships are to be estimated. Then, knowledge of linear and quadratic equations,
simultaneous equations, logarithms, co-ordinate geometry, calculus, etc., is absolutely
essential.
4) Oper at io n Re se arch : operation research & managerial economics are related to a
certain extent. For example, to arrive at decisions, same theory is used. Operations
research has developed the techniques of inventory control, and these techniques are
used in managerial economics.
5) Acco un ti ng : Accounting also contributes a lot of managerial economics. Take for
example,

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6) The profit-and-loss statement of a firm, which helps the manager to identify the specific
areas of loss and to arrive at suitable decisions. The whole range of accounts, in fact,
offers the manager data for decision-making and forward planning.

SC OP E OF M ANAG ER IA L EC ONO MI CS :

By virtue of its nature, managerial economics cannot be subjected to any hard and fast
boundaries. The scope of managerial economics is so wide that it embraces almost all the
problems and areas of the manager and the firm. The scope is explained in brief as under:

1) Ba si c Pro bl em / Re so urces Alloc at io n: Scarcity of resources is a given condition.

Ends are many. Managerial Economics has to begin its study with an understanding of the
basic economic problem. How best can these resources be allocated to competing needs?
The aim, of course is to achieve optimization. Some advanced tools such as linear
programming, etc. are used for this.

2) The ory of th e Fi rm : Managerial economics then proceeds to understand the firm vis-
à-vis the industry. What is a firm? How it is related to industry? What are the objectives of a
firm? By studying the objectives, one can find out the equilibrium position of a firm. All these
conditions therefore become a part, and in fact the starting point of the study of managerial
economics.

3) Or ga ni sat io n of Bus in ess: Any business can be organized along a variety of

alternative forms and at various optional scales. Therefore, various forms of business
organization as well as the business goals or objectives of a firm form a part of the scope of
managerial economics.

4) De ma nd An alys is and for ecast in g: It analyses carefully and systematically the

various types of demand which enable the manager to arrive at a reasonable estimate of
demand for the products/services of his company. He takes into account such concepts as
income elasticity, cross elasticity. The determinants of market demand, elasticity of demand,
measurement of the various types of elasticity of demand and demand forecasting along with
the various techniques of demand forecasting form an important part in the scope of the
subject.

5) Pr od uct io n fu nct io n: As the resources are scarce and also have alternate uses, the
inputs play a vital role in the economics of production. The factors of production (inputs) may
be combined in a particular way to yield the maximum output. When the prices of inputs
shoot up, a firm is forced to work out a combination of inputs so as to ensure that this
combination becomes the least-cost combination. In this way the production is pressed into
service by managerial economics. Like the Law of Demand, there is the Law of Supply which
applies to the market supply of firm’s products.

6) Co st An alys is: The determinants of costs, the methods of estimating costs, the
relationship between cost and output, the forecast of cost and profit—these are very vital to a

10
firm. Managerial economics touches these aspects of cost-analysis, an effective-knowledge
and application of which is cornerstone for the success of a firm.

7) Inv ent ory Man ag em en t: 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 which ensures the
capital productivity and smooth/ uninterrupted production. For this purpose, the managerial
economics will use such methods as ABC analysis, a simple simulation exercise and also a
mathematical model with a view to minimizing the inventory cost. It also goes deeper into
such aspects as the need for inventory control; it classifies inventories and discusses the
costs of carrying them.

8) Adv ert isi ng : The methods of determining the total advertisement costs and budget, the
measuring of the economic effects of advertising, are the problems of the manager. To
produce a commodity is one thing; 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.

8) Pr ic e Syst em : The central functions of an enterprise are not only production but
pricing as well. While cost of production has to be taken into account when pricing a
commodity, a complete knowledge of the price system is quite essential to the determination
of the price. For instance, an understanding of how a product has to be priced under different
kinds of competition for different markets is essential. Pricing is actually guided by
considerations of cost plus pricing and the policies of public enterprises. Finally there is such
a thing as price leadership and non-price competition. It is evident from these facts that the
price system touches upon several aspects of managerial economics and guides the
manager to take valid and profitable decisions.

9) C ap ita l B ud ge tin g: Capital is scarce, and it costs something. Now the problem is how
to arrive at the cost of capital; how to ensure that capital becomes rational; how to face up to
budgeting problems; how to arrive at investment decisions under conditions of uncertainty;
how to effect a cost benefit analysis, etc. These areas cannot be ignored by any manager.

It is obvious from the above discussion that managerial economics is applied economics. It
makes use of the tools which have been developed not only by economics but by other
disciplines as well. Two important areas of decision-making and forward planning, covered in
managerial economics, are essential to every stage of planning, production, marketing etc.
As such man ag er ia l eco no mi cs pl ays a very vi ta l rol e in the success fu l
bu si ness op er at io ns o f a fi rm .
CO NC EP TS & M ETHO DS U SE D IN M ANA GE RI AL E CONO MI CS

CO NC EP TS : By concept we mean a thing that is conceived. Alternatively, we can say

one’s notion. Managerial economics has certain terms like any other discipline. These terms
are called as Concepts. For example, Price. For a layman price means the money he pays
for acquiring a particular product. For a managerial economist, price means the payment that
a commodity commands in the market at a particular point of time. He also understands that

11
price fluctuates depending upon the forces of supply and demand. Hence, for a managerial
economist the concepts give a different notion.

CO NC EP TS OF MAN AG ER IA L ECO NOM IC S:

1) De ma nd : In the ordinary sense of the term, DEMAND means to ask for a particular
thing or asking for a thing authoritatively. In managerial economics, Demand means
(requirement) a desire to have a commodity, ability to pay the price for a commodity and
willingness to pay the price for the commodity. Then only, it constitutes a demand.

2) Sup ply : Generally, by supply we mean the availability of any commodity. The supply of
any commodity should not mean that the commodity is available freely e.g. Air. Air is
available freely but nobody pays any price for it.

Dem an d Supply
--c ons ti tu tes th e r eq ui re me nt . -- denotes the total quantity available for
--m eans th e co nsu mers ’ sale in the market.
req ui re me nt . --means producers’ production.
--m eans re qu ir em en t of a --means availability of a commodity at a
com mo di ty at a cer ta in pr ic e. certain price.

3) Pri ce : The price is the meeting point of demand and supply. This means the demand
(preparedness of consumer to pay a certain price) and supply (preparedness of seller to part
with the commodity for a certain price) should be same. Sometimes supply being constant,
demand shoots up & resultantly price shoots up. We say that demand outstripped supply. On
the contrary, when supply exceeds demand price falls. Therefore, there will be always a play
of demand and supply. The interaction of demand for and supply of a commodity determines
the price.

4) Co mp et iti on : Manufacturers produce their goods and compete with each other to sell
their products. When they compete with each other it is nothing but competition. Economic
theory starts explaining from perfect competition. It says that perfect competition is explained
under a set of following assumptions: i) The products are homogeneous, ii) Price is same in
all parts of market, iii) there is no comsumers’ ignorance etc. However, the perfect
competition doesn’t exist in reality. The price rises when the supply falls short of demand and
it reduces when supply increases.

5) Pro duc ti on : Production refers to the supply side of any commodity & the sum of all the
units produced forms a supply of a given commodity. The factors of production viz. Land,
Labour, Capital and Organization are the essentially required to produce any commodity.
These inputs are combined in varying proportion. That combination which yields maximum
output with least cost is called Optimum Combination. Production is also is governed by the
rate of output.

6) Distr ib ut ion : Whatever is produced has to be sold out. The selling part refers to
marketing. How to market the goods that are produced? This is where distribution enters.
From the factory the goods go to the authorized agents / wholesale dealers. Wholesaler
12
further distributes the goods to the retailers under him. From retailers the goods reach the
hands of the consumers.

7) Con su mp ti on and Co ns um pt io n Func ti on : Whenever a commodity is produced, it

is meant for consumption. The person who consumes is called the consumer. The person
who purchases a commodity, does not resell but consumes the commodity is called the
consumer. The act co nsu mi ng is cal led the co nsu mp ti on . Consumption
presupposes utility to a consumer. Consumption also has the level of satisfaction. The
amount of consumption by a consumer has an indirect relation to the price of that commodity
and the income of the consumer. Given the price of commodity and the consumer’s income,
the consumer may consume certain units of that commodity. This is the fu nct io n of
co nsu mp ti on .

8) Cos t: The expenses that are incurred in order to produce a commodity means the cost.
The manufacturer has to incur expenses on the production inputs such as land, labour, capital
and organization. These expenses constitute the cost of production. The pr ic e is generally
higher that the const of production. The difference is the pr of it .

9) Mo no po ly: Whenever there is only one producer of a particular commodity it is said to

be Mo no po ly. On the other hand, if there are two producers it is called Du op ol y. When
there are a few producers, it is called O li go po ly.

10 ) Pr of it : Expenses on factors of production is known as Cost of Production. Certain

amount is added to the cost of production which is called P ro fi t.

