Managerial Economics

(Unit – 1)
Long Questions:
Q1. Want do you mean by managerial economics? Explain its nature.
OR
“Managerial economics is both science as well as art.” Explain.
Q2. Describe significance, limitations and scope of managerial economics.
Q3. What do you mean by Micro-economics and Macro-economics? Explain their importance
and limitations.
Q4. Explain Law of Diminishing Marginal Utility. What are the limitations and importance of
this law? Describe?
OR
What do you mean by Law of Diminishing Marginal Utility? Does this law applicable to money?
What are the exceptions and limitations of this law? Explain.
Q5. What do you understand by Law of Equi-marginal Utility? Explain its importance and
limitations of this law.
Q6. What do you understand by indifference curve? What are the properties of Indifference
curve? Explain.

Short Questions:
Q1 .Explain micro-economics and macro-economics. Distinguish between Micro-economics and
Macro-economics.
Q2. Explain following concepts of Managerial Economics:
1. Opportunity Cost Principle
2. Marginal Analysis
3. Incremental Principle
4. Time Perspective Principle
5. Discounting Principle
6. Equi-marginal Principle

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 Long Questions
Q1. Want do you mean by managerial economics? Explain its nature.
OR
“Managerial economics is both science as well as art.” Explain.
Ans.
MANAGERIAL ECONOMICS
Managerial Economics is that part of economic theory which deals with the application of
economic tools and concepts to the solution of business problems.

NATURE OF MANAGERIAL ECONOMICS

The objective of the study of the nature of economics is to know whether economics is science or
an art or both.

(A) Is Economics a Science: To know that whether economics is a science or not, first we
have to understand the nature of science. Some important nature of science is as below:
 Science is a systematic study of a subject.
 Science establishes the relationship between cause and effect.
 The laws of science are universal.
 Experiments are possible in science.
 Scale of measurement.
Now we are in a position to decide whether economics is science or not.

Arguments in Favour of Economics being a Science:

1. Systematic Study: In economics there is a systematized collection, classification and
analysis of economic facts. The subject matter of economics is systematically divided
into consumption, production, exchange and distribution of wealth. All the laws of
economics are derived in a very systematic manner. Thus, economics satisfies the first
element of science.

2. Cause and Effect Relationship: Like the science, laws of economics also shows the
relationship between cause and effect. For example, when price of a product is changed,
demand of that product is also change. In the same way, laws of production states that
any change in the input of means of production, the production quantity also change.
Thus, economic laws also have a cause and effect relationship.

3. Universal Law: Laws of economics are also universal and equally applicable
everywhere like laws of science. Law of demand, law of supply, production laws etc. are
equally applicable in all the countries.

4. Experiments: Economists carry several experiments with the laws of economics.

Different economic laws have been experimented and tried to get out of economic evils.
The scope of experiments of economic laws is very wide. The laboratory of these
experiments is the whole world and men are the tool of these experiments.

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 5. Scale of Measurement: Economists possess the measuring tool of money to measure the
economic facts. Marshall said that measuring tool of money has made economics a more
certain and exact science than other social science.

On the basis of argument given above, it is proved that economics is a science.

(B) Is Economics an Art?

Art consists in doing something well. In simple words, art is the practical application of
knowledge for achieving definite ends. According to J. M. Keynes, “An art is system of
rules for the attainment of a given end.” On the basis of this definition, we find that
economics is, in certain respects, an art as well. There are several branches of economics
which offer us practical guidance in the solution of practical problems. For example, the
theory of consumption provides us the law of substitution which guides a consumer to
maximize his satisfaction from his expenditure on different items. Economics also tells us
how can an economy make most efficient and optimum use of its scarce resources. Thus,
economics as an art is the practical application of knowledge. It solves the fundamental
economic problems – the problem of scarcity and the problem of choice.

Conclusion: Thus, we can say that economics is both science as well as art.

Q2. Describe significance, limitations and scope of managerial economics.

Ans.
SIGNIFICANCE OF ECONOMICS
Everyone of us faces a number of questions in daily life, such as what determines the
price of bread and butter that we consume daily? Why water which is very useful to us is so
cheap, while diamond which is hardly useful, commands such a high price? Why is it so that
sellers give off-season discount on fans and fridges? Why does not government print unlimited
quantity of currency notes and distribute among the poor? Why does government levy heavy
taxes and duties? What cause unemployment? And so on.
Economics provides answers to such questions. That is why economics has become a
subject of study for academics, government officials, salesmen, professionals, businessmen etc.
Actually there is hardly any aspect of human life that is not explained in life. No one in the
society can remain untouched from the influence of economics. Significance of economics can
be understood as below:

1. Advantage to Consumer: Every consumer wishes to spend his limited income in such a
way that he gets maximum satisfaction. Economics suggests to the consumer the broad
principles by following which he can get maximum satisfaction out of his expenditure. For
example, the law of equi-marginal utility directs him to spend his money in such a way that
the utility of the last rupee spent on each item may be equal. By following this rule, he can
derive maximum satisfaction out of his expenditure.

