Managerial Economics : Definition, Nature, Scope

Managerial economics is a discipline which deals with the application of economic theory to business
management. It deals with the use of economic concepts and principles of business decision making.
Formerly it was known as “Business Economics” but the term has now been discarded in favour of
Managerial Economics.

Managerial Economics may be defined as the study of economic theories, logic and methodology which
are generally applied to seek solution to the practical problems of business. Managerial Economics is
thus constituted of that part of economic knowledge or economic theories which is used as a tool of
analysing business problems for rational business decisions. Managerial Economics is often called as
Business Economics or Economic for Firms.

Definitions

1. Managerial economics is the application of economic theory and methodology to decision

making problems faced by both public and private institutions.

                                                                                                                               -McGutgan and Moyer

2. Managerial economics is concerned with the application of economic principles and

methodologies to the decision process within the organization. It seeks to establish rules and
principles to facilitate the attainment of the desired economic goals of management.

                                                                                                                                 -Mansfield

3. Managerial economics is the fundamental academic subject which seeks to understand and to
analyse the problems of business decision taking.

                                                                                                                                  -D.C. Hayue

4. Managerial economics is the integration of economic theory with business practice for the
purpose of facilitating decision making and forward planning by management.

                                                                                                                 -Milton Spencer and Louis Siegelman

5. Managerial economics is the study of the allocation of the resources available to a firm or other
unit of management among the activities of unit.

                                                                                                                                  -W.W Haynes

6. Managerial economics concerns efficient direction of a business organization so as to make a

productive enterprise out of human and material resources.

                                                                                                                                   -Savage and Small

 7. 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 Seigelman

 Definitions

In the words of TJ. Webster, "Managerial economics is the synthesis of microeconomic theory and
quantitative methods to find optimal solutions to managerial decision-making problems?

In the words of Hirschey and Pappas, "Managerial economics applies economic theory and methods to
business and administrative decision making"

According to Mansfield, "Managerial economics provides a link between economic theory and decision
sciences in the analysis of managerial decision making?

Brigham and Poppas believe that managerial economics is "the application of economic theory and
methodology to business administration practice."

Hague on the other hand, considers managerial economics as "a fundamental academic subject which
seeks to understand and to analyse the problems of business decision-making."

According to McNair and Meriam, “Managerial economics is the use of economic modes of thought to
analyse business situations.”

According to 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 organisation
under the conditions of uncertainty”. Spencer and Siegelman define it as “The integration of economic
theory with business practices for the purpose of facilitating decision making and forward planning by
management.”

According to Hailstones and Rothwel, “Managerial economics is the application of economic theory and
analysis to practice of business firms and other institutions.” A common thread runs through all these
descriptions of managerial economics which is using a framework of analysis to arrive at informed
decisions to maximize the firm’s objectives, often in an environment of uncertainty. It is important to
recognize that decisions taken while employing a framework of analysis are likely to be more successful
than decisions that are knee jerk or gut feel decisions. 

Thus from the above definitions it can be concluded that Managerial economics is a science dealing with
the application of the economic theory to business management. Managerial economics provides an
insight into the application of economics to solving business problems. Managerial economics thus lies
between economics and business management and serves as bridge between the two disciplines.

According to Spencer and Siegelman:  “The integration of economic theory with business practice for
the purpose of facilitating decision-making and forward planning by management”.
According to McGutgan and Moyer: “Managerial economics is the application of economic theory and
methodology to decision-making problems faced by both public and private institutions”. 

Managerial economics studies the application of the principles, techniques and concepts of economics
to managerial problems of business and industrial enterprises. The term is used interchangeably with
micro economics, macro economics, monetary economics.  

Characteristics of Managerial Economics: 

(i) It studies the problems and principles of an individual business firm or an individual industry. It aids
the management in forecasting and evaluating the trends of the market.

(ii) It is concerned with varied corrective measures that a management undertakes under various
circumstances. It deals with goal determination, goal development and achievement of these goals.
Future planning, policy making, decision making and optimal utilization of available resources, come
under the banner of managerial economics.

(iii)  Managerial economics is pragmatic. In pure microeconomic theory, analysis is performed, based on
certain exceptions, which are far from reality. However, in managerial economics, managerial issues are
resolved daily and difficult issues of economic theory are kept at bay.

(iv) Managerial economics employs economic concepts and principles, which are known as the theory of
Firm or 'Economics of the Firm'. Thus, its scope is narrower than that of pure economic theory.

(v) Managerial economics incorporates certain aspects of macroeconomic theory. These are essential to
comprehending the circumstances and environments that envelop the working conditions of an
individual firm or an industry. Knowledge of macroeconomic issues such as business cycles, taxation
policies, industrial policy of the government, price and distribution policies, wage policies and
antimonopoly policies and so on, is integral to the successful functioning of a business enterprise.

(vi) Managerial economics aims at supporting the management in taking corrective decisions and
charting plans and policies for future. 

