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BUSINESS (MANAGERIAL) ECONOMICS

Module:1.1: Nature and Scope of Managerial Economics.
1.  o o o o Business Issues and Economic Theory Operational or Internal Issues: Choice of business (What to produce?) Choice of size of the firm (How much to produce) Choice of technology (How to produce ie choice of factor/input combinations) How to price the commodity, how to promote sales, how to face price competitions, how to decide on new investments, how to manage profits, how to manage inventory etc. Microeconomic Theory: Deals with some of these operational issues theory of demand, theory of production and cost, market structure and product/factor pricing, profit management etc.

 Environmental or External Issues: o Economic system of the country. o General trends in production, employment, income, price level, saving and investment. o Structure of financial institutions. o Nature and magnitude of foreign trade. o Monetary and fiscal policies, and industrial and labour policies. o Social factors like the value system of the society, property rights, and political environment. o Degree of openness of the economy and the influence of MNCs on the domestic market.  These are all the macroeconomic issues relevant to business decision – making: Trends in GDP, price trends, saving, investment, consumption, foreign trade, other economic policies.  Hence: Prominent role of micro and macro economics in the process of business decision – making.

B/M Economics: Subject Matter. o B/M Economics: Economics applied to decision making.

Use tools of economics to identify the problems, to organize and evaluate information, to compare alternative courses of action, to choose the best course of action, and to implement it. Provides the link between traditional economics and the decision sciences (Mathematics and Statistics) in management decision making. Also relevant to the management of non-profit organisations: Hospitals etc. Microeconomics in character, but macroeconomics, equally important for decision making by the business firm. More normative than positive: More prescriptive than descriptive.

Association of B/M Economics with other Sciences:

 Mathematical Tools:  Cost minimization, sales maximization and profit maximization etc.  Statistical Tools:  Most of business decisions based on probable economic events.  Use theory of probability and forecasting techniques.  Operational Research Theory:  An interdisciplinary solution – finding techniques.  Combines economics, mathematics and statistics to build models for solving specific business problems.  Ex: L.P – widely used in business decision – making.  Management Theory:  Behaviour of the firm to achieve certain predetermined objectives.  Accountancy: Data on functioning and performance of the firm.

● Cost analysis and supply forecasting – focusing on input prices. Capital Budgeting: Investment criteria and decisions. Product pricing and competitive strategies. product prices. technology flow etc. Risk analysis to suggest alternative courses of action to cope with. ● ● ● ● .4. and profitability analysis. Study and anticipation of government policies and planning business strategies accordingly. Functions of a Managerial / Business Economist: ● Demand forecasting by formulating econometric models.

short-run and intermediate-run perspective. building. Decision Rules and Tools of Analysis in B/M Economics.2: Basic Concepts. Time Perspective in B-Decision-Making. . • Maintain the right balance between the long-run. Principles. • Decision Making: A task of coordination along the time scale. • Building inventories of finished products: Need short-run time perspective. past. 1. present and future.Module: 1. land and introduction of a new product: Need long-run time perspective. • Investment in plant.

Opportunity cost of a decision: Sacrifice of the alternatives. C: Interest that could have been earned through investment in other ventures. Examples:  Invest ones own capital in once own business  O. • • O.  The O. C of managing once own business: Salary that be could have earned in other occupations.  O. C of availing an opportunity is the expected income foregone from the second best opportunity of using the resources.• • Opportunity Cost Principle: Most economic resources have more than one use  Have opportunity costs scarcity and alternative use of the resources  opportunity costs. C of watching cricket match by a student? • . C Concept: Can be applied to all kinds of business decisions where there are at past two alternative options involving costs and benefits.  The O.

To generalize: PV = present value γ = rate of interest FV1 = amount received at the end of first year FV1 = PV + PV(γ) = PV (1+γ) FV2 = PV (1+γ) (1+γ) = PV (1+γ)2 FVn = PV (1+γ)n If γ = 0 FVn = PV.95.05) = 100 at the end of first year. o .• • Discounting and compounding principle: Time Value of money and decision analysis  Future value of the present sum: Compounding o Let PV = Rs.05 FV1 = 95.24 γ = 0.24 + (95.24 X 0.

