Business

Economics
CHAPTER ONE
Contents

Nature and Scope of Business Economics

Concept of Utility
Law of Diminishing Marginal Utility
Law of Equi - Marginal Utility
Indifference Curve and its techniques.
Consumer Surplus.
Indifference Curve – map, features
Budget Line – Shifts, Consumer Equilibrium.
Economics studies that aspect of the individual
and society in which limited resources are used
to satisfy unlimited wants.

Thus it is a science of choice and is concerned

with the satisfaction of human wants
The term economics is derived
from the Greek words oikos and
nomos which put together mean
household management.
 Meaning of Managerial economics/
Business Economics

Managerial economics is the integration of economic theory with

business practice for the purpose of facilitating decision-making and
forward planning by management….. Spencer and Siegelman
It is the study of allocation of available resources to a business firm or
an organisation.
It deals in making rational choices to achieve maximum returns out of
minimum resources and efforts by choosing the best alternative course
of action.

It is economics as applied to decision making bridging gap between

economic theory and managerial practice.
 FEATURES AND SIGNIFICANCE OF
BUSINESS ECONOMICS
Applies economic theories to practical problems in business
Determines how competition and market structure determines sales
and prices
It is concerned with firm’s behaviour in optimal allocation of resources.
Incorporates elements of both micro as well as macro economics in
dealing with management problems.
It is the base for construction of an optimising model for profit
maximisation goal of the firm.
Helps analyse markets, industry trends, and macro trends
Helps solve business problems under conditions of uncertainty of
future
Economics is a science or an art?
 Economics is a science or an art

• It is considered as science if it is a systemized body of knowledge

which studies the relationship between cause and effect.

• Art is nothing but practice of knowledge.

• Where as science teaches us to know and art teaches us to do.

• It is science in it’s methodology and art in it’s application.

Science – Meaning & Characteristics
Science is a systematic study of facts and figures
which establish relationship between cause and
effect.

It is capable of measurement .

It has its own methodology.

It has ability to forecast

 Economics as science
Economics as well like science establishes a relationship between
cause and effect.

Ex: Law of demand – price decrease is the cause and demand increase
is the effect

Economics is capable of being measured (In terms of money)

Economics has its own methodology of study i.e., Induction (Particular

to general – assessing one student and drawing conclusion of the
entire class) and Deduction (General to particular)

Economics forecasts the future market conditions with the help of

statistical & non statistical tools.
ECONOMICS AS POSITIVE SCIENCE OR

NORMATIVE SCIENCE
Positive Economics explains the economic
phenomenon as what is , what was and
what will be.

Normative Economics prescribes what it

ought to be.
POSITIVE SCIENCE
Cause & Effect relationship – Law of Demand

No value judgment

States facts

Descriptive in nature
NORMATIVE SCIENCE

Value judgments

What ought to be
ART
The best way to perform any work is ART

An Art is a system of rules for the purpose of attainment

Characteristics of Art

Application

Practice of knowledge
 ECONOMICS AS ART
The various branches of economics viz., consumption,

production, public finance etc., provides practical

solutions to various economic problems which are faced

in everyday lives.
CONCLUSION
Economics may be treated as pure and positive economics
but as a tool of practical application it must have some
normative goals.
Hence economics is both positive & normative science.
Science indicates the facts / knowledge and Art indicates
the application
Hence, ECONOMICS IS BOTH SCIENCE & ART.
SCIENCE IN CASE OF METHODOLOGY & ART IN CASE OF
APPLICATION.
Science and Art are being complimentary to each other
Scope of Business Economics
Demand Forecasting

Cost Analysis

Profit Analysis

Capital Management
 Demand Forecasting
Every business firm initiates and continues its production process
on the basis of the anticipation of more demand for its goods in
the future.

It makes research and conducts market survey with a view to

know the tastes and fashions of the consumers.

It pools up the resources and starts production for meeting the

future demand.

Business Economics analyses the demand behavior and forecasts

the quantity demanded by the consumers.
Cost Analysis
Business Economics deals with the analysis of different costs
incurred by the business firms.

Every firm desires to minimize its costs and increase its output by
securing several economies of scale. But it does not know in
advance about the exact costs involved in production process.