2. Advantage to the Producer: Every producer wants to produce the maximum at the
minimum cost. The theory of economics throw light upon the costs and revenues at different

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 levels of output. It guides the producers to use more of productive factors. The technique of
Iso-product curves or Iso-quants helps in the attainment of least-cost combination.

3. Advantage to Businessmen: The study of economics imparts a habit of thought and

familiarity with business concepts which are extremely useful to big businessmen. For
instance, the methods of wage payment, scientific management, large scale production,
division of labour etc. are of profound significance to the businessmen.

4. Advantage to Labours: The labours also gain from the study of economics. The workers
come to know how wages are determined and measures which can be taken to raise the wage
level. How efficiency of labour can be increased. How trade unions can protect their
interests and promote their welfare. They can also know that, how labour legislations,
minimum wage acts, factory acts, provident fund acts, social insurance acts can do good to
the working community.

5. Advantage to Students: Every student must have an adequate knowledge of economics.

Students are to become doctors, engineers, administrators, lawyers, teachers etc. They are
also to work as producers, bureaucrats, social reformers etc. Thus, knowledge of economics
is of great importance to students.

6. Advantage to Social Reformers: Social problems are mainly economic in nature. To

remove social vices like drinking, crime etc., knowledge of their economic cause is
necessary. Social reformers have one main aim i.e., to increase the welfare of people which
can be achieved with the help of economics.

7. Advantage to the Society: Economics also contributes to the welfare of the society as a
whole. There are certain economic issues which are of direct interest to the society. For
instance, the problem of overpopulation, inflation, policy of economic liberalization,
unemployment, removal of subsidies etc. Economics carefully studies these issues and gives
its unbiased opinion.

8. Advantage to the Planners: Most of the countries prepare economic planning for their
economic growth. The planners have to make a rational allocation of national resources for
the country’s uplift. Economics does not only furnish necessary information to planners
about the potentiality of natural and manpower resources but also offers guidelines to how
these resources can be fully utilized.

LIMITATIONS OF ECONOMICS
1. Study of Human Activities Only: Economics deals with the activities of human beings.
Study of birds, animals and lifeless matters is beyond its scope.

2. Study of Economic Activities: Men perform several activities during his lifetime viz.
religious, social, cultural, political and economic. Economics does not deal with all these
human activities. It is concerned with only economic activities i.e., those activities which are
related to wealth and other non-economic activities lie outside the scope of economics.

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3. Study of Social Man: Under the economics we studies a social man only. The persons who
live in jungles and caves like a saint, monk etc. are not studied in economics.

4. Study of Normal Man: Economics is concerned with the study of normal man. It does not
deal with abnormal persons like drunkard, misers, criminals madman etc. Such persons
remain outside the purview of economics.
5. Measuring Tool of Money: Economics is concerned with those human activities and
aspirations which can be approximately measured in terms of money. If the question of
money does not come in any activity that will not fall within the scope of economics.

6. Other Things Being Equal: Though economic laws are scientific but not as exact as the
laws of pure science like physics and chemistry. The phrase ‘other things being equal’
means that economic laws will be true if there is no any change in other factors or if other
factors remain the same.

SCOPE OF MANAGERIAL ECONOMICS

The scope of managerial economics is very wide as it involves the application of economic
concepts and analysis to all the problems and analysis to all the problems and areas of the
manager and firm. In brief, scope of managerial Economics covers the following areas:

1. Theory of demand Analysis and Forecasting: demand analysis covers demand

determinants, demand distinctions and demand forecasting. Demand theory explains that
how do consumers behave when price of the commodity, their income etc. are change. The
knowledge of demand theory can, therefore, be helpful in the choice of commodities for
production. Demand forecasting is also very essential for managerial planning.

2. Theory of Production: Production theories explain the relationship between inputs and
outputs. There are so many theories which are helpful to producers like Return to a Factor,
Return to Scale, Isoquants etc. Theory of Return to a Factor explain how output increases
when units of one factor (input) are increased keeping other factors constant. Theory of
Return to Scale explains the effect on output when all the factors of input are increased
simultaneously. In the same way, Isoquant shows various combinations of two factors of
input viz. capital and labour which provide the same output. Thus various theories of
economics are very useful to producers.

3. Analysis of Market Structure: Economics explains different type of market structure viz.
Perfect market, Imperfect or Monopolistic Market, Oligopoly, Duopoly and Monopoly. It
also helps in understanding the role of a firm in different market situation as well as
determination of price of the product in different market situations.