24 (1+γ) 1+0.70 (1+γ)2 (1+0.100) PV = FV2 = 100 = 90.100) γ = 0. Present value of future sum: Discounting PV = Present Value FV1 = Amount receivable at the end of one year from now (Rs.05)2  For N Years: PV = FV1 + FV2 + … + FVN (1+γ) (1+γ)2 (1+γ)N .05 = Rate of discount PV = FV1 = 100 = 95.05 FV2 = Amount receivable two years from now (Rs.

PV → O.100 receivable one year from now: Rs. Lower PV Lower γ. higher PV γ If γ = O.100  NO time value for money. Relationship between PV and γ PV  Higher γ. PV of Rs. It should estimate the discounted value of net added earnings from that machine before venturing to buy it. . If γ → ∞.  Suppose a company is considering buying a new machine.

Marginal Principle and Decision Rule: • Concept of M.P widely used in business decision making: M U. .4. M P and M П. M C. • To apply Marginal Principle: Need TC and TR data for each and every unit of output. • M C = TCn – TCn – 1 TCn = total cost of producing n units TCn-1 = total cost of production of n-1 units M C = TCn – TCn – 1 = 2550 – 2500 = 50 Similarly: MR = TRn – TRn -1 • The decision rule: MR > MC: Carry on business activity MR < MC: ? MR = MC  Necessary Condition for П – maximization. M R.

MC2: Marginal cost of Labour and Capital MRP1 > MRP2 → Decision Rule? MC1 < MC2 .• Equi – Marginal Principle:  A rational decision – maker: Decision Rule The ratio of marginal returns and marginal costs of various uses of a given resource or Various resources in a given use is the same.  Ex1: Consumption basket MU1 = MU2 = … = MUn Equi – marginal MC1 MC2 MCn MU1 > MU2 → Decision Rule? MC1 < MC2  Ex2: Input use MRP1 = MRP2 = … = MRPn MC1 MC2 MCn MRP1. MRP2: MRP1 from input 1 (say labour) MRP2 from input 2 (say capital) MC1.

cost or profit with respect to change in output only. profitable  The contribution of a business decision: Difference between IR and IC. • Difference between marginal and incremental concepts:  M – Principle: Change in revenue.• Contribution Analysis and Incremental Concept:  IC = Change in total cost due to a specific decision  IR = Change in total revenue caused by a decision  IR > IC → Decision.  IC: Applicable with respect to any variable and for any extent of change. . Change in output is infinitesimally small.

 EP: Makes provision for insurable risks.  EP = TR – (Explicit Costs + Implicit Costs). depreciation.  Profit: Reward for risk-bearing .  Risk – Bearing Theory:  Companies bear risks – Non-availability of inputs and adequate market for products. and necessary minimum payment to shareholders to prevent them from withdrawing their capital.5. Profits: • Accounting Profit and Economic (pure) Profit:  AP = TR – Explicit Costs. new production techniques.  Innovation Theory: o Innovation in new products. new marketing strategies o Cost of innovations o Profits: Reward for innovation. • Theories of Profit: Sources of Profit.

 Same element of truth in all these theories. and those producing items like ice cream and fans. Profit is a reward for innovation.  Monopoly is the source of pure profit. risk – bearing. . Monopoly Theory of Profit:  Powers to control supply & price  Powers to prevent the entry of competitors  Sole ownership of certain crucial raw materials  Legal sanction and protection.  Managerial Efficiency Theory:  Profits – Reward for exceptional managerial skills  Hence profit for good performance.  Friction Theory of Profit: Ex: Severe and prolonged winter companies producing woolen garments. monopoly power and managerial efficiency.

