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MGT 105: MANAGERIAL ECONOMICS: UNIT-I

Unit I
Definition, Nature and Scope of Managerial Economics, Managerial Economics, Micro Economics and Macro Economics,
Managerial Economics and decision making, Definitions of Basic Concepts: Positive and Normative Approach, Optimization,
Marginal Analysis, Opportunity Cost, Economic Model: Static & Dynamics, Meaning and Determinant of Demand, Demand
Function, Law of Demand, Market Demand, Elasticity of Demand, Types of Elasticity, Measurement of Elasticity, Significance and
uses of Elasticity, Method of Demand Estimation, Demand Forecasting, Forecasting of an established product, Forecasting of a
new product

ECONOMICS: INTRODUCTION
The word Economics is derived from the Greek words “OKIOS NEMEIN” meaning household management .Father of Economics
Adam Smith in his book “ Wealth of Nations 1776” defined economics is the study of wealth (Wealth Definition). Alfred
Marshall in his book “Principles of Economic Science-1890” defined Economics is the study of mankind in the ordinary business
of life (Welfare Definition). Lionel Robbins gave us the most accepted scarcity-oriented definition of Economics. He says
Economics is a social science which studies human behavior as a relationship between unlimited wants and scarce means which
have alternative uses (Scarcity Definition). Economics Noble prize winner (1970) Paul Samuelson proposes a dynamic definition
in his book Economics (1948). Economics is the study of how people and society end up choosing with or without money to
employ scarce productive resources that could have alternative uses to produce various commodities and distribute them for
consumption, now or in the future among various persons and groups in society. Economic analysis is the cost and benefits of
improving patterns of resources use (Growth Definition).

MICRO- MACRO ECONOMICS:


Economic theory can be broadly divided into micro economics and macroeconomics. Economics noble prize winner (1969),
Ragner Frisch was the first to use the terms micro and macro in economics in 1933.
The terms micro and macro derived from Greek. Mikros means small and makros means large. In terms of economic study
Micro means individualistic and macro aggregative.
Micro Economics
Micro economics is the study of particular firms, households, individual prices and particular commodity. Micro economics is
based on the assumption of full employment and ‘ceteris paribus’ (other things remain constant).
Macro economics
Macro economics is the study of economic system as a whole. Macro economics studies aggregates values like National Income,
National output, general price level, total consumption, saving and investment of a country.

An Example of a microeconomic issue could be the effects of raising wages within a business. If a large business raises its
wages by 10 percent across the board, what is the effect of this policy on the pricing of its products going to be?
Since the cost of producing products has increased, the price of these products for consumers is likely to follow suit.
Likewise, what will happen if a company raises wages for its most productive employees but fires its least productive
workers? Likewise, what will happen if a company raises wages for its most productive employees but fires its least
productive workers?

An Example of Macroeconomic issue would be to observe the effects that low interest rates have on the national housing
market or the unemployment rate. Another common focus of macroeconomics is the way taxes affect the economics of a
nation. A macroeconomist would look at the effects of a decrease in income taxes using measures like GDP and national
income, rather than individual factors.
DEFINITION OF MANAGERIAL ECONOMICS
FEW DEFINITONS
Prof. Evan J Douglas - “Managerial economics
is concerned with the application of economic
principles and methodologies to the decision-
making process within the firm or
organization.”

Spencer and Siegleman defined managerial


Economics as “the integration of economic
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theory with business practice for the purpose


of facilitating decision making and forward
planning of management.”

Pappas & Hirschey - “Managerial economics


applies economic theory and methods to
business and administrative decision-
making.”

From the above definitions Nature of Managerial economics can be traced easily.
By Pashupati Nath Verma
MGT 105: MANAGERIAL ECONOMICS: UNIT-I
NATURE OF MANAGERIAL ECONOMICS
1. Managerial Economics is application oriented and uses the body of economic concepts and principles. Thus, we can say
managerial economics is Pragmatic (i.e. practical) in approach.
2. Managerial Economics is mainly used for managerial decision making and forward planning.
3. Managerial economics is deep rooted with micro-economics but it also uses macroeconomics concept also as both are
equally important for decision making and business analysis. Further, Managerial economics heavily depends on
mathematical and optimization techniques. Thus, we can say managerial economics is Eclectic (i.e. diverse).
4. Managerial Economics is more ‘Normative’ (i.e. focuses on prescriptive statement and help establishing rule aimed at
attaining the specified goal of business) than ‘Positive’ (i.e. describing the phenomenon). It is positive when it is confined to
statements about causes and effects and to functional relationships of economic variables. It is normative when it involves
norms and standards, mixing them with cause and effect analysis.
5. Managerial Economics is a Management Oriented Tool.

SCOPE OF MANAGERIAL ECONOMICS


All the economic theories, tools, and concepts are covered under the scope of managerial economics to analyze the business
environment. Scope of managerial economics is widening day by day with its continuous development.
Demand analysis and forecasting, Production, Supply and Cost Analysis, Pricing policy, Profit Policy, and Capital Management
is the major areas considered under the scope of managerial economics.

Demand Analysis and Forecasting: A business firm is an economic organisation which transforms productive resources into
goods to be sold in the market. A major part of business decision making depends on accurate estimates of demand. Demand
analysis and forecasting provided the essential basis for business planning and occupies a strategic place in managerial
economic. The Demand Analysis and Forecasting mainly covers: Demand Determinants, Demand Distinctions and Demand
Forecast.

Cost and Production Analysis: A study of economic costs, combined with the data drawn from the firm’s accounting records, can
yield significant cost estimates which are useful for management decisions. Production analysis frequently proceeds in physical
terms while cost analysis proceeds in monetary terms. The Cost and Production Analysis mainly covers : Cost concepts and
classification, Cost-output Relationships, Economics and Dis-economics of scale, Production function and Cost control.

Pricing Decisions, Policies and Practices: The success of a firm largely depends on how correctly the pricing decisions are taken.
The important aspects dealt with under pricing includes: Price Determination in Various Market Forms, Pricing Method,
Differential Pricing, Product-line Pricing and Price Forecasting.

Profit Management: In a world of uncertainty, expectations are not always realized so the profit planning and measurement
constitute a difficult area of managerial economic. The important aspects covered under this area are: Nature and Measurement
of profit, Profit policies and Technique of Profit Planning like Break-Even Analysis.

Capital Management: Among the various types business problems, the most complex and troublesome for the business
manager are those relating to a firm’s capital investments. Capital management implies planning and control of capital
expenditure. The important aspects covered under this area are: Cost of capital Rate of Return and Selection of Projects.

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By Pashupati Nath Verma


MGT 105: MANAGERIAL ECONOMICS: UNIT-I
MICRO, MACRO, AND MANAGERIAL ECONOMICS RELATIONSHIP
Microeconomics studies the actions of individual consumers and firms; managerial economics is an applied specialty of this
branch. Macroeconomics deals with the performance, structure, and behavior of an economy as a whole.

Managerial economics applies microeconomic theories and techniques to management decisions. It is more limited in scope as
compared to microeconomics.

Macroeconomists study aggregate indicators such as GDP, unemployment rates to understand the functions of the whole
economy. Macroeconomics models and their estimates are used by the government to assist in the development of economic
policy.

Microeconomics and managerial economics both encourage the use of quantitative methods to analyze economic data.
Managerial economic principles can aid management decisions in allocating these resources efficiently.