4. Pricing Theory: Price theory explains how prices are determined under different market
conditions, when price discrimination is desirable, to what extent advertising can be helpful
in expanding sales in a competitive market. Thus, price policy is helpful in determining the
price policy of the firm.

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5. Cost Analysis: Cost analysis is yet another function of managerial economics. It explains
various concepts of costs, their classification, cost-output relationships, economies and
diseconomies of scale, production control and cost control.

6. Profit Analysis: Profit making is the most common objective of all business undertakings.
But, making a satisfactory profit is not always guaranteed because a firm has to carry out its
activities under conditions of uncertainty. In this condition profit theory guides firm in the
measurement and management of profit, in making allowances for the risk premium, in
calculating the pure return on capital and pure profit and also for future profit planning.

7. Theory of capital and Investment Decision: capital like all other inputs, is a scarce and
expensive factor. Its efficient allocation and management is one of the most important tasks
of the managers. Knowledge of capital theory can contribute a great deal in investment-
decision making, choice of projects, maintaining capital intact, capital budgeting etc.

Q3. What do you mean by Micro-economics and Macro-economics? Explain their

importance and limitations.
Ans.
MICRO-ECONOMICS VS MACRO-ECONOMICS
The subject matter of economics has been divided into two parts – Micro-economics and Macro-
economics.
(A). MICRO-ECONOMICS
Microeconomics is the study of economic actions of individuals. In other words, it is a branch of
economic analysis which studies the economic behavior of individual units i.e., individual firm,
individual person.

Importance of Microeconomics:
1. Provides Tools for Economic Policies: Microeconomics provides the analytical tools for
evaluating the economic policies of the state.

2. Welfare Economics: It also provides tools for welfare economics. The structure of
welfare economics has been built on price theory which is a constituent part of
microeconomics. A study of individual unit is important from welfare point of view.

3. Help to Business Executives: Microeconomics helps to business executives in the

attainment of maximum output and minimum cost with the existing resources. It is
possible with the help of model of microeconomics.

4. Helpful to consumers: Microeconomics is also helpful to consumers. Various principles

show that how a consumer can achieve maximum satisfaction from his expenditure.
Thus, it is very useful to consumers also.

Limitations of Micro-economics:

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 1. Micro View of Economy: Micro analysis is concerned with the components part of an
economy and not with the general working of the economy. Thus, microeconomics fails
to give us a complete and correct picture of total economy.

2. Unrealistic Assumption: Every law of microeconomics assume that the given law will
be true if ‘all other things remain the same’. This is an unrealistic assumption because
in real economy any change in one thing affects other things.

3. Study of Parts: What is true in the case of individual units may not be true in case of
aggregates. For example, Savings by individual is a good thing, but if the entire
community starts saving more, effective demand will be reduced and unemployment will
start.

(B). MACRO-ECONOMICS
Macro-economics is the branch of economic theory which deals with the study of the economy
in aggregate with specific focus on unemployment, inflation, business cycle, growth, monetary
and fiscal policy etc.

Importance of Macroeconomics:
1. Helpful in Understanding the functioning of an Economy: It is only through
macroeconomic analysis that we can have an idea of an economies aggregate output,
income, consumption, saving, employment and the like.

2. Helpful in Formulation and Implementation of Economic Policies: Now a days

‘maximum social welfare’ is the sole objective of modern government. For achieving
this objective government formulates various policies which are formed with the help of
macroeconomic principles.

3. Study of Economic Development: Macroeconomics is of special importance for the

capital poor countries in understanding their basic problems and in suggesting various
ways and means through which that country may be develop.

4. Study of National Income: Macroeconomics has given various valuable concepts like
national income, social accounting studies etc. without which no economic policy or plan
can be formulated. The estimates of GNP provide economists with a most useful tool to
analyse the performance of an economy.

5. Study of Economic Fluctuations: Macroeconomic analysis helps us in understanding

and regulating the economic fluctuations.

6. Inflationary and Deflationary Gap: Macroeconomics is of great help in understanding

inflationary and deflationary gaps and then how to fill up both these gaps.

7. Suitable to All Economic System: Macroeconomic analysis is suitable to all economic

system viz. capitalistic or socialistic or mixed economy.

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 8. Solution of Economic Problems: macroeconomics provides modern governments a
solution to the problems of an economy like unemployment, rising and falling prices,
problem of over production etc.

Limitations of Macro-economics:
1. Dependence on Individual Units: We know that macroeconomics deals with
aggregates. But aggregates are the sum total of individuals. But the result of these
aggregates are sometimes different from the individual behavior. This is also called as
‘macroeconomic Paradoxes’ or “Fallacies of Composition’. For example, saving may
be a virtue for an individual but becomes a vice for an economy as a whole.