Plant. . • Firm:     May own one or more than one plant Exercises a unified control over its plants Separate legal entity Undertakes production to maximize profits.6. Firm and Industry: • Plant:  A technical unit of production  Technical similarity in the production processes of goods production within a plant  A body of persons working at a given place.

• Industry:  A group of firms  Some common factor among all the firms:  The raw material used and production technique employed – supply side.  Concept of cross elasticity of demand EXY = % change in quantity of X demanded % change in price of Y How do you decide degree of substitutability?  Can we use cross elasticity of supply also to classify industries? .  Firms compete more for capturing the market for their goods substitutability of goods. But: On the demand side.  To identify degree of competition among the firms in the market.  Firms compete more for same raw material raw material use criterion to classify industries. define industry as a group of firms producing closely substitutable products.  Products produced – Demand side.  Standard industrial classifications (SICs): Raw material used and similar production processes rather than the substitutability among products. these two are substitutes. Ex: Plastic buckets in the plastic industry. and metal bucket in metal working industry.

demand schedule. • Demand  Effective demand. .Module 1. • Importance of demand analysis to a decision – maker:  Existing potential demand for the product of the company  Business strategies to augment the demand for the company‟s product. • See Module 2 in the handout on “Orientation In Economics” for definition of demand. • Three characteristics of effective demand:  Desire for the product  Ability to pay for the product  Willingness to pay for the product.3: Demand Analysis: • Read Section 2 of Module 2 in the hand out on “Orientation In Economics”. demand curve and law of Demand.

raw materials etc.  Study consumer‟s goods under demand and producer‟s goods under supply.• Types of Demand:  Demand for consumer’s goods and producer’s goods  Goods/services used for final consumption → Consumer‟s goods  Producer‟s goods: Machines. .  Autonomous (Direct) and Derived (Indirect) Demand:  A (D) Demand: Demand not tied down with demand for some other goods. Ex:?  Implications to business decision-analysis.  D (I) Demand: All produced goods. buildings. Ex:?  Durable goods: Only services are consumed.  Perishable and durable goods  Perishable goods: Can be consumed only once.

) B–1 5 B–2 10 B–3 0 Market Demand 15 7 6 5 4 3 8 12 20 30 45 12 15 19 25 30 4 7 12 20 30 24 34 51 75 105 Assignment: Draw individual and market demand curves. .  Demand by Market Segments and Total Market:  Domestic and Foreign Markets  Rural and Urban Markets.  Price. Individual and Market Demand Milk Price Rs/Lit 8 Milk Demand (Litr. Income and Cross Demand: Refer to Section 2 of Module 2 in the hand out on “Orientation In Economics”.  Firm and Industry Demand:  Demand facing an industry (Say car industry)  Demand facing a firm (Demand for Maruti Car)  Refrigerators Industry and Godrej Refrigerator firm.

For Ex: ∂DX < O ∂PX : ∂DX < ? ∂PS < : ∂DX > ? ∂PC < :---------:---------- . A.F = Credit facility  N. T. PS. PS.E = Adv. POP.• Determinants of Demand and Demand Function:  Determinants of Market Demand: DX = fCPX. = Population of the country  I. M. NB.F.  Postulate demand for X and determinants i.e Explanatory Variables. ID  PX. = Income distribution pattern in the country. expenditure  C. E: As in orientation handout  A.B = Member of buyers  POP. E. M.D. T. PC. C.E. PC.

T. D: DX = f(PS). Complements and independent goods → Draw diagrams. OR C → Substitutes. inferior and neutral goods. . A. CD & ID  P. D: DX = f(PX). M. D: DX = f(M). PS. OR C → Normal. PC. Individual Consumer Demand Function: DX = fCPX. OR C DX = f(PC).E ……)  Three Kinds of Demand:  Recall: PD.  I. OR C  C. E.