Business Economics deals with the cost estimates and acquaints

the entrepreneurs with the cost analysis of their firm.
Profit Analysis
Every business firm aims to secure maximum profits.
But at the same time it faces uncertainty and risk in
getting profits. It has to make innovations in
production and marketing of its goods.

Business Economics deals with the matters relating to

profit analysis like profit techniques, policies and
break-even analysis.
Capital Management

Capital management is another topic dealt in

Business Economics. It denotes planning and
control of capital expenditure in business
organization. It studies matters like cost of
capital, rate of return, selection of best project
etc.
MICRO & MACRO ECONOMICS
 MEANING
MICRO ECONOMICS
Studies the decisions made by
individuals & business
concerning the distribution of
resources & prices of goods &
services.
It deals with specific industry or
sector, the connection of firms
& households in the market.
Ex: How a Co., can lower its
prices to increase its product
demand in the market.
MACRO ECONOMICS
It studies not only the behavior of
any particular company or
industries but the whole
economy.
It includes understanding how
unemployment, price levels,
growth rate affects the economy.
Ex: how an increase or decrease
in net imports would affect a
nation’s capital account
 MICRO ECONOMICS MACRO ECONOMICS

It deals with the decision making of It deals with the aggregate of the entire
single economic variables such as the economy such as national income,
demand, price, consumer etc., aggregate output, savings etc.,
It is narrow in scope & interprets the It has a wide scope & interprets the
small constituents of the entire economy economy of a country as a whole.
It helps in developing policies, It helps in developing policies,
appropriate resource distribution at firm appropriate resource distribution at
level economy level such as inflation,
unemployment level etc.,
Stages & Definitions of Economics
Wealth Definition (1776) • Adam Smith

Welfare Definition (1890) • Alfred Marshall

Scarcity Definition (1932) • L.Robbins

Growth Oriented Definition • Samuelsons

(1948)
• Jacob Viner
Need Oriented Definition
Wealth definition: Adam Smith,
Father of Economics – Science of
Wealth
Adam Smith, who is regarded as Father of
Economics, published a book titled ‘An Inquiry
into the Nature and Causes of the Wealth of
Nations’ in 1776.
He defined economics as “a science which
inquires into the nature and cause of wealth of
nations”.
He emphasized the production and growth of
wealth as the subject matter of economics.
 Features of Wealth Definition
CHARACTERISTICS:
Exaggerated the emphasis on wealth
It inquires the cause behind creation of wealth.
CRITICISMS:
It considered economics as a selfish science.
It defined wealth in a very narrow and restricted sense.
It considers only material and tangible goods.
It gave emphasis only to wealth and reduced man to
secondary place.
Welfare Definition (1890) Alfred
Marshall
In 1890, Alfred Marshall stated that “Economics is
a study of mankind in the ordinary business of life;

It is on one side a study of wealth; and on the

other side, a study of human welfare based on
wealth.
 Features of Welfare Definition
Characteristics:
It is primarily the study of mankind.
It is on one side a study of wealth; and on other side the study of
mankind.
Criticisms:
It restricts the scope of economics to the
study of persons living in organized
communities only.
Welfare in itself has a wide meaning which
is not made clear in definition.
Scarcity Concept
According to Lionel Robbins: “Economics is
the science which studies human behavior
as a relationship between ends and scarce
means which have alternate uses”

He emphasized on ‘choice under scarcity’. In

his own words, “Economics” is concerned
 Characteristics:
Economics is a positive science.

New concepts: Unlimited ends, scarce means, and

alternate uses of means.

It emphases on Choice – A study of human behavior

It tried to bring the economic problem which forms

the foundation of economics as a social science.

It takes into account all human activities.

Criticisms:
It does not focus on many important economic issues of
cyclical instability, unemployment, income
determination and economic growth and development.

It does not take into account the possibility of increase

in resources over time.

It has treated economics as a science of scarcity only.

PAUL A SAMUELSON
Growth Definition (1948)

According to Prof. Paul A Samuelson “Economics is the study of how men and

society choose with or without the use of money, to employ the scarce

productive resources which have alternative uses, to produce various

commodities over time and distribute them for consumption now and in future

among various people and groups of society. It analyses the costs and benefits

of improving pattern of resource allocation”.

This definition introduced the dimension of growth under scarce situation

Characteristics:
It is not merely concerned with the allocation of resources but also with the
expansion of resources.