(vii) Science is a system of rules and principles engendered for attaining given ends. Scientific methods
have been credited as the optimal path to achieving one's goals. Managerial economics has been is also
called a scientific art because it helps the management in the best and efficient utilization of scarce
economic resources. It considers production costs, demand, price, profit, risk etc. It assists the
management in singling out the most feasible alternative. Managerial economics facilitates good and
result oriented decisions under conditions of uncertainty. 

(viii) Managerial economics is a normative and applied discipline. It suggests the application of economic
principles with regard to policy formulation, decision-making and future planning. It not only describes
the goals of an organization but also prescribes the means of achieving these goals.
 Nature of Managerial Economics:

 The primary function of management executive in a business organisation is decision making

and forward planning.

 Decision making and forward planning go hand in hand with each other. Decision making means
the process of selecting one action from two or more alternative courses of action. Forward
planning means establishing plans for the future to carry out the decision so taken.

 The problem of choice arises because resources at the disposal of a business unit (land, labour,
capital, and managerial capacity) are limited and the firm has to make the most profitable use of
these resources.

 The decision making function is that of the business executive, he takes the decision which will
ensure the most efficient means of attaining a desired objective, say profit maximisation. After
taking the decision about the particular output, pricing, capital, raw-materials and power etc.,
are prepared. Forward planning and decision-making thus go on at the same time.

  A business manager’s task is made difficult by the uncertainty which surrounds business
decision-making. Nobody can predict the future course of business conditions. He prepares the
best possible plans for the future depending on past experience and future outlook and yet he
has to go on revising his plans in the light of new experience to minimise the failure. Managers
 are thus engaged in a continuous process of decision-making through an uncertain future and
the overall problem confronting them is one of adjusting to uncertainty.

  In fulfilling the function of decision-making in an uncertainty framework, economic theory can
be, pressed into service with considerable advantage as it deals with a number of concepts and
principles which can be used to solve or at least throw some light upon the problems of business
management. E.g are profit, demand, cost, pricing, production, competition, business cycles,
national income etc. The way economic analysis can be used towards solving business problems,
constitutes the subject-matter of Managerial Economics.

 Thus in brief we can say that Managerial Economics is both a science and an art.

Scope of Managerial Economics:

The scope of managerial economics is not yet clearly laid out because it is a developing    
science. Even then the following fields may be said to generally fall under Managerial Economics:

    1.  Demand Analysis and Forecasting

    2.  Cost and Production Analysis

    3.  Pricing Decisions, Policies and Practices

    4.  Profit Management

    5.  Capital Management

These divisions of business economics constitute its subject matter.

Recently, managerial economists have started making increased use of Operation Research
methods like Linear programming, inventory models, Games theory, queuing up theory etc., have also
come to be regarded as part of Managerial Economics.

   1.Demand Analysis and Forecasting: A business firm is an economic organisation which is

engaged in transforming productive resources into goods that are to be sold in the market. A major part
of managerial decision making depends on accurate estimates of demand. A forecast of future sales
serves as a guide to management for preparing production schedules and employing resources. It will
help management to maintain or strengthen its market position and profit base. Demand analysis also
identifies a number of other factors influencing the demand for a product. Demand analysis and
forecasting occupies a strategic place in Managerial Economics.

  2.Cost and production analysis: A firm’s profitability depends much on its cost of production. A
wise manager would prepare cost estimates of a range of output, identify the factors causing are cause
variations in cost estimates and choose the cost-minimising output level, taking also into consideration
the degree of  uncertainty in production and cost calculations. Production processes are under the
charge of engineers but the business manager is supposed to carry out the production function analysis
in order to avoid wastages of materials and time. Sound pricing practices depend much on cost control.
The main topics discussed under cost and production analysis are: Cost concepts, cost-output
relationships, Economics and Diseconomies of scale and cost control.

  3.Pricing decisions, policies and practices: Pricing is a very important area of Managerial
Economics. In fact, price is the genesis of the revenue of a firm ad as such the success of a business firm
largely depends on the correctness of the price decisions taken by it. The important aspects dealt with
this area are: Price determination in various market forms, pricing methods, differential pricing, product-
line pricing and price forecasting.

    4.Profit management: Business firms are generally organized for earning profit and in the
long period, it is profit which provides the chief measure of success of a firm. Economics tells us that
profits are the reward for uncertainty bearing and risk taking. A successful business manager is one who
can form more or less correct estimates of costs and revenues likely to accrue to the firm at different
levels of output. The more successful a manager is in reducing uncertainty, the higher are the profits
earned by him. In fact, profit-planning and profit measurement constitute the most challenging area of
Managerial Economics.

   5.Capital management: The problems relating to firm’s capital investments are perhaps the
most complex and troublesome. Capital management implies planning and control of capital
expenditure because it involves a large sum and moreover the problems in disposing the capital assets
off are so complex that they require considerable time and labour. The main topics dealt with under
capital management are cost of capital, rate of return and selection of projects. or

Nature and Scope of Managerial Economics

The most important function in managerial economics is decision-making. It involves the
complete course of selecting the most suitable action from two or more alternatives. The primary
function is to make the most profitable use of resources which are limited such as labor, capital, land
etc. A manager is very careful while taking decisions as the future is uncertain; he ensures that the best
possible plans are made in the most effective manner to achieve the desired objective which is profit
maximization.