2. Heterogeneous Units: macroeconomics studies different units of goods as common.

Different goods have their different measures. This is not possible to measure all the
goods with a common measuring tool.

3. Misleading Aggregates: The study of aggregates can be misleading also. For example,
the constant general price level does not mean that the prices of all goods have remained
the same. It may be due to the increase in the price of some goods offsetting the prices of
some other goods.

4. Structure of the Aggregate May More Important than the Aggregate Itself: For this,
it is necessary to break the aggregate into its component parts. For example, an increase
in national income hardly tells us anything about the standard of living and the level of
development of the country.

5. Sometimes Micro Changes are More Important than Macro Changes: Though the
general price level remains constant, prices of essential commodities may rise.

Q4. Explain Law of Diminishing Marginal Utility. What are the limitations and importance
of this law? Describe?
OR
What do you mean by Law of Diminishing Marginal Utility? Does this law applicable to
money? What are the exceptions and limitations of this law? Explain.
Ans.
LAW OF DIMINISHING MARGINAL UTILITY
The law of Diminishing Marginal Utility is one of the fundamental laws of economics. This law
states that “as the quantity consumed of a commodity goes on increasing, the utility derived
from each successive unit goes on diminishing, consumption of all other commodities
remaining the same.” In simple words, when a consumer consumes more and more units of a
commodity e.g., ice cream, keeping the consumption of all other commodities constant, the
utility which he derives with each successive cup of ice cream goes on diminishing and total
utility goes on increasing but at a decreasing rate. If this consumption become continue, then at a
point consumer’s total satisfaction will be maximum. At this point marginal utility will be zero.
If the consumer continues its consumption beyond this point, then he will get negative marginal

8
utility from the successive units which reduce his total satisfaction or total utility. This law
applies to all kinds of consumer goods, sooner or later.

Illustration:

Units of a Good Marginal Utility Total utility Description

Consumed (MU) (TU)
I 6 6
II 4 Positive 10 Increasing
III 2 12
IV 0 Zero 12 Point of Satiety
Maximum
V -2 10
VI -4 Negative 6
Decreasing

The above schedule clearly shows that up to the 3rd Unit of goods consumed marginal utility is
positive and total utility is increasing. At the 4 th Unit of the commodity marginal utility is zero
and total utility is maximum. This point is known as point of satiety or stage of full
satisfaction. At the 6th and 7th Units of the commodity marginal utility is negative and the total
utility is diminishing. We can understand it with the following diagram:

Assumptions:
1. Utility can be measured in
cardinal number.
2. Marginal utility of money
remains constant.
3. Marginal utility of every
commodity is independent.
4. Every unit of the commodity
being used is identical in size and
quality.
5. There is continuous
consumption of the
commodity..
6. Suitable and proper quantity of
the commodity is consumed.
7. There is no change in the income of the consumer.
8. There is no change in the price of the commodity and its substitute.
9. There is no change in the fashion, taste and habits of the consumer.
10. The goods and persons should be normal.
11. Goods are divisible.
Causes of the Operation of the law of Diminishing Marginal Utility:
1. Commodities are not Perfect Substitute: According to Boulding, the law applies
because commodities are not perfect substitutes. They are at best only imperfect

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 substitutes. They tend to be consumed on certain appropriate proportion. The consumer
secures the maximum satisfaction only, if these appropriate proportions are maintained.

2. Satisfaction of Particular Wants: Although all the wants of man cannot be satisfied, but
one particular want is fully satiable. For example, a person’s desire to drinking milk can
be fully satisfied if he continues increasing quantities of the commodity. Having reached
the point of satiety, use of one more unit of the commodity will yield zero marginal
utility. Thus, the law operates.

Exceptions / Limitations of the Law:

1. Initials Units: When the initial units of the commodity are used in very small and less
than the appropriate quantity, then the marginal utility from the additional units of that
commodity goes on increasing and the law may not operate. But this exception is not
correct. As we get adequate quantity of the commodity, then every additional unit will
yield less and less marginal utility.

2. Rare and Curious Things: The law does not apply to rare and curious things like old
coins, rare paintings, rare antiquities etc., collection of more and more units of such
things gives more and more satisfaction to the collector. But this exception is not true.
When a stamp collector comes to posses larger number of stamps of the same kind then
marginal utility definitely diminishes.

3. Drunkards: It is said that the law does not operate in case of drunkards. A drunkard is
said to obtain increasing utility prom each additional peg of wine. However, even in the
case of a drunkard, a stage comes when he losses his sense, thereby, marginal utility of
liquor starts to declining after the second or third drink finally becomes negative.