MICROECONOMICS MACROECONOMICS MANAGERIAL ECONOMICS


1. It is the study of individual economic It is the study of economy as a whole and It is the study of application of economic
units of an economy its aggregates. theory for business decision making in
individual economic units of an economy
2. It deals with individual income, It deals with aggregates like national It deals with individual income, individual
individual prices and individual output, income, general price level and national prices and individual output, etc. wrt a
etc. output, etc. business firm
3. Its Central problem is price Its central problem is determination of Its Central problem is optimum allocation
determination and allocation of resources. level of income and employment. of resources and decision making
4. Its main tools are demand and supply of Its main tools are aggregate demand and Its main tools are demand and supply as
a particular commodity/factor. aggregate supply of economy as a whole. well as production economies of a
particular commodity/factor.
5. It helps to solve the central problem of It helps to solve the central problem of full . It helps to solve the central problem of
what, how and for whom to produce in employment of resources in the economy. what, how, for whom and how much to
the economy produce in the economy
6. It discusses how equilibrium of a It is concerned with the determination of It discusses how equilibrium of a
consumer, a producer or an industry is equilibrium level of income and consumer, a producer or an industry is
attained. employment of the economy. attained with holding firms objective.
7. Price is the main determinant of Income is the major determinant of Firm’s objective as well as prices is the
microeconomic problems. macroeconomic problems. main determinant of microeconomic
problems.
8. Examples are: individual income, Examples are: National income, national Examples are: Pricing Decision, Make are
individual savings, price determination of savings, general price level, aggregate Buy Decision, Decision on Production
a commodity, individual firm's output, demand, aggregate supply, poverty, Technique, Decision on Inventory Policies,
consumer's equilibrium. unemployment etc. Employment & Training Decision, Project
Selection Decision

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By Pashupati Nath Verma


MGT 105: MANAGERIAL ECONOMICS: UNIT-I
MANAGERIAL ECONOMICS & DECISION MAKING
Decision making is an integral part of modern management. Decision making is the process of selecting one action from two or
more alternative course of actions. Resources such as land, labour and capital are limited and can be employed in alternative
uses, so the question of choice arises. Managers of business organizations are constantly faced with wide variety of decisions in
the areas of pricing, product selection, cost control, asset management and plant expansion. Manager has to choose best among
the alternatives by which available resources are most efficiently used for achieving the desired aims.

The steps for decision making like problem description, objective determination, discovering alternatives, forecasting
consequences are described below:

Define the Problem


What is the problem and how does it influence managerial objectives are the main questions. Decisions are usually made in the
firm’s planning process. Managerial decisions are at times not very well defined and thus are sometimes source of a problem.

Determine the Objective


The goal of an organization or decision maker is very important. In practice, there may be many problems while setting the
objectives of a firm related to profit maximization and benefit cost analysis. Are the future benefits worth the present capital?
Should a firm make an investment for higher profits for over 8 to 10 years? These are the questions asked before determining
the objectives of a firm.

Discover the Alternatives


For a sound decision framework, there are many questions which are needed to be answered such as: What are the
alternatives? What factors are under the decision maker’s control? What variables constrain the choice of options? The manager
needs to carefully formulate all such questions in order to weigh the attractive alternatives.

Forecast the Consequences


Forecasting or predicting the consequences of each alternative should be considered. Conditions could change by applying each
alternative action so it is crucial to decide which alternative action to use when outcomes are uncertain.

Make a Choice
Once all the analysis and scrutinizing is completed, the preferred course of action is selected. This step of the process is said to
occupy the lion’s share in analysis. In this step, the objectives and outcomes are directly quantifiable. It all depends on how the
decision maker puts the problem, how he formalizes the objectives, considers the appropriate alternatives, and finds out the
most preferable course of action.

Following are the important areas of decision making;


 Selection of product.
 Selection of suitable product mix.
 Selection of method of production.
 Product line decision.
 Determination of price and quantity.
 Decision on promotional strategy.
 Optimum input combination.
 Allocation of resources.
 Replacement decision.
 Make or buy decision.
 Shut down decision.
 Decision on export and import.
 Location decision.
 Capital budgeting.
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By Pashupati Nath Verma


MGT 105: MANAGERIAL ECONOMICS: UNIT-I
SOME DEFINITIONS
POSITIVE & NORMATIVE APPROACH:
Positive Science is a systematic knowledge of a particular subject wherein we study the cause and effect of an event. In other
words, it explains the phenomenon as: What is, what was and what will be. Under the study of positive science, principles are
formulated and they are tested on the yardstick of truth. Forecasts are made on the basis of them.
From this point of view, managerial economics owns Positive Approach, as it has its own principles/theories/laws by which
cause and effect analysis of business events/activities is done, forecasts are made and their validities are also examined.

Normative Science studies things as they ought to be. Ethics, for example, is a normative science. The focus of study is ‘What
should be’. In other words, it involves value judgment or good and bad aspects of an event. Therefore, normative science is
perspective rather than descriptive.
Managerial economics also has a normative approach as it suggests the best course of an action after comparing pros and cons
of various alternatives available to a firm. It also helps in formulating business policies after considering all positives and
negatives, all good and bad and all favors and disfavors. For instance, if a firm wants to raise 10% price of its product, it will
examine the consequences of it before raising its price. The hike in price will be made only after ascertaining that 10% rise in
price will not have any adverse impact on the sale of the firm.

On the basis of the above arguments and facts, it can be said that managerial economics is a blending of positive approach
with normative approach. It is positive when it is confined to statements about causes and effects and to functional
relationships of economic variables. It is normative when it involves norms and standards, mixing them with cause and effect
analysis. Managerial economics is not only a tool making, but also a tool using science. It not only studies facts of an economic
problem, but also suggests its optimum solution.

OPTIMIZATIONS:
Optimization is the process of finding an alternative with the most cost effective or highest achievable performance under the
given constraints, by maximizing desired factors and minimizing undesired ones. Optimization is very crucial activity in
managerial decision making process. According to the objective of the firm, the manager tries to make the most effective
decision out of all the alternatives available.

The optimal decisions differ from company to company ( Why???), and Practice of optimization is restricted by the lack of
full information, and the lack of time to evaluate what information is available.

The first step in optimization is to examine the methods to express economic relationship. Expression may be in the form of
Table, Graph, or by some Algebraic Expression. This Expression (Model) is then analyzed for optimization. We usually depend
upon mathematical concepts and operation research for optimization. In computer simulation (modeling) of business problems,
optimization is achieved usually by using linear programming techniques of operations research.

MARGINAL AND INCREMENTAL PRINCIPLE


Marginal analysis helps to assess the impact of a unit change in one variable on the other variable. The word ‘marginal’ is used
for small changes say ‘a unit change’. According to marginal analysis, as long as marginal benefit of an activity is greater than its
marginal cost, it pays for an organization to continue increase the activity.
In contrast; incremental concept applies to changes in revenue and cost due to a policy change.
The incremental principle states that a decision is profitable when:
 it increases revenue more than costs;
 it decreases some costs to a greater extent than it increases others;
 it increases some revenues more than it decreases others; and
 it reduces costs more than revenues.
Suppose a firm gets an order that brings additional revenue of Rs 3,000. The cost of production from this order is:
Rs
Labour 800
Materials 1,300
Overheads 1,000
Selling and administration expenses 700
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Full cost 3,800


At a glance, the order appears to be unprofitable.
But suppose the firm has some idle capacity that can be utilized to produce output for new order.
Then the incremental cost to accept the order will be: Rs
Labour 600
Materials 1,000
Overheads 800
Total Incremental cost 2,400
Incremental reasoning shows that the firm would earn a net profit of Rs 600 (Rs 3,000 – 2,400), though initially it appeared to
result in a loss of Rs 800. The order should be accepted.

