Basics of

Business Economics
 Definition

Business Economics* is

‘The application of economic theories and

methodologies to problems faced by
the business firms / industry’.

*Business Economics is also termed as Micro Economics, Managerial Economics

or Applied Economics.
 Application of economic theories

• Business managers faced with many

problems with changing business
environment after 2nd world war.

• Structural changes in the business led to

variability and unpredictability of
achievements in business.
• Traditional theories were not useful in
the application of modern business
 Theory of firm

• Theory of the firm: one man firm with

profit motive to professional managers
with multiple objectives.
• Objectives of modern firm: achieving
leadership in business, maintaining
customers good will or acquiring
financial goodness, preventing
competition etc
• Guiding principle has become avoiding
loss, survival in business and
reasonable profit.
 Cost concepts

• Cost of production : expenses incurred

for production of a commodity
• Accountants concept of cost: explicit
cost
• Economists concept of costs: work
performed by the entrepreneur, interest
on capital supplied by him, rent of land
and building owned by him.
• Difference between theoretical concept
of economics and practical business
 Profit concepts

• Wide variations between economic

theory and business practice in defining
the term profit.
• Gross and pure profit
• Economist cost is accounting profit-
implicit cost.
• Profit from the accounting sense but
loss from the economists sence.
 Decision making in business

• Core of managerial economics

• Scientific decisions after study of pros
and cons
• Quality of decisions will determine the
success of failures.
• Decision making is the process of
selecting a particular course of action
from among the various alternatives
• Presence of uncertainty makes it difficult
 The Business Environment

• Business Economics is about

– decision making in business
• external influences on the firm
– the business environment
• internal decisions of the firm
• the external effects of business decision making

• What do business economists do?

– description
– analysis
– recommendations
 Scope of Business Economics
• Resource allocation
– Production programming, transportation problems,
assignment problems

• Inventory and queuing problems

– Optimal level of stocks of raw materials and finished
goods
– Installing additional machines and hire extra labour

• Pricing problems
– How, what, when, strategies…

• Investment problems
– Investing in plants, raw materials, sources of funds,…
Business Economics and other disciplines

• Micro economic theory

• Macro economic theory
• Operations Research
• Theory of Decision Making
• Statistics
• Management theory and accounting
• Econometrics
Some economic concepts used by firms

• Demand and its elasticity

• Demand forecasting
• Cost analysis
• Revenue concepts
• Price determination under different
market structures
• Pricing methods in actual practice
• Break-even analysis
• Capital budgeting and management
• Criteria for public investment decisions
Application of Economic theory
Basic Concepts
 Basic Concepts

• Objectives of firm
• Theory of Demand and elasticity of
demand
• Theory of Supply
• Opportunity Cost
• Marginalism
• Production Possibility Curves
• Different types of Costs
• Time perspective of money and
discounting
 Basic Concepts

• Risk and uncertainty

• Profits
• Firm, industry and market
• GDP, GNP, NNP
• National income
• Aggregate demand and aggregate supply
• Per capita income
• Economic and econometric models
Objectives of Firm
 Firm’s Objectives

• Growth
• Profit Maximization
• Firm’s value maximisation
• Sales (revenue) maximisation subject to
some pre-determined profit
• Size maximisation
• Long-run survival
Theory of Demand
Demand Schedule for Ice Cream

Price Quantity
0.10 12
0.50 10
1.00 8
1.50 6
2.00 4
2.50 2
3.00 0
 Demand Curve

Price (Rs) Quantity

0.10 12
3.00 0.50 10
1.00 8
2.50 1.50 6
Price of Ice-Cream Cone

2.00 4
2.00 2.50 2
3.00 0
1.50

1.00

0.50

0 1 2 3 4 5 6 7 8 9 10 11 12
Quantity of Ice-Cream Cones
 Law of demand

As the price increases, demand decreases

and vice versa
 Concept of Elasticity
• … is a measure of how much buyers and sellers
respond to changes in market conditions

• It is the degree of responsiveness of

demand/supply to the change in the price/other
variables

• … allows us to analyze supply and demand with

greater precision.

• Law of demand reveals the relationship

between price and demand, whereas Elasticity
reveals the ‘degree of change’
 Price Elasticity of Demand

 Price elasticity of demand is the

percentage change in quantity
demanded given a percent change in
the price.