 PX↑ RI↓ → A decrease in his purchasing power. Buy more of X. PS  Hence less of X is demanded with a rise in price of X. if it is a normal good.  Note: In case of inferior goods: PX↓ → RI↑ . PX↑ → RI↓ . if it is a normal good. Why the inverse relationship between price and quantity demanded?  Substitution effect:  PX↓.Buy more of X.Buy less of X. Because still cheaper compared to other goods.  Income Effect:  PX↓ RI↑ → An increase in his purchasing power. prices of its substitutes remaining constant  Hence more of X is demanded with a fall in its price  PX↑. Buy less of X. . because the substitutes are cheaper.

 Exceptions to Law of (Price) Demand:  Giffen Goods  Articles of snob appeal  Speculation.  Why movement and why shift? .  Movement (Change in equality demand or extension and contraction of demand) and shift in demand (change in demand or increase and decrease in demand).

e│EP│. . but consider the size and ignore the sign. PO ∆P QO  Arc EP = ∆Q . P1 + P2  Average price elasticity between ∆P Q1 + Q2 two points Also called Mid – Point Formula  Sign of price elasticity coefficient: Negative. i.Module 1.4: Price Elasticity of Demand: • Recall from the handout on “Orientation in Economics”.  EP = Price Elasticity of D = % change in quantity of X demanded % change in price of X  Point EP = ∆Q .

D: │EP│= 1  % ∆Q =% ∆P ∆O PO  Perfectly ine. . D: │EP│= 0  % ∆Q = 0 for a QO given % ∆P PO  Perfectly /infinitely el. D: EP = ∞  All output is sold at the same price % ∆P = 0 PO  Draw diagrams for all five kinds of PED.o Five Kinds of Price Elasticity of Demand:  Elastic D: │EP│> 1  % ∆Q >% ∆P QO PO  Inelastic D: │EP│< 1  % ∆Q <% ∆P QO PO  Unitary el.

.o Total Revenue (Total Expenditure) Test and Price el. of D:  Recall: │EP│> 1  A Price change leads to more than proportionate change in Q – demanded. │EP│< 1  A price change leads to a less than proportionate change in Q – demanded. │EP│= 1  Price and quantity change in the same proportion.

16 Observe: Q: 1 to 5: │EP│>1 → P↓TR ↑ MR > 0 Q: 5 to 6: │EP│=1 → P↓TR MR = 0 Q: Greater than 6: │EP│< 1 → P↓TR↓MR < 0 .14 60 50 40 30 5 6 7 8 300 300 280 240 20 0 -20 -40 1.Price Elasticity and Revenue Relations Price (P) 100 90 80 70 Quantity (Q) 1 2 3 4 TR = P.44 1.29 0. E │EP│ 6.47 20 10 9 10 180 100 -60 -80 0.69 0.40 2.33 3.00 0.Q 100 180 240 280 MR MR= ∆TR ∆Q 80 60 40 Arc.

│EP│ Effect of P ↓ on Effects of P ↑ on TR >1 =1 <1 ↑ Constant ↓ MR >0 =0 <0 TR ↓ Constant ↑ MR <0 =0 >0 Do you agree with this analysis? .

. boats and buildings. • Number of uses:  Single – use commodities: Less elastic Ex: ?  Multi – use commodities: More elastic Ex: Aluminum used in  Construction of airplanes automobiles. • Consumer‟s income: Poor Consumers: More elastic Rich Consumers: Less/inelastic.Module 1.5: Determinants of Price Elasticity: • Nature of the commodity:  Luxury/Comforts: Price Elastic  Necessary Goods: Price Inelastic. Onion. • The products position in buyers Budget: The proportion of income spent on the commodity. • Availability of substitutes:  More number of substitutes: More Elastic Ex: Beverages  Less/no substitutions: Less elastic/inelastic Ex: Salt.

