Managerial Economics An

Insight

Index
Chapter 1 Basics of Managerial Economics
3 - 14
Chapter 2

Demand, Supply and Market Equilibrium

Chapter 3

Production and Cost Analysis

21 - 23

Chapter 4
26

Market Structures

Questions
27

15 - 20

24

Chapter 1 Basics of Managerial Economics

Economics is a social science. Its basic function is to study how people
individuals, households, firms and nations maximize their gains from their limited
or scarce resources and opportunities.
Micro Economics - Microeconomics looks at the smaller picture of the economy
and is the study of the behavior of small economic units.
Macro Economics It is the branch of economic analysis that deals with the study
of aggregates.
Microeconomics deals with the firms level and takes into consideration the decision
making power of individual units whereas macroeconomics deals with the economy
level and takes into consideration the impact of government policies on the
aggregates like national income and employment.
Managerial Economics
Managerial Economics and Business economics are the two terms, which, at times
have been used interchangeably. Of late, however, the term Managerial Economics
has become more popular and seems to displace progressively the term Business
Economics.

The prime function of a management executive in a business organization is

decision making and forward planning. Decision Making means the process of
selecting one action from two or more alternative courses of action whereas forward
planning means establishing plans for the future. The question of choice arises
because resources such as capital, land, labour and management are limited and
can be employed in alternative uses. The decision making function thus becomes
one of making choices or decisions that will provide the most efficient means of
attaining a desired end, say, profit maximization. Once decision is made about the
particular goal to be achieved, plans as to production, pricing, capital, raw
materials, labour, etc., are prepared. Forward planning thus goes hand in hand with
decision making.
A significant characteristic of the conditions, in which business organizations work
and take decisions, is uncertainty. And this fact of uncertainty not only makes the
function of decision making and forward planning complicated but adds a different
dimension to it. If knowledge of the future were perfect, plans could be formulated
without error and hence without any need for subsequent revision. In the real world,
however, the business manager rarely has complete information and the estimates
about future predicted as best as possible. As plans are implemented over time,
more facts become known so that in their light, plans may have to be revised, and a
different course of action adopted. Managers are thus engaged in a continuous
process of decision making through an uncertain future and the overall problem
confronting them is one of adjusting to uncertainty.
In fulfilling the function of decision making in an uncertainty framework, economic
theory can be pressed into service with considerable advantage. Economic theory
deals with a number of concepts and principles relating, for example, to profit,
demand, cost, pricing production, competition, business cycles, national income,
etc., which aided by allied disciplines like Accounting. Statistics and Mathematics
can be used to solve or at least throw some light upon the problems of business
management. The way economic analysis can be used towards solving business
problems. Constitutes the subject matter of Managerial Economics.
4

Definition of Managerial Economics

According to McNair and Meriam, "Managerial Economics consists of the use of
economic modes of thought to analyse business situation."
Spencer and Siegelman have defined Managerial Economics as "The integration
of economic theory with business practice for the purpose of facilitating decision
making and forward planning by management."
We may, therefore define Managerial Economics as the discipline which deals with
the application of economic theory to business management. Managerial Economics
thus lies on the borderline between economics and business management and
serves as a bridge between economics and business management.

Chart 1 Economics, Business Management and Managerial Economics.

Application of Economics to Business Management

The application of economics to business management or the integration of
economic theory with business practice, as Spencer and Siegelman have put it, has
the following aspects :1.

Reconciling traditional theoretical concepts of economics in relation to the

actual business behavior and conditions. In economic theory, the technique of
analysis is one of model building whereby certain assumptions are made and on
that basis, conclusions as to the behavior of the firms are drown. The assumptions,
however, make the theory of the firm unrealistic since it fails to provide a
satisfactory explanation of that what the firms actually do. Hence the need to
reconcile the theoretical principles based on simplified assumptions with actual
business practice and develops appropriate extensions and reformulation of
economic theory, if necessary.

2.

Estimating economic relationships, viz., measurement of various types of

elasticities of demand such as price elasticity, income elasticity, cross-elasticity,
promotional elasticity, cost-output relationships, etc. The estimates of these
economic relationships are to be used for purposes of forecasting.

3.

Predicting relevant economic quantities, eg., profit, demand, production,

costs, pricing, capital, etc., in numerical terms together with their probabilities. As
the business manager has to work in an environment of uncertainty, future is to be
predicted so that in the light of the predicted estimates, decision making and
forward planning may be possible.

4.

Using economic quantities in decision making and forward planning, that is,
formulating business policies and, on that basis, establishing business plans for
the future pertaining to profit, prices, costs, capital, etc. The nature of economic
forecasting is such that it indicates the degree of probability of various possible
outcomes, i.e. losses or gains as a result of following each one of the strategies
available. Hence, before a business manager there exists a quantified picture
indicating the number o courses open, their possible outcomes and the quantified
probability of each outcome. Keeping this picture in view, he decides about the
strategy to be chosen.

5.