 Economic theory and economic analysis are used to solve the problems of managerial
economics.

 Economics basically comprises of two main divisions namely Micro economics and Macro
economics.
  Managerial economics covers both macroeconomics as well as microeconomics, as both are
equally important for decision making and business analysis.

 Macroeconomics deals with the study of entire economy. It considers all the factors such as
government policies, business cycles, national income, etc.

 Microeconomics includes the analysis of small individual units of economy such as individual
firms, individual industry, or a single individual consumer.

All the economic theories, tools, and concepts are covered under the scope of managerial
economics to analyze the business environment. The scope of managerial economics is a continual
process, as it is a developing science. Demand analysis and forecasting, profit management, and capital
management are also considered under the scope of managerial economics.

Demand Analysis and Forecasting

 Demand analysis and forecasting involves huge amount of decision-making! Demand estimation
is an integral part of decision making, an assessment of future sales helps in strengthening the market
position and maximizing profit. In managerial economics, demand analysis and forecasting holds a very
important place.

Profit Management

Success of a firm depends on its primary measure and that is profit. Firms are operated to earn
long term profit which is generally the reward for risk taking. Appropriate planning and measuring profit
is the most important and challenging area of managerial economics.

Capital Management

Capital management involves planning and controlling of expenses. There are many problems
related to capital investments which involve considerable amount of time and labor. Cost of capital and
rate of return are important factors of capital management.

Demand for Managerial Economics

The demand for this subject has increased post liberalization and globalization period primarily
because of increasing use of economic logic, concepts, tools and theories in the decision making process
of large multinationals.

Also, this can be attributed to increasing demand for professionally trained management
personnel, who can leverage limited resources available to them and maximize returns with efficiency
and effectiveness.

Role in Managerial Decision Making

Managerial economics leverages economic concepts and decision science techniques to solve
managerial problems. It provides optimal solutions to managerial decision making issues

Importance of Managerial Economics 

Business and industrial enterprise aims at earning maximum proceeds. A good decision requires
fair knowledge of the aspects of economic theory and tools of economic analysis, which are directly
involved in the process of decision making. Since managerial economics is concerned with such aspects
and tools of analysis, it is pertinent to the decision making process.

Spencer and Siegelman have described the importance of managerial economics in a business
and industrial enterprise as follows:

1. Accommodating traditional theoretical concepts to the actual business behavior and

conditions

Managerial economics amalgamates tools, techniques, models and theories of traditional

economics with actual business practices and with the environment in which firm has to operate.
According to Edwin Mansfield, “ Managerial Economics attempts to bridge the gap between purely
analytical problems that intrigue many economic theories and the problems of policies that
management must face.”

2. Estimating economic relationships

Managerial economics estimates economic relationships between different business factors

such as income, elasticity of demand, cost volume, profit analysis etc.

3. Predicting relevant economic quantities

Managerial economics assist the management in predicting various economic such as cost,
profit, demand, capital, production, price etc. As a business manager has to function in an environment
of uncertainty, it is imperative to anticipate the future working environment in terms of the said
quantities.

4. Understanding significant external forces

The management has to identify all the important factors that influence a firm. These factors
can broadly be divided into two categories. Managerial economics plays an important role by assisting
management in understanding these factors.

 External factors

A firm cannot exercise any control over these factors. The plans, policies and programmes of the
firm should be formulated in the light of these factors. Significant external factors impinging on the
decision making process of a firm are economic system of the country, business cycles, fluctuations in
national income and national production, industrial policy of the government, trade and fiscal policy of
the government, taxation policy, licensing policy, trends in foreign trade o the country, general industrial
relation in the country and so on.

 Internal factors

These factors fall under the control of a firm. These factors are associated with business
operation, knowledge of these factors aids the management in making sound business decisions.

5. Basis of business policies

Managerial economics is the founding principle of business policies. Business policies are
prepared based on studies and findings of managerial economics, which cautions the management
against potential upheavals in national as well as international economy.

Thus, managerial economics is helpful to the management in its decision making process.

 
 DEMAND ANALYSIS It is necessary to estimate the demand for the goods or services before
they are produced and provided. The producers, for this purpose, heavily depend upon the data relating
to the pattern of consumption of these goods and services. The demand analysis provides them the
basis to take decisions relating to volume of production (How many products required to produce),
capital to be invested (How much amount to be invested) and so on.

DEMAND Demand for a commodity refers to the quantity of the commodity which an individual
consumer is willing to purchase at a particular time at a particular price.

A product or service is said to have demand when three conditions are satisfied.

(a)                 Desire to acquire - Desire of the consumer to buy the + Product

(b)                 Willingness to pay - His willingness to buy the product and

(c)                 Ability to pay - Ability to pay the specified price for it.

In Economics, use of the word ‘demand’ is made to show the relationship between the prices of
a commodity and the amounts of the commodity which consumers want to purchase at those price.