 Discounts to different customer groups like in airlines. E.  International trade: Decision to devalue a country‟s currency is based primarily on the price elasticities of imports and exports. senior citizens.Module 1. vacation travelers. restaurants etc to students.6: Practical Significance of the Concept of P.  Demand for higher wages: can be met when EP for the product is inelastic.  Taxation. D: • Questions facing a business firm:  5% P ↑ → Expected impact on sales?  Sales to increase by 10% → How much of reduction in price?  Whether reduced prices attract sufficient additional customers to offset lower revenue per unit.  Product pricing strategy by business firm:  Does it pay to reduce the price of a product the demand for which is inelastic or demand for which is elastic?  Does a price rise yield a rise in TR when demand is elastic or inelastic? .

7: Cross Elasticity of Demand: • Recall: DX = f (PR) Let related good by Y DX = f (PY) d DX = 0 d PY d DX > 0 d PY d DX < 0 d PY  X & Y are ………………. ?  X & Y are …………………. ? • Draw diagrams for all the three situations: • EXPY = ∆QX PYO ∆PY QXO  EXPY  O < when? .Module 1.. ?  X & Y are ………………….

• Consider the following examples: Monthly Demand of a Household Original Commodity P Tea Coffee 3 4 Q 50 30 P 3 5 Q 60 20 New Bread Butter 2 75 80 30 2 6 90 40 Question: Calculate cross elasticity efficients for Tea & Coffee and Bread and Butter and interpret results with respect to nature of relationships between commodities. .

Before fare change 45 Bus 40 2. Percentage change 45 … 35 … 400 … 300 … Compute: ERFB = % change in Rail Service % change in Fare of Bus Service .Cross Elasticity of Demand in Transport System Daily No. of Passengers Rail 500 Bus 200 Fare (Rs) Rail 1. After fare change 3.

 To define market structure:  Lower the value of CEC. consider price change by competing firms..  To define independent goods?  To measure the degree of threat due to competition in the market. compliments and independ goods? . Similarly to define complements:  C E C < 0 Goods are complements  Higher the negative C E C → Higher the degree of complementarily.. higher the monopoly power  Higher the value of CEC?  To forecast demand for its products.• Significance of C E D in Business Management:  To define substitutes:  C E Coefficient > 0  Goods are substitutes  Greater the C E C → Closer the substitutes  Smaller the C E C → ..  To define cluster of products: Substitutes..

G Neu. . G I. • EM = ∆QX ∆M • EM  O < MO QO N.Module 1. OR C d DX  O Normal Good dM < Neutral Good Interior Good. G. • Draw diagrams to illustrate three kinds of goods.8: Income Elasticity of Demand: • Recall: DX = f (M).

450 Q • Business Applications of IED:  Long – term business planning for luxuries & comforts: High IED. E EM > 1 → I D curve flatter EM < 1 → Steeper I D Curve EM < 0 → Downward sloping I D curve.  Taxation policy: High IEC Luxury goods Impose higher excise or sales tax. . E EM = 0 → Zero I.  High IED: A major determinant of construction industry and real estate business.• EM = 1 → Unitary I.  Sectoral Production Plans: Usefulness of estimates of IED coefficients. M IDC (EM=1) Draw other types of ID Curve in the same diagram.

automobiles etc.Module 1. .9: Additional Demand Elasticity Concepts: • Advertising elasticity. • Interest rate elasticities to forecast demand for housing. • Weather elasticity of demand for public utilities like electricity.

estimated religion.. income of the consumer …….  Market simulation (Consumer clinic or laboratory experiment) method: → Provide token money to a set of consumers. sex.10: Demand Estimation and Forecasting: • Methods of Estimating Demand Function:  Consumer interviews (Surveys)  Interview consumers on their consumption habits  Census and sample methods  Information on quantities of the concerned good bought at different periods at various prices of the product. → Too costly and consumer‟s may not take the experiment seriously.Module 1. their quality. prices of related goods. age group etc. .  Market Experiments Method:  Actual Experiment: Record consumer‟s reactions in different shop locations with respect to income. packaging etc and record shopping behaviour of consumers. → Vary prices of various goods.