By Pashupati Nath Verma


MGT 105: MANAGERIAL ECONOMICS: UNIT-I
OPPORTUNITY COST PRINCIPAL
Opportunity Cost is the cost of a decision in terms of the next best alternative not chosen i.e. Opportunity cost refers to the
value forgone in order to make one particular investment instead of another. Opportunity cost comes into play in any decision
that involves a tradeoff between two or more options. This cost arises because most economic resources have more than one
use.
For instance, Let's say you have $15,000 and your choice is to either buy shares of Company XYZ or leave the money in a FD that
earns 8% per year. If the Company XYZ stock returns 10%, you've benefited from your decision because the alternative would
have been less profitable. However, if Company XYZ returns 2% when you could have had % from the FD, then your opportunity
cost is (8% - 2% = 6%).

ECONOMIC MODEL
An economic model is a simplified description of reality, designed to yield hypotheses about economic behavior that can be
tested. Theoretical economic models seek to derive verifiable implications about economic behavior.
Types of Models
1-Visual Models, 2-Mathematical models 3-Empirical models 4-Simulation models
Visual Models
Visual models are simply pictures of an abstract economy; graphs with lines and curves that tell an economic story. These
models are relatively easy to understand, but are somewhat limited in their scope.
Mathematical Models
These are systems of mathematical equations relating number of economic variables. Some of these models can be quite large.
Even the smallest will have five or six equations and as many unknown variables. The manipulation and use of these models
require a good knowledge of algebra or calculus and operation research.
Few examples of mathematical model relating to demand and supply may be as follows:
S=a+bP or D=a+bP2, Here S denotes Supply, D denotes Demand and P price.
Empirical Models
Empirical models are mathematical models designed by use of empirical data. Empirical models aim to verify the qualitative
predictions of theoretical models and convert these predictions to precise, numerical outcomes.
For example, suppose in an economic study the following question is asked: "What will happen to investment if income rises
one percent?" The purely mathematical model might only allow the analyst to say, "Logically, it should rise. “ The user of the
empirical model, on the other hand, using actual historical data for investment, income, and the other variables in the model,
might be able to say, "By my best estimate, investment should rise by about two percent.

Simulation Models
A simulation model is a mathematical model that calculates the impact of uncertain inputs and decisions we make on outcomes
that we care about, such as profit and loss, investment returns, and environmental consequences in an experimental condition.
The computerized simulation model can show the interaction of numerous variables all at once, including hidden feedback and
secondary effects that are not so apparent in purely mathematical or visual models. Such a model can be created by writing
code in a programming language, statements in a simulation modeling language, or formulas in a Microsoft Excel spreadsheet.
STATIC VS. DYNAMIC MODEL
Economic analysis can be conducted either by using a static framework (static model) or a dynamic setting (dynamic model).
Static and dynamic modes of analysis can be differentiated in more than one ways.

In a static model (theory) the variables (cause-effect) are not dated i.e. they does not change with time. The demand-supply
model of market behavior is a static model. The model that demand depends on own price, supply depends on own price, with
an equilibrium condition that demand must equal supply, time does not enter into the picture at all and the variables are all
undated.

A dynamic model would be one where the relevant variables are dated i.e. they change with time. According to this criterion the
following would be a dynamic model.
Dt = f( Pt )
St = g( Pt-1 )
Dt = St
There is no lag in the demand relationship. Demand in period‘t’ depends on own price of the same period.
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However, in the supply relationship a gestation lag exists. Supply in period‘t’ depends on price prevailing in the previous period
(t-1). The price level in previous period (t-1) would have induced the producers to increase or decrease the supply, full impact of
such decisions are visible in time period ‘t’ only. For market to attain equilibrium, demand in period‘t’ must equal supply in
period ‘t’.

It must be noted that if one is concerned with the equilibrium configurations of a market for a good, one has to take recourse to
a static methodology. Equilibrium is a static concept. It describes the position of a market at rest. In contrast, disequilibrium
analysis must pertain to dynamics. In a static framework, we implicitly assume that market adjustment is instantaneous, and
without any loss of time, equilibrium is or is not restored. How the economic agent behaves in the disequilibrium situation is not
the concern of static analysis. This is where dynamic analysis sets in.

By Pashupati Nath Verma


MGT 105: MANAGERIAL ECONOMICS: UNIT-I
DEMAND: MEANING AND TYPES OF DEMAND
DEMAND: The demand for a commodity is the quantity of the good that is purchased over a specific of period of time at a
certain price.
The following five elements are inclusive in it:
1. Desire to acquire a commodity -willingness to have it,
2. Ability to pay for it-purchasing power to buy it,
3. Willingness to spend on it,
4. Given/particular price, and
5. Given/particular time period.
In demand first three elements i.e. desire to acquire the product, willingness to pay for it along with the ability to pay creates
the demand and last two elements i.e. price and time period decides the quantity of demand.

Types of Demand:
 Individual’s Demand and Market Demand
 Firm and Industry Demand
 Demand by Market Segments and by Total Market
 Autonomous and Derived Demand
 Domestic and industrial demand:
 New and replacement demand

INDIVIDUAL’S DEMAND AND MARKET DEMAND:


Individual demand refers to demand of a commodity by an individual buyer.: Market demand is the summation of demand for a
good by all individual buyers in the market. For example, if the market of good x has, say only three buyers then individual and
market demand (monthly) could be:

A firm would be interested in the market demand for its products while each consumer would be concerned basically with only
his own individual demand.

FIRM AND INDUSTRY DEMAND:


Goods are produced by more than one firm and so there is a difference between the demand facing an individual firm and that
facing an industry. For example, demand for Fiat car alone is a firm’s demand and demand for all kinds of cars is industry’s
demand.

DEMAND BY MARKET SEGMENTS AND BY TOTAL MARKET:


Different market segment may have different price, profit margins, competition, seasonal patterns or cyclical sensitivity, then it
may be worthwhile to distinguish the market by specific segments for a meaningful analysis. In that case, the total demand
would mean the total demand for the product from all market segments while a particular market segment demand would refer
to demand for the product in that specific market segment.

AUTONOMOUS AND DERIVED DEMAND:


The goods whose demand is not tied with the demand for some other goods are said to have autonomous demand, while the
rest have derived demand. Thus, the demand for all producer goods is derived demands as they are needed to obtain consumer
goods or producer goods. Though, there is hardly anything whose demand is totally independent of any other demand. But the
degree of this dependence varies widely from product to product.

DOMESTIC AND INDUSTRIAL DEMAND:


The distinction between domestic and industrial demand is very important from the pricing and distribution point of view of a
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product. For instance, the price of water, electricity, coal etc. is deliberately kept low for domestic use as compared to their
price for industrial use.

NEW AND REPLACEMENT DEMAND:


New demand is meant for an addition to stock, while replacement demand is meant for maintaining the old stock of
capital/asset intact. The demand for spare parts of a machine is a good example of replacement demand, but the demand for
new models of a particular item [say computer or machine] is a fine example of new demand. Generally, new demand is of an
autonomous type, while the replacement demand is induced one-induced by the quantity and quality of existing stock.
However, such distinction is more of a degree than of kind.