 It is a measure of how much the

quantity demanded of a good responds
to a change in the price of that good.
 Unit Elastic Demand

Elasticity = 1
Price

1. A 22% 5
increase
in price... 4

Demand

80 100 Quantity
2. ...leads to a 22% decrease in quantity.
 Inelastic Demand

Elasticity < 1
Price
In Rs

1. A 22% 5
increase
in price... 4

Demand

90 100 Quantity
2. ...leads to a 11% decrease in quantity.
 Elastic Demand

Elasticity > 1
Price

1. A 22% 5
increase
in price... 4

Demand

50 100 Quantity
2. ...leads to a 67% decrease in quantity.
 Perfectly Inelastic Demand

Elasticity = 0
Price Demand
in Rs

1. An 5
increase
in price... 4

100 Quantity
2. ...leaves the quantity demanded unchanged.
 Perfectly Elastic Demand

Elasticity = infinity
Price
1. At any price
above Rs. 4, quantity
demanded is zero.

4 Demand

2. At exactly Rs. 4,
consumers will
buy any quantity.

3. At a price below Rs. 4, Quantity

quantity demanded is infinite.
Supply
 Supply

Quantity supplied is the amount of a

good that sellers are willing and
able to sell.
 Supply Schedule

The supply schedule is a table that

shows the relationship between the
price of the good and the quantity
supplied.
Supply Schedule

Price Quantity
0.00 0
0.50 0
1.00 1
1.50 2
2.00 3
2.50 4
3.00 5
 Supply Curve

The supply curve is the upward-

sloping line relating price to
quantity supplied.
 Supply Curve

Price of
Ice-Cream
Cone
3.00 Price Quantity
0.00 0
2.50
0.50 0
2.00 1.00 1
1.50 2
1.50 2.00 3
2.50 4
1.00
3.00 5
0.50

Quantity of
0 1 2 3 4 5 6 7 8 9 10 11 12 Ice-Cream
Cones
 Law of Supply

The law of supply states that there

is a direct (positive) relationship
between price and quantity
supplied.
Elasticity of Supply
 Unit Elastic Supply

Elasticity = 1
Price
In Rs Supply

1. A 22% 5
increase
in price... 4

100 125 Quantity

2. ...leads to a 22% increase in quantity.
 Inelastic Supply

Elasticity < 1
Price
in Rs Supply

1. A 22% 5
increase
in price... 4

100 110 Quantity

2. ...leads to a 10% increase in quantity.
 Elastic Supply

Elasticity > 1
Price
In Rs
Supply
1. A 22% 5
increase
in price...
4

100 200 Quantity

2. ...leads to a 67% increase in quantity.
 Perfectly Inelastic Supply

Elasticity = 0
Price Supply
in Rs

1. An 5
increase
in price... 4

100 Quantity
2. ...leaves the quantity supplied unchanged.
 Perfectly Elastic Supply

Elasticity = infinity
Price
in Rs
1. At any price
above 4, quantity
supplied is infinite.

4 Supply

2. At exactly 4,
producers will
supply any quantity.

3. At a price below 4, Quantity

quantity supplied is zero.
Production Possibility Frontier
 The Production Possibilities Frontier

The production possibilities frontier is a graph

showing the various combinations of output
that the economy can possibly produce given
the available factors of production and
technology.
 The Production Possibilities Frontier

Quantity of
Computers
Produced
3,000 D

2,200
C
2,000 A

B
1,000

0 300 600 700 1,000 Quantity of

Cars Produced
 The Production Possibilities Frontier

Quantity of
Computers
Produced
3,000 D

2,200
C
2,000 A
Production
possibilities
frontier
B
1,000

0 300 600 700 1,000 Quantity of

Cars Produced
Costs
 Costs

Cost is
‘the expense incurred in producing a
commodity’
 Different types of Costs

• Real cost and Money cost

• Actual cost and Opportunity cost
• Past and Future cost
• Short run and Long run costs
• Variable and Fixed Costs
• Incremental costs and Sunk costs
• Direct and Indirect costs
• Replacement and Historical costs
Time Perspective
 Time Perspective

• Market Period (Very Short run)