Understanding significant external forces constituting the environment in

which the business is operating and to which it must adjust, e.g., business cycles,
fluctuations in national income and government policies pertaining to public
finance, fiscal policy and taxation, international economics and foreign trade,
monetary economics, labour relations, anti-monopoly measures, industrial
licensing, price controls, etc. The business manager has to appraise the relevance
and impact of these external forces in relation to the particular business unit and
its business policies.
Characteristics of Managerial Economics
6

It would be useful to point out certain chief characteristics of Managerial Economics,

in as much its they throw further light on the nature of the subject matter and help
in a clearer understanding thereof.
1.

Managerial Economics is micro-economic in character.

2.

Managerial Economics largely uses that body of economic concepts and

principles, which is known as 'Theory of the firm' or 'Economics of the firm'. In
addition, it also seeks to apply Profit Theory, which forms part of Distribution
Theories in Economics.

3.

Managerial Economics is pragmatic. It avoids difficult abstract issues of

economic theory but involves complications ignored in economic theory to face
the overall situation in which decisions are made. Economic theory appropriately
ignores the variety of backgrounds and training found in individual firms but
Managerial Economics considers the particular environment of decision making.

4.

Managerial Economics belongs to normative economics rather than positive

economics (also sometimes known as Descriptive Economics). In other words, it is
prescriptive rather than descriptive. The main body of economic theory confines
itself to descriptive hypothesis, attempting to generalize about the relations
among different variables without judgment about what is desirable or
undesirable. For instance, the law of demand states that as price increases.
Demand goes down or vice-versa but this statement does not tell whether the
outcome is good or bad. Managerial Economics, however, is concerned with what
decisions ought to be made and hence involves value judgments.

Production and Supply

Production analysis is narrower in scope than cost analysis. Production analysis
frequently proceeds in physical terms while cost analysis proceeds in monetary
terms. Production analysis mainly deals with different production functions and their
managerial uses.
Supply analysis deals with various aspects of supply of a commodity. Certain
important aspects of supply analysis are supply schedule, curves and function, law
of supply and its limitations. Elasticity of supply and Factors influencing supply.
Pricing Decisions, Policies and Practices
Pricing is a very important area of Managerial Economics. In fact, price is the life
blood of the revenue of a firm and as such the success of a business firm largely
depends on the correctness of the prices decisions taken by it. The important
aspects dealt with under this area are :- Price Determination in various Market
Forms, Pricing methods, Differential Pricing, Product-line Pricing and Price
Forecasting.

Profit Management
Business firms are generally organized for the purpose of making profits and, in long
run, profits provide the chief measure of success. In this connection, an important
point worth considering is the element of uncertainty exiting about profits because
of variations in costs and revenues which, in turn, are caused by torso both internal
and external to the firm. If knowledge about the future were fact, profit analysis
would have been a very easy task. However, in a world of certainty, expectations
are not always realized so that profit planning and measurement constitute the
difficult are of Managerial Economics. The important acts covered under this area
are :- Nature and Measurement of Profit, Profit Testing and Techniques of Profit
Planning like Break-Even Analysis.
Capital Management
Of the various types and classes of business problems, the most complex and able
some for the business manager are likely to be those relating to the firms
investments. Relatively large sums are involved, and the problems are so complex
that their disposal not only requires considerable time and labour but is a term for
top-level decision. Briefly, capital management implies planning and trolls of capital
expenditure. The main topics dealt with are :- Cost of Capital, Rate return and
Selection of Project.
The various aspects outlined above represent the major uncertainties which a ness
firm has to reckon with, viz., demand uncertainty, cost uncertainty, price certainty,
profit uncertainty, and capital uncertainty. We can, therefore, conclude the subject
matter of Managerial Economic consists of applying economic cripples and concepts
towards adjusting with various uncertainties faced by a ness firm.
Managerial Economics and Other Subjects
Yet another useful method of throwing light upon the nature and scope of
Managerial Economics is to examine its relationship with other subjects. In this
connection, Economics, Statistics, Mathematics and Accounting deserve special
mention.
Managerial Economics and Economics
Managerial Economics has been described as economics applied to decision
making. It may be viewed as a special branch of economics bridging the gulf
between pure economic theory and managerial practice.
Economics has two main divisions :- (i) Microeconomics and (ii) Macroeconomics.
Microeconomics has been defined as that branch of economics where the unit of
study is an individual or a firm. Macroeconomics, on the other hand, is aggregate in
character and has the entire economy as a unit of study.

Microeconomics, also known as price theory (or Marshallian economics) is the main
source of concepts and analytical tools for managerial economics. To illustrate
various micro-economic concepts such as elasticity of demand, marginal cost, the
short and the long runs, various market forms, etc., all are of great significance to
managerial economics. The chief contribution of macroeconomics is in the area of
forecasting. The modern theory of income and employment has direct implications
for forecasting general business conditions. As the prospects of an individual firm
often depend greatly on general business conditions, individual firm forecasts
depend on general business forecasts.
A survey in the has shown that business economists have found the following
economic concepts quite useful and of frequent application :1.