11) Op ti mi sa ti on : Optimisation means maximum. In pro duct io n when the factors of

production are combined in a particular fashion it gives a least cost combination. This least
cost of combination is the Optimum combination. In consumption, given the price and utility
of various commodities the consumer works out a combination of a number of different
commodities. This gives the consumer the highest satisfaction. This is known as optimization.

12 ) Mar gi n an d Aver ag e: A person may consume certain number of units of a particular

commodity and stop at a particular point. The last unit that he has consumed and that gave
him satisfaction is called the ma rg in al uni t. Marginal or Incremental Principle (MIP) is
significant. This is so because some businessmen take an erroneous view that to make
maximum profit they must make a profit on every job. The result is that they refuse orders
that do not cover full cost plus some profit. This could be better explained through a
numerical example.
OUT PU TOT AL MAR GI NA L AVERAG E
T CO ST CO ST COS T
0 20 -- --
1 28 8 (28 - 20) 28 ( 28 / 1)
2 37 9 (37 - 28) 18.5 ( 37 / 2)
3 47 10 (47 - 37) 15.7 ( 47 / 3)
4 58 11 (58 - 47) 14.5 (58 / 4)
5 68 10 (68 - 58) 13.6 (68 / 5)

13
13 ) Ela st ici ty: By elasticity we mean the change in the quantity demanded due to a
change in the price of that commodity. The elasticity is denoted by a Greek letter … And is
measured by the following formula:

E last ic ity = (Cha ng e in d ema nd ÷ Qu an ti ty d ema nd ed ) ÷

(C ha ng e i n Pr ice ÷ P rice )

14 ) Micr o an d Macr o Ana lys is: When we analyse the factors of a singly unit, it is
known as micro analysis. The macro analysis deals with the figures of an economy (of a
country) as a whole. For example, National Income.

MET HOD S O F M AN AGE RI AL E CO NOM IC S:

While solving the problems, some tools are employed to arrive at a solution. The tools are
employed in a systematic way. This systematic way of approach to any problem is known as
Methodology. In fact, method means the mode or rule of accomplishing an end. It is an
orderly procedure or, say, an instruction manual arranged systematically. The following are
the methods that are used by modern managers: i) In te rn al Dat a, ii)
Pu blis he d Da ta , iii) Fi el d In ves ti ga ti on , iv) Spec ia lis ed Age nc ies .
i) INT ER NA L DATA: All the facts and figures of a company are called the internal data.
The Manager is supposed to have a complete knowledge about his own company to solve
any business problem. These internal data are to be arranged in a systematic way. The
departments such as, Production, Sales, Inventory etc. are expected to keep a systematic
record of their achievements. For example, a Production department is expected to store the
data on how much it produced on each day. From this basic information one can arrive at the
production per month, per quarter, per year.
The internal data help to keep a close watch on functioning of all the departments & arrive at
precautionary / corrective measures.

ii) ASS OC IA TI ON S: Associations are the bodies created by the businessmen of the
same line. For example, Fan Makers’ Association, Soap Manufacturers’ Association. All the
manufacturers of a certain product form into an association. The associate members furnish
the information about their production, sales, inventory etc. These reveal which company is
selling more and which company is selling less, which company is maintaining a minimum
level of inventory and which company is maintaining a maximum level of inventory. The data
are useful in knowing where a company stands in the market. Manager can now know where
his company stands in the competition and can take suitable decisions to improve the
situation.

iii) PU BLI SH ED DATA: Manager has to refer to the published data which will give him a
total picture of the whole industry at All-India level. There are some publications brought out
by government as well as by some independent bodies. Examples are : DGTD, Five Year
Plan documents, Centre for Monitoring Indian Economy (CMIE). These publications data on
the number of units in production, installed capacity, production, advance information etc.
The CMIE data help in arriving at two important points : i) Whether the production is going up
or down, ii) The rate at which the capacity is being utilized. Thus this will help in knowing the

14
present supply position. On the demand side, the journal such as Fortnightly Journal of
Indian Economy publishes the demand at present as well as expected demand in future.

iv ) FIE LD IN VES TIG ATIO N: Above-mentioned data may not help a manager in
knowing the movement of a product in a particular area, the demand and supply in a
particular area, price prevalent in various markets in a given region and activities of the
competitors in a given region. To know the answers to these questions the company has to
take up Market Survey by using its own manpower.

v) SPEC IAL IS ED AG EN CI ES: To conduct a market survey is not an easy job. A

company may have enough resources but it may not have specialized persons to do such a
job. The company can engage services of any specialized agency and commission it to do
the job.

__________________________________________________________________________
______________________________

DEMAND ANALYSIS

Demand refers to the number of a commodity which a consumer buys at a particular price.
Further, the determinants of demand are analysed in depth, factors like desire, need,
willingness to purchase and purchasing power are also operative.

Th ere for e, de si re , ne ed , wil ling ne ss to purc has e a co mm od ity back ed by

th e nec essary pu rch asi ng po we r – t he se cons ti tu te a de ma nd .

DE MAN D AN D UTI LIT Y: People demand goods because they satisfy the wants of
the people. The utility means want-satisfying power of a commodity. It is also defined as
property of the commodity which satisfies the wants of the consumers. Utility of a good is
the important determinant of demand of a consumer from the goods they buy for
consumption. Consumer’s demand for consumer goods for their own satisfaction is called
direct demand. Utility is a subjective entity and resides in the minds of men. Being
subjective, different persons derive different amounts of utility from a given good. People
know utility of goods by means of introspection. The greater the utility he expects from a
commodity, the greater his desire for that commodity. It should be noted that no question
of ethics or morality is involved in the use of the word, “utility’ in economics.

DI ST IN CT ION BET WE EN “DE MAN D” & “QU AN TI TY DEMAN DE D”: The

concepts of demand and quantity demanded are often confused with each other.
DE MAN D represents the whole demand schedule or demand curve and shows how
price of a good is related to the quantity demanded which the consumers are willing and
able to buy, other factors (non-price or shift factors) which determine demand being held
constant. On the other hand QUA NT ITY DEM AND ED refers to the quantity which the
consumers buy at a particular price. The quantity demanded of a good varies with
changes in its price; it increases when price falls and decreases when price rises. The
change in demand for a commodity occur when there is a change in the factors other than
price namely, tastes and preferences of the people, income of the consumers, and prices
of related goods etc.
15
 TY PES OF “DEM AND ”:

1) Pr ic e D em an d: Price demand refers to the various quantities a consumer buys at a

various hypothetical prices. The price and demand together establish the relationship
between the price and the quantity demanded. But this relationship holds good only if
other things viz. co nsum er ’s inc om e, his tas tes an d pr ef ere nces, an d th e
pr ic es of oth er go od s ar e cons ta nt . Therefore, it is assumed that, other things
being equal, the price-demand relationship holds good.

2) In co me De ma nd : Income demand expresses the relationship between the level of

income and the quantity demanded. If the income of the consumer goes up, he may
go in for goods of superior quality. If his income falls, he may prefer to purchase a
product of an inferior quality. There is, thus, a relationship between the level of income
and the demand. However, here also, it has been assumed that the prices of related
commodities, tastes and desires do not change.

3) Cr oss De ma nd : Cross demand refers to the change in the quantity demanded of

one product as a result of a change in the price of another product. For example, if the
price of Coca Cola registers an increase, people may shift to Thumps Up. This means
that, because of the change in the price of Coca Cola, the demand for Thumps Up has
changed.

Fu nct io na l Re lat io ns hi p & De ma nd C urv e:

De ma nd Sch ed ul e: We observe from the demand schedule that, as the price

decreases the quantity demanded increased. This relationship is called a functional
relationship.

Ch ar act eris ti cs of Dem an d: In the above figure the demand curve slopes
downward from left to right. Indicating that as the price falls, the quantity demanded
increases. This demand function may, therefore written as: Qd = f ( Px) .
Qty.
Price Dem-
of X anded
No. of
in Rs. Units
10 2
9 4
8 6
7 7
6 8
5 9
4 10

16
 12

10

8
#REF!
6 #REF!
#REF!
4

0
2 4 6 7 8 9

That is, the quantity

demanded is a function of price. We do not consider what happens to price when the quantity
demanded decreases or increases. The price is an independent variable, while the quantity
demanded is a dependent variable. It is customary in mathematics to take the independent
variable on Y-axis and dependent variable on X-axis. Therefore, while price is Subject, the
quantity demanded is Relative. The relationship between price and demand is therefore an
inverse relationship.

De ma nd C urv e- is a graphic presentation of quantities of a good which will be quantities of a

good which will be demanded by the consumers at various possible prices at a given
moment of time. Demand schedule/ demand curve does not tell us what the price is, it only tells
us how much quantity of goods would be purchased by the consumer at various possible
prices. Further in drawing demand curve, we assume that buyer or consumer does not
exercise any influence over the price of the commodity, that is, he takes the price of the
commodity as given and constant for him.

In di vi du al De man d: The demand schedule of any one consumer in respect of any

commodity is called the individual demand; and this demand schedule depends upon the
following factors:

(i) Income of the individual; (ii) Price level of the commodity; (iii) Price of substitute; (iv)
Tastes and preferences of the consumer; (v) Social conventions.