4. Misers: It seems as if the law does not apply to misers who are interested only in
acquiring more and more of wealth. But according to Mayers, even this exception is also
not true. In the case of misers also, the law operates since the miser spends some money
in buying food and other necessities of life, instead of savings all of it. His shows that
utility to him of food , cloths etc., is greater than that of money which he spends to buy
these things.

5. Love of Display, Love of Power: Love of display, power are said to be other exceptions
to this law. The lust of this kind is almost instable and, therefore, the utility of every
additional unit of such commodity appears to be increasing. Such persons are, however,
abnormal men and economics does not study them.

6. Good Books, Poems, Music: It is said that by reading a good book, listening to a
melodious song or beautiful poem again and again one gets more utility than before. So
these are considered exceptions of this law. But it is also not correct. It is possible that up
to a certain limit, reading a good book, listening to a good song or music again and again
may give increasing utility. But after some time it may become boring.

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 7. Large Number of Consumers: Sometimes it is said that the utility of a commodity
begins to increase if a large number of people begins to use it. Telephone is the case
usually cited in this connection. As the number of persons who have telephonic increases,
the utility of the phone also rises because its owner can now talk to large number of
persons. This example is fallacious. If the owner of the telephone takes one or more
connections, naturally the utility of these additional connections will be less to him than
that of the former connection

Conclusion: Thus, we conclude that the law of diminishing marginal utility is true in all cases of
consumption.

Does this Law Apply to Money?

It seems that though the law of diminishing marginal utility is applicable to all type of goods, but
is not applicable to money. This is because no person ever feels satisfied with money, however
rich he may be. The more a man has, more greedy he is. It seems that the marginal utility is
never zero. Every man tries to earn the maximum amount of money he can. Therefore, money is
taken to be an exception to this law. But it is not so. The marginal utility of money also
diminishes with the increase in money. The importance of money to a rich man is not so much as
it is for a poor man. Thus, we can conclude that the law of diminishing marginal utility applies to
money also.

Criticism:
1. Measurement of Utility is not Possible: The main criticism is leveled against the
assumption that utility is measurable in cardinal numbers. But utility or satisfaction
relates to the state of mind and thus, is incapable to being measured.

2. Marginal Utility of Money does not Remain Constant: Further, the law assumes
that marginal utility of money remains the same throughout. But this is not so. When a
person makes purchases with money, the stock of money decreases, thereby, the marginal
utility of money should increase.

3. Utility is Relatively not Independent: The law also assumes independent utility. It
means the consumer directs his attention to one commodity alone. But this is contrary to
one’s everyday experience. In real life the consumer is always interested in the
consumption of a series of related goods. Thus marginal utility of every commodity is
certainly affected by the consumption of other commodities.

4. Unrealistic Assumption: This law is based on many unrealistic assumptions. It is

applicable only when the fashion, tastes, habits, income etc., of the consumer remain
constant. But in real life all these are ever changing.

Importance of the Law:

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 1. Bases of the Laws of Consumption: The law of diminishing marginal utility is one of
the basic laws of economics. It provides the foundation for various laws of consumption
viz. Law of Equi-marginal Utility, Law of Demand and the concept of Consumer Surplus.

2. Importance for the Consumer: The law of diminishing marginal utility is of great
importance to the consumer. It helps the consumer to plan his expenditure. It tells the
consumer that additional units of the same commodity will give him less utility. From
this fact that consumer takes note that he should not purchase more of the same
commodity.

3. Variety in Production: It is because of the application of the law of diminishing

marginal utility that variety in production is found. Continuous consumption of one type
of commodity will yield less marginal utility of the consumer. In order to get maximum
satisfaction the consumer is interested in purchasing variety of products. Hence, every
prudent producer should maintain the variety of the product.

4. The Law helps in Price Determination: The law of diminishing marginal utility helps
in price fixation. As per the level of marginal utilities, the prices of the goods and
services can be fixed high or low as the case may be.

5. Explanation of Paradox of Value: The law of diminishing marginal utility explains the
paradox of value or ‘Diamond Water Paradox’. According to this law, the price of a
commodity influenced by its marginal utility and not by total utility. The marginal utility
of diamond is higher than the marginal utility of water, because diamond is scarce
commodity whereas water is found in abundance. This is the reason, diamond is so costly
whereas water has little price or free good.

6. Bases of Progressive Taxation: The system of progressive taxation which levies higher
taxes on higher incomes and low taxes on low incomes is also based on the application of
the law to money since the marginal utility of the money to the rich is less, they are taxed
heavily than the poor whose marginal utility for money is more.