By Pashupati Nath Verma


MGT 105: MANAGERIAL ECONOMICS: UNIT-I
DETERMINANTS OF DEMAND
The demand for a good in a market depends on many factors. Some of the important factors are
1. Price of the good under consideration
2. Prices of Substitutes
3. Prices of Complements
4. Consumer Income level
5. Price Expectation
6. Consumer tastes and preferences
7. Advertising & Promotion
8. Socio economic and
9. Demographic factors
10. Climate
11. Government Policies
The impact of these determinants on Demand is:
1. Price effect on demand: Demand for a normal good x is inversely related to its own price (negative effect).
2. Substitution effect on demand: If y is a substitute of x, then as price of y increases, demand for x also increases (positive
effect).
3. Complementarity effect on demand: If z is a complementary of x, then as price of z increases, demand for x also
decreases (negative effect).
4. Income effect on demand: As income rises, consumers buy more of normal goods (positive effect) and less of inferior
goods (negative effect).
5. Price expectation effect on demand: Here the relation may not be definite as the psychology of the consumer comes
into play.
6. Consumer tastes and preferences effect: Taste, preference and habits of consumers may also have decisive influence on
the pattern of demand. Social customs, traditions and conventions are Socio – psychological determinants of demand –
these are non-economic and non-market factors.
7. Advertising & Promotional effect on demand: Advertisement has great influence on demand. It is in observed fact that
sales turnover of firm’s increases up to a point due to advertisement.
8. Socio-economic Factor effect: e.g accumulated wealth, band wagon effect also influence the demand.
9. Demographic Factors effect: Population composition also influences the demand.
10. Climate also influences the demand for different goods. For instance, the demand for coolers and A.C. Increases in
summers, while their demand declines in winters.
11. Government policy on taxes and subsidies also influences the demand of different goods differently. For instance,
increase in tax rates / imposition of new taxes reduces the demand, while increase in subsidies increases the demand.

DEMAND SCHEDULE AND DEMAND CURVE


DEMAND SCHEDULE: Demand schedule is a tabular statement showing how much of a commodity is demanded at different
prices, other factors remaining the same. In Demand Schedule prices placed in descending (or ascending) order and the
corresponding quantities which, consumers would like to buy per unit of time.

DEMAND CURVE: A demand curve is a locus of points showing various alternative price quantity combinations. The demand
schedule can be converted into a demand curve by plotting curve between Price & Demand in which prices are kept on vertical
axis and quantity on horizontal axis. Demand curve slopes downwards (negatively).
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WHY DOES THE DEMAND CURVE SLOPE DOWNWARDS (NEGATIVELY)


The demand curve slopes downwards mainly due to the law of diminishing marginal utility. The law of diminishing marginal
utility, states that an additional unit of a commodity gives a lesser satisfaction. Whenever price change, consumer starts to
compare utility of the commodity with money paid for it. Thus whenever price increases, commodity's utility goes down in
comparison to money paid for it, consumer starts buying less. Therefore, the consumer buys less at higher price and more at
lower price.

By Pashupati Nath Verma


MGT 105: MANAGERIAL ECONOMICS: UNIT-I
DEMAND FUNCTION
The demand for a particular commodity is influenced by so many factors- they together are known as determinants of demand
in technical jargon, it is stated as demand function. A demand function in mathematical terms expresses the functional
relationship between the demand for a product and its various determining factors. As, Demand function is a comprehensive
formulation which specifies the factors that influence the demand for the product. Hence the demand function can be written as

DX = f ( Px, Ps, Pc, Yd, T, A, W, C, E, P, G, U) A simplest demand function may be linear, otherwise it may
Here be non linear. Some specific demand functions are
Dx = Demand for x commodity (say, tea)
Px = Price of x commodity (of tea) a p
Ps = Price of substitute of x commodity (coffee) q
b
Pc = Price of complementary goods of x commodity
a
(sugar, milk) q b
Yd = Disposable income of the consumer pc
T = Taste and Preference of the consumer
A = Advertisement of x commodity a p
q
W = Wealth of purchaser b
C = Climate  bp
E = Price expectation of the consumer q  ae
P = Population
G = Govt. policies pertaining to taxes and subsidies
U = Other factors (unspecified/unidentified) Here a, b and c are constant, p denotes price and q demand.

Example of a Linear Demand Function for a commodity X Example of a Non-Linear Demand Function for a commodity
Dx =200-7Px D =1280(0.75)P
Corresponding Demand Schedule Corresponding Demand Schedule

CHANGES IN QUANTITY DEMANDED VERSUS CHANGES IN DEMAND


The changes in quantity demanded relates to the law of demand and referred as ‘extension (Demand increase due to fall in
price) ‘or ‘contraction (Demand decrease due to rising price)’ of demand due to change in price of the commodity itself, but the
changes in demand (Shift in Demand) is related to ‘increase’ or ‘decrease’ in demand due to due to changes in non-price
factors such as income, taste & preference, price of related goods etc.

In case of the changes in quantity demanded it can be shown on original demand curve by moving upward or downward on the
curve itself. But, in case of change or shift in demand, whole demand curve shift to the left or right from its previous location.

CHANGES IN QUANTITY DEMANDED CHANGE OR SHIFT IN DEMAND


Y Y
Price
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D
Contraction
of Demand
Price
3
Expansion of
(A) Demand
Px
2
D1
D D1 Increase in dd
1 D2 decrease in dd.
D2
10 D
20 30
X
O QD O Q.D. X

By Pashupati Nath Verma


MGT 105: MANAGERIAL ECONOMICS: UNIT-I
LAW OF DEMAND
Law of Demand: Law of demand states that there is a negative or inverse Law of demand:Inverse Relation
relationship between the price and quantity demanded of a commodity, between Price and Demand
other things remaining constant.
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Other things include other determinants of demand, viz., consumers’
income, price of the substitutes and complements, taste and preferences
8
of the consumer, etc. But, these factors remain constant only in the short
run. In the long run they tend to change. The law of demand, therefore, 6

Price
holds only in the short run. Law of demand is an empirical law, i.e., this law
is based on observed facts and can be verified with new empirical data. 4

FACTORS BEHIND THE LAW OF DEMAND 2


 Substitution Effect
 Income Effect 0
 Utility-Maximizing Behavior 0 200 400 600 800
Substitution Effect: Consumers substitute their demand from one Demand
commodity to another related commodity in case of change in price of
original commodity.
Income Effect: Price changes also effects real income of the consumer, which in turns affect the demand for the commodity.
Utility-Maximizing Behavior: The utility-maximizing behavior of the consumer under the condition of diminishing marginal
utility is also responsible for increase in demand for a commodity when its price falls.

EXCEPTIONS TO THE LAW OF DEMAND


 Veblen Effect
 Giffen Effect
 Expectations regarding further prices
 Speculative Demand
Veblen Effect:
Veblen has pointed out that there are some goods (known to be Veblen Goods after him) demanded by very rich people for
their social prestige. When price of such goods rise, their use becomes more attractive and their demand increases. Such goods
are termed as Veblen Goods. Examples of Veblen Goods are Luxury cars(Rolls-Royce phantom), apartments etc.
Giffen Effect:
Sir Robert Giffen discovered that when price of, an inferior good increases, income remaining the same, poor people cut the
consumption of the superior substitute so that they may buy more of the inferior good in order to meet their basic need. Such
Inferior goods is known as Giffen Goods. Example of Giffen Goods is potato in vegetables.
Expectations regarding further prices
If consumers expect a rise in the price of a storable commodity or durable goods, they would buy more of it at its current price
with a view to avoiding the pinch of price-rise in future.
Speculative Demand:
The law also does not hold true in case of speculative demand. Stock markets are the fine examples of speculative demand.

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By Pashupati Nath Verma


MGT 105: MANAGERIAL ECONOMICS: UNIT-I
SUMMARY

Page11

By Pashupati Nath Verma


MGT 105: MANAGERIAL ECONOMICS: UNIT-I
ELASTICITY OF DEMAND
The concept of elasticity of demand was introduced by Alfred Marshall. According to him “the elasticity (or responsiveness) of
demand in a market is great or small according as the amount demanded increases much or little for a given fall in price, and
diminishes much or little for a given rise in price”.
The law of demand explains that demand will change due to a change in the price of the commodity. But it does not explain the
rate at which demand changes to a change in price. The concept of elasticity of demand measures the rate of change in
demand.