Price elasticity of demand,

2.

Income elasticity of demand,

3.

Opportunity cost,

4.

The multiplier,

5.

Propensity to consume,

6.

Marginal revenue product,

7.

Speculative motive,

8.

Production function,

9.

Balanced growth, and

10.

Liquidity preference.

Business economics have also found the following main areas of economics as
useful in their work :1.

Demand theory,

2.

Theory of the firm-price, output and investment decisions,

3.

Business financing,

4.

Public finance and fiscal policy,

5.

Money and banking,

6.

National income and social accounting,

7.

Theory of international trade, and

8.

Economics of developing countries.

Managerial Economics and Management Accounting

Managerial Economics is also closely related to accounting, which is concerned with
recording the financial operations of a business firm. Indeed, accounting information
is one of the principal sources of data required by a managerial economist for his
decision making purpose. For instance, the profit and loss statement of a firm tells
how well the firm has done and the information it contains can be used by
managerial economist to throw significant light on the future course of action whether it should improve or close down. Of course, accounting data call for careful
interpretation. Recasting and adjustment before they can be used safely and
effectively.
It is in this context that the growing link between management accounting and
managerial economics deserves special mention. The main task of management
accounting is now seen as being to provide the sort of data which managers need if
they are to apply the ideas of managerial economics to solve business problems
correctly; the accounting data are also to be provided in a form so as to fit easily
into the concepts and analysis of managerial economics.
Uses of Managerial Economics
Managerial economics accomplishes several objectives.
First, it presents those aspects of traditional economics, which are relevant for
business decision making it real life. For the purpose, it calls from economic theory
the concepts, principles and techniques of analysis which have a bearing on the
decision making process. These are, if necessary, adapted or modified with a view
to enable the manager take better decisions. Thus, managerial economics
accomplishes the objective of building suitable tool kit from traditional economics.
Secondly, it also incorporates useful ideas from other disciplines such a psychology,
sociology, etc., if they are found relevant for decision making. In fact managerial
economics takes the aid of other academic disciplines having a bearing upon the
business decisions of a manager in view of the carious explicit and implicit
constraints subject to which resource allocation is to be optimized.
Thirdly, managerial economics helps in reaching a variety of business decisions.
1.

What products and services should be produced?

2.

What inputs and production techniques should be used?

3.

How much output should be produced and at what prices it should be sold?

4.

What are the best sizes and locations of new plants?

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5.

How should the available capital be allocated?

Fourthly, managerial economics makes a manager a more competent model builder.

Thus he can capture the essential relationships which characterize a situation while
leaving out the cluttering details and peripheral relationships.
Fifthly, at the level of the firm, where for various functional areas functional
specialists or functional departments exist, e.g., finance, marketing, personal
production, etc., managerial economics serves as an integrating agent by
coordinating the different areas and bringing to bear on the decisions of each
department or specialist the implications pertaining to other functional areas. It thus
enables business decision making not in watertight compartments but in an
integrated perspective, the significance of which lies in the fact that the functional
departments or specialists often enjoy considerable autonomy and achieve
conflicting coals.
Finally, managerial economics takes cognizance of the interaction between the firm
and society and accomplishes the key role of business as an agent in the attainment
of social and economic welfare. It has come to be realized that business part from
its obligations to shareholders has certain social obligations. Managerial economics
focuses attention on these social obligations as constraints subject to which
business decisions are to be taken. In so doing, it serves as an instrument in rehiring
the economic welfare of the society through socially oriented business decisions.
Role and Responsibilities of Managerial Economist
A managerial economist can play a very important role by assisting the
Management in using the increasingly specialized skills and sophisticated
techniques which are required to solve the difficult problems of successful decision
making and forward planning. That is why, in business concerns, his importance is
being growingly recognized. In developed countries like the U.S.A., large companies
employ one or more economists. In our country (India) too, big industrial houses
have come to recognize the need for managerial economists, and there are frequent
advertisements for such positions. Tatas and Hindustan Lever employ economists.
Indian Petrochemicals Corporation Ltd., a Government of India undertaking, also
keeps an economist.
Let us examine in specific terms how a managerial economist can contribute to
decision making in business.
In this connection, two important questions need be considered :1.

What role does he play in business, that is, what particular management
problems lend themselves to solution through economic analysis?

2.

How can the managerial economist best serve management, that is, what are
the responsibilities of a successful managerial economist?
Role of Managerial Economist
11

One of the principal objectives of any management in its decision making process is
to determine the key factors which will influence the business over the period
ahead. In general, these factors can be divided into two category, viz., (i) External
and (ii) Internal. The external factors lie outside the control management because
they are external to the firm and are said to constitute business environment. The
internal factors lie within the scope and operations of a firm and hence within the
control of management, and they are known as business operations.
To illustrate, a business firm is free to take decisions about what to invest, where to
invest, how much labour to employ and what to pay for it, how to price its products
and so on but all these decisions are taken within the framework of a particular
business environment and the firms degree of freedom depends on such factors as
the governments economic policy, the actions of its competitors and the like.
Environmental Studies
An analysis and forecast of external factors constituting general business
conditions, e.g., prices, national income and output, volume of trade, etc., are of
great significance since every business from is affected by them.
Certain important relevant questions in this connection are as follows :1.