In du stry / Mark et Dem an d: The industry demand is arrived at by considering the

quantities demanded by individual consumers at different prices. For example, if there are four
consumers – A,B,C & D – the demand schedule of all the four consumers for product X would
be the industry demand or market demand.

In du stry D ema nd fo r P ro du ct X
Pr ic e N umb er of Un its
of de ma nd ed b y i nd ivi du al s Ma rke t
X in De ma n
Rs . A B C D d
5 0 0 1 1 2
17
 4 1 1 2 2 6
3 2 3 4 4 13
2 4 4 5 5 18
1 5 6 7 8 26

The quantity demanded by each consumer differs because each consumer’s behaviour is
different. It cannot, therefore, be said that the industry demand is the sum total of individual
demand schedules; rather, the industry demand schedule is that aggregate of the individual
demand schedules.

The industry demand curve slopes downward from left to right, like that of the individual
demand curve. The only difference is that while the individual demand curve is not smooth and
regular, the industry demand curve is smooth and continuous. This is due to the fact an
individual behaves irrationally, and that, when the aggregate is taken, the irrationalities are
smoothened.

Limitations: When the Industry Demand Curve is drawn, it is assumed that the incomes and
tastes of the consumers and the prices of other commodities are constant or, alternatively, do
not change. In fact, however, these do change. Nevertheless, the industry demand is a close
approximation of reality, though it is not real.

TH E LA W O F D EM AND :

The law of demand in the words of Dr . Marsh al l, can be stated thus, “T he amou nt
de ma nd ed incr eas es with a fa ll in th e pric e an d dimin is hes wit h a ri se in
pr ic e, ot he r th ings rem ai nin g the sam e. ” There are so many determinants of
demand i.e. Price of own good, Income of individual, Price of related goods, Tastes &
Preferences of consumers, Advertising expenses incurred by producer. Ho we ver ,
th eo re tic al pur pos e of dema nd an alys is is to ex pl ai n th e be ha vi our of
ma rke t pr ic e, th e allo ca ti on of reso urces and th e dis tri bu ti on of inco me .
In this matter, price-demand relationship is important. Besides, to simplify the analysis of
demand, price-demand relationship can be studied in isolation.

As such, the law of demand specifies the Inverse / Indirect relationship between the Price
and Demand. If the Shift / Non-price factors undergo the change, the law of demand or
price – demand relationship does not hold good. Thus, the constancy of these shift
factors is an important qualification of the law of demand.

Exc ep ti ons to Las of De man d: Law of de ma nd is gen er al ly belie ve d to be

va li d in most of th e sit ua ti ons . Ho we ver the foll ow ing exc ept io ns hav e
be en p oi nt ed o ut .

1. Go ods hav in g pr est ig e val ue : According to an economists Thorstein Veblen,

some consumers measure the utility of a commodity entirely by its price i.e., for them,
the greater the price of a commodity, the greater it’s utility. The diamonds are
considered as prestige goods in the society and for the upper strata of the society the
18
 higher the price of diamonds, the higher the prestige value o them and therefore the
greater utility of them. In this case, the consumer will buy less of diamonds at a low
price because with the fall in price their prestige value goes down. On the other hand,
at a higher price the quantity demanded of diamonds by a consumer will increase.

2. Gi ffen Goo ds: Another exception to the law of demand was pointed out by Sir
Robert Giffen who observed that when the price of bread increased, the low-paid
British workers in the early 19th century purchased more bread and not less of it. This
was contrary to the law of demand. The reason given for this is that Giffen Goods are
inferior goods in whose case the negative income effect is very large which more than
offset the substitution effect. Therefore, in their case quantity demanded varies
directly with price. After the name of Sir Robert Giffen such goods in whose case there
is a direct price-demand relationship are called Giffen goods. In this situation the
demand curve slopes upward from left to right instead of sloping downward from left to
right. The demand curve rises instead of falling.

3. So me ot he r exc ep ti ons : There are some other exceptions to the law of demand
which are only apparent and not genuine. In other words, these exceptions to the law
of demand are false. Such situations are not exceptions to the Law but they are the
outcome of changes in other things. In other words, when a situation crosses the limits
laid down by the Law of Demand, the consumer’s behaviour is naturally contrary to the
Law. They are explained below in brief:

i) Ef fe cts of Ex pec ta ti ons : When the price of a product falls but the consumer
expect the price to fall further, the demand contracts instead of expanding. Actually
the consumers are waiting for price to reach it’s lowest level, so that they can place a
large demand at the market. Thus, the consumers are acting according to the law of
demand but their response to a fall in price is temporarily withheld by expectations.

ii) Popu la tio n: When population is growing, demand for everything grows,
whatever is the price.

iii) Com po si te Dema nd : When two products are complementary to each other,
their demand becomes composite demand e.g. scooter and petrol, ball-pen and refill.
With a fall in the price of scooters/ball-pen, their demand would increase and the
demand for petrol/refill would also increase even if petrol/refill prices are actually rising.

iv ) Hab its : Wants are habit-forming. Hence, when the price of a commodity
increases, the consumers cannot reduce their consumption of that product
immediately. They will require some time to change their habits.

v) Ig no ra nce: Sellers can increase their sales even after raising the price of a
product. This they can do by taking advantage of consumer’s ignorance, with the help
of heavy advertising. When an advertising tells you ‘your favourite soap is now
available in much better quality’ the consumer are willing to pay a high price for it
without examining whether there is really a change in the quality or not.

19
 Why th e D ema nd Cu rve sl op es d ow nw ar d o nly ?

i) In co me Effec t: When the price of a commodity falls and and chooses to buy the same
amount of quantity as before, some money will be left with him because he has to spend
less on the commodity due to its lower price. In other words, as a result of the fall in the
price of a commodity, consumer’s real income or purchasing power increases. This
increase in real income induces the consumer to buy more of that commodity. This is
called the income effect of the change in price.

ii) Su bs ti tu ti on Ef fe ct : When the price of a commodity falls, it becomes relatively

cheaper than other commodities. This induces the consumer to buy the commodity whose
price has fallen instead of other related commodities which have now become relatively
costlier/dearer. As a result of the substitution effect, the quantity demanded of the
commodity, whose price has fallen, rises. This substitution effect is more important than
the income effect. Marshall explained the downward-sloping demand curve with the aid of
this substitution effect alone, since he ignored the income effect of the price change. But
in some cases even the income effect of the price change is very significant and cannot
be ignored. Hicks and Allen who put forward an alternative theory of demand called as
indifference curve analysis of consumer’s behaviour explain this downward-sloping
demand curve with the help of both income and substitution effects.

Ex te nsi on an d Co nt rac ti on of D em an d & I ncre ase an d De cre ase in D em an d:

Several variable factors influence/affect the demand for a product. We isolated the price factor
and examined its effect on demand through the Law of Demand. To distinguish the effect of the
price-changes from the effect of changes in all other determinants demand (shift factors),
economists have introduced distinct terms: Extension and Increase in demand, and Contraction
and Decrease in demand. Price-changes cause the ‘extension’ of a ‘contraction of demand;
while all other shift-factors cause an ‘increase’ or a ‘decrease’ in demand.

As such, Extension in demand is caused by a fall in own price of good and Increase in demand
caused by changes in other shift-factors like income, prices of related goods, tastes and
preferences, advertising expenses, population etc. On the other hand, contraction in demand
caused by increase in the own price of good and decrease in demand is caused by changes in
other shift factors like income, prices of related goods, tastes and preferences, advertising
expenses, population etc.

Movement of Demand Curve: Shifting of the demand curve upwards and to the right of the
original demand curve shows Increase in Demand. The downward movement along the same
demand curve on the other hand, shows ‘Extension of Demand’. Any shift in the Demand
Curve downwards and to the left indicates a Decrease in Demand and an upward movement
along the same demand curve indicates ‘Contraction of Demand’.

20
SH IF TS IN D EMA ND C UR VE:

UPW AR D, RIG HW ARD (I NC RE ASE DOWNWARD, LEFTWARD (DECREASE IN

IN DE MAN D) DEMAND)

1) In cre ase in –Co ns um er ’s inco me , 1) Increase in- price of complementary goods.

Pri ce of su bsti tu te , Numb er of
cons um ers, Adve rti si ng ex pe nses . 2) Decrease in- price of substitute good,
Income of consumers,
2) Decr eas e in- Pr ic e of
com pl em en ta ry g oo ds. 3) Consumers expect that price will fall in
future.
3) Tastes & pr ef er ences ar e
fav ora bl e, fa sh io n, Co ns um ers 4) Product is out of fashion.
exp ect t ha t pr ice will i ncre ase.

DE MAN D FU NC TIO N: Q d = f ( P x, I, Pr , T, A )

This is read as “Quantity demanded is a function of Px-Own price of a commodity, I-Income of

the individual, Pr-Prices of related commodities, T-Tastes & preferences of individual
consumer, A-Advertising expenditure made by the producers of the commodity.”