TYPES OF ELASTICITY OF DEMAND


 Price elasticity of demand;
 Income elasticity of demand; and
 Cross-elasticity of demand
PRICE ELASTICITY OF DEMAND
Price elasticity of demand is generally defined as the responsiveness or sensitiveness of demand for a commodity to the
changes in its price. More precisely, elasticity of demand is the percentage changes in demand as a result of one per cent in the
price of the commodity.

Percentage Change in Quantity Demanded


Price elasticity of demand 
Percentage Change in Price
Q / Q
Symbolical ly, e p 
P / P
INCOME ELASTICITY OF DEMAND
Income elasticity of demand is the degree of responsiveness of demand to the change in income.
Percentage Change in Quantity Demanded
Income elasticity of demand 
Percentage Change in Income
Q / Q
Symbolical ly, eY 
Y / Y
CROSS-ELASTICITY OF DEMAND
The responsiveness of demand to changes in prices of related goods is called cross-elasticity of demand (related goods may be
substitutes or complementary goods). In other words, it is the responsiveness of demand for commodity x to the change in the
price of commodity y.
Percentage Change in Quantity Demanded of X
Cross - elasticity of demand 
Percentage Change in Price of related Commodity Y
QX / QX
Symbolical ly, ec 
PY / PY
Depending on how the demand changes, when price changes we can classify all demand curves in the following five categories:
 Perfectly inelastic demand(ep=0)
 Relatively Inelastic demand (ep<1)
 Unitary elastic demand (ep=1)
 Relatively Elastic demand (ep>1)
 Perfectly elastic demand (ep=∞)

What will be the implication of elasticity of demand on Total Revenue (TR)?


If ep=1 TR will not change with prices
If ep<1 TR will move in same direction with higher rate
If ep>1 TR will move in opposite direction at higher rate
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By Pashupati Nath Verma


MGT 105: MANAGERIAL ECONOMICS: UNIT-I

Page13

By Pashupati Nath Verma


MGT 105: MANAGERIAL ECONOMICS: UNIT-I

Page14

By Pashupati Nath Verma


MGT 105: MANAGERIAL ECONOMICS: UNIT-I
FACTORS INFLUENCING ELASTICITY OF DEMAND
1. Nature of commodity - These who have no substitute goods will have an inelasticity of demand. The consumers will buy
almost a fixed demand whether the price is higher or lower. Demand for luxuries, on the other hand, is elastic in nature.
2. Different uses of the commodity- A commodity that has several kinds of uses is apt to be elastic in demand. For each
single use demand may be inelastic so that when price of the commodity goes down only a little more is purchased for
every use.
3. Availability of substitute goods- When there exists a class substitute in the relevant price range, its demand will tend to be
elastic. But in respect of commodities having no substitutes, their demand will be the same inelastic.
4. Consumer’s income - Generally larger the income, the overall demand for commodities tends to be relatively inelastic. The
redistribution of income in favour of low income people may tend to make demand for some goods relatively inelastic.
5. Proportion of expenditure- Items that constitute a smaller amount of expenditure in a consumer’s family budget tend to
have a relatively inelastic demand, e.g., a person who watches a film every fort night is not likely to give it up when the
ticket rates are raised. But one who watches a film every alternate day perhaps may cut down his number of films. So is
the case with matches, sugar etc.
6. Durability of the commodity- In the case of durable goods, the demand generally tends to be inelastic in the short run,
e.g., furniture, bicycle radio, etc. In the perishable commodities, on the other hand, demand is relatively elastic, e.g., milk ,
vegetables, etc.
7. Influence of habit and customs- There are certain articles which have a demand on account of conventions, customs or
habit and in these cases, elasticity is less, e.g., Mangal Sutra to a Hindu bride or cigarettes to a smoker have inelasticity of
demand.
8. Complementary goods- Goods which are jointly demanded have less elasticity, e.g., ink, petrol have inelastic demand for
this reason.
9. Recurrence of demand- If the demand for a commodity is of a recurring nature, its price elasticity is higher than that of a
commodity which is purchased only once. For instance, bicycle, tape recorders, radios, etc. are purchased only once, hence
their price elasticity will be less. But the demand for cassettes or tape spools would be more price elastic.
10. Possibility of postponement- When the demand for a product can be postponed, it will tend to be price elastic. In the case
of consumption goods which are urgently and immediately required, their demand will be inelastic.

IMPORTANCE OF ELASTICITY OF DEMAND


IMPORTANCE TO PRODUCER: A producer has to consider elasticity of demand before fixing the price of a commodity. The
concept of elasticity of demand also influences the determination of the rewards for factors of production in a private enterprise
economy. If the demand for labour on a particular industry is relatively inelastic, it will be easier for the trade union to get their
wages raised. The same remarks apply to other factors of production whose demands are relatively inelastic.
The concept of elasticity, also, provides a guideline to the producers for the amount to be spent on advertisement. If the
demand for a commodity is elastic, the producers shall have to spend large sums of money on advertisements for increasing the
sales.

IMPORTANCE TO GOVERNMENT: If elasticity of demand of a product is low then government will impose heavy taxes on the
production of that commodity and vice – versa. The concept of elasticity of demand also helps the government in fixing an
appropriate foreign rate of exchange for its domestic currency in relation to the currencies of other countries. Before deciding to
devalue or revalue domestic currency in relation to foreign currencies the government has to study carefully the elasticites of
demand for its imports and exports.

IMPORTANCE IN FOREIGN MARKET: If elasticity of demand of a produce is low in the international market then exporter can
charge higher price and earn more profit. It is possible to calculate the terms of trade between two countries only by taking into
account the mutual elasticities of demand for each other’s products.
The rate of foreign exchange is also considered on the elasticity of imports and exports of a country.

IMPORTANCE TO BUSINESSMEN: The concept of elasticity is of great importance to businessmen. When the demand of a good
is elastic, they increases sale by towering its price. In case the demand' is inelastic, they are then in a position to charge higher
price for a commodity.

IMPORTANCE TO TRADE UNION: The trade unions can raise the wages of the labor in an industry where the demand of the
Page15

product is relatively inelastic. On the other hand, if the demand, for product is relatively elastic, the trade unions cannot press
for higher wages.

By Pashupati Nath Verma


MGT 105: MANAGERIAL ECONOMICS: UNIT-I
MEASUREMENT OF PRICE ELASTICITY OF DEMAND
We may use two measures of elasticity:
(a) Arc elasticity, measures elasticity of demand between any two points on a demand curve. It is known as arc elasticity.
(b) Point elasticity, measures elasticity of demand for a marginal change at some specific point on demand curve.
Important methods for calculating price elasticity of demand are
1) Percentage Method
2) Graphical Method
3) Mathematical Method
4) Total outlay Method
5) Arc method
PERCENTAGE METHOD
Prof. Flux tries to measure the price elasticity of demand with the help of percentage. This is measured as the relative change in
demand divided by relative change in price (or) percentage change in demand divided by percentage change in price.
Formula is Percentage Change in Quantity Demanded
Price elasticity of demand 
Percentage Change in Price
%Q
Symbolical ly, e p 
%P

Illustration1: Yesterday, the price of envelopes was $3 a box, Illustration2 : If Neil's elasticity of demand for hot dogs is
and Julie was willing to buy 10 boxes. Today, the price has constantly 0.9, and he buys 4 hot dogs when the price is $1.50
gone up to $3.75 a box, and Julie is now willing to buy 8 boxes. per hot dog, how many will he buy when the price is $1.00 per
Is Julie's demand for envelopes elastic or inelastic? What is hot dog?
Julie's elasticity of demand? Solution:
Solution: In the case of John let the new demand is X, %Change in
% Change in Quantity Quantity = (X – 4)/4.
(%∆Q) = (8-10)/(10)=-0.20=-20% or 20% (omit negative sign ) % Change in Price = (1.00 - 1.50)/(1.50) = -33%
% Change in Price Therefore:
(%∆P) = (3.75-3.00)/(3.00) = 0.25 = 25% . Elasticity = 0.9 =%∆Q/(%∆P=(X – 4)/4/(33%)
0.9 =(X – 4)/4)/(0.33)
Elasticity (eP) =%∆Q/%∆P= (-20%)/(25%) = 0.8 ((X - 4)/4) = 0.33/.9
Julie's elasticity of demand is inelastic, since it is less than 1. (X - 4)/4=0.37
X-4=1.47
X=5.47