What is the outlook for the national economy? What are the most important
local, regional or worldwide economic trends? What phase of the business cycle
lies immediately ahead?

2.

What about population shifts and the resultant ups and downs in regional
purchasing power?

3.

What are the demands prospects in new as well as established markets? Will
changes in social behavior and fashions tend to expand or limit the sales of a
companys products, or possibly make the products obsolete?

4.

Where are the market and customer opportunities likely to expand or contract
most rapidly?

5.

Will overseas markets expand or contract, and how will new foreign
government legislations affect operation of the overseas plants?

6.

Will the availability and cost of credit tend to increase or decrease buying?
Are money or credit conditions ahead likely to be easy or tight?

7.

What the prices of raw materials and finished products are likely to be?

8.

Is competition likely to increase or decrease?

9.

What are the main components of the five-year plan? What are the areas
where outlays have been increased? What are the segments, which have suffered
a cut in their outlay?
12

10.

What is the outlook regarding governments economic policies and

regulations?

11.

What about changes in defense expenditure, tax rates, tariffs and import
restrictions?

12.

Will Reserve Banks decisions stimulate or depress industrial production and

consumer spending? How will these decisions affect the companys cost, credit,
sales and profits?

Reasonably accurate answers to these and similar questions can enable

management to chalk out more wisely the scope and direction of their own business
plans and to determine the timing of their specific actions. And it is these questions
which present some of the areas where a managerial economist can make effective
contribution.
The managerial economist has not only to study the economic trends at the macro
level but must also interpret their relevance to the particular industry / firm where
he works. He has to digest the ever growing economic literature and advise top
management by means of short, business like practical notes.
In a mixed economy like India, the managerial economist pragmatically interprets
the intentions of controls and evaluates their impact. He acts as a bridge between
the government and the industry, translating the governments intentions and
transmitting the reactions of the industry. In fact, government policies charge out of
the performance of industry, the expectations of the people and political
expediency.
Business Operations
A managerial economist can also be helpful to the management in making decisions
relating to the internal operations of a firm in respect of such problems as price,
rate of operations, investment, expansion or contraction.
Certain relevant questions in this context would be as follows :1.
2.

What will be a reasonable sales and profit budget for the next year?
What will be the most appropriate production Schedules and inventory
policies for the next six months?

3.

What changes in wage and price policies should be made now?

4.

How much cash will be available next month and how should it be invested?

Specific Functions

13

A further idea of the role of managerial economists can be seen from the following
specific functions performed by them as revealed by a survey pertaining to Britain
conducted by K.J.W. Alexander and Alexander G. Kemp :1.

Sales forecasting.

2.

Industrial market research.

3.

Economic analysis of competing companies.

4.

Pricing problems of industry.

5.

Capital projects.

6.

Production programs.

7.

Security/investment analysis and forecasts.

8.

Advice on trade and public relations.

9.

Advice on primary commodities.

10.

Advice on foreign exchange.

11.

Economic analysis of agriculture.

12.

Analysis of underdeveloped economics.

13.

Environmental forecasting.

The managerial economist has to gather economic data, analyze all pertinent
information about the business environment and prepare position papers on issues
facing the firm and the industry. In the case of industries prone to rapid
technological advances, he may have to make a continuous assessment of the
impact of changing technology. He may have to evaluate the capital budget in the
light of short and long-range financial, profit and market potentialities. Very often,
he may have to prepare speeches for the corporate executives.
It is thus clear that in practice managerial economists perform many and varied
functions. However, of these, marketing functions, i.e., sales forecasting and
industrial market research, has been the most important. For this purpose, they may
compile statistical records of the sales performance of their own business and those
relating to their rivals, carry our analysis of these records and report on trends in
demand, their market shares, and the relative efficiency of their retail outlets. Thus
while carrying out their functions; they may have to undertake detailed statistical
analysis. There are, of course, differences in the relative importance of the various
functions performed from firm to firm and in the degree of sophistication of the
methods used in carrying them out. But there is no doubt that the job of a
managerial economist requires alertness and the ability to work under pressure.
14

Economic Intelligence
Besides these functions involving sophisticated analysis, managerial economist may
also provide general intelligence service supplying management with economic
information of general interest such as competitors prices and products, tax rates,
tariff rates, etc. In fact, a good deal of published material is already available and it
would be useful for a firm to have someone who understands it. The managerial
economist can do the job with competence.
Participating in Public Debates
Many well-known business economists participate in public debates. Their advice
and views are being sought by the government and society alike. Their practical
experience in business and industry ads stature to their views. Their public
recognition enhances their stature in the organization itself.
Indian Context
In the Indian context, a managerial economist is expected to perform the following
functions :1.

Macro-forecasting for demand and supply.

2.

Production planning at macro and micro levels.

3.