It analyzed how the expansion and growth of resources to be used to cope with
increasing human wants.

It is a more dynamic approach.

It considers the problem of resource allocation as a universal problem.

It focused on both production and consumption activities.

It is comprehensive in nature as it is both growth-oriented as well as future-

oriented.

It incorporated the features of all the earlier definitions

Criticisms:

It assumes that economics is relevant for

scarcity situations and it ignored surplus

resource conditions
UTILITY
What is Utility?
Satisfaction, happiness, benefit
Utility

An economic term referring to the total

satisfaction received from consuming a
good or service.
 Meaning: Utility
When a consumer consumes or buys a
commodity, he derives some benefit in the form
of satisfaction of a certain want. This benefit or
satisfaction experienced by the consumer is
referred to by economist as ‘utility’.
In simple words, capacity of commodity to satisfy
a human want.
Types of Utility
Types of Utility
A) Form Utility
B) Place Utility
C) Time Utility
FORM UTILITY
The utility arising when the form
of the product changes.
Example: A timber merchant
converts teak logs into furniture
and sells it, the merchant has
created form utility.
PLACE UTILITY
Transferring goods from place where it is available
in abundance to places where there is a scarcity
creates place utility.

A place utility can be created when a business man

take a product from A place (where it is in surplus)
and he sells it in place B(where it is deficit).
TIME UTILITY
Time utility can be created when the
product is available at a time when
earlier it wasn’t.
Example: Retailers offer large
supplies of backpacks in the late
summer, near the beginning of the
school year.
Utility Measures
Economists have offered their theories
of consumer behaviour on the basis of
measurement of utility.
There are two major approaches
1) Cardinal Utility Theory
2) Ordinal Utility Theory
 Cardinal Utility vs. Ordinal Utility

Cardinal Utility: Assigning numerical values to the

amount of satisfaction

Ordinal Utility: Not assigning numerical values to

the amount of satisfaction but indicating the order
of preferences, i.e., what is preferred to what
Example: Consider the result of an exam

• An ordinal ranking lists the students in order of

their performance
E.g., Harry did best, Henry did second best,
Simon did third best, and so on.

• A cardinal ranking gives the marks of the exam,

based on an absolute marking standard
E.g. Harry got 90,Henry got 85, Simon got 80,
and so on.
Cardinal Measurement of Utility
It is a numerical expression.

Utility can be measured in numerical terms

in its own units called ‘utils’.
CARDINAL MEASUREMENT OF UTILITY

Total Marginal
Utility Utility
Total Utility (TU)
Definition: Total utility means total satisfaction
experienced or attained by the consumer
regarding all the units of a commodity taken
together in consumption or acquired at a time.
Total utility is the total satisfaction received from
consuming a given total quantity of a good or
service.
Total Utility is more with larger stock and less with a smaller stock.
Mathematically, TU is a direct function of the number of units of a
commodity in consideration.

TUx = F(Qx)

Read: (Total utility of X is the increasing function of its quantity).

Whereas,
TUx = Total Utility of a commodity x..
F = Functional relation.
Qx = Quantity of X
Marginal Utility
Marginal utility (MU) of an additional unit. Change in
utility derived from consuming an additional unit of a
good.
Zero Utility – Consumption of an additional unit results
in no Utility
Negative Utility – Instead of giving utility , a unit gives
disutility
Relationship Between MU and TU
Theory of Demand
Concept of utility

The law of diminishing marginal utility

The law of qui-marginal utility

LAWS OF UTILITY ANALYSIS

UTILITY ANALYSIS

LAW OF LAW OF
DIMINISHING EQUI-MARGINAL
MARGINAL UTILITY UTILITY
LAW OF DIMINISHING MARGINAL
UTILITY
 6
4

LAW OF DIMINISHING MARGINAL

UTILITY
This is one of the most fundamental laws of
consumption.

Original version – Prof.H.H.Goosen

It described as the first law of Goosen.

Modified and Final version – Alfred Marshall.

hence , it is called as Marshallian law in Economics

 6
The law of diminishing marginal utility, as 5

defined by Alfred Marshall, states that

- “The additional benefit which a person

derives from a given increase of his stock, of
anything diminishing with every increase in the
stock that he already has”.
 Understanding the Law

It states that as the consumer

goes on consuming more and
more amount of commodity the
marginal utility of the
commodity goes on declining
becomes zero and finally
becomes negative.
 6
7

On the basis of the statement,

we can say that utility of a commodity
depends on the quantity of a commodity. It can
be expressed in terms a mathematical equation.