GRAPHICAL OR POINT METHOD


We can calculate the price elasticity of demand at a point on a demand curve by drawing a tangent on that point extended to
both the axis. Formula to find out ep through point method is,

Length of Lowert Segment


of Tangent
Price elasticity of demand 
Length of Upper Segment
of Tangent
Illustration3:In the adjacent case ep at point P will be given by

PM
Price elasticity of demand 
PR

MATHEMATICAL METHOD
If we have given Demand function in the form of Q=f(P) then price elasticity will
be given by dQ  P 
ep   
dP  Q 
Page16

Illustration4: If the equation for an item is Q  18  10 p - 3p , determine the price elasticity of demand at p=1.
2

Solution: At p=1, Q=18+10-3=25,


Further, dQ/dp=-6P+10, thus putting the value Q=25, p=1 and dQ/dp=6p+10 we will get elasticity at p=1
dQ P   p 
ep     6 p  10   (6 *1  10) *1/ 25  16 / 25
dP Q   Q  p1,Q25

By Pashupati Nath Verma


MGT 105: MANAGERIAL ECONOMICS: UNIT-I
TOTAL OUTLAY METHOD
Prof. Alfred Marshal tries to measure the price elasticity of demand with the help of total outlay method and he also says that
e=1 and e=0 does not exist in practical life and e>1,e=1 & e<1 have practical approach. Under this method elasticity will be of
three types:-
I E> 1 elasticity of demand:- When there is inverse relation between price and total outlay it means that when price increases
total outlay decreases and vice versa , it is known as e>1 elasticity of demand ie elastic demand.
II E=1 elasticity of demand:- Even if price increases or decreases but total outlay is constant, then it is known as e=1 or a unit
elasticity of demand or unitary elastic.
III E<1 elasticity of demand:- When there is positive or direct relationship between price total outlay it means as the price
increase total outlay increase & vice versa is known as E<1 elasticity of demand or inelastic demand.
Illustration5:
Price Per Unit ($) Quantity Demanded Total Expenditure / Total Outlay
20 10 Pens 200.0
10 30 Pens 300.0
The figure shows that at price of $20 per pen, the quantity demanded is 10 pens, the total
expenditure OABC ($200). When the price falls down to $10, the quantity demanded of
pens is 30. The total expenditure is OEFG ($300).
Since OEFG is greater than OABC, it implies that change in quantity demanded is
proportionately more than the change in price. Hence the demand is elastic (more than
one) E > 1.

Price Per Pen ($) Quantity Demanded Total Expenditure/Total Outlay


10 30 300
5 60 300
The figure shows that at price of $10 per pen, the total expenditure is OABC ($300). At a
lower price of $5, the total expenditure is OEFG ($300).
Since OABC = OEFG, it implies that the change in quantity demanded is proportionately
equal to change in price. So the price elasticity of demand is equal to one, i.e., E = 1.

Price Per Pen ($) Quantity Demanded Total Expenditure /Total Outlay
5 60 300
2 100 200

In the fig at a price of $5 per pen the quantity demanded is 50 pens. The total expenditure
is OABC ($300). At a lower price of $2, the quantity demanded is 100 pens.
The total expenditure is OEFG ($200). Since OEFG is smaller than OABC, this implies that
the change in quantity demanded is proportionately less than the change in price. Hence
price elasticity of demand is less than one or inelastic.

ARC METHOD
When we measure elasticity between any two particular points of the demand curve, it is
known as ARC elasticity of demand. When there is a major change in price or in a demand then
ARC elasticity of demand method is appropriate for the economist.
Original Quantity - New Qunatity/O riginal Quantity  New Qunatity
Price elasticity of demand 
OriginalPrice - New Price/Original Price  New Price
Q P1  P2
Symbolical ly, e p  X
P Q1  Q2
Where P1 & Q1 are price and quantity at first point (say, original price and quantity) and
P2 & Q2 are price and quantity at second point (say, new price and quantity)
Illustration6: Given the following Demand Schedule, price elasticity of demand between prices
9 to 11 will be calculated as follows:
Demand schedule
PRICE QUANTITY
Page17

9 164
10 160
11 156

Q P  P2 164  156 164  156 12 320


ep  X 1  X  X  202.11 (Ignore Sign)
P Q1  Q2 9  10 9  10  1 19

By Pashupati Nath Verma


MGT 105: MANAGERIAL ECONOMICS: UNIT-I
Example 1: You are given market data that says when the price of pizza is $4, the quantity demanded of pizza is 60 slices and the
quantity demanded of cheese bread is 100 pieces. When the price of pizza is $2, the quantity demanded of pizza is 80 slices and
the quantity demanded of cheese bread is 70 pieces. • Can the Price-Elasticity of Demand be calculated for either good? • If so,
calculate the PED.

Example 2: Consider the markets for widgets and cogs. You study survey data and observe that if widgets cost $5, then 100
widgets are demanded. You also observe that if widgets cost $3, then 150 cogs are demanded and if widgets cost $4 then 100
cogs are demanded. If cogs cost $2, then 125 cogs are demanded. • Can the Price-Elasticity of Demand be calculated for either
good? • If so, calculate the PED.

Example 3: Consider the market for widgets and cogs . You study survey data and observe that if widgets cost $5, then 100
widgets are demanded and 60 cogs are demanded. You also observe that if widgets cost $3, then 200 widgets are demanded
and 100 cogs are demanded. If cogs cost $2, then 125 cogs are demanded. • Can the Price-Elasticity of Demand be calculated for
either good? • If so, calculate the PED.

Example4: Calculate the elasticity coefficient from the data above for the interval where price changes from 8 to 7. Where is the
range of unit price elasticity of demand for the following demand curve?
Price 8 7 6 5 4 3
Quantity 3 4 5 6 7 8

Example5: If the price of good X decreases by 2.1% and the price elasticity of demand is 0.4, find the percentage change in
quantity demanded and the percentage change in revenue. If you want to increase revenue should you increase or decrease the
price in this case?

Case Study: Problem: Highway Blues

Ratan Sethi opened a petrol-pump cum retail store on Delhi – Agra Highway about two-hour drive from Delhi. His store sells
typical items needed by highway travelers like fast foods, cold drink, chocolates, hot coffee, children’s toys etc. He charges
higher price compared to the sellers in Delhi, yet he is able to maintain brisk sales – particularly of “Yours’ Special Pack” (YSP)
consisting of soft drink in a disposable plastic bottle and a packer of light snacks. The Highway travellers prefer to stop at his
store because, while their cars wait for with some other item in the store). Each year he could substantially enhance his sales by
providing Special Summer Price on YSP which is almost half of its regular price.

Last year while returning from Delhi, Ratan found that a new, big and modern grocery shop has come up 15 kms from Delhi on
the National Highway. It has affected his sales but only marginally. But last month another large convenience store has opened
just 5 km away from his store. He knows that the challenge has come to his doorsteps and he expects to be adversely affected
by the existence of these two stores. He needs to meet this challenge and decides to use the pricing strategy which he has been
using quite effectively till recently. He now permanently reduces the price of YSP to half of its existing price. But at the end of
the year Ratan finds that his sales in general and of YSP in particular had declined by 20 percent.