Capacity planning and product-mix determination.

4.

Economics of various productions lines.

5.

Economic feasibility of new production lines/processes and projects.

6.

Assistance in preparation of overall development plans.

7.

Preparation of periodical economic reports bearing on various matters such

as the companys product-lines, future growth opportunities, market pricing
situation, general business, and various national/international factors affecting
industry and business.

8.

Preparing briefs, speeches, articles and papers for top management for
various Chambers, Committees, Seminars, Conferences, etc.

9.

Keeping management informed o various national and international

developments on economic/industrial matters.

With the adoption of the New Economic Policy, in 1991, the macro-economic
Environment in India is changing fast at a pace that has been rarely witnessed
before. And these changes have tremendous implications for business. The
managerial economist has to play a much more significant role. He has to
constantly gauge the possibilities of translating the rapidly changing economic
15

scenario into viable business opportunities. As India marches towards globalization,

he will have to interpret the global economic events and find out how his firm can
avail itself of the carious export opportunities or of establishing plants abroad either
wholly owned or in association with local partners.
Responsibilities of Managerial Economist
Having examined the significant opportunities before a managerial economist to
contribute to managerial decision making, let us now examine how he can best
serve the management. For this, he must thoroughly recognize his responsibilities
and obligations.
A managerial economist can serve management best only if he always keeps in
mind the main objective of his business, viz., to make a profit on its invested capital.
His academic training and the critical comments from people outside the business
may lead a managerial economist to adopt an apologetic or defensive attitude
towards profits. Once management notices this, his effectiveness is almost sure to
be lost. In fact, he cannot expect to succeed in serving management unless he has
a strong personal conviction that profits are essential and that his chief obligation is
to help enhance the ability of the firm to make profits.
Most management decisions necessarily concern the future, which is rather
uncertain. It is, therefore, absolutely essential that a managerial economist
recognizes his responsibility to make successful forecasts. By making best possible
forecasts and through constant efforts to improve upon them, he should aim at
minimizing, if not completely eliminating, the risks involved in uncertainties, so that
the management can follow a more orderly course of business planning. At times,
he will have to reassure the management that an important trend will continue; in
other cases, he may have to point out the probabilities of a turning point in some
activity of importance to management. In any case, he must be willing to make
considered but fairly positive statements about impending economic developments,
based upon the best possible information and analysis and stake his reputation
upon his judgment. Nothing will build management confidence in a managerial
economist more quickly and thoroughly than a record of successful forecasts, welldocumented in advance and modestly evaluated when the actual results become
available.
A few corollaries to the above proposition need also be emphasized here.
First, he has a major responsibility to "alert management at the earliest possible
moment" in case he discovers an error in his forecast. By promptly drawing
attention to changes in forecasting conditions, he will not only assist management
in making appropriate adjustment in policies and programs but will also be able to
strengthen his own position as a member of the management team by keeping his
fingers on the economic pulse of the business.
Secondly, he must establish and maintain many contacts with individuals and data
sources, which would not be immediately available to the other members of the
management. Extensive familiarity with reference sources and material is essential,
16

but it is still more important that he knows individuals who are specialists in
particular fields having a bearing on his work. For this purpose, he should join
professional associations and take active part in them. In fact, one of the best
means of determining the caliber of a managerial economist is to evaluate his
ability to obtain information quickly by personal contacts rather than by lengthy
research from either readily available or obscure reference sources. Within any
business, there may be a wealth of knowledge and experience but the managerial
economist would be really useful if he can supplement the existing know-how with
additional information and in the quickest possible manner.
Again, if a managerial economist is to be really helpful to the management in
successful decision making and forward planning, he must be able to earn full
status on the business team. He should be ready and even offer himself to take up
special assignments, be that in study teams, committees or special projects. For, a
managerial economist can only function effectively in an atmosphere where his
success or failure can be traced not only to his basic ability, training and
experience, but also to his personality and capacity to win continuing support for
himself and his professional ideas. Of course, he should be able to express himself
clearly and simply and must always try to minimize the use of technical terminology
in communicating with his management executives. For, it is well-known that if
management does not understand, it will almost automatically reject. Further, while
intellectually he must be in tune with industrys thinking the wider national
perspective should not be absents from his advice to top management.

Chapter 2 : Demand, Supply and Market Equillibrium

Definition: The law of demand states that other factors being constant (cetris
peribus), price and quantity demand of any good and service are inversely related
to each other. When the price of a product increases, the demand for the same
product will fall.
Description: Law of demand explains consumer choice behavior when the price
changes. In the market, assuming other factors affecting demand being constant,
when the price of a good rises, it leads to a fall in the demand of that good. This is

17

the natural consumer choice behavior. This happens because a consumer hesitates
to spend more for the good with the fear of going out of cash.