MU x = f (Qx)
Assumptions of the
Law
 7
0

The Consumer acts rationally

The Commodity is homogenous

A commodity has no substitutes

Utility of a commodity can be measured in terms

of numbers
 71

Price of the commodity, income, tastes and habits

etc of a consumer remains constant

Utility of a product depends on the quantity of that

commodity alone
Illustration : Total And Marginal Utility 7
2

Chocolate Consumption
Number of Chocolate Total Utility Marginal Utility
In units In units

0 0 -
1 30 30
2 50 20
3 60 10
4 65 5
5 68 3
6 68 0
 7

Figure 3: Total And Marginal 3

Utility
Utils 70
60 Total Utility
50
40 1. The change in total utility from
30 one more Chocolate . . .
20
10

1 2 3 4 5 6
Ice Cream Cones per Week
2. is called the marginal utility 3. Marginal utility falls
Utils of an additional Chocolate. as more Chocolate are
30
20 consumed.
10
Marginal Utility
1 2 3 4 5 6
Chocolate
 7
4

Trends in Utility
 Total Utility goes on increasing at a
diminishing rate with consumption of
additional units

 Total Utility will be the highest when

Marginal Utility is Zero
 7

Trends in Utility 5

 Total Utility declines when Marginal Utility

becomes negative

 Marginal Utility will be the highest in the

beginning, decline in the latter stages,
becomes zero and negative at the end
Exceptions to the law…

THE LAW WILL NOT OPERATE UNDER FOLLOWING

CONDITIONS….
 7
7

Exceptions to the law

Either abnormal or
subnormal persons
 7
8

Exceptions to the law

Rare collections like
Stamps, coins etc
 7
9

Exceptions to the law

Size of the commodity
consumed is too small

If there is considerable interval

between the consumption of
additional units
 8
0

Exceptions to the law

In case of drunkards

In case of music listening

etc….
Practical
Importance
 8
2

Practical Importance
It is the basis for the negative
slope of the Demand curve

It is the basis for determining

the demand for the goods and
services.
 Practical Importance 8
3

It is the basis for progressive

taxation policy

It is the basis for advocating

redistribution of income in
favour of poor people
 8
4

Practical Importance
It is the basis for the theory of
value

It is the basis to distinguish

between value-in-exchange and
value-in-use
 8
5

Practical Importance
This law regulates the consumption
expenditure of consumers

The law applies not only to commodities

but also to money
THE LAW OF EQUI-
MARGINAL UTILITY
 Definition and explanation of the law:

The law of equi-marginal utility is simply an extension of the

law of diminishing marginal utility to two or more than two
commodities.

The law of equi-marginal, is known, by various names. It is

named as the Law of Substitution, the Law of Maximum
Satisfaction, the Law of Indifference, the Proportionate Rule
and the Goosen’s Second Law.
 THE LAW OF EQUI-MARGINAL UTILITY

According to this, a consumer is in equilibrium when he

distributes his given money income among various goods in such
a way that marginal utility derived from the last rupee spent on
each good is the same.
 Meaning

This law points out how a consumer can get

maximum satisfaction out of given expenditure
on different goods.
The law states that in order to get maximum
satisfaction, a consumer should spend his
limited income on different commodities in
such a way that the last rupee spent on each
commodity yields him equal marginal utility.
 1. Traditional Statement of the law
According to traditional statement consumer
will spend his money income in such a way that
last rupee spend on each product will give him
equal Satisfaction.