Definition of Demand:

Hibdon defines, “Demand means the various quantities of goods that would be purchased per
time period at different prices in a given market.”

Bober defines, “By demand we mean the various quantities of given commodity or service which
consumers would buy in one market in a given period of time at various prices, or at various incomes, or
at various prices of related goods.”

Demand for product implies:

a) desires to acquire it,

b) willingness to pay for it, and

c) Ability to pay for it.

All three must be checked to identify and establish demand. For example : A poor man’s desires
to stay in a five-star hotel room and his willingness to pay rent for that room is not ‘demand’, because
he lacks the necessary purchasing power; so it is merely his wishful thinking. Similarly, a miser’s desire
for and his ability to pay for a car is not ‘demand’, because he does not have the necessary willingness to
pay for a car. One may also come across a well-established person who processes both the willingness
and the ability to pay for higher education. But he has really no desire to have it, he pays the fees for a
regular cause, and eventually does not attend his classes. Thus, in an economics sense, he does not have
a ‘demand’ for higher education degree/diploma.
 It should also be noted that the demand for a product–-a commodity or a service–has no
meaning unless it is stated with specific reference to the time, its price, price of is related goods,
consumers’ income and tastes etc. This is because demand, as is used in Economics, varies with
fluctuations in these factors.

To say that demand for an Atlas cycle in India is 60,000 is not meaningful unless it is stated in
terms of the year, say 1983 when an Atlas cycle’s price was around Rs. 800, competing cycle’s prices
were around the same, a scooter’s prices was around Rs. 5,000. In 1984, the demand for an Atlas cycle
could be different if any of the above factors happened to be different. For example, instead of domestic
(Indian), market, one may be interested in foreign (abroad) market as well. Naturally the demand
estimate will be different. Furthermore, it should be noted that a commodity is defined with reference
to its particular quality/brand; if its quality/brand changes, it can be deemed as another commodity.

To sum up, we can say that the demand for a product is the desire for that product backed by
willingness as well as ability to pay for it. It is always defined with reference to a particular time, place,
price and given values of other variables on which it depends.

Demand Function and Demand Curve

Demand function is a comprehensive formulation which specifies the factors that influence the
demand for the product. What can be those factors which affect the demand?

For example,

Dx = D (Px, Py, Pz, B, W, A, E, T, U)

Here Dx, stands for demand for item x (say, a car)

Px, its own price (of the car)

Py, the price of its substitutes (other brands/models)

Pz, the price of its complements (like petrol)

B, the income (budget) of the purchaser (user/consumer)

W, the wealth of the purchaser

A, the advertisement for the product (car)

E, the price expectation of the user

T, taste or preferences of user

U, all other factors.

Briefly we can state the impact of these determinants, as we observe in normal circumstances:
 i) Demand for X is inversely related to its own price. As price rises, the demand tends to fall and
vice versa.

ii) The demand for X is also influenced by its related price—of goods related to X. For example, if
Y is a substitute of X, then as the price of Y goes up, the demand for X also tends to increase, and vice
versa. In the same way, if Z goes up and, therefore, the demand for X tends to go up.

iii) The demand for X is also sensitive to price expectation of the consumer; but here, much
would depend on the psychology of the consumer; there may not be any definite relation.

This is speculative demand. When the price of a share is expected to go up, some people may
buy more of it in their attempt to make future gains; others may buy less of it, rather may dispose it off,
to make some immediate gain. Thus the price expectation effect on demand is not certain.

iv) The income (budget position) of the consumer is another important influence on demand. As
income (real purchasing capacity) goes up, people buy more of ‘normal goods’ and less of ‘inferior
goods’. Thus income effect on demand may be positive as well as negative. The demand of a person (or
a household) may be influenced not only by the level of his own absolute income, but also by relative
income—his income relative to his neighbour’s income and his purchase pattern. Thus a household may
demand a new set of furniture, because his neighbour has recently renovated his old set of furniture.
This is called ‘demonstration effect’.

v) Past income or accumulated savings out of that income and expected future income, its
discounted value along with the present income—permanent and transitory—all together determine
the nominal stock of wealth of a person. To this, you may also add his current stock of assets and other
forms of physical capital; finally adjust this to price level. The real wealth of the consumer, thus
computed, will have an influence on his demand. A person may pool all his resources to construct the
ground floor of his house. If he has access to some additional resources, he may then construct the first
floor rather than buying a flat. Similarly one who has a color TV (rather than a black-and-white one) may
demand a V.C.R./V.C.P. This is regarded as the real wealth effect on demand.

vi) Advertisement also affects demand. It is observed that the sales revenue of a firm increases
in response to advertisement up to a point. This is promotional effect on demand (sales). Thus

vii) Tastes, preferences, and habits of individuals have a decisive influence on their pattern of
demand. Sometimes, even social pressure—customs, traditions and conventions exercise a strong
influence on demand. These socio-psychological determinants of demand often defy any theoretical
construction; these are non-economic and non-market factors—highly indeterminate. In some cases,
the individual reveal his choice (demand) preferences; in some cases, his choice may be strongly
ordered. We will revisit these concepts in the next unit.

