Unit 1

Introduction
2022-23
Meaning

 Business Economics is also called as Managerial Economics. It involves

application of economic theory and practice to business. In business, decision
making is very important. Decision making is a process of selecting one course
of action out of available alternatives. Thus business economics serves as a
link between economic theory and decision-making in the context of business.
SCOPE OF BUSINESS ECONOMICS
 Scope is nothing but the subject matter of business economics. Scope of Business Economics is very wide.
 1) Market Demand and Supply In economics both demand and supply are the important forces through
which market economy functions. Individual demand for a product is based on an individual’s choice /
Preferences among different products, price of the product, income etc. Individual demand is nothing but
desire backed by individual’s ability and willingness to pay. By summing up the demand of all the
consumers or individuals for the product we get market demand for that particular product. Individual
Supply is the amount of a product that producer is willing to sell at given prices. By summing up the supply
of all the producers for the product we get market supply for that particular product. The market price
where the quantity of goods supplied is equal to the quantity of goods demanded is called as equilibrium
price. Existence, growth and future of business or firm depends on what price market determines for its
product.
 2) Production and Cost Analysis Knowledge of business economics helps manager to do production and
cost analysis. Production analysis helps to understand process of production and to make optimum
utilization of available resources. Cost analysis on the other hand helps firm to identify various costs and
plan budget accordingly. Both production and cost analysis will help firm to maximize profit.
 3) Market structure and Pricing Techniques Markets are very important in business economics. Study of
markets such as perfect completion, monopoly, oligopoly, monopolistic market etc. is very significant for
producers. It is very imperative for manager or producer to identify type of market that will be there for
their products. Knowledge of markets and competition will help them to take better decision regarding
pricing of the product, marketing strategies etc. Pricing techniques, on the other hand, helps the firms to
decide best remunerative price at different kinds of markets.
 4) Forecasting and coverage of risk and uncertainty. Knowledge of business economics
helps manager to forecast future. For example Demand forecasting. It means estimation of
demand for the product for a future period. Demand forecasting enables an organization
to take various decisions in business, such as planning about production process,
purchasing of raw materials, managing funds in the business, and determining the price of
the commodity. Likewise forecasting future helps firm to take important decisions and
cover risk and uncertainty associated with those decisions.
 5) Inventory Management Knowledge of business economics will help producer to reduce
costs associated with maintenance of inventory such as raw materials, finished goods etc.
 6) Allocation of resources Business Economics provides advanced tools such as linear
programming which helps to achieve optimal utilisation of available resources.
 7) Capital Budgeting Capital budgeting or investment appraisal is an official procedure
used by firms for assessing and evaluating possible expenses or investments. It is a process
of planning of expenditure which involves current expenditure on fixed/durable assets in
return for estimated flow of benefits in the long run. Investment appraisal is the
procedure which involves planning for determining whether firm’s long term investments
such as heavy machinery, new plant, research and development projects are worth the
funding or not. Knowledge of business economics helps producer to take appropriate
investment decisions with the help of capital budgeting.
IMPORTANCE OF BUSINESS ECONOMICS
 1. Knowledge of business economics helps business organization to take
important decisions as it deals with application of economics in real life
situation.
 2. It helps manager or owner of firm to design policies suitable for their firm
or business.
 3. Business economics is useful in planning future course of action.
 4. It helps to control cost and monitor profit by doing cost benefit analysis.
 5. It helps in forecasting future for taking important decisions in present.
 6. It helps to set appropriate prices for various products by using available
pricing techniques.
 7. It helps to analyse effects of various government policies on business and
take appropriate decision.
 8. It helps to degree of efficiency of firms by using various economic tools.
The opportunity cost :
Cost/sacrifice of next best alternative foregone
Definition – the cost expressed in terms of the next best alternative sacrificed. Not
necessarily money!
 The opportunity cost is essentially opportunity lost because of scarcity of resources. The concept of opportunity cost is related to the
alternative uses of scarce resources. As noted earlier, resources, both natural and man-made, are scarce in relation to demand for them
to satisfy he ever growing human needs. Resources, though scarce, have alternative uses. The scarcity and the alternative uses of the
resources give rise to the concept of opportunity cost. In the context of a business firm, resources available to a business unit—be it an
individual firm, a joint stock corporation or a multinational—are limited. But the limited resources available to a firm can be put to
alternative uses. The difference between actual earning and its opportunity cost is called economic gain or economic profit. The concept
of opportunity cost assumes a great significance where economic gain is neither insignificant nor very large because then it requires a
careful evaluation of the two alternative options.
 The applicability of the opportunity cost concept is not limited to decisions on the use of financial resources. The concept can be applied
to all other kinds of issues involved in business decisions, especially where there are at least two alternative options involving costs and
benefits. For example, suppose a firm has to take a decision on whether to fire an efficient labour officer (for treating labour unkindly) in
settlement of a dispute with the labour union or to allow the matter to be taken to the labour court. If the firm decides to fire the labour
officer, then the loss of an efficient and reliable labour officer is the opportunity cost of buying peace with the labour union. If the firm
decides to retain the labour officer, come whatever may, then the cost of prolonged litigation, the cost arising out of a possible labour
strike and the consequent reduction in output are the opportunity costs of retaining the labour officer. Given the two options, the firm
will have to evaluate the cost and benefit of each option and take a decision accordingly.
  The scarcity and the alternative uses of the resources give rise to the concept of opportunity cost.
  The difference between actual earning and its opportunity cost is called economic gain or economic profit. The concept of opportunity
cost assumes a great significance where economic gain is neither insignificant nor very large because then it requires a careful evaluation
of the two alternative options.
Marginality
 Marginality concept assumes special significance where maximization or minimization problem is
involved, for example, maximization of a consumer’s utility, maximization of a firm’s profit,
minimization of cost, etc. The term ‘marginal’ refers to the change (increase or decrease) in total
quantity or value due to a one-unit change in its determinant. For example, given the factor prices,
the total cost of production of a commodity depends on the number of units produced. In this case,
‘marginal cost’ (MC) can be defined as the rise in total cost as a result of producing one additional
unit of a commodity. The marginal cost (MC) can be worked out as follows.
 Marginal cost (MC) = TCn – TCn – 1
 where TCn = total cost of producing n units and TCn – 1 = total cost of producing n – 1 units.
 For example, suppose total cost (TC) of producing 100 units of a commodity is `2500. When production
is increased to 101 units TC increases to `2550. In this case, TCn = `2550, TCn – 1 = `2500 (where n =
101 and n – 1 = 100).
 Then MC = TCn – TCn – 1 = `2550 – `2500 = `50
 Similarly, MR can be defined as the change in TR due to the sale of one additional unit of a product. It
can also be defined as:
 Marginal revenue (MR) = TRn – TRn – 1
 where TRn = total revenue from the sale of n units and TRn – 1 = total revenue from the sale of n – 1 units.
 Alternatively, if TC and TR are given in the form of functions, then MC and MR are defined as the first
derivatives of the TC and TR functions, respectively. Suppose TC and TR functions are given as TC = f(Q)
and TR = f(Q) Then the first derivative is calculated through calculus as follows.