The above diagram shows the demand curve which is downward sloping. Clearly
when the price of the commodity increases from price p3 to p2, then its quantity
demand comes down from Q3 to Q2 and then to Q3 and vice versa.
Supply and demand is perhaps one of the most fundamental concepts of economics
and it is the backbone of a market economy. Demand refers to how much (quantity)
of a product or service is desired by buyers. The quantity demanded is the amount
of a product people are willing to buy at a certain price; the relationship between
price and quantity demanded is known as the demand relationship. Supply
represents how much the market can offer. The quantity supplied refers to the
amount of a certain good producers are willing to supply when receiving a certain
price. The correlation between price and how much of a good or service is supplied
to the market is known as the supply relationship. Price, therefore, is a reflection of
supply and demand.
The relationship between demand and supply underlie the forces behind the
allocation of resources. In market economy theories, demand and supply theory will
allocate resources in the most efficient way possible. How? Let us take a closer look
at the law of demand and the law of supply.
A. The Law of Demand
18

The law of demand states that, if all other factors remain equal, the higher the price
of a good, the less people will demand that good. In other words, the higher the
price, the lower the quantity demanded. The amount of a good that buyers
purchase at a higher price is less because as the price of a good goes up, so does
the opportunity cost of buying that good. As a result, people will naturally avoid
buying a product that will force them to forgo the consumption of something else
they value more. The chart below shows that the curve is a downward slope.

A, B and C are points on the demand curve. Each point on the curve reflects a direct
correlation between quantity demanded (Q) and price (P). So, at point A, the
quantity demanded will be Q1 and the price will be P1, and so on. The demand
relationship curve illustrates the negative relationship between price and quantity
demanded. The higher the price of a good the lower the quantity demanded (A),
and the lower the price, the more the good will be in demand (C).
B. The Law of Supply
Like the law of demand, the law of supply demonstrates the quantities that will be
sold at a certain price. But unlike the law of demand, the supply relationship shows
an upward slope. This means that the higher the price, the higher the quantity
supplied. Producers supply more at a higher price because selling a higher quantity
at a higher price increases revenue.

19

A, B and C are points on the supply curve. Each point on the curve reflects a direct
correlation between quantity supplied (Q) and price (P). At point B, the quantity
supplied will be Q2 and the price will be P2, and so on.
Time and Supply
Unlike the demand relationship, however, the supply relationship is a factor of time.
Time is important to supply because suppliers must, but cannot always, react
quickly to a change in demand or price. So it is important to try and determine
whether a price change that is caused by demand will be temporary or permanent.
Let's say there's a sudden increase in the demand and price for umbrellas in an
unexpected rainy season; suppliers may simply accommodate demand by using
their production equipment more intensively. If, however, there is a climate change,
and the population will need umbrellas year-round, the change in demand and price
will be expected to be long term; suppliers will have to change their equipment and
production facilities in order to meet the long-term levels of demand.
C. Supply and Demand Relationship
Now that we know the laws of supply and demand, let's turn to an example to show
how supply and demand affect price.
Imagine that a special edition CD of your favorite band is released for $20. Because
the record company's previous analysis showed that consumers will not demand
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CDs at a price higher than $20, only ten CDs were released because the opportunity
cost is too high for suppliers to produce more. If, however, the ten CDs are
demanded by 20 people, the price will subsequently rise because, according to the
demand relationship, as demand increases, so does the price. Consequently, the
rise in price should prompt more CDs to be supplied as the supply relationship
shows that the higher the price, the higher the quantity supplied.
If, however, there are 30 CDs produced and demand is still at 20, the price will not
be pushed up because the supply more than accommodates demand. In fact after
the 20 consumers have been satisfied with their CD purchases, the price of the
leftover CDs may drop as CD producers attempt to sell the remaining ten CDs. The
lower price will then make the CD more available to people who had previously
decided that the opportunity cost of buying the CD at $20 was too high.
D. Equilibrium
When supply and demand are equal (i.e. when the supply function and demand
function intersect) the economy is said to be at equilibrium. At this point, the
allocation of goods is at its most efficient because the amount of goods being
supplied is exactly the same as the amount of goods being demanded. Thus,
everyone (individuals, firms, or countries) is satisfied with the current economic
condition. At the given price, suppliers are selling all the goods that they have
produced and consumers are getting all the goods that they are demanding.

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As you can see on the chart, equilibrium occurs at the intersection of the demand
and supply curve, which indicates no allocative inefficiency. At this point, the price
of the goods will be P* and the quantity will be Q*. These figures are referred to as
equilibrium price and quantity.
In the real market place equilibrium can only ever be reached in theory, so the
prices of goods and services are constantly changing in relation to fluctuations in
demand and supply.

Different types of Elasticity of Demand:

1. Price Elasticity of Demand Formula = % change in demand / % change in price
2. Income Elasticity of Demand Formula = % change in demand / % change in
income
3. Cross Elasticity of Demand Formula = % change in demand ( X) / % change in
price ( Y)
4. Advertisement Elasticity of Demand Formula = % change in demand / % change
in Advt. Budget
1. Price Elasticity of Demand:
We will discuss how sensitive the change in demand is to the change in price. The
measurement of this sensitivity in terms of percentage is called price Elasticity of
Demand. According to Marshall, Price Elasticity of Demand is the degree of
responsiveness of demand to the change in price of that commodity.
2. Income elasticity of demand:
In economics, the income elasticity of demand measures the responsiveness of the
quantity demanded of a good to the change in the income of the people demanding
the good. It is calculated as the ratio of the percent change in quantity demanded to
the percent change in income. For example, if, in response to a 10% increase in
income, the quantity of a good demanded increased by 20%, the income elasticity
of demand would be 20%/10% = 2.

