Ae11 Module-Managerial Economics

JOSEPH FRANCIS S.
PAMAONG, CPA
1
PREFACE
Managerial Economics is concerned about the application

of economic principles and methodologies to key
management decisions within organization. It provides
principles to foster the goals of the organization, as well
as a better understanding of the external business
environment in which an organization operates. The
overall objective of this book is to provide you with the
concepts and tools needed to aid managers in making
sound decisions.
While COVID19 is primarily affecting public health, spill

over effects can already be observed in education. The
birth of this module in managerial economics has been
triggered by the COVID19 pandemic. This module is
designed to aid the student in understanding the
important areas in managerial economics. To enhance
understanding, relevant inputs, examples, illustrations
and activities on how the concepts being applied are
included. Finally, this module focus on the basic concepts
and principles of managerial economics that the students
may apply in a real world of business.
MANAGERIAL ECONOMICS
2
WARM –UP ACTIVITY (PRE-ACTIVITY)
Locate the words in the grid by encircling at least 20 words related to Economics.
WORD PUZZLE
A E R U I O T T U O I A S D E T U O U
E R U E T E O Y W E O R R O B A L A S
E O S E U I C U I E U O I E A S E R O
E D E C U O F E R T E U I O W E S A E
E R U I I O R O D E N C O U E E C T X
E E O K G M G O R W E A I R E Y I A P
W L A T W E O E E P D E U R O P T K E
O W B E E E O N E A N D O Q P O S A N
W E A A E K O E O R A E T I O T A T S
P C S E I D R S E C M S A T E U L A E
E I I D E R A A R E E S D U S O E K S
R L R T R E A E M T D E D A O O S A P
F O E Y S A F V E R O U I D E S C L A
E V B E L A E E Y A I O U E N A A A G
C E D D R P L E Y T E O S E E A S N S
K U C R T E P E A D I S E Y A E L G U
T U P N I E D U N O R C A S E D E K R
J W P E O P L E S I E R R R O N R A E
A E D J O K E K A A G H O A E D O U O
M A S E A Y T I L I T U A S C O I M Y
J N O O X B A K A K A L N G O S H A E
A E M E T I Y L O P O N O M H A H A A
M S B L U O F Y O E T U T I T S B U S
A D T U P T U O S A N A A L L M A L I
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SELF-EVALUATION
After performing the word puzzle in the Warm-up Section, evaluate yourself by placing a check mark on the
column that best describes your ability to familiarize the cost terms. There are no wrong answers in this
section, so answer as objectively as possible.
Usually Sometimes Seldom Never
3 2 1 0
I am able to identify terms related to managerial

accounting or financial accounting.
I avoid confusing managerial accounting or financial

accounting cost terms from other accounting
terminologies.
TOTAL
Score Level of Proficiency
5-6 Proficient
3-4 Approaching Proficiency
1-2 Developing
0 Beginning
4
MODULE 1
COURSE LEARNING OUTCOME
EXPLAIN THE MANAGERIAL ECONOMICS CONCEPTS AND PRINCIPLES.
TOPIC LEARNING OUTCOMES
At the end of the course, you will be able to:
• Discuss the meaning, objectives, importance, functions, responsibilities and characteristic of managerial
economics.
• Construct demand schedule and demand curve.
• Compute the price elasticity of demand.
• Compare and contrast the different types of market structure.
LECTURE NOTES (INPUT)
CHAPTER 1 - INTRODUCTION
1.1 ECONOMICS AND MANAGERIAL ECONOMICS CONCEPTS
The term “economics” has been derived from a Greek Word “Oikonomia” which means
“household‟. Economics is a social science. It is called “social‟ because it studies mankind of society. It
deals with aspects of human behavior. It is called science since it studies social problems from a
scientific point of view. The development of economics as a growing science can be traced back in the
writings of Greek philosophers like Plato and Aristotle. Economics was treated as a branch of politics
during early days of its development because ancient Greeks applied this term to management of city- state,
which they called “Polis”.
Definition of Economics
A. Wealth Definition
Really the science of economics was born in 1776, when Adam Smith published his famous book “An
Enquiry into the Nature and Cause of Wealth of Nation”. He defined economics as the study of the nature
and cause of national wealth. According to him, economics is the study of wealth- How wealth is produced
and distributed. He is called as “father of economics” and his definition is popularly called “Wealth
definition”.
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B. Welfare Definition
It was Alfred Marshall who rescued the economics from the above criticisms. By his classic work
“Principles of Economics”, published in 1890, he shifted the emphasis from wealth to human welfare.
According to him wealth is simply a means to an end in all activities, the end being human welfare. He adds,
that economics “is on the one side a study of the wealth; and the other and more important side, a part of the
study of man”. Marshall gave primary importance to man and secondary importance to wealth.
C. Scarcity Definition
Lionel Robbins formulated his own conception of economics in his book “The Nature and Significance of
Economic Science” in 1932. According to him, “Economics is the science which studies human behavior as
a relationship between ends and scares means which have alternative uses”. He gave importance to four
fundamental characters of human existence such as;
1. Unlimited wants- In his definition “ends” refers to human wants which are boundless or unlimited.
2. Scarcity of means (Limited Resources) – the resources (time and money) at the disposal of a person to
satisfy his wants are limited.
3. Alternate uses of Scares means- Economic resources not only scarce but have alternate uses also. So one
has to make choice of uses.
4. The Economic Problem –when wants are unlimited, means are scarce and have alternate uses, the
economic problem arises. Hence we need to arrange wants in the order of urgency.
D. Modern Definition
The credit for revolutionizing the study of economics surely goes to Lord J.M Keynes. He defined
economics as the “study of the administration of scares resources and the determinants of income and
employment”.
Prof. Samuelson recently given a definition based on growth aspects which is known as Growth definition.
“Economics is the study of how people and society end up choosing, with or without the use of 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 or groups in society.
Economics analyses the costs and the benefits of improving patterns of resources use”.
Simple Definition
Economics is the science of making decisions in the presence of scarce resources.
Meaning and Definition of Managerial Economics.
Managerial Economics shows how economic analysis can be used in formulating policies. Managerial
economics bridges the gap between traditional economic theory and real business practices in two ways.
Firstly, it provides number of tools and techniques to enable the manager to become more competent to take
decisions in real and practical situation. Secondly, it serves as an integrating course to show the interaction
between various areas in which the firm operates.
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Managerial economics is concerned with the application of business principles and methodologies to the
decision making process within the firm or organization under the conditions of uncertainty. It seeks to
establish rules and principles to facilitate the attainment of the desired economic aim of management. These
economic aims relate to costs, revenue and profits and are important within both business and non business
institutions.
Managerial Economics as “the integration of economic theory with business practice for the purpose of
facilitating decision making and forward planning of management” managerial economics helps the
managers to analyze the problems faced by the business unit and to take vital decisions. They have to choose
from among a number of possible alternatives. They have to choose that course of action by which the
available resources are most efficiently used.
Managerial economics is something that concerned with business efficiency”.
Managerial Economics is the study of how to direct scares resources in a way that mostly effectively
achieves a managerial goal”.
Objectives and Uses (importance) of managerial Economics
Objectives:
The basic objective of managerial economics is to analyze the economic problems faced by the business.
The other objectives are:
1. To integrate economic theory with business practice.

2. To apply economic concepts and principles to solve business problems.
3. To allocate the scares resources in the optimal manner.
4. To make all-round development of a firm.
5. To minimize risk and uncertainty
6. To helps in demand and sales forecasting.
7. To help in profit maximization.
8. To help to achieve the other objectives of the firm like industry leadership, expansion implementation of
policies etc...
SELF CHECK QUESTIONS 1.1 (ENABLING ACTIVITY)
Instruction: Fill in the blanks with suitable or correct word/words.
1. ____________________ is the study of how to direct scares resources in a way that mostly effectively
achieves a managerial goal”.
2. The term “economics” has been derived from a Greek Word “_____________” which means
“_________________‟.
3. _______________ is the science of making decisions in the presence of scarce resources.
4. Adam Smith is called as “father of economics” and his definition is popularly called
“________________”.
5. ______________ of means limited resources.
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1.2 Objectives and Uses (importance) of managerial Economics
Objectives: The basic objective of managerial economics is to analyze the economic problems faced by the
business. The other objectives are:
1. To integrate economic theory with business practice.

2. To apply economic concepts and principles to solve business problems.
3. To allocate the scares resources in the optimal manner.
4. To make all-round development of a firm.
5. To minimize risk and uncertainty
6. To helps in demand and sales forecasting.
7. To help in profit maximization.
8. To help to achieve the other objectives of the firm like industry leadership, expansion implementation of
policies etc...
Importance: In order to solve the problems of decision making, data are to be collected and analyzed in the
light of business objectives. Managerial economics provides help in this area. The importance of managerial
economics maybe relies in the following points:
1. It provides tool and techniques for managerial decision making.

2. It gives answers to the basic problems of business management.
3. It supplies data for analysis and forecasting.
4. It provides tools for demand forecasting and profit planning.
5. It guides the managerial economist.
6. It helps in formulating business policies.
7. It assists the management to know internal and external factors influence the business.
Following are the important areas of decision making;
a) Selection of product.
b) Selection of suitable product mix.
c) Selection of method of production.
d) Product line decision.
e) Determination of price and quantity.
f) Decision on promotional strategy.
g) Optimum input combination.
h) Allocation of resources.
i) Replacement decision.
j) Make or buy decision.
k) Shut down decision.
l) Decision on export and import.
m) Location decision.
n) Capital budgeting.
Scope of Managerial / Business Economics
The scope of managerial economics refers to its area of study. Scope of Managerial Economics is wider than
the scope of Business Economics in the sense that while managerial economics dealing the decisional
problems of both business and non-business organizations, business economics deals only the problems of
business organizations. Business economics giving solution to the problems of a business unit or profit
oriented unit. Managerial economics giving solution to the problems of non-profit organizations like
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schools, hospital etc. The scope covers two areas of decision making (A) operational or internal issues and
(B) Environmental or external issues.
A) Operational/internal issues
These issues are those which arise within the business organization and are under the control of the
management. They pertains to simple questions of what to produce, when to produce, how much to produce
and for which category of consumers. The following aspects may be said to be fall under internal issues.
1. Demand analysis and Forecasting: - The demands for the firms product would change in response to
change in price, consumers income, his taste etc. which are the determinants of demand. A study of the
determinants of demand is necessary for forecasting future demand of the product.
2. Cost analysis: - Estimation of cost is an essential part of managerial problems. The factors causing
variation of cost must be found out and allowed for it management to arrive at cost estimates. This will helps
for more effective planning and sound pricing practices.
3. Pricing Decisions: - The firms aim to profit which depends upon the correctness of pricing decisions. The
pricing is an important area of managerial economics. Theories regarding price fixation helps the firm to
solve the price fixation problems.
4. Profit Analysis: - Business firms working for profit and it is an important measure of success. But firms
working under conditions of uncertainty. Profit planning become necessary under the conditions of
uncertainty.
5. Capital budgeting: - The business managers have to take very important decisions relating to the firms
capital investment. The manager has to calculate correctly the profitability of investment and to properly
allocate the capital. Success of the firm depends upon the proper analysis of capital project and selecting the
best one.
6. Production and supply analysis: - Production analysis is narrower in scope than cost analysis.
Production analysis is proceeds in physical terms while cost analysis proceeds in monitory term. Important
aspects of supply analysis are; supply schedule, curves and functions, law of supply, elasticity of supply and
factors influencing supply.
B) Environmental or external issues
It refers to the general business environment in which the firm operates. A study of economic environment
should include:
1. The types of economic system in the country.