You may now note that there are various determinants of demand, which may be explicitly
taken care of in the form of a demand function. By contrast, a demand curve only considers the price-
demand relation, other things (factors) remaining the same. This relationship can be illustrated in the
form of a table called demand schedule and the data from the table may be given a diagrammatic
representation in the form of a curve. In other words, a generalized demand function is a multivariate
function whereas the demand curve is a single variable demand function.

Dx = D(Px)

In the slope—intercept from, the demand curve which may be stated as

Dx = α + β Px, where α is the intercept term and β the slope which is negative because of inverse
relationship between Dx and Px.

Suppose, β = (-) 0.5, and α = 10

Then the demand function is : D=10-0.5P

Kinds of Demand:

Three kinds of demand may be distinguished:

(a) Price demand,

(b) Income demand, and

(c) Cross demand.

Price Demand:
 This demand refers to the various quantities of a commodity or service that a consumer would
purchase at a given time in a market at various hypothetical prices. It is assumed that other things such
as consumers’ income, his tastes and prices of related goods remain unchanged.

The demand of the individual consumer is called Individual Demand and the aggregate demand
of all the consumers combined for the commodity or service is called Industry Demand. The total
demand for the product of an individual firm at various prices is known as firm’s demand or Individual
Seller’s Demand.

Income Demand:

The income demand refers to the various quantities of goods and services which would be
purchased by the consumer at various levels of income. Here we assume that the prices of the
commodity or service as well as the prices of related goods and the tastes and desires of consumers do
not change.

The price demand expresses relationship between prices and quantities and the income demand
brings out the relationship between income and quantities demanded. For preparing demand schedule
of income demand, we write incomes in one column and quantities purchased at these incomes in the
second column. Superior goods or high-priced articles command brisk sales when income increases. On
the other hand, inferior goods command large sales when incomes are at a lower level.

Cross Demand:

Cross demand means the quantities of a good or service which will be purchased with reference
to changes in the price not of this good but of other related goods. These goods are either substitutes or
complementary good. A change in price of tea will affect demand for coffee. Similarly, if horses become
sheep, demand for carriages may increase. In order to prepare demand schedule of this type of demand,
we write prices of one commodity in one demand the quantities purchased of the other commodity in
the second column.

Determinants of Demand

The knowledge of the determinants of market demand for a product or service and the nature
of relationship between the demand and its determinants proves very helpful in analyzing and
estimating demand for the product. It may be noted at the very outset that a host of factors determines
the demand for a product or service. In general, following factors determine market demand for a
product or service:

1. Price of the product

2. Price of the related goods-substitutes, complements and supplements

3. Level of consumers income

4. Consumers taste and preference

 5. Advertisement of the product

6. Consumers expectations about future price and supply position

7. Demonstration effect or ‘bend-wagon effect’

8. Consumer-credit facility

9. Population of the country

10. Distribution pattern of national income.

These factors also include factors such as off-season discounts and gifts on purchase of a good,
level of taxation and general social and political environment of the country. However, all these factors
are not equally important. Besides, some of them are not quantifiable. For example, consumer’s
preferences, utility, demonstration effect and expectations, are difficult to measure. However, both
quantifiable and non-quantifiable determinants of demand for a product will be discussed.

1. Price of the Product

The price of a product is one of the most important determinants of demand in the long run
and the only determinant in the short run. The price and quantity demanded are inversely related to
each other. The law of demand states that the quantity demanded of a good or a product, which its
consumers would like to buy per unit of time, increases when its price falls, and decreases when its price
increases, provided the other factors remain’ same. The assumption ‘other factors remaining same’
implies that income of the consumers, prices of the substitutes and complementary goods, consumer’s
taste and preference and number of consumers remain unchanged. The price-demand relationship
assumes a much greater significance in the oligopolistic market in which outcome of price war between
a firm and its rivals determines the level of success of the firm. The firms have to be fully aware of price
elasticity of demand for their own products and that of rival firm’s goods.

2. Price of the Related Goods or Products

The demand for a good is also affected by the change in the price of its related goods. The
related goods may be the substitutes or complementary goods.

 Substitutes: Two goods are said to. be substitutes of each other if a change in price of one good
affects the demand for the other in the same direction. For instance goods X and Y are
considered as substitutes for each other if a rise in the price of X increase demand for Y, and vice
versa. Tea and coffee, hamburgers and hot-dog, alcohol and drugs are some examples of
substitutes in case of consumer goods by definition, the relation between demand for a product
and price of its substitute is of positive nature. When, price of the substitute of a product (tea)
falls (or increase), the demand for the product falls (or increases).

 Complementary Goods: A good is said to be a complement for another when it complements

the use of the other or when the two goods are used together in such a way that their demand
 changes (increases or decreases) simultaneously. For example, petrol is a complement to car
and scooter, butter and jam to bread, milk and sugar to tea and coffee, mattress to cot, etc. Two
goods are termed as complementary to each other. If an increase in the price of one causes a
decrease in demand for the other. By definition, there is an inverse relation between the
demand for a good and the price of its complement. For instance, an increase in the price of
petrol causes a decrease in the demand for car and other petrol-run vehicles and vice versa
while other thing’s remaining constant.