MU1 = MU2 = …………….MUn

 Explanation
Income= Rs 5
Price of Apples and Orange = Rs. 1

Rupee MU of MU of
Apples Orange Y
1st 10 7 MU
10 apple
2nd 8 6 (2nd
rupee.) 8 MU Orange
6
3rd 6 (3rd 5
rupee)
4
4th

Gain
4 4
2
5th 2 3
O 1 2 3 4 5 X O 1 23 4 5 X
Units of Money
 2. Modern Statement
Modern economist also call it as the ‘ Law of
Proportionality’.
According to them a person gets maximum
satisfaction when the weighted marginal utilities
are equal. In other words, when marginal utilities
of one commodity divided by its price and the
marginal utility of the other commodity divided
by its price are equal.
MUa MUb MUc
-------- = ------------ = -----------
Pa Pb Pc
 Total money=Rs24
Price of X= Rs 2
Price of Y= Rs 3
MU of x & y MU of money Expenditure

Units MUx MUy MUx/Px MUy/Py

1 20 24 10 8

2 18 21 9 7

3 16 18 8 6

4 14 15 7 5

5 12 9 6 3

6 10 3 5 1
 Consumer’s choice under Law of Equi -marginal utility

Y Y

10
9

8
7

6
5
MUx/Px
4

3 MUy/Py

O
1 2 3 4 5 6 X O 1 2 3 4 5 6 X
Quantity of X Quantity of Y
Y

10
9

8
7
6

5
4

Gain
3

O
1 2 3 4 5 6 X O 1 2 3 4 5 6 X
Quatity of X Quantity of Y
Assumptions:

 Independent utilities. The marginal utilities of different commodities are

independent of each other and diminishes with more and more purchases.

 Constant marginal utility of money. The marginal utility of money remains constant
to the consumer as he spends more and more of it on the purchases of goods.

 Utility is cardinally measurable.

 Every consumer is rational in the purchase of goods.

 Limited money income. A consumer has limited amount of money income to spend.
As we know, every consumer has unlimited wants.

However, the income at his disposal at any time is limited. The

consumer is therefore, faced with a choice among many
commodities that he can and would like to pay.

He therefore, consciously or unconsciously compares the

satisfaction which he obtains from the purchase of the
commodity and the price which he pays for it. If he thinks the
utility of the commodity is greater than the utility of money, he
buys that commodity.
As he buys more and more of that commodity, the utility of the
successive units begins to diminish. He stops further purchase of the
commodity at a point where the marginal utility of the commodity and
its price are just equal.

If he pushes the purchase further from his point of equilibrium, then the
marginal utility of the commodity will be less than that of price and the
household will be a loser.
 Criticism
Consumer are not fully rational
Consumer is not calculating
Non availability of goods
Influence of fashion, customs and habits
Tastes and preferences are not constant
Change in income and price
Complementary goods
Marginal utility of money does not remain constant
 This law is known as the Law of Maximum Satisfaction because a consumer

tries to get the maximum satisfaction from his limited resources by so planning

his expenditure that the marginal utility of a rupee spent in one use is the same

as the marginal utility of a rupee spent on another use.

 It is known as the Law of Substitution because consumer continues substituting

one good for another till he gets the maximum satisfaction. It is called the Law

of Indifference because the maximum satisfaction has been achieved by

equating the marginal utility in all the uses.

 The consumer then becomes indifferent to read just his expenditure unless

some change takes place in his income or the prices of the commodities, etc.
CONSUMER SURPLUS
CONSUMER SURPLUS

The concept of consumer surplus is derived

from the law of diminishing marginal utility.
Let us take a look at an
example of consumer surplus.
No of Units Marginal Utility Price Consumer
Surplus
1 30 20 10

2 28 20 8

3 26 20 6

4 24 20 4

5 22 20 2

6 20 20 0

7 18 20 -
Further, the consumer is in equilibrium when
the marginal utility is equal to the price. That is, he
purchases those many numbers of units of a good at
which the marginal utility is equal to the price. Now, the
price is fixed for all units. Hence, he gets a surplus for all
units except the one at the margin. This extra utility is
consumer surplus.
 CONSUMER SURPLUS