2. The general trend in production, employment, income, prices, savings and investments
3. Trends in the working of financial institutions like banks, financial corporations, insurance companies
etc..
4. Magnitude and trends in foreign trade.
5. Trends in labor and capital market.
6. Government economic policies viz., industrial policy, monitory policies, fiscal policy, price policy etc…
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SELF CHECK QUESTIONS 1.2 ENABLING ACTIVITY
Write letter A if the statement pertains to “Operational/internal issues” and letter B if it is Environmental
or external issues.
1. _____ Philippine government entered into foreign trade deals with China.
2. _____ The manager has to calculate correctly the profitability of investment.
3. _____ The price of the firms product will be marked up by 20% to cover its cost.
4. _____ Due to COVID19 production is down and unemployment rate increases.
5. _____ Managers projected that demand of its product will decrease.
2.3 FUNCTIONS AND RESPONSIBILITIES OF MANAGERIAL ECONOMIST
A managerial economist can play an important role by assisting the management to solve the difficult
problems of decision making and forward planning. Managerial economists have to study external and
internal factors influencing the business while taking the decisions. The important questions to be answered
by the managerial economists include:
1. Is competition likely to increase or decrease?

2. What are the population shifts and their influence in purchasing power?
3. Will the price of raw materials increase or decrease?
4. Managerial economist can also help the management in taking decisions regarding internal operation of
the firm.
Following are the important specific functions of managerial economist;
1. Sales forecasting. 2. Market research.

3. Production scheduling 4. Economic analysis of competing industry.
5. Investment appraisal. 6. Security management analysis.
7. Advise on foreign exchange management. 8. Advice on trade.
9. Environmental forecasting. 10. Economic analysis of agriculture Sales forecasting
The responsibilities of managerial economists are the following;

1. To bring reasonable profit to the company.
2. To make accurate forecast.
3. To establish and maintain contact with individual and data sources.
4. To keep the management informed of all the possible economic trends.
5. To prepare speeches for business executives.
6. To participate in public debates
7. To earn full status in the business team.
Chief Characteristics of Managerial or Business economics.
Following are the important feature of managerial economics:

1) Managerial economics is Micro economic in character. Because it studies the problems of a business firm,
not the entire economy.
2) Managerial economics largely uses the body of economic concepts and principles which is known as
“Theory of the Firm” or “Economics of the firm”.
3) Managerial economics is pragmatic. It is purely practical oriented. So Managerial economics considers
the particular environment of a firm or business for decision making.
4) Managerial economics is Normative rather than positive economics (descriptive economics). Managerial
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economics is prescriptive to solve particular business problem by giving importance to firms aim and
objectives.
5) Macroeconomics is also useful to managerial economics since it provides intelligent understanding of the
environment in which the business is operating.
6) It is management oriented.
Managerial economics as a tool for decision making and forward planning.
Decision making: Decision making is an integral part of modern management. Perhaps the most important
function of the business manager is decision making. 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 is 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.
Decision making process involves the following elements;
1. The identification of the firms objectives.

2. The statement of the problem to be solved.
3. The listing of various alternatives.
4. Evaluation and analysis of alternatives.
5. The selection best alternative
6. The implementation and monitoring of the alternative which is chosen.
Forward Planning: -Future is uncertain. A firm is operating under the conditions of risk and uncertainty.
Risk and uncertainty can be minimized only by making accurate forecast and forward planning. Managerial
economics helps manager in forward planning which means making plans for the future. A manager has to
make plan for the future e.g. Expansion of existing plants etc...The study of macroeconomics provides
managers a clear understanding about environment in which the business firm is working. The knowledge of
various economic theories viz, demands theory, supply theory etc. also can be helpful for future planning of
demand and supply. So managerial economics enables the manager to make plan for the future.
Microeconomics VS Macroeconomics
Microeconomics the branch of economics that focuses on actions of particular agents within the economy,
like households, workers, and business firms.
Macroeconomics the branch of economics that focuses on broad issues such as growth, unemployment,
inflation, and trade balance.
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Economics VS Managerial economics.
Economics Managerial Economics
1. Dealing both micro and macro aspects 1. Dealing only micro aspects
2. Both positive and normative science. 2. Only a normative science.
3. Deals with theoretical aspects 3. Deals with practical aspects.
4. Study both the firm and individual. 4. Study the problems of firm only.
5. Wide scope 5. Narrow scope.
Modified True or False
Instruction: Write TRUE if the statement is valid and FALSE if otherwise. If the statement is FALSE,
write the word FALSE and underline the word(s) that make it wrong.
_______ 1. Managerial economics helps manager in forward planning which means making plans for the
present.
________ 2. Microeconomics is useful to managerial economics since it provides intelligent understanding
of the environment in which the business is operating.
________ 3. Managerial economists have to study external and internal factors influencing the business
while taking the decisions.
________ 4. Making decisions is an integral part of modern management.
________ 5. Sales prediction is one of the important specific functions of managerial economist.
________ 6. Managerial Economics is wide in scope.
________ 7. Managerial Economics deals with the study both the firm and individual.
________ 8. Macroeconomics the branch of economics that focuses on actions of particular agents within
the economy, like households, workers, and business firms.
________ 9. Resources such as land, labour and capital are unlimited.
________ 10. Managerial economics is prescriptive to solve particular business problem by giving
importance to firms aim and objectives.
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CHAPTER 2 – DEMAND CONCEPTS
2.2 Meaning of Demand
Demand is a common parlance means desire for an object. But in economics demand is something more
than this. In economics „Demand‟ means the quantity of goods and services which a person can purchase
with a requisite amount of money. According to Prof. Hidbon,“Demand means the various quantities of
goods that would be purchased per time period at different prices in a given market. Thus demand for a
commodity is its quantity which consumer is able and willing to buy at various prices during a given period
of time. Simply, demand is the behavior of potential buyers in a market.
“Demand in economics means demand backed up by enough money to pay for the goods demanded”. In
other words, demand means the desire backed by the willingness to buy a commodity and purchasing power
to pay. Hence desire alone is not enough. There must have necessary purchasing power, ie, .cash to purchase
it. For example, everyone desires to possess Benz car but only few have the ability to buy it. So everybody
cannot be said to have a demand for the car. Thus the demand has three essentials-Desire, Purchasing power
and Willingness to purchase.
Demand Analysis Demand analysis means an attempt to determine the factors affecting the demand of a
commodity or service and to measure such factors and their influences. The demand analysis includes the
study of law of demand, demand schedule, demand curve and demand forecasting. Main objectives of
demand analysis are;
1) To determine the factors affecting the demand.

2) To measure the elasticity of demand.
3) To forecast the demand.
4) To increase the demand.
5) To allocate the recourses efficiently
Law of Demand The law of Demand is known as the „first law in market”. Law of demand shows the
relation between price and quantity demanded of a commodity in the market. In the words of Marshall “the
amount demanded increases with a fall in price and diminishes with a rise in price”.
According to Samuelson, “Law of Demand states that people will buy more at lower price and buy less at
higher prices”. In other words while other things remaining the same an increase in the price of a commodity
will decreases the quantity demanded of that commodity and decrease in the price will increase the demand
of that commodity. So the relationship described by the law of demand is an inverse or negative relationship
because the variables (price and demand) move in opposite direction. It shows the cause and effect
relationship between price and quantity demand.
NOTE: Demand is the willingness to buy a commodity and ability to buy it.
Individual demand Schedule
An individual demand schedule is a list of quantities of a commodity purchased by an individual consumer

at different prices. The following table shows the demand schedule of an individual consumer for apple.
When the price falls from P10 to P8, the quantity demanded increases from one to two. In the same way as
price falls, quantity demanded increases. On the basis of the above demand schedule we can draw the
demand curve as follows;
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PRICE OF APPLE
QUANTITY DEMANDED
(IN PESO)
10 1
8 2
6 3
4 4
2 5
The demand curve shows the inverse relation between price and demand of apple. Due to this inverse
relationship, demand curve is slopes downward from left to right. This kind of slope is also called
“negative slope”.
Market demand schedule
Market demand refers to the total demand for a commodity by all the consumers. It is the aggregate quantity
demanded for a commodity by all the consumers in a market. It can be expressed in the following schedule.
FIGURE 2.1
PRICE PER DOZEN DEMAND BY CONSUMER
MARKET DEMAND
(IN PESOS) A B C D
10 1 2 0 0 3
8 2 3 1 0 6
6 3 4 2 1 10
4 4 5 3 2 14
2 5 6 4 3 18
Derivation of market demand curve is a simple process. For example, let us assume that there are four
consumers in a market demanding eggs. When the price of one dozen eggs is P10, A buys one dozen and B
buys 2 dozens. When price falls to P8, A buys 2 , B buys 3 and C buys one dozen. When price falls to P6, A
buys 3 b buys 4,C buys 2 and D buys one dozen and so on. By adding up the quantity demanded by all the
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four consumers at various prices we get the market demand curve. So last column of the above demand
schedule gives the total demand for eggs at different prices.
DO IT YOURSELF:
INSTRUCTION: Construct a demand schedule based on FIGURE 2.1
Q
U
T
Y
PRICE
Assumptions of Law of Demand
Law of demand is based on certain basic assumptions. They are as follows
1) There is no change in consumers’‟ taste and preference

2) Income should remain constant.
3) Prices of other goods should not change.
4) There should be no substitute for the commodity.
5) The commodity should not confer any distinction.
6) The demand for the commodity should be continuous.
7) People should not expect any change in the price of the commodity.
Why does demand curve slopes downward?
1) Law of Diminishing Marginal utility

As the consumer buys more and more of the commodity, the marginal utility of the additional units falls.
Therefore the consumer is willing to pay only lower prices for additional units. If the price is higher, he will
restrict its consumption.
2) Income effect.
When the price of the commodity falls, the real income of the consumer will increase. He will spend this
increased income either to buy additional quantity of the same commodity or other commodity.
3) Substitution effect.
When the price of tea falls, it becomes cheaper. Therefore the consumer will substitute this commodity for
coffee. This leads to an increase in demand for tea.
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4) Different uses of a commodity.

Some commodities have several uses. If the price of the commodity is high, its use will be restricted only for
important purpose. For e.g. when the price of tomato is high, it will be used only for cooking purpose. When
it is cheaper, it will be used for preparing jam, pickle etc...
5) Psychology of people.
Psychologically people buy more of a commodity when its price falls. In other word it can be termed as
price effect.
Exceptions to the Law of Demand. (Exceptional Demand Curve).
The basic feature of demand curve is negative sloping. But there are some exceptions to this. I.e... In certain
circumstances demand curve may slope upward from left to right (positive slopes). These phenomena may
due to;
1) Giffen paradox.
The Giffen goods are inferior goods is an exception to the law of demand. When the price of inferior good
falls, the poor will buy less and vice versa. When the price of maize falls, the poor will not buy it more but
they are willing to spend more on superior goods than on maize. Thus fall in price will result into reduction
in quantity. This paradox is first explained by Sir Robert Giffen.
2) Veblen or Demonstration effect.

According to Veblen, rich people buy certain goods because of its social distinction or prestige. Diamonds
and other luxurious article are purchased by rich people due to its high prestige value. Hence higher the
price of these articles, higher will be the demand.
3) Ignorance
Sometimes consumers think that the product is superior or quality is high if the price of that product is high.
As such they buy more at high price.
4) Speculative Effect
When the price of commodity is increasing, then the consumer buy more of it because of the fear that it will
increase still further.
5) Fear of Shortage
During the time of emergency or war, people may expect shortage of commodity and buy more at higher
price to keep stock for future.
6) Necessaries
In the case of necessaries like rice, vegetables etc., People buy more even at a higher price.
7) Brand Loyalty
When consumer is brand loyal to particular product or psychological attachment to particular product, they
will continue to buy such products even at a higher price.
8) Festival, Marriage etc.