n. U) Where: Dg = demand for groundnut oil Y = national income Po = price of groundnut oil Pv = price of vanaspathi Pg = price of pure ghee U = „other‟ determinants of g. Regression Method: → Identify variables which influence demand for a particular commodity → Collect data → Select appropriate functional form → Estimate the function Ex: Demand Function for Groundnut Oil Dg = f (Y.o → Time series or cross section data. Pv. Pg. . Po.

try to match the opinions by bringing experts to-gether and to arrive at a consensus. → Under DM: Collect opinions from experts. Instead of taking averages.  Why D. Forecasting: An estimate of the future demand. .  Levels of D. F?  Production planning  Sales forecasting  To control business and inventory  To plan long term growth and investment programmes. F:  Micro Level: Forecast by an individual business firm. based on laws of probability.  Demands Forecasting Methods:  Consumers‟ survey  Experts‟ opinion → Simple expert opinion poll → Delphi Method: An extension of the simple expert opinion poll → Use Delphi Method (DM) to consolidate the divergent expert opinion and to arrive at a compromise estimate of future demand.• Demand Forecasting  D.  Industry Level:  Macro Level: Ex: Country consumption function.

M.• Statistical Methods:  Trend method to extrapolate Dg = f (T) Where: Dg = demand for groundnut oil T = Time (Years)  Barometric Method of Forecasting  Meteorologists use the barometer to forecast weather conditions on the basis of movements of mercury in the barometer. A) Where: Dx = Quantity of x demanded Px = Price of X Ps = Price of substitutes M = Consumer‟s income A = Advertisement expenditure . prices. lending rate for loans  Econometric Method: Regression Method  Simple or Bivariate Regression Technique: Y = f (X) Y = Sugar consumed Y = Population  Multivariate Regression Dx = f (Px.  So use relevant economic indicators such as GDP. Ps.

. . . The number 2 is twice the site of number 1  Measure utility of commodities A & B by utilis: A: 20 utils B: 40 utils  B Yields twice the utility of it. . .Module 1.. III. by how much size relation of number not known  Rank utility. . .. II. • Ordinal numbers: I. 3. . and explain consumer behaviour without the assumption of measurable utility.  II > I. . Cardinal and Ordinal numbers and C and O Utility Concepts • Cardinal numbers: 1.11: Theoretical Foundation of Consumer Behaviour: 1. 2. but II less than III  Don‟t know. 4.. .

S G  TU = M U of S. S)  TU = M U of G.  Rationality: Buys the commodity yielding highest amount of utility per rupee. . utility of money: Sine.2.  Utility is cardinally measurable. money is used as a measure of utility.  Utility function exists: TU =  (G. Measurable by the price that the consumer is prepared to pay. G S  Constant marginal. The Marshallian Cardinal Utility Theory: • Assumptions:  Maximization of satisfaction.

 Diminishing M U. of oranges consumed 0 1 2 3 4 TU 0 20 35 45 50 MU 20 15 10 5 5 6 7 8 53 55 56 56 3 2 1 0 9 10 55 53 -1 -2 . • Law of Diminishing M U: No.

 Develop both TU and MU curves from this data.  What are the implications of this law to a business manager? • Consumer Equilibrium and the Marshallian Proportionality Rule: MUA = MUB ……… = MUZ = K PA PB PZ  Can we say that K is the MU of money i.  The LDMU: As an individual increases consumption of a given product (say orange) holding consumption of other products constant.e MUM?  How does a consumer behaviour when: MUA  MUB ? PA < PB . MU derived from consumption eventually diminishes.  Observe how behaviour of TU and MU related.

 Consumer Equilibrium: MUX = PX  If MU of X is measured in terms of money. then the MU curve becomes the demand curve of the good. C could enter IV Quadrant? .• LDMU and Demand Curve:  Co ↑ MU ↓ → P ↓ D ↑ Co ↓ MU ↑ → P ↑ D ↓  Hence inverse relationship between P and Quantity demanded. P MU/Price P1 P2 MU/Demand O  At P1 → Q1 At P2 → Q2 Q1 Q2 Q  MU curve could enter IV Quadrant whether D.