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3. Cross elasticity of demand:

In economics, the cross elasticity of demand and cross price elasticity of demand
measures the responsiveness of the quantity demand of a good to a change in the
price of another good.
It is measured as the percentage change in quantity demanded for the first good
that occurs in response to a percentage change in price of the second good. For
example, if, in response to a 10% increase in the price of fuel, the quantity of new
cars that are fuel inefficient demanded decreased by 20%, the cross elasticity of
demand would be -20%/10% = -2.
4. Advertisement Elasticity of Demand:
The degree of responsiveness of quantity demanded to the change in the
advertisement expense of expenditure.
Ea= Change in quantity demanded x original advertisement expenses
Change in advertisement expenses original quantity demanded

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Chapter 3: Basic concepts of production and cost theory

Production is the creation of goods and services from inputs or resources,
such as labor, machinery and other capital equipment, land, raw materials, and
so on.
Production function is the relationship between the quantity of inputs and
quantity of outputs. It is a schedule (or table or mathematical equation) showing
the maximum amount of output that can be produced from any specified set of
inputs, given the existing technology.
Many different inputs are used in production. We can define the maximum
output

to be a function of

Where

the level of usage of the various inputs. That is,

are inputs.

But in our discussion we will generally restrict our attention to the simpler case
of a product whose

production entails only one or two inputs. We will normally

use capital and labor as the two inputs. Hence, the production function we will
usually be concerned with is:

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Technical efficiency and economic efficiency

Technical efficiency is achieved when the maximum possible amount of
output is being produced with a given combination of inputs. The definition
of a production function assumes that technical efficiency is being achieved
for any particular combination of inputs. Thus technical efficiency is implied
by the production function.
Economic efficiency is achieved when the firm is producing a given
amount of output at the lowest possible cost.
Short run and long run: When analyzing the process of production, it is
convenient to introduce

the classification of inputs as fixed or variable.

A fixed input is one for which the level of usage cannot readily be
changed. No input is ever absolutely fixed. However, the cost of immediately
varying the use of input may be so great that, for all practical purposes, the
input is fixed. For example, buildings, major pieces of machinery, and
managerial personnel are considered fixed inputs.
A variable input is one for which the level of usage may be changed
quite readily in response to desired changes in output. Many types of labor
services as well as certain raw and processed materials would be in this
category.
Short run refers to that period of time in which the level of usage of one or
more of the inputs is fixed. Therefore, in the short run, changes in output
must be accomplished exclusively by changes in the use of the variable
inputs. In the context of our simplified production function, we might
considered capital to be the fixed input and write the resulting short-run
production function as:
Long run is defined as that period of time ( or planning horizon ) in which
all inputs are

variable.

Fixed or variable proportions: most of the discussion in this chapter

and next chapter refers to

production functions that allow at least some

substitution of one input for another in reaching an output target.

Variable proportions: When substitution is possible, we say inputs may
be used in variable proportions. As a consequence, producer must
determine not only the optimal level of output but also the optimal
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combination of input. Variable proportions production means that

output can be changed in the short run by changing the variable inputs
without changing the fixed inputs. And it means that the same output can
be produced using different combinations of inputs.
Fixed proportions production means that there is one, and only one,
ratio or mix of inputs that can be used to produce a good. If output is
expanded or contracted, all inputs must be expanded or contracted. In such
cases, the producer has little discretion about what combination of inputs to
employ. The only decision is how much to produce.
Production in the short run: production with only one variable input
We begin the analysis of production in the short run with the simplest kind of shortrun situation: only one

variable input and one fixed input:

Total product, average product, and marginal product

Total product

: assume that the input of capital is fixed, then

Average product

is the total product (output) divided by the amount

of the variable input. The average product of labor

is the total

product divided by the number of workers:

Marginal product

is the additional output attributable to using one

additional unit of input.

Law of diminishing marginal product is the principle that as the number
of the units of the variable input increases, other inputs held constant, a point
will be reached beyond which the marginal product decreases.
Increasing (Decreasing)

causes the total product curve, average product

curve, and marginal product curve to shift upward (downward).