In certain occasions like festivals, marriage etc. people will buy more even at high price.
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When price raises from OP to OP1 quantity demanded also increases from OQ to OQ1. In other words, from
the above, we can see that there is positive relation between price and demand. Hence, demand curve (DD)
slopes upward.
CHANGES IN DEMAND (SHIFTERS OF DEMAND)
Demand of a commodity may change. It may increase or decrease due to changes in certain factors. These
factors are called determinants of demand. These factors include;
1) Price of a commodity
2) Nature of commodity
3) Income and wealth of consumer
4) Taste and preferences of consumer
5) Price of related goods (substitutes and compliment goods)
6) Consumers‟ expectations.
7) Advertisement
Note: Demand and price are inversely related.
Note: Income and Demand are Directly related.
a.) If substitutes of a particular commodity are available in the market and the price of the substitute rises,
demand for the commodity rises.
Substitute Demand
Substitute Demand
b.) If complements are available
Complements Demand
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Note: If expectation of future prices is high, then more demand is there at present and vice versa.
Note: Other than above mentioned determinants, quantity demanded is also dependent upon population, composition
of population, geographical conditions etc.
Demand Function.
There is a functional relationship between demand and its various determinants. I.e., a change in any
determinant will affect the demand. When this relationship expressed mathematically, it is called Demand
Function. Demand function of a commodity can be written as follows:
D = f (P, Y, T, Ps, U)
Where, D= Quantity demanded P= Price of the commodity

Y= Income of the consumer T= Taste and preference of consumers.
Ps = Price of substitutes U= Consumers expectations & others
f = Function of (indicates how variables are related)
Extension and Contraction of Demand.
Demand may change due to various factors. The change in demand due to change in price only, where other
factors remaining constant, it is called extension and contraction of demand. A change in demand solely due
to change in price is called extension and contraction. When the quantity demanded of a commodity rises
due to a fall in price, it is called extension of demand. On the other hand, when the quantity demanded falls
due to a rise in price, it is called contraction of demand. It can be understand from the following diagram.
When the price of commodity is OP, quantity demanded is OQ. If the price falls to P2, quantity demanded
increases to OQ2. When price rises to P1, demand decreases from OQ to OQ1. In demand curve, the area a
to c is extension of demand and the area a to b is contraction of demand. As result of change in price of a
commodity, the consumer moves along the same demand curve.
Shift in Demand (Increase or Decrease in demand)
When the demand changes due to changes in other factors, like taste and preferences, income, price of
related goods etc... , it is called shift in demand. Due to changes in other factors, if the consumers buy more
goods, it is called increase in demand or upward shift or shift to the right. On the other hand, if the
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consumers buy fewer goods due to change in other factors, it is called downward shift or decrease in
demand or shift to the left. The increase and decrease in demand (upward shift and downward shift) can be
expressed by the following diagram.
D is the original demand curve. Demand curve shift upward due to change in income, taste & preferences
etc of consumer, where price remaining the same. In the above diagram demand curve D1- D1 is showing
upward shift or increase in demand and D2-D2 shows downward shift or decrease in demand.
IDENTIFICATION:
____________________ 1. D = f (P, Y, T, Ps, U)

____________________ 2. Is a list of quantities of a commodity purchased by an individual consumer at
different prices.
____________________ 3. The law where the consumer is willing to pay only lower prices for additional
units. If the price is higher, he will restrict its consumption.
____________________ 4. Refers to the total demand for a commodity by all the consumers.
____________________ 5. Means the various quantities of goods that would be purchased per time period
at different prices in a given market.
Instruction: Write TRUE if the statement is valid and FALSE if otherwise. If the statement is FALSE,
write the word FALSE and underline the word(s) that make it wrong.
_______ 1. A change in demand solely due to change in price is called extension and contraction.
_______ 2. When the demand changes due to changes in other factors, like taste and preferences, income,
price of related goods and other factors other than price, it is called shift in demand.
_______ 3. Demand means the desire backed by the willingness to buy a commodity and purchasing power
to pay.
_______ 4. Taste and preferences of sellers is a determinant of demand.
_______ 5. When the price of the commodity falls, the real income of the consumer will increase, this
situation is called “Substitution effect”.
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2.2 ELASTICITY OF DEMAND
Meaning of Elasticity
Law of demand explains the directions of changes in demand. A fall in price leads to an increase in quantity demanded
and vice versa. But it does not tell us the rate at which demand changes to change in price. The concept of elasticity of
demand was introduced by Marshall. This concept explains the relationship between a change in price and consequent
change in quantity demanded. Nutshell, it shows the rate at which changes in demand take place.
Elasticity of demand can be defined as “the degree of responsiveness in quantity demanded to a change in price”. Thus
it represents the rate of change in quantity demanded due to a change in price. There are mainly two types of elasticity
of demand:
1. Price Elasticity of Demand
2. Income Elasticity of Demand
3. Cross Elasticity of Demand
Price Elasticity of Demand Price Elasticity of demand measures the change in quantity demanded to a change in price.
It is the ratio of percentage change in quantity demanded to a percentage change in price. This can be measured by the
following formula.
PRICE ELASTICITY = Proportionate Change in Quantity Demanded

Proportionate Change in Price
OR
PRICE ELASTICITY (Q2-Q1)/Q1

=
(P2-P1)/P1
Where: Q1 = Quantity demanded before price change

Q2 = Quantity demanded after price change
P1 = Price charged before price change
P2 = Price charge after price change.
5 TYPES OF ELASTICITY OF DEMAND
There are five types of price elasticity of demand. (Degree of elasticity of demand) Such as perfectly elastic demand,
perfectly inelastic demand, relatively elastic demand, relatively inelastic demand and unitary elastic demand.
1) Perfectly elastic demand (infinitely elastic)

When a small change in price leads to infinite change in quantity demanded, it is called perfectly elastic demand. In
this case the demand curve is a horizontal straight line as given below. (Here ep= ∞)
20
2) Perfectly inelastic demand

In this case, even a large change in price fails to bring about a change in quantity demanded. I.e. the change in price
will not affect the quantity demanded and quantity remains the same whatever the change in price. Here demand curve
will be vertical line as follows and ep= 0
3) Relatively elastic demand

Here a small change in price leads to very big change in quantity demanded. In this case demand curve will be fatter
one and ep=>1
21
4) Relatively inelastic demand

Here quantity demanded changes less than proportionate to changes in price. A large change in price leads to small
change in demand. In this case demand curve will be steeper and ep=<1
5) Unit elasticity of demand (unitary elastic)

Here the change in demand is exactly equal to the change in price. When both are equal, ep= 1, the elasticity is said to
be unitary.
The above five types of elasticity can be summarized as follows:
22
INCOME ELASTICITY
Income Elasticity is a measure of responsiveness of potential buyers to change in income. It shows how the quantity
demanded will change when the income of the purchaser changes, the price of the commodity remaining the same. It
may be defined thus: The Income Elasticity of demand for a good is the ratio of the percentage change in the amount
spent on the commodity to a percentage change in the consumer’s income, price of commodity remaining constant.
Thus,
Income Elasticity = Proportionate change in the quantity purchased

Proportionate change in Income
Income elasticity of demand mainly of three types:
1) Zero income Elasticity.

2) Negative income Elasticity
3) Positive income Elasticity
Zero income elasticity – In this case, quantity demanded remain the same, eventhough money income increases.ie,
changes in the income doesn’t influence the quantity demanded (Eg. salt, sugar etc). Here Ey (income elasticity) = 0
Negative income elasticity -In this case, when income increases, quantity demanded falls. Eg, inferior goods. Here
Ey = < 0.
Positive income Elasticity - In this case, an increase in income may lad to an increase in the quantity demanded. i.e.,
when income rises, demand also rises. (Ey =>0) This can be further classified in to three types:
a) Unit income elasticity; Demand changes in same proportion to change in income.i.e, Ey = 1

b) Income elasticity greater than unity: An increase in income brings about a more than proportionate increase in
quantity demanded.i.e, Ey =>1
c) Income elasticity less than unity: when income increases quantity demanded is also increases but less than
proportionately. I.e., Ey =<1
Business decision based on income elasticity.
The concept of income elasticity can be utilized for the purpose of taking vital business decision. A businessman can
rely on the following facts.
If income elasticity is greater than Zero, but less than one, sales of the product will increase but slower than the
general economic growth.
If income elasticity is greater than one, sales of his product will increase more rapidly than the general economic
growth.
Firms whose demand functions have high income elasticity have good growth opportunities in an expanding
economy. This concept helps manager to take correct decision during business cycle and also helps in forecasting the
effect of changes in income on demand.
Cross Elasticity of Demand
Cross elasticity of demand is the proportionate change in the quantity demanded of a commodity in response to
change in the price of another related commodity. Related commodity may either substitutes or complements.
Examples of substitute commodities are tea and coffee. Examples of compliment commodities are car and petrol.
Cross elasticity of demand can be calculated by the following formula;
23
Cross Elasticity = Proportionate Change in Quantity Demanded of a Commodity

Proportionate Change in the Price of Related Commodity
If the cross elasticity is positive, the commodities are said to be substitutes and if cross elasticity is negative, the
commodities are compliments. The substitute goods (tea and Coffee) have positive cross elasticity because the
increase in the price of tea may increase the demand of the coffee and the consumer may shift from the consumption
of tea to coffee.
Complementary goods (car and petrol) have negative cross elasticity because increase in the price of car will reduce
the quantity demanded of petrol.
The concept of cross elasticity assists the manager in the process of decision making. For fixing the price of product
which having close substitutes or compliments, cross elasticity is very useful.
Importance of Elasticity.
The concept of elasticity of demand is much of practical importance;
1. Production- Producers generally decide their production level on the basis of demand for their product. Hence
elasticity of demand helps to fix the level of output.
2. Price fixation- Each seller under monopoly and imperfect competition has to take into account the elasticity of
demand while fixing their price. If the demand for the product is inelastic, he can fix a higher price.
3. Distribution- Elasticity helps in the determination of rewards for factors of production. For example, if the demand
for labour is inelastic, trade union can raise wages.
4. International trade- This concept helps in finding out the terms of trade between two countries. Terms of trade
means rate at which domestic commodities is exchanged for foreign commodities.
5. Public finance- This assists the government in formulating tax policies. In order to impose tax on a commodity, the
government should take into consideration the demand elasticity.
6. Nationalization- Elasticity of demand helps the government to decide about nationalization of industries.
7. Price discrimination- A manufacture can fix a higher price for the product which have inelastic demand and lower
price for product which have elastic demand.
Determinants of elasticity.
Elasticity of demand varies from product to product, time to time and market to market. This is due to influence of
various factors. They are;
1. Nature of commodity- Demand for necessary goods (salt, rice,etc,) is inelastic. Demand for comfort and luxury
good are elastic.
2. Availability/range of substitutes – A commodity against which lot of substitutes are available, the demand for that is
elastic. But the goods which have no substitutes, demand is inelastic.
3. Extent /variety of uses- a commodity having a variety of uses has a comparatively elastic demand. Eg.Demand for
steel, electricity etc..
4. Postponement/urgency of demand- if the consumption of a commodity can be post pond, then it will have elastic
demand. Urgent commodity has inelastic demand.
5. Income level- income level also influences the elasticity. E.g. Rich man will not curtail the consumption quantity of
fruit, milk etc, even if their price rises, but a poor man will not follow it.
6. Amount of money spend on the commodity- where an individual spends only a small portion of his income on the
commodity, the price change doesn’t materially affect the demand for the commodity, and the demand is inelastic...
(match box, salt Etc)
7. Durability of commodity- if the commodity is durable or repairable at a substantially less amount (eg.Shoes), the
demand for that is elastic.
8. Purchase frequency of a product/time –if the frequency of purchase of a product is very high, the demand is likely
to be more price elastic.
24
9. Range of Prices- if the products at very high price or at very low price having inelastic demand since a slight change
in price will not affect the quantity demand.
10. Others – the habit of consumers, demand for complimentary goods, distribution of income and wealth in the
society etc., are other important factors affecting elasticity.
REMEMBER THE FORMULAS
How Do We Interpret the Income Elasticity of Demand?
Income elasticity of demand is used to see how sensitive the demand for a good is to an income change. The higher the
income elasticity, the more sensitive demand for a good is to income changes. A very high income elasticity suggests
that when a consumer's income goes up, consumers will buy a great deal more of that good. A very low price elasticity
implies just the opposite, that changes in a consumer's income has little influence on demand.
Choose the best answer of the following questions.
1. The price elasticity of demand is the:

a) percentage change in quantity demanded divided by the percentage change in price
b) percentage change in price divided by the percentage change in quantity demanded
c) dollar/peso change in quantity demanded divided by the dollar/peso change in price
d) percentage change in quantity demanded divided by the percentage change in quantity supplied.
2) The sensitivity of the change in quantity demanded to a change in price is called