Q1. Where has Ratan Sethi gone wrong?

Q2. If he was a managerial economist, how do you think he would have handled the situation?
Page18

By Pashupati Nath Verma


MGT 105: MANAGERIAL ECONOMICS: UNIT-I
DEMAND ESTIMATION
Estimation of demand and forecasting of demand both of these sometime misunderstood to be the same but they are
different: Demand estimation attempts to quantify the links between the level of demand for a product and the variables which
determines it whereas demand forecasting simply attempts to predict the level of sales at some particular future date. For this
reason the set of techniques used may differ, although there will be some overlap between the two.

In general, an estimation technique can be used to forecast demand but a forecasting technique cannot be used to estimate
demand. A manager who wishes to know how high demand is likely to be in two years’ time might use a forecasting technique.
A manager who wishes to know how the firm’s pricing policy could be used to generate a given increase in demand would use
an estimation technique
STAGES IN DEMAND ESTIMATION
Demand estimation involves a number of stages. Some of these stages may be omitted in the simpler methods of estimation,
like the first two steps (for simpler estimates). However, with a statistical study, or econometric analysis there are essentially
seven stages:

1. Statement of a theory or hypothesis: Identification of relationship between economic variables(Usually based on some
empirical experience or based on some well established theory)
An example of such a theory might be that the quantity people buy of a particular product might depend more on the past
price than on the current price
2. Model specification: Developing mathematical equation satisfying relationship between economic variables
Various alternative models may be specified at this stage, since economic theory is often not robust enough to be definitive
regarding the details of the form of model.
3. Collection of Data: Collecting data related to economic variables considered in Model developed earlier from relevant
sources.
4. Estimation of parameters of the Model: On the basis of collected data, parameters values are estimated (these values
parameter defines that how and how much the different variables are related)
5. Checking goodness of fit. Once a model, or maybe several alternative models, have been estimated, it is necessary to
examine how well the models fit the data and to determine which model fits best.
6. Hypothesis testing. Having determined the best model, we want to test the hypothesis stated in the first step; in the
example quoted we want to test whether current price or past price has a greater effect on sales.
7. Development of estimates based best model.

METHODS OF DEMAND ESTIMATION


There are a variety of ways that can be used to estimate demand, each of which has certain advantages and disadvantages.

CONSUMER SURVEYS: (Questioning the consumer to determining his behavior). These are based questioning the consumer to
determining his consumption behavior using questionnaire, interviews etc.
Advantages:
• They give up to date information about the current market scenario.
• Much useful information can be obtained that would be difficult to uncover in other ways; for example, if consumers
are ignorant of the relative prices of different brands, it may be concluded that they are not sensitive to price changes.
This can be exploited by the firms for their best possible interest.
Disadvantages: Validity, Reliability, Sample Bias.

MARKET EXPERIMENTS: (Direct market experiments to understand the changes in demand due to changes in it s depended
variables) Here consumers are studied in an artificial environment. Laboratory experiments or consumer clinics are used to test
consumer reactions to changes in variables in the demand function in a controlled environment. Experimenter need to be
careful in such experiments as the knowledge of being in the artificial environment can affect the consumer behavior.
Advantages:
Direct observation of the consumers takes place rather than something of a hypothetical theoretical model.
Disadvantages:
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There is less control in this case, and greater cost; furthermore, some customers who are lost at this stage may be difficult to
recover.
Experiments need to be long lasting in order to reveal proper result.

STATISTICAL TECHNIQUES: These are various quantitative methods to find the exact relationship between the dependent
variable and the independent variable(s).
• The most common method is regression Analysis :
• Simple (bivariate) Regression: Y = a + bX
• Multiple Regression: Y = a +bX1 + c X2 +dX3 +..

By Pashupati Nath Verma


MGT 105: MANAGERIAL ECONOMICS: UNIT-I
DEMAND FORECASTING
Large numbers of firms produce for a future anticipated demand. Accurate demand forecasting is necessary in order to produce
right quantities at the right time and arrange well in advance for the various factors of production like raw materials, equipment,
machine accessories, labor and building. These forecasting based decisions will influence current level of production, which is
dependent upon anticipated future demand.
Demand forecasting reduces the uncertainties associated with business. A forecast is a prediction or estimation of a future event.
Accuracy of a forecast is determined by its nearness to the actual value in future.

NEED FOR FORECASTING


1. Long Range Strategic Planning for corporate objectives such as profit, market share, Return on Capital Employed (ROCE),
strategic acquisitions, international expansion, etc.
2. Annual Budgeting for operating plans such as annual sales, revenues, profits
3. Annual Sales Plans for regional and product specific targets.
4. Resource Needs Planning for HRM, Production, Financing, Marketing, etc

TYPE OF DEMAND FORECASTING

1. LONG TERM DEMAND (forecast are related to the need for capacity expansion or reduction depending upon the demand in
the long run ie more than 5 years)

2. MEDIUM TERM FORECAST (deals with business cycles that usually last for periods from two to five years.)

3. SHORT TERM DEMAND (forecast is done for production schedules of less than one year; It is done to deal with annual
variations in sales).

APPROACHES TO FORECASTING

1. JUDGMENTAL APPROACHES: the forecast is based upon the judgment and expertise of experts.
2. EXPERIMENTAL APPROACHES: A demand experiment is conducted among a small group of consumers who are adequately
representative of characteristics of general population. This type of approach is adopted when the product being introduced
is new, and there is no pre-existing data available.
3. RELATIONAL CAUSAL APPROACHES: Interviews and other methods are used to determine the reasons why consumers
purchase a particular product. Once these reasons are clear, the forecast can be done.
4. TIME SERIES APPROACHES: Sales and other data for different markets, for different periods of time is analyzed to get a
general trend or pattern in sales.

Page20

By Pashupati Nath Verma


MGT 105: MANAGERIAL ECONOMICS: UNIT-I
METHODS FOR DEMAND FORECASTING OF AN ESTABLISHED PRODUCT
Demand forecasting for an established product is easier than a new product as at least we have some historical data
in case of established product. Various techniques used in this case are discussed below in some detail.

The methods used may be divided broadly into two categories, qualitative and quantitative. Demand forecasting is full of
uncertainties due to changing conditions. Consumer behavior is unpredictable as it is motivated and influenced by a multiplicity
of forces. Every method developed for forecasting has its advantages and disadvantages and selection of the right method is
crucial to make as accurate as possible forecast. A right combination of quantitative and qualitative methods is to be used.

QUALITATIVE TECHNIQUES

Qualitative techniques are generally used when there is insufficient data available for quantitative analysis. They are also known
as subjective methods as they are dependent upon intuition based on experience, intelligence, and judgment. They are also
preferred for giving a quick estimate and cost savings.
Some of these techniques are as follows

OPINION POLE METHODS: As the name suggest, forecast in this method is subjected to opinion of respondent. Respondents
may be either of the Consumers or Sales-force or Experts. On the basis of respondent we can further classify this category as
follows:
1. Consumer’s Survey or Survey of Buyer’s Intention
2. Sales force opinion
3. Experts Opinion

CONSUMER’S SURVEY OR SURVEY OF BUYER’S INTENTION: Under this category consumers are surveyed (in personal or by
phone or by post or using internet) to know the consumer’s buying intention about the product during a specific time period.
While surveying, there are three main methods for the interviews.
Complete Enumeration method: All the Sample Survey Method: A sample of End use Method: Information about the
consumers of the product are consumers is interviewed. end use of the product is collected from
interviewed and their future plans for Advantage: Low Cost the industrial users to calculate the
product is ascertained. Disadvantage: Requires expertise. demand in industries, exports etc.
Advantage: First hand unbiased Advantage: Useful in case of
information intermediate product
Disadvantage: High Cost, Disadvantage: Not useful in case of, ‘too
many’ end uses

SALES FORCE OPINION METHODS: This method is based on gathering opinion of sales personnel who are closer to customers.
Method can be used to forecast competitive technologies that are emerging in the market.
Advantage: Low Cost, Fast, May be used for new product.
Disadvantage: Not useful for long range forecast, Correction and Adjustment factor needed.