 The decision rule: Suppose a profit-maximizing firm is faced with a problem—

 how much to produce so that profit is maximized?
 One simple decision rule under the marginal principle is that a business activity (production and sale)
must be carried out so long as its MR > MC. As regards profit maximizing output, economists use the
marginality principle to set a necessary condition for profit maximizing output. The necessary condition
for profit maximizing output is that MC must be equal to MR. That is, profit is maximum where
 MR = MC
 In simple words, the profit of a firm is maximized at that level of output and sale where the cost of
producing one additional unit equals the revenue from the sale of that unit of output. The application of
the marginal principle for profit maximization has certain serious limitations which must be borne in
mind.
Use of Marginal Analysis in ‘decision
making’
 Economic rule of decision making:
 Cost<Benefit, do it !
 Cost> Benefit, don’t do it!
 If you want to know how much – use Marginal Analysis for ‘decision making’
 Marginal Cost < Marginal Benefit, do it !
 Marginal Cost> Marginal Benefit, don’t do it!
 1st Car price=20K, benefit=50k
 2nd Car price = 20K, benefit=10K
 Total Cost= 40K, Total Benefit=60k
 Marginal Benefit> Marginal Cost for 1 st car-go for it!
 Marginal Benefit< Marginal Cost for 2 nd Car- don’t go for it!
Equi-marginal Principles