a) income elasticity. b) cross-elasticity.
c) price elasticity of demand. d) coefficient of elasticity.
3) The sensitivity of the change in quantity consumed of one product to a change in the price of a related product is
called
a) cross-elasticity. b) substitute elasticity.
c) complementary elasticity. c) price elasticity of demand.
25
4) When a one percent change in price results in a one percent change in quantity demanded in the opposite direction,
demand is
a) relatively inelastic. b) unitary elastic.
c) perfectly elastic. d) perfectly inelastic.
5) The owner of a produce store found that when the price of a head of lettuce was raised from 50 cents to $1, the
quantity sold per hour fell from 18 to 8. The arc elasticity of demand for lettuce is
a) -0.56. b) -1.15.
c) -0.8. c) -1.57.
6) If the consumption of sugar does not change at all following a price increase from 49 cents per pound to 58 cents
per pound, the demand for sugar is considered to be
a) relatively inelastic. b) perfectly elastic.
c) perfectly inelastic. d) unitary elastic.
7) If a firm decreases the price of a product and total revenue decreases, then
A) the demand for this product is price elastic.
B) the demand for this product is price inelastic.
C) the cross elasticity is negative.
D) the income elasticity is less than 1.
8) If the price of a product is increased and total revenue received from the sale of this product increases, then the
price elasticity of demand for the product is
a) elastic. b) inelastic.
c) unitary. d) None of the above.
9) If the price of a product is decreased and total revenue received from the sale of this product does not change, then
the price elasticity of demand for the product is
a) elastic. b) inelastic.
c) unitary. d) None of the above.
10) If the price elasticity of supply of a product is elastic and the product price increases, then the increase in the
product supply should be
a) greater than the increase in price. b) less than the increase in price.
c) the same as the increase in price. d) Can't be determined from this information.
Analytical Questions
1) The initial price of a cup of coffee is $1, and at that price, 400 cups are demanded. If the price falls to $0.90, the
quantity demanded will increase to 500.
a. Calculate the (arc) price elasticity of demand for coffee.
b. Based on your answer, is the demand for coffee elastic or inelastic?
c. Based on your answer to a., if the price of coffee is increased by 10%, what will happen to the revenues from
coffee? Carefully explain how you know.
Answer:
a. Arc elasticity = -2.11
b. Elastic
c. Revenues will fall. Demand is elastic, and thus a 1% increase in price will lead to a greater percentage decrease in
quantity demanded. Revenues fall because the price increase does not make up for the reduction in sales.
Supply
26
SUPPLY
Supply also involves the relationship between price and quantity.
Supply is the quantity of goods and services that producers are willing to offer at various possible prices.
Law of Supply
The Law of Supply is a direct relationship between price and quantity supplied.
The Law of Supply states that producers will offer more of a product at higher prices and less of a product at lower
prices. Producers supply more goods and services when they can sell them at higher prices. They will supply fewer
goods and services when they must sell them at lower prices.
Supply Schedule
A supply schedule shows the relationship between the price of a good and the quantity producers are willing to supply.
The supply schedule lists each quantity of a product that producers are willing to supply at various market prices.
Supply schedules and curves are a snapshot because they represent a specific time period.
Supply curves
A supply curve plots the information from a Supply Schedule on a graph. This allows us to easily and quickly make
decisions on supply.
Normal supply curves reflect a steady relationship between quantity and price, like the graph on the right.
Elasticity of Supply
Degree to which price changes affect the quantity supplied. There are two sides, elastic and inelastic.
Elastic- when a small change in price causes a major change in the quantity supplied.
Inelastic- when a change in price does not affect the quantity supplied.
The Big Idea: A small increase in the cost of production may result in a cut back in quantity supplied.
27
Supply Shifts
Supply can change for a variety of reasons other than price including:
1. price of resources
✓ Any price increase or decrease in resources will effect their costs
✓ Resources include raw materials, electricity and workers’ wages.
2. government tools
✓ Tools include taxes, subsidies and regulation, which can change how much a company is willing to produce
✓ Taxes: payment to fund government services. Taxes add to cost of production
✓ Subsidies: payments to private businesses to ensure an affordable supply of some essential goods like dairy,
wheat, etc.
✓ Regulations: rules on how a business can operate which are meant to protect the consumer
3. technology
✓ New technology can reduce the costs of production, leading to an increase in supply.
4. competition
✓ Competition increases supply because there are more companies producing similar goods.
Example: As new video game consoles come out, the demand for new games increases. As such, more suppliers come
to the market, creating plenty of supply.
5. prices of related goods

✓ Suppliers may choose to produce different goods which are selling for a higher profit.
Example: farmer growing wheat will want to switch to growing corn if the price of corn goes up.
6. producer expectations
✓ If the producers think the demand for or the price of their products will increase they will increase their
supply.
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Equilibrium
The goal of supply and demand is to reach equilibrium between the two. By reaching the equilibrium there are exactly
enough goods to be sold, at a price the producers are willing to supply at. All items will be sold, and there will be
nothing left over, nor anyone still demanding the product.
SELF CHECK QUESTIONS 2.3
1) Which of the following will not cause a short-run shift in the supply curve?
A) a change in the number of sellers B) a change in the cost of resources
C) a change in the price of the product D) a change in future expectations
2) Which of the following is a key determinant of both supply and demand?

A) income B) future expectations/expectations
C) tastes and preferences D) sales tax
3) A market is in equilibrium when

A) supply is equal to demand. B) the price is adjusting upward.
C) the quantity supplied is equal to the quantity demanded. D) tastes and preference remain constant.
4) Which of the following indicates that there is a shortage in the market?

A) Demand is rising. B) Demand is falling.
C) Price is rising. D) Price is falling.
5) Which of the following would cause a decrease in the price of a product?

A) an increasing shift in the supply of a product and no shift in demand
B) a decreasing shift in the supply of a product and no shift in demand
C) an increasing shift in the demand for product and no shift in supply
D) an increasing shift in the demand for product and a decreasing shift in supply
29
MARKET STRUCTURES
Introduction The determination of price of the product is an important managerial function. Price affects profit through
its effect both on revenue and cost, profit is concerned with the difference between cost and the revenue .It always
depends on cost and volume of sales. Therefore the management always tries to find out the optimum combination of
price and output which offers the maximum profit to the firm. Thus pricing occupies on important place in economic
analysis of firms. The knowledge of market and market structure with which a firm operates is more helpful in price
output decisions. Market in economic term means a meeting place where buyers and sellers deal directly or indirectly.
Clark and Clark defines market as that “any body of persons who are in intimate business relations and carry on
extensive transactions in any commodity”. Market structures are different market forms based on the degree of
competition prevailing in the market.
Perfect Competition
The term perfect competition is used in wider sense perfect competition means all the buyers and sellers in the market
are aware of price of products .The following are the characteristics of perfectly competitive market
1. Large number of buyers and sellers in the market
2. Homogeneous product
3. Free entry or exit
4. All the buyers and sellers in the market have perfect knowledge about the market conditions.
5. Perfect mobility of factor of production
6. Absence of transportation costs.
When the first three assumptions are satisfied there exists pure competition .competition becomes perfect only when
all the assumptions are satisfied. In perfect competition, the demand for the output for each producer is perfectly
elastic .With the larger number of firms and homogeneous products, no individual firm is in a position to influence the
price.
Monopoly
Monopoly means `single `selling. In brief, monopoly is a market situation in which there is only one seller or producer
of a product for which no close substitution is available .As there is only one firm under monopoly, that single firm
constitutes the whole industry .The monopolist can fix price of his product and can pursue an independent price
policy. A monopolist can take the decision about the price of his product .For ex:- electricity , water supply companies
etc.
Features The following are the important features of monopoly:
1. One seller and a large number of buyers.

2. No close substitutes for the product.
3. Monopolist is not the price taker and the price maker.
4. Monopolist can control the supply.
5. No entry of new firm to the market.
6. Firm and industry are the same
Causes of Monopoly
1. Legal restrictions
2. Exclusive ownership or control over the raw materials.
3. Economies of large scale production
4. Exclusive knowledge of a production technique.
30
Difference between perfect competition and Monopoly
1. Under perfect competition there are many sellers but in the case of monopoly, there is only one seller
2. Individual seller has no control over the market supply in the case of perfect competition. But in the case of
Monopoly individual seller controls the supply.
3. Products are identical in the case of perfect competition, but there is only one product in the case of Monopoly.
4. Under perfect competition, there are free entry and exit of firms. But the Monopolist blocks the entry.
5. The Monopolist discriminates the price but there is uniform price in perfect competition.
6. Firm and Industry is different in the case of perfect competition, they are same in the case of Monopoly.
Monopolistic Competition
In the present World market, it can be seen that there is no monopoly and there is no real competition. There is a mix
up of the two. This situation is generally known as Monopolistic competition. According to Prof .E. H Chemberlin of
America, Monopolistic Competition means a market situation In which competition is imperfect. The products of the
firms under monopolist competition, are mainly close substitutes to each other .
Features /Assumptions of Monopolistic Competition.
The following are the important features of Monopolistic Competition.
1. There are large numbers of producers or sellers

2. It deals with differentiated products.
3. There are free entry and exit of firms to the markets.
4. The selling cost determines the demand for the products.
5. There is no association of firms
6. There is no price competition.
7. There is lack of knowledge of the market.
Perfect Competition Monopolistic Competition

Products are identical Products are differentiated
It is not a real concept It is real concept .
Large Number of buyers and sellers Buyers and Sellers are not so large
Perfect knowledge of market Condition Lack of perfect knowledge of market Condition
Selling Cost do not play any role Selling cost has an important role
They are price takers They are price markers
Oligopoly
Oligopoly is a situation in which there are so few sellers that each of them is conscious of the results upon the price of
the supply. Which he individually places upon the market. According to J .Stigler Òligopoly is that situation in which
a firm bases its market policy in part on the expected behavior of a few close revels`. Further, they may produce
homogeneous or differentiated products.
Characteristics
Oligopoly is a distinct market condition. It has the following features:
1. The firms are inter dependent in decision making .

2. Advertising should be effective.
3. Firms should have group behavior.
4. Indeterminateness of demand curve .
5. The number of firms or producers or sellers are very small .
31
6. Product are identical or close substitutes to each other

7. There is an element of Monopoly
Price Determination Under Oligopoly
Pricing many be in condition of independent pricing, pricing under-price leadership and pricing under collusion.
An oligopolist always guesses about his competitors’ reaction. They assume that if one decides to decrease the price,
the others will also reduce the price. The assumption is that each oligopolist will act and react in a way that keep
condition tolerable for all the members of the industry. If one firm reduces the price of the product, the others will be
compelled to reduce the price. But sometimes, if one increases the price, the other will not increase the price. The
firms in Oligopoly do not increase the prices due to the possibility of losing the customers to rivals who do not raise
their prices. Firms usually do not change their price in response to small changes in costs.
Pricing Under Collusive Oligopoly
The term Collusion means `to play together`. To avoid the competition among the firms, monopolistic firms arrive at a
formal agreement called cartel. It is common sales agency formed to eliminate competition and fix such a price and
output that will maximize profit of member firms. The firms output and price are determined by this cartel.
PRICE
Price is the monetary value of a good, service or resource established during a transaction. Price can be set by a seller
or producer when they possess monopoly power, and are said to be price makers, or set through the market itself,
when firms are price takers. Price can also be set by the buyer when they posses some monopsony power.
Pricing under Price Leadership
The price leadership means the leading firm determines the price and others follow it. All the firms in the industry
adjusts, the price fixed by the price leader. The large firm, who fixes the price, is known as the price maker and the
firms, who follow it are known as price –takers. The price leadership may be four types. They are:
1. Dominant price leadership- In this situation, there exists many small firms and one large firm and the large firm
fixes the price and the small firms in the market accept that price.
2. Barometric Price Leadership- Under this situation one reputed and experienced firm fixes the price and others may
follow it.
3. Aggressive Price Leadership– Under this market condition, one dominating firm fixes the price and they compel all
others in the industry to follow the price.
4. Effective Price Leadership- Under this condition, there are small number of firms in the industry.
Price Discrimination
A monopolist is in a position to fix the price of his product .He enjoys the control of supply of the product. A
monopolist is able to charge different price for his products to the different customers. This is known as price
discrimination. According to Mrs. John Robinson „the act of selling the same article, produced under single control at
different prices to different buyers is known as price discrimination. This is also known as differential pricing.
Types of Price Discrimination
1. Price relatively elastic portion of the demand curve of the first degree – charging different price for different
persons for the same product.
2. Price discrimination of the second degree – Under this, the buyers are classified into different divisions.
3. Price discrimination of the third degree – Here, the markets are divided according to elasticity of demand.
32
Conditions of Price Discrimination
There are three conditions to be satisfied to apply the price discrimination, They are:
1. There must be more than one separate market
2. The markets must have different elasticity of demand
3. The market should be such that no buyer of the market may enter the other market and vice versa
,
Dumping
When monopolist works in home market as well as foreign market, he is able to discriminate the price between these
two markets, If he has monopoly in home market, and he faces competition in to foreign market, he will be able to
charge higher prices for his products in home market. This practice is known as dumping` or `price dumping.
MAIN TASK QUESTIONS
QUESTION 1: (ESSAY)
1. Define managerial economics.