3. Consumers Income

Income is the basic determinant of market demand since it determines the purchasing power of
a consumer. Therefore, people with higher current disposable income spend a larger amount on goods
and services than those with lower income. Income-demand relationship is of more varied nature than
that between demand and its other determinants. While other determinants of demand, e.g., product’s
own price and the price of its substitutes, are more significant in the short-run, income as a determinant
of demand is equally important in both short run and long run. Before proceeding further to discuss
income-demand relationships, it will be useful to note that consumer goods of different nature have
different kinds of relationship with consumers having different levels of income. Hence, the managers
need to be fully aware of the kinds of goods they are dealing with and their relationship with the income
of consumers, particularly about the assessment of both existing and prospective demand for a product.

For the purpose of income-demand analysis, goods and services maybe grouped under four
broad categories, which ate: (a) essential consumer goods, (b) inferior goods, (c) normal goods, and (d)
prestige or luxury goods. To understand all these terms, it is essential to understand the relationship
between income and different kinds of goods.

1. Essential Consumer Goods (ECG): The goods and services of this category are called ‘basic
needs’ and are consumed by all persons of a society such as food-grains, salt, vegetable oils,
matches, cooking fuel, a minimum clothing and housing. Quantity demanded for these goods
increases with increase in consumer’s income but only up to certain limit, even though the total
expenditure may increase in accordance with the quality of goods consumed, other factors
remaining the same. Consumer’s demand for essential goods increases only until a
particular income level. It tends to saturate beyond this level of income.

2. Inferior goods: Inferior goods are those goods whose demand decreases with the increase in
consumer’s income. For example millet is inferior to wheat and rice; coarse, textiles are inferior
to refined ones, kerosene is inferior to cooking gas and travelling by bus is inferior to travelling
by taxi. The relation between income and demand for an inferior good is under the assumption
that other determinants of demand remain the same demand for such goods rises only up to a
certain level of income, and declines as income increases beyond this level.

3. Normal goods: Normal goods are those goods whose demand increases with increase in the
consumer income. For example, clothing’s  household furniture and automobiles. Demand for
such goods increases with the increases in consumer income but at different rates at different
 levels of income. Demand for normal goods increases rapidly with the increase in the
consumer’s income but slows down with further increase in income. Up to certain level of
income the relation between income and demand for all type of goods is similar. The difference
is of only degree.Therefore, it is important to view the income-demand relations in the light of
the nature of product and the level of consumer’s income.

4. Prestige and luxury goods: Prestige goods are those goods, which are consumed mostly by rich
section of the society, e.g., precious stones, antiques, rare paintings, luxury cars and such other
items of show-off. Whereas luxury goods include jewellery, costly brands of cosmetics, TV sets,
refrigerators, electrical gadgets and cars. Demand for such goods arises beyond a certain level of
consumer’s income, i.e., consumption enters the area of luxury goods. Producers of such goods,
while assessing the demand for their goods, should consider the income changes in the richer
section of the society and not only the per capita income.

4. Consumer’s Taste and Preference

Consumer’s taste and preference play an important role in determining demand for a product.
Taste and preference depend, generally, on the changing life-style, social customs, religious values
attached to a good habit of the people. Change in these factors changes consumer’s taste and
preferences. As a result, consumers reduce or give up the consumption of some goods and add new
ones to their consumption pattern. For example, following the change in fashion, people switch their
consumption pattern from cheaper, old-fashioned goods to costlier ‘mod’ goods, as long as price
differentials are proportionate with their preferences. Consumers are prepared to pay higher prices for
‘mod goods’ even if their virtual utility is the same as that of old-fashioned goods. The manufacturers of
goods and services that are subject to frequent change in fashion and style, can take advantage of this
situation in two ways:

1. They can make quick profits by designing new models of their goods and popularizing them
through advertisement, and

2. They can plan production in a better way and can even avoid over-production if they keep an
eye on the changing fashions.

5. Advertisement Expenditure

Advertisement costs are incurred with the objective of increasing the demand for the goods.
This is done in the following ways:

 By informing the potential consumers about the availability of the goods.

 By showing its superiority to the rival goods.

 By influencing consumers choice against the rival goods, and

 By setting fashions and changing tastes.

 The impact of such effects shifts the demand curve upward to the right. In other words, when
other factors’ remain same, the expenditure on advertisement increases the volume of sales to the
same extent.

The relationship between demand and advertisement cost is based on the following

assumptions:

 Consumers are fairly sensitive and responsive to various modes of advertisement.

 The rival firms do not react to the advertisements made by a firm.

 The level of demand has not already reached the saturation point. Advertisement beyond this
point will make only marginal impact on demand.

 Per unit cost of advertisement added to the price does not make the price prohibitive for
consumers, as compared particularly to the price of substitutes.

 Others determinants of demand, e.g., income and tastes, etc., are not operating in the reverse
direction.