For many purposes in economics, it is useful to focus on the relationship between quantity
demanded of a good and it’s own price, while keeping other determining factors such as
income, prices of other good, tastes & preferences constant. And hence, Later, it was obvious
that income, tastes and preferences also exert influence on demand. An d he nc e, Q d = f
( P x).

Ot her de te rm in in g fa ct ors like , ( I, Pr , T, A ) ar e ca lle d as ‘Shif t Fac tors ’ or

‘No n-P ri ce Fac tors ’.

Th e f ac tors w hic h a ffect th e de ma nd a re :

i) Pric es: A change in the price of a commodity may bring about a change in the quantity
demanded. If the price rises, people shift to substitutes. This means that it is not only the price
of a commodity but the prices of substitutes as well which have a telling effect on the quantity
demanded.

ii) The Nu mbe r of Con su me rs: The number of consumers depends upon: i) Size of
th e po pu la tio n, i i) S tr uct ure of Pop ul at ion ,

iii) Tra nspo rt & Co mm un ica ti on . An increase in population leads to an increase in the
demand for certain goods and vice versa.

21
iii) Inco me & Inc om e Dis tri bu ti on : The income exerts an influence on the demand for
any commodity. When the income of a person rises, he may go in for more superior quality of
goods. If it falls, he is likely to search for substitutes. If the inc om e dis tri bu ti on is less
uneven & the gap between rich and poor is narrow, the basket of goods and services
demanded by such society would be different from the one demanded by the group of
consumers with high income disparities.

iv ) In fla ti on : The general price level rises during inflation and the real income of the
consumers falls. Therefore, consumers automatically reduce their demand.

v) Cl ima te : Climate has a direct influence on demand. In winter there is a great demand for
woolen clothes and the demand for electric fans increases in the summer.

vi ) Tas tes an d Pre fe re nces & Ne ed s: Fashions change often. Therefore, whenever a
new fashion comes in, there is a demand for it. Needs of the consumer influence the intensity of
their wants. Once a need is satisfied, his want of that commodity goes down on the scale of
preference.

vi i) Exp ect at io ns of th e Cons um ers : If the consumer expects a further fall in the price,
the initial fall in the price will not be followed by a rise in demand. Instead, demand will contract
as a result of a fall in price.

vi ii) Adv ert is em en t: Advertisements create demand for a product by informing the
consumer that the commodity being advertised is available at the market. It also persuades the
consumer to buy the commodity concerned by bringing to his notice several qualities of the
product.

ix ) Pro vis io ns of Soc ia l Sec uri ty: In a society where social security measures like
sickness insurance, Medicare, maternity benefits, accident insurance & old-age pensions etc
are adequate and comprehensive, people tend to spend more out of a given level of income.
x) Oth er Fac il iti es : Other facilities like Hire Purchase, warranty, Post sales services for
free home delivery etc. influence demand for the product concerned.

It is obvious that all these factors, which exert an influence on demand, also act as limitations.

Thr ee Effects of De man d:

Three Effects of

DEMAND

SUBSTITUTION
INCOME EFFECT PRICE EFFECT
EFFECT

i) Inc om e Effect : The income effect may be defined as an effect on the quantity
demanded following a change in income, other things being equal. As a rule, a rise in income
but not in prices induces a consumer to buy more goods. When income rises while prices
22
remain constant, a villager in India goes in for a better variety grains. Therefore, we may say
that inferior goods are those goods for which the inco me e ffect is ne ga tive .

ii) Subst it ut io n Effec t: The substitution effect is an effect which follows a change in
relative prices. It means a change in the quantity demanded because of the change in relative
prices when the real income is constant. If the consumer purchases a larger quantity of a
product because that product has become cheaper, the substitution effect is deemed to have
taken place.

iii) Pri ce Ef fe ct: The price effect operates when the quantity demanded of a commodity
changes due to a change in its price, while income and the prices of other goods remain
constant. The price effect embraces other effects as well, namely the income effect and the
substitution effect.

MAN AG ER IA L USE S OF DE MAN D ANA LYSI S:

Two br oa d f unc ti on s: i) Forecasting, ii) Manipulating the demand.

An ci lla ry f un ct io ns: i) Performance appraisal of the salesman,

ii) Fixing up of sales quota of salesman,

iii) To observe the trend of company’s competitive position.,

Bu t w hil e d iscuss in g th e ab ov e as pec ts, on e h as t o ke ep i n mind th e e last ic ity

of a co mp any ’s pr od ucts.

EL AST IC IT Y:

This concept was introduced by economists like Cou rn ot an d Mill; but was developed by
Dr . Alfr ed M ars ha ll . Elasticity of demand can be defined as, “T he ex te nt to wh ich th e
qu an ti ty dem an de d of a com mo dity cha ng es in res po nse to a give n ch an ge in
pr ic e. In oth er wo rds, ela st ici ty of de ma nd is the cap aci ty of th e dema nd to
ex pa nd or con trac t i n res po nse to a g iv en ch an ge in p ri ce .”

CO NC EP T OF ELA STI CIT Y:

As developed by Marshall, the concept of elasticity was applied to price-elasticity. But later on,
the concept was made more inclusive. Elasticity of demand is concept of judging the
responsiveness of demand to several factors which determine demand for a commodity. But all
the factors are not equally important from the point of view of wither theoretical analysis or
practical policies. Efforts , therefore are made to measure the responsiveness of demand to
changes in certain important factors like price, income, prices of related products, sales
promotion etc. It is also important to note that the degree of responsiveness of quantity
demanded to price changes varies from product to product.

PR IC E E LAS TI CIT Y OF D EMA ND :

23
 Definition by Dr. Marshall: “The elasticity of demand in market is great or small according to the
amount demanded increases much or little for a given rise in the price.” Expressed in more
accurate mathematical terms, price elasticity of demand is the ratio of proportionate change in
the quantity demanded of a commodity to a given proportionate change in its price.

Ep = Percentage change in demand ÷ Percentage change in price.

Here, due to the inverse relationship between price and quantity demanded, either the
numerator or the denominator will be negative. As such Ep will always be a negative quantity.
But because it is always negative, the minus sign is generally omitted.

TY PES OF PRI CE E LAS TI CI TY :

1) Per fec tly Ela st ic Dema nd : This refers to that situation where the slightest rise in
price causes the quantity demanded to fall to zero; and conversely the slightest fall in price
causes an infinite increase in the quantity demanded of the commodity. The demand thus is
hypersensitive and the elasticity of demand is infinity. This is an extreme case of elasticity which
is very rarely to be found in practice but is of great theoretical importance.
Ep = 5 ÷ 0 = ∞, Here, Ep = ∞.

Thus infinite elasticity of demand means that the firm can sell any number of commodity at the
ruling price, but if the price is increased by 1 paisa, the demand will come down to zero.

2) Per fec tly In ela sti c Dem an d: It refers to a situation where the demand is unaffected
even after a substantial change in price and therefore the elasticity of demand is said to be
zero. Ep = 0 ÷ 50 = 0, Here, Ep = 0.

3) Hig hly Elas tic Dem an d: Highly elastic demand is one where a small proportionate fall
in price leads to a sizeable proportionate increase in demand and vice versa.
Ep = 40 ÷ 20 = 2, Here, Ep > 1.

4) Ine la st ic De man d: Inelastic demand is one where a large proportionate fall in price is
followed by a small proportionate rise in demand and vice versa.
Ep = 5 ÷ 10 = 0.5, Here, Ep < 1.

5) Uni t Elas tic it y of Dema nd : This is the situation when proportionate change in price is
accompanied by an equal proportionate changein the quantity demanded.
Ep = 20 ÷ 20 = 1, Here, Ep = 1.

De te rm in an ts of Pr ic e Ela st ici ty of De man d: The responsiveness or the elasticity of

the demand for commodity will be more or less depending upon a wide variety of factors
influencing the elasticity of demand. These factors are:

i) Degree of Necessity, ii) The proportion of Consumer’s

Income spent on the commodity,

iii) Habits, iv) Existence of Substitute,

v) Number of Uses of the Commodity, vi) Durable Goods,

24
vii) Time, viii) Range of Prices.

MEA SUR EME NT OF E LAST IC ITY :

Measurement of elasticity is of managerial use, for a change in price affects the quantity
demanded; and in the event of any decision by the management about increasing or
decreasing the price, it has a telling effect on demand

There are three methods of measuring the elasticity of demand.

(i ) The Tot al Out la y/E xp en di tur e/ Rev en ue Met ho d: The total amount expended by
the consumer is the total outlay and which obviously is the revenue of the seller. In this
method the measurement of elasticity is based on the total outlay of the consumer. When the
change in price results in a fall in the total outlay, the elasticity is less than unity (i.e. inelastic
demand). Ma rsh al l says : “If the elasticity of demand is equal to unity for all the prices of a
commodity, any fall in the price will cause a proportionate increase in the amount bought. And
therefore, will make no change in the total outlay of the purchasers on the commodity.”

Ep > 1 : Total Outlay increases as a result of fall in Price & Total Outlay decreases as a result
of rise in Price. Indirect relation.

Ep < 1 : Total Outlay decreases as a result of fall in Price & Total Outlay increases as a result
of rise in Price. Direct relation.