2. Discuss the importance of managerial economics.
3. Explain the objectives of managerial economics in business.
4. Enumerate and explain the functions of managerial economics.
5. Discuss managerial economics as a tool for decision making and forward planning.
Needs improvement Approaching standards Good Excellent

1 pts 2 pts 3 pts 4 pts
What you are writing

You put thought into What you are writing about
about is clear and
this, but there is no real is clear. You answered the
well-expressed,
Ideas and Content There is no clear or specific evidence of learning. question. Some support may
including specific
explanation in answer to More specific be lacking, or your
examples to
the question. information is needed or sentences may be a bit
demonstrate what
you need to follow the awkward. Overall, a decent
you learned. Well
directions more closely. job.
done!
Your answer included

all the terms from
Only one term from the the lesson that
Use of terms several terms from the
No terms from the lesson lesson is used in the applied to the
lesson, demonstrating
are used. answer. Try for a few question asked. All
adequate understanding of
more, next time. terms are fully
the material.
defined and used in
the proper context.

Sentences are
complete and they
Some sentences are
Sentence Fluency Sentences are incomplete or connect to one
complete and easy to Sentences are complete and
too long. It makes reading another easily when
undersand. Others able to be understood.
them difficult. they are read out
require some work.
loud. Your writing
'flows.'
33
QUESTION 2:
Construct a demand curve base on the demand schedule and make a short analysis.
PRICE QUANTITY DEMANDED

(PESO) PER MONTH
15 1
12 2
9 3
6 5
3 7
Construct a demand schedule base on the demand curve and make a short analysis.
34
QUESTION 3:
1. Suppose price rises from P15 to P17 and quantity demanded decreases by 20%. Compute the elasticity of demand?
2. How to calculate price elasticity of demand?
3. A business puts up its prices by 10%. Explain whether demand is elastic or inelastic if sales fall by:
a) 8%
b) 12%
c) 17%
4. Calculate the price elasticity of demand if:
a) Price goes up 20% leading to a fall in quantity demanded of 10%
b) Price falls by 5% leading to a rise in quantity demanded of 10%
5. Over the last 14 months a power company has increased its price for electricity by 40%, demand has fallen by 6%.
What is the price elasticity of demand? Is this demand elastic or inelastic?
QUESTION 4:
Construct a comparison and contrast matrix of the following types of market structure.
1. Perfect Competition
2. Monopolistic Competition
3. Monopoly
4. Oligoply
35
MODULE 2
COURSE LEARNING OUTCOME
DISCUSS THE PRODUCTION AND COST CONCEPTS.
TOPIC LEARNING OUTCOMES
• Explain the laws of production and law on diminishing returns

• Identify the cost concepts, classification, pattern and behaviour.
• Construct schedule of cost of goods manufactured and sold.
WARM-UP (PRE-ACTIVITY)
Write an essay describing the pictures below. (At least 10 sentences)
36
SELF-EVALUATION
After performing the Warm-up Section, evaluate yourself by placing a check mark on the column
that best describes your ability to describe your visual understanding. There are no wrong answers
in this section.
Usually Sometimes Seldom Never
3 2 1 0
I am able to describe the picture in the warm-

up section.
I am able to understand each of these

descriptions.
TOTAL
Score Level of Proficiency
5-6 Proficient
3-4 Approaching Proficiency
1-2 Developing
0 Beginning
LECTURE NOTES (INPUT)
PRODUCTION AND COST CONCEPTS.
Introduction
In Economics the term production means process by which a commodity (or commodities) is transformed in to a
different usable commodity. In other words, production means transforming inputs (labour ,machines ,raw materials
etc.) into an output. This kind of production is called manufacturing. An input` is good or service that goes in to the
process of production and “output is any good or service that comes out of production process.
You can't make something from nothing. You need supplies, equipment, resources, and some know-how, too. How much
you have of these things can affect your production. In economics, a production function is a way of calculating what
comes out of production to what has gone into it. The formula attempts to calculate the maximum amount of output you can
get from a certain number of inputs.
37
The factors of production are:
• Physical capital (K), or tangible assets that are created for use in the production process. This includes such things
as buildings, machines, computers, and other equipment.
• Labor (L), or input of skilled and unskilled activities of human workers.
• Land (P), which includes natural resources, raw materials, and energy sources, such as oil, gas, and coal.
• Entrepreneurship (H), which is the quality of the business intelligence that is applied to the production function.
Fixed and variable inputs.
In economic sense, a fixed input is one whose supply is inelastic in the short run .Therefore, all of its users cannot buy
more of it in short run. Conceptually, all its users, cannot employ more of it in the short run. If one user buys more of
it, some other users will get less of it. A variable input is defined as one whose supply in the short run is elastic,
eg:Labour, raw materials etc. All the users of such factors can employ larger quantity in the short run. In technical
sense a fixed input remains fixed (constant) up to a certain level of output whereas a variable input changes with
change in output.
Production function
Production function shows the technological relationship between quantity of output and the quantity of various inputs
used in production. Production function is economic sense states the maximum output that can be produced during a
period with a certain quantity of various inputs in the existing state of technology. In other words, it is the tool of
analysis which is used to explain the input - output relationships. In general, it tells that production of a commodity
depends on the specified inputs. In its specific tem it presents the quantitative relationship between inputs and output.
Inputs are classified as:
1. Fixed input or fixed factors

2. Variable input or variable factors
Short run and Long run
Short run refers to a period of time in which the supply of certain inputs (E.g. :- plant, building ,machines, etc) are
fixed or inelastic. Thus an increases in production during this period is possible only by increasing the variable input .
In some Industries, short run may be a matter of few weeks or a few months and in some others it may extent even up
to three or more years.
The long run refers to a period of time in which supply of all the input is elastic; but not enough to permit a change in
technology. In the long run, the availability of even fixed factor increases. Thus in the long run, production of
commodity can be increased by employing more of both variable and fixed inputs.
The laws of production
Production function shows the relationship between a given quantity of input and its maximum possible output. Given
the production function, the relationship between additional quantities of input and the additional output can be easily
obtained. This kind of relationship yields the law of production. The traditional theory of production studies the
marginal input-output relationship under (I) Short run; and (II) long run. In the short run, input-output relations are
studied with one variable input, while other inputs are held constant .The Law of production under these assumptions
are called “the Laws of variable production”. In the long run input output relations are studied assuming all the input
to be variable.
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Cobb-Douglas Production Function
n 1928, Charles Cobb and Paul Douglas presented the view that production output is the result of the amount of labor and
physical capital invested. This analysis produced a calculation that is still in use today, largely because of its accuracy.
The Cobb-Douglas production function reflects the relationships between its inputs - namely physical capital and labor -
and the amount of output produced. It's a means for calculating the impact of changes in the inputs, the relevant efficiencies,
and the yields of a production activity.
Law of Diminishing Returns (Law of Variable Proportions)

The Laws of returns states the relationship between the variable input and the output in the short term. By
definition certain factors of production (e.g.-Land, plant, machinery etc.) are available in short supply during
the short run. Such factors which are available in unlimited supply even during the short periods are known
as variable factor. In short-run therefore, the firms can employ a limited or fixed quantity of fixed factors
and an unlimited quantity of the variable factor. In other words, firms can employ in the short run varying
quantities of variable inputs against given quantity of fixed factors. This kind of change in input
combination leads to variation in factor proportions. The Law which brings out the relationship between
varying factor properties and output are therefore known as the Law of variable proportions.
The variation in inputs lead to a disproportionate increase in output more and more units of variable factor
when applied cause an increase in output but after a point the extra output will grow less and less. The law
which brings out this tendency in production is known as‟ Law of Diminishing Returns` The Law of
Diminishing returns levels that any attempt to increase output by increasing only one factor finally faces
diminishing returns. The Law states that when some factor remain constant, more and more units of a
variable factor are introduced the production may increase initially at an increasing rate; but after a point it
increases only at diminishing rate. Land and capital remain fixed in the short-term whereas labour shows a
variable nature.
The above table illustrates several important features of a typical production function .With one variable
input.- here both Average Product (AP) and Marginal Product (MP) first rise ,reach a maximum - then
decline. Average product is the product for one unit of labor. It is arrived at by dividing the Total Product
(TP) by number of workers Marginal product is the additional product resulting term additional labor. It is
found out by dividing the change in total product by the change in the number of workers. The total output
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increases at an increasing rate till the employment of the 4th worker. The rate of increase in the marginal
product reveals this .Any additional labor employed beyond the 4th labor clearly faces the operation of the
Law of Diminishing Returns. The maximum marginal product is 16 after which it continues to fall,
ultimately becoming negative. Thus when more and more units of labor are combined with other fixed
factors the total output increase first at an increasing rate then at a diminishing rate finally it becomes
negative.
Law of Returns to scale
In the long –run all the factor of production are variable, and an increase in output is possible by increasing
all the inputs. The Law of Returns to scale explains the technological relationship between changing scale of
input and output. The law of returns of scale explain how a simultaneous and proportionate Increase in all
the inputs affect the total output. The increase in output may be proportionate, more than proportionate or
less than proportionate. If the increase in output is proportionate to the increase in input, it is constant
Returns to scale .If it is less then proportionate it is diminishing returns to scale. The increasing returns to
the scale comes first, then constant and finally diminishing returns to scale happens.
Increasing Returns to scale
When proportionate increase in all factor of production results in a more than proportionate increase in
output and this results first stage of production which is known as increasing returns to scale. Marginal
output increases at this stage. Higher degree of specialization, falling cost etc. will lead higher efficiency
which result increased returns in the very first stage of production.
Constant Returns to scale
Firms cannot maintain increasing returns to scale indefinitely after the first stage, firm enters a stage when
total output tends to increase at a rate which is equal to the rate of increase in inputs. This stage comes in to
operation when the economies of large scale production are neutralized by the diseconomies of large scale
operation. Diminishing Returns to scale in this stage, a proportionate increase in all the input result only less
than proportionate increase in output. This is because of the diseconomies of large scale production. When
the firm grows further, the problem of management arise which result inefficiency and it will affect the
position of output.
Economies of Scale, the factors which cause the operation of the laws of returns the scale are grouped under
economies and diseconomies of scale. Increasing returns to scale operates because of economies of scale and
decreasing returns to scale operates because of diseconomies of scale where economies and diseconomies
arise simultaneously. Increasing returns to scale operates when economies of scale are greater then the
diseconomies of scale and returns to scale decreases when diseconomies .overweight the economies of scale.
Similarly when economies and diseconomies are in balance, returns to scale becomes constant. When a firm
increases all the factor of production it enjoys the same advantages of economies of production. The
economies of scale are classified as;
1. Internal economies.
2. .External economies
Internal economies of scale

Internal economies are those which arise form the explanation of the plant-size of the firm .Internal
economies of scale may be classified;
(a) Economies in production.
(b) Economies in marketing
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(c) Economies in economies