EXPERT’S OPINION METHODS: This is a qualitative forecasting technique in which a panel of experts working together in a
meeting arrives at a consensus through discussion & ranking the ideas. Subjective estimates of experts are identified. Method
emphasize on group exercise. It involves key stakeholders: company executives, dealers, distributors, suppliers, marketing
consultants, professional association members.
Advantage: Easy and Quick method of forecasting
Disadvantage: Too much weight to executives opinions truth telling??

Delphi Method is one of the formalized technique of Expert’s Opinion Method:


Delphi Method: A qualitative forecasting technique in which panel of experts working separately and not meeting, arrive at a
consensus through the summarizing of idea by a skilled coordinator. This is similar to jury opinion, but also incorporates a
structured process to minimize the undesirable aspects of group interactions and improve reliability and accuracy, It Reduces
“group-think” and it is effective method of long-range forecasting, Sometimes there may not be any consensus among experts
Page21

Procedure of Delphi Method:


1. Choose the experts to participate representing a variety of knowledgeable people in different areas
2. Through a questionnaire (or E-mail), obtain forecasts (and any premises or qualifications for the forecasts) from all
participants
3. Summarize the results and redistribute them to the participants along with appropriate new questions
4. Summarize again, refining forecasts and conditions, and again develop new questions
5. Repeat Step 4 as necessary and distribute the final results to all participants

By Pashupati Nath Verma


MGT 105: MANAGERIAL ECONOMICS: UNIT-I
QUANTITATIVE TECHNIQUES

TREND PROJECTION: Time series analysis in statistics provides techniques by which all trend components, cyclic component &
Seasonal Component and their effects on demand are isolated and identified. Techniques used for measuring the trend are:
Graphical Method Method of Semi-Averages Method of Moving Averages Method of Least Square
Annual Sales data is Entire set of historical data is In this method an averaging period By the method of least square a
plotted on paper and divided in to two parts. A is selected and forecast for the functional relation between
trend line is drawn trend line is drawn through next period is the arithmetic demand and its determinant is
through the points the averages of the two average of the AP most recent developed by the use of this
for making halves for making forecast. actual demands. functional relation demand is
projection/forecast. This technique is useful only This technique is useful when forecasted.
This method is simple in case of linear trend there is a cyclic variation the Functional relation by this
and less expensive. demand. Sometimes weighted method may be a polynomial or
MAs also used. an exponential relation.

METHOD OF REGRESSION ANALYSIS: Regression analysis establishes a relationship between a dependent variable and one or
more independent variables. In simple linear regression analysis there is only one independent variable. Simple linear regression
can also be used when the independent variable X represents a variable other than time. Multiple regression analysis is used
when there are two or more independent variables.
An example of a multiple regression equation is:
Y = 50.0 + 0.05X1 + 0.10X2 – 0.03X3
where: Y = firm’s annual sales ($millions)
X1 = industry sales ($millions)
X2 = regional per capita income ($thousands)
X3 = regional per capita debt ($thousands)

BOX JENKINS METHOD: Box Jenkins Method also known as ARIMA(‘Auto-Regressive Integrated Moving Average’) models, this is
an empirically driven method of systematically identifying, estimating, analyzing and forecasting time series. This method is used
only for short term predictions since it is suitable only for demand with stationary time series sales data, i.e. the one that does
not reveal the long term trend.
The models are designated by the level of auto regression, integration and moving averages (P,d,q) where P is the order of
regression, d is the order of integration and q is the order of moving average.
There are 3 components of the ARIMA process:
 AR(Autoregressive) process.
 MA(Moving Average) process.
 Integration process.
AR process: Of order ‘p’, generates current observations as a weighted average of the past observations over p periods,
together with a random disturbance in the current period.
Yt=μ+a1Yt-1+a2Yt-2+….+apYt-p+et

MA process: Order q, each observation of Yt is generated by the weighted average of random disturbances over the past q
periods.
Yt= μ +et-c1et-1-c2et-2+….-cqet-q
Integrated Process: Ensures that the time series used in the analysis is stationary. The previous 2 equations are combined to
form:
Yt=a1Yt-1+a2Yt-2+...+apYt-p+μ+et-c1et-1-c2et-2+…-cqet-q

LEADING INDICATORS METHOD


If there are frequent turning points then trend method cannot explain the relationship fully between time and sales as there is
negative relationship sometimes, while at other it is positive. Therefore some other indictor is used which shows a similar
variation as the commodity. It can be GNP, personal income, bank rate, WPI, Industrial production, Employment Rate etc. There
might be some time lag or lead in case of these indictors affecting the demand of the product. After identifying the product, one
may use the regular least square approach to get the sales forecast. This is also known as barometric method as indicator is used
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as a barometer to forecast the demand.

By Pashupati Nath Verma


MGT 105: MANAGERIAL ECONOMICS: UNIT-I
METHODS FOR DEMAND FORECASTING OF AN NEW PRODUCT
To forecast demand for new products, we can use either of the following four methods:
1. Survey of Buyer’s Intention
2. Test Marketing
3. Life Cycle segment Analysis
4. Historical Analogy Method
5. Bounding curves Method
SURVEY OF BUYER’S INTENTION: Discussed earlier.
LIFE CYCLE SEGMENT ANALYSIS: Sales curve of any commodity eventually turns
out to be ‘S’ shaped. This is known as product life cycle. The first stage is Research
and Development, where product is market tested. No sales occur but a lot of
expenditure is incurred. In Introduction stage product is launched and commercial
exploitation and marketing begins. Sales grow in the next two stages of ‘market
development’ and ‘exploitation’. Intensive advertising and sales promotion is
done. At this optimum level of resource utilization the firm gets maximum profit
here. As similar products by competitors flood the market, growth rate of sales
decline in the ‘maturity’ stage. Price elasticity is very high, and in the later
‘saturation’ stage the high cross elasticity between different brands makes rate of
sales growth zero. Marketing becomes ineffective, but firms maintain quality,
services etc to maintain market share. Eventually this leads to the phase of
decline the product life comes to an end. In this method forecasting is done on the basis of stage of PLC it is running in the
industry.
TEST MARKETING: It involves selecting a test area which can be regarded as true sample of total market. The product is
launched in that area in the same manner in which it is intended to be used when product is launched nationally. All marketing
devices are selected with this in mind. The sales data of the product in the test area is then used to forecast the demand for the
product nationally.
This method is costly and time consuming. Considerable energy and effort goes as all marketing devices are used for a small
area. Selection of an appropriate test area is also difficult. The test needs to be run for a long period of time, to be sure about
the sales data. Also differences in sociological and psychological characteristics need to be taken into account for this data. The
launch if product in a test area gives competitors to prepare for the imitation of the product or prepare their own strategies to
deal with the product.
HISTORICAL ANALOGY METHOD: This method is used for forecasting demand for a new product or an existing product when
introduced in a new area. When it is an existing product, then its sales data for a previous place (which has similar socio-
economic conditions as the place where the product is being introduced) is taken for studying and estimating the future
demand. In such cases one has to carefully account for sociological and psychological differences. Generally, places which are as
similar as possible are taken for studying. If the product has not been used anywhere, then the past consumption pattern of
some other similar product is taken as basis for forecasting the demand for the product.
The process is difficult as it is tough to find very similar locations, account for all the differences or find a similar product.

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By Pashupati Nath Verma