(i i) Pro po rt io na l Me th od : This refers to poi nt elast ic ity . Under this method, the
percentage change in price is compared to the percentage change in the quantity demanded.
The formula is written as follows:

Pr ic e elast ic ity = Pro po rt io na te ch an ge in the amo un t de ma nd ed /

Pr op or ti on at e c ha ng e i n pr ic e

Alternatively, = (Change in demand Amount demanded) (Change in price Price)

(i ii) The Ge om etr ic Me th od : The elasticity of demand can also be worked out
geometrically.

CR OS S EL AST IC IT Y OF DEM AN D:

“Degree of responsiveness of demand for one good in response to the change in price of
another good represents the Cross elasticity of demand of one good to the other.”

25
If good ‘Y’ is a substitute for good ‘X’ then as a result of the fall in price of good ‘Y’ from OP1 to
OP2, the demand curve of good ’X’ will shift to the leftward & downwards, that is, the demand
for good ‘X’ will be decreased. This is because as the quantity of a good increases, the
marginal utility of its substitute good declines and therefore the entire marginal utility curve of
the substitute good shifts to the left.

If the good ‘X’ is instead of being substitute is a complement of good ‘Y’ , the resultant increase
in its quantity demand of good ‘Y’ due to fall in its price would have caused the increase in
demand for good ‘X’ and hence demand curve of good ‘X’ will shift to right. It should be noted
again that in the concept of cross elasticity of demand, while the price of one good changes,
there is a change in the quantity demanded of another good.

Co ef fi ci en t of Cr oss ela st ic ity of de man d of ‘X’ fo r ‘Y’ = (% ch an ge in qty .

de ma nd ed o f ‘X’) ÷( % c ha ng e i n p ric e o f go od ‘ Y’)

Cross elasticity can also be measured by another formula which is said to be mathematically
more rational:

QX 2 – QX1 PY2 – PY1 QX 2 = Rev ise d qua nt ity dem an de d of

go od ‘ X’, QX 1 = Or ig in al qu an ti ty de ma nd ed o f “X”

QX 2 + QX1 PY2 + PY1 PY2 = Re vi se d pri ce of

go od ‘ Y’, P Y1 = Or ig ina l pr ic e o f g oo d ‘Y’

Su bs ti tu te & C om ple me nt ary go ods :

Su bs ti tu te / Co mp et ing Goo ds: ↑ Pr ic e of on e go od : ↑ De ma nd of ot he r

go od

↓ Pri ce of one goo d : ↓ De man d of

ot he r g oo d

As such the re is DI RE CT re la ti on sh ip bet we en Pr ic e & Dema nd & hen ce “Ec

of t wo su bst it ut es g oo ds i s PO SI TI VE .”

Co mp lem en ta ry Goo ds: ↑ Pric e of one goo d : ↓ Dem an d of oth er

go od

↓ Pri ce of one goo d : ↑ De man d of

ot he r g oo d

As such the re is IN DI RE CT rel at ion sh ip bet we en Pr ic e & Dem an d & henc e

“Ec of t wo c om pl em en ta ry g oo ds i s NE GA TI VE. ”

26
PR OB LE D 1: If a price of coffee rises from Rs. 4.50 per hundredgram to Rs. 5.00 per
hundred grams and as a result consumer’s demand for tea increases from 60 hundred grams to
70 hundred grams, the calculate the Ec of tea for coffee?

PR OB LE M 2 : Because the price of Y increases from Rs. 10 to Rs. 12 per kg; the sales of
the firm producing commodity X rises to 220 Kg from 200 kg Find out the cross elasticity and
state relationship between X & Y commodities?

US ES OF C RO SS E LAST IC ITY OF DE MAN D:

Perfect substitutes and complementaries are very rarely found. But, broadly speaking, there is
complementarity or substitutability among several commodities. Under such circumstances,
the entrepreneur can judge the effect of his pricing policy on the quantities demanded of the
product of others and vice-versa on the basis of cross – elasticity of demand.

1. FOR MU LATING PR OP ER PRIC E ST RATEG Y: Multi product forms often

use this concept, e.g. Maruty Udyog produces Maruti 800, Maruti van, Maruti
Esteem. These products are good substitutes of each other and hence Ec of
demand between them is very high. If Maruti Udyog decides to lower price of Maruti
800, it will significantly affect demand for Maruti van and Maruti esteem. Therefore, it
will formulate a proper price strategy fixing appropriate price for its various products.
Further, example of Gillete Company – razors and razor blades, which are
complementaries with high Ec of demand.

2. DE CI DI NG BO UN DA RI ES OF IND US TR Y & in me as uri ng

int err el at io ns hi p bet we en indus tri es : An industry nis defined as a group of
firms producing similar products (i.e. products with a high positive cross elasticity of
demand. E.g. M-esteem, Daewoo Ceilo, Opel Astra). They belong to automobile
industry. Therefore, anyone can’t raise price without losing sales to other firms.

3. DE CI DI NG CA SES RE LATIN G TO ANT ITR US T LAWS AND

MO NOP OL IST IC P RA CT IC ES IN U. S. A. : in order to reduce competition then
one dominant firm or different firms try to merge with each other to form a cartel.
E.g. In 1995 Coca-Cola purchased the firm producing Thumps Up, Gold Spot, Limca
and made efforts to take over ‘Pure Drinks’ – producer of Campa – Cola but failed.

__ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ _
__ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ _

IN CO ME ELAST IC ITY : “In co me elas tic it y of dem an d sho ws th e de gr ee of

res po nsiv en ess of qua nt ity de man de d of a goo d to a sma ll cha ng e in th e
inco me o f c ons um ers. ”

Ei = ( % c ha ng e i n pu rch ases of go od ) ÷ ( % c ha ng e i n In co me of i nd ivi du al )

For mu la I :

For mu la II : Q2 – Q1 Y2 – Y1 Q2 = Re vis ed qua nt it y

de ma nd ed , Y2 = Re vis ed In co me ,
27
 Q2 + Q1 Y2 + Y1 Q1 = Or ig in al qu an ti ty
de ma nd ed , Y1 = Ori gi na l i nc om e.

PR OB LE M 1 : Income of an individual increases from Rs. 300 to Rs. 320 per week and as a
result the purchases of goods also increases from 25 units to 30 units per week. Calculate the
income elasticity of demand for a good?

PR OB LE M 2 : A consumer spends Rs. 60 per month on sugar when his income is Rs. 1500
per month. When his income increases to Rs. 1800 per month he spends Rs. 84 on sugar.
Whal will be income elasticity for sugar?

Type o f In co me elas ti ci ty o f de ma nd :

1. NEGA TI VE INC OM E EL AST IC IT Y: When there is inverse relationship between

Income & demand, the income elasticity is said to be negative. The demand for Inferior
type of goods is of this type.

2. ZERO IN CO ME ELAS TI CI TY : Change in income has no effect on quantity demanded.

E.g. demand for salt.

3. UNI T INCO ME ELAST IC ITY : Demand increases in the same proportion in income.
Unit elasticity of a demand is considered to be a dividing line between necessaries and
comforts. Hence Ei < 1 for Necessaries and Ei > 1 for Comforts.

4. LOW IN CO ME ELAS TI CI TY : Wh en Inc om e elas tic it y is pos it iv e i.e . gr ea ter

th an ze ro, bu t less tha n 1, we say inc om e elas tic it y is rel at iv ely less. It
su gg ests t ha t such co mm od it y m us t b e n ec essary on e.

5. HIG H IN CO ME EL AST IC IT Y: As opp os ed to ab ov e ca te gory , we ge t hig h

inco me el as tic it y of dema nd for pro duc ts wh ic h sa tis fy th e co nsu me rs
co mf orts and Lux uri es . The Inc om e ela st ici ty fo r dif fe re nt pr od ucts dife rs
wid el y: It te nd s to be very h ig h in resp ect of l ux ury goo ds e.g . gol d, j ew el ler y,
pr eci ous sto nes , pain tin gs cars etc. It als o te nd s to be very lo w in res pect of
co mm od it ies l ike sa lt , v an asp at i, ma tc hes , ke rose ne , w as hi ng so ap et c.

LU XU RY GOOD S: A goo d ha vi ng inc om e elast ic ity mo re th an one and whi ch

th er ef ore bu lks lar ger in cons um er ’s bu dg et as he bec om es ric her is ca lle d
Lu xur y. NEC ESS ARI ES : a goo d wi th an in co me ela st ici ty less tha n one and
wh ic h cla ims dec lin in g pr op ort io n of a co nsu mer ’s inco me as he beco me s
ri ch er i s c al le d a ne cess ity .