(d) Economies in transport and storage
External Economies of scale External or pecuniary economies to large size firms arise from the discounts
available to it due to;
1 . Large scale purchase of raw materials
2 . Large scale acquisition of external finance at low interest
3 . Lower advertising rate fun advertising media.
4 . Concessional transport charge on bulk transport.
5. Lower wage rates if a large scale firm is monopolistic employer of certain kind of specialized labour.
Thus External economies of scale are strictly based on experience of large –scale firms or well managed
small scale firms. Economies of scale will not continue forever. Expansion in the size of the firms beyond a
particular limit, too much specialization, inefficient supervision and improper labor relations etc will lead to
diseconomies of scale.
Isoquant curve.
The terms “Isoquant” has been derived from the Greek word iso means èqual` and Latin word quantus
means `quantity`. The isoquant curve is therefore also known as`` equal product curve `òr production
indifference curve. An isoquant curve is locus of point representing the various combination of two inputs –
capital and labour –yielding the same output. It shows all possible combination of two inputs, namely-
capital and labor which can produce a particular quantity of output or different combination of the two
inputs that can give in the same output. An isoquant curve all along its length represents a fixed quantity of
output.
The following table illustrates combination of capital (K) and labour (L) which give the same output say-
20units. The combinations of A uses one unit of „K‟ and 12 units of „L‟ to produce is20 units. likewise the
combinations B,C,D and E give the same output --20 units.
COMBINATION CAPITAL LABOR OUTPUT

A 1 12 20
B 2 8 20
C 3 5 20
D 4 3 20
E 5 2 20
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Cost Concepts, Classification, Patterns and Behaviour
2.1 INTRODUCTION
The term cost simply means cost of production. It is the expenses incurred in the production of goods. It is the sum of
all money-expenses incurred by a firm in order to produce a commodity. Thus it includes all expenses from the time
the raw material are bought till the finished products reach the wholesaler.
A managerial economist must have a proper understanding of the different cost concept which are essential for clear
business thinking. The cost concept which are relevant to business operation and decision can be grouped on the basis
of their purpose under two overlapping categories:
1. Concept used for accounting purpose

2. Concept used in economics analysis of the business
In accounting, costs can be classified differently depending on the needs of management. For example, the
Prologue mentioned that financial accounting is concerned with reporting financial information to external
parties, such as stockholders, creditors, and regulators. In this context, costs are classified in accordance with
externally imposed rules to enable the preparation of financial statements. Conversely, managerial
accounting is concerned with providing information to managers within an organization so that they can
formulate plans, control operations, and make decisions. In these contexts, costs are classified in diverse
ways that enable managers to predict future costs, to compare actual costs to budgeted costs, to assign costs
to segments of the business (such as product lines, geographic regions, and distribution channels), and to
properly contrast the costs associated with competing alternatives.
Costs are assigned to cost objects for a variety of purposes including pricing, preparing profitability studies,
and controlling spending. A cost object is anything for which cost data are desired—including products,
customers, and organizational subunits.
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Summary of Cost Classifications
1. Assigning costs to cost objects

• Direct cost (can be easily traced)
• Indirect cost (cannot be easily traced)
2. Accounting for costs in manufacturing companies
• Manufacturing costs
• Direct materials
• Direct labor
• Manufacturing overhead
• Nonmanufacturing costs
• Selling costs
• Administrative costs
3. Preparing financial statements

• Product costs (inventoriable)
• Period costs (expensed)
4. Predicting cost behavior in response to changes in activity

• Variable cost (proportional to activity)
• Fixed cost (constant in total)
• Mixed cost (has variable and fixed elements)
5. Making decisions
• Differential cost (differs between alternatives)
• Sunk cost (should be ignored)
• Opportunity cost (foregone benefit)
Direct Cost
A direct cost is a cost that can be easily and conveniently traced to a specified cost object.
Indirect Cost
An indirect cost is a cost that cannot be easily and conveniently traced to a specified cost object.
Manufacturing Costs
Most manufacturing companies further separate their manufacturing costs into two direct cost categories,
direct materials and direct labor, and one indirect cost category, manufacturing overhead/factory overhead.
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Direct Materials
Direct materials refers to raw materials that become an integral part of the finished product and whose costs
can be conveniently traced to the finished product.
The materials that go into the final product are called raw materials. This term is somewhat misleading
because it seems to imply unprocessed natural resources like wood pulp or iron ore. Actually, raw materials
refer to any materials that are used in the final product; and the finished product of one company can
become the raw materials of another company.
Direct Labor
Direct labor consists of labor costs that can be easily traced to individual units of product. Direct labor is
sometimes called touch labor because direct labor workers typically touch the product while it is being
made.
Note: Managers occasionally refer to their two direct manufacturing cost categories as prime costs. Prime
cost is the sum of direct materials cost and direct labor cost.
Manufacturing Overhead
Manufacturing overhead, the third manufacturing cost category, includes all manufacturing costs except
direct materials and direct labor. For example, manufacturing overhead includes a portion of raw
materials know as indirect materials as well as indirect labor. Manufacturing overhead also includes other
indirect costs that cannot be readily traced to finished products such as depreciation of manufacturing
equipment and the utility costs, property taxes, and insurance premiums incurred to operate a manufacturing
facility. Although companies also incur depreciation, utility costs, property taxes, and insurance premiums
to sustain their nonmanufacturing operations, these costs are not included as part of manufacturing overhead.
Only those indirect costs associated with operating the factory are included in manufacturing overhead.
Indirect materials are raw materials, such as the glue used to assemble a chair, whose costs cannot be
easily or conveniently traced to finished products.
Indirect labor refers to employees, such as janitors, supervisors, materials handlers, maintenance workers,
and night security guards, that play an essential role in running a manufacturing facility; however, the cost
of compensating these people cannot be easily or conveniently traced to specific units of product. Since
indirect materials and indirect labor are difficult to trace to specific products, their costs are included in
manufacturing overhead.
Nonmanufacturing Costs
Nonmanufacturing costs are often divided into two categories: (1) selling costs and (2) administrative costs.
Selling costs include all costs that are incurred to secure customer orders and get the finished product to the
customer. These costs are sometimes called order-getting and order-filling costs. Examples of selling costs
include advertising, shipping, sales travel, sales commissions, sales salaries, and costs of finished goods
warehouses. Selling costs can be either direct or indirect costs.
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For example, the cost of an advertising campaign dedicated to one specific product is a direct cost of that
product, whereas the salary of a marketing manager who oversees numerous products is an indirect cost with
respect to individual products.
Administrative costs include all costs associated with the general management of an organization rather
than with manufacturing or selling. Examples of administrative costs include executive compensation,
general accounting, secretarial, public relations, and similar costs involved in the overall, general
administration of the organization as a whole.
Note: Nonmanufacturing costs are also often called selling, general, and administrative (SG&A) costs or
just selling and administrative costs.
Cost Classifications for Preparing Financial Statements
Product Costs
For financial accounting purposes, product costs include all costs involved in acquiring or making a
product. Product costs “attach” to a unit of product as it is purchased or manufactured and they stay attached
to each unit of product as long as it remains in inventory awaiting sale. When units of product are sold, their
costs are released from inventory as expenses (typically called cost of goods sold) and matched against sales
on the income statement. Because product costs are initially assigned to inventories, they are also known as
inventoriable costs.
For manufacturing companies, product costs include direct materials, direct labor, and manufacturing
overhead. A manufacturer’s product costs flow through three inventory accounts on the balance sheet—
Raw Materials, Work in Process, and Finished Goods—prior to being recorded in cost of goods sold on the
income statement. Raw materials include any materials that go into the final product. Work in process
consists of units of product that are only partially complete and will require further work before they are
ready for sale to the customer. Finished goods consist of completed units of product that have not yet been
sold to customers.
Period Costs
Period costs are all the costs that are not product costs. All selling and administrative expenses are treated
as period costs. For example, sales commissions, advertising, executive salaries, public relations, and the
rental costs of administrative offices are all period costs. Period costs are not included as part of the cost of
either purchased or manufactured goods; instead, period costs are expensed on the income statement in the
period in which they are incurred using the usual rules of accrual accounting. Keep in mind that the period in
which a cost is incurred is not necessarily the period in which cash changes hands. For example, as
discussed earlier, the cost of liability insurance is spread across the periods that benefit from the insurance—
regardless of the period in which the insurance premium is paid.
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DETERMINATION OF PRODUCT AND PERIOD COST
Product Cost Period Cost

Depreciation on salespersons’ X
cars
Rent on equipment used in the X
factory
Lubricants used for machine X
maintenance
Salaries of personnel who work X
in the finished goods warehouse
Soap and paper towels used by X
factory workers at the end of a
shift
Factory supervisors’ salaries X
Heat, water, and power consumed X

in the factory
Materials used for boxing X
products for shipment overseas
(units are not normally boxed)
Advertising costs X
Workers’ compensation X
insurance for factory employees
Depreciation on chairs and tables X
in the factory lunchroom
The wages of the receptionist in X
the administrative offices
Cost of leasing the corporate jet X
used by the company's executives
The cost of renting rooms at a X
Florida resort for the annual sales
conference
The cost of packaging the X
company’s product
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Cost Classifications for Predicting Cost Behavior
Cost behavior refers to how a cost reacts to changes in the level of activity. As the activity level rises and
falls, a particular cost may rise and fall as well—or it may remain constant. For planning purposes, a
manager must be able to anticipate which of these will happen; and if a cost can be expected to change, the
manager must be able to estimate how much it will change. To help make such distinctions, costs are often
categorized as variable, fixed, or mixed. The relative proportion of each type of cost in an organization is
known as its cost structure. For example, an organization might have many fixed costs but few variable or
mixed costs. Alternatively, it might have many variable costs but few fixed or mixed costs.
Variable Cost
A variable cost varies, in total, in direct proportion to changes in the level of activity. Common examples
of variable costs include cost of goods sold for a merchandising company, direct materials, direct labor,
variable elements of manufacturing overhead, such as indirect materials, supplies, and power, and variable
elements of selling and administrative expenses, such as commissions and shipping costs.
For a cost to be variable, it must be variable with respect to something. That “something” is its activity base.
An activity base is a measure of whatever causes the incurrence of a variable cost. An activity base is
sometimes referred to as a cost driver. Some of the most common activity bases are direct labor-hours,
machine-hours, units produced, and units sold.
To provide an example of a variable cost, consider Bukidnon Travel and Tours a small company that
provides daylong whitewater rafting excursions on rivers in the Kitanglad Mountains. The company
provides all of the necessary equipment and experienced guides, and it serves gourmet meals to its guests.
The meals are purchased from a caterer for P30 a person for a daylong excursion. The behavior of this
variable cost, on both a per unit and a total basis, is shown below:
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Number of Guests Cost of Meals per Guest Total Cost of Meals

250 P30 P7,500
500 P30 P15,000
750 P30 P22,500
1,000 P30 P30,000
While total variable costs change as the activity level changes, it is important to note that a variable cost is
constant if expressed on a per unit basis. For example, the per unit cost of the meals remains constant at P30
even though the total cost of the meals increases and decreases with activity. The table above illustrates that
the total variable cost rises and falls as the activity level rises and falls. At an activity level of 250 guests, the
total meal cost is P7,500. At an activity level of 1,000 guests, the total meal cost rises to P30,000.
Fixed Cost
A fixed cost is a cost that remains constant, in total, regardless of changes in the level of activity.
Manufacturing overhead usually includes various fixed costs such as depreciation, insurance, property taxes,
rent, and supervisory salaries. Similarly, selling and administrative costs often include fixed costs such as
administrative salaries, advertising, and depreciation of nonmanufacturing assets. Unlike variable costs,
fixed costs are not affected by changes in activity. Consequently, as the activity level rises and falls, total
fixed costs remain constant unless influenced by some outside force, such as a landlord increasing your
monthly rent.
To continue the Bukidnon Travel and Tours example, assume the company rents a building for P5000 per
month to store its equipment. The total amount of rent paid is the same regardless of the number of guests
the company takes on its expeditions during any given month.
Because total fixed costs remain constant for large variations in the level of activity, the average fixed cost
per unit becomes progressively smaller as the level of activity increases. If Bukidnon Travel and Tours has
only 250 guests in a month, the P5000 fixed rental cost would amount to an average of P20 per guest. If
there are 1,000 guests, the fixed rental cost would average only P5 per guest. The table below illustrates this
aspect of the behavior of fixed costs. Note that as the number of guests increase, the average fixed cost per
guest drops.
Monthly Rental Cost Number of Guests Average Cost per Guest