 The equi-marginal principle was originally associated with consumption theory

and the law is called ‘the law of equi-marginal utility’. The law of equi-
marginal utility states that a utility maximizing consumer distributes his
consumption expenditure between various goods and services he/she
consumes in such a way that the marginal utility derived from each unit of
expenditure on various goods and service is the same. This pattern of
distribution of consumption expenditure maximizes a consumer’s total utility.
Example of Equi-marginal Principles
Cont….
Product A is of $5; Product B is of $10
Incremental principle
 Incremental principle states that a decision is profitable if revenue increases more than costs; if costs reduce more than revenues; if increase in
some revenues is more than decrease in others; and if decrease in some costs is greater than increase in others. The incremental concept is closely
related to the marginal costs and marginal revenues of economic theory. Incremental concept involves two important activities which are as
follows:
 Estimating the impact of decision alternatives on costs and revenues.
 Emphasizing the changes in total cost and total cost and total revenue resulting from changes in prices, products, procedures, investments or
whatever may be at stake in the decision.
The two basic components of incremental reasoning are as follows:
 Incremental cost: Incremental cost may be defined as the change in total cost resulting from a particular decision.
 Incremental revenue: Incremental revenue means the change in total revenue resulting from a particular decision.
The incremental principle may be stated as under:
A decision is obviously a profitable one if:
 It increases revenue more than costs
 It reduces costs more that revenues.
 It decreases some costs to a greater extent than it increases other costs
 It increases some revenues more than it decreases other revenues
Some businessmen hold the view that to make an overall profit, they must make a profit on every job. Consequently, they refuse orders that do not
cover full cost (labour, materials and overhead) plus a provision for profit. Incremental reasoning indicates that this rule may be inconsistent with profit
maximization in the short run. A refusal to accept business below full cost may mean rejection of a possibility of adding more to revenue than cost. The
relevant cost is not the full cost but rather the incremental cost. A simple problem will illustrate this point.
 The order at first appears to be unprofitable. However, suppose, if there is idle capacity, which
can be, utilized to execute this order then the order can be accepted. If the order adds only Rs.
500 of overhead (that is, the added use of heat, power and light, the added wear and tear on
machinery, the added costs of supervision, and so on), Rs. 1,000 by way of labour cost because
some of the idle workers already on the payroll will be deployed without added pay and no extra
selling and administrative cost then the incremental cost of accepting the order will be as follows.
While it appeared in the first instance that the order will result in a loss of Rs. 1,000, it
now appears that it will lead to an addition of Rs. 1,500 (Rs. 5,000- Rs. 3,500) to profit.
Incremental reasoning does not mean that the firm should accept all orders at prices,
which cover merely their incremental costs. The acceptance of the Rs. 5,000 order
depends upon the existence of idle capacity and labour that would go unutilized in the
absence of more profitable opportunities. Earley’s study of “excellently managed” large
firms suggests that progressive corporations do make formal use of incremental analysis.
It is, however, impossible to generalize on the use of incremental principle, since the
observed behaviour is variable.
Equations and relationship – Average,
total, marginal Cost (AC, TC and MC)
TC=TVC+TFC
AC=TC/OUTPUT PRODUCED
MC=TCN-TCN-1 or MC=Δ TC / Δ Q

Equations and relationship – Average,

total, marginal Revenue (AR, TR and MR)
TR=PRICE*OUTPUT SOLD
AR=TR/OUTPUT SOLD
MR=TRN-TRN-1
Output Total Average Marginal
Produced Cost Cost Cost

Chart Title
0 12 - -
60
1 18 18 6 56
47
2 22 11 4 36
27
22
3 27 9 5 18
11 11
9.4
13
10
6 9 9 8
4 5
4 36 9 9 1 2 3 4 5 6 -4
7