Q5. What do you understand by Law of Equi-marginal Utility? Explain its importance and
limitations of this law.
Ans.
LAW OF EQUI-MARGINAL UTILITY
Law of Equi-marginal Utility is the second important law of the utility analysis. This law was
first propounded by a French engineer Mr. H. H. Gossen. It is, therefor, also known as
“Gossen’s Second Law”. This law points out how a consumer can get maximum satisfaction out
of given expenditure on different goods.
The law states that in order to get maximum satisfaction, a consumer should spend his
limited income on different commodities in such a way that the last rupee spent on each
commodity yields him equal marginal utility. In the words of Dr. Marshall – “If a person has a
thing which he can put in several uses, he will distribute it among these uses in such a way, that
he has the same marginal utility in all.”

Illustration:

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The law can be illustrated with the help of the following table. Suppose a person has Rs. 5 which
he wants to spend on Apples and Bananas. Let us suppose that the price of both the goods is Rs.
1 per unit. Marginal utilities which he expects to derive from each rupee spent on both these
goods is as below:
Rupee Marginal Utility of Apple Marginal Utility of Banana
I 10 7
II 8 6
III 6 5
IV 4 4
V 2 3

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Assumption:
1. Cardinal measurement of utility is possible.
2. Marginal utility of money remains constant.
3. Income of the consumer remains constant.
4. Fashion, taste and preferences remain constant.
5. Prices of the commodity remain constant.
6. Commodities are divisible in small units.
7. Consumer is rational.
8. Consumption takes place at a given time period.
9. The utilities of different goods are independent.

Limitations of the Law:

1. Consumers are not Fully Rational: The law is based on the assumption that consumers
are perfectly rational. But this assumption is not correct. Some consumers are careless
and idle by nature. They may be influenced by customs, fashion and habits and may not
take decisions rationally.

2. Consumer is not Calculating: The law is also based on the consumption that a
consumer consistently calculates the utility derived by him from his expenditure. In real
life, no consumer makes the calculation to equalizes the marginal utility of various
products.

3. Non-availability of certain Goods: At times, certain useful commodities are not

available in the market and consumers have to buy other less useful commodities in their
place.

4. Influence of Fashion, Customs and Habits: Sometimes customs, fashion and habits
influence the purchase decision of the consumer and he may purchase more of such
goods which give less utility.

5. Taste and Preferences are not Constant: When there is changer in the tastes and
preferences of the consumer, it disturbs the consumption schedule of the consumer.
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 6. Ignorance of the Consumer: The consumer may be ignorant of some more useful
alternatives, he might be unaware of the prices or of substitutes etc. Ignorant and careless
consumers seldom obtain maximum satisfaction.

7. Change in Income and Prices: Income of the consumer changes and also the prices of
goods often fluctuate. Due to this, utilities also keep on changing. In this condition, it is
difficult to compare their marginal utilities for achieving maximum satisfaction.

8. Measurement of Utility is not Possible: The main criticism is leveled against the
assumption that utility is measurable in cardinal numbers. But utility or satisfaction
relates to the state of mind and thus, is incapable to being measured.

9. Marginal Utility of Money does not Remain Constant: Further, the law assumes
that marginal utility of money remains the same throughout. But this is not so. When a
person makes purchases with money, the stock of money decreases, thereby, the marginal
utility of money should increase.

Importance of the Law:

1. Consumption: Every consumer wants to get maximum satisfaction from his expenditure.
By following this law, a consumer can get maximum satisfaction from his expenditure.

2. Production: Every producer aims at earning maximum profit. To achieve this objective
he must utilize different factors of production i.e., land, labour, capital etc., in such a way
that the marginal productivity of each factor is equal.

3. Exchange: In all our exchanges this principle works. A person engaged in barter trade
will continue to exchange his commodities with those of other persons till their marginal
utilities are equalized.

4. Public Finance: The law is also applicable in the fields of public finance. Taxes are
levied in such a manner that the marginal sacrifice of each tax-payer is equal.

5. International Trade: Maximum gain from international trade is achieved through the
principle of substitution. The trader exports a commodity which has lower marginal
utility and imports a commodity which has a higher marginal utility.

6. Price Determination: When there is scarcity of a commodity, we starts substituting the

less scarce or cheaper goods for the more scarce and costly goods. Thus, demand for
higher priced goods decreases and their prices come down.

Q6. What do you understand by indifference curve? What are the properties of
Indifference curve? Explain.
Ans.

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 CONCEPT OF INDIFFERENCE CURVE
An indifference curve is a curve which represents different combinations of ‘X’ and ‘Y’ that
yields equal satisfaction to the consumer. Thus, consumer becomes indifferent among all
available combinations of those goods.