P5,000 250 P20
P5,000 500 P10
P5,000 750 P6.67
P5,000 1,000 P5
Note: As a general rule, we caution against expressing fixed costs on an average per unit basis in internal
reports because it creates the false impression that fixed costs are like variable costs and that total fixed costs
actually change as the level of activity changes.
For planning purposes, fixed costs can be viewed as either committed or discretionary. Committed fixed
costs represent organizational investments with a multiyear planning horizon that can’t be significantly
reduced even for short periods of time without making fundamental changes. Examples include investments
in facilities and equipment, as well as real estate taxes, insurance premiums, and salaries of top management.
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Discretionary fixed costs (often referred to as managed fixed costs) usually arise from annual decisions by
management to spend on certain fixed cost items. Examples of discretionary fixed costs include advertising,
research, public relations, management development programs, and internships for students.
SAMPLE: DETERMINATION WHETHER IT IS VARIABLE OR FIXED COST
Cost Item Variable Fixed Selling and Product Cost

Administrative
Cost
Hamburger buns at a X x
Wendy’s outlet
Advertising by a X x
dental office
Apples processed X x
and canned by Del
Monte
Shipping canned X x
apples from a Del
Monte plant to
customers
Insurance on a x x
Bausch & Lomb
factory producing
contact lenses
Insurance on IBM’s x x
corporate
headquarters
Salary of a x x
supervisor
overseeing
production of
printers at Hewlett-
Packard
Commissions paid to X x
Encyclopedia
Britannica
salespersons
Depreciation of x x
factory lunchroom
facilities at a
49
General Electric
plant
Steering wheels X x
installed in BMWs
The Linearity Assumption and the Relevant Range
Management accountants ordinarily assume that costs are strictly linear; that is, the relation between cost on
the one hand and activity on the other can be represented by a straight line within a narrow band of activity
known as the relevant range. The relevant range is the range of activity within which the assumption that
cost behavior is strictly linear is reasonably valid.
The concept of the relevant range is important in understanding fixed costs. For example, suppose the
Mayor Clinic rents a machine for P20,000 per month that tests blood samples for the presence of leukemia
cells. Furthermore, suppose that the capacity of the leukemia diagnostic machine is 3,000 tests per month.
The assumption that the rent for the diagnostic machine is P20,000 per month is only valid within the
relevant range of 0 to 3,000 tests per month. If the Mayo Clinic needed to test 5,000 blood samples per
month, then it would need to rent another machine for an additional P20,000 per month. It would be difficult
to rent half of a diagnostic machine. This situation shows that the fixed rental cost is P20,000 for a relevant
range of 0 to 3,000 tests. The fixed rental cost increases to P40,000 within the relevant range of 3,001 to
6,000 tests.
Summary of Variable and Fixed Cost Behavior
(Behavior of the Cost (within the relevant range)
Cost In Total Per Unit

Variable cost Total variable cost increases and Variable cost per unit remains
decreases in proportion to constant.
changes in the activity level.
Fixed cost Total fixed cost is not affected by Fixed cost per unit decreases as
changes in the activity level the activity level rises and
within the relevant range. increases as the activity level
falls.
Mixed Costs
A mixed cost contains both variable and fixed cost elements. Mixed costs are also known as semi-variable
costs. Examples of social security taxes, material handling, personnel services, heat, light, and power. These
cost elements must be divided into their proper element.
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The relationship between mixed cost and the level of activity also be expressed in the following equations:
Y = a + bX
In this equation,
Y = The total mixed cost
a = The total fixed cost (the vertical intercept of the line)
b = The variable cost per unit of activity (the slope of the line)
X = The level of activity
The independent variable is called also the explanatory variable or cost driver. In cost estimation, we
identify some independent variable (the activity) and the functional relationship that permit computation of
the corresponding value of the dependent variable (the cost).
The High-Low Method
The High-Low Method of analyzing mixed costs is based on costs observed at both the high and low levels
of activity within the relevant range. The idea is management go about in estimating the fixed and variable
components of the mixed cost.
Steps in Applying the High-Low Cost Estimation
1. Obtain relevant data on past coasts and related actual activity levels.
2. Estimate the variable cost per unit or rate using the following equation.
Variable cost rate or per unit= Cost at highest activity – Cost at lowest activity
Highest activity – Lowest activity
3. Fixed cost = Total Cost at highest activity – (Variable cost per unit x Highest activity stated in units)
Fixed cost = Total Cost at lowest activity – (Variable cost per unit x Lowest activity stated in units)
Sample Problem:
Data for the past 10 months were collected for Jopams Inc. to estimate the variable and fixed manufacturing
overhead.
The following data on supplies cost and direct labor hours from January to October are available.
X Y
Direct Labor Supplies Cost

Hours
20 50
40 110
60 150
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20 70
30 80
40 100
50 150
10 60
30 110
50 120
REQUIRED:
Determine the variable cost rate per hour and the fixed cost portion using high-low method.
SOLUTION:
1. Variable cost rate per hour = P150 – P60
60-10
= P90
50
= P1.80
2. FIXED COST:
At 60-hour level At 10-hour level
FC = P150 – (P1.80 X 60) FC = P60 – (P1.80 X 10)
= P150 – P108 = P60 – P18
= P42 = P42
Cost Terminology
To improve your understanding of some of the definitions and concepts introduced so far, consider the
following scenario. A company has reported the following costs and expenses for the most recent month:
(The following amount are assumed to be in terms of Philippine Peso)
Direct materials 69,000

Direct labor 35,000
Variable manufacturing overhead 15,000
Fixed manufacturing overhead 28,000
Total manufacturing overhead 43,000
Variable selling expense 12,000
Fixed selling expense 18,000
Total selling expense 30,000
Variable administrative expense 4,000
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Fixed administrative expense 25,000

Total administrative expense 29,000
These costs and expenses can be categorized in a number of ways, some of which are shown below:
Product cost = Direct materials + Direct labor + Manufacturing overhead

= 69,000 + 35,000 + 43,000
= 147,000
Period cost = Selling expense + Administrative expense

= 30,000 + 29,000
= 59,000
Conversion cost = Direct labor + Manufacturing overhead

= 35,000 + 43,000
= 78,000
Prime cost = Direct materials + Direct labor

= 69,000 + 35,000
= 104,000
Variable = Direct materials + Direct labor + Variable manufacturing manufacturing cost

overhead
= 69,000 + 35,000 + 15,000
= 119,000
Total fixed cost = Fixed manufacturing + Fixed selling + Fixed administrative overhead expense
expense
= 28,000 + 18,000 + 25,000
= 71,000
Sunk Cost and Opportunity Cost
A sunk cost is a cost that has already been incurred and that cannot be changed by any decision made now
or in the future. Because sunk costs cannot be changed by any decision, they are not differential costs. And
because only differential costs are relevant in a decision, sunk costs should always be ignored.
To illustrate a sunk cost, assume that a company paid P50,000 several years ago for a special-purpose
machine. The machine was used to make a product that is now obsolete and is no longer being sold. Even
though in hindsight purchasing the machine may have been unwise, the P50,000 cost has already been
incurred and cannot be undone. It would be folly to continue making the obsolete product in a misguided
attempt to “recover” the original cost of the machine. In short, the P50,000 originally paid for the machine is
a sunk cost that should be ignored in current decisions.
Opportunity cost is the potential benefit that is given up when one alternative is selected over another. For
example, assume that you have a part-time job while attending college that pays P200 per week. If you
spend one week at the beach during spring break without pay, then the P200 in lost wages would be an
opportunity cost of taking the week off to be at the beach. Opportunity costs are not usually found in
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accounting records, but they are costs that must be explicitly considered in every decision a manager makes.
Virtually every alternative involves an opportunity cost.
The Traditional Format Income Statement
This type of income statement organizes costs into two categories—cost of goods sold and selling and
administrative expenses. Sales minus cost of goods sold equals the gross margin. The gross margin minus
selling and administrative expenses equals net operating income.
The cost of goods sold reports the product costs attached to the merchandise sold during the period. The
selling and administrative expenses report all period costs that have been expensed as incurred. The cost of
goods sold for a merchandising company can be computed directly by multiplying the number of units sold
by their unit cost or indirectly using the equation below:
NOTE: Cost of goods sold = Beginning merchandise inventory + Purchases – Ending merchandise
inventory
For example, let’s assume that the company purchased P3,000 of merchandise inventory during the period
and had beginning and ending merchandise inventory balances of P7,000 and P4,000, respectively. The
equation above could be used to compute the cost of goods sold as follows:
Cost of goods sold = Beginning merchandise inventory + Purchases – Ending merchandise inventory
= 7,000 + 3,000 – 4,000
= 6,000
Although the traditional income statement is useful for external reporting purposes, it has serious limitations
when used for internal purposes. It does not distinguish between fixed and variable costs. For example,
under the heading “Selling and administrative expenses,” both variable administrative costs (400) and fixed
administrative costs (P1,500) are lumped together (P1,900). Internally, managers need cost data organized
by cost behavior to aid in planning, controlling, and decision making. The contribution format income
statement has been developed in response to these needs.
Comparing Traditional and Contribution Format Income Statements for Merchandising Companies
(all numbers are given)
Traditional Format
Sales 12,000.00
Less: Cost of goods sold* 6,000.00
Gross margin 6,000.00
Selling and administrative expenses:
Selling 3,100.00
Administrative 1,900.00 5,000.00
1,000.00
54
*For a manufacturing company, the cost of goods sold would include some variable costs, such as direct
materials, direct labor, and variable overhead, and some fixed costs, such as fixed manufacturing overhead.
Income statement formats for manufacturing companies will be explored in greater detail in a subsequent
chapter.
Contribution Format
Sales 12,000
Variable expenses:
Cost of goods sold 6,000.00
Variable selling 600.00
Variable administrative 400.00 7,000
Contribution margin 5,000
Fixed expenses:
Fixed selling 2,500.00
Fixed administrative 1,500.00 4,000.00
Net operating income 1,000.00
The Contribution Format Income Statement
The crucial distinction between fixed and variable costs is at the heart of the contribution approach to
constructing income statements. The unique thing about the contribution approach is that it provides
managers with an income statement that clearly distinguishes between fixed and variable costs and therefore
aids planning, controlling, and decision making.
The contribution approach separates costs into fixed and variable categories, first deducting all variable
expenses from sales to obtain the contribution margin. For a merchandising company, cost of goods sold is a
variable cost that gets included in the “Variable expenses” portion of the contribution format income
statement. The contribution margin is the amount remaining from sales revenues after all variable expenses
have been deducted. This amount contributes toward covering fixed expenses and then toward profits for the
period.
The contribution format income statement is used as an internal planning and decision-making tool. Its
emphasis on cost behavior aids cost-volume-profit analysis, management performance appraisals, and
budgeting. Moreover, the contribution approach helps managers organize data pertinent to numerous
decisions such as product-line analysis, pricing, use of scarce resources, and make or buy analysis.
55
FORMAT AND COMPUTATION:
Schedule of cost of goods manufactured

Direct materials:
Raw materials inventory, beginning -
Add: Purchases of raw materials -
Raw materials available for use -
Deduct: Raw materials inventory, ending -
Raw materials used in production -
Direct labor -
Manufacturing overhead -
Total manufacturing cost -
Add: Work in process inventory, beginning -
Total -
Deduct: Work in process inventory, ending -
Cost of goods manufactured -
Computation of cost of goods sold

Finished goods inventory, beginning -
Add: Cost of goods manufactured -
Goods available for sale -
Deduct: Finished goods inventory, ending -
Cost of goods sold -
Income statement
Sales -
Less: Cost of goods sold -
Gross margin -
Less: Administrative expenses -
Selling expenses -
Net operating income -
SELF TEST QUESTIONS 2.1 (ENABLING ACTIVITY)
TRUE/FALSE QUESTIONS:
Write the word TRUE if the statement is correct and FALSE if the statement is wrong.
1. Manufacturing overhead is an indirect cost with respect to units of product.