– Supply of out put is fixed, hence response to demand is
nil

• Short run
– Some increase in output is possible by better utilisation
of factors of production
– However, plant and machinery can not be changed

• Long run
– All factors are variable and there are no fixed inputs
Examples for Time Perspective

Market Period

1. Raise in price 2. Profit

to increase profit increases

4. Sharp decline
3. Sales decreases
in the profits

Long run Short run

 Examples for Time Perspective

2. Cut down the

1. Reduce costs money for labour
welfare

Market Period
3. Cost reduces,
5. Reduce in
Profitability
Profitability
increases

Long run 4. Adverse effect

On labour
productivity
Short run
Discounting
 Discounting

This concept is based on the simple notion

that –

“A rupee today, is worth more than a

rupee tomorrow”
Underlying principle in discounting

i. Uncertainty
ii. Capability of money to earn Interest

Example…
If the rate of interest is 8%, Present value of
my Rs. 100 is
PV = Rs.100 / 1 + 8 % = Rs. 92.59
Risk and Uncertainty
• Foreseeable risks
– Fire, theft, death, sinking of ship,…

• Unforeseeable risks
– Competitive uncertainties
– Technological uncertainties
– Cyclical uncertainties
– Uncertainties caused by government policies
Profit
 Profit

• Total Revenue – Total Cost = Profit

• Accounting Profit
– Total Revenue – explicit or actual costs (rents,
labour, wage, interest,…)

• Economic Profit
– Total Revenue – (explicit + implicit costs)
Firm, Industry and Market
 Firm, Industry and Market

• Firm is a unit of production that employs

factors of production (or inputs) to produce
goods and services under given state of
technology

• Point to ponder
– Do firms always try to ‘Maximise Profits’?
 Firm, Industry and Market

• Industry – it includes firms which are in some form

related to each other closely. This ‘closeness’ is
generally defined in terms of two criteria

• Product Criterion
– Group of firms whose products are close substitutes

• Process Criterion
– Group of firms which follows similar processes
(technology, use of raw materials, methods of
production, channels of production,…)
 Firm, Industry and Market

• Market – Location or a region in which

buyers and sellers of a particular commodity
are in regular communication (market for white
goods in India, market for luxury cars in India,…)
GDP, GNP, NNP, National Income
 Gross Domestic Product (GDP)

• Gross Domestic Product is = total value of

goods and services produced in a country
during the year – income from investment
abroad

GDP @ Factor 2001-02 2002-03 2003-04

Cost
(in ‘000 Crs )
At Current Prices 2081.5 2254.9 2591.8

At 93-94 Prices 1267.9 1318.4 1430.5

Source – Indian Economic Survey 2004-05
 Gross National Product (GNP)

Gross National Product = GDP + income from

abroad – income earned by foreigners in the
domestic market.

GNP 2001-02 2002-03 2003-04

(in ‘000 Crs )
At Current Prices 2065.9 2241.7 2505.7

At 93-94 Prices 1257.6 1310.5 1422.5

Source – Indian Economic Survey 2004-05
 National Income

National income is the aggregate factor of

income (i.e., earning from labour and capital
etc) which arises from the current
production of goods and services by the
nation’s economy.
 Net National Product (NNP)

NNP is the market value of a country’s output

of goods and services, after deducting the
capital that has been used up in the
production process

Among the deductions to be made are;

depreciation charges, accidental damages
to fixed capital assets and outlays charges
to current account

NNP = GNP - Depreciation

Aggregate Demand, Aggregate Supply
and Per Capita Income
 Aggregate Demand

Aggregate demand* is the total demand for goods

and services in the economy

It can be segmented into demands of

- Households for consumer goods and services
- Firms and Govt for investment goods
- Central and state Govt’s for goods and services
- Exports

* Aggregate demand determines the level of production and employment

 Aggregate Supply

Aggregate Supply of goods and services in

the economy available to meet aggregate
demand.

It consists of domestically produced goods

and services + Imports
Aggregate Supply of Electric Power

Production of Electric Power in India

Year Mega Watts
91-92 69, 065
95-96 83,293
99-00 98,185
03-04 112,682
Source: Ministry of Power, GOI
 Per Capita Income (PCI)

If the national income of a country is divided

by the total population, we get the average
income per head, which is known as per
capita income

National Income
PCI =
Total Population