Indifference Schedule:
An indifference schedule is a schedule which represents various combinations of two goods
which yield equal satisfaction to the consumer. The following is an imaginary indifference
schedule representing the various combinations of two goods ‘X’ (say cups of coffee) and ‘Y’
(say biscuits).
Indifference Schedule
Combination Good – X Good - Y
A 1 12
B 2 8
C 3 5
D 4 3
E 5 2

In this table, five different combinations ABCD and E of two goods, cups of coffee (X) and
biscuits (Y) are presented. All these combinations give equal satisfactions to the consumer and
he is indifferent among all the combinations.

Indifference Curve
The graphic presentation of indifference schedule is indifference curve. When we plot all the five
combination of indifference schedule given above on the graph, we find the following curve
which is called indifference curve.

Indifference Map
A diagram showing a number of indifference curves corresponding to different indifference
schedules of the consumer is called indifference map. In other words, a set or family of

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indifference curves is called indifference map. In this map, a lower indifference curve represents
lower level of satisfaction and a higher indifference curve represents higher level of satisfaction.

Assumptions of the Indifference Curve Analysis:

1. Consumers are rational.
2. Utility is immeasurable, rather it is comparable.
3. There is diminishing marginal rate of substitution.
4. There are two goods x and y.
5. Consumer is capable of ranking all combinations of goods according to the satisfaction
they yield.
6. This analysis assumes transitivity. It means if combination A is preferable to B, and B to
C, then A is also preferable to C.
7. There is consistency in consumer’s behavior. It means that if at any given time a
consumer prefers A combination to B, then at another time he will not prefer B
combination to A.

Properties of Indifference Curves:

1. Indifference Curves Slopes Downward from Left to Right: It implies that an
indifference curve has a negative slope. Thus, if a consumer uses more quantity of one
good, he has to reduce the units of other goods in order to remain on the same level of
satisfaction.
From the diagram given below it is clear that when the consumer gets MM 1
additional quantity of X-commodity, he reduces NN1 quantity of Y-commodity so that he
can remain on the same level of satisfaction.

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2. Indifference Curves are Convex to the Origin: Indifference curves are not only
negatively sloped but are also convex to the origin. The convexity of the indifference
curve implies two properties:
 The two commodities are imperfect substitutes for one another.
 The marginal rate of substitution (MRS) between the two goods decreases as a
consumer moves along an indifference curve. This characteristic of indifference curve
is based on the postulate of diminishing marginal rate of substitution.

3. Indifference Curves cannot Intersect Each Other: This is because of the fact that each
indifference curve represents different level of satisfaction.

As shown in the above figure, there are two indifference curves IC 1 and IC2 which are
intersecting each other at the point A. Point C on IC2 shows higher satisfaction than point
B on IC1 because point C is situated on the upper indifference curve. But point A is

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 situated on both the indifference curves which shows that at this point both indifference
curves are providing same level of satisfaction which is impossible because the two
indifference curves can never shoe the same level of satisfaction.
4. Higher Indifference Curve Represent Higher level of Satisfaction:

5. Indifference Curves Need not be Paralled to Each Other:

6. Indifference Curves do not Touch either X-axis or Y-axis:

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 Short Questions
Q1 .Explain micro-economics and macro-economics. Distinguish between Micro-economics
and Macro-economics.
Ans.
Micro-Economics: Microeconomics is the study of economic actions of individuals. In other
words, it is a branch of economic analysis which studies the economic behavior of individual
units i.e., individual firm, individual person.

Macro-Economics: Macro-economics is the branch of economic theory which deals with the
study of the economy in aggregate with specific focus on unemployment, inflation, business
cycle, growth, monetary and fiscal policy etc.

Difference between Micro-economics and Macro-economics

S. No. Base Microeconomics Macroeconomics
1 Study It includes the study of It studies the whole economy.
individuals e.g., individual
person, individual firm etc.
2 Assumptions Assumption of ‘other things It does not include such
being equal’ or ‘full assumptions.
employment’ are presumed.
3 Subject It deals with determination of It deals with national income,
Matter price, consumer’s equilibrium general price level, trade cycle,
etc. economic growth etc.
4 Mortality It deals with individuals and It is concerned with the
individuals are mortal. Thus, the aggregate. It studies the
tool of the study of problem of the whole
microeconomics i.e., man is economy. The tool of its study
mortal. is society and society never
dies.
5 Paradox If an individual saves, his family If the whole society starts
will be benefited. savings, it will reduce the
effective demand which would
have an adverse effect on
employment.
6 Simplicity Microeconomic analysis is Macroeconomic analysis is
simple. complex.