In the absence of these conditions, the advertisement effect on sales may be unpredictable.

6. Consumers Expectations

Consumers’ expectations regarding the future prices, income and supply position of goods play
an important role in determining the demand for goods and services in the short run. If consumers
expect a rise in the price of a storable good, they would buy more of it at its current price with a view to
avoiding the possibility of price rise future. On the contrary, if consumers expect a fall in the price of
certain goods, they postpone their purchase with a view to take advantage of lower prices in future,
mainly in case of non-essential goods. This behavior of consumers reduces the current demand for the
goods whose prices are expected to decrease in future. Similarly, an expected increase in income
increases the demand for a product. For example, announcement of dearness allowance, bonus and
revision of pay scale induces increase in current purchases. Besides, if scarcity of certain goods is
expected by the consumers on account of reported fall in future production, strikes on a large scale and
diversion of civil supplies towards the military use causes the current demand for such goods to increase
more if their prices show an upward trend. Consumer demand more for future consumption and
profiteers demand more to make money out of expected scarcity.

7. Demonstration Effect

When new goods or new models of existing ones appear in the market, rich people buy them
first. For instance, when a new model of car appears in the market, rich people would mostly be the first
buyer, LED TV sets and Blu-Ray Drives were first seen in the houses of the rich families some people buy
new goods or new models of goods because they have genuine need for them. Some others do so
because they want to exhibit their affluence. But once new goods come in fashion, many households
buy them not because they have a genuine need for them but because their neighbors have bought the
same goods. The purchase made by the latter category of the buyers are made out of such feelings as
jealousy, competition, equality in the peer group, social inferiority and the desire to raise their social
status. Purchases made on account of these factors are the result of what economists call
‘demonstration effect’ or the ‘Band-wagon-effect’. These effects have a positive effect on demand. On
the contrary, when goods become the thing of common use, some people, mostly rich, decrease or give
up the consumption of such goods. This is known as ‘Snob Effect’. It has a negative effect’on the
demand for the related goods.

8. Consumer-Credit Facility

Availability of credit to the consumers from the sellers, banks, relations and friends encourages

the consumers to buy more than what they would buy in the absence of credit availability. Therefore,
the consumers who can borrow more can consume more than those who cannot borrow. Credit facility
affects mostly the demand for durable goods, particularly those, which require bulk payment at the time
of purchase.

9. Population of the Country

The total domestic demand for a good of mass consumption depends also on the size of the
population. Therefore, larger the population larger will be the demand for a product, when price, per-
capita income, taste and preference are given. With an increase or decrease in the size of population,
employment percentage remaining the same, demand for the product will either increase or decrease.

10. Distribution of National Income

The level of national income is the basic determinant of the market demand for a good. Apart
from this, the distribution pattern of the national income is also an important determinant for demand
of a good. If national income is evenly distributed, market demand for normal goods will be the largest.
If national income is unevenly distributed, i.e., if majority of population belongs to the lower income
groups, market demand for essential goods, including inferior ones, will be the largest whereas the
demand for other kinds of goods will be relatively less.

Law of Demand
Suppose you want to buy mangoes at Rs.100 per dozen you buy 6 dozens. If the price of
mangoes increase to 200/- then how much will you buy? Definitely less quantity of goods. What kind of
relationship is there between the price and quantity demanded? There is inverse relation.

The law of demand explains the functional relationship between price of a commodity and the
quantity demanded of the same. It is observed that the price and the demand are inversely related
which means that the two move in the opposite direction. An increase in the price leads to a fall in the
demand and vice versa.
 The law of demand states that “Ceteris paribus (other things remaining the same), higher the
price, lower the demand and vice versa”.

The law is stated primarily in terms of the price and quantity relationship. The quantity
demanded is inversely related to its price. Here we consider only two factors i.e. price and quantity
demanded. All the other factors which determine are assumed to be constant. Which are those factors?

The basic assumptions of Law of Demand are;

 Income of the consumer is constant.

 There is no change in the availability and the price of the related commodities (i.e.
complimentary and substitutes)

 There are no expectations of the consumers about changes in the future price and income.

 Consumers’ taste and preferences remain the same.

 There is no change in the population and its structure.

If the income of the consumer, prices of the related goods, and preferences of the consumer
remain unchanged, then the change in quantity of good demanded by the consumer will be negatively
correlated to the change in the price of the good or service. The change in price will be reflected as a
move along the demand curve.

law of Demand table

Price of Demand of
product product

2 10

4 8

6 6

8 4

10 2
 Exceptions to the law of Demand :There are certain exceptions to the law of demand in other
words, the law of demand is not applicable in the following cases.

(1) Giffen Goods:

People whose incomes are low purchase more of a commodity such broken rice,
bread, potato (which is their staple food) when its prices rises. Inversely when its price falls, instead of
buying more, they buy less of this commodity and use the savings for the purchase of better goods such
as meat. This phenomenon is called Giffens paradox and such goods are giffen goods.