US ES OF I NC OM E EL AST IC IT Y OF DEM AND :

4. EC ONO MI C DEVEL OP ME NT: Whe n nat io na l inc om e ris es, we ca n

fi nd ou t how mu ch will be th e incre ase in dem an d for a gi ve n pr od uct
wit h E i o f de ma nd f or th at pr od uct . As suc h f ir ms pr od uci ng pr od ucts
of hig h Ei wil l gain mor e tha n pro po rt io na te ly to th e in cre ase in
na ti on al inco me . E.g. Lu xur ie s – dur in g boo m pe ri od , de ma nd
incr eases very mu ch , a nd de cl ine sh arp ly du ri ng rec essi on ary pr io d.
28
5. EC ONO MI C FL UC TU ATIO NS : Ec on om ic flu ct ua ti ons are
ch arac ter ist ic fe at ur es of cap it ali st eco no my . Phases of pros per ity &
de pr essi on alt er na te in such a eco no my . Th e conc ept of Ei of
de ma nd can be a very us ef ul gu ide to find out wh at pro duc ts wou ld
be dem an de d du ri ng pros per ity an d de pr essi on . Th e dem an d fo r
pr od uct wi th low Ei will no t be gre at ly affect ed by ec on om ic
fl uc tu at io ns (bo om s & recess io ns) e.g . nec essar ie s – du ri ng boo m
pe ri od the ir de ma nd will no t in cre ase mu ch an d du ri ng recess io n it
wil l no t de cre ase shar pl y. They are to a goo d ext en t rec essi on-
pr oo f. Of cours e to shar e th e ben ef it of in cre asi ng na ti on al inc om e,
fi rm s cu rre nt ly pro duc in g pro duc ts with low inc om e elas tic it y wo uld
try to en te r the ind us tri es , th e de ma nd for wh os e pro duc ts is hig hly
inco me e la st ic.

6. EC ONO MI C PLAN NI NG : The co nce pt of Ei of dem an d is of a gre at

he lp while pla nn ing for a eco no my as a who le . Pla nn ers ha ve to se t
ta rg ets of pr od uct io n in ter ms of phys ic al qua nt iti es for vari ous
sect ors of ec on om y. Plan ne rs can est im at e th e poss ib le incr ease in
de ma nd as a res ul t of th e ta rg et ed rat e of gro wt h of th e ec on om y.
Th is wo ul d ma ke ph ysic al t ar ge ts mor e r ea li st ic / a ccur ate .

7. DE MAN D FOR EC AST ING : Wi th the he lp of st at ist ic al inf or ma ti on

re gar di ng tr en ds in gr ow th of inc om e as wel l as the cha ng es of
distr ib ut ion of inco me , the fir m can fo rec ast the dem an d fo r its
pr od uct by u si ng i nc om e e las tic ity of d em an d as a gu id e.

8. FOR EI GN TRA DE : Cou nt ry nee ds to ta ke in to acco un t th e inc om e

elas ti ci ty of de ma nd for it s impo rts as well as exp orts. A co un try
ex por ti ng ag ri cu lt ur al pr od ucts an d art ic les of nec essi ty faces an
inco me – ine last ic de ma nd , co mp are d to a cou ntry ex por ti ng ar ti cl es
of lux ury . For ex am pl e, In dia has bee n an exp ort er of jute , te a,
co ffe e an d spic es; but th e de man d fo r all th es e pr od ucts is in co me
ine la st ic. The rat e of gr ow th of ex por ts th er efo re ha s re ma in ed
re la ti ve ly low. As aga in st th is In dia ’s de ma nd for imp or ts like
elec tro ni cs, mac hi ner y, consu me r du ra bl es et c. is inco me el as tic .
Co ns eq ue nt ly , the ra te of gro wt h of Ind ia’ s impo rts ha s re ma ine d
hig h. Thus we hav e bee n fac in g pr ob le m of an incre asi ng tr ad e
de fi ci t in Ind ia du ri ng last few ye ars. Th e inc om e ela sti ci ty co nce pt
is als o us ef ul i n pu blic f ina nc e, l abo r p oli cy , i nd us tri al p oli cy e tc.

29
 Ma na ge ri al Us es of Ela st ici ty: Elasticity is of enormous help to the management when
pricing decisions are taken. For example, if product is very highly differentiated and if there are
no close substitutes, elasticity will be less than unity. The firm may then increase its price.
When the product is an essential one, it may play only on elasticity and not bother about the
repercussions of demand. There are, of course, limits to this. One cannot charge exorbitant
price; but, within reasonable limits, the firm can maximize its revenue.

Sa les Po te nt ial : The elasticity of demand exerts its influence on sales. The reference here
is not to an individual, for reduction in price may not induce all the individuals to purchase more.
A reduction in price of some products like radio set may bring in new buyers. Therefore, price
reduction will have telling effect on the market as a whole.

Su bs ti tu tes an d Co mp lem en ta ri es : When a firm is manufacturing substitutes, it may

make use of the concept of arc elasticity. In the managerial decisions in respect of products
which are substitutes and complementaries, the arc elasticity is an important and useful tool.

Co ns um er G oo ds a nd P ro duc er G oo ds:

Commodities are generally divided into two categories, namely producer goods and consumer
goods. Producer goods are those goods which are generally purchased by producers in order
to manufacture some consumer goods. Producer goods re not meant for final consumption,
while consumption goods re those goods which are consumed finally by consumers. A
Forecast of the demand for producer goods is more complicated than that of the demand for
consumer goods, for the following three distinct reasons:

i) The buyers of producer goods re professionals and experienced. Therefore, price-wise,

they are sensitive to substitutes.

ii) The attitudes and motives of the buyers of producer goods are purely economical because
the products are bought by them with a view to making profits.

iii) The demand for producer goods is a derived demand from the consumer goods.
Therefore, the demand for them is directly related to demand for consumer goods. It has
been pointed out that the demand for consumer goods depends upon several factors,
which have already been discussed. In any forecast for the demand for producer goods,
these factors have to be constantly kept in mind with a view to ensuring the precision and
accuracy of any analysis of demand forecast.

De ri ve d De man d an d Au to no mous De man d:

If the demand for a product is directly related to the purchase of some parent product, it is
known as derived demand. Sometimes a dependent product may be a component in the
production or completion of another item. The demand for all the producer goods, raw materials
and components or machines, for example, is a derived one. However, this definition of derived
/ autonomous demand is purely arbitrary. It may be pointed out here that a derived demand has
30
less price elasticity than an autonomous demand when other substitutes are equally available.
E.g. a cut of twenty percent in the price of, say steel would lower the cost of a car by only about
five percent.

However some products are so closely related to others tn their use that there is no distinction
among demand determinants. E.g. a television set. Antennas will be purchased for each unit.
The demand for antennas, therefore, depends directly upon the demand for television units.
Here, the television is the parent product and the antenna is derived one.

If the variability in the proportions and the increase in the number of uses is evident, it would be
difficult to tie up the demand to the parent product. e.g. small electric motors have no other
primary uses; but if we try to analyse the demand for them in terms of their many alternative
uses, the task become tedious.

MAR KET ST RU CT UR E:

The demand analysis is no doubt very useful exercise in the study of a individual seller’s
demand. However, the relation of company’s sales to its price derives from the industries
demand schedule. But the relationships widely differ, depending upon the structure of an
industry. The important aspects of this structure are:

(a) Th e n um be r o f se ll ers ;

(b) Th e e xt en t of p ro duc t d if fe re nt ia ti on .

This can be well illustrated with different combinations of above two aspects as under:

i) Mo no po ly fi rm : There is only one seller and the product is unique. The

company demand curve and the industry demand curve will be identical. Now, the
seller’s price, i.e. the quantity relationship, is quite definite; but, in practice,
substitution competition is so prevalent that any product which closely resembles
the monopoly product would pose many great problems.

ii) Ol ig op oly sit ua ti on : There are very few sellers. There can be a situation in
oligopoly in which products are homogeneous; for example, aluminium, steel etc.
Now, in a competitive context, business can be easily snatched away by rivals. In
this situation, the demand curve of the company is very uncertain, for it depends
very much on the actions of the rivals. If the price cut is ordered by a firm, it will
have to face a chain of reactionary repercussions, which are indistinguishable from
a price war.

iii) Dif fer en ti at ed pr od ucts in co nd it ions of Oli go po ly: The sellers are very
few but the products are differentiated. When the products of rival firms differ
radically in their physical form, the demand for the product which is acceptable to
consumers would be better. E.g. ECTV television. In this situation the product is
preferred by the consumer and is also differentiated from other similar products,
with the result that the demand for it is stable and secure. Consumers are

31
 attracted by the superiority of the product or its relative efficiency, and therefore, do
not bother abut its high price.

iv) Pr od uct is st an dar di ze d an d se lle rs are many: The competition is so

stiff that the industry demand is completely different from that of the individual
seller’s demand curve. The individual seller has to accept the market price; and,
moreover, he cannot alter the price.

v) Pr od ucts ar e differe nt ia te d an d the re ar e many sel le rs: Here, the

demand curve in the industry has very little meaning; the differentiation is so
pronounced that an individual seller’s demand function is like that of a single
monopolist in the sense that no firm will worry about the effect of an alteration in
prices.

DEMAND FORECASTING

Forecasting means to know the trend or behaviour after a period of time. This
trend or behaviour can be increasing or decreasing one. Demand always
refers to sales. Therefore, when we say future demand, we mean future
sales.

Demand is a function of sales: D=fS

ΔD = ΔS … We are saying that a marginal increasein demand is equal to

marginal increase in Sales.