Q2. Explain following concepts of Managerial Economics:

7. Opportunity Cost Principle
8. Marginal Analysis
9. Incremental Principle
10. Time Perspective Principle
11. Discounting Principle
12. Equi-marginal Principle
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Ans.
1. Opportunity Cost Principle: Economics makes abundant use of fundamental concept of
opportunity cost. In the words of Ferguson, “the alternative or opportunity cost of
producing one unit of commodity ‘X’ is the amount of commodity ‘Y’, that must be
sacrificed in order tp use resoyurces to produce ‘X’ rather than ‘Y’.” Thus, the
opportunity cost of anything is the next best alternative that could be earned by the same
factors. The opportunity cost, thus, is the “cost of sacrificed alternative.” For
example, Mr. X has Rs. 10,000. He has two options to use this money – either invest it in
his business or deposite in a bank @ 5% per annum. It is clear that, if he deposite this
money in a bank, he will earn an interest of Rs. 500. But suppose he decides to invest this
money in his business. Thus, he is loosing an opportunity of earning interest income of
Rs. 500. In other words, he is sacrificing the interest income of Rs 500. So, here the
opportunity of interest income of Rs. 500 which he could earn, willb we called
Oopportunity cost.

2. Marginal Analysis or Incremental Principle: The concept of Marginal Analysis or

Incremental Principle is most significant in taking production decisions. Marginal or
Incremental Analysis involves estimating the impact of decision alterbnatives on cost and
revenue. There are two basic components of Marginal or Incremental Principle:
Incremental Cost and Incremental Revenue.
 Incremental Cost: It is defined as the increase in total cost as a result of increase
in the level of output.
 Incremental Revenue: It is defined as the increase in total revenue as a result of
increase in the level of output.
A manager always determines the worth of a decision if Incremental Revenue is more
than Incremental Cost.
Difference between Marginal and Incremental Concepts
The distinction between the two can be illustrated by an example. Suppose, 100 workers
on a land area of one hectare can produce 200 tonnes of wheat. If one more worker is
employed, total production increases to 202 tonnes. Hence marginal production due to the
employment of one additional worker is 2 tonnes. In real life, factor of production may
not be properly divisible. If 110 workers are employed, total production is 210 tonnes of
wheat. Now the incremental output is 10 tonnes of wheat. Here the average incremental
output is one tonne per worker whereas in the first case marginal output was 2 tonnes of
wheat. This example proves that in marginal analysis unit change is important but
in case of incremental analysis bulk changes are more important. The main
differences between marginal and incremental concepts are as under:
S. No. Marginal Concept Incremental Concept
1 It is expressed in terms of unit It is expressed in terms of bulk changes.
change
2 Marginalism assumes single variable Incrementalism assumes multi-variable
function i.e., revenue depends upon function.
output.
3 Marginal Concept is more specific. Incremental Concept is more general.
4 All marginal concepts are All incremental concepts need not be
incremental concepts. marginal concepts.

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3. Time Perspective Principle: The time perspective principle explains that the decision
maker must give due consideration to time element in his decisions. Generally, time may
be divided as short-run and long-run.

 Short-run: It is the time period in which volume of output cannot be changed by altering
the size of the firm and the scale of plant. The output can be increased or decreased only
by changing the variable inputs such as raw material, use of machines etc.

 Long-run: It is defined as the time period in which the size of the firm and the scale of
plant can be changed to change the volume of output.

Before taking the decision, a manager should consider the time factor. For example, a
company receives an order of additional 5,000 units per month for 3 months. It can be
met by extra use of machinery as well as by employing some additional workers. But, if
this order were be for 10 years then it would be recommended to purchase some new
machines to meet this order.

4. Discounting Principle: Discounting principle implies that if a decision affects costs and
revenues at future dates, it is necessary to discount those costs and revenues to present
values before a valid comparison of alternatives. Discounting principle occupies a very
important place in managerial economics because a rupee tomorrow is worth less than a
rupee today. For example, a person is offered a choice to make between a gift of Rs. 100
today or Rs. 100 next year. Naturally, he will choose Rs. 100 today. There are twio
reasons for it: (i) the future is uncertain and there may be uncertainty in getting Rs. 100 if
the present opportunity is not availed of, (ii) Even if he is sure to receive the gift in
future, today’s Rs. 10 can be invested so as to earn interest, say @ 5%, so that one year
after the Rs. 100 of today will become Rs. 105 whereas if he does not accept Rs. 100
today, he will get Rs. 100 only after one year. Naturally, he would prefer the first
alternative because he is likely to gain Rs. 5 in future. The present value of future cash is
calculated as below

5. Equi-Marginal Principle: Equi-marginal principle states that in order to get maximum

satisfaction, a consumer should spend his limited income on different commodities in
such a way that the last rupee spent on each commodity yields him equal marginal utility.
In the words of Dr. Marshall – “If a person has a thing which he can put in several
uses, he will distribute it among these uses in such a way, that he has the same marginal
utility in all.”

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