From the table above, we see that as the consumption

increase from 1 to 2 units, the marginal utility falls from
30 to 28. This diminishes further as he increases
consumption. Now,
The actual price of the unit is fixed.
Therefore, the consumer enjoys a surplus on all
purchases until the sixth unit. When he buys the sixth
unit, he is in equilibrium, since the price he is willing to
pay is equal to the actual price of the unit.
Graphical Representation
 Explanation
Next, if OP is the price of a unit of the commodity, the consumer is
in equilibrium only when he purchases OQ units. In other words,
when marginal utility is equal to the price OP.
Further, the Qth unit does not yield any surplus since the price and
marginal utility is equal.
However, for the purchase of all units before the Qth unit, the
marginal utility is greater than the price, offering a surplus to the
consumer.
In above graph, the total utility is equal to the area under the
marginal utility curve up to point Q (ODRQ). However, for price =
OP, the consumer pays OPRQ. Hence, he derives extra utility equal
to DPR which is consumer surplus.
 Limitations
It is difficult to measure the marginal utilities of different units of
a commodity consumed by a person. Hence, the
precise measurement of consumer’s surplus is not possible.
For necessary goods, the marginal utilities of the first few units
are infinitely large. Hence the consumer’s surplus is infinite for such
goods.
The availability of substitutes also affects the consumer’s surplus.
Deriving the utility scale for prestigious goods like diamonds is
very difficult.
We cannot measure the consumer’s surplus in terms of money.
This is because the marginal utility of money changes as a
consumer makes purchases and his stock of money diminishes.
This concept is acceptable only on the assumption that we can
measure utility in terms of money or otherwise. Many modern
economists are against the concept.
ORDINAL APPROACH
 ORDINAL APPROACH
Ordinal measurement implies comparison and ranking
without quantification of the magnitude or differences
of satisfaction enjoyed by the consumer.
In ordinal sense, utility is viewed as the level of
satisfaction rather than amount of satisfaction.

Indifference curves have been devised to represent the

ordinal measurement of utility.
 Scale of Preferences
A rational consumer seeks to maximize his level of
satisfaction from the goods he buy.
Usually, he is confronted with combinations of many
goods and may have several alternatives in this context.
He would certainly rank them according to the different
levels of satisfaction in order to decide priorities. Such
a conceptual ordering of different goods and their
combinations in a set order of preferences is termed as
the scale of preferences.
 Scale of Preferences
Combination between Level of Ranking order of
apples and bananas satisfaction preference
derived
a) 12 apples + 12 bananas Highest I

b) 10 apples + 10 Bananas Lesser than a II

c) 5 apples + 5 bananas Lesser than b III

Indifference Schedule
An indifference schedule may be defined as a
schedule of various combinations of two
commodities which yield the same level of
satisfaction to the consumer.
Indifference Schedule
Draw Indifference map for the above indifference
schedule.
Properties of indifference curve
Indifference curve slope downwards to right

When a consumer wants to have more of a commodity, he/she will have to

give up some of the other commodity, given that the consumer remains on
the same level of utility at constant income. As a result, the indifference
curve slopes downward from left to right.
Indifference curve is convex to the origin

According to diminishing marginal rate of substitution, the rate of

substitution of commodity X for Y decreases more and more with each
successive substitution of X for Y.
The above table represents various combination of
coffee and cigarette that gives a man same level of
utility.
When the man drinks 12 cup of coffee, he consumes
1 cigarette every day.
When he started consuming two cigarettes a day, his
coffee consumption dropped to 8 cups a day.
In the same way, we can see other combinations as 3
cigarettes + 5 cup coffee, 4 cigarettes + 3 cup coffee
and 5 cigarettes + 2 cup coffee.
Indifference curve cannot intersect each other

Each indifference curve is a representation of

particular level of satisfaction.
The level of satisfaction of consumer for any given
combination of two commodities is same for a
consumer throughout the curve.
Thus, indifference curves cannot intersect each
other.
Higher indifference curve represents higher level of satisfaction

Higher the indifference curves, higher will be the level of satisfaction. This means, any
combination of two goods on the higher curve give higher level of satisfaction to the
consumer than the combination of goods on the lower curve.
Marginal Rate of Substitution
Marginal Rate of Substitution
The marginal rate of substitution (MRS) quantifies the amount
of one good a consumer will give up to obtain more of
another good.
◦ It is measured by the slope of the indifference curve.
◦ Along an indifference curve there is a diminishing marginal
rate of substitution.

Chapter 3: Consumer Behavior SLIDE 132

Example:
The MRS of X for Y represents the amount of
Y which the consumer has to give up for the
gain of one additional unit of X so that his or
her level of utility (satisfaction) remains the
same.
Formula:
Y
MRSxy 
X
MRSxy = Marginal rate of substitution of X for Y
Delta Y = A small change in the quantity of Y
Delta X = A small change in the quantity of X