Total Cost 12 Average Cost - Marginal Cost -

5 47 9.40 11
6 60 10 13
7 56 8 -4
Total, Marginal and Average Revenue
Output Price Total Average Marginal
Sold Revenue Revenue Revenue
Chart Title
1 10 10 10 10 28 30 30 28
24 24
2 9 18 9 8 18 18

3 8 24 8 6 10 9
8 8
6 7 6
10
4 5 4 3
2 0 2 1
4 7 28 7 4 1 2 3 4 5 6 -2
7 8
-4 9 10
-6 -8
5 6 30 6 2
Total Revenue Average Revenue
6 5 30 5 0 Marginal Revenue

7 4 28 4 -2
8 3 24 3 -4
9 2 18 2 -6
10 1 10 1 -8
Relationship between Total, Average
and Marginal
 Total and Marginal: Marginal measures any change in the total values.
Change in total Marginal
increasing Positive
declining Negative
Rise at increasing rate Rise
Rise at diminishing rate Fall
 Marginal and Average
 When marginal is greater than average, average will rise.
 When marginal is equal to average , average will remain constant
 When marginal is less than average, average will fall
Variables

 A variable is something whose magnitude can change or can take on different

values.
 An economic model is simplified representation of real world phenomena. For
example, the law of demand is used to understand the relationship between
price and quantity demanded.
 Two types of variables: endogenous and exogenous variable
 E.g. in price determination (ss=dd): price, supply and demand are endogenous as
they are within the model or controllable variables in the model.

 Dependent and Independent Variables: example demand depends on price

prevailing in market, so demand is dependent variable depending on price which
is independent variable.
Functions
 A function shows the relationship between 2 or more variables.
 For e.g. C=F(Y)
Where, C is aggregate consumption, Y is disposable income and F stands for functional relation.

Equations
• An equation specifies the relationship
between the dependent and independent
variables.
• Qx =f (Px)
• Qx= a – b (Px)
• Here ‘a’ parameter has a positive value and
is not dependent on price, this shows that
when price will be zero still the quantity
demanded will not be zero.
 A graph is a diagram showing how 2 or more sets of data or variables are related to one another.
 Curves : the line depicts the relationship between the variables.
 Slopes: show us how fast or at what rate the dependent variable is changing in response to a change in the independent variable.
The rate at which a dependent variable changes due to unit change in an independent variable.
1. Positive Slope: upward sloping, indicating direct relation (i.e. if 1 variable’s value increases other variable’s value also
increases)
2. Negative Slope: downward sloping, indicating inverse relation (i.e. if 1 variable’s value increases other variable’s value will
decrease)
3. Linear / Straight line: the slope is same at all points
4. Non-Linear curve: slope is different at different points

Intercepts: the intercept is the point at

which the line or the curve crosses the
vertical axis.
 Market Demand
 Individual demand for a product is based
on an individual’s choice / Preference
among different products, price of the
product, income etc. Individual demand
is nothing but desire backed by
individual’s ability and willingness to
pay. By summing up the demand of all
the consumers or individuals for the
product we get market demand for that
particular product.
Diagram 1A.1 represents demand curve of
individual A, individual B and Market
Demand. DA is a demand curve of
individual A. DB is the demand curve of
individual B. DM is the market demand
curve. All curves are downward sloping
indicating negative relationship between
price and quantity demanded.
Market Supply
 Individual Supply is the amount of a product
that producer is willing to sell at given prices.
By summing up the supply of all the producers
for the product we get market supply for that
particular product.

Diagram 1A.2 represents supply curve of producer A,

producer B and Market supply. SA is a supply curve
of producer A. SB is the supply curve of producer B.
SM is the market supply curve. All curves are upward
sloping indicating positive relationship between
price and quantity demanded.
Equilibrium Price
 The market price where the quantity of
goods supplied is equal to the quantity
of goods demanded is called as
equilibrium price. This is the point at
which the market demand and market
supply curves intersects.