The Nature of Economic Costs
Opportunity cost: The cost of using resources to produce a good or
service is the opportunity

cost to the owners of the firm using those

resources. The opportunity cost is what the owners must give up to use a
26

resource. The opportunity cost of using an input or a resource is classified as

either an explicit cost or an implicit cost.
An explicit cost is an out-of-pocket monetary payment for the use of a
resource. It is an accounting cost. An explicit cost is the opportunity cost of
using resources that are owned by others.
An implicit cost is the foregone return the firms owners could have
received had they used their own resources in their best alternative use. An
implicit cost is the opportunity cost of using resources that are owned by the
owners of the firm.
Normal profit is the implicit cost of using own-supplied resources.
Variable costs are costs that will change when output changes. The
payments for variable inputs are variable costs. Examples of variable costs
are payments for many types of labor, ingredient inputs or raw materials, or
energy used in production.
Fixed costs are costs that will not change when output changes. The
payments for fixed inputs are fixed costs. In the short run some inputs are
fixed.
In the long run all costs are variable costs.
Chapter 4 : Market Structures
For defining market structure we first need to understand what market is? Market is
a place where buyers and sellers meet and exchange goods or services. And now if
we extend this concept a little more, there are certain conditions which create the
structure of a market. Such conditions can be condensed in the following
Number of Buyers
Number of sellers
Buyer Entry Barriers
Seller Entry Barriers
Size of the firm
Product Differentiation/ Homogeneous Product
Market Share
Competition
The above factors are the quick reference if you need to judge the market structure
and under which one particular firm belongs to.

Classification of Market Structure

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As there are lot many factors deciding on the market structure, there are lot many
variations as well determining the particular market structure in the economy. If we
try to explore that individually it might not crystallize our concept.
Thus, lets look at the following chart to understand the varied market structures

From the above chart now its clear that how the market structure can be defined by
the various factors and their way of exercising certain power over the market.
However if we consider the gradual increase of competition from least to maximum,
we will come up to the following conclusions
1.

Monopoly

2.

Oligopoly

3.

Monopolistic Competition

4.

Perfect Competition

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Now lets look at some of the examples of all the market structure mentioned above
so that the concept can dig into your mind and facilitate in your application of
market structure
Monopoly Companies which are state owned and entry for other players
are not allowed. If we take example from Indian perspective there is one example
we can think of is Indian railway which is the monopoly as there is no other
contributor exercising in the same market.

Oligopoly In US and other countries people buy their automobiles from

different companies. Here the buyers are many, sellers are few, and competition
is high.

Monopolistic Competition Lets take a common example. Look around

your locality. There are some good numbers of restaurants serving their
customers. Though they might be producing same kind of recipes, the branding
would be different. And thats the catch of monopolistic competition. Many
buyers, many sellers, almost same product but different branding and fierce
competition.

Perfect Competition Though in concept perfect competition exists,

however in real life only near perfect competition can exist. And the staple food
and vegetables we buy from the market is perfect competition. However when
they start branding they move toward oligopoly.

In case of Monopsony and Oligopsony there are almost no practical

examples though they are just the opposite of monopoly and oligopoly
respectively (buyers rule).
How Understanding Market Structure Would Help You?

Before reading this article or prior to studying about market structure we could have
underestimated the value of comprehending different kind of market structure. But

29

after knowing about them now we can line up with a quite good number of benefits

When we know the market structure it helps us understanding a major chunk

about a particular company and which market structure it belongs to. Thus we
can measure the market share, forces operating in the same market structure, its
competitors, and line of products and range of competition.

When we know about a company it helps us in investment. Whether we

should go for putting our money into the company or not, how risky the
investment could be, how much could we lose and most importantly whether
there is any other choice available or not!

The study of market structure provides us with a vision which could intuitively
tell us what would be the future economy, who would be the market leaders,
whose demand would be greater, whose goods or services might become
obsolete in the future and what would be the factors which would control the
whole market?

It facilitates where we are as a buyer or seller. When we know the market

structure, we can understand in which side we are as of now? We can also
understand that there is any barrier to entry into the market or not, whether
there is any influence we can bring into the market place, what kind of market
structure we would belong to and a lot more!

It gives a general idea about how demand and supply work in a market place
and how consumerism can eat away or benefit our ability to live well. Different
types of products/services, different kinds of buyers and sellers, their different
roles and continuous effort to create better product or to solve a problem would
then become more understandable when we acquire the bits and pieces about
structures a particular market follows.
In Conclusion

The importance of market structure in an economy cannot be over emphasized as

the effect of market structure on an economy, its development or degradation is
recently been realized. Thus we as the part of the economy need to understand the
value of this concept while dealing with others (buyers/sellers) in any market place
to yield the optimum benefit and to create win-win situation for all of us.

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Questions on Managerial Economics

1 Define managerial economics with definition.
2 How does managerial economics differ from economics ?
3 Write a short note on managerial economists.
4 Explain the scope of managerial economics.
5 Managerial economics is the integration of economic theory with business
practice for the purpose of facilitating decision making and forward planning by
management? Explain.
6 Construct a demand and supply schedule as per the data given below.

Price

Demand

Supply

15

50

15

20

40

20

25

30

25

30

15

30

35

10

35

7 Explain types of elasticity. What is the link between elasticity and business decision
making.
8 Define production function.
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9 Explain the difference between explicit and implicit cost.

10 Explain the features of following market structures.
1 Oligopoly
2 Monopolistic Competition

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