2. Depreciation on office equipment would not be included in the cost of goods manufactured.
56
3. Rent on a factory building used in the production process would be classified as a period cost and as a
fixed cost.
4. Period costs are found only in manufacturing companies, not in merchandising companies.
5. Depreciation on equipment a company uses in its selling and administrative activities would be classified
as a product cost.
6. The cost of goods manufactured is calculated by adding the amount of work in process at the end of the
year to the cost of raw materials used, direct labor worked, and manufacturing overhead incurred for the
year and then subtracting work in process at the beginning of the year.
7. A publisher that sells its books through agents who are paid a constant percentage commission on each
book sold would classify the commissions as a fixed cost.
8. The amount that a manufacturing company could earn by renting unused portions of its warehouse is an
example of an opportunity cost.
9. Variable costs per unit are affected by changes in activity.
10. Labor fringe benefits may be charged to direct labor or manufacturing overhead while overtime
premiums paid usually are considered a part of manufacturing overhead.
MULTIPLE CHOICE QUESTIONS:
1. The term that refers to costs incurred in the past that are not relevant to a decision is:
A) marginal cost. B) indirect cost.
C) period cost. D) sunk cost.
2. John Johnson decided to leave his former job where he earned P12 per hour to go to a new job where he
will earn P13 per hour. In the decision process, the former wage of P12 per hour would be classified as a(n):
A) sunk cost. B) direct cost.
C) fixed cost. D) opportunity cost.
3. Fixed costs expressed on a per unit basis:

A) will increase with increases in activity. B) will decrease with increases in activity.
C) are not affected by activity. D) should be ignored in making decisions since
they cannot change.
4. All of the following would be classified as product costs except:

A) property taxes on production equipment. B) insurance on factory machinery.
C) salaries of the advertising staff. D) wages of machine operators.
5. Depreciation on a personal computer used in the marketing department of a manufacturing firm would be
classified as:
A) a product cost that is fixed with respect to the company's output.
B) a period cost that is fixed with respect to the company's output.
C) a product cost that is variable with respect to the company's output.
D) a period cost that is fixed with respect to the company's output.
57
6. Property taxes on a company's factory building would be classified as a(n):

A) product cost. B) opportunity cost.
C) period cost. D) variable cost.
7. Prime cost consists of:

A) direct labor and manufacturing overhead.
B) direct materials and manufacturing overhead.
C) direct materials and direct labor.
D) direct materials, direct labor and manufacturing overhead.
8. Prime cost and conversion cost share what common element of total cost?
A) Direct materials. B) Direct labor.
C) Variable overhead. D) Fixed overhead.
9. Direct material cost is a:

Conversion cost Prime cost
A) No No
B) No Yes
C) Yes Yes
D) Yes No
10. The salary paid to the president of King Company would be classified on the income statement as a(n):
A) administrative expense. B) direct labor cost.
C) manufacturing overhead cost. D) selling expense.
11. The cost of lubricants used to grease a production machine in a manufacturing company is an example of
a(n):
A) period cost. B) direct material cost.
C) indirect material cost. D) none of the above.
12. Indirect labor is a part of:

A) Prime cost. B) Conversion cost.
C) Period cost. D) Nonmanufacturing cost.
13. The costs of staffing and operating the accounting department at Central Hospital would be considered
by the Department of Surgery to be:
A) direct costs. B) indirect costs.
C) incremental costs. D) opportunity costs.
14. A cost incurred in the past that is not relevant to any current decision is classified as a(n):
A) period cost. B) opportunity cost.
C) sunk cost. D) differential cost.
15. Wages paid to a timekeeper in a factory are a:

Prime cost Conversion cost
A) Yes No
B) Yes Yes
C) No No
D) No Yes
58
MAIN TASK QUESTIONS
QUESTION 1:
1. Discuss the concept of “Production Function”

2. Explain the doctrine of “ Law of Production Function”.
3. What is Cobb-Douglas Production Function?
4. Discuss the concept of “Law of Diminishing Returns”.
5. How can an economic manager or business manager improve the productivity of an organization?
RUBRIC FOR ESSAY QUESTIONS

1 pts 2 pts 3 pts 4 pts
What you are writing

You put thought into What you are writing about
about is clear and
this, but there is no real is clear. You answered the
well-expressed,
Ideas and Content There is no clear or specific evidence of learning. question. Some support may
including specific
explanation in answer to More specific be lacking, or your
examples to
the question. information is needed or sentences may be a bit
demonstrate what
you need to follow the awkward. Overall, a decent
you learned. Well
directions more closely. job.
done!

all the terms from
Only one term from the the lesson that
Use of terms several terms from the
No terms from the lesson lesson is used in the applied to the
lesson, demonstrating
are used. answer. Try for a few question asked. All
adequate understanding of
more, next time. terms are fully
the material.
defined and used in
the proper context.

Sentences are
complete and they
Some sentences are
Sentence Fluency Sentences are incomplete or connect to one
complete and easy to Sentences are complete and
too long. It makes reading another easily when
undersand. Others able to be understood.
them difficult. they are read out
require some work.
loud. Your writing
'flows.'
59
QUESTION 2:
I. Cost Terms: Identify each of the following statements with fixed costs or variable costs by writing “fixed” or
“variable” in the space provided.
______ a. A cost that varies in total with changes in the activity level.
______ b. A cost that varies on a per-unit basis with changes in the activity level.
______ c. A cost that remains fixed per unit with changes in the activity level.
______ d. A cost that remains fixed in total with changes in the activity level.
II. Cost Classification, Terms and Behavior

The ECON Company began operations several years ago. The company purchased a building and, since
only half of the space was needed for operations, the remaining space was rented to another firm for rental
revenue of P20,000 per year. The success of ECON Company's product has resulted in the company needing
more space. The renter's lease will expire next month and ECON will not renew the lease in order to use the
space to expand operations and meet demand.
The company's product requires materials that cost P25 per unit. The company employs a production
supervisor whose salary is P2,000 per month. Production line workers are paid P15 per hour to manufacture
and assemble the product. The company rents the equipment needed to produce the product at a rental cost
of P1,500 per month. Additional equipment will be needed as production is expanded and the monthly rental
charge for this equipment will be P900 per month. The building is depreciated on the straight-line basis at
P9,000 per year.
The company spends P40,000 per year to market the product. Shipping costs for each unit are P20 per unit.
The company plans to liquidate several investments in order to expand production. These investments
currently earn a return of P8,000 per year.
Required:
Complete the answer sheet above by placing an "X" under each heading that identifies the cost involved.
The "Xs" can be placed under more than one heading for a single cost, e.g., a cost might be a sunk cost, an
overhead cost, and a product cost. An "X" can thus be placed under each of these headings opposite the cost.
Variable Fixed Direct Direct Manufacturing Period Opportunity Sunk

Cost Cost Materials Labor Overhead Cost Cost Cost
Rental
revenue
Materials
costs
Production
supervisor
salary
Production
line
workers
wages
Equipment
rental
60
Building
depreciation
Marketing
costs
Shipping
costs
Return on
present
investments
QUESTION III:
The following data have been taken from the accounting records of BEAUTY Corporation for the just
completed year. (All amount are in Philippine Peso)
Raw materials inventory, beginning 70,000.00

Purchases of raw materials 170,000.00
Raw materials inventory, ending 80,000.00
Direct labor 210,000.00
Manufacturing overhead 200,000.00
Work in process inventory, beginning 30,000.00
Work in process inventory, ending 20,000.00
Finished goods inventory, beginning 100,000.00
Finished goods inventory, ending 70,000.00
Sales 950,000.00
Administrative expenses 180,000.00
Selling expenses 140,000.00
Required:
a. Prepare a Schedule of Cost of Goods Manufactured in good form.
b. Compute the Cost of Goods Sold.
c. Using data from your answers above as needed, prepare an Income Statement in good form.
61
REFLECT UPON (REFLECTION ACTIVITY)
1. What are the difficulties that you encountered in studying the managerial economics and cost concepts?
2. How can you apply your learnings of managerial economics and cost concepts in your everyday life
experiences (you may include your future plan)?
62
EXTEND YOUR KNOWLEDGE:

(REINFORCEMENT ACTIVITY)
Learn more about the managerial accounting and cost concepts in these Web sites:
1. https://courses.lumenlearning.com/tcc-managacct/chapter/the-statement-of-cost-of-goods-
manufactured/
2. https://www.yourarticlelibrary.com/cost-accounting/cost/study-notes-on-cost-concept-and-
classification-cost-accounting/74316
3. https://www.managementstudyguide.com/managerial-economics.htm
4. https://saylordotorg.github.io/text_principles-of-managerial-economics/s01-introduction-to-
managerial-eco.html
63
64

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Ae11 Module-Managerial Economics

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JOSEPH FRANCIS S.

Managerial Economics is concerned about the application

While COVID19 is primarily affecting public health, spill

WARM –UP ACTIVITY (PRE-ACTIVITY)

I am able to identify terms related to managerial

I avoid confusing managerial accounting or financial

Score Level of Proficiency

3-4 Approaching Proficiency

COURSE LEARNING OUTCOME

EXPLAIN THE MANAGERIAL ECONOMICS CONCEPTS AND PRINCIPLES.

TOPIC LEARNING OUTCOMES

At the end of the course, you will be able to:

LECTURE NOTES (INPUT)

1.1 ECONOMICS AND MANAGERIAL ECONOMICS CONCEPTS

Economics is the science of making decisions in the presence of scarce resources.

Meaning and Definition of Managerial Economics.

Managerial economics is something that concerned with business efficiency”.

Objectives and Uses (importance) of managerial Economics

1. To integrate economic theory with business practice.

SELF CHECK QUESTIONS 1.1 (ENABLING ACTIVITY)

Instruction: Fill in the blanks with suitable or correct word/words.

1.2 Objectives and Uses (importance) of managerial Economics

1. To integrate economic theory with business practice.

1. It provides tool and techniques for managerial decision making.

Following are the important areas of decision making;

Scope of Managerial / Business Economics

B) Environmental or external issues

1. The types of economic system in the country.

SELF CHECK QUESTIONS 1.2 ENABLING ACTIVITY

2.3 FUNCTIONS AND RESPONSIBILITIES OF MANAGERIAL ECONOMIST

1. Is competition likely to increase or decrease?

Following are the important specific functions of managerial economist;

1. Sales forecasting. 2. Market research.

The responsibilities of managerial economists are the following;

Chief Characteristics of Managerial or Business economics.

Following are the important feature of managerial economics:

Managerial economics as a tool for decision making and forward planning.

1. The identification of the firms objectives.

Economics VS Managerial economics.

Economics Managerial Economics

2. Both positive and normative science. 2. Only a normative science.

3. Deals with theoretical aspects 3. Deals with practical aspects.

5. Wide scope 5. Narrow scope.

SELF CHECK QUESTIONS 1.3 (ENABLING ACTIVITY)

Modified True or False

________ 6. Managerial Economics is wide in scope.

________ 9. Resources such as land, labour and capital are unlimited.

CHAPTER 2 – DEMAND CONCEPTS

2.2 Meaning of Demand

1) To determine the factors affecting the demand.

Individual demand Schedule

An individual demand schedule is a list of quantities of a commodity purchased by an individual consumer

Market demand schedule

Assumptions of Law of Demand

Law of demand is based on certain basic assumptions. They are as follows

1) There is no change in consumers’‟ taste and preference

Why does demand curve slopes downward?

1) Law of Diminishing Marginal utility

4) Different uses of a commodity.

Exceptions to the Law of Demand. (Exceptional Demand Curve).

2) Veblen or Demonstration effect.

8) Festival, Marriage etc.

CHANGES IN DEMAND (SHIFTERS OF DEMAND)