D = S … is a static, and

ΔD = ΔS … is dynamic.

But sales, that is governed by certain factors. Hence we can say S = f S. that
is sales is a function of factors. Therefore, the factors affecting the sales or
demand will have to be carefully studied. These factors are,

1. Inflation Rate, 2. Interest Rates,

3. Consumer spending, 4. Business

Investment,

5. Government Budget and, 6. Imports /

Exports.

1) Inflation Rate: Mild rate of inflation gives rise to a mild increase in

prices. This gives encouragement to businessmen to produce more.
32
 Business climate looks rosy. However, when inflation rate increases
purchasing power falls which produce discouraging results. During
deflation prices tend to fall. Demand falls. Recession sets in.
Production falls. The business climate will be pessimistic.

2) Interest Rates: An increase in the rate of interest discourages the

business investments and business climate looks pessimistic and dull.
And when the interest rates reduced businessmen can borrow more
money for business investment.

3) Consumer spending: if consumer spending is on a higher side,

naturally demand looks up and vice-versa.

4) Business investment: If business investment in economy is

experiencing a boom, then the demand outlook will be better and when
it is dull then demand will be on the lower side.

5) Government Budget: The Government budget of every year will have

a telling effect on the business climate and hence demand. If the
budget resorts to a heavy dose of direct and indirect taxes then prices
shoot-up and demand falls.

6) Import / Export: Heavy imports compel the domestic producers to cut

down the production and consequently demand falls. The restrictions
on imports encourage domestic producers and as a result the demand
increases. Similar is the case with the exports.

In addition to the above, we are aware of the implicit & explicit factors which
influence the purchase of any commodity and hence demand. They are:

FACTORS

IMPLICIT EXPLICIT

Desire to purchase Price

Need to purchase Population

Ability to pay Income

Willing to purchase Inflation

Business climate

IMPORTANCE & NEED OF DEMAND FORECASTING:

33
 1. To make plans for future levels of production: Future is unknown
and uncertain. However, managers have to make plans for future
levels of production in the present. It always takes time for building up
productive capacity to produce a product. Machines have to be
ordered and installed, the required skilled labour has to e employed
and trained, funds have to be arranged to fund production. If the future
demand for the product is not known in advance proper planning for
future production cannot be done. To reduce this uncertainty in
planning for future production levels, demand forecasting is essential.
Good forecasting of demand reduces uncertainty of environment in
which business decisions are made.

2. To calculate the rate of return of capital investment: Capital

investment yields returns over a number of years in future. The
decision regarding the investment is taken by comparing the rate of
return on capital investment with the current rate of interest.

3. To plan for corrective measures to improve the demand: If the

demand forecast of a firm reveals that the demand for its product is not
enough it can think of increasing expenditure on advertisement,
pursue other strategies such as properly adjusting its price policy or
model of its product.

4. In deciding the launch of a new product or in planning to enter an

industry: Demand forecast are needed not only by established firms
but also by the new firms who are planning to enter an industry.
Inadequate demand forecast for the product will prevent the entry of
firms in the industry. Further established firms may be interested in
predicting demand for a new product which they will be launching.

It is evident from the above that demand forecast plays an important role
in planning for future level of production,

--for launching a new product,

--for expanding production capacity (i.e. making further capital

investment),

--for entering an industry.

This helps a manager to acquire the needed plant and capital equipment,
the quantity of required raw materials, the necessary skilled labour and
other type of human resources. Therefore, forecast of demand greatly
helps in business decisions by reducing uncertainty under which firm
operates.

Types of Demand Forecasts:

34
i) Short-term demand forecasts are usually made for period up to one
year such as for a month, a quarter or a whole year. Short-term demand
forecasts are made in order to know the effect of present policies of the firm
relating to relative price, advertising outlay, product model etc. on the
demand for the product and also due to changes in government’s fiscal and
monetary policies. For a short-term demand forecast, it can be reasonably
expected that the present demand will continue in the short run too or it will
increase by a certain given proportion. For the short-term demand forecast,
opinion of the experienced and well-informed managers can play an
important role. Short-term forecasts of demand are made for the established
products of the firms.

ii) Long-term demand forecasts relate to those forecasts which are made
for a period of more than a year; it may even be fice, ten or even twenty
years. Long-term forecasts of demand are usually made when a new
product has to be launched. More sophisticated techniques such as
econometric or statistical methods are used to make long-term forecast. In
order to estimate good returns from capital investment relatively more
accurate demand forecasts are needed which should be made by using
statistical methods.

The demand forecast for a product may be in respect of,

i) Aggregate demand, that is, total demand for output in the economy at a
future time. It is usually measured by the level of gross national product
(GNP).

II) Total demand for the product of an industry. It usually depends on

the levels of overall economic activity or the performance of some major
sectors of the economy.

III) The demand for the product of an individual firm. It depends on

industry’s demand forecast or its sales estimates. Generally, an individual
firm estimates its future demand by considering industry’s demand forecast
(i.e. its sales forecast) and its expected market share.

METHODS OF DEMAND FORECASTING:

There are several methods which can be used to forecast future demand for
the products. The following are some of the important alternative techniques
used for forecasting demand:

1. Consumer Survey Method.

2. Expert Opinion.
3. Market Experiments.
4. Time Series Analysis.
5. Economic Method.

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1. Consumer Survey Method: This is the direct method to get the
information abut future demand for goods. Surveys are important
techniques for short-term forecasts. If the data from existing sources are
not available, the firm conducts their own survey. The survey method is
used when a firm is planning to introduce a new product or making
substantial changes in the existing product. Surveys generally involve use of
conducting consumer interviews or sending mailed questionnaire asking
consumers about their intentions or plans about demand for goods.
Consumers usually plan their spending on such goods as refrigerator, CTV,
cars, housing in advance. As such survey indicates intentions of consumers
about their future spending on consumer goods.

There are two types of surveys (1) Completer Enumeration and (2)
Sample Survey.

i) Complete Enumeration: Just like population census in this all existing

buyers and prospective buyers of a product are asked questions about
quantity of product they plan to buy in future at a given price. With the
information so gathered regarding intentions of all consumers to buy a
commodity, total demand for the product and changes in it resulting from
changes in price can be estimated. The chief merit of this method is that it is
free from any bias or value judgment of the investigator. The investigator
simply records the data. But it is very costly, tedious and cumbersome
process. Therefore, it cannot be applied when a large number of consumers
are involved.

ii) Sample Survey Method: Though technique of complete enumeration

method provides useful data, it is highly expensive and time consuming.
Therefore, an alternative method of consumer survey, namely, Sample
Survey is adopted. In this method, only a few consumers are selected at
random or on a stratified basis. Through personal interviews or mailed
questionnaire, questions are asked about their intended demand and their
response to changes in price, their incomes, and prices of related products.
The data so collected is classified and tabulated for analysis of consumer’s
demand. Thus, the total demand of a sample of consumers is divided by the
size of sample to arrive at the average demand of a consumer in the sample
and then this average is multiplied by the total number of consumers.

This method is less costly and less cumbersome and involves less data
error. But for getting accurate results, the choice of a sample is very critical.
Therefore, for getting correct results, sample size should be sufficiently large
to be a true representative of the population and further it should be selected
at a random so that it is free from bias.

Limitations: This method is of great help when the producer and the
consumer come into direct contact or where the major share in one’s market
demand is that of a handful of big customers. However, a firm dealing with
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individual consumers cannot depend upon this method because of following
limitations: i) The buyers / respondents may not give correct answers or
what they tell us is their desire and not their plan of purchase. Ii) The
buyers, many times, are not able to tell even broadly how much of a product
they are likely to demand in future. Iii) This method proves to be very costly
where the number of buyers is very large.

2) Expert Opinion Method:

An alternative method of demand forecasting is to obtain views of specialists

who are well-informed about the market possibilities of a product. These
experts may be executives & sales managers of the firm. There may be
outside experts such as consultant firms, investment analysts who are
professionally trained for the purpose of forecasting demand.

i) Expert Panel Method:

Although predictions of demand by experts are not always based on any

hard data but they can provide useful information about demand. There are
various methods of confirming the opinion of experts. One such method is
Delphi technique which is explained below:

Delphi Technique: First the opinion of a number of experts about future

demand is obtained. Then, each expert is told about the prediction o the
other experts and asked in the light of the other’s views whether he would
revise his prediction about future demand. The experts are again shown
each other’s revised forecasts and asked to reconsider their forecasts further
till a consensus is reached or until referring the opinion of others again to the
experts results in little or no change in demand forecasts.

Evidence form the USA shows that Delphi technique is widely used as it is
relatively less expensive. However, the usefulness of expert opinion
depends on the skill and insight of the experts. This method is also not free
from problems. Quite often outside experts charge heavy fees and those
who consider themselves experts may not like to be influenced by the
predictions of others on a panel of experts. As a result, there may not be any
revision in subsequent rounds.

ii) Survey of Sales Force:

When it is very costly or otherwise not possible to conduct survey or seek

expert opinion, a firm may enquire from its sales-representatives of
salesmen about their estimates of sales in future. Thus, in this method
information regarding likely sales is obtained from those who are closest to
the market and have an intimate insight of the market. The responses of
various salesmen are then aggregated to arrive at a total demand forecast
for the product.