(2) Veblen Goods:

Products such as jewels, diamonds and so on confer distinction on the part of

the user. In such case, the consumers tend to buy more goods when price increased, and less purchase
when price decreased. Such goods are called Veblen Goods.

(3) Where there is a shortage of necessities :

If the consumers fear that these could be shortage of necessities, then this law
of demand does not applicable. They may tend to buy more than what they require immediately, even
if the price of the product increases.

(4) In case of ignorance of price changes :

When the customer is not familiar with the changes in the price, he tends to buy
even if there is increase in price.

Understanding law of demand using demand schedule

This law can be explained with the help of demand schedule and demand curve as presented
below:

Demand Schedule is a tabular representation of various combinations of price and quantity

demanded by a consumer during a particular period of time. An imaginary demand schedule is given
below:

The above demand schedule shows negative relationship between price and quantity demanded
for a commodity.

Initially, when a price of a good is Rs.10 per kg, quantity demanded by the consumer is 10 kg.
 As the price decrease from Rs.10 per kg to Rs.8 per kg and then to Rs.6 per kg, quantity
demanded by the consumer increases from 10 kg to 20 kg and then to 30 kg respectively.

Further, fall in price from Rs.6 per kg to Rs.4 per kg and then to Rs.2 per kg, results in increase in
quantity demanded by the consumer from 30 kg to 40 kg and then to 50 kg, respectively.

Thus, from the above schedule we can conclude that there is opposite inverse relationship in
between price and quantity demanded for a commodity.

Understanding law of demand using demand curve

It is the graphical representation of demand schedule. In other words, it is a graphical

representation of the quantities of a commodity which will be demanded by the consumer at various
particular prices in a particular period of time, other things remaining the same.

We can show, the above demand schedule through the following demand curve:

In the figure above, price and quantity demanded are measured along the y-axis and x-axis
respectively. By plotting various combinations of price and quantity demanded, we get a demand curve
DD1 derived from points A, B, C, D and E.

This is a downward sloping demand curve showing inverse relationship between price and
quantity demanded.

Limitations/Exceptions of law of demand

Inferior goods/ Giffen goods

 Some special varieties of inferior goods are termed as giffen goods. Cheaper varieties of goods
like low priced rice, low priced bread, etc. are some examples of Giffen goods.

This exception was pointed out by Robert Giffen who observed that when the price of bread
increased, the low paid British workers purchased lesser quantity of bread, which is against the law of
demand. Thus, in case of Giffen goods, there is indirect relationship between price and quantity
demanded.

Goods having prestige value

This exception is associated with the name of the economist, T.Velben and his doctrine of
conspicuous conception. Few goods like diamond can be purchased only by rich people. The prices of
these goods are so high that they are beyond the capacity of common people. The higher the price of
the diamond the higher the prestige value of it.

In this case, a consumer will buy less of the diamonds at a low price because with the fall in
price, its prestige value goes down. On the other hand, when price of diamonds increase, the prestige
value goes up and therefore, the quantity demanded of it will increase.

Price expectation

When the consumer expects that the price of the commodity is going to fall in the near future,
they do not buy more even if the price is lower.

On the other hand, when they expect further rise in price of the commodity, they will buy more
even if the price is higher. Both of these conditions are against the law of demand.

Fear of shortage

When people feel that a commodity is going to be scarce in the near future, they buy more of it
even if there is a current rise in price.

For example: If the people feel that there will be shortage of L.P.G. gas in the near future, they
will buy more of it, even if the price is high.

Change in income

The demand for goods and services is also affected by change in income of the consumers.

If the consumers’ income increases, they will demand more goods or services even at a higher
price. On the other hand, they will demand less quantity of goods or services even at lower price if there
is decrease in their income. It is against the law of demand.

Change in fashion

The law of demand is not applicable when the goods are considered to be out of fashion.
 If the commodity goes out of fashion, people do not buy more even if the price falls. For
example: People do not purchase old fashioned shirts and pants nowadays even though they’ve become
cheap. Similarly, people buy fashionable goods in spite of price rise.

Basic necessities of life

In case of basic necessities of life such as salt, rice, medicine, etc. the law of demand is not
applicable as the demand for such necessary goods does not change with the rise or fall in price.

Importance of law of demand?

1.Determination of price The study of law of demand is helpful for a trader to fix the price of a
commodity. He knows how much demand will fall by increase in price to a particular level and how
much it will rise by decrease in price of the commodity. The schedule of market demand can provide the
information about total market demand at different prices. It helps the management in deciding
whether how much increase or decrease in the price of commodity is desirable.

2. Importance to Finance Minister The study of this law is of great advantage to the finance
minister. If by raising the tax the priceincreases to such an extend than the demand is reduced
considerably. And then it is of no use to raise the tax, because revenue will almost remain the same. The
tax will be levied at a higher rate only on those goods whose demand is not likely to fall substantially
with the increase inprice.

3. Importance to the Farmers Goods or bad crop affects the economic condition of the farmers.
If a goods crop fails to increase the demand, the price of the crop will fall heavily. The farmer will have
no advantage of the good crop and vice-versa.