Diagram 1A.3 represents Equilibrium Price. DM is the

market demand curve. DM is downward sloping curve
indicating inverse or negative relationship between price
and quantity demanded. SM is the market supply curve.
SM is upward sloping curve indicating direct or positive
relationship between price and quantity supplied. DM and
SM curves intersect each other at point E where
equilibrium price is 30 and equilibrium quantity
demanded and supplied is 8 units.
Market Equilibrium

 Equilibrium price indicates no surplus and no shortage as demand=supply

• Qdx= Qsx • Substituting value of (Px)

• a – b (Px) = -ca + b • Qdx= Qsx
(Px) • a – b (Px) = -ca + d (Px)
• 100 – 10(Px) = - • 100 – 10(Px) = -40+30(Px)
40+30(Px) • 100-10(3.50)=-40+30(3.50)
• 100+40=10 (Px) +30 • 100-35=-40+105
(Px) • 65 units=65 units
• 140=40 (Px) • Thus, Demand=Supply i.e. equilibrium
• 140/40= (Px)
SHIFTS IN DEMAND AND SUPPLY
CURVES AND EQUILIBRIUM
 SHIFTS / CHANGES IN DEMAND : Shifts in
demand takes place due to changes in non-
price factors such as income, population,
government policies, tastes, preferences,
habits, fashion etc. Whenever there are
favourable changes in these factors then the In the above diagram D is the original demand curve.
demand curve shifts outward. It is also known At price P, OQ quantity is demanded. If there are
as Increase in Demand. Whenever there are
favourable changes in the non-price factors affecting
unfavourable changes in these factors then
the demand curve shifts inward. It is also demand then the demand curve shifts outward and
known as Decrease in demand. becomes D1. Here we can see that at same price P,
now more quantity i.e. OQ1 quantity is demanded. If
there are unfavourable changes in the non-price
factors affecting demand then the demand curve
shifts inward and becomes D2. Here we can see that
at same price P, now less quantity i.e. OQ2 quantity
is demanded. Shift from D to D1 is known as Increase
in Demand and shift from D to D2 is known as
Decrease in Demand.
SHIFTS / CHANGES IN SUPPLY
 Shifts in supply takes place due to changes in
non-price factors such as cost of production,
government policies, state of technology etc.
Whenever there are favourable changes in
these factors then the supply curve shifts
outward. It is also known as Increase in
supply. Whenever there are unfavourable
changes in these factors then the supply
curve shifts inward. It is also known as
Decrease in supply.
In the above diagram S is the original supply curve. At
price P, OQ quantity is supplied. If there are favourable
changes in the non-price factors affecting supply then
the supply curve shifts outward and becomes S1. Here
we can see that at same price P, now more quantity i.e.
OQ1 quantity is Supplied. If there are unfavourable
changes in the non-price factors affecting supply then
the supply curve shifts inward and becomes S2. Here we
can see that at same price P, now less quantity i.e. OQ2
quantity is supplied. Shift from S to S1 is known as
Increase in Supply and shift from S to S2 is known as
Decrease in Supply
SHIFTS IN EQUILIBRIUM
 The market price where the quantity of goods
supplied is equal to the quantity of goods
demanded is called as equilibrium price. This
is the point at which the market demand and
market supply curves intersects. Whenever
there are changes in demand and supply,
position of equilibrium will change.
Change in Equilibrium due to Change in supply and
demand
 At times there may be simultaneous changes
in both demand and supply. In such a
situation, the change in the equilibrium price
will depend upon the relative magnitude of
the changes in demand and supply. .
 In figure A, the initial demand curve is DD
and supply is SS. The equilibrium price is OP.
Both demand and supply increase by the
same magnitude. Therefore, the price
remains same, but quantity increases from
OQ to OQ1.
 In fig B, original equilibrium price is OP.
Demand increases to D1D1 and supply
decreases to S1S1. As a result price rises
from OP to OP1. And quantity reduces from
OQ to OQ1
 Nature of demand curve in different
markets

Horizontal/Perfectly elastic Downward sloping demand curve for a

monopolistically competitive firm
is relatively more elastic than
that of a monopoly