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This method is cheap & easy to do. It has further advantage of increasing
the motivation of salesmen to achieve the self-selected target for which they
had made a forecast when they were asked to provide their prediction for
future sales. This method also suffers from certain limitations. First,
salesmen may not provide correct forecast. Some salesmen would like to
impress the management and their predictions may be too optimistic. On
the other hand, some salesmen would make too pessimistic sales forecast
so that they get higher payments for exceeding the targets based on their
forecast. However, as a result of experience some corrective factors are
applied to sales estimates furnished by salesmen before aggregating them
to arrive at a total demand forecast for the product.

3) Market Experiments:

This method is used when a business firm when they make changes in price,
advertising expenditure, or want to introduce a new product in the market. In
the survey method consumers do not necessarily behave in the way they say
when surveyed. This problem can be partly overcome by the use of market
experiments. The two types of market experiments are generally used : i)
Test Marketing and ii) Controlled Experiments.

i) Test Marketing: First step is to select a particular test area which

accurately represents the whole market in which the new product is to be
launched. The test area may consist of several cities and towns, or a
particular representative region of the country or a sample of consumers
taken from a mailing list. By introducing a new product in the test market
consumer’s response about it can e judged. By choosing more than one test
area, the firm can assess the effects on demand of the various alternative
marketing strategies like change in price, advertising, packaging, product
model etc. In this way consumer’s response to changes in price, advertising
or product model can be known.

Market experiments are based on actual consumer behaviour and not on

merely their intentions to buy the commodity as in the consumer survey
method. However, test marketing has some limitations. They are very costly
and much time consuming. When price is increased the consumers may
switch over to the products of the rival firms. Once the experiment is over
and price is reduced to the original level it may e difficult to regain the lost
customers. It is often difficult to select an area which accurately represents
the potential market. The firm cannot control all the factors that influence
demand for a product. Lastly, because most test experiments last only for a
short period, the changes in price or advertising to know consumer’s
response may go unnoticed by them in such a short period.

ii) Controlled Experiments: Controlled experiments are conducted to test

the demand for a new product by a firm or to test the demands for various
brands of a product. In this method, a sample of some consumers of a
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product which are representative of the target market is selected. They are
asked to visit a shopping store of a firm and they are asked which and how
much of each brand they would buy at different prices. Their preferences
are recorded. The price of the product or its model may be changed and the
experiment is repeated.

The merit of controlled experiments is that they are likely to provide more
accurate results than those of consumer survey. As a limitation, the
controlled experiments may be biased in the process of selection of a
sample of consumers. The selected consumers may not respond accurately
when they know that they are a part of an experiment being conducted and
their behaviour is being recorded. Therefore, the technique of controlled
experiment is generally adopted as a supplement to statistical technique of
forecasting demand.

FIRM AND TYPES OF FIRMS

Firm: In managerial economics, a firm occupies athe central position,

because the managerial decisions are taken at the level of the firm.
Traditionally firm refers to a ‘manufacturing unit’. Economic literature
refers to ‘any business unit including an agricultural one.

Meaning of a firm:

“The firm may be defined as an independently administered business

unit.” –by Hanson.

“The firm is defined as the unit that uses factors of production to produce commodities that
it then sells either to other firms, to households or to central authorities (Government,
public agencies etc.). The firm is thus the unit that makes the decisions regarding the
employment of factors of production and the output of commodities.” -by Prof.
Lipsey.

“A firm is a business unit which hires productive resources for the purpose of producing
goods and services.”

Firm is a centre where decisions regarding-

-What,Where, How & How much to produce,

-Distribution, Advertising, Sales & those regarding facing competition, are taken.

The Firm & Industry : “All firms producing a given product, together make an industry.”
39
 Nature of comkpetitive industry_ a) Large number of firms are available. B) The productis
homogeneous, c) There is a freedom of entry in an industry.

The Firm & Plant: A plant is a technical unit of a given capacity of output, e.g. Sugar plant.
A sugar factory (a firm engaged in production of sugar) may have Sugar plant, Alcohol
plant, Cattle-feed plant etc.

TY PES OF FI RM / BUS IN ESS O RGA NI SATIO NS :

1. Proprietary, 2. Partnership, 3. Joint Stock

Company,

4. Co-operative Society, 5. Public Sector Undertaking.

1) PROPRIETARY:

The organizer of the ‘one-man’ concern, invests his own capital, initiates,
organizes and directs all economic activities and takes the entire risks,
e.g. Sole producers, traders, professional like doctors, pleaders, CAs,
artisans etc.

Advantages of Proprietary firm:

Advantages of Proprietary firm Disadvantages of Proprietary firm

* Maximum efficiency, Prudent * No certainty of existence,

Management,
* Limited capital
* Personal relations with
customers & employees. * Limited managerial ability.

* Prevention of economic
concentration.

Profit motivation, Secrecy of

business,

Flexibility in operation

Easy formation, Self-employment.

2. PARTNERSHIP FIRM:

Definition as per section 4 of Indian Partnership Act- “ Partnership is the

relationship between the persons who have agreed to share prodit of
business carried on by all or any of them acting for all. Owners of the
partnership are individually known as ‘partners’ and collectively a ‘firm’

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 and the name under which business is carried on is referred to as ‘firm-
name.”

Characteristics:

i) Minimum number of prsons required to form a partnership firm is two nd

maximum number is 10 for banking business and 20 for other.

ii) Contract- the relationship between partners is that of contractual

nature.

iii) Partnership in business- Partners must actually start and engage

in business venture (any trade, occupation, profession) rather
than their combination for holding some property in joint
ownership.

iv) Profit sharing- Objective is to make & share a profits and not
charitable one.

v) Common management- Each partner is both an agent and

Principe for himself & others. Every partner has the right of
management and it can’t be taken away by restrictive agreement.

vi) Other features- Joint & several liabilities, general agency is

partnership, restriction on transfer of interest, mutual confidence
and trust and easy dissolution.

Advantages of Partnership firm Disadvantages of Partnership firm

* Close re la tio ns w ith cus to me rs, * Business instability, Unlimited liability,

* Simp le fo rm at io n, La rg e cap it al * Business interest can be transferred with

bas e, the consent of other partners only,

* Bet ter mana ge me nt , Pers on al * Lack f confidence of public as there is no

inte rest ,
* Fle xi bi lity in ope ra ti on , Spr ea di ng
the r isk,
* P ro tec ti on o f m ino ri ty in te res t
* U nli mit ed l iab ilit y,
binding to publish accounts & business
affairs.
* Inadequacy of capital- limit on number of
partners limits the capital amount.
* Lack of harmony, No separate legal
existence.

C) JOINT-STOCK COMPANY:

This is considered to be the best form modern industries in the evolution of different
forms of ownerships. It is popular in private sectors and commercial organizations. It
originated in England after the industrial revolution when production became capital

41
intensive. In this form of organization, the financial resources of large number of
persons are pooled together. East India Company brought this form in India.

Definition by Prof. Haney : “A company is voluntary association of individuals for

profit having a capital divided into transferable shares, the ownership of which is the
condition of membership.”

Features : i) Legal entity, ii) Limited liability, iii) Share capital, iv) Transferability
of shares, v) Common seal, vi) Continuity of life.

RManagement: Legal liability of shareholders is limited to the face-vaalue of shares

that they possess. Board of directors decide the policy and also keep directsupervision
on working of company through salaried managers who have a direct control.

Advantages of Joiont-Stock Disadvantages of Joint Stock

Company Company

* Opportunity to people of small * Lack of efficiency,

means
*No effective control over Board of
* Vaast amount of capital is possible, Directors , Managers,

* Democratic pattern of working, *Increase in disputes,

* Continuity of life, *Speculation,

* Opportunity for Good *Exploitation – since ownership is

Entrepreneurs, separated from control,

* Spreading of risks & losses, *Lack of initiative and responsibility,

*Potentiality of Growth, Effective *Unfair monopoly practices,

management.
*Minority neglected,
*Public confidence, Transferability of
shares, *Economic concentration.

*Correlation between risks & returns,

*Tax concessions, Social contribution,

D) A CO-OPERATIVE SOCIETY:

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This is an alternative to the Joint Stock Company for avoiding defects of Joint
Stock Company.

Definition: “A form of organization wherein persons voluntarily associate

together as human beings on a basis of equality for the economic interest of
themselves.”

Features:

FEATURES –“CO-OPERATIVE
SOCIETY”

*Voluntary Association, *Abolition of parasites,

*Each for all & all for each – Service & *Cash trading,
not self –interest is prime motive,
*Registration unde Co-operative
*Avoidance of competition, One man Societies act, Income-tax, stamp duty
one vote, exemption,

*Membership is open to all, *Elected management,

*All surplus is not distributed- 20% *Self-dependence – is important goal,

retained,

*Moral aspect, mutual confidence,

ideal common tendency to help each
other, liberal thinking

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